Question 1: Sion Plc: A Capital Expenditure Decision

Sion plc is considering the introduction of a new product that has evolved from work undertaken by the company’s R&D department. The R&D work has cost £700,000 to complete and is expected to finish by the end of next month. The manufacture of the product will require investment of £5 million in a new plant and machinery. It will also require the use of some equipment already owned by the company. This is fully depreciated for tax purposes but could be sold today for £0.6 million. If used on the project it will have no resale value at the end of the project. The company anticipates it could manufacture and sell 20,000 units of the product per annum and the company’s market research has found there is a market for this level of sales at a price of £250 per unit. The variable costs of production would be £120 per unit and there would also be fixed costs of £250,000 per annum to take into account. The activity would be allocated overheads of £60,000 per annum to cover the company’s total R&D expenditure and head office expenses. In addition the activity will be charged £100,000 per annum for the space utilised in the company’s production unit, even though at present the company has considerable free space available for which it has no alternative use. The expenditure on plant and machinery would be depreciated for tax purposes on a straight-line basis over an anticipated product life of four years. At the end of the four years it is anticipated that the plant could be sold for £0.9 million. The project would require holding stocks of raw materials and components worth £120,000 and 3,750 units of the final product ready for sale.

a) If the tax rate is 30 per cent and required rate of return is 14 per cent is this a profitable investment? State and explain all the critical assumptions..
(13MARKS)

b) Use sensitivity analysis and scenario analysis to improve your capital budgeting analysis. You should use your own input estimates. Write a brief report on your findings.

(7MARKS)

(TOTAL 20 MARKS)

Question 2: Valuation of a Company’s Shares

Collect the price earnings ratios for three companies in the same country for the years 2011 to 2016. You can use the data set provided for the London Stock Exchange or pick your own companies. The data set has the constituents of the FTSE 100, and the P/E ratios are for the end of each year from 2008 to 2016. The data also gives the P/E ratios for the FTSE 100 index.

Discuss the factors that might explain the differences in the price earnings ratios of the three companies you have chosen and the changes that have occurred in their price earnings ratios over the period. (Choose companies with a range of P/E ratios, to give you one with a relatively low value, one with a relatively high value, and another with a middling value. Although not necessary, firms from the same industry helps for comparison reasons)

You should use the insights provided by valuation models on the determinants of the price-earnings ratios in your discussion, but you should also discuss the role of any other factors that might influence the reported values of price-earnings ratios of the companies you have chosen.

(20 MARKS)

Question 3: Portfolio Analysis

The attached file (Stock returns 2007-16) gives monthly returns for securities drawnfrom the FT ALL Share Index for the period January 2007 and December 2016.

a) Create four equally weighted portfolios of one, five, ten, and fifteen securities. Determine, using the appropriate Excel function (see fx))the standard deviation and variances of the monthly returns for each of the companies included in the portfolios. (Use the 120 months of returns data in the calculations and use the Excel functions identified as Variance.P and Standard Deviation P.)

Next determine the monthly returns on the four portfolios along with the standard deviation of these returns. The monthly portfolio returns are simply the average of the monthly returns for each security included in the portfolio.

Compare the average value of the standard deviations of the returns on the securities included in each portfolio with the standard deviation of portfolio’s returns. Comment on the difference between the outcomes.

Discuss the consequences of increasing the number of securities in the portfolios. Compare your results to those of the studies of naïve diversification.
(8 MARKS)

Determine the variance of each security and the co-variances for each pair of securities in the portfolio of five securities using the relevant Excel function. Employ this information to calculate the standard deviation of the portfolio returns using the equally weighted portfolio risk equation. Compare your results to those obtained for the portfolio in part i above.
(4 MARKS)

b) Determine the betas for BP, an oil and gas company, and Ferguson (Formerly Wolseley), a distributor of plumbing and heating products, by regressing the returns for each of the two companies on the returns for the FT ALL Share Index (the first column in the spread-sheet).
i. Explain what the values of the betas (the slope coefficients in the regression) indicate and discuss the factors that might explain the differences in the values of the betas of the two companies.
ii. Comment on the implications of the estimated value of beta for investors and the cost of capital for the two companies

(Approximately 500 words)
(8MARKS)
(TOTAL 20 MARKS)

Question 4
For a company of your choice (but not any you have used in previous questions), undertake the following activities:

a) Research your firm’s business model, particularly its sources of revenue and its profit margins. What sort of revenue growth do you think it will be able to maintain in the next ten years? Do you think it will be able to maintain its current profit margins?
(15MARKS)

b) Perform a valuation of your firm based on your analysis in part a) using the following steps
i) Formulate a realistic model of revenue growth over the next ten years, and constant thereafter.
ii) Formulate a model for profit margins for the next ten years. You may assume that profit margin remains constant or you may choose to vary it over the first ten years. Assume a constant profit margin from year ten onwards.
iii) Carry out a dividend discount model valuation based on i) and ii) as follows. You must use and justify an appropriate weighted average cost of capital for your firm.
(15 MARKS)

c) How does your valuation compare to the valuations based on the recent movements of yourfirm’s share price? What do the current share price movements tell you about the market’s estimations of your firm’s prospects?
(10MARKS)
(TOTAL 40 MARKS)

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