Answer All Questions in Section A
Question 1
Hiram Finnegan Int. (HFI) is a high-tech company in designing computer software. Due to high market demand for its products, the company is going to expand its business by considering three projects. The three projects all have the same maturity of three years. The first project is called “Alpha” that needs an initial investment of £20 million. Alpha is able to generate a cash flow of £70 million at the end of the first year, the second cash flow of £10 million at the end of the second year, and the last cash flow of £10 million at the of the third year. The second project is called “Beta” that needs an initial investment of £10 million. Beta is forecasted to have a cash flow of £15 million at the end of the first year, the second cash flow of £40 million at the end of the second year, and the final cash flow of £10 million at the end of the third year. The third project is called “Gamma” that needs an initial investment of £10 million now and a further investment of £5 million at the end of the first year. Gamma will have a cash flow of £60 million at the end of the second year and the final cash flow of £10 million at the end of the third year. Assume the annual discount rate is 12%.
(i) Calculate net present values (NPV) and the profitability index (PI) for Alpha, Beta and Gamma. Assume that the three projects are independent of each other, which project(s) should be accepted in terms of NPV and PI (10 marks)?
(ii) Calculate payback periods for Alpha and Beta. Consider Alpha and Beta. If these two projects are mutually exclusive -i.e. HFI can only accept either Alpha or Beta, should you use NPV or payback method to evaluate the two projects and what are the differences between the two methods? (8 marks)
(iii) Assume that HFI only has a £20 million budget, which project(s) should HFI invest in? Please justify your answer. (7 marks)
Question 2
Bradford plc. is financed through bonds and ordinary shares. The bonds were issued five years ago at a par value of £100 with a total funds raised 30 million. These bonds carry an annual coupon payment of £10, and are due to be redeemed in four years. Investors currently require a yield of 6% on the bonds. The firm also has 3,000,000 ordinary shares outstanding at the current price of £45.54. Bradford plc. is now reviewing its capital budget for the next year. It has paid a £1 dividend per share over the past several years, and its shareholders expect the dividend to remain constant over the next several years. The company forecasts that it will require £13 million to fund all its profitable projects and its net income will be £12m for the next year
i) What is the current capital structure of Bradford plc.? (10 marks)
ii) If the firm follows the residual dividend model and maintains its current capital structure, what will be the company’s dividend per share and payout ratio for the next year? (8 marks)
iii) Suppose the firm’s management decides to continue to pay the £1 per share and maintain its target capital structure and capital budget.
What is the minimum amount of new common stock that the company would have to issue to meet each of its objectives? (7 marks)