INDEX NUMBER:

…………………………………………
…

Open University of Mauritius

BA (HONS) BUSINESS ACCOUNTING AND FINANCE [OUba001]
BSc (HONS) FINANCE AND TAXATION [OUbs002]
BSc (HONS)BUSINESS MANAGEMENT/SPECIALISATION [OUbs003/007]

EXAMINATION FOR: November/December 2018

MODULE: Business Finance

[OUba001222/OUbs002223/OUbs003214/OUbs007214]

DURATION: 2 Hours

READING TIME: 10 Minutes

INSTRUCTIONS TO CANDIDATES

1. The paper consists of Section A and Section B.

2. Section A is Compulsory and must be answered on the question Paper itself.
3. Answer ANY TWO (2) questions from Section B on the answer booklet
provided.
4. Always start a new question on a fresh page.
5. Calculator is allowed. Such calculator should not be programmable and should
not contain any storage date.
6. Formulae sheet is attached.
7. Total marks: 100

This question paper contains 4 questions and 13 pages.

Page 1 of 13
 SECTION A
COMPULSORY

QUESTION 1 (40 MARKS)

Circle the correct answer.

(a) The cost of monitoring management is considered to be a (an):

A bankruptcy cost
B transaction cost
C agency cost
D institutional cost
(1 mark)

(b) Which of the following term refers to the difference between the present value
of cash inflows and the present value of cash outflows? Select correct option:

A Net Present Value (NPV)

B Average Accounting Return (AAR)
C Internal Rate of Return (IRR)
D Payback
(1 mark)

(c) Which of the following statements about capital market efficiency is/are
correct?

(1) Insider information cannot be used to make abnormal gains in a strong

form efficient capital market
(2) In a weak form efficient capital market, a company’s share price reacts
to new information the day after it is announced
(3) A company’s share price reacts quickly and accurately to newly-
released information in a semi-strong form efficient capital market

A 1 and 2 only
B 1 and 3 only
C 3 only
D 1, 2 and 3
(2 marks)

Page 2 of 13
(d) An "aggressive" common stock would have a "beta"

A equal to zero
B greater than one
C equal to one
D less than one
(1 mark)

(e) A measure of "risk per unit of expected return."

A standard deviation
B coefficient of variation
C correlation coefficient
D beta
(1 mark)

(f) What is Gordon's 'bird in the hand' fallacy?

A Investors prefer early resolution of uncertainty and apply a lower discount

rate to later dividends.
B Investors prefer early resolution of uncertainty and apply a higher discount
rate to later dividends.
C Investors prefer later resolution of uncertainty and apply a higher discount
rate to later dividends.
D Investors prefer later resolution of uncertainty and apply a lower discount
rate to later dividends.
(1 mark)

(g) Which of the following is typically the most important economy or synergy
which is sought from Mergers and Acquisitions activity?

A Economies of scope from applying existing resources to new uses, at little

additional cost.
B Revenue and marketing synergies from new, enhanced, or more efficient
distribution.
C Economies of scale effects from organizational learning.
D Economies of scale from doing away with duplication of function between
the two firms.
(1 mark)

Page 3 of 13
(h) Which of the following is the amount of time required for an investment to
generate cash flows sufficient to recover its initial cost?

A Yield to maturity
B Maturity Period
C Payback period
D Accounts Receivable period
(1 mark)

(i) Which of the following comes under the head of accounting criteria for capital
budgeting decision?

A Payback Period
B Net Present Value
C Internal Rate of Return
D Average Accounting Return
(1 mark)

(j) Suppose the initial investment for a project is Rs16 million and the cash f
lows are Rs4 million in the first year and Rs9 million in the second and Rs5
million in the third. The project will have a payback period of:

A 2.6 Years
B 3.1 Years
C 3.7 Years
D 4.1 Years
(2 marks)

(k) IJK Co. is estimating its WACC. The company has collected the following
information:

 Its capital structure consists of 40 percent debt and 60 percent common

equity.
 The company has 20-year bonds outstanding with a 9 percent annual
coupon that are trading at par.
 The company’s tax rate is 40 percent.
 The risk-free rate is 5.5 percent.
 The market risk premium is 5 percent.
 The stock’s beta is 1.4

Page 4 of 13
 What is the company’s WACC?

A 9.71%
B 9.66%
C 8.31%
D 11.18%
(2 marks)

(l) As the director of capital budgeting for ABC Corporation, you are evaluating
two mutually exclusive projects with the following net cash flows:

Project
X Project Z
Cash Cash
Year Flow Flow
-
0 $100,000 -$100,000
1 50,000 10,000
2 40,000 30,000
3 30,000 40,000
4 10,000 60,000

If ABC’s cost of capital is 15 percent, which project would you choose?

A Neither project.
B Project X, since it has the higher IRR.
C Project Z, since it has the higher NPV.
D Project X, since it has the higher NPV.
(3 marks)

(m) Assume an investment manager has created a portfolio with the Stock A and
Stock B. Stock A has an expected return of 20% and a weight of 30% in the
portfolio. Stock B has an expected return of 15% and a weight of 70%. What
is the expected return of the portfolio?

A 15.6%
B 16.5%
C 26.5%
D 65.2%
(2 marks)
Page 5 of 13
(n) Why should financial managers strive to maximize the current value per share
of the existing stock?

A doing so guarantees the company will grow in size at the maximum

possible rate
B doing so increases employee salaries
C because they have been hired to represent the interests of the current
shareholders
D because this will increase the current dividends per share.
(1 mark)

(o) According to the capital-asset pricing model (CAPM), a security's expected

(required) return is equal to the risk-free rate plus a premium (1 mark)

A equal to the security's beta

B based on the unsystematic risk of the security
C based on the total risk of the security
D based on the systematic risk of the security

(1 mark)

(p) A statistical measure of the degree to which two variables (e.g., securities'
returns) move together.

A coefficient of variation
B variance
C covariance
D certainty equivalent
(1 mark)

(q) This type of risk is avoidable through proper diversification.

A portfolio risk
B systematic risk
C unsystematic risk
D total risk
(1 mark)

Page 6 of 13
(r) An investor believes that they can make abnormal returns by studying past
share price movements.

In terms of capital market efficiency, to which of the following does the

investor’s belief relate?

A Fundamental analysis
B Operational efficiency
C Technical analysis
D Semi-strong form efficiency
(1 mark)

(s) To compute the required rate of return for equity in a company using the
CAPM, it is necessary to know all of the following EXCEPT:

A The risk-free rate.

B The beta for the firm.
C The earnings for the next time period.
D The market return expected for the time period

(1 mark)

(t) Which of the following statements are correct?

(1) If a capital market is weak form efficient, an investor cannot make

abnormal returns by using technical analysis
(2) Operational efficiency means that efficient capital markets direct funds to
their most productive use
(3) Tests for semi-strong form efficiency focus on the speed and accuracy of
share price responses to the arrival of new information.

A 1 and 2 only
B 1 and 3 only
C 2 and 3 only
D 1, 2 and 3
(2 marks)

Page 7 of 13
(u) A company is evaluating an investment project with the following forecast
cash flows:

Year 0 1 2 3 4
Cash flow
(6·5) 2·4 3·1 2·1 1·8
($m)

Using discount rates of 15% and 20%, what is the internal rate of return of the
investment project?

A 15·8%
B 17·2%
C 17·8%
D 19·4%

(3 marks)

(v) The greater the beta, the …………………………… of the security involved.

A greater the unavoidable risk

B greater the avoidable risk
C less the unavoidable risk
D less the avoidable risk
(1 mark)

(w) Assume that the risk-free rate is 5 percent and that the market risk premium is
7 percent.

If a stock has a required rate of return of 13.75 percent, what is its beta? (3
marks)

A 1.25
B 1.35
C 1.37
D 1.60
E 1.96

(3 marks)

Page 8 of 13
(x) Consider the following information for the financial asset A.
State of the World State 1 State 2 State 3
Probability of occurrence 0.10 0.50 0.40
Rates of Return (%) 4.00 6.00 9.00

The expected return on this asset is:

A 7.00%
B 8.00%
C 8.50%
D 23.00%
(3 marks)

(y) XYZ is planning a new coal mine, which will cost $430,000 to build, with the
expenditure occurring next year. The mine will bring cash inflows of $200,000
annually over the subsequent seven years. It will then cost $170,000 to close
down the mine over the following year. Assume all cash flows occur at the end
of the year. Alternatively, XYZ may choose to sell the site today. What minimum
price should XYZ set on the property, given a 16% required rate of return?

A $280,913.
B $325,859.
C $376,872.
D $390,587
(3 marks)

Page 9 of 13
 SECTION B

ANSWER ANY TWO (2) QUESTIONS

QUESTION 2 (30 MARKS)

(a) Extract from: The agency problem, agency cost and proposed solutions thereto:
A South African perspective by J H HaIl

The development and growth of listed firms during the past few decades has
caused an ever-widening gap between ownership and management. The agency
theory addresses this relationship between owners (shareholders) and the
custodians of their wealth, that is, the management of a firm. If management's
goals differ from those of the firm, an agency problem arises and the owners have
to incur agency cost to overcome this problem.

Discuss the conflicts that may occur between the principal and the agent and the
techniques that can be used to motivate managers to act in shareholder’s best
interest.
(10 marks)

(b) M&A case study: Amazon and Zappos; Article from Street of Walls 2013

Amazon.com is a customer-centric company for three kinds of customers:

consumers, sellers and enterprises. The Company serves consumers through its
retail websites, and focus on selection, price, and convenience. It also provides
easy-to-use functionality, fulfillment and customer service. Amazon is the largest
online retailer in the nation, with revenues exceeding $45 billion annually.

Zappos.com was the #1 online seller of shoes at the time of the deal, stressing
customer service. It stocks 3 million pairs of shoes, handbags, apparel and
accessories, specializing in some 1,000 brands that are difficult to find in
mainstream shopping malls. Through its website (and 7,000 affiliate partners),
Zappos.com distributes stylish and moderately priced footwear to frustrated and
shop-worn customers nationwide. In 2008, one year prior to the deal, Zappos
reported annual revenues exceeding $630 million.

M&A Deal Announced: In July 2009, Amazon announced that it had reached an
agreement to acquire Zappos in a deal that was valued at $847 million. The
Purchase Price of the deal was financed with approximately 10 million shares of
Amazon common stock and $40 million of Cash and Restricted Stock units on the
balance sheet.

M&A Deal Closed: In November 2009, Amazon announced that it had closed the
previously announced acquisition of Zappos. Given the closing price of Amazon
stock on the previous Friday (October 30, 2009), the deal was valued at
approximately $1.2 billion (including fees).

Page 10 of 13
 Explain the benefits and limitations resulting from the Amazon and Zappos’s
merger and acquisition.
(10 marks)

(c) Dividend policy is one of the most complex aspects in finance. The reality is that
dividend policy is more commonly an instrument of wealth distribution than it is an
instrument of wealth creation.

Compare and contrast the Dividend irrelevance theory as proposed by Miller and
Modigliani (M&M) with that of the Bird in hand theory of dividend policy which was
put forward by Litner and Gordon.
10 marks)

QUESTION 3 (30 MARKS)

(a) Use the information below to answer the following questions.

State Probability Return on Stock A Return on Stock B

1 4% 49% -41%
2 87% 35% 9%
3 4% 27% 32%
4 5% 42% 19%

i. Find the Expected Return on Stock A (3 marks)

ii. Find the Variance of the returns on Stock A (3 marks)
iii. Find the Standard Deviation of the returns on Stock A. (3 marks)
iv. Find the Expected Return on Stock B (3 marks)
v. Find the Variance of the returns on Stock B (3 marks)
vi. Find the Standard Deviation of the returns on Stock B (3 marks)
vii. Find the Covariance between the returns on Stock A and Stock B
(4 marks)
viii. Find the Correlation Coefficient between the returns on Stock A and Stock
B.
(3 marks)

(b) Distinguish between weak form, semi-strong form and strong form stock market
efficiency.
(5 marks)

Page 11 of 13
QUESTION 4 (30 MARKS)

Pera Ltd went public by issuing 5 million shares of common stock @ $10 per share.
The shares are currently trading at $15 per share.

Current risk free rate is 6%, market risk premium is 9% and the company has a beta
coefficient of 1.4.

During last year, it issued 50,000 bonds of $1,000 par paying 10% coupon annually
maturing in 20 years. The bonds are currently trading at $900. The cost of Debt is
10.61%.

The tax rate is 30%.

(a) Calculate the market value of equity (2 marks)

(b) Calculate the market value of debt (3 marks)

(c) Calculate the cost of equity (4 marks)

(d) Calculate the Weighted Average Cost of Capital (WACC) of Pera Ltd

(6 marks)

(e) Explain the term systematic risk (3 marks)

(f) Explain the term unsystematic risk (3 marks)

(g) How do systematic risk and unsystematic differ from each other? (4 marks)

(h) State the limitations of the Capital Asset Pricing Model (CAPM) (5 marks)

Page 12 of 13
 Formulae sheet

Risk and Returns Formulae

Page 13 of 13