Question No.

1:

Part (a):

The Return on Capital Employed is calculated as the ratio of the accounting profitgenerated by

an investment project to the required capital outlay, expressed as a percentage.

The capital employed figure normally comprises:

Share capital + Retained Earnings + Long-term borrowings

(The same as Equity + Non-current liabilities from the balance sheet)

Capital employed is a good measure of the total resources that a business has available to it,

although it is not perfect. For example, a business might lease or hire many of its production

capacity (machinery, buildings etc.) which would not be included as assets in the balance sheet.

Advantage:

ROCE has three main advantages.

a) evaluating the project on the basis of a percentage rate of return is a familiarconcept

b) the method evaluates the project on the basis of its profitability, which manymanagers

believe should be the focus of the appraisal

 c) Manager’s own performance is often evaluated by shareholders in terms

ofthecompany’s overall return on capital employed so it is logical to

evaluateindividual capital investment in the same way.

Disadvantage:

The main disadvantages are the following:

a) The method uses profits, not cash flows

b) It ignores the time value of money

c) It is an ambiguous concept. There are many variants that no generalagreement exists on

how capital employed should be calculated.

d) Because the method shows percentages, it is unable to take into account thefinancial size

of a project when alternatives are compared.

Part (b):

Part (i)

Years Project A Project B Cumulative CF-A Cumulative CF-B

0 -1000 -100 -1000 -100

1 520 57 -480 -43

2 410 48 -70 5

3 310 40 240 45
PP-A = 2+70/310=2,23 years

PP-B = 1+43/48=1,90 years

Part (ii)

Its name describes its operation: how quickly the incremental benefits thataccrue to a company

from an investment project ‘pay back’ the initial capitalinvested (benefits being normally defined

in terms of after-tax cash flows). Orsimply: when do we get our money back?

Part (iii)

Independent: accept only B, since B has a PP of 1.90<2, and A has a PP of2.23>2

Mutually exclusive, again only B, since A has a PP of 2.23>2

Part (IV)

Advantages:

a) Easy to understand the logic

b) Quick and simple to calculate

c) Thought to lead to automatic selection of the less risky project

d) Saves management the trouble of having to forecast cash flows over the whole of a

project’s life

e) Convenient method to use in capital rationing situations

Disadvantages:

a) The decision is concentrated purely on the cash flows that arise within thepayback period,

and flows that arise outside this period are ignored.

b) The option not to invest is generally one of the options open to the decisionmaker. An

investment of zero will always produce an immediate payback.

c) It does not allow for the ‘time value of money’.

Part (V):

Calculate the projects’ Net Present Values (NPV)

NPV-A = -1000 + 520(1+10%)-1+ 410(1+10%)-2+ 310(1+10%)-3= €44.478

NPV-B = -100 + 57(1+10%)-1+ 48(1+10%)-2+ 40(1+10%)-3= €21.540

Part (VI):

NPV is based on the fundamental principle that an investment is worthwhile undertaking if the

money derived from the investment is greater than the money put in. A project’s net present

value indicates the increase in shareholders’ wealth that it will generate if it is undertaken.

Part (VII)

Independent: accept both A and B, since both NPVs>0

Mutually exclusive, accept A, since NPV-A > NPV-B

Question No. 2:

Part (a)

i. ENPV-A = 20%x145 + 60%x120 + 20%x95 = 120

ii. ENPV-B = 20%x138 + 60%x118 + 20%x108 = 120

The ENPV is the same for both projects (120), which reveals the main limitation of this method

which is that ENPV does not take account of risk, because risk is concerned with the likelihood

that the actual performance may diverge from what is expected

II

VAR-A = (20%x1452+ 60%x1202+ 20%x952) – 1202= 250

So, ST.DEV-A = SQRT(250)=15.81

VAR-B = (20%x1382+ 60%x1182+ 20%x1082) – 1202= 96

So, ST.DEV-B = SQRT(96)=9.79

Project A is riskier
 III

Based on the above results, we should recommend Project B which has the same NPV but

smaller risk (i.e. variance and SD)

Part (b)

All economic units dislike the uncertain nature of an investment’s outcome:

They are said to be risk-averse. This does not mean that they are unwilling to undertake a risky

investment. It means that they will require a reward or taking on a risky investment; this reward

is expressed in terms of expected return.

Question No. 3:

Part (a)

 Long-term loans are available by banks and other financial institutions at both fixed and

floating interest rates.

 The cost of bank loans is usually a floating rate of 3-6 % above the bank base rate,

depending on the perceived risk of the company

 Payments of the bank loan include both interest and capital elements

 Long-term bank loans cannot be sold on directly by the company to a third party; the

growth of securitization however allows banks to parcel up debts as securities and sell

them on a market.

II

Present Value factor: = 3.312

Annual Instalment = 500,000 / 3.312 = 150,966

III

Opening Add 8% Less Closing Capital

Year Year
Balance Interest repayment Balance Elements
1 500,000.00 40,000.00 150,966.00 389,034.00 1 110,966.00
2 389,034.00 31,122.72 150,966.00 269,190.72 2 119,843.28
3 269,190.72 21,535.26 150,966.00 139,759.98 3 129,430.74
4 139,759.98 11,180.80 150,966.00 - 4 139,785.20
 Part (b)

Students should refer to the following:

 Debt providers’ return is interest, which has significant differences when compared to

equity providers’ return, which is dividends:

o Interest payments are tax deductible, while dividends are not.

o Interest payments are legally protected, meaning that they are compulsory,

whereas dividend payments are not.

o Debtholders rank higher than shareholders in the hierarchy in the event of

liquidation.

o Debtholders face lower risk when compared with shareholders of the same

company, so they will require lower return, so form the company’s perspective,

cost of debt will be lower than cost of equity.

Question No. 5:

Part (a)

Zeta Theta

EBIT 20 20

Debt 50

No. of Shares 10 40

Coupon Rate 10%

Price of Debts 0.9 = 90/100 -

Per Bond

Price of Share 8 3

Interest Payment 5= 50*10% 0

Dividend payment 19.2 = 20-0.8 20 = 20-0

Value of Equity 80 = 10*8 120 = 40*3

Value of Debt 45 = 50*0.9 0

Cost of Capital 0.194 = (19.2+5)/(80+45) 0.166 = 20/120

Value of company

(VoE + VoD) 125 120

II

There seems to be disequilibrium in the market, since the valuations lead to different results,

which shouldn’t be the case in equilibrium.

 Part (b)

 In the real world we find companies have all sorts of capital structures.

 An alternative view of the gearing decision was developed by Myers to try to explain this

observed variety of different capital structures.

 It is known as the ‘pecking order theory’ and is attracting increasing interest as a theory

that provides real insight into the practice of the capital structure decision.

 According to the pecking order theory:

 Rule 1: Finance the company as much as possible through the use of retained earnings.

 Rule 2: If external finance has to be used, issue debt until debt capacity is reached and

only then, if +NPV projects still remain to be financed, issue equity