Financial Management, Answers

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THE UNIVERSITY OF WARWICK Examination: Summer 2009 FINANCIAL MANAGEMENT

SPECIMEN ANSWERS

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IB1140 Page 2 of 18 ---------------------------------------------------------------------------------------------------------------SECTION A Answer ALL of the questions in this section Each question is worth 2 marks ---------------------------------------------------------------------------------------------------------------1. Which of the following statements is most consistent with the evidence on market efficiency? (a) (b) (c) (d) (e)

Security prices rapidly reflect new relevant information. It is easy to forecast the direction of future security price changes in the short run. Short-run price changes occur independently of information reaching the market. On average, most securities are mis-priced. In the absence of legal constraints, investors with inside information are not able to earn excess returns. (2 marks) ---------------------------------------------------------------------------------------------------------------2. If a firm’s share price decreased during the past week, what is the best forecast that one can make about this week’s price change? (a) (b) (c) (d) (e) The share price will reverse all of last week’s loss and more. The share price will continue last week’s decline. The share price will not change until new information is released. The share price is equally likely to increase or decrease. The share price is more likely to decrease than increase.

(2 marks) ---------------------------------------------------------------------------------------------------------------3. If investors can consistently profit from analysing published financial information, then the market can, at best, be characterised as: (a) (b) (c) (d) (e)

weak-form efficient. semi-strong-form efficient. strong-form efficient. inefficient. Impossible to say without knowing more about the published information. (2 marks) ----------------------------------------------------------------------------------------------------------------

IB1140 Page 3 of 18 4. Which project appraisal method is best described by the following characteristics? (i) (ii) It is easy to understand and to explain. It may lead to incorrect decisions when comparing mutually-exclusive investments. (iii) It may be useful when the budget available for capital investment is limited. (a) (b) (c) (d) (e) Payback period. Accounting rate of return. Internal rate of return. Net present value. Profitability index.

(2 marks) ---------------------------------------------------------------------------------------------------------------5. Why might the investment criterion IRR > R lead to the wrong investment decision in the case of mutually-exclusive projects? (a)

The graphs of NPV vs. R for these projects cross over for some value of the discount rate R. (b) The cash flows of mutually-exclusive projects change sign more than once. (c) Mutually-exclusive projects have multiple values of IRR. (d) The criterion for capital investment is IRR < R. (e) The criterion IRR > R does not lead to the wrong decision. (2 marks) ---------------------------------------------------------------------------------------------------------------6. Company X has to choose between undertaking Project A now or Project B in two years’ time. Both projects have the same expected future cash flows, but Project B will require a lower initial investment thanks to anticipated technological advances over the coming two years. Company X uses a cost of capital of 13% for both projects. The Net Present Value of Project A equals £500,000. By how much must the investment cost of Project A exceed that of Project B for Company X to prefer to wait two years and invest in Project B? (a) (b) (c) (d) (e) £108,427 £138,450 £391,573 £500,000 None of the above. (2 marks)

IB1140 Page 4 of 18 Denote the initial investment in Project A and Project B by IA and IB, respectively. The expected future...
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