BUSI4402-E1
A LEVEL 4 MODULE, AUTUMN SEMESTER 2023-2024
BUSI4402 CORPORATE FINANCIAL STRATEGY
Answer any ONE question
The maximum number of words is 750 (excluding tables and charts)
Answer ONE question
Each question is worth 100 marks
Question 1
1 a) Johnson Electronics PLC is listed in the FTSE 100 index and has both equity and debt financing on its balance sheet at a ratio of 1:1. The firm has an BBB+ credit rating from S&P Global Ratings. The firm’s cost of debt is 12% and the credit risk premium on this debt is 2%. In recent years Johnson’s stock has outperformed or underperformed the FTSE 100 index’s risk premium by a factor of 1.5. The return on the FTSE 100 index has averaged 18% over the last 5 years. As an equity analyst you have been tasked to provide the following information as well as including a brief explanation for each answer to the head of equity investments of your bank:
i) Johnson’s cost of equity.
ii) The beta of Johnson’s debt.
iii) The beta of Johnson’s assets.
iv) Johnson’s cost of capital (20%)
b) Johnson is concerned about the impact its level of leverage is having on its credit rating and has decided to reduce its debt to equity ratio to 30:70. The CFO of Johnson believes that this strategy will reduce its cost of debt by 1 percentage point.
i) Briefly explain how Johnson might reduce its leverage ratio? (5%)
ii) Provide an explanation for why a lower leverage ratio could reduce the company’s cost of debt? (5%)
iii) Calculate the impact this change in financial structure will have on the firm’s cost of equity, debt beta, asset beta and its WACC. Explain your answers. (20%)
c) “A company can incur costs of financial distress without ever going bankrupt.” Explain how this can happen. Provide a real-world example of a firm facing these types of costs. (15%)
d) Explain the term credit market conditions (CMC)? What is the current state of CMC in the UK? Use diagrams to explain your answer. (15%)
e) In the last few months, we have seen the highest levels of interest rates in the UK since before the global financial crisis. What impact has this had on firms cost of capital? Explain your answer. What strategies might CFOs and/or firms adopt in response to an expectation of rising interest rates? Do rising interest rates affect all firms in the same way? Explain you answer. (20%)
Question 2
2. Abigail Grace has a £900,000 fully diversified portfolio. She subsequently inherits ABC Company shares worth £100,000. Her financial adviser provided her with the following forecast information:
Risk and Return Characteristics
Expected Monthly Returns Standard Deviation of Monthly Returns
Original Portfolio 0.67% 2.37%
ABC Company 1.25 2.95
The correlation coefficient of ABC stock returns with the original portfolio returns is 0.40.
a) The inheritance changes Grace’s overall portfolio and she is deciding whether to keep the ABC stock. Assuming Grace keeps the ABC stock.
i) Calculate the expected return of her new portfolio which includes the ABC stock. ii) Briefly explain the term covariance in the context of portfolio risk and explain how it is measured. Calculate the covariance of ABC stock returns with the original portfolio returns.
iii) Calculate the standard deviation of her new portfolio, which includes the ABC stock.
iv) Where will the new portfolio lie compared to the original portfolio in the risk- return space? What explains this result? Should Grace keep ABC stock? (5+10+10+10=35%)
b) If Grace sells the ABC stock, she will invest the proceeds in risk-free government securities yielding a return of 0.42% monthly. Assuming Grace sells the ABC stock and replaces it with the government securities.
i) Calculate the expected return of her new portfolio, which includes the government securities.
ii) Calculate the covariance of the government security returns with the original portfolio returns. Explain your answer.
iii) Standard deviation of her new portfolio, which includes the government securities.
iv) Compare the risk of this portfolio with that of the portfolio in question 2a. Explain your answer.
v) If you were her financial advisor, would you recommend that she sells ABC stock and invest the funds into government securities? Explain your answer. (25%)
c) On the basis of conversations with her husband, Grace is considering selling the $100,000 of ABC stock and acquiring $100,000 of XYZ Company shares instead. XYZ stock has the same expected return and standard deviation as ABC stock. Her husband comments,
“It doesn’t matter whether you keep all of the ABC stock or replace it with $100,000 of XYZ stock.” State whether her husband’s comment is correct or incorrect. Explain your response. (10%)
d) The return on the risk-free asset is 5%. You are given the following information:
|
Security
|
E(R) -%
|
SD -%
|
Correlation with Market portfolio
|
Beta
|
|
Firm A
|
10
|
31
|
?
|
.85
|
|
Firm B
|
14
|
?
|
.50
|
1.40
|
|
Firm C
|
16
|
65
|
.35
|
?
|
|
Market portfolio
|
12
|
20
|
1
|
1
|
i) What is the correlation between security A and the market portfolio?
ii) What is the standard deviation of security B?
iii) What is the beta of security C? Give an interpretation of its value?
iv) Is the stock of Firm A correctly priced according to the capital asset pricing model (CAPM)? What about the stock of Firm C? If these securities are not correctly priced, what is your investment recommendation for someone with a well-diversified portfolio? (30%)