Study Guide-Brief of Strategic Financial Management(SFM) Syllabus

As with its predecessor there are three very important things to note about the syllabus and the examination structure, which you must take account of in your preparation for the examination.
1.For all practical purposes the exam is virtually compulsory. This means you cannot avoid any major area of the syllabus in your studies.
2.The examination will be highly discursive. You should anticipate that at least 60% of the marks will be for discussion not computation.
3.The examiner attaches considerable importance to general, background, financial knowledge. The paper is set in the belief that all Part Three students are regular readers of a quality business newspaper.

The syllabus identifies five key areas. These are:
1.investment decisions
2.risk analysis
3.global financial management
4.treasury management
5.financial forecasting.

It is almost certain that the compulsory questions will come from these key areas and these are the topics that you should be concentrating on over the next five months and these will be the focus of the lectures.

Knowledge checklist for topic one:

At the end of this unit you should be able to:
1.understand the components of the basic CAPM formula and be able to explain how they can be found in practice;
2.appreciate the significance of the CAPM in terms of the practical limitations of portfolio theory;
3.explain what a beta value measures which means you must understand the difference between systematic and unsystematic risk;
4.describe and explain alpha values and discuss their significance;
5.understand the nature of the security market line;
6.do the calculations to ungear and regear a beta. These calculations are extremely important. They come up in almost every examination;
7.describe equity betas, asset betas, debt betas, geared betas and ungeared betas. This means you need to know what they measure, how they are calculated and when they are used;
8.explain and discuss potential conflicts between PT and CAPM in the evaluation of investment opportunities;
9.explain the rationale for the use of the WACC in project appraisal;
10.calculate the cost of equity using both the dividend valuation model and the CAPM;
11.explain the reasons for different estimates of the cost of equity using the two models;
12.calculate the cost of both dated and undated loan stock which means you must be able to do IRR calculations;
13.calculate the cost of loan stocks with variable redemption dates and those with interest which is not payable annually;
14.understand the nature of convertible loan stocks and the problems of estimating the cost of a convertible;
15.calculate a WACC.

Questions for Topic One

1 Five wealthy firms
Five wealthy firms have each put ￡200,000 at your disposal to invest for the next two years. The funds can be invested in one or more of four specified projects and in the money market. The projects are not divisible and cannot be postponed. The firms require a minimum return of 24% over the two years.
Details of the possible investments are:

InitialCost ReturnOver2Years StandardDeviation
(￡1000) (%) (%)
Project1 600 22 7
Project2 400 26 9
Project3 600 28 15
Project4 600 34 13
Money market 100 18 5
Minimum

Correlation coefficients of returns over 2 years
Between projects Between projects Between projects
&market portfolio &money market
1 and 2 0.70 1 and market portfolio 0.68 1 and money market 0.40
1 and 3 0.62 2 and market portfolio 0.65 2and money market 0.45
1 and 4 0.56 3 and market portfolio 0.75 3 and money market 0.55
2 and 3 0.65 4and market portfolio 0.88 4 and money market 0.60
2 and 4 0.57
3and4 0.76
Between the money market and the market portfolio 0.40
The risk free rate is estimated to be 16% the market return 27% and the variance of returns on the market 100% over the two year periods.

You are required:
(a) to evaluate how the ￡1m should be invested using
first: portfolio theory
second: CAPM (15marks)
(b)to explain why portfolio theory and CAPM might give different solutions as to how the money should be invested. (5marks)
(c) to discuss the main problems of using CAPM in investment appraisal. (10marks)
(total 30marks)

2 Rodif
Rodifin plc is considering investing in one of two short term portfolios of four short term financial investments in diverse industries. The correlation between the returns of the individual components of these investments is believed to be negligible:
Portfolio 1
Investment Beta ExpectedReturn% StandardDeviation Amount Invested(million)

A 1.4 16 7 3.8
B 0 6 2 5.2
C 0.7 10 5 6.1
D 1.1 13 13 2.9

Portfolio 2
Investment Beta ExpectedReturn% StandardDeviation Amount Invested(million)
A 1.2 14 9 7.1
B 0.8 11 4 2.7
C 0.2 7 3 5.4
D 1.5 17 14 2.8
The managers of Rodif are not sure of how to estimate the risk of these portfolios as it has been suggested to them that either portfolio theory or the CAPM will give the same measure of risk. The market return is estimated to be 12.5% and the risk free rate is 5.5%.

Required
(1)Discuss whether or not portfolio theory and CAPM give the same portfolio measure (10marks)
(2)Using the above data estimate the risk and return of the two portfolios and recommend which one should be selected.(10marks)
(Total:20marks)

3. Munxay plc is composed of only four investment projects details of which are as follows:
Project %of company Annual %return Risk % standard Correlation
market value in last 5 y deviation w/ market
1 28 10 15 0.55
2 17 18 20 0.75
3 31 15 14 0.84
4 24 13 18 0.62
The risk free rate is expected to be 5% per year, the market return 14% per year, and the standard deviation of market returns 13%
Required:
(a)Assume the company‘s shares are currently priced based upon the assumption that the last five year’s experiences will continue for the foreseeable future. Evaluation whether or not share price of the company is undervalued or overvalued.
(5 marks)
(b) Discuss why your results in (a) above might not correctly identify whether or not the share price of the firm is undervalued or overvalued
(5marks)