Revision Pack 4 May 2011

8/2/2019 Revision Pack 4 May 2011

http://slidepdf.com/reader/full/revision-pack-4-may-2011 1/27

Examination Information

This is a three hour closed book written examination, worth 50% towards your finalgrade. The examination will contain 6 questions of equal marks, coveringcomputational and discursive aspects of the syllabus. You will be required to answer

any 4 questions. Note that a greater depth of knowledge than in the in-class test willbe required to gain reasonable marks.

Remember that the revision pack should not be used exclusively for your revision.You are expected to use all your lecture, seminar and in-class test materials as well.

Revision Session 1

Topics (Corporate objectives /Capital market /Capital structure / Dividend policy)

Lecture Question – (Q1) and (Q4)

Seminar Question - (Q2)

Revision Session 2

Topics (Portfolio theory / CAPM / Foreign exchange risk / Working capital management/

Mergers & Acquisitions)

Lecture Question – (Q16)Seminar Question - (Q6)

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Question 1 (Lecture Question)

On February 10th SBU plc shares were listed on the stock exchange at 120p. There were 25

million 25p shares in issue at that date.On February 11th SBU announced to the press that it had unexpectedly discovered a newdeposit of minerals with a net present value of £7.25 million.On February 17th the company announced that it was intending to raise £4m to financedevelopment of the deposit by means of a rights issue which was to be priced at 80p.

Required:

a) Assuming the market is semi-strong form efficient, calculate the market capitalizationon February 11th after the announcement to the press.

b) How many shares will be issued to raise the £4 million?c) Calculate the market capitalization of the company after the rights issue.

d) What is the Theoretical Ex-rights Price?e) At what price are the rights likely to be traded?f) Why do companies issue rights at a discount?g) Why do companies normally make rights issues for new equity capital rather than

public issues?

Question 2 (Tutorial Question)

TC plc has 20 million ordinary shares of 50p each in issue. These shares are listed on the stock exchange at 160p. The directors of the company require additional long-term capital and havedecided to make a one-for-four rights issue at 130p per share.An investor with 2,000 shares in TC has contacted you for investment advice. She is undecidedwhether to take up the rights issue, sell the rights, or allow the rights offer to lapse. She alsoinforms you that she has savings of £1,000 in the bank.

Required:

a) Calculate the theoretical ex-rights price of an ordinary share b) Calculate the value at which the rights are likely to be traded.c) Evaluate each of the options being considered by the investor.d) From the company’s viewpoint, how critical is the pricing of a rights issue likely to be?

Question 3

Three senior directors of Engot plc are discussing the company’s financial gearing. Mr A believes that the financial gearing is 89%, Dr B believes that it is 134% and Ms C believes it is134%.

Summarised Consoloditated Balance sheet as at 31 December 2002

£’000

Fixed Assets 16,700

Current AssetsStock 7,040

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Debtors 4,800Cash at bank and in hand 2,700

14,540

Creditors: anounts falling due within one year

8% loan stock 2003 1,000Bank loans and overdrafts 2,800Trade Creditors 7,200Corporation Tax 1,410Proposed Dividends 510Accruals and deferred income 2,860

15,510

Net current liabilities 970

Total Assets less current liabilities 15,730

Creditors: Amounts falling due after more than one year

Bank Loans (5,600)12% Debentures repayable 2017 (1,800)

NET ASSETS 8,330

Capital and Reserves

Called up share Capital (10p Nominal Value) 2,200Share premium account 1,940Revenue Reserves 4,190

Shareholders’ Funds 8,330

Current Market Data for Engot plc:

• Ordinary share price 94p

• 8% loan stock £98

• 12% debentures price £108

You are required to:

a) explain how each director has estimated the financial gearing and suggest how eachdirector might argue that his/hers is the most appropriate measure of financial gearing. Statewith reasons which measure of gearing you prefer.

b) Explain why financial gearing might be important to a company.c) Discuss what factors might limit the amount of debt finance that a company uses.

Answer - Question 3

a) Financial gearing is a measure of the proportionate relationship between a company’s borrowings and its equity finance, i.e. it is a measure of capital structure.There are a number of ways in which gearing may be calculated: either expressing debt as a

proportion of total finance or as a proportion of equity. It can also be measured either using book values or market values. In addition, the debt may be calculated to include all

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borrowings, or simply, those that are deemed to be part of the company’s long-termfinancing.The three gearing ratios have been calculated in the following ways:Mr A is basing the gearing ratio on long-term loans and equity at book value. He isexcluding short-term borrowings.

5,600 + 1,800 = 89%8,330

Dr B is basing the gearing ratio on book values and including all borrowings including short-term.

5,600 + 1,800 + 1,000 + 2,800 = 134%8,330

Ms C is basing the gearing ratio on market values and including all borrowings including short-term:

Market value of equity = Number of shares X share price= 22,000,000 X 94p = £20,680,000

Market value of loan stock = £1,000,000 x 98/100 = £980,000

Market value of debentures = £1,800,000 x 108/100 = £1,944,000

5,600 + 1,944 + 980 + 2,800 = 55%20,680

b) Financial gearing is important for a company as:i. High gearing increases the risk perceived by ordinary shareholders since interest

payments are paid first from operating profits and thus cause earnings attributable toordinary shareholders to fluctuate more significantly. In addition, in the event of liquidation, debt holders have priority over the assets of the company.

ii. A company that has a high level of debt may encounter difficulties in raising further finance.

iii. At very high levels of gearing the risk of default on interest payments or redemption becomes greater with the associated risk of bankruptcy.

iv. The company’s weighted average cost of capital is likely to increase at very high levels of gearing and the company value will fall.

c) Factors which might limit the amount of debt finance that a company may use include thefollowing:

i. Existing loan covenants or clauses in the company’s Articles of Association may limitfurther borrowing.ii. Inadequate cashflows and interest cover may prevent lenders from being willing to

subscribe to further debt.iii. The company may have no further assets to offer as security for debt.iv. Higher risk is associated with high gearing and therefore new borrowings may demand

a return which is too high for the company to afford.


(a) The Dumas company, an all equity financed company have maintained a constant dividend policy over the last six years. They have just paid a dividend of 40p on a current share price of £2.

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Note: the market value of equity includes all

shareholders’ funds and so the share

premium account and retained profit should

not be added.



Required

Determine the company's cost of equity capital

(b) The company wishes to undertake a project and is going to finance it by issuing £2 million of

6% irredeemable debentures at par allowing the company to continue the same dividend policy.There are currently 4 million ordinary shares in issue, but due to the debt financing the share pricewill drop to £1.80. The company pays corporation tax at 40%pa.

Required

Determine the company's weighted average cost of capital.

(c) If instead of issuing debt the company reduces the dividend paid to 30p to assist in financing anew project, instead of taking on debt financing. It is estimated that, if the current dividend isreduced and the project is undertaken, current earnings would increase by 3%pa.

RequiredHow would the share price change as a result of temporary reducing the dividend, assuming theshareholders would still require the same return calculated in (a)?

Question 5

Brook Brothers Plc has in issue 3,000,000 £1 ordinary shares quoted at £3.40 (cum div) and£1,000,000 8% debentures quoted at £89 (ex. Int.)The company has paid the following dividends per share:

4 years ago 80p3 years ago 81p2 years ago 83p1 year ago 85pJust paid 87p

Brook Brothers are considering investing £1,200,000 in a new project which is expected togenerate the following after tax net cash inflows:

Year End 1 2 3 4 5

Cash flows (£000) 400 500 600 400 200

The company’s tax rate is 30%pa.

Required

a) Determine the cost of equity capital, the cost of debt capital and the weighted averagecost of capital.

b) Advise the company on whether it should undertake the proposed investment.c) Discuss the assumptions you have made in each stage of your analysis, which might in

practice not be true.Answer – Question 5

Share price(XDIV) = 340 – 87 = 253p

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MVE =3m x £2.53 = £7.59mGrowth rate g = 4th root of 87/80 – 1 = 1.02119 -1 = 0.02119 = 2.12%K e = D1/MV + g = 87 x 1.02119/253 + 0.02119 = 0.3724 = 37.24%

K d after tax = 8/89 x (1- 0.30) = 0.0629 = 6.29%

WACC = £7.59m x 37.24 + £0.89m x 6.29 = 34%£7.59m + £0.89m

(b)Year: 0 1 2 3 4 5CF(£000) (1200) 400 500 600 400 200DF(34%) 1.000 0.746 0.557 0.416 0.310 0.231PV (1200) 298.4 278.5 249.6 124 46.2 NPV = (£203,300)Reject project as NPV is negative.(c)Assumptions

• Used constant dividend model based on past dividend payments. The rate of 2.12% is

an average. It could vary from this value or the company made not be able to achievesufficient earnings to maintain the dividend growth pattern.

• We have discounted the project using the WACC as the discount rate. This can only beused as a discount rate as long as the financial risk of the project is the same as theaverage financial risk of existing projects.

We cannot use the WACC as the discount factor if the gearing has changed as the financial risk would also change. In this situation it would depend how we financed the project. Strictlyspeaking we would need to finance the project using equity and debt in a proportion which willnot change the gearing

Question 6 – (Tutorial Question)

Alpha Ltd(Extracts from annual accounts)

£Stocks: raw materials 250,000

work in progress 115,000finished goods 186,000

Purchases 1,070,000Cost of goods sold 1,458,000Sales 1,636,000

Debtors 345,000Trade creditors 162,000

(a) What is the length of the operating cycle?(b) The company's management believe that if the average debtors collection period were

reduced to 45 days, sales would fall by 25%. The company relies heavily on overdraftfinancing at a cost of 14% per annum. By how much would a reduction in the collection

period affect annual profit, assuming that average stocks and creditors vary with salesvolume and that the costs of goods sold is variable with sales?

Question 7

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Mars Ltd currently achieves credit sales of £140,000 per month. Profits are as follows:£

Sales 140,000Cost of sales(75% variable, 25% fixed)100,000Gross profit 40,000

Bad debt(1% of sales) (1,400)Other costs (18,600)

Net profit 20,000

The management think that by increasing the period of credit allowed to customers from 1month to 2 months, sales will rise by 25%, but bad debts would increase to 5% of sales.The increase would leave fixed costs, average stocks and average creditors unaffected. Thecompany's cost of capital is 15%pa.By how much would the new credit policy increase annual profits after the new additionalfinancing costs.

Answer – Question 7

Debtors under current policy 140,000Debtors under new policy (2 months x £140,000 x 1.25) 350,000Increase in debtors 210,000

£ £Annual financing cost of higher debtors(£210,000 x 15%) (31,500)Bad debts:Current policy £1,400 x 12 months 16,800

New policy (5% x £140,000 x 1.25 x 12months) 105,000Increase in bad debts (88,200)Extra contribution from higher sales(12months x 25% x £(140,000 - 75,000) 195,000Increase in annual profits 75,300

Question 8

(a) The return on two investments A and B is expected to be as follows, depending on the

state of the economy:

Economy Probability Return A (%) Return B (%)

Boom 0.2 14 21

Normal 0.5 11 7

Recession 0.3 -1 1

Is it possible to evaluate investment is preferable, based on the expected return and the risk (asmeasured by the standard deviation) of each?

(b) The investment A is being evaluated against investment C, whose expected returns are

as follows:

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Economy Probability Return C (%)

Boom 0.2 24

Normal 0.5 10

Recession 0.3 4

Is it still possible to evaluate which investment is preferable, based on the expected returnand the risk (as measured by the standard deviation) of each? Your answer should includecalculation of the coefficients of variance, and a discussion of the extent to which thecoefficient of variance is useful in choosing between alternative investments. Illustrate your discussion by attempting to evaluate investment A against a further investment D, whoseexpected returns are as follows:

Economy Probability Return D (%)

Boom 0.2 25

Normal 0.5 8

Recession 0.3 4

Answer - Question 8

(a) Investments A and B :

Since Investment A has the same expected return but a lower risk than

Investment B, A clearly dominates B and should be preferred.(b) Investment C :

The problem here is that both the return and risk of Investment C arehigher than those of Investment A. We cannot say that C dominates Abecause of higher return, or that A dominates C because of lower risk. The coefficients of variation of the two investments are calculated below:

The coefficient of variation provides a relative measure of the risk per unitof expected return and, using this measure, investment A seems to beriskier than investment C.However, the coefficient of variation has limited usefulness because therelevant question is not which investment has higher risk per unit of return,but whether an individual investor would be prepared to accept an increaseof 1% in risk to increase the return by 3%. This would depend on the risk-return utility function of the individual investor – i.e. how much extra riskthe investor is prepared to accept per unit of additional return. The more

risk-averse the investor is, the greater will be the amount of additionalreturn required to persuade the investor to take on extra risk.

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This demonstrates the limitations of the coefficient of variation even moreclearly. Like C, D has both higher risk and higher return than A, but it alsohas a similar coefficient of variation.

Question 9

A takeover bid has been made for Song plc by a competitor. The directors of Song plc have

decided to resist the bid as it will not benefit the current shareholders. As a Financial

Consultant, you have been approached by the board of Song plc to offer an advice on a defence

strategy against the takeover bid.

Required:

a) Identify five possible financial anti-takeover defences and explain how Song plc

can use these defences to resist a hostile takeover.

b) Explain some of the key factors that are likely to contribute to a merger or

acquisition failing to live up to expectation.

c) Explain the term “Management Buy-Out” (MBO) and advantages of using MBO as

a divestment strategy.


a) Financial anti-takeover defences

• Enhanced profit forecast• Revalue assets

• Seek a White Knight

• Golden parachutes for senior managers

• Poison pills strategy

• Share re-purchase (buybacks)

• Promise of a higher dividend b)

• Target management attitudes and culture difference

•

Lack knowledge of industry or target company• Poor management practices in target company

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• Little or no experience of acquisition

• Lack compatibility of systems

c) (MBO) and advantages of using MBO as a divestment strategy.

• Sale of unwanted business to an existing management; this way, the business becomes an independent company.

• Strong links may be retained.

• Avoid the sale to the a competitor

Advantages

• MBO can normally be quickly arranged – as supposed to external sales

• Maintaining trade links

• An external buyer might be wary of buying the company if it suspects the skills

of the managers may lost soon after the sale

• “Smooth negotiations” with existing managers.

• Low publicity

Question 10

The sales for 2010 of Painted Hall plc, a small printing company were £300,000. Sales for 2011are expected to rise by 25%. Current assets and liabilities vary directly with sales. Due to therapid growth, the company will also need to spend around £50,000 on new capital investmentand on replacement capital expenditure during 2011. The following information is provided onthe level of current assets and liabilities for 2010.

Current assets and liabilities as at 31 December 2010

Stock £42,000Debtors £38,000Cash £12,000Creditors £22,000

a) Determine the increased net working capital required to meet the higher sales levelduring 2011.

b) Determine the company’s total additional financial requirements for 2011.

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c) Explain the term “operating cash cycle” and why this concept is important in thefinancial management of a business.

d) Discuss ways in which a company might invest its short-term cash surpluses, explaining

briefly the factors to be considered before making these investment decisions.


(a) Current net working capital needs (2010) is:(stock + debtors + cash) – creditors= (£42,000 + £38,000 + £12,000) – £22,000= £70,000

2010 allow for a 25% increase = £87,500

(b) Capital expenditure + additional working capital= £50,000 + £17,500 = £67,500

c)

• OCC is the length of time between when a business makes payments to its suppliesfor raw materials and when the business receives payment from its customers

• The longer this period the greater the financing requirements – leading to greater risk.

• Possible liquidation without additional working capital

d) Short-term cash surpluses should invested on a short-term basis without risk of capitalloss

Selection – the following should be considered:

• The size of the surplus

• How easy is it to get back the cash invested

• The maturity

• Risk and yield of different investment

• Any penalty for early liquidation

Short-term instruments:• Term deposits

• Sterling certificate of deposits

• Treasury bills

• Sterling commercial paper

• Gilts

Question 11

JJ plc published the following year end forecast profit and loss six months ago.

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£ (m)

Turnover 150

Less

Cost of sales 100

Other costs 20

Profit 30

At recent board meeting the finance director informed the board that the turnover and cost of

sales figures will be revised downwards by 4% and 8% respectively, due to a loss of a major

contract in the Middle East.

The following working capital ratios are expected to apply:

Stock holding = 30 days

Debtors payment = 60 days

Creditors payment = 40 days

Required:

a) Calculate the projected working capital position based on the revised data.

b) Discuss the possible reasons why a company might experience cash flow problems

and suggest ways in which such problems might be alleviated.

c) Summarise the services that may be obtained from various forms of agreement for

the factoring of trade debts and invoice discounting.

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Answer - Question 11

a)

Adjusted Forecast profit

£’000 less Adj Revised (£’m)

Turnover 150 (£150m x 4%) = £6m 144LessCost of sales 100 (£100m x 8%)= £8m 92Other costs 20Revised forecast profit 32

Projected working capital £’m

Stock 30 days / 365 days x £92m= 7.562Debtors 60 days / 365 days x £144m = 23.671Less:Creditors 40 days / 365 days x £92m= 10.082Total = 21.151

b)

• Making losses, since continuing losses will lead to cash-flow problems

• Inflation – since historical profit may be insufficient to replace assets

• Poor credit control – rate of bad debt

• Seasonal business

• Significant one-off items of payment – repayment debt capital.

How to alleviate

• Postpone capital expenditure

• Offer discounts to potential customers

• Sell non-core assets

• Cost reduction programme

c)• Factoring – the factor takes over the responsibility of collecting outstanding

amount from the debtors

• Factor is also prepared to advance up to 80% of an approved outstanding

debt to the company.

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• Invoice discounting is a service offered to business whereby a financial

institution is prepared to advance a sum equivalent to 80% of outstanding

trade debtor

• The amount advanced is usually paid within an agreed period – e.g. 60days.

• The company is responsible for collecting the outstanding amount from

debtors.

Question 12

a) Critically discuss the extent to which research has shown capital markets to be efficient.You should include an explanation of the Efficient Market Hypothesis and the threeforms of the hypothesis in your discussion.

b) Given the following corporate objectives, provide a reasoned argument explainingwhich of them should be the main goal of the financial manager.

i) Profit maximisationii) Sales maximisationiii) Maximisation of shareholders wealth


a) Explanation of the EMH

The efficient market hypothesis - share prices fully reflect available information. The value of shares is reflected by the new information.Assumptions – large number of analysts competitively seeking out and appraising informationwhich is assumed be equally available.Discussion should cover the 3 forms (weak, semi-strong and strong) of EMH, the empiricaltests of the 3 levels of EMH and any criticism of EMH.

b)

i) Profit maximisation

• Profit figures can be manipulated,

• Estimated figures (provisions)• Risk is not taken into account.

ii) Sales maximisation

• Can lead to bankruptcy – overtrading

• Bad debts – effect on cash flow.

Maximisation of shareholders wealth

• Takes into account the above factors.

• Relevant to the long term success of a company.Effective use of financial resources to generation healthy earnings

Question 13

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PKY Bank plc quotes the following rates for euro versus Sterling (£):

1.6296 – 1.6320

a) How many euros would a firm receive when selling £10 million

b) How much sterling would it receive when selling €12 million


Remember the bank always wins, so it sells euros at 1.6296, and buys at 1.6320

a) Selling £10 million, its receipts are (10m x 1.6296)= €16.296 b) Selling €10 million, its receipts are (10m /6.6320) = £6.127m

Question 14

On 30th September, a UK exporter sells goods worth £10 million to a German importer on threemoth’s credit. The customer is billed in euros, for which the spot rate versus sterling is (€1.6 -£1). The three-month forward rate is €1.62 - £1.

1) What is the amount invoiced?

2) If the spot rate is €1.7 to £1 at the settlement date, what is the exporter’s gain or loss,assuming, it does not hedge?3) If the rate is €1.5 to £1 at the settlement date, what is the exporter’s gain or loss

assuming it does not hedge?4) If the exporter takes forward cover, what is the cost of the hedge

i) Compared to the current spot rate?ii) Compared to case (2)?iii) Compared to case (3)?


1) Amount invoiced = (£10m x €1.6) = €16m2) With spot rate at €1.7 - £1) = (€16/1.7) = £9.412m. Hence , the loss compared to the

current spot rate = (£10 - £9.412) = £0.588m3) With spot at €1.5 - £1, the sale proceeds are (€16/1.5) = £10.667. In this case, the

exporter gains £0.667m from exchange rate change.4) If the exporter sells forward, the contracted proceeds are €16m /1.6 = £9.877m.

i) The cost of the hedge is thus £0.123, i.e. 1.2% of the sterling value of the deal.

ii) If sterling falls to €1.5 to £1, the forward contract guarantees theexporter £9.877m, but it could have received £10.667m had it nothedged. There is opportunity cost of (£10.667 - £9.877m) = £0.790m.

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iii) If the sterling rises to €1.7 - £1, the forward contract still guarantee theexporter £9.877m, but it would have received £9.412m had it not beenhedged. The exporter is thus better off by (£9.877m - £9.412m = £0.465.

If the exporter thinks there is an equal chance of a 10% variation in the €/£ exchange rate, it

must balance an opportunity cost from hedging of £0.75m if sterling falls against being better off by £0.465m if sterling rises.

Question 15

The respective interest rates in the USA and the UK are 9% and 10% respectively in annualterms. If the spot exchange rate is US$1.6000 to £1, what is the forward rate if IRP (InterestRate Parity) applies?


According to Interest Rate Parity:Forward Rate = Spot rate X (1 + US interest rate / 1+ UK interest Rate)

= 1.600 x (1.09 / 1.10) = 1.5834Therefore, US Dollar is stronger on forward market.


Kandyline plc, a British manufacturer of processed foods, is expanding itsoperations through foreign direct investment. The company has ordered the

construction of a new factory in Vilnius, and a final payment of 2,500,000Lithuanian litas (LTL) for the factory is due to the overseas buildingcontractors in three months’ time. Kandyline currently has no spare cashother than to meet normal working capital needs, but would be receiving£0.75 million from sale of a property in about three months’ time.

Current rates in the foreign exchange and money markets are as under:

Foreign exchange marketGBP/LTL

Spot 3.4056 – 3.4093

1 month forward 3.4068 - 3.4108

3 months’ forward 3.4106 – 3.4149

Money Market Borrowing Deposit

Great Britain Pound 6% 4%

Lithuanian Lita 9% 7%

Required:

(a) Describe the benefits of foreign direct investment.(b) Using suitable calculations where necessary, discuss the advantages and

disadvantages of the alternatives that are available to Kandyline plc for

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managing the transaction risk of the final payment due to the overseascontractor.

In-class tests (1 & 2)

Finance (FINA 1027)

In-class Test (28/02/11)

Answer only 7 questions Duration: 1 hour

Question 1What are the advantages and disadvantages which may accrue to the company andits shareholders, of obtaining a full stock exchange listing?

(Total marks 10)

Question 2

Explain and compare the following methods by which a company’s shares could bebrought to the market:

a. private placing b. offer for sale at fixed pricec. offer for sale by tender

(Total marks 10)

Question 3

a) Briefly discuss what is meant by maximising shareholders wealth and how acompany does attempt to achieve this objective?

(6 marks)b) Explain the Efficient Market Hypothesis.

(4 marks)(Total marks 10)

Question 4

a) Which of the following are essential aspects of a financial manager’sknowledge?

a) Investment appraisal methods

b) Financial marketsc) Cash managementd) All of the above

(5 marks)b) Which of the following statements are correct?

1) Maximising annual profits maximises shareholders wealth2) A financial manager should recognise the interdependence of

investment, financing and dividends.3) Divergence of ownership and control leads to agency problem.

a) 1 is correctb) 1, 2 and 3 are correctc) 1 and 2 are correctd) 2 and 3 are correct

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Question 5

Dumas plc has just paid a cash dividend of 20p per share. Investors require a

16% return from investment such as this.If dividend is expected to grow at a steady 8% per year, what is the currentvalue of the equity? (5 marks)

What will the equity be worth in five years time?(5 marks)

(Total marks 10)

Question 6

Explain why certain levels of risk cannot be avoided even in a well diversifiedportfolio.

(Total marks 10)

Question 7

A three year bond with a 10% coupon pays interest of £10 (£100 *10%) annually. If the interest rate unexpectedly rises to 12%, what will be the quoted price of thebond? Comment on the quoted price.

(Total marks 10)

Question 8

The launch of Sony’s PlayStation 3 was delayed until November 2006, givingMicrosoft’s Xbox 360 a full year on the market without competition. Imagine that it isnow November 2005 and you are the marketing manager for the PlayStation. Youestimate that if PlayStation 3 were ready to be launched immediately, you could sell$2 billion worth of the console in the first year. However, if your launch is delayed ayear, you believe that Microsoft head start will reduce you first-year sales by 20%. If interest rate is 8%, what is the cost of a delay of the first year’s revenues in terms of dollars in 2005?

(Total marks 10)

Question 9

What are prices of 7% and 11% £1,000 bonds with 5 years to maturity assuming10% discount rate and annual coupon payment?

(Total marks 10)

Question 10

Suppose equity in PKG plc has a beta of 0.80. The market risk premium is 6%, andrisk-free rate is 6%. PKG’s last dividend was £1.20 per share, and the dividend isexpected to grow at 8% indefinitely. The current market value of equity (ordinaryshare) is £45.

Calculate PKG’s cost of equity capital (ke), using CAPM and dividend valuationmodel (DVM)?

(Total marks 10)

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END OF TEST

In-class Test Marking Scheme 28th Feb 2011

Question 1

Advantages

• Marketability of shares means listed shares are viewed to be less risky – it helps lower cost of capital.

• Ready price – valuation purpose

• Access to a wider pool finance

• Facilitation of growth by acquisition

• Efficient market price – gives confidence trading in the company’s shares,

•

Transferability of shares / raise new capital• Credit rating – creditworthy

• High profile1 mark for each point, maximum of 5 marks

Disadvantages

• Cost of quotation

• Market expectation – pressure to meet expectation

• Admin & disclosure requirements – complying with various stock exchange rules &regulations (transparency).

• Dilution of control

• Risk of takeover

• Public scrutiny – financial analyst, press & investors1 mark for each point, maximum of 5 marks

Total (10 marks)

Question 2

Methods – Share issue on the stock marketPrivate placing

• Sales to be sold are first acquired by the issuing house (normally a merchant bank)

• Shares are then placed with client of issuing house

• Low cost, since no advertisement• Lower risk 1 mark for each point, maximum of 3 marks

Offer for sale

• Shares are acquired by issuing house or a broker at an agreed price

• Shares are offered to the public at marginally higher price.

• Offer for sale will be underwritten institutional investors.

• Underwriters will accept the shares not taken up by the market, in return for a fee.1 mark for each point, maximum of 3 marks

Total (10 marks)

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Tender

• Minimum price set & public invited to bid.

• Striking price is set.

• Method is used when the market turbulent or no direct comparison on the market.1 mark for each point, maximum of 3 marks + 1 bonus point for introduction.

Total (10 marks)Question 3

a)

• An increase in shareholders wealth may result from an increase in the market value of the shares held or a dividend payment. Note that a shareholder’s return will be made upof capital growth and cash return (dividend yield)

• Maximising share holders wealth is attempting to manage the company so that the totalmarket share value is maximised or maximising the total market value of the company

(Equity + debt).

• This is justified as shareholders are the legal owners of the company and they haveinvested in the company in an attempt to increase their wealth.

• The equity market is an important source of funds for a company and to attract thesefunds the company must adequately reward the providers of the funds. The companycan do this by operating in a profitable manner accepting only projects with a positive

NPV.

• Maintain a dividend growth policy by retaining some of the earnings to promotegrowth.

2 marks for each point, maximum of 6 marks

b)

• The efficient market hypothesis - share prices fully reflect available information inan instantaneously.

• The value of shares is reflected by the new information.2 marks for each point, maximum of 4 marks

Total (10 marks)

Question 4

a) (d) 5 marls

b) (d) 5 marks

Total (10 marks)

Question 5

(a) MV = Div(1 + g)/ Ke – g

MV = 20(1.08) / (.16 – 8) 3 marks

21.6 /.08 = 270p 2 marks

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(b) D5 = D1 * (1 + g)^5

20 * (1.08)^5

29.4p 2 marks

Price in 5 years

29.4(1.08) /.08 = 396.7p 3 marks

Total (10 marks)

Question 6

• Risk may be divided into systematic and unsystematic risk.

• Systematic risk refers to the extent to which a company’s cash-flows areaffected by factors not specific to the company – inflation, interest rates etc.

•Unsystematic risk refers to the extent to which a company’s cash-flows areaffected by company-specific factors e,g. quality of managers, effectivenessof R&D, the skill of its labour force

• Unsystematic risk can be diversified away,

• Systematic risk, however , cannot be diversified away, since it is experiencedby all companies

• The risk of a well-diversified portfolio will be similar to the systematic risk of the market as whole.

(2 marks for each point, maximum of 10 marks)Total (10 marks)

Question 7

12% £

Year 1 – 3 £10 x 2.44 = 24.44 3 marks

Year 3 £100 x .712 = 71.20 3 marks

Bond price = 95.64 1 mark

Comments

£95.64 is less than £100 therefore the bond said to sell at a discount. With interest now at 12%,newly issued bond with 12% coupon rate will sell at £100.

3 marks

Total (10 marks)

Question 8

Reduction in Sales revenue = $2 billion x 20% = $0.4billion 2 marks

Net sales revenue ($2 billion - $400,000) = $1.6billion 2 marks

Present value of sales revenue @ 8% = $1.6 billion x .926 =$1.482 billion 3 marks

Cost of delay of one year = $2billion - $1.482 billion = $518 million 3 marks

Total (10 marks)

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Question 9

7%

Year £ x 10% D/Factor £1 - 5 70 x 3.791 = 265.37 2 marks

5 1,000 x .621 = 621.00 2 marksPrice = 886.28 1 mark

10%

Year £ x 10% D/Factor £1 – 5 110 x 3.791 = 417.01 2 marks

5 1,000 x .621 = 621.00 2 marks

Price = 1,038.01 1 mark

Total (10 marks)

Question 10

CAPM

Ke = Rf + (Rm – Rf) * beta= 6% + 0.8* 6% 3 marks= 10.8% 1 marks

Projected dividend = £1.20 *(1.08) = £1.296 2 marksKe = (£1.296 /£45) + .08 2 marks

= 10.88% 2 marks

Total (marks 10)

In-class Test (01/03/2011)

Answer only 7 questions Duration: 1 hour Question 1What are the functions and areas of responsibility under the control of a financemanager in a public limited company?

(Total marks 10)

Question 2a) What is meant by “agency problem” in the context of a public limited

company?(4 marks)

b) How is it possible for the agency problem to be reduced in a company?(6 marks)(Total marks 10)

.

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Question 3Explain the similarities and difference between convertible loan stocks and loanstocks with warrants.

(Total marks 10)

Question 4South plc issued 12% irredeemable debenture at a par value of £100, 7 years ago.The current market price of the debenture is £94 and the company pays acorporation tax at 35%.What is the cost of debenture?

(Total marks 10)Question 5Suggest factors that should be considered before paying out dividend toshareholders.

(Total marks 10)

Question 6

ABC plc has 10 million shares of £1 nominal value in issue. Current shares aretrading at £1.84 each. ABC is about to raise additional finance to support a futureexpansion programme by rights issue in the proportion of 2 for 5. The rights issuewill be priced at 30% discount of the current market price.

i) Calculate theoretical ex-right price (TERP)(5 marks)

ii) Calculate the trading value of the right(5 marks)(Total marks 10)

Question 7Linfield plc has paid dividends per share over the past few years, as follows:

2005 11.0p2006 12.5p2007 14.0p2008 17.0p2009 20.0pThe market price per share of Linfield is currently quoted at £5.00 ex-dividend. What is the rate of return required by investors in Linfield’s equity

implied by the Dividend Growth Model? (Total marks 10)

Question 8 A company has in issue a 10 per cent bond, redeemable at the option of thecompany between one to five years from now. What factors do you think will beconsidered by the company in reaching a decision on when to redeem the bond?

(Total marks 10)

Question 9John has £10,000, which he could deposit in savings account offering an interest of

6% per annum. John’s brother wants him to lend the money to him instead,promising to repay him after 10 years with double the amount lent.

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Required:i) Purely on financial considerations, would it be worthwhile for John to

lend the money to his brother rather than placing it in a savingsaccount? (Support with calculations)

(5 marks)

ii) Alternatively, John’s brother offers to pay him £500 every year, withoutany repayment of the principal amount of £10,000. Would this proposalbe worthwhile in financial terms for John?


Question 10Briefly outline the advantages and disadvantages for obtaining a full listing on arecognised stock exchange.

(Total marks 10)

END OF TEST

In-class Test Marking Scheme 28th Feb 2011

Question 1Financial planning and forecasting

Investment appraisal

Financial decisions

Capital market operations

Working capital management

Dividend policy formulation.

2 mark for each point, maximum of 10 marksTotal (10 marks)

Question 2

a)•

Divorce of ownership and control• Principal and agent relationship

• Divergent goal and an asymmetry of information

• Managers act to maximise their own wealth rather than the shareholders’ wealth.1 mark for each point, maximum of 4 marks

b)• Do nothing if costs of divergent behaviour are low.

• Monitor agents, if contracting or divergent behaviour costs are high.

• Use a reward / punishment contract, if contracting or divergent behaviour costs arehigh.2 mark for each point, maximum of 6 marks

Total (10 marks)

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Question 3

Similarities• Long term debt 2 marks

• Payment of fixed interest 2 marks

• Interest is tax deductible expense 2 marks

DifferencesConvertible loan stocks are fixed-term securities – either secured or unsecured – which maybe converted at the option of the holder, into ordinary shares of the same company.

2 marksLoan stocks with warrants - the loan stocks cannot themselves be converted into ordinaryshares but give the holder the right to subscribe for ordinary shares in future at a fixed price.

2 marksTotal (10 marks)

Question 4Cost of Debenture

Int (1 – tax) / MV debenture 2 marks

12 (1 – 35%) / 94 4 marks

7.8 / 94 2 marks

8.3% 2 marks

Total (10 marks)

Question 5Investment opportunity

Profit

Clientele

Signal effect

Article of association

Availability of cash

2 mark for each point, maximum of 10 marksTotal (10 marks)

Question 6

i) Discount

£1.84 @ 35% = .55p 1 mark

Rights issue Price (£1.84 - .55p) = £1.29 1 mark

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2 new share @ £1.29 = £2.58 1 mark

5 old shares @ £1.84 = £9.20 1 mark

7 shares = £11.78

TERP = £11.78 / 7 = £1.68 1 mark

ii) Value of right ( £1.68 - £1.29) = 39p 5 mark

Question 7

11p (1 +g)^4 = 20p 1 mark

(1 +g)^4 = 20p/11p 1 mark

g = 15.8% 2 marks

Implied Ke = 20p (1.158)/ 500p +0.158 4 marks

0.4632 +0.158 = 20.43% 2 marks

Total (10 marks)

Question 8

• The length of time remaining to maturity

• General level of interest rates

• The rate of return on other securities – ordinary shares

• Expectation of likely movement in interest rates and inflation

• The required return of investors in debenture

(2 marks for each point, maximum of 10 marks)Total (10 marks)

Question 9

i) Bank : £10,000 x (1.06)^10 2

marks

£10,000 x 1.7908 = £17,908 2

marks

Therefore accept £20,000 from the brother should be accepted

1 mark

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ii) Perpetuity

£500/.06 = £8,333 3 marks

£8,3333 is less than the £10,000 therefore proposal not worthwhile –

should not be accepted.

2 marks

Total (10 marks)Question 10

Advantages

• Opens up avenues to raise finance

• Marketability of shares

• Raises the profile of the company

• Better credit rating

• Company’s shares can be used to fund future takeover.

1 mark for each point, maximum of 5 marks

Disadvantages

•

Cost of floatation

• Cost of compliance with listing rules

• Company may be open to a hostile takeover bid

• Dilution of control will result from wider share ownership

• The need to satisfy increased shareholders expectation.

1 mark for each point, maximum of 5 marks

Total (10 marks)

Documents

Revision Pack 4 May 2011