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Audit and Assurance Study Videos – 50% OFF – Promo Code : 50FIFTY – Quick Purchase

PFM 5-2

Question 01 (Tulip Co)
Question 02 (JJ Co)
Question 03 (LFCC Co)
Question 04 (Brash Co)
Question 01 (Tin Co)
Question 02 (Fence Co)
Question 03 (Grenarp Co)
Question 04 (Spot Co)
Question 05 (AMH Co)
Question 06 (Tufa Co)
Question 07 (Corfe Co)
Question 08 (Bar Co)
Question 09 (Nugfer Co)
Question 10 (Cozine Inc)
Question 11 (Tfr Co)
Question 12 (Dinla Co)
Question 13 (King Co)
Question 01 (Tulip Co)

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1 / 5

Tulip Co (Mar/Jun 19)

The following scenario relates to questions 228–232.

Tulip Co is a large company with an equity beta of 1.05. The company plans to expand existing business by acquiring a new factory at a cost of $20 million. The finance for the expansion will be raised from an issue of 3% loan notes, issued at nominal value of $100 per loan note. These loan notes will be redeemable after five years at nominal value or convertible at that time into ordinary shares in Tulip Co with a value expected to be $115 per loan note.

The risk-free rate of return is 2.5% and the equity risk premium is 7.8%.

Tulip Co is seeking additional finance and is considering using Islamic finance and, in particular, would require a form which would be similar to equity financing.

238. What is the cost of equity of Tulip Co using the capital asset pricing model?

2 / 5

239. Using estimates of 5% and 6%, what is the cost of debt of the convertible loan notes?

3 / 5

240. In relation to using the dividend growth model to value Tulip Co, which of the following statements is correct?

4 / 5

241. Which of the following statements about equity finance is correct?

5 / 5

242. Regarding Tulip Co’s interest in Islamic finance, which of the following statements is/are correct?

  1. Mudaraba involves an investing partner and a managing or working partner
  2. Murabaha could be used to meet Tulip Co’s financing needs

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Question 02 (JJ Co)

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1 / 8

JJ Co

The following scenario relates to questions 233–237.

The board of JJ Co are in discussion about the various risk types that face the business. It is evident that there is considerable confusion and disagreement.

Operating risk

Some of the directors feel that given the increasing volume of trade having fixed costs is the best thing to do. ‘How can it be risky to have fixed costs when we know how much they are and that they don’t change overly much from one year to the next’ was one comment. There was also a discussion about changing the cost structure. It was thought that this would be difficult as most staff, for example, were paid a salary and moving them on to an hourly rate would be opposed by them.

Gearing risk

The directors were more aware in this area, with some favouring a more traditional view of gearing and others remembering Modigliani and Miller (M&M) fondly from their studies.

243. In relation to changing the cost structure of Freedling which of the following statements are true?

(1) Cost structures are very difficult to change. Once a business is set up the mix of variable and fixed cost is also set and changes are often simply not possible.

(2) If you change from a fixed cost to a variable cost dominated structure the variable cost per unit is often greater than the fixed cost per unit.

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244. Indicate, by clicking in the relevant boxes, whether the following statements on operating gearing are true or false?

A. Variable costs are risky because they change as volume changes. Given JJ is growing the year on year variable cost level has changed a lot as well

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B. Given the level of fixed costs do not change considerably from one year to the next, having a lot of fixed cost in JJ’s cost structure would mean that they had low levels of operating risk.

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245. Under M&M no tax which of the following statements are true?

(1) It does not matter how a business raises finance.

(2) Shareholders, given the M&M assumptions, will recognise the level of risk inherent in any extra debt and compensate themselves by a commensurate increase in required return to leave the company WACC unaltered and without any inherent gain.

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246. Assuming the board were considering raising more debt, indicate, by clicking in the relevant boxes, whether the assertion that the WACC of the business would fall holds true or not in the following models.

A. Under M&M no tax

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B. Under M&M with corporation tax

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C. At low levels of gearing under the traditional theory of gearing

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247. In traditional theory diagrams the cost of debt line is often drawn with a slight tail, arcing upwards at very high levels of gearing. Indicate which of the following statements about this feature are true?

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Question 03 (LFCC Co)

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1 / 6

LFCC Bank

The following scenario relates to questions 248–252.

The board of LFCC bank is discussing their investment appraisal methodology as they have a new project under consideration. They have agreed that using the CAPM approach is sensible as they feel it likely that most of their shareholders will have a well-diversified shareholding in the stock market as a whole.

There has been some dispute about which risks constitute specific risks in the bank and which risks are more systematic in nature partly driven by the nature of the banks operations. Equally, no one seems quite sure what the required return derived from the CAPM formula actually represents.

The finance director has produced the following data relating to the bank itself, the financial market and the new project it is considering:

Data

Required return on existing debt 6.0%
Cost of existing debt to the bank 4.8%
Return on short dated government securities 5.2%
Return in the stock market 12.8%
Equity beta of the bank 1.35
Beta of the new project 1.52
Asset beta of the bank 1.15

 248. Which of the following risks could be correctly described as a systematic risk in this case?

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249. In the CAPM what would be the value to use for the risk free rate of return (Rf), from the data above?

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250. In the CAPM formula R = Rf + βj(Rm – Rf) where βj represents the project beta, R represents…………A………..(the cost of equity capital/the required return on the new project) and the market risk premium is represented by………B……… ((Rm – Rf)/Rm)

Pick the correct answers to complete the sentences.

A.

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B.

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251. What is the percentage required return on the new project as derived from the CAPM formula above, to two decimal places?

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252. What is the meaning of a beta value of 1?

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Question 04 (Brash Co)

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1 / 6

Brash Co

The following scenario relates to questions 253–257.

Brash Co can buy a new piece of sophisticated machinery for $500,000 by borrowing under a secured loan at 8%. It has also researched the possibility of leasing the asset.

The company’s finance director is a little rusty on leasing issues as the business has never leased before and he has worked in Brash Co for 20 years. He said ‘I studied leasing years ago but I think leasing is cheaper than borrowing because the lease company has access to greater amounts of finance and so benefits from economies of scale on that front’.

The managing director is sceptical, arguing that leasing companies are commercial and so each deal must be assessed on its merits. He commented: ‘We have to careful here, I know the lease companies are always responsible for the maintenance but that can’t be free!’

The lease offer is as follows:

The lease will be over 5 years with lease payments of $146,000 annually in advance (at the start of each accounting period). Tax is payable 1 year after the accounting year-end and the corporation tax rate is 25%. Maintenance is payable by the lessor and costs $20,000 per annum payable at the end of each year, including the last year in preparation for sale. The residual value is expected to be $40,000 (the expected tax written down value at the end of the lease) and the lessor will retain that.

253. Indicate, by clicking in the relevant boxes, whether the statements made by the finance director and the managing director are true or false?

A. Statement by the finance director

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B. Statement by the managing director

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254. In a calculation to compare the cost of leasing with cost of borrowing to buy the asset above, which of the following costs are not relevant?

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255. What is the present value of the maintenance cash flows, after tax?

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256. What is the present value of the tax relief on the lease payments, after tax, to the nearest $000?

6 / 6

257. Which of the following statements about the potential effects of taking on a lease are true?

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Question 01 (Tin Co)

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258. Tin Co (Mar/Jun 18)

Tin Co is planning an expansion of its business operations which will increase profit before interest and tax by 20%. The company is considering whether to use equity or debt finance to raise the $2m needed by the business expansion.

If equity finance is used, a 1 for 5 rights issue will be offered to existing shareholders at a 20% discount to the current ex dividend share price of $5.00 per share. The nominal value of the ordinary shares is $1.00 per share.

If debt finance is used, Tin Co will issue 20,000 8% loan notes with a nominal value of $100 per loan note.

Financial statement information prior to raising new finance:

  $’000
Profit before interest and tax 1,597
Finance costs (interest) (315)
Taxation (282)
Profit after tax 1,000

 

  $’000
Equity  
Ordinary shares 2,500
Retained earnings 5,488
Long-term liabilities:  
7% loan notes 4,500
Total equity and long-term liabilities 12,488

The current price/earnings ratio of Tin Co is 12.5 times. Corporation tax is payable at a rate of 22%.

Companies undertaking the same business as Tin Co have an average debt/equity ratio (book value of debt divided by book value of equity) of 60.5% and an average interest cover of 9 times.

Required

A. (i) Calculate the theoretical ex rights price per share.

Currently 2.5 million shares @$5 = $12.5 million value
Rights issue 0.5 million shares @$4 = $2 million
After rights issue 3 million shares   $14.5 million value

TERP = $14.5m/3m = $4.83

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(ii) Assuming equity finance is used, calculate the revised earnings per share after the business expansion.

$’000                                        Notes

Increased PBIT                   1,916                                      Increase of 20% on 1,597

Finance costs (interest)       (315)

Revised profit before tax    1,601

Taxation at 22%                 (352)

Revised profit after tax      1,249

 

Total number of shares 3,000,000                           1 for 5 rights issue, so 500,000 extra shares

Revised earnings per share 0.42 (1,249/3,000)

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(iii) Assuming debt finance is used, calculate the revised earnings per share after the business expansion.

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(iv) Calculate the revised share prices under both financing methods after the business expansion.

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(v) Use calculations to evaluate whether equity finance or debt finance should be used for the planned business expansion.

Gearing

$’000 Current Equity finance raised Debt finance raised
Book value of debt 4,500 4,500 4,500 + 2,000 = 6,500
Book value of equity 2,500 + 5,488 = 7,988 7,988 + 2,000 = 9,988 7,988
Debt/equity ratio 4,500/7,988 = 56.3% 4,500/9,988 = 45.1% 6,500/7,988 = 81.4%

Sector average D/E using BV = 60.5%

The gearing of Tin Co at 56.3% is just below the sector average gearing of 60.5%. If equity finance were used, gearing would fall even further below the sector average at 45.1%. If debt finance were used, gearing would increase above the sector average to 84.4%, this may concern shareholders.

Interest cover

$’000 Current Equity finance raised Debt finance raised
 PBIT 1,597 1,916 1,916
Interest 315 315 315 + 160 = 475
 Interest cover 1,597/315 = 5.1 1,916/315 = 6.1 1,916/475 = 4.0

Sector average interest cover = 9 times

Interest cover calculations show that raising equity finance would make the interest cover of Tin Co look much safer. When debt finance is used, interest cover of 4·0 times looks quite risky compared to the sector average.

 Share price changes

The shareholders of Tin Co experience a capital gain of $0.63 per share compared to the current share price ($5.63 – $5.00) if debt finance is used, compared to a capital gain of $0.42 per share compared to the TERP ($5.25 – $4.83) if equity finance is used.

Although using debt finance looks more attractive, it comes at a price in terms of increased financial risk. It might be decided, on balance, that using equity finance looks to be the better choice.

6 / 6

B. Discuss TWO Islamic finance sources which Tin Co could consider as alternatives to a rights issue or a loan note issue.

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Question 02 (Fence Co)

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1 / 4

259. Fence Co (June 14 – Amended)

The equity beta of Fence Co is 0.9 and the company has issued 10 million ordinary shares. The market value of each ordinary share is $7.50. The company is also financed by 7% bonds with a nominal value of $100 per bond, which will be redeemed in seven years’ time at nominal value. The bonds have a total nominal value of $14 million. Interest on the bonds has just been paid and the current market value of each bond is $107.14.

Fence Co plans to invest in a project which is different to its existing business operations and has identified a company in the same business area as the project, Hex Co. The equity beta of Hex Co is 1.2 and the company has an equity market value of $54 million. The market value of the debt of Hex Co is $12 million.

The risk-free rate of return is 4% per year and the average return on the stock market is 11% per year. Both companies pay corporation tax at a rate of 20% per year.

Required:

A. Calculate the current weighted average cost of capital of Fence Co.

Cost of equity

The current cost of equity can be calculated using the capital asset pricing model.

Equity or market risk premium = 11 – 4 = 7%

Cost of equity = 4 + (0.9 × 7) = 4 + 6.3 = 10.3%

After-tax cost of debt After-tax interest payment = 100 × 0.07 × (1 – 0.2) = $5.60 per bond

Year Cash flow $ 5% discount PV ($) 4% discount PV ($)
0 market value (107.14) 1.000 (107.14) 1.000 (107.14)
1 – 7 interest 5.60 5.786 32.40 6.002 33.61
7 redemption 100.00 0.711 71.10 0.760 76.00
        (3.64)   2.47

After-tax cost of debt = IRR = 4 + ((5 – 4) × 2.47)/(2.47 + 3.64) = 4 + 0.4 = 4.4%

Market value of equity = 10,000,000 × 7.50 = $75 million

Market value of Fence Co debt = 14 million × 107.14/100 = $15 million

Total market value of company = 75 + 15 = $90 million

WACC = [Ve/(Ve + Vd)] × ke + [Vd/(Ve + Vd)] × kd

WACC = [75/90] × 10.3 + [15/90] × 4.4 = 9.3%

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B. Calculate a cost of equity which could be used in appraising the new project.

3 / 4

C. Explain the difference between systematic and unsystematic risk in relation to portfolio theory and the capital asset pricing model.

4 / 4

D. Discuss the significance of the efficient market hypothesis (EMH) for the financial manager.

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Question 03 (Grenarp Co)

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1 / 3

260. Grenarp Co (6/15, amended)

Grenarp Co is planning to raise $11,200,000 through a rights issue. The new shares will be offered at a 20% discount to the current share price of Grenarp Co, which is $3.50 per share. The rights issue will be on a 1 for 5 basis and issue costs of $280,000 will be paid out of the cash raised. The capital structure of Grenarp Co is as follows:

  $m $m
Equity    
Ordinary shares (par value $0.50) 10  
Reserves 75  
    85
Non-current liabilities    
8% loan notes   30
    115

The net cash raised by the rights issue will be used to redeem part of the loan note issue. Each loan note has a nominal value of $100 and an ex interest market value of $104. A clause in the bond issue contract allows Grenarp Co to redeem the loan notes at a 5% premium to market price at any time prior to their redemption date. The price/earnings ratio of Grenarp Co is not expected to be affected by the redemption of the loan notes.

The earnings per share of Grenarp Co is currently $0.42 per share and total earnings are $8,400,000 per year. The company pays corporation tax of 30% per year.

Required

A. Evaluate the effect on the wealth of the shareholders of Grenarp Co of using the net rights issue funds to redeem the loan notes.

2 / 3

B. Discuss whether Grenarp Co might achieve its optimal capital structure following the rights issue.

3 / 3

C. Discuss THREE sources and characteristics of long-term debt finance which may be available to Grenarp Co.

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Question 04 (Spot Co)

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1 / 3

261. Spot Co (Dec 13 – Amended)

Spot Co is considering how to finance the acquisition of a machine costing $750,000 with an operating life of five years. There are two financing options.

Option 1

The machine could be leased for an annual lease payment of $155,000 per year, payable at the start of each year.

Option 2

The machine could be bought for $750,000 using a bank loan charging interest at an annual rate of 7% per year. At the end of five years, the machine would have a scrap value of 10% of the purchase price. If the machine is bought, maintenance costs of $20,000 per year would be incurred.

Required:

A. Evaluate whether Spot Co should use leasing or borrowing as a source of finance, explaining the evaluation method which you use. (Ignore taxation).

2 / 3

B. Discuss the attractions of leasing as a source of both short-term and long-term finance

3 / 3

C. In Islamic finance, explain briefly the concept of riba (interest) and how returns are made by Islamic financial instruments.

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Question 05 (AMH Co)

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1 / 2

262. AMH Co (June 13 Amended)

AMH Co wishes to calculate its current cost of capital for use as a discount rate in investment appraisal. The following financial information relates to AMH Co:

Financial position statement extracts as at 31 December 20X2

  $000 $000
Equity    
Ordinary shares (nominal value 50 cents) 4,000  
Reserves 18,000  
    22,000
Long-term liabilities    
4% Preference shares (nominal value $1) 3,000  
7% Bonds redeemable after six years 3,000  
Long-term bank loan 1,000  
    7,000
    29,000

The ordinary shares of AMH Co have an ex div market value of $4.70 per share and an ordinary dividend of 36.3 cents per share has just been paid. Historic dividend payments have been as follows:

Year 20X8 20X9 20Y0 20Y1
Dividends per share (cents) 30.9 32.2 33.6 35.0

The preference shares of AMH Co are not redeemable and have an ex div market value of 40 cents per share.

The 7% bonds are redeemable at a 5% premium to their nominal value of $100 per bond and have an ex interest market value of $104.50 per bond.

The bank loan has a variable interest rate that has averaged 4% per year in recent years. AMH Co pays profit tax at an annual rate of 30% per year.

Required:

A. Calculate the market value weighted average cost of capital of AMH Co.

Cost of equity

The geometric average dividend growth rate in recent years:

(D0/Dn years ago) 1/n – 1

(36.3/30.9)1/4 – 1 = 1.041 – 1 = 0.041 or 4.1% per year

 

Using the dividend growth model:

Ke = Do (1 + g)/P0 + g

Ke = [(36.3 × 1.041)/470] + 0.041 = 0.080 + 0.041 = 0.121 or 12.1%

 

Cost of preference shares

As the preference shares are not redeemable:

Kp = D0/P0

Kp = 0.04/0.40 = 0.1 = 10%

 

Cost of debt of loan notes

The annual after-tax interest payment is 7 × 0.7 = $4.9 per loan note.

 Using linear interpolation:

Year Cash flow $ 5% DF PV ($) 4% DF PV ($)
0 Market price (104.5) 1.000 (104.5) 1.000 (104.5)
1 – 6 Interest 4.9 5.076 24.87 5.242 25.69
6 Redemption 105 0.746 78.33 0.790 82.95 
        (1.30)   4.14

After-tax cost of debt = 4 + [((5 – 4) × 4.14)/(4.14 + 1.30)] = 4 + 0.76 = 4.8%

Cost of debt of bank loan

If the bank loan is assumed to be perpetual (irredeemable), the after-tax cost of debt of the bank loan will be its after-tax interest rate, i.e. 4% × 0.7 = 2.8% per year.

Market values

Number of ordinary shares = $4,000,000/$0.5 = 8 million shares

  $000
Equity: 8m × 4.70 = 37,600
Preference shares: 3m × 0.4 = 1,200
Redeemable loan notes: 3m × 104.5/100 = 3,135
Bank loan (book value used) 1,000
Total value of AMH Co 42,935

WACC calculation

WACC = [Ve/(Ve + Vd + Vp)] × ke + [Vp/(Ve + Vd + Vp)] × kp + [Vd/(Ve + Vd + Vp)] × kd

WACC = [37,600/42,935] × 12.1 + [1,200/42,935] × 10 + [3,135/42,935] × 4.8 + [1,000/42,935] × 2.8 = 11.3%

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B. Discuss how the capital asset pricing model can be used to calculate a projectspecific cost of equity for AMH Co, referring in your discussion to the key concepts of systematic risk, business risk and financial risk.

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Question 06 (Tufa Co)

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263. Tufa Co (Sep/Dec 17)

The following statement of financial position information relates to Tufa Co, a company listed on a large stock market which pays corporation tax at a rate of 30%.

  $m $m
Equity and liabilities    
Share capital 17  
Retained earnings 15  
Total equity   32
Non-current liabilities    
Long-term borrowings 13  
Current liabilities 21  
Total liabilities   34
Total equity and liabilities   66

The share capital of Tufa Co consists of $12m of ordinary shares and $5m of irredeemable preference shares.

The ordinary shares of Tufa Co have a nominal value of $0.50 per share, an ex dividend market price of $7.07 per share and a cum dividend market price of $7.52 per share. The dividend for 20X7 will be paid in the near future. Dividends paid in recent years have been as foIlows:

Year 20X6 20X5 20X4 20X3
Dividend ($/share) 0.43 0.41 0.39 0.37

The 5% preference shares of Tufa Co have a nominal value of $0.50 per share and an ex dividend market price of $0.31 per share.

The long-term borrowings of Tufa Co consists of $10m of loan notes and a $3m bank loan. The bank loan has a variable interest rate.

The 7% loan notes have a nominal value of $100 per loan note and a market price of $102.34 per loan note. Annual interest has just been paid and the loan notes are redeemable in four years’ time at a 5% premium to nominal value.

Required

A. Calculate the after-tax weighted average cost of capital of Tufa Co on a market value basis.

Interest rate of loan notes (%) 7
Nominal value of loan notes ($) 100.00
Market price of loan notes ($) 102.34
Time to redemption (year) 4
Redemption premium (%) 5
Tax rate (%) 30

 

Year Item $ 5% DF PV ($) 6% DF PV ($)
0 MV (102.34) 1.000 (102.34) 1.000 (102.34)
1–4 Interest 4.90 3.546 17.38 3.465 16.98
4 Redeem 105.00 0.823 86.42 0.792 83.16
        1.45   (2.20)

IRR (%) = 5 + (1.45/(1.45 + 2.20)) = 5.40

Alternatively IRR can be calculated using the =IRR spreadsheet function based on these cash flows:

Time 0 1 2 3 4
  (102.34) 4.9 4.9 4.9 109.9

This approach also gives an IRR of 5.4%

Cost of bank loan (%) = 5.40 (assumed)

The total market value of the loan notes = $10m x 102.34/100 = $10.234m

Cost of preference shares = dividend/market price = (0.05 x $0.50)/$0.31 = 8.06%

The total market value of the preference shares = $5m/$0.5 nominal value x $0.31 market value = $3.1m.

Cost of ordinary shares using

 Re = d0 (1+g) +g

P0

The current dividend can be calculated as the difference between the ex div and the cum div share price: $7.52 – $7.07 = $0.45.

Annual growth over 4 time periods between 20X3 and 20X7 is  0.45 1/4 -1 = 5%

0.37

Po = the ex div share price of $7.07

So cost of equity = 0.45 × 1.05 + 0.05 = 0.117 or 11.7%

7.07

There are 24m ordinary shares ($12m/$0.5 nominal value), so Ve = 24m shares x $7.07 = $169.68m

Total capital employed using market values = $10.234 loan notes + $3m bank loan + $3.1m preference shares + $169.68m ordinary shares = $186.014m

Overall WACC = (11.7 x 169.68/186.014) + (8.1 x 3.1/186.014) + (5.40 x 10.234/186.014) + (5.4 x 3/186.014) = 11.19%

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B. Discuss the circumstances under which it is appropriate to use the current WACC of Tufa Co in appraising an investment project.

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C. Discuss THREE advantages to Tufa Co of using convertible loan notes as a source of longterm finance.

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Question 07 (Corfe Co)

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264. Corfe Co (Mar/Jun 19)

The following information has been taken from the statement of financial position of Corfe Co, a listed company:

  $m $m
Non-current assets   50
Current assets    
Cash and cash equivalents 4  
Other current assets 16  
    20
Total assets   70

 

  $m $m
Equity and reserves    
Ordinary shares 15  
Reserves 29  
    44
Non-current liabilities    
6% preference shares 6  
8% loan notes 8  
Bank loan 5  
    19
Current liabilities   7
Total equity and liabilities   70

The ordinary shares of Corfe Co have a nominal value of $1 per share and a current ex-dividend market price of $6.10 per share. A dividend of $0.90 per share has just been paid.

The 6% preference shares of Corfe Co have a nominal value of $0.75 per share and an exdividend market price of $0.64 per share.

The 8% loan notes of Corfe Co have a nominal value of $100 per loan note and a market price of $103.50 per loan note. Annual interest has just been paid and the loan notes are redeemable in five years’ time at a 10% premium to nominal value.

The bank loan has a variable interest rate.

The risk-free rate of return is 3.5% per year and the equity risk premium is 6.8% per year. Corfe Co has an equity beta of 1.25. Corfe Co pays corporation tax at a rate of 20%.

 

Investment in facilities

Corfe Co’s board is looking to finance investments in facilities over the next three years, forecast to cost up to $25 million. The board does not wish to obtain further long-term debt finance and is also unwilling to make an equity issue. This means that investments have to be financed from cash which can be made available internally. Board members have made a number of suggestions about how this can be done:

Director A has suggested that the company does not have a problem with funding new investments, as it has cash available in the reserves of $29 million. If extra cash is required soon, Corfe Co could reduce its investment in working capital.

Director B has suggested selling the building which contains the company’s headquarters in the capital city for $20 million. This will raise a large one-off sum and also save on ongoing property management costs. Head office support functions would be moved to a number of different locations rented outside the capital city.

Director C has commented that although a high dividend has just been paid, dividends could be reduced over the next three years, allowing spare cash for investment.

Required

A. Calculate the after-tax weighted average cost of capital of Corfe Co on a market value basis.

ke = 3.5% + (1.25 x 6.8%) = 12.00%

kpref = (0.06 x 0.75)/0·64 = 7.03%

 

Loan notes

After tax interest payment 8% x (1 – 0·2) = 6.4%
Nominal value of loan notes 100.00
Market value of loan notes 103.50
Time to redemption (years) 5
Redemption premium (%) 10

 

Year   $ 5% DF PV ($) 10% DF PV ($)
0 MV (103.50) 1.000 (103.50) 1.000 (103.50)
1–5 Interest 6.40 4.329 27.71 3.791 24.26
5 Redeem 110.00 0.784 86.24 0.621 68.31
        10.45   (10.93)

IRR = 5 + ((10 – 5) x (10.45/(10.45 + 10.93))) = 7.44%

Alternatively IRR can be calculated using the =IRR spreadsheet function based on these cash flows:

Time 0 1 2 3 4 5
  (103.5) 6.4 6.4 6.4 6.4 116.4

This approach gives an IRR of 7.3%

This figure can also be used for the cost of debt of the bank loan.

Market values and WACC calculation

  BV ($m) Nominal MV MV ($m) Cost (%) MV x Cost(%)
Equity shares 15 1.00 6.10 91.50 12.00 1,098.00
Preference shares 6 0.75 0.64 5.12 7.03 35.99
Loan notes 8 100 103.50 8.28 7.44 61.60
Bank loan 5 5.00 7.44 37.20 109.90 1,232.79

WACC = 100% x 1,232.79/109.90 = 11.22%

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B. Discuss the views expressed by the three directors on how the investment should be financed.

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Question 08 (Bar Co)

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265. Bar Co (12/11, amended)

Bar Co is a stock exchange listed company that is concerned by its current level of debt finance. It plans to make a rights issue and to use the funds raised to pay off some of its debt. The rights issue will be at a 20% discount to its current ex dividend share price of $7.50 per share and Bar Co plans to raise $90m. Bar Co believes that paying off some of its debt will not affect its price/earnings ratio, which is expected to remain constant.

STATEMENT OF PROFIT OR LOSS INFORMATION

  $m
Revenue 472.0
Cost of sales 423.0
Profit before interest and tax 49.0
Interest 10.0
Profit before tax 39.0
Tax 11.7
Profit after tax 27.3

STATEMENT OF FINANCIAL POSITION INFORMATION

  $m
Equity  
Ordinary shares ($1 nominal) 60.0
Retained earnings 80.0
  140.0
Long-term liabilities  
8% bonds ($100 nominal) 125.0
  265.0

The 8% bonds are currently trading at $112.50 per $100 bond and bondholders have agreed that they will allow Bar Co to buy back the bonds at this market value. Bar Co pays tax at a rate of 30% per year.

Required

A. Calculate the theoretical ex-rights price per share of Bar Co following the rights issue.

2 / 4

B. Calculate and discuss whether using the cash raised by the rights issue to buy back bonds is likely to be financially acceptable to the shareholders of Bar Co, commenting in your answer on the belief that the current price/earnings ratio will remain constant.

3 / 4

C. Calculate and discuss the effect on the financial risk of Bar Co of using the cash raised by the rights issue to buy back bonds, as measured by its interest coverage ratio and its book value debt to equity ratio.

4 / 4

D. Discuss the dangers to a company of a high level of gearing, including in your answer an explanation of the following terms:

(i) Business risk

(ii) Financial risk

(i) Business risk, the inherent risk of doing business for a company, refers to the risk of making only low profits, or even losses, due to the nature of the business that the company is involved in. One way of measuring business risk is by calculating a company’s operating gearing or ‘operational gearing’.

Operating gearing =                Contribution / Profit before interest and tax (PBIT)

The significance of operating gearing is as follows.

1 If contribution is high but PBIT is low, fixed costs will be high, and only just covered by contribution. Business risk, as measured by operating gearing, will be high.

2 If contribution is not much bigger than PBIT, fixed costs will be low, and fairly easily covered. Business risk, as measured by operating gearing, will be low.

 

(ii)

A high level of debt creates financial risk. This is the risk of a company not being able to meet other obligations as a result of the need to make interest payments. The proportion of debt finance carried by a company is therefore as significant as the level of business risk. Financial risk can be seen from different points of view.

1 The company as a whole. If a company builds up debts that it cannot pay when they fall due, it will be forced into liquidation.

2 Payables. If a company cannot pay its debts, the company will go into liquidation owing payables money that they are unlikely to recover in full.

3 Ordinary shareholders. A company will not make any distributable profits unless it is able to earn enough PBIT to pay all its interest charges, and then tax. The lower the profits or the higher the interest-bearing debts, the less there will be, if there is anything at all, for shareholders.

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Question 09 (Nugfer Co)

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266. Nugfer Co (Dec 10 – Amended)

The following financial position statement as at 30 November 2010 refers to Nugfer Co, a stock exchange-listed company, which wishes to raise $200m in cash in order to acquire a competitor.

  $m $m
Assets    
Non-current assets   300
Current assets   211
Total assets   511
Equity and liabilities    
Share capital 100  
Retained earnings 121  
Total equity   221
Non-current liabilities    
Long-term borrowings   100
Current liabilities    
Trade payables 30  
Short-term borrowings 160  
Total current liabilities   190
Total liabilities   290
Total equity and liabilities   511

The recent performance of Nugfer Co in profitability terms is as follows:

Year ending 30 November 2007 2008 2009 2010
  $m $m $m $m
Revenue 122.6 127.3 156.6 189.3
Operating profit 41.7 43.3 50.1 56.7
Finance charges (interest) 6.0 6.2 12.5 18.8
Profit before tax 35.7 37.1 37.6 37.9
Profit after tax 25.0 26.0 26.3 26.5

Notes:

(1) The long-term borrowings are 6% bonds that are repayable in 2012.

(2) The short-term borrowings consist of an overdraft at an annual interest rate of 8%.

(3) The current assets do not include any cash deposits.

(4) Nugfer Co has not paid any dividends in the last four years.

(5) The number of ordinary shares issued by the company has not changed in recent years.

(6) The target company has no debt finance and its forecast profit before interest and tax for 2011 is $28 million.

Required:

A. Evaluate suitable methods of raising the $200 million required by Nugfer Co, supporting your evaluation with both analysis and critical discussion.

Nugfer Co is looking to raise $200m in cash in order to acquire a competitor. Any recommendation as to the source of finance to be used by the company must take account of the recent financial performance of the company, its current financial position and its expected financial performance in the future, presumably after the acquisition has occurred.

 

Recent financial performance

The recent financial performance of Nugfer Co will be taken into account by potential providers of finance because it will help them to form an opinion as to the quality of the management running the company and the financial problems the company may be facing. Analysis of the recent performance of Nugfer Co gives the following information:

Year 2007 2008 2009 2010
Operating profit 41.7 43.3 50.1 56.7
Net profit margin 34% 34% 32% 30%
Interest coverage ratio 7 times 7 times 4 times 3 times
 Revenue growth   3.8% 23.0% 20.9%
Operating profit growth   3.8% 15.7% 13.2%
Finance charges growth   3.3% 101.6% 50.4%
Profit after tax growth   4.0% 1.2% 0.8%

Geometric average growth in revenue = (189.3/122.6)0.33 – 1 = 15.6%

Geometric average operating profit growth = (56.7/41.7)0.33 – 1 = 10.8%

One positive feature indicated by this analysis is the growth in revenue, which grew by 23% in 2009 and by 21% in 2010. Slightly less positive is the growth in operating profit, which was 16% in 2009 and 13% in 2010. Both years were significantly better in revenue growth and operating profit growth than 2008. One query here is why growth in operating profit is so much lower than growth in revenue. Better control of operating and other costs might improve operating profit substantially and decrease the financial risk of Nugfer Co.

The growing financial risk of the company is a clear cause for concern. The interest coverage ratio has declined each year in the period under review and has reached a dangerous level in 2010. The increase in operating profit each year has clearly been less than the increase in finance charges, which have tripled over the period under review. The reason for the large increase in debt is not known, but the high level of financial risk must be considered in selecting an appropriate source of finance to provide the $200m in cash that is needed.

 

Current financial position

The current financial position of Nugfer Co will be considered by potential providers of finance in their assessment of the financial risk of the company. Analysis of the current financial position of Nugfer Co shows the following:

Debt/equity ratio = long-term debt/total equity = 100 × (100/221) = 45%

Debt equity/ratio including short-term borrowings = 100 × ((100 + 160)/221) = 118%

The debt/equity ratio based on long-term debt is not particularly high. However, the interest coverage ratio indicated a high level of financial risk and it is clear from the financial position statement that the short-term borrowings of $160m are greater than the long-term borrowings of $100m. In fact, short-term borrowings account for 62% of the debt burden of Nugfer Co. If we include the short-term borrowings, the debt/equity ratio increases to 118%, which is certainly high enough to be a cause for concern. The short-term borrowings are also at a higher interest rate (8%) than the long-term borrowings (6%) and as a result, interest on short-term borrowings account for 68% of the finance charges in the statement of profit or loss.

 It should also be noted that the long-term borrowings are bonds that are repayable in 2012. Nugfer Co needs therefore to plan for the redemption and refinancing of $100m of debt in two years’ time, a factor that cannot be ignored when selecting a suitable source of finance to provide the $200m of cash needed.

 

Recommendation of suitable financing method

There are strong indications that it would be unwise for Nugfer Co to raise the $200m of cash required by means of debt finance, for example the low interest coverage ratio and the high level of gearing.

If no further debt is raised, the interest coverage ratio would improve after the acquisition due to the increased level of operating profit, i.e. (56.7m + 28m)/18.8 = 4.5 times. Assuming that $200m of 8% debt is raised, the interest coverage ratio would fall to ((84.7/(18.8 + 16)) = 2.4 times and the debt/equity ratio would increase to 100 × (260 + 200)/221 = 208%.

If convertible debt were used, the increase in gearing and the decrease in interest coverage would continue only until conversion occurred, assuming that the company’s share price increased sufficiently for conversion to be attractive to bondholders. Once conversion occurred, the debt capacity of the company would increase due both to the liquidation of the convertible debt and to the issuing of new ordinary shares to bond holders. In the period until conversion, however, the financial risk of the company as measured by gearing and interest coverage would remain at a very high level.

If Nugfer Co were able to use equity finance, the interest coverage ratio would increase to 4.5 times and the debt/equity ratio would fall to 100 × (260/(221 + 200)) = 62%. Although the debt/equity ratio is still on the high side, this would fall if some of the short-term borrowings were able to be paid off, although the recent financial performance of Nugfer Co indicates that this may not be easy to do. The problem of redeeming the current long-term bonds in two years also remains to be solved.

However, since the company has not paid any dividend for at least four years, it is unlikely that current shareholders would be receptive to a rights issue, unless they were persuaded that dividends would be forthcoming in the near future. Acquisition of the competitor may be the only way of generating the cash flows needed to support dividend payments.

A similar negative view could be taken by new shareholders if Nugfer Co were to seek to raise equity finance via a placing or a public issue.

Sale and leaseback of non-current assets could be considered, although the nature and quality of the non-current assets is not known. The financial position statement indicates that Nugfer Co has $300m of non-current assets, $100m of long-term borrowings and $160m of short-term borrowings. Since its borrowings are likely to be secured on some of the existing non-current assets, there appears to be limited scope for sale and leaseback.

Venture capital could also be considered, but it is unlikely that such finance would be available for an acquisition and no business case has been provided for the proposed acquisition.

While combinations of finance could also be proposed, the overall impression is that Nugfer Co is in poor financial health and, despite its best efforts, it may not be able to raise the $200m in cash that it needs to acquire its competitor.

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B. Briefly explain the factors that will influence the rate of interest charged on a new issue of bonds.

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Question 10 (Cozine Inc)

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267. Cozine Inc.

(a) Cozine Inc. has recently obtained a listing on the Stock Exchange. 90% of the company’s shares were previously owned by members of one family but, since the listing, approximately 60% of the issued shares have been owned by other investors.

Cozine’s earnings and dividends for the five years prior to the listing are detailed below:

Years prior to listing Profit after tax ($) Dividend per share (cents)
5 1,800,000 3.6
4 2,400,000 4.8
3 3,850,000 6.16
2 4,100,000 6.56
1 4,450,000 7.12
Current year 5,500,000 (estimate)  

The number of issued ordinary shares was increased by 25% three years prior to the listing and by 50% at the time of the listing. The company’s authorised capital is currently $25,000,000 in 25¢ ordinary shares, of which 40,000,000 shares have been issued. The market value of the company’s equity is $78,000,000.

The board of directors is discussing future dividend policy. An interim dividend of 3.16 cents per share was paid immediately prior to the listing and the finance director has suggested a final dividend of 2.34 cents per share.

The company’s declared objective is to maximise shareholder wealth.

Required:

(i) Comment upon the nature of the company’s dividend policy prior to the listing and discuss whether such a policy is likely to be suitable for a company listed on the Stock Exchange.

The first step is to try to determine exactly what is Cozine’s current dividend policy.

Year prior to listing Number of shares EPS Growth over previous year Dividend per share Payout ratio
5 21,333,333 8.44¢ − 3.6¢ 42.7%
4 21,333,333 (Note 2) 11.25¢ 33% 4.8¢ 42.7%
3 26,666,667 14.44¢ 28% 6.16¢ 42.7%
2 26,666,667 15.38¢ 6% 6.56¢ 42.7%
1 26,666,667 (Note 1) 16.69¢ 8.5% 7.12¢ 42.7%
Current 40,000,000 13.75¢ (est) –18% 5.5¢ (proposed) 40%

Note 1- 40,000,000 = 26,666,667 / 1.5

Note 2 – 26,666,667 =21333,333 / 1.25

Cozine appears to be adopting a policy of a fixed payout ratio of 42.7% pa over the five year period. In general such a policy can lead to wide variations in dividends per share. In Pavlon’s case over the last five years earnings have been rising and a continual (though declining) growth in dividend has resulted.

If it is believed that share price is affected by dividend policy then these fluctuations in dividends and the decline in growth could depress equity value.

Most listed companies attempt to adopt a stable or rising level of dividend per share even in the face of fluctuating earnings. This approach is taken in order to maintain investor confidence. If Cozine were to continue with its present policy and earnings were to decline the resultant dividend could have serious repercussions for share price.

2 / 3

(ii) Discuss whether the proposed final dividend of 2.34 cents is likely to be an appropriate dividend: о If the majority of shares are owned by wealthy private individuals; and о If the majority of shares are owned by institutional investors.

3 / 3

B. The company’s profit after tax is generally expected to increase by 15% per year for three years, and 8% per year after that. Cozine’s cost of equity capital is estimated to be 12% per year. Dividends may be assumed to grow at the same rate as profits.

Required:

Use the dividend valuation model to give calculations to indicate whether Cozine’s shares are currently under- or over-valued.

If the company’s profits and dividends are expected to increase initially by 15% pa then investors will expect this year’s dividend to be 7.12¢ × 1.15 = 8.188¢.

Value of first three years’ dividend

Year Dividend   PV factor 12% Present value
Current 7.12 × 1.15 = 8.188 0.893 7.312
2 8.188 × 1.15 = 9.416 0.797 7.505
3 9.416 × 1.15 = 10.829 0.712 7.710
        22.527

Note for simplicity we assume that the current dividend is one year hence.

Value of dividends years 4 – ∞

=  d(1+g)  = 10.829(1.08)  = 292.383

i – g        0.12 – 0.08

This gives the value of the perpetuity as at year 3. To obtain year 0 values we must discount back.

292.383 × 0.712 = 208.2

Value of share at time 0 = 22.527 + 208.2 = 231¢

Since the current market value of Cozine’s shares is $78m/40m = $1.95 the share appears to be undervalued.

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