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

PFM 6-2

Question 01 (Yellow Plc)
Question 02 (JOJO Co)
Question 03 (Costco Co)
Question 04 (Bluebell Co)
Question 05 (Minn Inc)
Question 06 (Corhig Co)
Question 07 (Close Co)
Question 07 (Pronto Co)
Question 01 (NN Co)
Question 02 (Phobis Co)
Question 01 (Yellow Plc)

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1 / 8

Yellow plc

The following scenario relates to questions 297–301

Yellow plc is a growing company specialising in making accessories for mobile phones and tablets. The company is currently all-equity financed with 2 million ordinary shares in issue. The existing shareholders are mainly family members and friends. The directors of Yellow need to raise finance to fund a new factory and are considering a range of options including flotation and venture capital. Future growth is anticipated to be the following:

Earnings next year = $0.25m, expected to grow at 7% pa

Dividend next year = $0.14m, expected to grow at 4% pa

Flotation

Tulip plc, a listed company with similar business activities to Yellow has a P/E ratio of 9, an equity beta of 1.2 and gearing, measured as Debt: Equity of 1:2. Yellow is expected to grow faster than Tulip plc, at least in the short term.

If flotation is approved, then the issue share price would be set at a 15% discount to fair value. The directors of Yellow do not believe that an asset valuation is of much use here.

Venture capital

The directors of Yellow have been in discussion with 4Ts, a listed venture capital company. As well as contributing equity, 4Ts would seek to spread the risk of their investment by also investing in the form of 4–year 5% secured redeemable bonds and also convertible preference shares. The risk adjusted return on similar bonds has been estimated at 6%.

Corporation tax is currently 30%.

297. Which of the following statements, concerning the usefulness of asset based methods of business valuation, is correct?

2 / 8

298. Calculate the value of Yellow plc’s equity beta to 2 dp

3 / 8

299. Calculate the issue price of Yellow shares to the nearest cent using the dividend valuation model with a cost of equity of 14%.

4 / 8

300. What is the market value of the redeemable bonds?

5 / 8

301. Indicate whether the following statements concerning 4Ts’ perspective are true or false?

A. 4Ts will accept a lower level of dividends on the convertible preference shares compared to normal preference shares

6 / 8

B. The current shareholders of Yellow would be willing to sell a majority equity stake to 4Ts

7 / 8

C. 4Ts are likely to prefer to use CAPM in valuing Yellow shares

8 / 8

D. 4Ts’ investment in the preference shares will have the lowest risk out of the three methods of finance offered due to the option to convert.

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Question 02 (JOJO Co)

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1 / 5

JOJO Co

The following scenario relates to questions 302–306.

JOJO Co is an unlisted company that has performed well recently. It has been approached by a number of companies in the industry as a potential acquisition target.

The directors of JOJO Co are looking to establish an approximate valuation of the company.

Recent information on the earnings per share and dividend per share of JOJO Co is as follows:

Year to September 20X3 20X4 20X5 20X6
Earnings $m 6 6.5 7.0 7.5
Dividend $m 2.4 2.6 2.8 3.0

JOJO Co has an estimated cost of equity of 12% and $5m ordinary shares in issue with a par value of $0.50.

There has been no change in the number of ordinary shares in issue over this period.

JOJO Co pays corporation tax at a rate of 20%.

Listed companies similar to JOJO Co have a price/earnings ratio of 15.

302. What is the value of a share in JOJO Co using the dividend growth model?

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303. Which of the following statements are true in relation to problems in using the dividend growth model to value a company?

3 / 5

304. What is the value of JOJO Co using the price/earnings ratio method?

4 / 5

305. A high price/earnings ratio is usually seen as an indication that:

5 / 5

306. Which of the following statements are true about JOJO Co’s dividend policy?

1 Shareholders achieve steady dividend growth.

2 The dividend payout ratio is constant.

3 The dividend cover is 2.5.

4 Shareholders are indifferent between reinvesting in the business and the payment of a dividend.

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Question 03 (Costco Co)

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1 / 7

Costco Co

The following scenario relates to questions 307–311.

The finance director of Costco Co has been asked to provide values for the company’s equity and loan notes. Costco Co is a listed company and has the following long-term finance:

  $m
Ordinary shares 7.8
7% Convertible loan notes 8.0
  15.8

The ordinary shares of Costco Co have a nominal value of $0.25 per share and are currently trading on an ex-dividend basis at $7.10 per share. An economic recovery has been forecast and so share prices are expected to grow by 8% per year for the foreseeable future.

The loan notes are redeemable after six years at their nominal value of $100 per loan note, or can be converted after six years into 10 ordinary shares of Costco Co per loan note. The loan notes are traded on the capital market.

The before-tax cost of debt of Costco Co is 5% and the company pays corporation tax of 20% per year.

307. What is the equity market value of Costco Co (to two decimal places)? $

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308. Assuming conversion, what is the market value of each loan note of Costco Co?

3 / 7

309. Which of the following statements about the equity market value of Costco Co is/are true?

1) The equity market value will change frequently due to capital market forces.

2) If the capital market is semi-strong form efficient, the equity market value will not be  affected by the release to the public of insider information.

3) Over time, the equity market value of Costco Co will follow a random walk.

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310. Indicate, by clicking in the relevant boxes, whether the following are assumptions that are made by the dividend growth model.

A. Investors don’t make rational decisions

5 / 7

B. Dividends show either constant growth or zero growth

6 / 7

C. The dividend growth rate is less than the cost of equity

7 / 7

311. Why might valuations of the equity and loan notes of Costco Co be necessary?

1 The company is planning to go to the market for additional finance.

2 The company has received a takeover bid from a rival company.

3 The securities need to be valued for corporate taxation purposes.

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Question 04 (Bluebell Co)

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1 / 5

Bluebell Co (Mar/Jun 19)

The following scenario relates to questions 312–316.

Extracts from the financial statements of Bluebell Co, a listed company, are as follows:

  $m
Profit before interest and tax 238
Finance costs (24)
Profit before tax 214
Corporation tax (64)
Profit after tax 150
  $m
Assets  
Non-current assets  
Property, plant and equipment 768
Goodwill (internally generated) 105
  873
Current assets  
Inventories 285
Trade receivables 192
  477
Total assets 1,350
Equity and liabilities  
Total equity 688
Non-current liabilities  
Long-term borrowings 250
Current liabilities  
Trade payables 312
Short-term borrowings 100
Total current liabilities 412
Total liabilities 662
Total equity and liabilities 1,350

A similar size competitor company has a price/earnings ratio of 12.5 times.

This competitor believes that if Bluebell Co were liquidated, property, plant and equipment would only realise $600 million, while 10% of trade receivables would be irrecoverable and inventory would be sold at $30 million less than its book value.

Separately, Bluebell Co is considering the acquisition of Dandelion Co, an unlisted company which is a supplier of Bluebell Co.

312. What is the value of Bluebell Co on a net realisable value basis?

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313. What is the value of Bluebell Co using the earnings yield method?

3 / 5

314. When valuing Bluebell Co using asset-based valuations, which of the following statements is correct?

4 / 5

315. Which of the following is/are indicators of market imperfections?

1 Low volume of trading in shares of smaller companies

2 Overreaction to unexpected news

5 / 5

316. Which of the following statements is correct?

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Question 05 (Minn Inc)

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1 / 7

Minn Inc

The following scenario relates to questions 317–321.

Daniel Fred is a fund manager within Minn Inc, a global investment company. He has recently identified the following potential acquisition targets:

Company P is an unquoted, property development company with a portfolio of over two hundred houses at various stages of renovation. It has been loss making for the last two years due to the economic downturn. Daniel believes that new government legislation will bring a welcome boost to the housing market.

Company Q  is an unquoted shoe manufacturer. It has also suffered in the recent recession but the directors are confident that the company is past the worst and growth lies ahead:

  • Earnings are expected to be $12.5 million next year and expected to grow at 2% per annum
  • Dividends will be $5 million for each of the next three years and then expected to grow at 3% thereafter.

Daniel has located a similar listed company that has an earnings yield of 12% and a cost of equity of 14%.

Company R is a quoted fashion retailer. Daniel believes that the current share price of $2.58 undervalues the company significantly, making it a suitable target. He is also interested in Company R as he feels it would have a good fit with his existing fund portfolio and would diversify away some risk.

317. Which of the following valuation methods is most suitable for valuing Company P?

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318. Calculate the value of company Q using the dividend valuation model.

3 / 7

319. Calculate the value of Company Q by reference to its predicted earnings, in millions of dollars, to one decimal place.

4 / 7

320. Which of the following statements concerning Daniel’s opinion that Company R is undervalued is true?

5 / 7

321. Indicate, by clicking in the relevant boxes, whether the following statements concerning whether Daniel should buy Company R to diversify away portfolio risk are true or false.

A. The shareholders of Minn Inc. are unlikely to value such diversification

6 / 7

B. Daniel should always try to reduce the average beta of his portfolio

7 / 7

C. Daniel should seek to diversify away any systematic risk in his portfolio

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Question 06 (Corhig Co)

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1 / 8

Corhig Co (6/12, amended)

The following scenario relates to questions 322–326.

Corhig Co is a company that is listed on a major stock exchange. The company has struggled to maintain profitability in the last two years due to poor economic conditions in its home country and as a consequence it has decided not to pay a dividend in the current year. However, there are now clear signs of economic recovery and Corhig Co is optimistic that payment of dividends can be resumed in the future. Forecast financial information relating to the company is as follows:

Year 1 2 3
Earnings ($’000) 3,000 3,600 4,300
Dividends ($’000) nil 500 1,000

The current average price/earnings ratio of listed companies similar to Corhig Co is five times.

The company is optimistic that earnings and dividends will increase after Year 3 at a constant annual rate of 3% per year.

322. Using Corhig Co’s forecast earnings for Year 1 and the average P/E ratio of similar companies, what is the value of Corhig Co using the price/earnings ratio method?

2 / 8

323. Are the following statements true or false?

A. A P/E valuation using average earnings of $3.63m would be more realistic than the P/E ratio method calculated above.

3 / 8

B. Using the average P/E ratio of similar companies is appropriate in this situation.

4 / 8

234. Assuming that the cost of equity is 12%, what is the present value of Corhig Co’s Year 2 dividend?

5 / 8

325. Corhig Co plans to raise debt in order to modernise some of its non-current assets and to support the expected growth in earnings. This additional debt would mean that the capital structure of the company would change and it would be financed 60% by equity and 40% by debt on a market value basis. The before-tax cost of debt of Corhig Co would increase to 6% per year. In order to stimulate economic activity the Government has reduced the tax rate for all large companies to 20% per year.

Assuming that the revised cost of equity is 14%, what is the revised weighted average aftertax cost of capital of Corhig Co following the new debt issue (give your answer to 2 decimal places)?

6 / 8

326. Match the description of the risk to the type of risk.

A. Risk linked to the extent to which the company’s profits depend on fixed, rather than variable, costs

7 / 8

B. Risk that shareholder return fluctuates as a result of the level of debt the company undertakes

8 / 8

C. Risk that shareholder cannot mitigate by holding a diversified investment portfolio

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Question 07 (Close Co)

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Close Co (12/11, amended)

The following scenario relates to questions 327–331.

Recent financial information relating to Close Co, a stock market listed company, is as follows.

  $m
Profit after tax (earnings) 66.6
Dividends 40.0

STATEMENT OF FINANCIAL POSITION INFORMATION

  $m $m
Non-current assets   595
Current assets   125
Total assets   720
Equity    
Ordinary shares ($1 nominal) 80  
Retained earnings 410  
    490
Non-current liabilities    
6% bank loan 40  
8% bonds ($100 nominal) 120  
    160
Current liabilities   70
Total equity and liabilities   720

Financial analysts have forecast that the dividends of Close Co will grow in the future at a rate of 4% per year. This is slightly less than the forecast growth rate of the profit after tax (earnings) of the company, which is 5% per year. The finance director of Close Co thinks that, considering the risk associated with expected earnings growth, an earnings yield of 11% per year can be used for valuation purposes.

Close Co has a cost of equity of 10% per year.

327. Calculate the value of Close Co using the net asset value method.

2 / 5

328. Calculate the value of Close Co using the dividend growth model (DGM).

3 / 5

329. Calculate the value of Close Co using the earnings yield method (in millions to 1 decimal places).

4 / 5

330. The DGM has been used by financial analysts to value Close Co. Are the following statements about the DGM true?

5 / 5

331. Close Co is considering raising finance via convertible bonds. Which of the following statements is correct about the current market value of a convertible bond where conversion is expected?

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Question 07 (Pronto Co)

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Pronto Co.

The following scenario relates to questions 332–336.

It is now 1st January 20X9 . UPC Co is looking make a bid for entire share capital of Pronto Co, a small family-owned company that makes specialist gears for high performance racing bikes. Pronto Co’s products have had a niche but loyal customer base for many years but demand started to soar in late 20X6 when it was revealed that all the gold medal winners in the cycling events at the Olympics were using a new revolutionary gear type developed and patented by Pronto Co. The sale has been agreed in principle but a valuation still needs to be agreed for Pronto Co. The following information is available:

Pronto Co – Statement of Financial Position

  Note $000s
Non-current assets 1 400
Current assets 2 50
Total assets   450
Share capital (50 cent ords.)   100
Reserves   170
Bank Loans – repayable 20X8   140
Current liabilities   40
Total equity and liabilities   450

Note 1: Included in non-current assets is specialist machinery that has a NBV of $100,000, would cost $500,000 to replace but would only be able to be sold for scrap of $25,000 if disposed of.

Note 2: Current assets have a net realisable value of $40,000

Pronto Co – Summary statements of financial position

$000s 20X4 (audited) 20X5 (audited) 20X6 (audited) 20X7 (audited) 20X8 (unaudited) 20X9 (forecast)
Profit after tax (10) 20 60 130 140 156
Dividends paid – 10 30 65 70 78

A similar quoted company has been found that has a cost of equity of 15% and a quoted P/E ratio of 10.

332. Calculate the asset value of Pronto Co’s shares using net realisable value

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333. Calculate the asset value of Pronto Co’s shares using replacement cost.

3 / 5

334. Indicate, by clicking in the relevant boxes, whether the following statements concerning the use of asset valuations for Pronto Co with the information given are true.

4 / 5

335. Calculate the share price of Pronto Co using earnings

5 / 5

336. What growth rate should be used if estimating the value of Pronto Co using the dividend valuation model? Give your answer as a percentage to 1 dp.

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Question 01 (NN Co)

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1 / 4

337. NN C (Dec 10 – Amended)

The following financial information refers to NN Co:

Current statement of financial position

  $m $m
Assets    
Non-current assets   101
Current assets    
Inventory 11  
Trade receivables 21  
Cash 10  
    42
Total assets   143
Equity and liabilities    
Ordinary share capital 50  
Preference share capital 25  
Retained earnings 19  
Total equity   94
Non-current liabilities    
Long-term borrowings   20
Current liabilities    
Trade payables 22  
Other payables 7  
Total current liabilities   29
Total liabilities   49
Total equity and liabilities   143

NN Co has just paid a dividend of 66 cents per share and has a cost of equity of 12%. The dividends of the company have grown in recent years by an average rate of 3% per year. The ordinary shares of the company have a par value of 50 cents per share and an ex div market value of $8.30 per share.

The long-term borrowings of NN Co consist of 7% bonds that are redeemable in six years’ time at their par value of $100 per bond. The current ex interest market price of the bonds is $103.50.

The preference shares of NN Co have a nominal value of 50 cents per share and pay an annual dividend of 8%. The ex div market value of the preference shares is 67 cents per share.

NN Co pay profit tax at an annual rate of 25% per year.

Required:

A. Calculate the equity value of NN Co using the following business valuation methods:

(i) the dividend growth model

(ii) net asset value.

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B. Calculate the after-tax cost of debt of NN Co.

The after-tax cost of debt of NN Co can be found by linear interpolation

The annual after-tax interest payment = 7 × (1 – 0.25) = 7 × 0.75 = $5.25 per year

Year Cash flow ($) 5% Discount factor Present value ($)
0 (103.50) 1.000 (103.50)
1–6 5.25 5.076 26.65
6 100 0.746 74.60
      (2.25)

 

Year Cash flow ($) 4% Discount factor Present value ($)
0 (103.50) 1.000 (103.50)
1–6 5.25 5.242 27.52
6 100 0.790 79.00
      3.02

After-tax cost of debt = 4 + [(1 × 3.02) / (3.02 + 2.25)] = 4 + 0.57 = 4.6%

3 / 4

C. Calculate the weighted average after-tax cost of capital of NN Co.

4 / 4

D. Explain the concept of market efficiency and distinguish between strong form efficiency and semi-strong form efficiency.

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Question 02 (Phobis Co)

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1 / 3

338. Phobis Co. (Dec 07 – Amended)

(a)

Phobis Co is considering a bid for Danoca Co. Both companies are stock-market listed and are in the same business sector. Financial information on Danoca Co, which is shortly to pay its annual dividend, is as follows:

Number of ordinary shares 5 million
 Ordinary share price (ex div basis) $3.30
Earnings per share 40.0c
Proposed payout ratio 60%
Dividend per share one year ago 23.3c
Dividend per share two years ago 22.0c
Equity beta 1.4

Other relevant financial information

Average sector price/earnings ratio 10
Risk-free rate of return 4.6%
Return on the market 10.6%

Required:

Calculate the value of Danoca Co using the following methods:

(i) price/earnings ratio method

(ii) dividend growth model

and discuss the significance, to Phobis Co, of the values you have calculated, in comparison to the current market value of Danoca Co.

2 / 3

B. Phobis Co has in issue 9% bonds which are redeemable at their par value of $100 in five years’ time. Alternatively, each bond may be converted on that date into 20 ordinary shares of the company. The current ordinary share price of Phobis Co is $4.45 and this is expected to grow at a rate of 6.5% per year for the foreseeable future. Phobis Co has a cost of debt of 7% per year.

Required:

Calculate the following current values for each $100 convertible bond:

(i) market value

(ii) floor value

(iii) conversion premium.

3 / 3

C. Discuss the significance to a listed company if the stock market on which its shares are traded is shown to be semi-strong form efficient.

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