ALL 15 questions are compulsory and MUST be attempted

Each question is worth 2 marks.

1. The owners of JKL (pvt) Ltd wish to dispose of their entire investment in the company. JKL has an issued share capital of $1m of $0.50 nominal value ordinary shares. The owners have made the following valuations of JKL's assets and liabilities:

The net realisable value of the non-current assets exceeds their book value by $3m. The current assets include $2m of accounts receivable which are thought to be irrecoverable.

What is the minimum price per share that the owners should accept for JKL (to the nearest whole $)?

2. Which TWO of the following are descriptions of basis risk?

3. Janice Co is switching from using mainly long-term fixed rate finance to fund its working capital to using mainly short-term variable rate finance.

Which of the following statements about the change in Janice Co's working capital financing policy is true?

4. Which of the following would you expect to be the responsibility of financial management?

5. Which TWO of the following government actions would lead to an increase in aggregate demand?

6. Which of the following is an advantage of implementing just-in-time inventory management?

7. Indicate, by ticking the relevant boxes, whether the following statements are true or false in relation to business valuation.

A. The earnings yield method and the dividend growth model should give similar values for a company

B. Market capitalization represents the maximum value for a company

C. The price/earnings ratio is the reciprocal of the earnings yield

D. The price/earnings ratio should be increased if the company being valued is riskier than the valuing company.

8. The price/earnings ratio should be increased if the company being valued is riskier than the valuing company.

9. Pentacle Co has announced that it will pay an annual dividend equal to 55% of earnings. Its earnings per share is $0.80, and it has ten million shares in issue. The return on equity of Pentacle Co is 20% and its current cum dividend share price is $4.60.

What is the cost of equity of Pentacle Co?

10. Which of the following statements about interest rate risk hedging are correct or incorrect?

A. An interest rate floor can be used to hedge an expected increase in interest rates.

B. The cost of an interest rate floor is higher than the cost of an interest rate collar.

C. The premium on an interest rate option is payable when it is exercised.

D. The standardised nature of interest rate futures means that overand under-hedging can be avoided.

11. Which TWO of the following are roles of the money market?

12. KEW Co is planning an investment of $10 million for a six-month period starting in three months' time.

KEW Co is worried about interest rates falling and hedges the risk using an appropriate forward rate agreement (FRA).

Details of the FRAs available to KEW Co are as follows:

6-9 FRA 2.80%-3.10%

3-9 FRA 3.00%- 3.20%

Assume that in three-months' time, interest rates are 3.50%.

Which of the following shows the correct impact on cashflow for KEW to settle the FRA?

13. Joui Co decides to offer an 4% early settlement discount that half of all customers take up. They pay in one month instead of the usual two. Joui Co pays interest on its overdraft facility at 12% per year.

What impact will this have?

A. Cash operating cycle

B. Accounting profit

14. A company has created an interest rate floor by purchasing an interest rate call option, in order to manage its interest rate exposure.

Which of the following statements concerning the company are true?

15. Which TWO of the following are limitations of using the dividend valuation method to value an unlisted company?

SECTION B

ALL 15 questions are compulsory and MUST be attempted

Each question is worth 2 marks.

The following scenario relates to questions 16 to 20.

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

16. Calculate the value of DNT Co using the earnings yield method.

17. Are the following statements true or false?

A. If the P/E ratio of DNT Co is lower than the average sector P/E ratio then the market does not view the growth prospects of DNT very favourably.

B. If the P/E ratio of DNT Co is higher than the average sector ratio then an acquisition by TML Co could result in improved financial performance of DNT Co

18. Using a cost of equity of 13% and a dividend growth rate of 4.5%, calculate the value of DNT Co using the dividend growth model.

19. Calculate the market capitalisation of DNT Co.

20. Which TWO of the following are true?

The following scenario relates to questions 21–25.

Syilvia Co currently has the following long-term capital structure:

The 8% loan notes are convertible into eight ordinary shares per loan note in seven years' time. If not converted, the loan notes can be redeemed on the same future date at their nominal value of $100. Syilvia Co has a cost of debt of 9% per year.

The ordinary shares of Syilvia Co have a nominal value of $1 per share. The current ex dividend share price of the company is $10.90 per share and share prices are expected to grow by 6% per year for the foreseeable future. The equity beta of Par Co is 1.2.

21. The loan notes are secured on non-current assets of Syilvia Co and the bank loan is secured by a floating charge on the current assets of the company.

Arrange the following sources of finance of Syilvia Co in order of the risk to the investor with the riskiest first.

Order of risk (1st, 2nd etc)

1 Redeemable preference shares

2 Loan notes

3 Bank loan

4 Ordinary shares

22. What is the conversion value of the 8% loan notes of Syilvia Co after seven years (to 2 decimal places)?

23. Assuming the conversion value after 7 years is $126.15, what is the current market value of the 8% loan notes of Syilvia Co?

24. Which of the following statements relating to the capital asset pricing model is correct?

25. Which TWO of the following statements are problems in using the price/earnings ratio method to value a company?

The following scenario relates to questions 26 to 30.

Boston Co has been prevented by the competition authorities from buying a competitor, Tesla Co, on the basis that this prevents a monopoly position arising. Boston Co has therefore decided to expand existing business operations instead and as a result the finance director has prepared the following evaluation of a proposed investment project for the company:

$m

Present value of sales revenue             6,657

Present value of variable costs             2,777

Present value of contribution               3,880

Present value of fixed costs                 1,569

Present value of operating cash flow   2,311

Initial capital investment                     1,800

Net present value                                   511

The project life is expected to be four years and the finance director has used a discount rate of 10% in the evaluation.

The investment project has no scrap value.

The finance director is considering financing the investment project by a new issue of debt.

26. What is the change in sales volume which will make the NPV zero?

27. Which of the following statements relating to sensitivity analysis is/are correct?

1. Although critical factors may be identified, the management of Boston Co may have no control over them.
2. A weakness of sensitivity analysis is that it ignores interdependency between project variables.
3. Sensitivity analysis can be used by Boston Co to assess the risk of an investment project.

28. Using the average investment method and assuming operating cash flows of $729,000 per year, what is the return on capital employed of the investment project?

29. Which of the following statements relating to debt finance is correct?

30. Which of the following statements relating to competition policy is/are correct?

SECTION C

BOTH questions are compulsory and MUST be attempted

31. Brick Co

Brick Co is a listed company in the house construction industry. Over the past five years results have been disappointing and as a result the share price has fallen from a high of $3.50 per share five years ago to only $1.05 per share today. This deterioration in the performance and share price has been accompanied by an increase in financial gearing to a high level.

Brick Co’s capital structure is as follows:

Brick Co's loan notes are quoted at $65 per loan note and both the loan notes and the bank loan are secured. Brick Co's equity beta is 2.3.

New venture

To improve performance, Brick Co is considering the construction of commercial properties such as office blocks and industrial complexes. This is a new activity for Brick Co and it is expected that the risks involved will be different from its current activity. The financial director has proposed that a project-specific discount rate should be used to appraise the new venture, but the commercial director does not believe this is necessary.

HCP Co. undertakes commercial construction projects similar to those being considered by Brick Co. HCP has an equity beta of 1.25. HCP has $100m of ordinary shares in issue, currently quoted at $2.60 per $1 nominal value ordinary share. The company also has $110m of loan notes in issue, currently quoted at $96 per $100 nominal value.

Both companies pay tax at 20%, the risk-free rate is 4% and the expected return on the market portfolio is 10%.

Required:

A.
(i) Using the Capital Asset Pricing Model, calculate Brick Co’s current cost of equity and a project-specific cost of equity suitable for the new venture.
(ii) Referring to your calculations above, comment briefly on the view of the commercial director.

B. Discuss THREE problems Brick Co may be facing as a result of its current high level of gearing.(

C. In respect of both equity and debt, discuss the risk-return relationship and how it affects Brick Co’s financing costs

32. JAVA Co

JAVA Co. is a small company that is finding it difficult to raise funds to acquire a new machine costing $750,000. JAVA Co would ideally like a four-year loan for the full purchase price at a before interest tax rate of 8.6% per year.

The machine would have an expected life of four years. At the end of this period the machine would have a residual value of $50,000. Tax-allowable servicing costs for the machine would be $23,000 per year. Tax-allowable depreciation on the full purchase price would be available on a 25% reducing balance basis.

A leasing company has offered a contract whereby JAVA Co could have use of the new machine for four years in exchange for an annual lease rental payment of $200,000 payable at the start of each year. The contract states that the leasing company would undertake maintenance of the machine at no additional cost to JAVA Co. At the end of four years the leasing company would remove the machine from the manufacturing facility of JAVA Co.

JAVA Co pays corporation tax of 30% one year in arrears.

Required

A. For the new machine:

(i) Calculate the present value of the cost of borrowing to buy.
(ii) Calculate the present value of the cost of leasing.
(iii) Recommend which option is more attractive in financial terms to JAVA Co.

B.
(i) Discuss general reasons why investment capital may be rationed.
(ii) Discuss ways in which the external capital rationing experienced by JAVA Co might be overcome.