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?

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

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

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

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

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.

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

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.

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.

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

B. Under M&M with corporation tax

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

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?

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

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

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

250. In the CAPM formula R = R_f + β_j(R_m – R_f) where β_j 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……… ((R_m – R_f)/R_m)

Pick the correct answers to complete the sentences.

A.

B.

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

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

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

B. Statement by the managing director

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?

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

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

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

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:

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.

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

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

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

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

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

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.

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

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

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

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:

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.

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

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

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).

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

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

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

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:

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.

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.

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%.

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:

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.

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

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