Tulip Co (Mar/Jun 19)
The following scenario relates to questions 1–5.
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.
1. What is the cost of equity of Tulip Co using the capital asset pricing model?
2. Using estimates of 5% and 6%, what is the cost of debt of the convertible loan notes?
3. In relation to using the dividend growth model to value Tulip Co, which of the following statements is correct?
4. Which of the following statements about equity finance is correct?
5. 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
The following scenario relates to questions 6–10.
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.
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.
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.
6. 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.
7. 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.
8. 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.
9. 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.
B. Under M&M with corporation tax
C. At low levels of gearing under the traditional theory of gearing
10. 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?
The following scenario relates to questions 11–15.
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:
Required return on existing debt
Cost of existing debt to the bank
Return on short dated government securities
Return in the stock market
Equity beta of the bank
Beta of the new project
Asset beta of the bank
11. Which of the following risks could be correctly described as a systematic risk in this case?
12. In the CAPM what would be the value to use for the risk free rate of return (Rf), from the data above?
13. In the CAPM formula R = Rf + βj(Rm – Rf) where βj represents the project beta, R represents…………………..(the cost of equity capital/the required return on the new project) and the market risk premium is represented by……………… ((Rm – Rf)/Rm)
Pick the correct answers to complete the sentences.
15. What is the meaning of a beta value of 1?
The following scenario relates to questions 16–20.
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.
16. 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
17. 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?
18. What is the present value of the maintenance cash flows, after tax?
20. Which of the following statements about the potential effects of taking on a lease are true?
A. The use of leasing as opposed to purchasing an asset could turn a negative NPV project into a positive NPV one
B. If shareholders see that there is a significant lease in place then they may perceive an increase in risk