Revision Package: AF208

Note below your Final Exam Coverage:

Section A:

40 Multiple Choice: Chapter 7-13 (40 marks)

Section B: 30 marks
Chapters 7,10,11,12 and 13
Section C: 30 marks
Case Study: Chapters 8 and 9
Chapter 7: Cost of Capital

Financial Problem 7.13

Given a 30% corporate tax rate and the following information for Pitosporum Ltd:
10,000 bonds with a face value of $100, a coupon rate of 12 per cent, an issue price of $92.30, and
5 years to maturity. Coupons are paid semi-annually. Use the approximate cost of debt method.

70,000 11 per cent preference shares with a face value of $2 and net proceeds of $1.86.

500,000 ordinary shares with an issue price of $3.00, dividend growth rate 1 per cent per annum
in perpetuity. The last dividend was $0.15 and the next dividend is due in about 1 year. Flotation
costs will be 3.5% of the issue price.

Calculate the cost of each source of finance if the marginal investor is an Australian resident who
can fully utilise imputation credits. Using the weightings associated with issuing the proposed
amount of each security, calculate the weighted average cost of capital.

Working

(100  92.30)
6
k d ,bt  10  7.04%
(100  92.30)
2
Because the coupon payments are made semi-annually, the kd calculated is the cost of debt for 6
months. To convert this to an annual cost, we need to use the effective rate

k eff  1  0.0704  1  14.58%

2

D
(1  t c )
k p ,bt 
NPp

0.22
(1  0.30)
k p ,bt   16.9%
1.86
0.15(1  0.01)
(1  0.30)
k e,bt   0.01  8.48%
3.00(1  0.035)
 n
WACC   k xWx
x 1

Amount of Weighted
Source of funds financing Wx kx (%) cost
Debt 923 000 0.369 14.58 5.3807
Preference shares 130 200 0.052 16.9 0.8788
Ordinary equity 1 447 500 0.579 8.48 4.91
2 500 700 1 11.17%

(b) Calculate the cost of each source of finance if the marginal investor is an overseas resident.
Using the weightings associated with issuing the proposed amount of each security, calculate the
weighted average cost of capital.

k d ,at  0.14581  0.30  10.206

D
k p ,at 
NPp

0.22
k p ,at   11.83%
1.86
0.15(1  0.01)
k e,at   0.01  6.23%
3.00(1  0.035

Amount of Weighted
Source of funds financing Wx kx (%) cost
Debt 923 000 0.369 10.206 3.766
Preference shares 130 200 0.052 11.83 0.615
Ordinary equity 1 447 500 0.579 6.23 3.607
2 500 700 1 7.988%
Chapter 9 Planning Investments: Some Real World complications
New York Pizza is considering replacing an existing oven with a new, more sophisticated oven. The
old oven was purchased three years ago at a cost of $20,000, and this amount was being depreciated
under MACRS using a 5-year recovery period. These are the depreciating rates per year:
5- year %
1 20
2 32
3 19.2
4 11.52
5 11.52
6 5.76

The oven has five years of usable life remaining. The new oven being considered costs $30,500,
requires $1,500 in installation costs, and would be depreciated under MACRS using 5-year recovery
period. The old oven can currently be sold for $22,000 without incurring any removal or cleanup costs.
The firm pays taxes at a rate of 40 percent on both ordinary income and capital gains. The revenues and
expenses (excluding depreciation) associated with the new and the old machines for the next five years
are given in the following table.
New Oven Old Oven

Year Revenue Expenses Year Revenue Expenses

(exclude. (exclude.
Depreciation) Depreciation)

1 $300,000 $288,000 1 $270,000 $264,000

2 $300,000 $288,000 2 $270,000 $264,000

3 $300,000 $288,000 3 $270,000 $264,000

4 $300,000 $288,000 4 $270,000 $264,000

5 $300,000 $288,000 5 $270,000 $264,000

The discount rate of 10% is used.

Required:
1. Calculate the initial cash outflow associated with replacement of the old oven by the new
one.
2. Determine the incremental cash flows associated with the proposed replacement. Be sure
to consider the depreciation in year 6.

3. Should the replacement take place?

Chapter 10: Short Term Finance: Working Capital

Financial Problem 10.10

James Soo decides to buy an already issued promissory note in the market. She buys a $200 000
note to yield 5.95%. The note has 67 days to maturity. How much does Jamie pay?

200 000 200 000

P = = $197 843.51
 67  1.0109
1  0.0595  
 365 

Financial Problem 10.9

Bill Smith Sportstore has funds to invest for a short period. Bill, the owner, approaches his bank
and finds he can lend funds to other businesses for short periods via the bank-accepted bill
medium. Bill is happy that there is little risk with the bank acceptance of the security. Bill pays
over the funds to finance a $100 000 commercial bill for 180 days at 6.3% yield. How much does
Bill pay to the bank? How much will Bill be repaid at the end of the period?

100 000 100 000

P = = $96 983.80
 180  1.0311
1  0.063  
 365 

Repayment = $100 000

Chapter 11: Managing Current Assets
11.10 Billabong Bagel Bakery specialises in making bagels to an original Jewish recipe, but adds
distinctive Australian flavours such as wattle seed and lemon myrtle. Wattle seed is harvested
seasonally from a number of species that produce edible seed. Billabong uses about 52 kg of seed
a year and does not like to run out of supplies. Seed is packed in 100 g packets; there are no bulk
packs. Additionally, seed must be kept refrigerated to retain the best flavour. Billabong estimates
that order costs average $30 because often it takes an hour of an employee’s time and several
phone calls to different sellers to find supplies. Holding costs are also relatively high at $5 per 100
g due to the need for refrigeration.
What is the EOQ?

2 DO
Q
H

2  520  30
Q
5

Q  6240

= 79 packets

11.19 A Woolies Petroleum outlet has a throughput of 140 000 litres of ULP fuel each week.
Purchases are always made in multiples of 1000 litres. Holding costs including evaporation
and variation in volumes due to temperature changes are estimated to be $10 per 1000
litres. Ordering costs are $1 per order. What is the EOQ, calculated on weekly data?

2  140  1
Based on 1000 litre units, Q  = 5.29 × 100 litres = 5290 litres
10
Chapter 12: Long Term External Finance
12.2 Dog-eared Books buys and sells second-hand paperback books. The manager needs to
reorganise the business’s finances from short-term to long-term debt. She decides to take
out an FDA for $50 000 at 7.5% p.a., compounded monthly over 4 years. She also agrees
to repay the loan on a fixed monthly schedule. What is the monthly payment?
PVAn
C
[1  (1  k ) n ]
k
50,000
C
0.075  48
[1  (1  ) ]
12
0.075
12
50 000
= = $1208
41.3584
12.9 Greenridge Nursery has just contracted to supply eucalypt seedlings in tubes to five
mining companies for their landscape rehabilitation work after open-cut mining. The
contracts are for the supply of 20 000 tubes monthly for the next 3 years. Greenridge
needs to upgrade its propagation house, including the hotbeds and watering system, and to
increase the size of its growing out area and its automatic watering system. The expansion
works will cost $100 000. Greenridge is offered lease finance for $100 000 over 2 years or 3
years, with lease payments due semi-annually, starting immediately. The lease finance is
available at 9.00% pa.

(a) What is the amount of each lease payment with the 3-year option with no residual?


 1  1  0.0455 
100 000  C  C  

 0.045 
100 000  C  C  4.3900
100 000  C  4.3900  C  5.39C
100 000
C  $18 552.95
5.39
 (b) What is the amount of each lease payment with the 2-year option with no residual?


 1  1  0.0453 
100 000  C  C  

 0.045 
100 000  C  C  2.749
100 000  C  2.749  C  3.749C
100 000
C  $26 674.03
3.749

(c) What is the amount of each lease payment with the 3-year option with a $20 000
residual payable 3 years from now?

The $20 000 residual has a PV of $15 357.91. The PV of the lease is $84 642.09


 1  1  0.0455 
84 642.09  C  C  

 0.045 
84 642.09  C  C  4.3900

84 642.09  C  4.3900  C = 5.39C

84 642.09
C = $15 703.54
5.39
(d) What is the amount of each lease payment with the 2-year option with a $20 000
residual payable 2 years from now?

The $20 000 residual has a PV of $16 771.23. The PV of the lease is $83 228.77


 1  1  0.0453 
83 228.77  C  C  

 0.045 
83 228.77  C  C  2.749

83 228.77  C  2.749  C = 3.749C

83 228.77
C = $22 200.26
3.749
12.14 AON is a South Australian biotechnology company that develops vaccines. It needs to
raise $20 million to fund new research. It has 10 million ordinary shares on issue, and
these are currently selling on the ASX for $13.20. The directors decide to make a 1-for-5
rights issue at $10 subscription. What are the theoretical ex-rights and rights prices?

N Pm  S  NPm  S
Using equations 12.2 and 12.1 RP  and Px 
N 1 N 1

NPm  S
Px 
N 1
5  13.20  10 76
Px   = $12.67
6 6
N Pm  S 
RP 
N 1
513.20  10 16
RP   = $2.67
6 6

Chapter 13 Dividend Policy

13.4 Suppose a typical shareholder of Central Coast Bank (CCB) hold shares for more than 12
months and pay 45 cents of personal tax on each dollar of additional ordinary income. The
company has just announced a fully franked dividend of $1.50 per share. The company
tax rate is 30%. CCB shares are currently selling at a cum-dividend price of $20 per
share. Estimate the ex-dividend price of CCB shares.

The difference between the cum-dividend and the ex-dividend price can be
expressed as

 (1 - t p ) 
PCD - PXD  D  
 (1  t c )(1  t g ) 

Thus, the ex-dividend price is:

  (1 - t p ) 
PXD  PCD  D  
 (1  t c )(1  t g ) 
 (1 - 0.45) 
 $20  $1.50 
 (1  0.30)(1  0.452 ) 
= $18.48
13.5 In question 13.4, if the typical investor of CCB shares holds shares for less than 12
months, what would be your estimate of the ex-dividend price.

 (1 - 0.47) 
PXD  20  1.50 
 (1  0.30)(1  0.47) 
= $17.86
Error 0.45 instead of 0.47

13.6 Bell Corporation has 1 million ordinary shares outstanding and a price-earnings multiple
of 25. The firm’s annual earnings is $500 000. It is considering a 20% bonus share issue to
supplement its current low cash dividend policy.
(a) What is the firm’s current share price? How will it be affected by the proposed bonus
share issue?
(b) Suppose you hold 100 Bell shares. What will be the impact of a bonus issue on the total
value of your shares?

P
Current share price =    EPS  25 
$500 000
(a)
E 1 000 000

= $12.50

A 20% bonus issue will decrease Bell share price from $12.50 to $10.42
[= $12.50/1.20]

(b) The market value of 100 shares prior to the bonus issue was $1250 [= $12.50 – 100]. Following
the bonus issue the investor will receive 20 additional shares but the share price will be reduced to
$10.42, leaving the total value of the portfolio unchanged [$10.42 – 120 = $1250].
13.4 Explain the dividend irrelevance arguments advanced by Miller and Modigliani?

The dividend irrelevance arguments are based on the assumptions that the investment decisions of a
firm can be made independently of the dividend decisions and capital markets are perfect. The value of
a company depends on the investment decisions not on the dividend decisions. A company that pays a
high dividend is likely to provide a lower future growth and capital gain than a comparable company
with a low dividend policy. However, in a perfect capital market with no taxes, no transaction costs and
the same borrowing and lending rate, investors are indifferent over receiving dividends and capital
gains. They are concerned with total return, not the composition of total return. Thus, the dividend
policy might influence the temporal pattern of cash flows but not the value of the company because
shareholders can change the temporal pattern of cash flows for themselves by buying or selling shares.

13.5 ‘The investment decision is separable from dividend decision.’ Do you agree with this
statement? Explain your answer.

This statement holds in a perfect capital market. If a company can borrow or lend funds at the same rate
and raise capital from external sources to finance any project with a positive net present value, a change
in dividend policy will not affect its ability to invest. In this case, investment decisions are independent
of dividend decisions. However, in an imperfect capital market with transaction costs, the cost of
internal equity is like to be less than the cost of external equity, and the company’s ability to raise
external capital depends on its risk characteristics, earnings history and future growth prospects. Hence,
the company’s investment decisions might depend on its dividend decisions. A high dividend policy
may induce a company to decrease investment in an imperfect capital market.