Examination Information

This is a three hour closed book written examination, worth 50% towards your final grade. The examination will contain 6 questions of equal marks, covering computational and discursive aspects of the syllabus. You will be required to answer any 4 questions. Note that a greater depth of knowledge than in the in-class test will be required to gain reasonable marks. Remember that the revision pack should not be used exclusively for your revision. You are expected to use all your lecture, seminar and in-class test materials as well.

Revision Session 1 Topics (Corporate objectives /Capital market /Capital structure / Dividend policy) Lecture Question Seminar Question (Q1) and (Q4) (Q2)

Revision Session 2 Topics (Portfolio theory / CAPM / Foreign exchange risk / Working capital management/ Mergers & Acquisitions) Lecture Question Seminar Question (Q16) (Q6)

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Question 1 (Lecture Question) On February 10th SBU plc shares were listed on the stock exchange at 120p. There were 25 million 25p shares in issue at that date. On February 11th SBU announced to the press that it had unexpectedly discovered a new deposit of minerals with a net present value of 7.25 million. On February 17th the company announced that it was intending to raise 4m to finance development of the deposit by means of a rights issue which was to be priced at 80p. Required: a) Assuming the market is semi-strong form efficient, calculate the market capitalization on February 11th after the announcement to the press. b) How many shares will be issued to raise the 4 million? c) Calculate the market capitalization of the company after the rights issue. d) What is the Theoretical Ex-rights Price? e) At what price are the rights likely to be traded? f) Why do companies issue rights at a discount? g) Why do companies normally make rights issues for new equity capital rather than public issues? Question 2 (Tutorial Question) TC plc has 20 million ordinary shares of 50p each in issue. These shares are listed on the stock exchange at 160p. The directors of the company require additional long-term capital and have decided to make a one-for-four rights issue at 130p per share. An investor with 2,000 shares in TC has contacted you for investment advice. She is undecided whether to take up the rights issue, sell the rights, or allow the rights offer to lapse. She also informs you that she has savings of 1,000 in the bank. Required: a) Calculate the theoretical ex-rights price of an ordinary share b) Calculate the value at which the rights are likely to be traded. c) Evaluate each of the options being considered by the investor. d) From the companys viewpoint, how critical is the pricing of a rights issue likely to be? Question 3 Three senior directors of Engot plc are discussing the companys financial gearing. Mr A believes that the financial gearing is 89%, Dr B believes that it is 134% and Ms C believes it is 134%. Summarised Consoloditated Balance sheet as at 31 December 2002 Fixed Assets Current Assets Stock 000 16,700 7,040 2|Page

Debtors Cash at bank and in hand Creditors: anounts falling due within one year 8% loan stock 2003 Bank loans and overdrafts Trade Creditors Corporation Tax Proposed Dividends Accruals and deferred income 2,860 Net current liabilities Total Assets less current liabilities 970

4,800 2,700 14,540 1,000 2,800 7,200 1,410 510 15,510

15,730

Creditors: Amounts falling due after more than one year Bank Loans (5,600) 12% Debentures repayable 2017 (1,800) NET ASSETS 8,330

Capital and Reserves Called up share Capital (10p Nominal Value) 2,200 Share premium account 1,940 Revenue Reserves 4,190 Shareholders Funds Current Market Data for Engot plc: Ordinary share price 94p 8% loan stock 98 12% debentures price 108 8,330

You are required to: a) explain how each director has estimated the financial gearing and suggest how each director might argue that his/hers is the most appropriate measure of financial gearing. State with reasons which measure of gearing you prefer. b) Explain why financial gearing might be important to a company. c) Discuss what factors might limit the amount of debt finance that a company uses. Answer - Question 3 a) Financial gearing is a measure of the proportionate relationship between a companys borrowings and its equity finance, i.e. it is a measure of capital structure. There are a number of ways in which gearing may be calculated: either expressing debt as a proportion of total finance or as a proportion of equity. It can also be measured either using book values or market values. In addition, the debt may be calculated to include all 3|Page

borrowings, or simply, those that are deemed to be part of the companys long-term financing. The three gearing ratios have been calculated in the following ways: Mr A is basing the gearing ratio on long-term loans and equity at book value. He is excluding short-term borrowings. 5,600 + 1,800 = 89% 8,330 Dr B is basing the gearing ratio on book values and including all borrowings including shortterm. 5,600 + 1,800 + 1,000 + 2,800 = 134% 8,330 Ms C is basing the gearing ratio on market values and including all borrowings including shortterm: Market value of equity = Number of shares X share price = 22,000,000 X 94p = 20,680,000 Market value of loan stock = 1,000,000 x 98/100 = 980,000 Market value of debentures = 1,800,000 x 108/100 = 1,944,000 5,600 + 1,944 + 980 + 2,800 = 55% 20,680
Note: the market value of equity includes all shareholders funds and so the share premium account and retained profit should not be added.

b) Financial gearing is important for a company as: i. High gearing increases the risk perceived by ordinary shareholders since interest payments are paid first from operating profits and thus cause earnings attributable to ordinary shareholders to fluctuate more significantly. In addition, in the event of liquidation, debt holders have priority over the assets of the company. ii. A company that has a high level of debt may encounter difficulties in raising further finance. iii. At very high levels of gearing the risk of default on interest payments or redemption becomes greater with the associated risk of bankruptcy. iv. The companys weighted average cost of capital is likely to increase at very high levels of gearing and the company value will fall. c) Factors which might limit the amount of debt finance that a company may use include the following: i. Existing loan covenants or clauses in the companys Articles of Association may limit further borrowing. ii. Inadequate cashflows and interest cover may prevent lenders from being willing to subscribe to further debt. iii. The company may have no further assets to offer as security for debt. iv. Higher risk is associated with high gearing and therefore new borrowings may demand a return which is too high for the company to afford . Question 4 (Lecture Question) (a) The Dumas company, an all equity financed company have maintained a constant dividend policy over the last six years. They have just paid a dividend of 40p on a current share price of 2. 4|Page

Required Determine the company's cost of equity capital (b) The company wishes to undertake a project and is going to finance it by issuing 2 million of 6% irredeemable debentures at par allowing the company to continue the same dividend policy. There are currently 4 million ordinary shares in issue, but due to the debt financing the share price will drop to 1.80. The company pays corporation tax at 40%pa. Required Determine the company's weighted average cost of capital. (c) If instead of issuing debt the company reduces the dividend paid to 30p to assist in financing a new project, instead of taking on debt financing. It is estimated that, if the current dividend is reduced and the project is undertaken, current earnings would increase by 3%pa. Required How would the share price change as a result of temporary reducing the dividend, assuming the shareholders would still require the same return calculated in (a)? Question 5 Brook Brothers Plc has in issue 3,000,000 1 ordinary shares quoted at 3.40 (cum div) and 1,000,000 8% debentures quoted at 89 (ex. Int.) The company has paid the following dividends per share: 4 years ago 3 years ago 2 years ago 1 year ago Just paid 80p 81p 83p 85p 87p

Brook Brothers are considering investing 1,200,000 in a new project which is expected to generate the following after tax net cash inflows: Year End Cash flows (000) 1 400 2 500 3 600 4 400 5 200

The companys tax rate is 30%pa. Required a) Determine the cost of equity capital, the cost of debt capital and the weighted average cost of capital. b) Advise the company on whether it should undertake the proposed investment. c) Discuss the assumptions you have made in each stage of your analysis, which might in practice not be true.
Answer Question 5

Share price(XDIV) = 340 87 = 253p 5|Page

MVE =3m x 2.53 = 7.59m Growth rate g = 4th root of 87/80 1 = 1.02119 -1 = 0.02119 = 2.12% Ke = D1/MV + g = 87 x 1.02119/253 + 0.02119 = 0.3724 = 37.24% Kd after tax = 8/89 x (1- 0.30) = 0.0629 = 6.29% WACC = 7.59m x 37.24 + 0.89m x 6.29 7.59m + 0.89m = 34%

(b) Year: 0 1 2 3 4 5 CF(000) (1200) 400 500 600 400 200 DF(34%) 1.000 0.746 0.557 0.416 0.310 0.231 PV (1200) 298.4 278.5 249.6 124 46.2 NPV = (203,300) Reject project as NPV is negative. (c) Assumptions Used constant dividend model based on past dividend payments. The rate of 2.12% is an average. It could vary from this value or the company made not be able to achieve sufficient earnings to maintain the dividend growth pattern. We have discounted the project using the WACC as the discount rate. This can only be used as a discount rate as long as the financial risk of the project is the same as the average financial risk of existing projects. We cannot use the WACC as the discount factor if the gearing has changed as the financial risk would also change. In this situation it would depend how we financed the project. Strictly speaking we would need to finance the project using equity and debt in a proportion which will not change the gearing
Question 6 (Tutorial Question)

Alpha Ltd (Extracts from annual accounts) Stocks: raw materials 250,000 work in progress 115,000 finished goods 186,000 Purchases 1,070,000 Cost of goods sold 1,458,000 Sales 1,636,000 Debtors 345,000 Trade creditors 162,000 (a) (b) What is the length of the operating cycle? The company's management believe that if the average debtors collection period were reduced to 45 days, sales would fall by 25%. The company relies heavily on overdraft financing at a cost of 14% per annum. By how much would a reduction in the collection period affect annual profit, assuming that average stocks and creditors vary with sales volume and that the costs of goods sold is variable with sales?

Question 7

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Mars Ltd currently achieves credit sales of 140,000 per month. Profits are as follows: Sales 140,000 Cost of sales(75% variable, 25% fixed)100,000 Gross profit 40,000 Bad debt(1% of sales) (1,400) Other costs (18,600) Net profit 20,000 The management think that by increasing the period of credit allowed to customers from 1 month to 2 months, sales will rise by 25%, but bad debts would increase to 5% of sales. The increase would leave fixed costs, average stocks and average creditors unaffected. The company's cost of capital is 15%pa. By how much would the new credit policy increase annual profits after the new additional financing costs. Answer Question 7 Debtors under current policy Debtors under new policy (2 months x 140,000 x 1.25) Increase in debtors Annual financing cost of higher debtors (210,000 x 15%) Bad debts: Current policy 1,400 x 12 months New policy (5% x 140,000 x 1.25 x 12months) Increase in bad debts Extra contribution from higher sales (12months x 25% x (140,000 - 75,000) Increase in annual profits Question 8 (a) The return on two investments A and B is expected to be as follows, depending on the state of the economy: Economy Boom Normal Recession Probability 0.2 0.5 0.3 Return A (%) 14 11 -1 Return B (%) 21 7 1 140,000 350,000 210,000 (31,500) 16,800 105,000 (88,200) 195,000 75,300

Is it possible to evaluate investment is preferable, based on the expected return and the risk (as measured by the standard deviation) of each? (b) The investment A is being evaluated against investment C, whose expected returns are as follows: 7|Page

Economy Boom Normal Recession

Probability 0.2 0.5 0.3

Return C (%) 24 10 4

Is it still possible to evaluate which investment is preferable, based on the expected return and the risk (as measured by the standard deviation) of each? Your answer should include calculation of the coefficients of variance, and a discussion of the extent to which the coefficient of variance is useful in choosing between alternative investments. Illustrate your discussion by attempting to evaluate investment A against a further investment D, whose expected returns are as follows: Economy Boom Normal Recession Probability 0.2 0.5 0.3 Return D (%) 25 8 4

Answer - Question 8
(a) Investments A and B:

Since Investment A has the same expected return but a lower risk than Investment B, A clearly dominates B and should be preferred.
(b) Investment C:

The problem here is that both the return and risk of Investment C are higher than those of Investment A. We cannot say that C dominates A because of higher return, or that A dominates C because of lower risk. The coefficients of variation of the two investments are calculated below:

The coefficient of variation provides a relative measure of the risk per unit of expected return and, using this measure, investment A seems to be riskier than investment C. However, the coefficient of variation has limited usefulness because the relevant question is not which investment has higher risk per unit of return, but whether an individual investor would be prepared to accept an increase of 1% in risk to increase the return by 3%. This would depend on the riskreturn utility function of the individual investor i.e. how much extra risk the investor is prepared to accept per unit of additional return. The more risk-averse the investor is, the greater will be the amount of additional return required to persuade the investor to take on extra risk. 8|Page

This demonstrates the limitations of the coefficient of variation even more clearly. Like C, D has both higher risk and higher return than A, but it also has a similar coefficient of variation. Question 9 A takeover bid has been made for Song plc by a competitor. The directors of Song plc have decided to resist the bid as it will not benefit the current shareholders. As a Financial Consultant, you have been approached by the board of Song plc to offer an advice on a defence strategy against the takeover bid.

Required:

a)

Identify five possible financial anti-takeover defences and explain how Song plc can use these defences to resist a hostile takeover. Explain some of the key factors that are likely to contribute to a merger or acquisition failing to live up to expectation.

b)

c)

Explain the term Management Buy-Out (MBO) and advantages of using MBO as a divestment strategy.

Answer Question 9 a) b) Financial anti-takeover defences Enhanced profit forecast Revalue assets Seek a White Knight Golden parachutes for senior managers Poison pills strategy Share re-purchase (buybacks) Promise of a higher dividend Target management attitudes and culture difference Lack knowledge of industry or target company Poor management practices in target company 9|Page

Little or no experience of acquisition Lack compatibility of systems

c) (MBO) and advantages of using MBO as a divestment strategy. Sale of unwanted business to an existing management; this way, the business becomes an independent company. Strong links may be retained. Avoid the sale to the a competitor

Advantages MBO can normally be quickly arranged as supposed to external sales Maintaining trade links An external buyer might be wary of buying the company if it suspects the skills of the managers may lost soon after the sale Smooth negotiations with existing managers. Low publicity

Question 10 The sales for 2010 of Painted Hall plc, a small printing company were 300,000. Sales for 2011 are expected to rise by 25%. Current assets and liabilities vary directly with sales. Due to the rapid growth, the company will also need to spend around 50,000 on new capital investment and on replacement capital expenditure during 2011. The following information is provided on the level of current assets and liabilities for 2010. Current assets and liabilities as at 31 December 2010 Stock Debtors Cash Creditors 42,000 38,000 12,000 22,000

a) Determine the increased net working capital required to meet the higher sales level during 2011. b) Determine the companys total additional financial requirements for 2011.

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c) Explain the term operating cash cycle and why this concept is important in the financial management of a business. d) Discuss ways in which a company might invest its short-term cash surpluses, explaining briefly the factors to be considered before making these investment decisions. Answer Question 10 (a) Current net working capital needs (2010) is: (stock + debtors + cash) creditors = (42,000 + 38,000 + 12,000) 22,000 = 70,000 2010 allow for a 25% increase = 87,500 (b) Capital expenditure + additional working capital = 50,000 + 17,500 = 67,500 c) d) OCC is the length of time between when a business makes payments to its supplies for raw materials and when the business receives payment from its customers The longer this period the greater the financing requirements leading to greater risk. Possible liquidation without additional working capital

Short-term cash surpluses should invested on a short-term basis without risk of capital loss Selection the following should be considered: The size of the surplus How easy is it to get back the cash invested The maturity Risk and yield of different investment Any penalty for early liquidation Short-term instruments: Term deposits Sterling certificate of deposits Treasury bills Sterling commercial paper Gilts Question 11

JJ plc published the following year end forecast profit and loss six months ago. 11 | P a g e

 (m)

Turnover Less Cost of sales Other costs Profit

150

100 20 30

At recent board meeting the finance director informed the board that the turnover and cost of sales figures will be revised downwards by 4% and 8% respectively, due to a loss of a major contract in the Middle East.

The following working capital ratios are expected to apply:

Stock holding Debtors payment Creditors payment

= = =

30 days 60 days 40 days

Required:

a)

Calculate the projected working capital position based on the revised data.

b)

Discuss the possible reasons why a company might experience cash flow problems and suggest ways in which such problems might be alleviated.

c)

Summarise the services that may be obtained from various forms of agreement for the factoring of trade debts and invoice discounting.

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Answer - Question 11 a) Adjusted Forecast profit 000 less Turnover 150 Less Cost of sales 100 Other costs Revised forecast profit Adj (150m x 4%) = 6m (100m x 8%)= 8m Revised (m) 144 92 20 32 m = 7.562 23.671 10.082 21.151

Projected working capital Stock 30 days / 365 days x 92m= Debtors 60 days / 365 days x 144m Less: Creditors 40 days / 365 days x 92m= Total =

b) Making losses, since continuing losses will lead to cash-flow problems Inflation since historical profit may be insufficient to replace assets Poor credit control rate of bad debt Seasonal business Significant one-off items of payment repayment debt capital.

How to alleviate Postpone capital expenditure Offer discounts to potential customers Sell non-core assets Cost reduction programme c)
Factoring the factor takes over the responsibility of collecting outstanding amount from the debtors Factor is also prepared to advance up to 80% of an approved outstanding debt to the company.

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Invoice discounting is a service offered to business whereby a financial institution is prepared to advance a sum equivalent to 80% of outstanding trade debtor The amount advanced is usually paid within an agreed period e.g. 60days. The company is responsible for collecting the outstanding amount from debtors.

Question 12 a) Critically discuss the extent to which research has shown capital markets to be efficient. You should include an explanation of the Efficient Market Hypothesis and the three forms of the hypothesis in your discussion. b) Given the following corporate objectives, provide a reasoned argument explaining which of them should be the main goal of the financial manager. i) ii) iii) Profit maximisation Sales maximisation Maximisation of shareholders wealth

Answer Question 12 a) Explanation of the EMH The efficient market hypothesis - share prices fully reflect available information. The value of shares is reflected by the new information. Assumptions large number of analysts competitively seeking out and appraising information which is assumed be equally available. Discussion should cover the 3 forms (weak, semi-strong and strong) of EMH, the empirical tests of the 3 levels of EMH and any criticism of EMH. b) i) Profit maximisation Profit figures can be manipulated, Estimated figures (provisions) Risk is not taken into account. Sales maximisation Can lead to bankruptcy overtrading Bad debts effect on cash flow.

ii)

Maximisation of shareholders wealth Takes into account the above factors. Relevant to the long term success of a company. Effective use of financial resources to generation healthy earnings Question 13 14 | P a g e

PKY Bank plc quotes the following rates for euro versus Sterling ():

1.6296 1.6320

a) How many euros would a firm receive when selling 10 million

b) How much sterling would it receive when selling 12 million

Answer Question 13 Remember the bank always wins, so it sells euros at 1.6296, and buys at 1.6320 a) Selling 10 million, its receipts are (10m x 1.6296)= 16.296 b) Selling 10 million, its receipts are (10m /6.6320) = 6.127m Question 14 On 30th September, a UK exporter sells goods worth 10 million to a German importer on three moths credit. The customer is billed in euros, for which the spot rate versus sterling is (1.6 1). The three-month forward rate is 1.62 - 1. 1) What is the amount invoiced? 2) If the spot rate is 1.7 to 1 at the settlement date, what is the exporters gain or loss, assuming, it does not hedge? 3) If the rate is 1.5 to 1 at the settlement date, what is the exporters gain or loss assuming it does not hedge? 4) If the exporter takes forward cover, what is the cost of the hedge i) Compared to the current spot rate? ii) Compared to case (2)? iii) Compared to case (3)? Answer Question 14 1) Amount invoiced = (10m x 1.6) = 16m 2) With spot rate at 1.7 - 1) = (16/1.7) = 9.412m. Hence , the loss compared to the current spot rate = (10 - 9.412) = 0.588m 3) With spot at 1.5 - 1, the sale proceeds are (16/1.5) = 10.667. In this case, the exporter gains 0.667m from exchange rate change. 4) If the exporter sells forward, the contracted proceeds are 16m /1.6 = 9.877m. i) The cost of the hedge is thus 0.123, i.e. 1.2% of the sterling value of the deal. ii) If sterling falls to 1.5 to 1, the forward contract guarantees the exporter 9.877m, but it could have received 10.667m had it not hedged. There is opportunity cost of (10.667 - 9.877m) = 0.790m.

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iii)

If the sterling rises to 1.7 - 1, the forward contract still guarantee the exporter 9.877m, but it would have received 9.412m had it not been hedged. The exporter is thus better off by (9.877m - 9.412m = 0.465.

If the exporter thinks there is an equal chance of a 10% variation in the / exchange rate, it must balance an opportunity cost from hedging of 0.75m if sterling falls against being better off by 0.465m if sterling rises. Question 15 The respective interest rates in the USA and the UK are 9% and 10% respectively in annual terms. If the spot exchange rate is US$1.6000 to 1, what is the forward rate if IRP (Interest Rate Parity) applies? Answer Question 15 According to Interest Rate Parity: Forward Rate = Spot rate X (1 + US interest rate / 1+ UK interest Rate) = 1.600 x (1.09 / 1.10) = 1.5834 Therefore, US Dollar is stronger on forward market. Question 16 (Lecture Question) Kandyline plc, a British manufacturer of processed foods, is expanding its operations through foreign direct investment. The company has ordered the construction of a new factory in Vilnius, and a final payment of 2,500,000 Lithuanian litas (LTL) for the factory is due to the overseas building contractors in three months time. Kandyline currently has no spare cash other than to meet normal working capital needs, but would be receiving 0.75 million from sale of a property in about three months time. Current rates in the foreign exchange and money markets are as under: Foreign exchange market GBP/LTL Spot 1 month forward 3 months forward Money Market Great Britain Pound Lithuanian Lita Required: (a) Describe the benefits of foreign direct investment. (b) Using suitable calculations where necessary, discuss the advantages and disadvantages of the alternatives that are available to Kandyline plc for 16 | P a g e 9% 3.4056 3.4093 3.4068 - 3.4108 3.4106 3.4149 Borrowing 6% 7% Deposit 4%

managing the transaction risk of the final payment due to the overseas contractor. In-class tests (1 & 2)

Finance (FINA 1027) In-class Test (28/02/11)

Answer only 7 questions Duration: 1 hour

Question 1 What are the advantages and disadvantages which may accrue to the company and its shareholders, of obtaining a full stock exchange listing?
(Total marks 10) Question 2

Explain and compare the following methods by which a companys shares could be brought to the market:
a. private placing b. offer for sale at fixed price c. offer for sale by tender (Total marks 10) Question 3

a) Briefly discuss what is meant by maximising shareholders wealth and how a company does attempt to achieve this objective? (6 marks) b) Explain the Efficient Market Hypothesis.
(4 marks) (Total marks 10)

Question 4 a) Which of the following are essential aspects of a financial managers knowledge? a) b) c) d) Investment appraisal methods Financial markets Cash management All of the above

(5 marks) b) Which of the following statements are correct? 1) Maximising annual profits maximises shareholders wealth 2) A financial manager should recognise the interdependence of investment, financing and dividends. 3) Divergence of ownership and control leads to agency problem. a) b) c) d) 1 is correct 1, 2 and 3 are correct 1 and 2 are correct 2 and 3 are correct

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(5 marks) (Total marks 10) Question 5

Dumas plc has just paid a cash dividend of 20p per share. Investors require a 16% return from investment such as this. If dividend is expected to grow at a steady 8% per year, what is the current value of the equity? (5 marks) What will the equity be worth in five years time?
(Total marks 10) Question 6

(5 marks)

Explain why certain levels of risk cannot be avoided even in a well diversified portfolio.
(Total marks 10) Question 7

A three year bond with a 10% coupon pays interest of 10 (100 *10%) annually. If the interest rate unexpectedly rises to 12%, what will be the quoted price of the bond? Comment on the quoted price.
(Total marks 10) Question 8

The launch of Sonys PlayStation 3 was delayed until November 2006, giving Microsofts Xbox 360 a full year on the market without competition. Imagine that it is now November 2005 and you are the marketing manager for the PlayStation. You estimate that if PlayStation 3 were ready to be launched immediately, you could sell $2 billion worth of the console in the first year. However, if your launch is delayed a year, you believe that Microsoft head start will reduce you first-year sales by 20%. If interest rate is 8%, what is the cost of a delay of the first years revenues in terms of dollars in 2005?
(Total marks 10) Question 9

What are prices of 7% and 11% 1,000 bonds with 5 years to maturity assuming 10% discount rate and annual coupon payment?
(Total marks 10)

Question 10

Suppose equity in PKG plc has a beta of 0.80. The market risk premium is 6%, and risk-free rate is 6%. PKGs last dividend was 1.20 per share, and the dividend is expected to grow at 8% indefinitely. The current market value of equity (ordinary share) is 45. Calculate PKGs cost of equity capital (ke), using CAPM and dividend valuation model (DVM)? (Total marks 10)

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END

OF

TEST

In-class Test Marking Scheme 28th Feb 2011 Question 1

Advantages Marketability of shares means listed shares are viewed to be less risky it helps lower cost of capital. Ready price valuation purpose Access to a wider pool finance Facilitation of growth by acquisition Efficient market price gives confidence trading in the companys shares, Transferability of shares / raise new capital Credit rating creditworthy High profile 1 mark for each point, maximum of 5 marks Disadvantages Cost of quotation Market expectation pressure to meet expectation Admin & disclosure requirements complying with various stock exchange rules & regulations (transparency). Dilution of control Risk of takeover Public scrutiny financial analyst, press & investors 1 mark for each point, maximum of 5 marks Total (10 marks) Question 2 Methods Share issue on the stock market Private placing Sales to be sold are first acquired by the issuing house (normally a merchant bank) Shares are then placed with client of issuing house Low cost, since no advertisement Lower risk 1 mark for each point, maximum of 3 marks Offer for sale Shares are acquired by issuing house or a broker at an agreed price Shares are offered to the public at marginally higher price. Offer for sale will be underwritten institutional investors. Underwriters will accept the shares not taken up by the market, in return for a fee. 1 mark for each point, maximum of 3 marks Total (10 marks)

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Tender Minimum price set & public invited to bid. Striking price is set. Method is used when the market turbulent or no direct comparison on the market. 1 mark for each point, maximum of 3 marks + 1 bonus point for introduction. Total (10 marks) Question 3 a) An increase in shareholders wealth may result from an increase in the market value of the shares held or a dividend payment. Note that a shareholders return will be made up of capital growth and cash return (dividend yield) Maximising share holders wealth is attempting to manage the company so that the total market share value is maximised or maximising the total market value of the company (Equity + debt). This is justified as shareholders are the legal owners of the company and they have invested in the company in an attempt to increase their wealth. The equity market is an important source of funds for a company and to attract these funds the company must adequately reward the providers of the funds. The company can do this by operating in a profitable manner accepting only projects with a positive NPV.

Maintain a dividend growth policy by retaining some of the earnings to promote growth. 2 marks for each point, maximum of 6 marks b) The efficient market hypothesis - share prices fully reflect available information in an instantaneously. The value of shares is reflected by the new information. 2 marks for each point, maximum of 4 marks Total (10 marks) Question 4 a) b) (d) (d) 5 marls 5 marks Total (10 marks) Question 5 (a) MV = Div(1 + g)/ Ke g MV = 20(1.08) / (.16 8) 21.6 /.08 = 270p 3 marks 2 marks 20 | P a g e

(b) D5 = D1 * (1 + g)^5 20 * (1.08)^5 29.4p Price in 5 years 29.4(1.08) /.08 = 396.7p Question 6 Risk may be divided into systematic and unsystematic risk. Systematic risk refers to the extent to which a companys cash-flows are affected by factors not specific to the company inflation, interest rates etc. Unsystematic risk refers to the extent to which a companys cash-flows are affected by company-specific factors e,g. quality of managers, effectiveness of R&D, the skill of its labour force Unsystematic risk can be diversified away, Systematic risk, however , cannot be diversified away, since it is experienced by all companies The risk of a well-diversified portfolio will be similar to the systematic risk of the market as whole. (2 marks for each point, maximum of 10 marks)
Total (10 marks)

2 marks

3 marks Total (10 marks)

Question 7 12% Year 1 3 10 x 2.44 = 24.44 Year 3 100 x .712 = 71.20 Bond price = 95.64 3 marks 3 marks 1 mark

Comments 95.64 is less than 100 therefore the bond said to sell at a discount. With interest now at 12%, newly issued bond with 12% coupon rate will sell at 100. 3 marks Total (10 marks) Question 8 Reduction in Sales revenue = $2 billion x 20% = $0.4billion 2 marks Net sales revenue ($2 billion - $400,000) = $1.6billion 2 marks Present value of sales revenue @ 8% = $1.6 billion x .926 =$1.482 billion 3 marks Cost of delay of one year = $2billion - $1.482 billion = $518 million 3 marks Total (10 marks)

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Question 9 7% Year 1-5 5 10% Year 15 5 Question 10 x 70 x 1,000 x x 110 x 1,000 x 10% D/Factor 3.791 = .621 = Price = 10% D/Factor 3.791 = .621 = Price = 265.37 621.00 886.28 417.01 621.00 1,038.01

2 marks 2 marks 1 mark 2 marks 2 marks 1 mark Total (10 marks)

CAPM Ke = Rf + (Rm Rf) * beta = 6% + 0.8* 6% = 10.8% Projected dividend = 1.20 *(1.08) = 1.296 Ke = (1.296 /45) + .08 = 10.88% 3 marks 1 marks 2 marks 2 marks 2 marks Total (marks 10)

In-class Test (01/03/2011)

Answer only 7 questions Duration: 1 hour Question 1 What are the functions and areas of responsibility under the control of a finance manager in a public limited company? (Total marks 10) Question 2 a) What is meant by agency problem in the context of a public limited company? (4 marks) b) How is it possible for the agency problem to be reduced in a company? (6 marks) (Total marks 10) .

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Question 3 Explain the similarities and difference between convertible loan stocks and loan stocks with warrants. (Total marks 10) Question 4 South plc issued 12% irredeemable debenture at a par value of 100, 7 years ago. The current market price of the debenture is 94 and the company pays a corporation tax at 35%.What is the cost of debenture? (Total marks 10) Question 5 Suggest factors that should be considered before paying out dividend to shareholders. (Total marks 10) Question 6 ABC plc has 10 million shares of 1 nominal value in issue. Current shares are trading at 1.84 each. ABC is about to raise additional finance to support a future expansion programme by rights issue in the proportion of 2 for 5. The rights issue will be priced at 30% discount of the current market price. i) ii) Calculate theoretical ex-right price (TERP) (5 marks) Calculate the trading value of the right (5 marks) (Total marks 10) Question 7 Linfield plc has paid dividends per share over the past few years, as follows: 2005 11.0p 2006 12.5p 2007 14.0p 2008 17.0p 2009 20.0p The market price per share of Linfield is currently quoted at 5.00 exdividend. What is the rate of return required by investors in Linfields equity implied by the Dividend Growth Model? (Total marks 10) Question 8 A company has in issue a 10 per cent bond, redeemable at the option of the company between one to five years from now. What factors do you think will be considered by the company in reaching a decision on when to redeem the bond? (Total marks 10) Question 9 John has 10,000, which he could deposit in savings account offering an interest of 6% per annum. Johns brother wants him to lend the money to him instead, promising to repay him after 10 years with double the amount lent. 23 | P a g e

Required: i) Purely on financial considerations, would it be worthwhile for John to lend the money to his brother rather than placing it in a savings account? (Support with calculations) (5 marks) ii) Alternatively, Johns brother offers to pay him 500 every year, without any repayment of the principal amount of 10,000. Would this proposal be worthwhile in financial terms for John? (5 marks) (Total marks 10) Question 10 Briefly outline the advantages and disadvantages for obtaining a full listing on a recognised stock exchange. (Total marks 10) END OF TEST

In-class Test Marking Scheme 28th Feb 2011

Question 1
Financial planning and forecasting Investment appraisal Financial decisions Capital market operations Working capital management Dividend policy formulation. 2 mark for each point, maximum of 10 marks Total (10 marks)

Question 2 a)
Divorce of ownership and control Principal and agent relationship Divergent goal and an asymmetry of information Managers act to maximise their own wealth rather than the shareholders wealth. 1 mark for each point, maximum of 4 marks Do nothing if costs of divergent behaviour are low. Monitor agents, if contracting or divergent behaviour costs are high. Use a reward / punishment contract, if contracting or divergent behaviour costs are high. 2 mark for each point, maximum of 6 marks Total (10 marks)

b)

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Question 3 Similarities
Long term debt Payment of fixed interest Interest is tax deductible expense 2 marks 2 marks 2 marks

Differences
Convertible loan stocks are fixed-term securities either secured or unsecured which may be converted at the option of the holder, into ordinary shares of the same company.

2 marks
Loan stocks with warrants - the loan stocks cannot themselves be converted into ordinary shares but give the holder the right to subscribe for ordinary shares in future at a fixed price.

2 marks Total (10 marks) Question 4

Cost of Debenture Int (1 tax) / MV debenture 12 (1 35%) / 94 7.8 / 94 8.3% 2 marks 4 marks 2 marks 2 marks Total (10 marks)

Question 5
Investment opportunity Profit Clientele Signal effect Article of association Availability of cash 2 mark for each point, maximum of 10 marks Total (10 marks)

Question 6

i) Discount 1.84 @ 35% = .55p Rights issue Price (1.84 - .55p) = 1.29 1 mark 1 mark

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2 new share @ 1.29 5 old shares @ 1.84 7 shares TERP

= 2.58 = 9.20

1 mark 1 mark

= 11.78 = 11.78 / 7 = 1.68 1 mark 5 mark

ii) Value of right ( 1.68 - 1.29) = 39p

Question 7
11p (1 +g)^4 = 20p (1 +g)^4 = 20p/11p g = 15.8% 1 mark 1 mark 2 marks

Implied Ke = 20p (1.158)/ 500p +0.158 0.4632 +0.158 = 20.43%

4 marks 2 marks Total (10 marks)

Question 8 The length of time remaining to maturity General level of interest rates The rate of return on other securities ordinary shares Expectation of likely movement in interest rates and inflation The required return of investors in debenture

(2 marks for each point, maximum of 10 marks) Total (10 marks) Question 9

i)

Bank : 10,000 x (1.06)^10 marks 10,000 x 1.7908 = 17,908 marks Therefore accept 20,000 from the brother should be accepted 1 mark

2 2

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ii)

Perpetuity 500/.06 = 8,333 3 marks

8,3333 is less than the 10,000 therefore proposal not worthwhile should not be accepted. 2 marks

Total (10 marks) Question 10

Advantages Opens up avenues to raise finance Marketability of shares Raises the profile of the company Better credit rating Companys shares can be used to fund future takeover. 1 mark for each point, maximum of 5 marks Disadvantages Cost of floatation Cost of compliance with listing rules Company may be open to a hostile takeover bid Dilution of control will result from wider share ownership The need to satisfy increased shareholders expectation. 1 mark for each point, maximum of 5 marks

Total (10 marks)

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