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Department of Accounting and Finance
M.Sc. Finance
And
M.Sc. International Accounting and Financial Studies
Finance III and IV
Tuesday 8th May 2007 10.00am – 1.00pm (3 hours)
Instructions for Candidates
Answer ALL Questions from Section A (in the spaces provided),
ONE Question from Section B (in the answer book) and ONE
Question from Section C (in the answer book)
[Failure to comply will result in papers not being marked]
Calculators must not be used to store text and/or formulae nor be capable of communication. Invigilators may require calculators to be reset. All answers are to be written in the spaces provided in ink. Please write clearly as illegible writing cannot be marked. If more space is required the answer can be continued on the back of the page where the question appears. Failure to follow these requirements will lead to a deduction of marks.
To Be Completed (please write clearly)
Family Name:
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Course (please indicate by ticking appropriate box)
M.Sc. Finance M.Sc. IAFS
For Examiners Use Only
SOLUTIONS
SEC
TION A
TOTAL
MARKS
investment
100 shares at £5.00 £
30 shares at £4.00 £
Overall investment £
Value of investment
130 shares at £4.77 £
ii) Initial investment
100 shares at £5.00 £
Sell 30 rights
30 rights at £0.77 £
Overall investment £
Value of investment
130 shares at £4.77 £
c) Consider the case for
having the issue underwritten.
(2 marks)
k = E1/V u = 30/240 = 0.
b) If the interest rate is 6 per cent determine the cost of equity capital and the
weighted average cost of capital the company can anticipate if it restructures its financing, issuing debt worth £80 million and using the funds to buy back equity.
ke = 0. +(0.125 – 0.06) 80/160 =
WACC = 0. 80/240 + 0.1575 160/ = 0.
(2 marks)
Q3. Nicholls plc has a debt to equity ratio of one to three and the overall value of the
company (debt plus equity) is £800 million. The company’s expected earnings before interest and tax is £148 million, it is anticipated that this level of expected earnings will be maintained indefinitely into the future, the interest rate is 8 per cent, and the tax rate is 30 per cent.
a) Determine the value of the company, and its cost of capital if Nicholls was financed entirely by equity rather than on its current geared basis
(3 marks)
Vu = VG – tc B G = 800 - 200 x 0.3 = 740
ke^ = EBIT (1 – t^ c)/V^ u^ = 148(1 – 0.30)/740 = 0.
b) Determine the company’s cost of equity capital and its weighted average cost of capital given the company’s level of gearing.
(2 marks)
ke = (148 – 200 x 0.08) (1 – 0.30)/600 = 0.
= 0.14 + (0.14 – 0.08) (1 – 0.30) 200/600 = 0.
WACC = 148 (1 – 0.30)/800 = 0.
= 0.154 600/800 + 0.08 (1 – 0.30) 200/800 = 0.
Using the Miller (Debt and Taxes) model determine the value of the tax advantages of debt for a company if the corporate tax rate is 30 per cent, the effective personal tax rate on equity income is 10 per cent, and the effective personal tax rate on debt income is 16 per cent, the company’s debt level is
£200m and the market value of the company on an all equity financed basis is
£740m.
(2 marks)
V G = 740 + 200 [1 – (1 – 0.30)(1 – 0.10)/(1 – 0.16)] = 790
Q5. a) An investor bought some shares at a price of 120p last year and these shares
are now trading at 180p. As the upper value placed on the shares by the investor is 160p she has decided to sell the shares, but is not sure whether to do so immediately or wait for the shares to go ex-dividend over the next few days. It is anticipated that the price will fall on the ex-dividend day by less than the declared dividend of 30p. The investor will be liable for capital gains tax at 20 per cent and income tax at 30 per cent. By how much will the share price have to fall to make it worthwhile for the investor to sell now and forego the dividend?
b)
(3 marks)
(PB - P0) (1 – t g) = (P A - P 0) (1 – tg) + D(1 – t p) PB = P A + D(1 – t p)/(1 – tg)
PB - PA = D(1 – t p)/(1 – t g)
190 - PA = 30 (1 – 0.3)/(1 – 0.2)
PA = 190 – 30 (1 – 0.3)/(1 – 0.2)
= 190 – 26.
= 163.
If the share price is expected to fall by more than 26.25p it will be advantageous to sell prior to the payment of the dividend.
The management of Raith plc only increase the company’s dividend when it is believed that the new dividend level can be sustained. The company appears to have set a long term target payout ratio of 70 per cent and past experience suggests it adjusts the dividend payment by 50 per cent of the difference between the target dividend and the last dividend paid. The company's last dividend per share was 80p, and its earnings per share for the next three years are expected to be 150p, 190p, and 170p.
i. What dividends can the company be expected to pay over the next three years if earnings are in line with the forecast?
(2 marks)
Last EPS *
Yr Dividend EPS target Discrepancy Adjustment Dividend
ii. Comment on the expected dividend payment in year 3.
(1 mark)
iii. Identify one factor that might influence the payout ratio and one factor that might influence the adjustment ratio adopted by a company, and explain your choice of factors.
(2 marks)
8.260870 for 50m
1 for 6.
b) The management of Davidson believes its shares are undervalued by the
market and that the market is unlikely to recognise immediately the benefits the takeover can be expected to produce. How will these views of management affect the company’s choice of financing for the proposed takeover?
(2 marks)
Q7. Resolven plc’s customers take 60 days to pay for goods purchased on credit. The
finance director has proposed the introduction of a 2 per cent discount for payment within ten days to try to reduce the company’s cost of extending credit. It is anticipated that 70 per cent of customers would take advantage of the discount and pay their bills within ten days. The average credit period for this group of customers will be 8 days. The remaining 30 per cent are expected to take an average of 70 days to clear their accounts.
a) Given an interest rate is 13 per cent determine whether the introduction of a discount will be profitable.
Current Policy: PV(£1) = 1(1.13) -(65/365)^ = 0.
(2 marks)
Proposed Policy: PV(£1) = 1x0.70x 0.98-(8/365) + 1 x 0.30 x (1.13)-(70/365)
= 0.6842 + 0.
= 0.
b) What difference will it make to the profitability of the introduction of a discount if this leads to a 10 per cent increase in demand for the company’s products and the typical profit margin is 30 per cent of the selling price? All the additional sales would be paid for within the ten day period to take advantage of the discount, and the average credit period taken by this group is estimated to be 8 days.
(2 marks)
The value of incremental sales (0.10) given profit margain (0.30)
0.30 x .10 x 0.98(1.13) -(8/365) = 0.
Add to the benefits of the proposed policy
= 0.9723 + 0.0293 = 1.0016 > 0.9785 = 1.
Q9. a) Croy plc. is considering the possibility of leasing rather than buying some
equipment it needs to acquire. The equipment would cost £80,000 to purchase. The working life of the machine is anticipated to be four years and the residual value of the machine is expected to be negligible. Leasing the equipment would involve an initial payment of £18,000 and four annual payments of the same amount. The annual net cash flows after tax from the investment in the equipment are expected to be £24,000 for each of the next four years. The equipment qualifies for straight-line depreciation over the four year period and the tax rate is 30 per cent. Croy plc. is able to borrow at
8 per cent, but its overall cost of capital is closer to 20 per cent. The company currently employs no long term borrowing.
Determine the net present value of the leasing proposal.
(3 marks)
Purchase Price 80000
Lease Payment 18000
No. Of Payments 5
Tax Rate 0.
Interest Rate 0.
Yrs
Purchas e
Price Saved
Lease
Payment
Lease
Payment
After Tax C a
Tax Saving
Lost On Ca Ncf
Pvf (After Tax Interest Rate)
Present
Value
0 80000 -18000 -12600 0 67400 1.0000 67400.
1 -18000 -12600 20000 -6000 -18600 0.9470 -17613.
2 -18000 -12600 20000 -6000 -18600 0.8968 -16679.
3 -18000 -12600 20000 -6000 -18600 0.8492 -15795.
4 -18000 -12600 20000 -6000 -18600 0.8042 -14957.
b) Explain why it is not necessarily profitable either to employ the lease or to undertake the investment even if the investment’s expected net cash flows are sufficient to cover the payments required by the lease contract.
(2 marks)
Average Stock Holding = 619
Cost of stock holding = £6,
Number of production runs per annum = 9,000/1,237 = 7.
Cost of moulds = 9,000/1,237 x £850 = £6,
Total Costs = £12,
(TOTAL 50 MARKS)
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For Examiners Use Only
Page
Total
Cumulative
Mark
Section B Answer ONE Question
Q1. “ Rights issues have been perceived as a way of raising additional equity capital at minimum cost while protecting the interests of a company’s shareholders. But such issues also force the shareholders to participate in the fund raising process, either by subscribing to the issue or the sale of their rights. ” Explain and discuss. (25 MARKS)
Q2. Explain and evaluate the view that an optimal capital structure can be determined by trading off the bankruptcy and agency costs associated with debt against the tax advantages of debt. (25 MARKS)
Q3. Explain what is meant by information asymmetry and discuss how this concept is employed in the analysis of equity issues. (25 MARKS)
Q4. Outline and explain the Lintner model of dividend behaviour and discuss its
consistency with the analysis of dividend policy put forward by Miller and Modigliani. (25 MARKS)
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