MA826 Examination-Solutions 2008 Question 1 Debentures are used to raise large amounts of funds.

They have a fixed redemption date and carry a fixed rate of interest so that the company has a known debt servicing commitment. Debentures are loans secured on some or all of the assets of the company. If the company fails to make one of the coupon payments or the capital repayment, the stockholder can either appoint a receiver to intercept income from the secured asset or take possession of the secured asset and sell it to meet the debt. There are two type of debenture: In a mortgage debenture, there is a fixed charge i.e., debenture is secured on a specific asset mentioned in the legal documentation. The company can sell or alter the secured asset only with the debenture holder's permission. By contrast, in a floating charge debenture the company can change the secured assets in the normal course of business. These charges together with the appointment of a trustee are designed to reduce the risk to the holder. But the security is ultimately dependents on company's continued profitability to meet the required payments, though in practice neither is guaranteed. The interest paid on debentures representing the return to the debenture holder is dependent on the risk and marketability of debentures. As the company is stable and secure, the required margin for debentures issued is likely to be about VJYo higher than on government bonds of similar term and coupon. Compared to government bonds, debentures are less marketable since there are larger spreads between buying and selling prices and lower volumes are traded due to a smaller issue size (eg 20m). Marketability is higher at the time of a new issue. Unlike debentures, unsecured loan stock are loans which are not secured on assets of the company. A trustee oversees the interests of the ULS holders. The trust deed often restricts further borrowing. Interest payments are a legal obligation of the company. If the company is liquidated, the ULS holders will rank equally with the other creditors of the company. All the above are designed to reduce the risk but ULS are more risky than debentures since ULS holders are even more dependent on company's continued profitability to pay the required interest. The yield margin over government bonds tends to be slightly higher than for debentures in a given company, to reflect the higher risk. Marketability of ULS is similar to debentures. The security provided by the company in debentures, would enable it to reduce the cost of finance compared to ULS. However, debentures offer the company less flexibility hi changing the secured assets.

MA526-MA826 Examination 2008

Solution Question 2 (a) 1 -for-3 rights issue @ 2.20 Number of share 600000 Current price 3 New shares= 600000/3 = Funds raised= 2.20 (200000) =

200000 440000 2.80 1800000 2240000

Theoretical ex-rights price = (3(3)+1 (2.20))/4= () Value of shares before the issue = 600000 (3) = Cost of taking up the issue= 440000 value of shares after the issue = 800000(2.8) = As 2240000 - 440000 = 1800000 there is no gain or loss.

The market price will be close to the theoretical ex-rights price depending on: (1) The expense of the issue (2) Market's perception of the company after the issue. This factor is difficult to calculate. (3) Often immediately after a rights issue the share price is below the theoretical ex-rights price for three reasons: (i) Company loses market support if the reason for the issue is to resolve some financial difficulty. (ii) Increased supply of shares if some shareholders sell their shares. (iii)Company loses favour with shareholders since they have to spend money to buy the rights.

Q3 Solution

a) Turnover cost of sales gross profit

70000 10000 600 00

tax
band allowance starting basic higher 5225 2230 32370 20175 60000 National Insurance Earned rate Nl Income 60000 20% 12000 Income After Tax + Nl 32585.6 rate 0% 10% 22% 40% tax 0 223 7121.4 8070 15414.4

b)
exactly the same as (a)

Turnover cost of sales gross profit wages net profit tax post tax profit net dividend gross dividend Sara's tax + Nl National Insurance

70000 10000 60000 10000 50000 15000 35000 35000 38888.89

Earned Income rate Nl 10000 20% Personal Tax band Allowance starting rate earned basic rate earned basic rate dividend higher rate dividend

2000

rate

5225 2230 2545 29825 9063.889 48888.89

tax 0.0% 0 10.0% 223 22.0% 559.9 10.0% 2982.5 32.5% 2945.764 6711.164

net income after tax & Nl

40177.73

In making the decision to pay dividends, a company's board have to choose between immediate income and the prospect of higher income in the future. For listed companies the prospect of higher future dividends will be reflected in a higher share price and capital appreciation. Factors which affect the dividend policy are: Stock markets: show adverse reaction to dividend cut announcements. Managers tend to be conservative in good years particularly in cyclical industries and smaller companies. Cash reserves: Companies with large cash reserves that fear a takeover bid may distribute generously in order to encourage customer loyalty and limit the size of the "cash pile". Two effects: higher dividends would mean higher dividend yield compared to others, which leads to higher support for the share price. Also investors could view large cash reserves as a sign of weakness. Tax: If a large proportion of shareholders are non-taxpayers then the company may distribute a large proportion of its earnings. Growth opportunities: Companies hi high growth industries may find that the need for capital investment may exceed their capacity to borrow and may prefer to use earnings rather than resort to frequent rights issues. Stability and consistency: Since companies with high payout policies tend to attract investors who expect high payouts and vice versa, any move from one to the other will cause adverse market reaction. Question 5 In carrying out the audit, the auditors should be able to form an opinion as to whether: proper accounting records have been kept accounting policies are in line with the regulations and are applied consistently the accounts are in agreement with the accounting records directors reports are consistent with the accounts. If the financial statements give a true and fair view, then the auditor should issue an unqualified opinion. The wording of the standard report can be modified to reflect auditor's wish to highlight areas of uncertainty or if the auditor is unable to issue an unqualified opinion. There are various degrees of qualification. Qualified opinion may be issued when: There is limitation on the scope of the auditors' examination Auditors disagree with the treatment or disclosure of a matter in the financial statements. The qualified auditor's opinion will adversely affect the confidence of the public as regards the company's directors presenting a true picture of the state of the company and may cause a fall in the share price, if the public decides that the true picture could be worse than the accounts present.

Question 6. (i) Company ABCD WXYZ Difference

Fixed rate

6.5%

7.5%

1%

Floating rate

LfflOR+0.5%

LfflOR+1%

0.5%

Relative difference

0.5%

So there is an exploitable difference of 0.5% p.a, and a mutually beneficial swap is possible. Assume the gain is split 75% / 25%. ABCD would get an effective discount of 0.5% x 75% = 0.375% on its floating rate. WXYZ would get an effective discount of 0.5% x 25% = 0.125% on its fixed rate.

LEBOR+1%

LIBOR+1%

ABCD

WXYZ

6.5%

7.375% (= 6.5% + 0.5 + 0.375%)

Gain Overpayment on floating

(11)
ABCD Fixed To Market From WXYZ Gain

6.5% Floating ToWXYZ LfflOR+1% 0.875% - 0.5% = 0.375%

7.375% Opportunity cost LIBOR+0.5%

0.875% Gain - 0.5%

Net Gain WXYZ Fixed

ToABCD 7.375% To Market LIBOR+1% 0.125 + 0 = 0.125%

Opportunity cost 7.5% From ABCD LIBOR+1%

Gain 0.125% Gain 0

Floating

Net Gain

(ii) Alternative solution

Gain LIBOR+0.125% HLffiOR+0.5%) -0.375%] LIBOR+1%

ABCD

WXYZ

6.5%

6.5%

ABCD Fixed To Market 6.5% ToWXYZ LIBOR+0.125% 0 + 0.375% = 0.375% From WXYZ 6.5% Opportunity cost LEBOR+0.5% Gain 0 Gain 0.375%

Floating

Net Gain

WXYZ Fixed ToABCD 6.5% To Market LfflOR+1% 1% - 0.875% = 0.125% Opportunity cost 7.5% FromABCD LIBOR+0.125% Gain 1% Gain -0.875

Floating

Net Gain
( * * *\)

Potential gain to ABCD over 5 years is: 5,000,000 x 0.00375 x 5 = 93750 Since this exceeds 40,000 the company should proceed. Potential gain to WXYZ over 5 years is: 5,000,000 x 0.00125 x 5 - 31250 Since this exceeds 20,000 this company should also proceed. (iv) Payback period for WXYZ Annual return = 31250 /5 = 6250 (Gain after 3 year is 6250 x 3 = 18750 < 20,000 cost) Payback over 3 years is 20,000 / 6250 = 3.2 years Therefore Financial Director's criterion is not met. The criterion seems inappropriate since the interest swap is not a project in its own right, it is a mechanism for reducing the cost (or increasing the return) on another project, which presumably must have met the criterion in order to be proceeding.

Question 7 (a) Cost year

-4.5 Revenues

1
2

1.5
1.5

3 4 5

2.5 2.5 3.5

Discount rate factor 0952 1388 .296 .889 0.857339 1.286008 0.793832 1.984581 0.73503 1.837575 0 6 0 8 2.382041 .853

0.08

NPV= -4.5+1 .5/1 .08 NPV

.08)A2 4.379094

.08)A3

.08)M

.08)A5

Revenue in year Roadworks in year 1 2 3

1 1.5 1.5 1.5 2
1.2 1.5 1.5 3 2 2 2.5 4 2 2 2 5 3.5 2.8 2.8

NPV1 = -4.5+1 .5/1 .08 NPV2= -4.5+1 .5/1 .08 NPV3= -4.5+1 .5/1 .08

.08)A2 .08)A2 .08)A2

.08)A3 .08)A3 .08)A3

.08)M .08)M .08)A4

.08)A5 = .08)A5 = .08)A5 = 3.347086585

3.357461
3.138254 3.53517

E(NPV) = 0.5(3.357)+0.25(3.1 38)+ 0.25(3.535)= (iii)

Road repairs affect the accessibility of the store and is a specific risk. Question 8
(i)

Equity 800 Debt 200 Return E 0.12 Return D 0.06 ra = 0.12(800/1000) + 0.06(200/10000 = 10.8% is the return to assets before restructuring. After restructuring Equity 600 Debt 400 0.108 = re(600/1000) + 0.06(400/1000) re= 0.14
(ii)
WACC = 0.14(600/1000) + 0.07(400/10000 =

0.108

0.112

or 11.2%

(Mi) Companies employ two principle method of finance to carry out their operations: equity and debt Gearing or leverage refers to either of the ratios Debt/Equity or Debt / (Equity + Debt). The alternative forms of finance carry different costs due to the nature of the risks involved. Equity carries more risk than debt and so is more costly; shareholders expect a higher return for taking a higher risk, both systematic and specific. The overall cost to the company of financing its operations is a weighted average of the cost of these two forms of finance, expressed as follows: WACC = wd (D/(D+E)) + we(E/(D+E)) Where, WACC = weighted average cost of capital, Wd ,we are costs of debt and equity and D and E are market value of debt and equity respectively. The traditional view emphasizes the role of gearing in reducing the cost of capital. It focuses on the amount of debt the company could safely raise without risking bankruptcy in severe recession. It argues that though debt carries a risk, it is cheaper than equity and so companies could take advantage of the cheaper finance by increasing gearing as long as they could cope with recession. As Wd < we the higher D/(D+E) ratio would reduce WACC. There are several assumptions relating to the traditional view. The most important is that the return expected by the shareholders remains the same as gearing increases. Miller and Modigliani offered the alternative argument that gearing was irrelevant, as each increase in debt would be accompanied by an increase in the cost of equity, hi a highly geared company the equity holders would enjoy a proportionately larger return in good tunes and a poorer return in bad tunes compared to a lower geared company. So as debt increases, the return to equity holders would be much more volatile and the equity holders would expect a higher return for higher risk. The higher gearing would result in higher expected return to equity and the cost of capital would not decrease. By borrowing in the market, Miller and Modigliani argue, the company is not engaging in anything that the shareholders could not do themselves, as they could borrow and pay for the additional finance. In this analysis a tax free environment is assumed. If tax is taken into account, then it is possible to reduce the cost of capital by increasing the debt burden. However if a high proportion of debt makes it difficult for the company to raise debt at the same cost as before, that is, if the risk of debt increases, then the cost of debt would also increase and the tax advantage would be eroded. The increased gearing may result hi higher cost of equity and debt and higher WACC.

MA526-MA826 Exam 2008 Question 9 solution

High demand 1100000

Manufacture

450000

Success P=0.65

-150000

Make Prototype

4747:

44750

70000

No prototype

1000000

400000

-200000

432500 700000 450000

432500 100000 Lowdemand

Expected profit: Prototype Node 3 : 1100000 (0.35) + 450000 (0.35) -150000 (0.3) = 497500 Node 4 : 700000 (0.35) + 450000 (0.35) + 100000 (0.3) = 432500 Node 1: 49750 ( 0.65) + 432500 ( 0.35) = 44750 No prototype Node 7: 1000000 ( 0.35) + 400000 ( 0.35) -200000 ( 0.3) = 430000 Node 8: 700000 ( 0.35) + 450000 ( 0.35) + 10000 ( 0.3) - 432500 Node 2: Select 432500 Choice between 474750 - 30000 = 444750 at node 1 and 432500 at node 2. Select 444750. The company should produce the prototype. If the test is successful it should make the component and if the test fails it should buy it.

Question 10 Income statement Sales cost of sales gross profit admin & distribution Operating profit finance costs Pre tax profit

000,000 240 135 105

by deduction calculated as 240 x 0.4375 = gross profit - operating profit =pre tax + loan Interest

30.5 74.5
40 34.5 9.7 24.8

= 400*0.1
add tax to 24.8 given .248 x number of shares

tax
Profit attributable to ordinary shareholders

balance sheet Assets non current

million

550

given

Current bank balance debtors stock total assets Equity ordinary shares reserves 10 164.8 2 40 10

given
60.83333/365'sales =sales * 15.20833/365

602

=100M
total equity - 34.5A 1973684 = 174.8 deduct the 10 to get reserves

Liabilities long term 10% loan stock short term . creditors tax total equity + llabs

400

given

17.5 9.7

from

current ratio, 52/1.9117647-9.7, check quick ratio given

1.544118

602

(v) Analysis, Whizzbang's gross profit margin is completely in line with the industry norm which suggests its basic manufacturing process is comparable to most other firms in the industry. However Whizzbang is much more highly geared, and is generating a much lower overall return on capital than comparable firms. This suggests that either its administration and distribution costs are disproportionately large relative to the norm (though in isolation they don't look high compared with turnover), or the firm has a lot of capital tied up in non current assets which aren't being efficiently utilised. The greater degree of gearing has enabled them to generate a comparable return on equity to other firms in the sector, however their lower P/E ratio than the norm may reflect the market's concerns that the level of risk for this firm is greater than the norm in terms of failure and/or and profit volatility, and suggests investors aren't expecting significant growth. (5 marks)