2021

1. The correct response

• Advising on sources of finance appropriate for a company

• Advising on investment in non current assets

2.
The correct response
 Shareholder wealth maximisation is the primary financial objective for a company
listed on a stock exchange
 Financial objectives should be quantitative so that their achievement can be
measured
 The agency problem means that shareholder wealth is not being maximised.

Examples of non financial objectives

• Quality products
• Good after sales service
• Responsibilities to Society
• Increase in market share

Objectives are 'SMART' if they are specific, measurable, achievable, realistic and,
timely.

3. G Co

Dividends yield

D1 0.06 + .08

= ---------------- = --------------------- x 100 = 8.0%

p0 1.83 - .08

4. Miller Co
$m $m
Operating Profit 20.5
Less interest ($10m x 5%) (0.5)
PBT 20.0
Less tax @ 20% ( 4.0)
PAT 16.0
Less preference dividends (2.0)
Earnings attributable to ordinary Shareholders 14.0
Equity earnings are $14m ( $16m less $2m), and when divided by the 7m ordinary shares this results in an EPS of
$2.00

2
5.
Current After repayment
of $4m loan
Long term debt ? $7.2m
Equity $20m $20m
Gearing(D/E) 56% 36%
Therefore long term Debt= (56% x $20m) = $11.2

Current After repayment

of $4m loan
PBIT $4.0m $4.0m
Interest ? $1.21
Interest cover 3.2 ?

Interest = (4.0/3.2) $1.25

Interest saved of $4m = $.04
Interest cover = 4.0/1.21=3.3 times

Revise ALL ratios

Dividends per share
Dividends payout = ----------------------------------
EPS

PAT
Return on equity =-------------------x 100
Equity

6. The correct response is statements 1 and 2

Statement 1 is correct
Insider information cannot be used to make abnormal gains in a strong form efficient capital
market .

Statement 2 is not correct

In a weak form share price reacts to past information only.

Statement 3 is correct
The Co’s share price reacts quickly and accurately to newly-released information in a semi-
strong form efficient capital market are correct.

3
7. The correct response is technical analysis (chartism)
Technical analysts believe past trading activity and price changes of a security can be
valuable indicators of the security's future price movements.
Technical analysts do not believe in the three forms of market efficiency.

8. Statements 1, 2 and 5 are true

Note :
Statement 3
The remunerations of the executive directors should be decided by a committee consisting
of independent non executive directors.

Statement 4
The Corporate governance best practice aims to manage the risk and not to minimise the
risk

9.
Statement 1 is incorrect
Monetary policy seeks to influence aggregate demand by increasing or decreasing
the money raised through INTEREST.

Statement 2 is correct
Fixed exchange rate system
Fixed exchange rate currencies derive value by being fixed (or pegged) to another currency
to ensure that the value of their currency remains relatively stable.

Floating exchange rate system

The exchange rate is an equilibrium between demand and supply in the foreign exchange
market.

Statement 3 is incorrect
Fiscal policy seeks to influence the economy and economic growth by increasing or
decreasing TAXATION rates

Statement 4 is correct
The effect of a weaker exchange rate is to reduce the price of exports and increase the costs
of imports

Policies to reduce a current account deficit involve:

 Devaluation of exchange rate (make exports cheaper – imports more expensive)
 Reduce consumption and spending on imports (e.g. tight fiscal policy/higher taxes)
 Supply side policies to improve the competitiveness of domestic industry and exports.

Statement 5 is incorrect
This will lead to a weakening of domestic currency according to PPPT

4
10. Statements 3 and 4 are correct
1. Maturity transformation is seen as a benefit. Many short term deposits can be
transformed into long term loans or vice versa
2. Interest rate transformation is the essential economic function of banks and other
intermediaries, which enables both borrowers and investors to meet their differencing
preferences in relation to interest rates.

11. Statements 1 and 3 are correct

Securitization, the practice of pooling together various types of debt instruments
such as mortgages and other consumer loans, typically for the purpose of raising
cash by selling them as bonds to investors.

Securitization provides lenders with liquidity and is an effective means of diversifying

their portfolios to reduce risk.

• Securitisation allows a company or a bank to raise finance by selling assets

or income streams into a special purpose vehicle (SPV).

12.
Statements 1 and 3 are correct
 Commercial paper is a source of short term finance.
 Commercial paper is riskier than Treasury Bills and will therefore carry a higher yield

Note on Features of Money Market Instruments

It offers interest income while maintaining easy access to cash.
• Maintains Liquidity in the Market.
• Provides Funds at a Short Notice.
• Helps in monetary policy.
• Treasury Bills (T-Bills)
• Commercial Papers.
• Certificates of Deposits (CD)

5
13
Increase in value = $3.96m – $3.94m = $0.02m
As a percentage of the original value = $0.02m/$3.94m = 0.5076%
Annualising this value = 0.5076% x 365/45 = 4.12%

14
Annualised yield on this commercial paper
= (1.50 /98.50) x 360/180 = 3.05%

15.
Net present value of both projects:
NPV of X = ($15,000) + 2.487 x $8,000 = $4,896
NPV of Y = ($15,000) + 0.751 x $26,000 = $4,526
Select the project with the higher net present value, gives Project X.

16 The ROCE calculation is as follows

• Depreciation per year = $9,000/5 years = $1,800
• Profit per year = $3,000 – $1,800 = $1,200
Profit $1200
• ROCE = ---------------------------- = ----------------------------- = 13.33%
Initial investment $9000
The target ROCE is 15% therefore the project would be rejected

Payback
• Project payback calculation
$9,000
= ------------------------------ = 3 years
$3,000
Target payback is 2.5 years therefore the project would be rejected
Therefore the correct answer is neither 1 nor 2

6
17. The correct response is statement 3
Statement 1 is not correct
Sales Volume sensitivity
Net present value
Sensitivity = ----------------------------------------------------------------------
PV of the post tax contribution.

The first statement explains sales price sensitivity

Net present value
Sensitivity = ----------------------------------------------------------------------
PV of the post tax sales income.

Statement 2
The correct discount rate should be risk free rate of investment and not CAPM- derived
project specific cost of capital.

Statement 3 - Simulation models

The statement concerning simulation models is true, they use probabilities to carry out a
statistical analysis of possible project outcomes.

Statement 4 - Risk and uncertainty

Risk can quantified and uncertainty cannot be quantified
The statement concerning simulation models is true, they use probabilities to carry out a
statistical analysis of possible project outcomes.

18. The correct answer is $15,701

Year 1 PV = 10,000 x 1.05 x 0.877 = $9,209
Year 2 PV = 20,000 x 1.052 x 0.769 = $16,957
Year 3 PV = 25,000 x 1.053 x 0.675 = $19,535
NPV = 9,209 + 16,957 + 19,535 - 30,000
= $15,701
19.
Sales volume sensitivity
150,000
= ------------------------ x 100 = 20%
750,000
Fall in production and sales volume for the NPV to be zero
= 20% x 50,000 = 10,000 units

7
20
Pesos per $1 1.60
Dollar is the base currency (hb)
Peso is the counter currency (hc)
Six month forward rate
1 + .015
= 1.60 x -----------------------------
1 + .005
=1.62

8
The scenario relates Question 21 – 25 on risk management.

9
21. What type of exchange rate risk would Marigold Co experience with the
$100,000 loss in its consolidated financial statements?

A Economic

B Translation

C Transaction

D Political

Question 22

If Marigold Co uses the forward market to hedge the MS receipt, what amount
will be received (to the nearest $)?

Question 23

10
Question 24

Marigold Co is now considering the use of an option to hedge the currency risk on
the MS receipt. Its bank has offered an over-the-counter option with an exercise
price of MS1.1250 per $.

Which TWO of the following statements concerning the option are TRUE?

A The option will be more expensive to set up compared with either the forward
contract or money market hedge

B An imperfect hedge will result as the option will be for a standard amount of
currency and only a whole number of contracts may be used

C If the $ was to strengthen against the MS, Marigold Co is likely to be worse off
by using the option compared to either the forward contract or money market
hedge

D Using an option hedge will mean that Marigold Co is obligated to exercise the
option in three months irrespective of the spot rate on the day

Question 25
Marigold Co is unsure whether to use a forward contract or a money market hedge and is
comparing the relative advantages and disadvantages of the two. Which of the following
statements is true?
A The forward contract has the advantage of being tailored precisely to Marigold Co's
requirements but the money market hedge will be a standardised instrument resulting
in an imperfect hedge

B The forward contract will result in Marigold Co receiving the dollar equivalent of the
MS receipt in three months' time, whereas the money market hedge will provide
Marigold Co with dollar receipts today

C The forward contract will result in the effective rate of exchange being fixed whereas
the money market hedge will allow Marigold Co to benefit from favourable movement
in the exchange rate

D Marigold Co will be obligated to fulfil the forward contract in three months' time
whereas the money market hedge could be traded on an exchange to another party
before settlement

11
Marigold Co
21. The correct answer is B.
Translation risk is the gain/loss arising from the retranslation of a foreign
subsidiary's results.

22.
Expected Receipt in three months MS 300,000
MS per £
Three month forward rate 1.0850 1.1125
Buy MS Sell MS

The appropriate forward rate is 1.1125 MS per $1.

Dollar receipts =MS 300,000 / 1.1125 = $269,663

23. Receipt MS 300,000

Borrow MS at 1% for three months
Invest $ at 1.5% for three months
• Borrowing rate pro-rated for three months = 4% x 3/12 = 1%
• Amount to borrow = MS300,000 / 1.01 = MS297,030
• Amount to deposit = MS297,030 / MS1.1250 = $264,027

12
24.The correct answers are A and C
Statement A.
• Payment of the option premium upfront will make the option the more expensive
means of hedging.
Statement C
• A strengthening of the $ will result in a worse spot rate than the exercise price,
forcing exercise of the option. This, along with the premium cost will mean that
Marigold Co will be worse off than if they had used the other instruments which offer
better rates than even the exercise price.
Statement B
• Standard contract sizes only apply to tradable options, not over-the-counter options
which will be tailored to the needs of the customer.
Statement D
• An option hedge will give the company the rights but not an obligation to exercise the
option

25. The correct answer is B.

• A money market hedge will bring the cash translation forward and will therefore
provide $ today which could be spent rather than deposited.
• The forward contract will not do this, as it will be settled at the set future date.

Additional Notes of Forward contract and money market

 The money market hedge, like a forward contract, fixes the exchange rate for a
future transaction.
 The money market hedge can be customized to precise amounts and dates. Though
this degree of customization is also available in currency forwards, the forward
market is not readily accessible to everyone.
 The money market hedge is more complicated than regular currency forwards. It
may be suitable for hedging occasional or one-off transactions, but it may be too
cumbersome for frequent transactions. 

13
26. A cash budget was drawn up as follows:

October November December

$ $ $
Receipts
Credit sales 20,000 11,000 14,500
Cash sales 10,000 4,500 6,000
30,000
Payments
Suppliers 13,000 4,200 7,800
Wages 4,600 2,300 3,000
Overheads 3,000 1,750 1,900

Net cash flow 9,400 7,250 7,800

Opening Bal (11,000) (2,000) 5,250
Closing Bal (2,000) 5250 13,050

14
27 . The correct response is D, as follows:
Raw material effect using raw material purchases
5
= (100m x 50%) x --------------- = $684,932
365

Work in progress effect using cost of goods sold

4
=100m x ------------------- = $1,095,890
365

Finished goods effect using cost of goods sold

5
= 100m x ----------------------- =$1,369,863
365
Reduction in inventory = 684,932 + 1,095,890 + 1,369,863
= $3,150,685 or $3.151m

28. Optimum cash Conversion (Q)

D =150,000
Co = $80
Ch =($0·044 – $0·0056)
Q = $25,000 (apply formula)
The optimum amount of short-term investments to convert into cash in each transaction is
therefore $25,000

29. The correct answer is that statements 1,2 and 3 are correct.

Statement 1 is correct
There is a relationship between the level of working capital and the level of business activity,
so that as the level of business activity (sales) increases, the amount of working capital
should increase as well, if overtrading is to be avoided.
Statement 1 is therefore correct.

Statement 2 is correct
An increase in the cash operating cycle leads to an increase in the period for which finance
needs to be used to support business operations, and hence, all things being equal, an
increase in finance charges and a decrease in profitability.

Statement 3 is correct.
Statement three is true by definition, since overtrading means that a company or
organisation has insufficient capital to support its level of business activity, i.e. it is under-
capitalised.

Statement 4 is not correct.

Overcapitalisation is the result of too much long term capital

15
30. All three statements are correct.

Statement 1 is correct.

When the upper limit is reached, sufficient securities are purchased to reduce the cash
balance back to the return point. In this case $10m - $4m = $6m.

Therefore statement 1 is correct.

Statement 2 is correct

When the lower limit is reached, sufficient securities are sold to increase the cash balance
return point. In this case $4m - $1 = $3m. Therefore statement 2 is correct.

Statement 3 is correct.

An increase in variance will therefore increase the spread. Therefore statement 3 is correct.

31. The correct answer is $30,200

Ordering cost
600,000
= ----------------------- x 200 = $1,200 per year
100,000

Consumption during one week lead time = 600,000/50 = 12,000 units

Buffer inventory = Re-order level less lead time usage

= 20,000 – (12,000 x 1) = 8,000 units

Average inventory held during the year = 8,000 + (100,000/2) = 58,000 units

Holding cost = 58,000 x $0·50 = $29,000 per year

Total cost = ordering cost plus holding cost = $1,200 + $29,000

= $30,200 per year

32. All the three statements are correct

16
33. The correct answer is D.
• A conservative working capital investment policy refers to a higher amount
invested in working capital.
• It does not relate to the proportions of permanent to fluctuating current assets so
statement 1 is incorrect.

• Long-term finance is not generally less expensive than short-term finance; it is more
expensive as it is riskier for the lender, so statement 2 is also incorrect.

34. Dusty Co

Current Accounts receivables

= $1,500,000 m x 30 = $123,288
365

New level of Sales = 1,500,000 x 1.15 = 1,725,000

Receivable after the policy change

60
= $1,725,000 x ---------- = $283,563
365
Increase in receivables= $283,563 - $123,288 =$160,275

Financial evaluation
Increase cost in financing receivable =160275 x 8% = $ 12,822
Increase in bad debts (W) = $ 54,000
Increase in cost $ 66,822

Increase in Contribution (W2) = (1,725,000 – 1,500,000) x 40% = $ 90,000

Savings by introducing change in policy

= $ 90,000 - $66,822 =$23,178
The new policy is financially acceptable.

W1
$ $
Sales (say) 100 Sales 100
C.O.S 75 Variable 60
Cont 40
Fixed 15
Profit 25 Profit 25

Therefore the C/S ratio = 40%

W2
New level of bad debts = 1,725,000 x 4% = $69,000
Current level of bad debts = 1,500,000 x 1% = $15,000
Increase in bad debts $54,000

17
18
35.
Option 1
No discount
Receivables = $20 m x 60 =$ 3,287,671
365
With discount
Average Collection period with discount =(0.35 x 30) + (0.65 x 60) = 49.5 days
Revised (New) level of receivables = $20 m x 49.5
365
= $2,712,329
Reduction in trade receivables =$3,287,671 - $2,712,329 =$575,342

Savings
Finance cost savings 575342 x 8% = $46,027
Bad debt savings = $100,000
Total Savings $ 146,027

Costs
Costs of discount
($20 m x 35% x1.0%) $70000
Administration Costs $20000
$90000
The introduction of this cash discount will save a net amount of $56,027.

Option 2
Savings
Finance costs savings (W1) $131,507
Administration costs savings $160,000
Bad debts savings $200,000
Total savings $491507
Costs

Annual Fee of factor $ 20m x 1.75 % $350,000

Additional interest on advance
= $1,643,835 x 80% x 4% $52,603
$402,603
The offer is financially acceptable as there is a net savings of $88,904

W1 –
Current level of trade receivable $3,287,671
Using the services of the factor
Revised trade Receivables = 20 m x 30/365 $1,643,835
Reduction in trade receivables $1,643,835
Finance cost savings $1,643,835 x 8% $131,507

It is better to retain the services of the factor as this will result in a net savings of
$88,904, compared to a savings of $56,027 with the discount.

19
20
36
Earnings per share (EPS)
Dividends cover =-------------------------------------------------
Dividends per share

EPS = $0.10 x 4 =$0.40

Market price per share (Po)

P/E ratio = --------------------------------------------------
EPS

Po = $.40 x 5 = $2.00

Do x (1 + g)) (0.1 x (1 +.08))

ke = ------------------- + g =-------------------------- +.08
Po 2
= 13.4%.
 
Example 37 LCo
Degear the equity beta of new business area

Assume that the beta debt is zero Ignore tax T =0

Ve
ßa = ße --------------------------------------- + 0
(Ve + Vd(1 – T))
75
= 2.0 x ---------------------------------------
75 + 25
= 1.5

The asset beta does not need to be regeared because the company L is 100 % equity
financed

Using capital asset pricing model

Project-specific cost of equity: = Rf + (E(rm) – Rf) ßa
=5 + (4 x 1.5)
= 11 %

21
38. SY Co

Assume that the beta debt is zero

Degear equity beta of Trant Co

Ve
ßa = ße ------------------------------- + 0
(Ve + Vd(1 – T))
3
Ba = 1.54 --------------------------------------
3 + 2 ( 1-.40)
ßa = 1.1

Regear asset beta of Trant Co reflect financial risk of SY Co

Ve
ßa = ße ------------------------------- + 0
(Ve + Vd(1 – T))
3
1.1 = ße --------------------------------------
3 + 1( 1-.40)
ße = 1.32

Using capital asset pricing model

Project-specific cost of equity: = Rf + (E(rm) – Rf) ße
=5 + (3 x 1.32)
= 8.96 % = 9.0% to 1 decimal place

39
Statements 2 and 3 are correct

Note
A bonus issue
It is an offer of free additional shares to existing shareholders.No cash is raised

Payment of dividends
The general meeting can approve the recommendation of the board of directors or reduce
the amount of dividend to be distributed, but it cannot increase the amount of dividend to
be distributed.

40 Snare Co
After-tax cost = Before-tax cost x ( 1 -T)
4% = Before tax cost x ( 1 -.20)
Before-tax cost of the bank loan= 4% /.8= 5%

Before-tax cost (5%) = Rf + 3%

Risk-free rate of return = (5% - 3% ) =2%

Equity risk premium = 5%

Cost of equity of Snare Co = 2% + (5%x 1.4) =9·0%

22
41 Drumlin
41 The correct response is as follows:
Theoretical ex rights price
Existing 4 shares @ $8.00 $32.00
New 1 share @ $6.00 $ 6.00
5 Shares $38.00

Theoretical ex rights price $38/ 5 = $7.60

Value of a right per existing share = Market price before rights issue – TERP
Value of a right per existing share = $8.00 -$7.60
= $0.40

Alternatively
Theoretical ex rights price = $7.60
 Value of a right per new share =TERP – Rights issue price
= $7.60 - $6.00
= $1.60
Value of a right per existing share = $1.60/4
= $0.40

42- Simon
Value of a right per existing share = Market price before the rights issue- TERP

TERP = $7.00 – $0.40 = $6.60.

The value of a right per new share

=value of a right per existing share x number of shares needed for one right.

Value of a right per new share= 4 x $0.40 = $1.60

Value of a right per new share = TERP - Rights issue price

$1.60 = $6.60 - Rights issue price
Right issue price = $6.60 – $1.60 = $5.00

43
$000
Sales 60,000
Variable cost of sales 30,000
Contribution 30,000
Fixed cost of sales 20,000
Profit 10,000
Operational gearing = Contribution / PBIT
= 30000/10000= 3times

23
44. The correct answers are TRUE, TRUE and TRUE.

 SMEs are seen as higher risk due to a lack of trading history as well as fewer
assets to provide security.
 The lack of suitable assets for security will often make it difficult to obtain bank
finance unless the founders provide personal guarantees on the debt.
 These guarantees mean the sacrificing of limited liability as the founders will
now be personally liable for the debt.

45. Retained earnings are a source of equity finance

46
 Murabaha is similar to trade credit and therefore would not meet Tulip Co’s
needs.
 It is correct to state that Mudaraba is a form of equity finance and involves an
investing partner and a managing or working partner

Please revise Islamic finance

 Murabaha (trade credit)
 Mudaraba (equity finance)
 Musharaka(venture capital).
 Ijara(lease finance)
 Sukuk (Islamic bonds)

47 (from examiner’s report)

Taking the three statements one at a time:

1. A scrip (or bonus) issue of new equity shares.

A scrip issue usually alters the share capital by issuing new shares free of charge to
existing shareholders, based on their existing shareholding (e.g.one new share for
every three already held). This changes a company’s reserves into share capital
( equity) but it does not raise any cash.
Therefore, statement 1 cannot be the correct answer
 
2. A reduction in dividend paid.
A reduction in dividend paid would mean that less cash is paid as dividend and
therefore more would be available for the project.
As dividend is paid from equity earnings it is equity finance and this statement is
correct.
 
3. Sale of redeemable preference shares.
A sale of redeemable preference share would increase the cash available for the
project, but these are non-current liabilities and not equity finance. This is because
there is an obligation to pay the holder of this type of share at some specified point in
the future.
Therefore, statement 3 is not correct answer.
 

24
48

25
50. Constructed Response question – rights issue

26
27
50 La forge Co
(a)(i) TERP

Current number of shares = $35m / $0.50 = 70m

Rights Issue price = $2.60 x (1 – 0.3) = $1.82 per share
Number of shares to be issued = $25.48m / $1.82 = 14 million shares

MV before rights issue =70m shares at $2.60 = $182.0m

Rights issue 14m shares at $1.82 = $25.48

After rights issue 84 m shares = $182.0m +25.48m=$207.48m

TERP = 207.48/84= $2.47

(a)(ii) Value of a right (VOR)

VOR per new share = $2.47 - $1.82 = $0.65 per new share
VOR per existing share = $0.65 / 5 = $0.13 per existing share

(b)(i) Rights issue

Forecast PAT = $16.56m + $4.5m x (1 - 0.2) = $20.16m
Forecast EPS = $20.16m / 84m = $0.24 per share
Forecast share price = $0.24 x 11 = $2.64 per share

(b)(ii) Loan notes

Extra interest = $25.48m x 6% = $1.53m

Forecast PAT = $16.56m + ($4.5m - $1.53m) x (1 – 0.2)

= $18.94m

Forecast EPS = $18.94m / 70m = $0.2706 per share

Forecast share price = $0.2706 x 11 = $2.98 per share

(c) Methods of issuing new equity shares

Rights issue
A rights issue involves issuing shares to the existing shareholders in proportion to their
existing holding.

Rights issues are often successful, easier to price and are cheaper to arrange than a public
issue but the amount of finance raised is limited as there is a finite amount that shareholders
will be willing to invest.

A rights issue would be mandatory if shareholders have not elected to waive their pre-
emptive rights.

28
Private placing
A private placing is when a company, usually with the assistance of an intermediary, seeks
out new investors on a one-to-one basis.

Shares are normally issued to financial institutions when performing a placing rather than to
individuals.

This can be a useful source of new equity for an unlisted company but control of the
company will be diluted as a result.
A placing is also cheaper to arrange than a public issue but only useful for relatively small
issues.

Public offer
If the company is listed, it may undertake a public offer whereby shares are offered for sale
to the public at large.

This is an expensive way of issuing shares as there are significant regulatory costs involved
and like the placing, control of the existing shareholders will be diluted.

A public issue will, however, allow very large amounts of equity finance to be raised, and will
also give a wide spread of ownership.

Initial public offering (IPO)

If the company is not listed, it can list through the process of an IPO which will raise equity at
the same time.

An IPO will be more expensive than a public offer as there are further regulations having
to be complied with, increasing costs.

Consequently, only a large company wishing to raise a significant amount of finance would
consider this option.

(d) The director’s suggestion of reducing the forthcoming dividend would raise at
most, $5.6m (70m x $0.08).

This would provide 22% ($5.6m / $25.48m) of the total finance required and in itself, would
not be sufficient.

This would reduce the amount of new external finance needing to be raised, potentially
reducing financing cost, but there are further problems with this suggestion

Signalling effect
The signalling argument suggests that the dividend announcement will send a message or
“signal” to the market.

Generally, a reduction in dividend (such as proposed here) could be interpreted as bad news
by investors and result in a fall in La Forge Co’s share price

29
Clientele effect
Different investors have different needs relating to income or capital growth.

La Forge Co has consistently paid dividends in the past so switching to a lower/zero pay-out
could alienate some shareholders, resulting in large volumes of share sales.

Given the different shareholders that La Forge Co has, this could be a real issue for them

Liquidity preference
Generally, it is thought that shareholders prefer to receive some dividend now as this is a
certain return compared with the more risky and uncertain future dividends or capital growth.

Recommendation
Given that La Forge Co is a listed company with different shareholders and has consistently
paid dividends in the past, a reduction in dividend could damage shareholder relations and
possibly result in reduced shareholder wealth.

The reduction in dividend is not recommended.

30
31
32
51 GXG (a)

Option 1

The current value of GXG Co, using the existing 3% dividend growth rate:

Dividends per share = $1,600,000 ÷10,000,000 = $.16 = 16c

16c x (1 + ·03)
Po =----------------------------- = 275 c
(0·09 – 0·03)

The current value of GXG = 10m x $2.75 = $27·5 million

Dividends paid from the end of the third year onwards.

Using dividend growth model
Do (1 + g) D1
Po =-------------------- = --------------------
Ke - g Ke - g
D3 25
P2 = -------------------- = -------------------
Ke - g .09 - .04
P2 = 500c

Po = 500c x DF ( r = 9%; n =2)

= 500 c x.842 =421c

Value of GXG under option1 = $4.21 x 10m = $42.1M

The proposal will increase shareholder wealth by $42·1m – $27·5m = $14·6 m
and so is likely to be acceptable to shareholders.

33
Option 2
Raising $3.2m after issue costs of $100,000 by issuing new shares at a price of
$2.50

The cash to be raised =$3,200,000m + $100,000 = $3,300,000

The number of shares issued
3,300,000
= ------------------------- = 1,320,000 shares
2·50
Total number of shares after the stock market listing =10,000,000 +1,320,000
= 11,320,000 shares

$
Current Profit before tax 3,250,000
Before tax return on Investment= 0·18 x 3·2m 576,000
3,826,000
Less tax @20% (765,200)
Revised earnings $3,060,800

Revised earnings per share

3,060,800
= ----------------------- x 100 = 27 cents per share
11,320,000
Current earnings per share
2,600,000
= ----------------------- x 100 = 26 cents per share
10,000,000

The earnings per share has increased by 1 cent per share, which existing shareholders may
find acceptable.

However, the balance of ownership and control will change as a result of the new
shareholders, and no information has been provided about expected future dividends.

34
(c) Option 3
Issue $3.2m of bonds paying interest of 6%, redeemable in 10 years time at par
Increase in before-tax income = 0·18 x 3·2m = $576,000

Interest on new debt = 3,200,000 x 0·06 = $192,000

(c) Revised income statement
$
Revised operating profit = (3,200,000 x 18%) + 3,450,000 = 4,026,000
Revised interest = (3,200,000 x 6%) + 200,000 = (392,000 )
Revised profit before tax 3,634,000
Taxation ( 727,000)
Revised profit after tax 2,907,000

Revised earnings per share

2,907,000
= ------------------------------- x 100 = 29.1 cents per share
10,000,000
Current earnings per share
2,600,000
= ------------------------------ x 100 = 26 cents per share
10,000,000
Earnings per share would increase by 3·1 cents per share

3,450,000
Current interest cover = ------------------------ = 17 times
200,000
4,026,000
Revised interest cover = ---------------------------- =10 times
392,000
The increase in earnings per share would be welcomed by shareholders.
The decrease in interest cover is not serious and the increase in financial risk is
unlikely to upset shareholders.

35
Traditional view
The WACC decreases as gearing is introduced.

As gearing increases, both equity and debt providers start to be concerned.

Higher returns are demanded by the providers of finance and so WACC increases.

It reaches a minimum and then starts to increase again.

The optimal level of gearing is where the WACC is at its minimum level

Modigliani and Miller (M&M) view

Ignoring taxes, the cost of 'cheap' loan finance is precisely offset by the increasing cost of
equity, so WACC remains constant at all levels of gearing.

Taking taxation into account, interest is cheap enough to cause WACC to fall despite
increasing cost of equity.
This leads to an all-debt-financing conclusion.

Modern view
M&M are probably right that gearing is only beneficial because of tax relief.
At high levels of gearing, investor worries about the costs of the business going into
enforced liquidation ('bankruptcy') become significant and required returns (both equity and
debt) would increase at high levels of gearing.

Conclusion:
A business should gear up to a point where the benefits of tax relief are balanced by
potential costs of bankruptcy and interest rate increases – here WACC will be at a minimum
and value of the business at a maximum.

36
37
38
52. Yellow Co
Consider one preference share
A 4% irredeemable preference pays interest of
$1 x 4% = $.04 annually.
Dividends
Ex-div market value = --------------------------------------
Return on Preference
$.04
Ex-div market value = ----------------------------------- = $.80
.05
MV of preference shares = 10,000 x $0.8 =$8,000

53 Black Co
Consider $100 nominal value
• A 5% irredeemable debenture pays interest of $100 x 5% = $5 annually.
$5
• Ex-interest market value = ------------- = $50.
0.1
• Therefore the cum interest market value is: $50 + $5 = $55.

Note
1. The market price is cum interest.
2. Interest about to be paid needs to be added.

54.The correct response is as follows:

Per share DF @10% PV
Year 1: 0 .909 0
Year 2 $0·25 0.826 .2065
Year 3: $0·50 0.751 .3755
Year 4 to Inf (w) 5.5252
6.1072
Share price = $6·11 per share

Working

Year 4 to perpetuity
D4
P3 = ----------------------------------
Ke - g

.50 x (1 +.03)
P3 = -----------------------------------
.10 - .03

= $7.357
PV of dividends from Year 4 to infinity = 7.357 x .751 = 5.5252

39
55 D Inc
Dividends payout =40%

Current EPS of the company = 50 cents per share.

Dividends per share (Do) (40% x 50c) = 20 cents

Dividends growth rate (g) = 3 % to perpetuity.

Ke = 4% + (5% x 1.4) =11%

20c x ( 1 + .03)
Po =---------------------------------------------- = $2.58
.11 - .03

56
Expected Share price =3.25 x ( 1+.08) 3 =$4.094064
Conversion Value = 25 x$4.094064 = $102.35

Market value= PV of interest + PV of conversion value

= ($6 x 2.673 ) + ($102.35 x .840)

Market value = $16.04 + $85.97

= $102

57. Skava Co
Let the geometric average dividend growth rate is g
.311(1+ g)3 = .360

(1+ g) = (.360/.311)1/3

g = (.360/.311)1/3 – 1 = 5%

The ex div share price (Po)

.360 x (1 +·05)
=-------------------------------------- = $5.40
(0·12 – 0·05)

58. P Co
Div per share
Dividends Payout = ---------------------------------------------
EPS
EPS =(16/.4) =40c

Average sector price/earnings ratio 10

Market price per share ( 40c x 10) =400c

Number of ordinary shares = 5 million

Value of D Co using the price/earnings ratio method = 5m x $4 = $20m

40
 

Bluebell Co
59
Non current assets + Current Assets – Total Liabilities

60.The value of Bluebell Co on a net realisable value

$m
Non-current assets
Property, plant and equipment 600.0
Inventories (285 -30) 255.0
Trade receivables (192 x .9) 172.8
––––––
1027.8
less Total liabilities (662)
––––––
$365·8m

61. The value of Bluebell Co using the earnings yield method

Earnings
= -------------------------
Earnings yield
$150m
=----------------------------------- =$1875m
1/12.5
62
The correct answers are statements 1 and 5
An asset valuation would be useful for an asset stripping acquisition
Book value will normally be a meaningless figure as it will be based on historical costs

Statement 2
The workforce is an intangible assets and not reflected in asset valuation.

Statement 3
Cash flow based valuation discounts the value of future cash Flows

Statement 4
Replacement costs do not measure deprival value

63
The correct answer is statement 2 and statement 5
 The Co would pay a higher price to gain control of Dandelion

 In a semi-strong form efficient market, insider trading opportunities occur between

the time that new information about the business happens and the time the news is
released to the public

41
42
43
44
64.
The correct answer is 1 and 3.

Smoothing is an interest rate risk hedging which involves maintain a balance between fixed
rate and floating rate debt

The difference between the amounts of interest-sensitive assets and liabilities is a

description of gap exposure.
 

65 Awan Co
The correct responses are B and D.  

The appropriate FRA would be a 2 v 6 FRA.

With respect to futures, to hedge against interest rate decreases, interest rate futures should
be bought now.

66
Actual interest is payable at 3.75%
Because of FRA at 2.85%

The Financial institution pays the company

$14m( 3.75% -2.85%) x 7/12 = $73,500

67
The correct response is as follows:
Statement 2,5 and 6

Under a collar, the buyer can buy an interest rate floor and simultaneously sell an interest
CAP, thus limiting the premium cost for the company, since a premium is received for the
option sold.
The cost of buying an option alone (such as a floor) is higher than for a collar.

68
Correct answers are Futures contracts and exchange-traded options

• Futures contracts, whether interest rate futures or currency futures, relate to a

standard quantity of an underlying asset.
• Exchange-traded options, by definition, are traded on an exchange and are therefore
standardised in nature, whether interest rate options or currency options.

All of the other instruments can be tailored to the exact requirements of the hedge. 

69. All the three statements are correct

45
Notes
Forward rate agreement
A forward rate agreement (FRA) is the interest rate equivalent of a forward exchange
contract (FEC).

It is an agreement between a bank and a customer to fix an interest rate on an agreed

amount of funds for an agreed future period.

The FRA is tailored to the customer’s needs and so is a bespoke contract rather than a
standardised contract.

Interest rate options

Interest rate options can be used to hedge an adverse interest rate movement, while
allowing the buyer to let the option lapse in order to benefit from favourable interest rate
movements.

Interest rate futures

With interest rate futures, a borrower hedges against an interest rate increase by selling
futures now and buying futures on a future date, while a lender hedges against an interest
rate decrease by buying futures now and selling them on a future date.

Standard contract sizes

Exchange tradable options and futures contracts are the instruments which have standard
contract sizes.

70 Using exchange rates based on interest rate parity

Expected rate in 6 months
1 +.05
= 5.0 x ------------------------------ = 5.0847
1+ .0325
Expected rate in 12months
1 + 0.1
= 5.0 x ------------------------------ = 5.1643
1 + .065

6 months 12 months
Cash flows (pesos) 200 m 380 m
Exchange rate 5.0847 5.1643
Cash flows ($) 39.33 m 73.58 =112.91m

71.
The correct answer is B
A Co can hedge interest rate risk on borrowing by selling interest rate futures now
and buying them back in the future

46
72.
(a) (i) For investment decision 1

47
48
(b) (i)
Approach Crocket Co should use to determine the optimum replacement cycle
for the company car fleet

1. The cash flows must be determined for each cycle under consideration (3, 4 and 5
years).
These cash flows will include:
 the initial outlay of the car fleet,
 maintenance and running costs and
 the residual value of the car fleet at the end of the cycle.

2. Discount these cash flows at a suitable discount rate to determine the present
value (PV) for each cycle. The PVs will be negative as they represent the cost of
running the company car fleet with no relevant income attributable.

49
3. To allow for the difference in timescales, the PV for each cycle will need
converting to an equivalent annual cost (EAC).
The EAC would be calculated by taking each cycle’s PV and dividing by the annuity
factor, taking into account the discount rate and the replacement cycle.
For example, the three-year PV will need to be divided by a three-year annuity factor
The EAC will represent the annuity cash flow.

4. Once the EAC has been calculated for each cycle, select the lowest (cheapest)
EAC and this will indicate the optimum replacement cycle for the fleet.
By comparing the EAC for each cycle, a common timescale (one year) will be
considered making the figures comparable.

Qu 72
(c) Inflation in investment appraisal
When appraising an investment, the treatment of inflation needs to be considered as
it will affect both cash flows and the required rate of return used as the discount rate.

Real-terms and nominal-terms approaches to investment appraisal differ in the way

that the effects of inflation are incorporated into the appraisal calculation.

Nominal-terms approach
With the nominal-terms approach, the cash flows incorporate the effects of specific
rates of inflation to sales, material costs and other cash flows.

The cost of capital would also need to include the effects of general inflation.

50
The uncertainty surrounding the rates of inflation that Crocket Co faces with this
project will certainly make an appraisal in nominal-terms more difficult to prepare
with any accuracy and this should be considered when reviewing the results.

Real-terms approach
A real terms approach would exclude the effects of general inflation.

Therefore, nominal cash flows incorporating the effects of specific inflation rates
would be deflated by the general rate of inflation to give real-terms cash flows.

The discount rate will also exclude the effects of inflation.

Consequently, a real discount rate would be used which represents the investors’
base level of return for risk before inflation is taken into account.

Choice of approach
A real-terms approach would result in a much easier appraisal exercise for Crocket
Co as the uncertainty surrounding the estimation of inflation is removed, however, a
number of conditions must be met in order for the real-terms approach to be suitable.
1. Firstly, there must be a single rate of inflation affecting all of the project’s cash
flows.
Given that the estimated increase in material costs is different to the expected rise in
sales prices this means that a real-terms approach is already deemed unsuitable.

As Crocket Co expects the rate of inflation on sales to be less than the rate of
inflation on its costs, particularly materials, then it would be expected that any real-
terms NPV is likely to be overstated compared to a nominal-terms NPV as costs will
be rising faster than income.

51
Secondly, the single rate of inflation affecting the cash flows must also be the same
as the general rate of inflation suffered by investors.
If the inflation rate affecting cash flows is the same as the inflation rate ignored by
the real discount rate, this common rate of inflation can be ignored.
Given that Crocket Co expects the general rate of inflation to differ from the rates
affecting sales and material cost, this also means a real terms approach ignoring
specific inflation is not suitable.

Recommendation
As a result of the above conditions not being met, use of the real-terms approach will
not be suitable for Crocket Co to appraise this project.
A nominal-terms approach should be used.

Investment decision 4

52
Comments

53
Based on the chief engineer’s assumptions, the project generates a positive NPV of
$7·026 million.

On the other hand, when the finance director’s objections are incorporated into the
appraisal, the expected NPV is only $5.61 million for alternative 1 and $3.26m for
alternative 2.

It should be noted that the expected NPV of $5.61 million is an average. In other
words, it is the average NPV if the project is carried out repeatedly which may not be
useful in the case of a one-off development opportunity.

Based on the calculations above, there is a 20% chance that the NPV will be
negative at $71,000, which may pose a risk the directors are not prepared to take.

The directors’ attitude to risk will be an important factor in the final decision.

Furthermore, the analysis largely depends upon the values of the probabilities
prescribed, the range of possible outcomes and the accuracy of the revenue and
cost assumptions.

Sensitivity analysis may be useful in testing the impact of variations in each of

these variables on the final outcome.

54
Investment decision Project H

(i) Sales price sensitivity

(ii) Variable cost sensitivity

(iii) Discount rate sensitivity

55
56
57
Spine Co
58
59
Thank you for everything.

My best wishes are with you

All the best for your exams

60