December 2014–June 2015 Edition

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PL
STUDY QUESTION BANK
ACCA
M
Paper P4 | ADVANCED FINANCIAL
MANAGEMENT
SA

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ACCA

PL PAPER P4

ADVANCED FINANCIAL MANAGEMENT

M
STUDY QUESTION BANK
SA

For Examinations to June 2015

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Acknowledgement

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Accountants and have been reproduced by kind permission.

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 STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

CONTENTS

Question Page Answer Marks Date worked

Tables and formulae (v)

ROLE OF FINANCIAL STRATEGY

1 Agency relationships 1 1001 13

2 Ethics (ACCA D03) 1 1002 15

SECURITY VALUATION AND THE COST OF CAPITAL

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3 Cost of capital 1 1003 15
4 Gaddes (ACCA J03) 2 1005 15
5 Stock market efficiency 3 1007 10

WEIGHTED AVERAGE COST OF CAPITAL AND GEARING

6
7
8

10
11
12
Redskins
Berlan
Kulpar (ACCA D00)

PORTFOLIO THEORY AND CAPM

9 Maltec (ACCA J01)

Wemere
Crestlee (ACCA D92)
Hotalot (ACCA J89)
PL 3
4
5

6
6
8
9
1008
1010
1013

1015
1016
1018
1021
20
20
30

5
25
25
25
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BASIC INVESTMENT APPRAISAL

13 Amble 10 1023 25
14 Progrow (ACCA D95) 11 1025 40

ADVANCED INVESTMENT APPRAISAL

15 Tampem (ACCA D06) 14 1030 15

SA

16 Project review (ACCA J09) 15 1032 28

BUSINESS VALUATION

17 Daron (ACCA D96) 16 1036 40

18 Mercury training (ACCA J08) 18 1041 28

MERGERS AND ACQUISITIONS

19 Bigun 20 1043 25
20 Demast (ACCA J94) 21 1046 30
21 Laceto (ACCA J01) 23 1050 40
22 Miniprice & Savealot (ACCA PP) 25 1053 30

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 ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

Question Page Answer Marks Date worked

CORPORATE RECONSTRUCTION AND RE-ORGANISATION
23 Dricom (ACCA D97) 27 1056 30
24 Aster (ACCA J97) 29 1061 30
25 MBO 31 1063 10

EQUITY ISSUES AND DEBT ISSUES

26 Equity and debt issues 31 1065 16
27 IXT 31 1066 25
28 New debt issue (ACCA D07) 33 1069 20

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DIVIDEND POLICY
29 Pavlon 34 1071 20
30 TYR (ACCA D02) 35 1073 15

OPTIONS
31
32

34
35
36
Storace
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Uniglow (ACCA J02)
Bioplasm (ACCA D03)

FOREIGN EXCHANGE RISK MANAGEMENT

33 Forun (ACCA J94)

Participating option (ACCA D00)

MJY (ACCA D05)
35
36

37
39
40
40
1075
1076

1078
1082
1085
1086
15
15

40
16
10
15

INTEREST RATE RISK MANAGEMENT

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37 Omnitown 41 1087 25
38 Manling 42 1089 25
39 Murwald (ACCA D94) 43 1093 30
40 Turkey 44 1096 18

THE ECONOMIC ENVIRONMENT FOR MULTINATIONALS

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41 Global debt (ACCA J04) 44 1098 15

42 Beela Electronics (ACCA D01) 44 1099 15
43 IMF (ACCA PP) 45 1100 10

INTERNATIONAL OPERATIONS
44 Polycalc 45 1101 16
45 Avto (ACCA D03) 46 1103 40
46 Servealot (ACCA J06) 48 1107 15
47 Kandover (ACCA D06) 48 1108 15

FINANCIAL STATEMENT ANALYSIS

48 Noifa Leisure 49 1111 25
49 Twello 51 1113 25
50 Sparks 53 1115 12
51 Wurrall (ACCA J04) 54 1118 40

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 STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Formulae

Modigliani and Miller Proposition 2 (with tax)

Vd
ke = kei + (1 – T) (kei – kd)
Ve

The Capital Asset Pricing Model

E(ri) = Rf + βi[E(rm) – Rf]

The asset beta formula

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 Ve   Vd 1  T  
βa =  βe  +  βd 
 Ve  Vd 1  T    Ve  Vd 1  T  

The Growth Model

PL PO =
D O 1  g 
re  g 
Gordon’s growth approximation

g = bre

The weighted average cost of capital

 Ve   Vd 
WACC =  k e +   k d 1  T 
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 Ve  Vd   Ve  Vd 

The Fisher formula

(1 + i) = (1 + r)(1 + h)

Purchasing power parity and interest rate parity

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1  h c  1  i c 
S 1 = S0 × F 0 = S0 ×
1  h b  1  i b 

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 ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

Modified Internal Rate of Return

1
 PVR  n
MIRR =   1  re   1
 PVI 

The Black-Scholes option pricing model

c = PaN(d1) – PeN(d2)e-rt

Where:

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d1 =

1n (Pa /Pe )  r  0.5s 2 t 
s t

d2 = d1 – s t

PL The Put Call Parity relationship

p = c – Pa + Pee-rt
M
SA

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 STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Present value table

Present value of 1 i.e. (1 + r)–n

where r = discount rate
n = number of periods until payment

Discount rate (r)

Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 1

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2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826 2
3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751 3
4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683 4
5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621 5

6 0.942 0.888 0.837 0.790 0.746 0.705 0.666 0.630 0.596 0.564 6
7
8
9
10

11
12
13
14
15
0.933
0.923
0.914
0.905

0.896
0.887
0.879
0.870
0.861
0.871
0.853
0.837
0.820

0.804
0.788
0.773
0.758
0.743
0.813
0.789
0.766
0.744

0.722
0.701
0.681
0.661
0.642
PL 0.760
0.731
0.703
0.676

0.650
0.625
0.601
0.577
0.555
0.711
0.677
0.645
0.614

0.585
0.557
0.530
0.505
0.481
0.665
0.627
0.592
0.558

0.527
0.497
0.469
0.442
0.417
0.623
0.582
0.544
0.508

0.475
0.444
0.415
0.388
0.362
0.583
0.540
0.500
0.463

0.429
0.397
0.368
0.340
0.315
0.547
0.502
0.460
0.422

0.388
0.356
0.326
0.299
0.275
0.513
0.467
0.424
0.386

0.350
0.319
0.290
0.263
0.239
7
8
9
10

11
12
13
14
15
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(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 1
2 0.812 0.797 0.783 0.769 0.756 0.743 0.731 0.718 0.706 0.694 2
3 0.731 0.712 0.693 0.675 0.658 0.641 0.624 0.609 0.593 0.579 3
4 0.659 0.636 0.613 0.592 0.572 0.552 0.534 0.516 0.499 0.482 4
5 0.593 0.567 0.543 0.519 0.497 0.476 0.456 0.437 0.419 0.402 5
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6 0.535 0.507 0.480 0.456 0.432 0.410 0.390 0.370 0.352 0.335 6
7 0.482 0.452 0.425 0.400 0.376 0.354 0.333 0.314 0.296 0.279 7
8 0.434 0.404 0.376 0.351 0.327 0.305 0.285 0.266 0.249 0.233 8
9 0.391 0.361 0.333 0.308 0.284 0.263 0.243 0.225 0.209 0.194 9
10 0.352 0.322 0.295 0.270 0.247 0.227 0.208 0.191 0.176 0.162 10

11 0.317 0.287 0.261 0.237 0.215 0.195 0.178 0.162 0.148 0.135 11
12 0.286 0.257 0.231 0.208 0.187 0.168 0.152 0.137 0.124 0.112 12
13 0.258 0.229 0.204 0.182 0.163 0.145 0.130 0.116 0.104 0.093 13
14 0.232 0.205 0.181 0.160 0.141 0.125 0.111 0.099 0.088 0.078 14
15 0.209 0.183 0.160 0.140 0.123 0.108 0.095 0.084 0.074 0.065 15

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 ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

Annuity table

1  (1  r )  n
Present value of an annuity of 1 i.e.
r

where r = discount rate

n = number of periods

Discount rate (r)

Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

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1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 1
2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736 2
3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487 3
4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170 4
5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791 5

6
7
8
9
10

11
12
13
5.795
6.728
7.652
8.566
9.471

10.37
11.26
12.13
5.601
6.472
7.325
8.162
8.983

9.787
10.58
11.35
PL
5.417
6.230
7.020
7.786
8.530

9.253
9.954
10.63
5.242
6.002
6.733
7.435
8.111

8.760
9.385
9.986
5.076
5.786
6.463
7.108
7.722

8.306
8.863
9.394
4.917
5.582
6.210
6.802
7.360

7.887
8.384
8.853
4.767
5.389
5.971
6.515
7.024

7.499
7.943
8.358
4.623
5.206
5.747
6.247
6.710

7.139
7.536
7.904
4.486
5.033
5.535
5.995
6.418

6.805
7.161
7.487
4.355
4.868
5.335
5.759
6.145

6.495
6.814
7.103
6
7
8
9
10

11
12
13
14 13.00 12.11 11.30 10.56 9.899 9.295 8.745 8.244 7.786 7.367 14
15 13.87 12.85 11.94 11.12 10.38 9.712 9.108 8.559 8.061 7.606 15
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(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 1
2 1.713 1.690 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.528 2
3 2.444 2.402 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.106 3
4 3.102 3.037 2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.589 4
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5 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127 3.058 2.991 5

6 4.231 4.111 3.998 3.889 3.784 3.685 3.589 3.498 3.410 3.326 6
7 4.712 4.564 4.423 4.288 4.160 4.039 3.922 3.812 3.706 3.605 7
8 5.146 4.968 4.799 4.639 4.487 4.344 4.207 4.078 3.954 3.837 8
9 5.537 5.328 5.132 4.946 4.772 4.607 4.451 4.303 4.163 4.031 9
10 5.889 5.650 5.426 5.216 5.019 4.833 4.659 4.494 4.339 4.192 10

11 6.207 5.938 5.687 5.453 5.234 5.029 4.836 4.656 4.586 4.327 11
12 6.492 6.194 5.918 5.660 5.421 5.197 4.988 4.793 4.611 4.439 12
13 6.750 6.424 6.122 5.842 5.583 5.342 5.118 4.910 4.715 4.533 13
14 6.982 6.628 6.302 6.002 5.724 5.468 5.229 5.008 4.802 4.611 14
15 7.191 6.811 6.462 6.142 5.847 5.575 5.324 5.092 4.876 4.675 15

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 STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Standard normal distribution table

0·00 0·01 0·02 0·03 0·04 0·05 0·06 0·07 0·08 0·09

0·0 0·0000 0·0040 0·0080 0·0120 0·0160 0·0199 0·0239 0·0279 0·0319 0·0359
0·1 0·0398 0·0438 0·0478 0·0517 0·0557 0·0596 0·0636 0·0675 0·0714 0·0753
0·2 0·0793 0·0832 0·0871 0·0910 0·0948 0·0987 0·1026 0·1064 0·1103 0·1141
0·3 0·1179 0·1217 0·1255 0·1293 0·1331 0·1368 0·1406 0·1443 0·1480 0·1517
0·4 0·1554 0·1591 0·1628 0·1664 0·1700 0·1736 0·1772 0·1808 0·1844 0·1879

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0·5 0·1915 0·1950 0·1985 0·2019 0·2054 0·2088 0·2123 0·2157 0·2190 0·2224
0·6 0·2257 0·2291 0·2324 0·2357 0·2389 0·2422 0·2454 0·2486 0·2517 0·2549
0·7 0·2580 0·2611 0·2642 0·2673 0·2703 0·2734 0·2764 0·2794 0·2823 0·2852
0·8 0·2881 0·2910 0·2939 0·2967 0·2995 0·3023 0·3051 0·3078 0·3106 0·3133
0·9 0·3159 0·3186 0·3212 0·3238 0·3264 0·3289 0·3315 0·3340 0·3365 0·3389

1·0
1·1
1·2
1·3
1·4

1·5
1·6
1·7
0·3413
0·3643
0·3849
0·4032
0·4192

0·4332
0·4452
0·4554
0·3438
0·3665
0·3869
0·4049
0·4207

0·4345
0·4463
0·4564
0·3461
0·3686
0·3888
0·4066
0·4222

0·4357
0·4474
0·4573
PL 0·3485
0·3708
0·3907
0·4082
0·4236

0·4370
0·4484
0·4582
0·3508
0·3729
0·3925
0·4099
0·4251

0·4382
0·4495
0·4591
0·3531
0·3749
0·3944
0·4115
0·4265

0·4394
0·4505
0·4599
0·3554
0·3770
0·3962
0·4131
0·4279

0·4406
0·4515
0·4608
0·3577
0·3790
0·3980
0·4147
0·4292

0·4418
0·4525
0·4616
0·3599
0·3810
0·3997
0·4162
0·4306

0·4429
0·4535
0·4625
0·3621
0·3830
0·4015
0·4177
0·4319

0·4441
0·4545
0·4633
1·8 0·4641 0·4649 0·4656 0·4664 0·4671 0·4678 0·4686 0·4693 0·4699 0·4706
1·9 0·4713 0·4719 0·4726 0·4732 0·4738 0·4744 0·4750 0·4756 0·4761 0·4767
M
2·0 0·4772 0·4778 0·4783 0·4788 0·4793 0·4798 0·4803 0·4808 0·4812 0·4817
2·1 0·4821 0·4826 0·4830 0·4834 0·4838 0·4842 0·4846 0·4850 0·4854 0·4857
2·2 0·4861 0·4864 0·4868 0·4871 0·4875 0·4878 0·4881 0·4884 0·4887 0·4890
2·3 0·4893 0·4896 0·4898 0·4901 0·4904 0·4906 0·4909 0·4911 0·4913 0·4916
2·4 0·4918 0·4920 0·4922 0·4925 0·4927 0·4929 0·4931 0·4932 0·4934 0·4936

2·5 0·4938 0·4940 0·4941 0·4943 0·4945 0·4946 0·4948 0·4949 0·4951 0·4952
SA

2·6 0·4953 0·4955 0·4956 0·4957 0·4959 0·4960 0·4961 0·4962 0·4963 0·4964
2·7 0·4965 0·4966 0·4967 0·4968 0·4969 0·4970 0·4971 0·4972 0·4973 0·4974
2·8 0·4974 0·4975 0·4976 0·4977 0·4977 0·4978 0·4979 0·4979 0·4980 0·4981
2·9 0·4981 0·4982 0·4982 0·4983 0·4984 0·4984 0·4985 0·4985 0·4986 0·4986

3·0 0·4987 0·4987 0·4987 0·4988 0·4988 0·4989 0·4989 0·4989 0·4990 0·4990

This table can be used to calculate N(d), the cumulative normal distribution functions needed for the
Black-Scholes model of option pricing. If di> 0, add 0·5 to the relevant number above. If di< 0, subtract
the relevant number above from 0·5.

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 ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

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PL
M
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 STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Question 1 AGENCY RELATIONSHIPS

Explain the term “agency relationships” and discuss the conflicts that might exist in the relationship
between:

(a) shareholders and managers;

(b) shareholders and creditors.

Explain the steps that might be taken to overcome these conflicts.

(13 marks)

Question 2 ETHICS

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Discuss, and provide examples of, the types of non-financial, ethical and environmental issues
that might influence the objectives of companies. Consider the impact of these non-financial,
ethical and environmental issues on the achievement of primary financial objectives such as the
maximisation of shareholder wealth.
(15 marks)

Question 3 COST OF CAPITAL

(a)

(iii)
(iv)
(v)
PL
Calculate the current pre-tax cost of the following debts:

(i)
(ii)
A 10% coupon irredeemable debenture issued at par.
A 10% irredeemable debenture trading at $85 per $100 face value.
A 10% redeemable debenture trading at $74 with three years to redemption at par.
A 10% redeemable debenture trading at par, with three years to redemption at par.
A 5% irredeemable $1 preference share trading at $0.65.
(4 marks)
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(b) Calculate the current post-tax cost with a corporation tax rate of 35% of the debts in (a)
above. (3 marks)

(c) Given the following data about share prices, compute the cost of equity in each case:

(i) Market price per share $1.50 ex-dividend. Dividend just paid 7.5 cents, which is
expected to remain constant.
SA

(ii) Market price per share $1.65 cum-dividend. Dividend about to be paid 15 cents,
which is expected to remain constant.

(iii) Market price per share $1.20 ex-dividend. Dividend just paid 24 cents, with
expected annual growth rate of 5%.

(iv) Market capitalisation of equity $10 million. Dividend just paid $1.5 million, which
is expected to remain constant.
(4 marks)

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 ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

(d) Compute the market price of the following equities:

(i) W has 50,000 $1 ordinary shares in issue, current dividend per share 10 cents
expected to remain constant; cost of equity 10%.
(ii) X has 1,000 $1 ordinary shares in issue, total dividend $500, no growth expected;
cost of equity 15%.
(iii) Y has 1 million ordinary shares, the dividend just paid was 10 cents per share and it
is expected to grow at 5% per year; cost of equity 15%.
(iv) Z has 10,000 shares in issue, dividends for the next five years are expected to be
constant at 10 cents per share and then grow at 5% per year to perpetuity; cost of
equity 15%. (4 marks)

E
(15 marks)

Question 4 GADDES

(a) Briefly discuss possible reasons for an upward sloping yield curve. (4 marks)

(b)

PL
The financial manager of Gaddes Co’s pension fund is reviewing strategy regarding the fund.
Over 60% of the fund is invested in fixed rate long-term bonds. Interest rates are expected to
be quite volatile for the next few years. It is currently June 20X3.

Among the pension fund’s current investments are two AAA rated bonds:

(1)
(2)
Zero coupon June 20Y8
12% Gilt June 20Y8 (interest is payable semi-annually)

The current annual redemption yield (yield to maturity) on both bonds is 6%. The semi-
annual yield may be assumed to be 3%. Both bonds have a par value and redemption value of
M
$100.

Required:

(i) Estimate the market price of each of the bonds if interest rates (yields):

(a) increase by 1%;

(b) decrease by 1%.
SA

The changes in interest rates may be assumed to be parallel shifts in the yield curve
(yield changes by an equal amount at all points of the yield curve). (6 marks)

(ii) Comment on and briefly explain the size of the expected price movements from
the current prices and how such changes in interest rates might affect the
strategy of the financial manager with respect to investing in the two bonds.
(3 marks)

(iii) Comment on how the bond investment strategy of the financial manager may
be affected if the yield curve was expected to steepen (the gap between short-
and long-term interest rates to widen) and interest rates are expected to rise.
(2 marks)

(15 marks)

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 STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Question 5 STOCK MARKET EFFICIENCY

The following statement contains several errors with reference to the three levels of market efficiency:

“According to the efficient market hypothesis all share prices are correct at all times. This is
achieved by prices moving randomly when new information is publicly announced. New
information from published accounts is the only determinant of the random movements in
share price.

“Fundamental and technical analysis of the stock market serves no function in making the
market efficient and cannot predict future share prices. Corporate financial managers are also
unable to predict future share prices.”

E
Required:

Explain the errors in the above statement.

(10 marks)

Question 6 REDSKINS

PL
Redskins Co is a holding company owning shares in various subsidiary companies. Its directors are
currently considering several projects to increase the range of the business activities undertaken by
Redskins and its subsidiaries. The directors would like to use discounted cash flow techniques in their
evaluation of these projects but as yet no weighted average cost of capital has been calculated.

Redskins has an authorised share capital of 10 million 25 cents ordinary shares, of which 8 million have
been issued. The current ex-div market price per ordinary share is $1.10. A dividend of 10 cents per
share has been paid recently. The company’s project analyst has calculated that 18% is the most
appropriate cost of equity capital. Extracts from the latest statement of financial position for both the
group and the holding company are given below:
M
Redskins and Subs Redskins
$000 $000
Issued Share Capital 2,000 2,000
Share Premium 1,960 1,960
Reserves 3,745 708
_____ _____
Shareholders’ funds 7,705 4,668
_____ _____
SA

Redskins and Subs Redskins

Minority interests 895 –
_____ _____
3% irredeemable 1,400 –
9% debentures 1,500 1,500
6% loan stock 2,000 2,000
Bank loans 1,540 600
_____ _____
6,440 4,100
_____ _____

All debt interest is payable annually and all the current year’s payments will be made shortly. The
cum-interest market prices for $100 nominal value debt are $31.60 and $103.26 for the 3%
irredeemable and 9% debentures respectively. Both the 9% debentures and the 6% loan stock are
redeemable at par in 10 years’ time. The 6% loan stock is not traded on the open market but the analyst
estimates that its actual pre-tax cost is 10% per year. The bank loans bear interest at 2% above base
rate (which is currently 11%) and are repayable in six years. The effective corporation tax rate of
Redskins is 30%.

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 ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

Required:

(a) Calculate the weighted average cost of capital. (8 marks)

(b) Discuss the problems that are encountered in the estimation of a company’s weighted
average cost of capital when:

(i) bank overdrafts; and

(ii) convertible loan stock,

are used as sources of long-term finance. (6 marks)

(c) Outline the fundamental assumptions that are made whenever the weighted average cost

E
of capital of a company is used as the discount rate in net present value calculations.
(6 marks)

(20 marks)

Question 7 BERLAN

(a)

PL
Berlan Co has annual earnings before interest and tax of $15 million. These earnings are
expected to remain constant. The market price of the company’s ordinary shares is 86 cents
per share cum-div and of debentures $105.50 per debenture ex-interest. An interim dividend
of six cents per share has been declared. Corporate tax is at the rate of 35% and all available
earnings are distributed as dividends.

Berlan’s long-term capital structure is shown below:

Ordinary shares (25 cents par value)

$000
12,500
Reserves 24,300
______
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36,800
16% debenture 31 December 20X4 ($100 par value) 23,697
______
60,497
______
Required:
SA

Calculate the weighted average cost of capital of Berlan. Assume that it is now 31
December 20Xl. (7 marks)

(b) Canalot Co is an all equity company with an equilibrium market value of $32.5 million and a
cost of capital of 18% per year.

The company proposes to repurchase $5 million of equity and to replace it with 13%
irredeemable loan stock.

Canalot’s earnings before interest and tax are expected to be constant for the foreseeable
future. Corporate tax is at the rate of 35%. All profits are paid out as dividends.

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 STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Required:

Use Modigliani and Miller’s model with corporate tax to demonstrate how this change
in the capital structure of Canalot Co will affect its:

(i) market value;

(ii) cost of equity; and
(iii) weighted average cost of capital. (7 marks)

(c) Explain how financial gearing affects a firm’s weighted average cost of capital according
to the traditional trade-off view and Modigliani and Miller’s model with corporate tax.
Suggest why, in practice, firms do not adopt the optimal capital structure as suggested
by Modigliani and Miller. (6 marks)

E
(20 marks)

Question 8 KULPAR CO

The finance director of Kulpar Co is concerned about the impact of capital structure on the company’s

More than 6·5

4·0 – 6·5
PL
value, and wishes to investigate the effect of different capital structures.

He is aware that as gearing increases the required return on equity will also increase, and the company’s
interest cover is likely to decrease. A decrease in interest cover could lead to a change in the
company’s credit rating by the leading rating agencies. He has been informed that the following
changes are likely:

Interest cover Credit rating

AA
A
Cost of long term debt
8·0%
9·0%
1·5 – 4·0 BB 11·0%
M
The company is currently rated A.

Summarised financial data:

$ million
Net operating income 110
Depreciation 20
___
SA

Earnings before interest and tax 90

Interest 22
___
Taxable income 68
Tax (30%) 20·4
Net income 47·6
Capital spending 20

Market value of equity is $458 million, and of debt $305 million.

Kulpar’s equity beta is 1·4. The beta of debt may be assumed to be zero.
The risk free rate is 5·5% and the market return 14%.
The company’s growth rate of cash flow may be assumed to be constant, and to be unaffected by any
change in capital structure.

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 ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

Required:

(a) Determine the likely effect on the company’s cost of capital and corporate value if the
company’s capital structure was:
(i) 80% equity, 20% debt by market values;
(ii) 40% equity, 60% debt by market values.
Recommend which capital structure should be selected.
Any change in capital structure would be achieved by borrowing to repurchase existing
equity, or by issuing additional equity to redeem existing debt, as appropriate.
The current total firm value (market value of equity plus market value of debt) is consistent

E
with the growth model (CF1/(k – g)) applied on a corporate basis. CF1 is next year’s free cash
flow, k is the weighted average cost of capital (WACC), and g the expected growth rate.
Company free cash flow may be estimated using EBIT(1 – t) + depreciation – capital
spending.
State clearly any other assumptions that you make. (20 marks)

(b)

Question 9 MALTEC
PL
Discuss possible reasons for errors in the estimates of corporate value in part (a) above.
(10 marks)

Maltec Co is a company that has diversified into five different industries in five different countries.
The investments are each approximately equal in value. The company’s objective is to reduce risk
(30 marks)

through diversification and it believes that the return on any investment is not correlated with the return
on any other investment.
M
Required:

Discuss the validity of Maltec’s objective of risk reduction through international diversification.

(5 marks)
SA

Question 10 WEMERE

The managing director of Wemere, a medium-sized private company, wishes to improve the company’s
investment decision-making process by using discounted cash flow techniques. He is disappointed to
learn that estimates of a company’s cost of capital usually require information on share prices which,
for a private company, are not available. His deputy suggests that the cost of equity can be estimated
by using data for Folten Co, a similar sized company in the same industry whose shares are listed on the
AIM, and he has produced two suggested discount rates for use in Wemere’s future investment
appraisal. Both of these estimates are in excess of 17% per year which the managing director believes
to be very high, especially as the company has just agreed a fixed rate bank loan at 13% per year to
finance a small expansion of existing operations. He has checked the calculations, which are
numerically correct, but wonders if there are any errors of principle.

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 STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Estimate 1: capital asset pricing model

Data have been purchased from a leading business school:

Equity beta of Folten 1.4

Market return 18%
Treasury bill yield 12%
The cost of capital is 18% + (18% – 12%) 1.4 = 26.4%.

This rate must be adjusted to include inflation at the current level of 6%. The recommended
discount rate is 32.4%.

Estimate 2: dividend valuation model

E
Year Folten
Average share price Dividend per share
(cents) (cents)
20X5 193 9.23
20X6 109 10.06
20X7
20X8
20X9

D1
The cost of capital is
P
g
where
PL
D1 = expected dividend
P = current ex-div share price
96
116
130
10.97
11.95
13.03

14.20
11.01%
138
9%

g = growth rate of dividends

M
When inflation is included the discount rate is 17.01%.

Other financial information on the two companies is presented below:

Wemere Folten
$000 $000
Non-current assets 7,200 7,600
SA

Current assets 7,600 7,800

Less: Current liabilities 3,900 3,700
______ ______
10,900 11,700
______ ______
Financed by:
Ordinary shares (25 cents par value) 2,000 1,800
Reserves 6,500 5,500
Term loans 2,400 4,400
______ ______
10,900 11,700
______ ______
Notes:
(1) Wemere’s board of directors has recently rejected a take-over bid of $10.6 million.
(2) Corporate tax is at the rate of 35%.

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 ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

Required:

(a) Explain any errors of principle that have been made in the two estimates of the cost of
capital and produce revised estimates using both of the methods.

State clearly any assumptions that you make. (14 marks)

(b) Discuss which of your revised estimates Wemere should use as the discount rate for
capital investment appraisal. (4 marks)

(c) Discuss whether discounted cash flow techniques, including discounted payback, are
useful to small unlisted companies. (7 marks)

E
(25 marks)

Question 11 CRESTLEE

Crestlee Co is evaluating two projects. The first involves a $4.725 million expenditure on new
machinery to expand the company’s existing operations in the textile industry. The second is a

Non-current assets
Current assets
PL
diversification into the packaging industry and will cost $9.275 million.

Crestlee’s summarised statement of financial position, and those of Canall Co and Sealalot Co, two
quoted companies in the packaging industry, are shown below:

Less: Current liabilities

Crestlee
$m
96
95
(70)
Canall
$m
42
82
(72)
Sealalot
$m
76
65
(48)
___ __ __
M
121 52 93
___ __ __
Financed by:

Ordinary shares1 15 10 30
Reserves 50 27 50
Medium and long-term loans2 56 15 13
___ __ __
SA

121 52 93
___ __ __
Ordinary share price (cents) 380 180 230
Debenture price ($) 104 112 –
Equity beta 1.2 1.3 1.2
1
Crestlee and Sealalot 50 cents par value, Canall 25 cents par value.
2
Crestlee 12% debentures, Canall 14% debentures, Sealalot medium-term bank loan.

Crestlee proposes to finance the expansion of textile operations with a $4.725 million 11% loan stock
issue and the packaging investment with a $9.275 million rights issue at a discount of 10% on the
current market price. Issue costs may be ignored.

Crestlee’s managers are proposing to use a discount rate of 15% per year to evaluate each project.

The risk free rate of interest is estimated to be 6% per year and the market return 14% per year.
Corporate tax is at a rate of 33% per year.

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 STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Required:

(a) Determine whether 15% per year is an appropriate discount rate to use for each of these
projects. Explain your answer and state clearly any assumptions that you make.
(19 marks)

(b) Crestlee’s marketing director suggests that it is incorrect to use the same discount rate each
year for the investment in packaging as the early stages of the investment are more risky and
should be discounted at a higher rate. Another board member disagrees saying that more
distant cash flows are riskier and should be discounted at a higher rate.

Discuss the validity of the views of each of the directors. (6 marks)

E
(25 marks)

Question 12 HOTALOT

Hotalot Co produces domestic electric heaters. The company is considering diversifying into the
production of freezers. Data on four listed companies in the freezer industry and for Hotalot are shown
below:

Non-current assets
Working capital

Financed by:
PL Freezeup Glowcold Shiverall Topice Hotalot
$000 $000 $000 $000 $000
14,800 24,600 28,100 12,500 20,600
9,600 7,200 11,100 9,600 12,700
______ ______ ______ ______ ______
24,400 31,800 39,200 22,100 33,300
______ ______ ______ ______ ______

Bank loans 5,300 12,600 18,200 4,000 17,400

M
Ordinary shares 4,000 9,000 3,500 5,300 4,000
Reserves 15,100 10,200 17,500 12,800 11,900
______ ______ ______ ______ ______
24,400 31,800 39,200 22,100 33,300
______ ______ ______ ______ ______
Turnover 35,200 42,700 46,300 28,400 45,000
Earnings per share (cents) 25 53.3 38.1 32.3 106
Dividend per share (cents) 11 20 15 14 40
SA

Price/earnings ratio 12:1 10:1 9:1 14:1 8:1

Beta equity 1.1 1.25 1.30 1.05 0.95

The par value per ordinary share is 25 cents for Freezeup and Shiverall, 50 cents for Topice and $1 for
Glowcold and Hotalot.

Corporate debt may be assumed to be almost risk free and is available to Hotalot at 0.5% above the
Treasury Bill rate which is currently 9% per year. Corporate taxes are payable at a rate of 35%. The
market return is estimated to be 16% per year. Hotalot does not expect its financial gearing to change
significantly if the company diversifies into the production of freezers.

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 ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

Required:

(a) The equity beta of Hotalot is 0.95 and the alpha value is 1.5%. Explain the meaning and
significance of these values to the company. (4 marks)

(b) Estimate what discount rate Hotalot should use in the appraisal of its proposed
diversification into freezer production. (11 marks)

(c) Corporate debt is often assumed to be risk free. Explain whether this is a realistic
assumption and calculate how important this assumption is likely to be to Hotalot’s
estimate of a discount rate in (b) above. (5 marks)

(d) Discuss whether systematic risk is the only risk that Hotalot’s shareholders should be

E
concerned with. (5 marks)

(25 marks)

Question 13 AMBLE

Direct costs (per unit)

Labour
PL
Amble Co is evaluating the manufacture of a new consumer product. The product can be introduced
quickly and has an expected life of four years before it is replaced by a more efficient model. Costs
associated with the product are expected to be:

3.5 skilled labour hours at $5 per hour.

4 unskilled labour hours at $3 per hour.
M
Materials

6 kilos of material Z at $1.46 per kilo.

Three units of component P at $4.80 per unit.
One unit of component Q at $6.40.
Other variable costs: $2.10 per unit.

Indirect costs
SA

Apportionment of management salaries $105,000 per year.

Tax allowable depreciation of machinery $213,000 per year.
Selling expenses (not including any salaries) $166,000 per year.
Apportionment of head office costs $50,000 per year.
Rental of buildings $100,000 per year.
Interest charges $104,000 per year.
Other overheads $70,000 per year (including apportionment of building rates $20,000).

(Note: rates are a local tax on property.)

If the new product is introduced it will be manufactured in an existing factory and will have no effect
on rates payable. The factory could be rented for $120,000 per year (not including rates), to another
company if the product is not introduced.

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 STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

New machinery costing $864,000 will be required. The machinery is to be depreciated on a straight-
line basis over four years and has an expected salvage value of $12,000 after four years. The machinery
will be financed by a four year fixed rate bank loan, at an interest rate of 12% per year. Additional
working capital requirements may be ignored.

The product will require two additional managers to be recruited at an annual gross cost of $25,000
each and one manager currently costing $20,000 will be moved from another factory where he will be
replaced by a deputy manager at a cost of $17,000 per year. 70,000 kilos of material Z are already in
inventory and are not required for other production. The realisable value of the material is $99,000.

The price per unit of the product in the first year will be $110 and demand is projected at 12,000,
17,500, 18,000 and 18,500 units in years 1 to 4 respectively.

E
The inflation rate is expected to be approximately 5% per year and prices will be increased in line with
inflation. Wage and salary costs are expected to increase by 7% per year and all other costs (including
rent) by 5% per year. No price or cost increases are expected in the first year of production.

Corporate tax is at the rate of 35% payable in the year the profit occurs. Assume that all sales and costs
are on a cash basis and occur at the end of the year, except for the initial purchase of machinery which

Required:

(a)

(b)
the new product.
PL
would take place immediately. No inventory will be held at the end of any year.

Calculate the expected internal rate of return (IRR) associated with the manufacture of

Discuss what is meant by an asset beta.

(15 marks)

If you were told that the company’s asset beta is 1.2, the market return is 15% and the
risk free rate is 8%, discuss whether you would recommend introducing the new
M
product. (5 marks)

(c) Amble is worried that the government might increase corporate tax rates.

Show by how much the tax rate would have to change before the project is not
financially viable. A discount rate of 17% per year may be assumed for part (c).
(5 marks)
SA

(25 marks)

Question 14 PROGROW

Progrow Co is a company with 350 employees located in Southern England. The company has two
main products: a manually operated lifting jack for cars and a range of high quality metal gardening
tools. The products are sold in car accessory shops, garden centres and “do it yourself” superstores.

The company’s production manager has just learned that a new process incorporating new machines
could be used in the manufacture of the jacks. The process would require some extra factory space,
which is currently surplus to the company’s needs (and could not be rented to an external user), and
would require 25% less direct labour than current jack production techniques. No expansion in jack
production from the current level of 250,000 units per year is proposed. The cost of the new machines
would total $535,000 and the machines would require incremental annual maintenance costing
approximately $45,000 in current prices. The existing machinery could be sold for $125,000 (after any
tax effects including the balancing allowance on disposal). This amount would be received in one
year’s time. If the new machines are not purchased, the existing machinery is expected to be kept for a
further five years after which time the after tax scrap value is expected to be negligible.

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 ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

Prices and costs currently associated with the company’s products are:
Garden tools
Jacks (average)
$ $
Selling price (per unit) 11.20 7.80
Direct costs (per unit)
Skilled labour 1.80 0.50
Unskilled labour 2.30 2.80
Materials 3.60 2.40
Indirect costs
Apportionment of management salaries 0.43 0.26
Apportionment of head office overhead 0.54 0.44

E
Incremental annual interest costs associated with the finance of the new machines are $10,000.

As the company is located in a government approved development area, expenditure on any new
machinery would be eligible for first year tax allowable depreciation of 50%, with a 25% reducing
balance thereafter. The expected working life of the machines is five years at the end of which they are
expected to have a scrap value of $40,000.

PL
If the machines are purchased 26 skilled and 24 unskilled workers would be made redundant.
Redundancy costs are on average $9,000 for skilled workers and $5,000 for unskilled workers. Twenty
of the remaining skilled workers would need to retrain to use the new machines at a cost of $750 per
person. These are all tax allowable costs.

As an alternative to buying the new machines the company could use the spare factory space to expand
garden tool production. For a capital equipment expenditure of $200,000 the existing annual
production of 400,000 garden tools could be increased by 70,000 units per year. Expenditure on this
capital equipment is also eligible for 50% first year tax allowable depreciation and a 25% reducing
balance thereafter. This new equipment would have a scrap value of $14,000 after five years.
M
The managing director of Progrow is concerned that failure to invest in the new jack manufacturing
process might lead to the company losing significant market share in the jack market if competitors
were able to reduce their prices in real terms as a result of introducing the new process.

If the new jack manufacturing process is introduced Progrow proposes that prices of jacks would be
kept constant for the next few years. Garden tool prices are expected to increase by an average of 5%
per year, wage and material costs by 6% per year. All other production and maintenance costs are
SA

expected to increase by 4% per year.

The financial gearing of Progrow is not expected to change with either the adoption of the new jack
production process, or expansion of garden tool production.

The company is listed on the AIM1 and its overall beta equity is 1.30. The average beta equity of other
garden tool manufacturers is 1.4, but no data is available for jack manufacturers. The average market
weighted gearing of other garden tool manufacturers is 50% equity and 50% debt.

The appropriate risk free rate is 7% and the estimated market return 14%. Corporate taxation is at the
rate of 25% and is payable one year in arrears. It is now late in the current tax year.

1
Alternative Investments Market

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 STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Summarised statement of financial position of Progrow as at 31 March

$000
Noncurrent assets 2,800
Current assets 2,400
Less: Current liabilities (1,950)
_____
3,250
_____
Non-current liabilities
Clearing bank term loan 400
15% secured bond (redeemable at par after 10 years) 1,000
Issued share capital (25 cents par) 700

E
Reserves 1,150
_____
3,250
_____

The company’s ex-div share price is 162 cents and bond price $125. Garden tool and jack manufacture

assumed to occur at year-ends.

Required:

(a)
PL
represent 60% and 40% respectively of the company’s total market value. All cash flows may be

Corporate debt may be assumed to be risk free.

Prepare a report advising the directors of Progrow whether to purchase the new
machines or to expand garden tool production. Highlight in your report any further
information requirements, or other factors that might influence the decision process.
Relevant calculations, including expected net present values, should form an appendix to
M
your report. State clearly any assumptions that you make. (28 marks)

(Approximately 20 marks are available for calculations and 8 for discussion)

(b) The managing director’s daughter is attending a university degree course in accounting and
finance. During a telephone call to his daughter the managing director mentioned the possible
alternative investments. She replied that she had learned that:
SA

(i) Net present value is not an appropriate technique to use for strategic investment
decisions as it ignores any future options that might occur due to the use of the new
machines, or from the expansion of garden tool production.

(ii) The use of betas is suspect, as the capital asset pricing model (CAPM) has
significant theoretical and practical weaknesses. She suggested consideration of the
arbitrage pricing theory as an alternative to using CAPM.

The managing director has only recently been convinced of the benefit of using net present
value and is left confused by his daughter’s comments.

Required:

Discuss the validity of the comments made by the managing director’s daughter and
whether or not the managing director should take them into account in the investment
decision process. (12 marks)

(40 marks)

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 ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

Question 15 TAMPEM

The financial management team of Tampem Co is discussing how the company should appraise new
investments. There is a difference of opinion between two managers:

Manager A believes that net present value should be used as positive NPV investments are
quickly reflected in increases in the company’s share price.

Manager B states that NPV is not good enough as it is only valid in potentially restrictive
conditions and should be replaced by APV (adjusted present value).

Tampem has produced estimates of relevant cash flows and other financial information associated with
a new investment. These are shown below:

E
Year 1 2 3 4
$000 $000 $000 $000
Investment pre-tax
operating cash flows 1,250 1,400 1,600 1,800

Notes:

(i)

(ii)

(iii)
PL
The investment will cost $5,400,000 payable immediately, including $600,000 for working
capital and $400,000 for issue costs. $300,000 of issue costs is for equity and $100,000 for
debt. Issue costs are not tax allowable.

The investment will be financed 50% equity, 50% debt which is believed to reflect its debt
capacity.

Expected company gearing after the investment will change to 60% equity, 40% debt by
market values.
M
(iv) The investment’s equity beta is 1·5.

(v) Debt finance for the investment will be an 8% fixed rate debenture.

(vi) Capital allowances are at 25% per year on a reducing balance basis.

(vii) The corporate tax rate is 30%. Tax is payable in the year that the taxable cash flow arises.
SA

(viii) The risk free rate is 4% and the market return 10%.

(ix) The after tax realisable value of the investment as a continuing operation is estimated to be
$1·5 million (including working capital) at the end of year 4.

(x) Working capital may be assumed to be constant during the four years.

Required:

(a) Calculate the expected NPV and APV of the proposed investment. (10 marks)

(b) Discuss briefly the validity of the views of the two managers. Use your calculations in
(a) to illustrate and support the discussion. (5 marks)

(15 marks)

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 STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Question 16 PROJECT REVIEW

You have been conducting a detailed review of an investment project proposed by one of the divisions
of your business. Your review has two aims: first to correct the proposal for any errors of principle and
second, to recommend a financial measure to replace payback as one of the criteria for acceptability
when a project is presented to the company’s board of directors for approval. The company’s current
weighted average cost of capital is 10% per annum.

The initial capital investment is for $150 million followed by $50 million one year later. The post-tax
cash flows, for this project, in $million, including the estimated tax benefit from capital allowances for
tax purposes, are as follows:

Year 0 1 2 3 4 5 6

E
Capital investment (plant and machinery):
First phase –127·50
Second phase –36·88
Project post-tax cash flow ($ millions) 44·00 68·00 60·00 35·00 20·00

Company tax is charged at 30% and is paid/recovered in the year in which the liability is incurred. The

(1)

(2)
PL
company has sufficient profits elsewhere to fully utilise capital allowances on this project. Capital
investment is eligible for an initial capital allowance of 50% followed by writing down allowances of
25% per annum on a reducing balance basis.

You notice the following points when conducting your review:

An interest charge of 8% per annum on a proposed $50 million loan has been included in the
project’s post-tax cash flow before tax has been calculated.

Depreciation for the use of company shared assets of $4 million per annum has been charged
in calculating the project post-tax cash flow.
M
(3) Activity based allocations of company indirect costs of $8 million have been included in the
project’s post-tax cash flow. However, additional corporate infrastructure costs of $4 million
per annum have been ignored which you discover would only be incurred if the project
proceeds.

(4) It is expected that the capital equipment will be written off and disposed of at the end of year
six. The proceeds of the sale of the capital equipment are expected to be $7 million which
SA

have been included in the forecast of the project’s post-tax cash flow. You also notice that an
estimate for site clearance of $5 million has not been included nor any tax saving recognised
on the unclaimed writing down allowance on the disposal of the capital equipment.

Required:

(a) Prepare a corrected project evaluation using the net present value technique supported
by a separate assessment of the sensitivity of the project to a $1 million change in the
initial capital expenditure. (14 marks)

(b) Estimate the discounted payback period and the duration for this project commenting
on the relative advantages and disadvantages of each method. (5 marks)

(c) Draft a brief report for presentation to the board of directors with a recommendation
on the acceptability of this project and on the techniques that the board should consider
when reviewing capital investment projects in future. (8 marks)

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 ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

Professional marks will be awarded in part (c) for the clarity, presentation and
persuasiveness of the report. (1 mark)

(28 marks)

Question 17 DARON

The senior managers of Daron, a company located in a European country, are reviewing the company’s
medium term prospects. The company is in a declining industry and is heavily dependent on a single
product. Sales volume is likely to fall for the next few years. A general election will take place in the
near future and the managers believe that the future level of inflation will depend on the result of the
election. Inflation is expected to remain at approximately 5% per year if political party A wins the
election, or will quickly move to approximately 10% per year if party B wins the election. Opinion

E
polls suggest that there is a 40% chance of party B winning. An increase in the level of inflation is
likely to reduce the volume of sales of Daron.

Projected financial data for the next five years, including expected inflation where relevant, are shown
below:
Political party A wins, inflation 5% per year

Variable costs
Fixed costs
PL
Operating cash flows:
Sales

Other financial data:

Incremental working capital* –
Tax allowable depreciation
20X7

28
17
3

4
$million

29
18
20X8

(1)
3
20X9

26
16
3

(2)
3
20Y0

22
14
3

(3)
2
20Y1

19
12
3

(3)
1

Political party B wins; inflation 10% per year million

M
20X7 20X8 20X9 20Y0 20Y1
Operating cash flows: $m $m $m $m $m
Sales 30 26 24 20 16
Variable costs 18 16 15 12 11
Fixed costs 3 3 4 4 4
Other financial data:
Incremental working capital* 1 (2) (2) (3) (3)
SA

Tax allowable depreciation 4 3 3 2 1

*A bracket signifies a decrease in working capital:

Tax allowable depreciation will be negligible after 20Y1 in both cases.

Cash flows after year 20Y1, excluding tax savings from tax allowable depreciation, are expected to be
similar to year 20Y1 cash flows for a period of five years, after which substantial new fixed investment
would be necessary in order to continue operations.

Working capital will remain approximately constant after the year 20Y1.

Corporate taxation is at a rate of 30% per year and is expected to continue at this rate. Tax may be
assumed to be payable in the year that the income arises.

Daron’s current ordinary share price is 92 centos (100 centos = $1).

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 STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Summarised statement of financial position of Daron as at 31 March 20X6

$ million
Tangible non-current assets 24
Net current assets 12
__
Total assets less current liabilities 36
__
Loans and other borrowings falling due after one year 14
Capital and reserves:
Called up share capital (25 centos par value) 5
Reserves 17
__

E
36
__

The company can currently borrow long term from its bank at an interest rate of 10% per year. This is
likely to quickly rise to 15.5% per year if the political party B wins the election.

PL
The real risk free rate (i.e. excluding inflation) is 4% and the real market return is 10%.

Daron’s equity beta is estimated to be 1.25. This is not expected to significantly change if inflation
increases.

Three alternatives are available to the managers of Daron:

(i) Recommend the sale of the company now. An informal, unpublicised, offer of $20 million
for the company’s shares has been received from a competitor.

(ii) Continue existing operations, with negligible capital investment for the foreseeable future.
M
(iii) If the political party A wins the election, diversify operations by buying a going concern in
the hotel industry at a cost of $9 million. The purchase would be financed by the issue of
10% convertible debentures. Issue costs are 2% of the gross sum raised. Daron has no
previous experience of the hotel industry.

Financial projections of the hotel purchase

SA

$ million
20X7 20X8 20X9 20Y0 20Y1

Turnover 9 10 11 12 13
Variable costs 6 6 7 7 8
Fixed costs 2 2 2 2 2
Other financial data:
Incremental working capital 1 – – 1 –

Tax allowable depreciation is negligible for the hotel purchase. The after tax realisable value
of the hotel at the end of year 20Y1 is expected to be $10 million, including working capital.
The systematic risk of operating the hotels is believed to be similar to that of the company’s
existing operations.

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 ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

Required:

(a) Using the above data, prepare a report advising the managers of Daron which, if any, of
the three alternatives to adopt. Include in your report comment on any weaknesses/
limitations of your data analysis. Relevant calculations, including:

(i) estimates of the present values of future cash flows from existing operations;
and

(ii) the estimated adjusted present value (APV) of diversifying into the hotel
industry

should form appendices to your report.

E
The book value and market value of debt may be assumed to be the same. State clearly
any other assumptions that you make. (32 marks)

(Approximately 20 marks are available for calculations and 12 for discussion.)

(b)

PL
Details of the possible convertible debenture issue for the purchase of the hotel are as follows:

10% $100 convertible debentures 20Y0, issued and redeemable at par. The debentures are
convertible into 60 ordinary shares at any date between 1 January 20X2 and 31 December
20X4. The debentures are callable for conversion by the company subject to the company’s
ordinary share price exceeding 200 centos between 1 January 20X2 and 31 December 20X4
and puttable for redemption by the debenture holders if the share price falls below 100 centos
between the same dates.

Required:
M
Discuss the implications for Daron if the diversification is financed with convertible
debentures with these terms. (8 marks)

(40 marks)

Question 18 MERCURY TRAINING

Mercury Training was established in 1999 and since that time it has developed rapidly. The directors
SA

are considering either a flotation or an outright sale of the company.

The company provides training for companies in the computer and telecommunications sectors. It
offers a variety of courses ranging from short intensive courses in office software to high level risk
management courses using advanced modelling techniques. Mercury employs a number of in-house
experts who provide technical materials and other support for the teams that service individual client
requirements. In recent years, Mercury has diversified into the financial services sector and now also
provides computer simulation systems to companies for valuing acquisitions. This business now
accounts for one third of the company’s total revenue.

Mercury currently has 10 million, 50c shares in issue. Jupiter is one of the few competitors in
Mercury’s line of business. However, Jupiter is only involved in the training business. Jupiter is listed
on a small company investment market and has an estimated beta of 1·5. Jupiter has 50 million shares
in issue with a market price of 580c. The average beta for the financial services sector is 0·9. Average
market gearing (debt to total market value) in the financial services sector is estimated at 25%.

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 STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Other summary statistics for both companies for the year ended 31 December 2007 are as follows:

Mercury Jupiter
Net assets at book value ($million) 65 45
Earnings per share (c) 100 50
Dividend per share (c) 25 25
Gearing (debt to total market value) 30% 12%
Five year historic earnings growth (annual) 12% 8%

Analysts forecast revenue growth in the training side of Mercury’s business to be 6% per annum, but
the financial services sector is expected to grow at just 4%.

Background information

E
The equity risk premium is 3·5% and the rate of return on short-dated government stock is 4·5%.
Both companies can raise debt at 2·5% above the risk free rate.
Tax on corporate profits is 40%.

Required:

(a)

(b)

(c)
PL
Estimate the cost of equity capital and the weighted average cost of capital for Mercury
Training. Explain the circumstances where each of the two rates would be used.

Advise the owners of Mercury Training on a range of likely issue prices for the
company. (10 marks)
(10 marks)

Discuss the advantages and disadvantages, to the directors of Mercury Training, of a

public listing versus private equity finance as a means of disposing of their interest in
the company. (8 marks)
M
(28 marks)
SA

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 ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

Question 19 BIGUN

The acquisition committee of Bigun Co is considering making takeover bids for two competitors, Klein
Co and PTT Co. Summarised financial data is given below for the three companies:

Statement of financial position as at 31 March 20Y2

Bigun $m Klein $m PTT $m

Non-current assets 50 8.6 6.4
Current assets 431 6.7 9.5
Less: Current liabilities 27 3.0 3.9
—— 16 —— 3.7 —— 5.6
—— —— ——

E
66 12.3 12.0
—— —— ——
Financed by
Ordinary shares (50c) 17 5.02 2.82
Reserves 30 1.3 3.7
—— —— ——

1
2
3
4
5
Long term debt
PL
of which $5 million cash
$1 ordinary shares
——

——
47
193

66

8% debentures 20Z5 – 20Z8 currently trading at $80

11% debentures 20Y2 – 20Y4 currently trading at $110
7 year 10% bank loan
6.3
6.04
——
12.3
——
6.5
5.55
——
12.0
——

Bigun Klein PTT

M
Average sales growth 20X8 – 20Y2 8% 10% 8%
Average growth in profit after tax and interest
on medium and long-term debt 20X8 – 20Y2 6% 10.5% 9.5%
Average payout ratio 20X8 – 20Y2 60% 40% 75%
P/E ratio at 31 March 20Y2 18.4:1 18.6:1 –
Estimated required return on equity 9.5% 12% 13%
Profit before tax and interest on medium and
SA

long-term debt for year ended 31 March 20Y2 $10m $1.5m $1.4m

The corporation tax rate is 35%.

Required:

(a) Prepare a report advising the main board of Bigun of the possible cost of acquiring each
of the companies. (15 marks)

(b) Discuss alternative terms that might be offered to the shareholders of Klein and PTT
and the implications of these terms for the shareholders of Bigun. (10 marks)

(25 marks)

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 STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Question 20 DEMAST

Demast Co has grown during the last five years into one of the UK’s most successful specialist games
manufacturers. The company’s success has been largely based on its Megaoid series of games and
models, for which it holds patents in many developed countries. The company has attracted the interest
of two companies, Nadion, a traditional manufacturer of games and toys, and BZO International, a
conglomerate group that has grown rapidly in recent years through the strategy of acquiring what it
perceives to be undervalued companies.

Summarised financial details of the three companies are shown below:

Demast Co

E
Summarised statement of financial position as at 31 December 20X3

$000 $000
Non-current assets (net) 8,400
Current assets
Inventory 5,500
Receivables
Cash

Less: PL
Current liabilities
Trade payables
Tax payable
Overdraft
3,500
100
______

4,700
1,300
1,200
______
9,100

(7,200)
______
10,300
Medium and long term loans (3,800)
______
M
Net assets 6,500
______
Financed by
Ordinary shares (25 cents nominal) 1,000
Reserves 5,500
______
6,500
SA

______

Summarised income statement for the year ended 31 December 20X3

$000
Turnover 27,000
Profit before tax 4,600
Taxation 1,380
_____
3,220
Dividends (1,500)
_____
Retained earnings 1,720
_____

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 ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

Additional information:

(1) The realisable value of inventory is believed to be 90% of its book value.
(2) Land and buildings, with a book value of $4 million were last revalued in 20X0.
(3) The directors of the company and their families own 25% of the company’s shares.

Demast Nadion BZO Int

Turnover ($m) 27 112 256
Profit before tax ($m) 4.6 11 24
Non-current assets ($m net) 8.4 26 123
Current assets ($m) 9.1 41 72
Current liabilities ($m) 7.2 33 91
Overdraft ($m) 1.2 6 30

E
Long term liabilities ($m) 3.8 18 35
Interest payable ($m) 0.5 3 10
Share price (cents) – 320 780
EPS (cents) 80.5 58 51
Estimated required return on equity 16% 14% 12%
Growth trends per year
Earnings
Dividends
Turnover
PL 12%
9%
15%
6%
5%
10%

Assume that the following events occurred shortly after the above financial information was produced:

7 September – BZO makes a bid for Demast of two ordinary shares for every three shares of Demast.
The price of BZO’s ordinary shares after the announcement of the bid is 710 cents. The directors of
Demast reject the offer.
13%
8%
23%

2 October – Nadion makes a counter bid of 170 cents cash per share plus one $100 10% convertible
M
debenture 20X8, issued at par, for every $6.25 nominal value of Demast’s shares. Each convertible
debenture may be exchanged for 26 ordinary shares at any time between 1 January 20X7 and 31
December 20X9. Nadion’s share price moves to 335 cents. This offer is rejected by the directors of
Demast.

19 October – BZO offers cash of 600 cents per share. The cash will be raised by a term loan from the
company’s bank. The board of Demast are all offered seats on subsidiary boards within the BZO
group. BZO’s shares move to 680 cents.
SA

20 October – The directors of Demast recommend acceptance of the revised offer from BZO.

24 October – BZO announces that 53% of shareholders have accepted its offer and makes the offer
unconditional.

Required:

(a) Discuss the advantages and disadvantages of growth by acquisition. (7 marks)

(b) Discuss whether or not the bids by BZO and Nadion are financially prudent from the
point of view of the companies’ shareholders. Relevant supporting calculations must be
shown. (17 marks)

(c) Discuss problems of corporate governance that might arise for the shareholders of
Demast and BZO. (6 marks)

(30 marks)

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 ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

It has been suggested that the nature of the managerial labour market negates much of the
agency problem. A manager’s wealth is made up of present wealth plus the present value of
future income. The better the manager’s performance, the higher the company’s share price,
and the greater the salary, both now and in the future, the manager can obtain. The manager’s
desire for wealth maximisation will tend to cause him to act in the shareholders’ interests.

The main way in which creditors might protect themselves against conflicts of interest with
shareholders is to insist on restrictive covenants being incorporated into loan agreements.
Such covenants might restrict the level of additional debt finance that might be raised, or
prevent management (here acting on the shareholders’ behalf) from disposing of major
tangible assets without the agreement of the providers of debt, or restrict the level of
dividends that can be paid. Additionally, if creditors perceive that they are being unfairly
treated, they can either refuse to provide further credit, or only agree to provide future credit

E
at higher than normal rates, both of which are likely to have adverse effects on shareholder
wealth, and are deterrents to managers acting unfairly against the creditors’ interests.

Answer 2 ETHICS

Non-financial issues, ethical and environmental issues in many cases overlap, and have become of

PL
increasing significance to the achievement of primary financial objectives such as the maximisation of
shareholder wealth. Most companies have a series of secondary objectives that encompass many of
these issues.

Traditional non-financial issues affecting companies include:

 Measures that increase the welfare of employees such as the provision of housing, good and
safe working conditions, social and recreational facilities.

These might also relate to managers and encompass generous perquisites.

M
 Welfare of the local community and society as a whole. This has become of increasing
significance, with companies accepting that they have some responsibility beyond their
normal stakeholders in that their actions may impact on the environment and the quality of
life of third parties.

 Provision of, or fulfilment of, a service. Many organisations, both in the public sector and
private sector provide a service, for example to remote communities, which would not be
provided on purely economic grounds.
SA

 Growth of an organisation, which might bring more power, prestige, and a larger market
share, but might adversely affect shareholder wealth.

 Quality. Many engineering companies have been accused of focusing upon quality rather
than cost effective solutions.

 Survival. Although to some extent linked to financial objectives, managers might place
corporate survival (and hence retaining their jobs) ahead of wealth maximisation. An obvious
effect might be to avoid undertaking risky investments.

Ethical issues of companies have been brought increasingly into focus by the actions of Enron and
others. There is a trade-off between applying a high standard of ethics and increasing cash flow or
maximisation of shareholder wealth. A company might face ethical dilemmas with respect to the
amount and accuracy of information it provides to its stakeholders. An ethical issue attracting much
attention is the possible payment of excessive remuneration to senior directors, including very large
bonuses and “golden parachutes”.

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 STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Should bribes be paid to facilitate the company’s long-term aims? Are wages being paid in some
countries below subsistence levels? Should they be? Are working conditions of an acceptable
standard? Do the company’s activities involve experiments on animals, genetic modifications, etc?
Should the company deal with or operate in countries that have a poor record of human rights? What is
the impact of the company’s actions on pollution or other aspects of the local environment?

Environmental issues might have very direct effects on companies. If natural resources become
depleted the company may not be able to sustain its activities, weather and climatic factors can
influence the achievement of corporate objectives through their impact on crops, the availability of
water etc. Extreme environmental disasters such as typhoons, floods, earthquakes, and volcanic
eruptions will also impact on companies’ cash flow, as will obvious environmental considerations such
as the location of mountains, deserts, or communications facilities. Should companies develop new
technologies that will improve the environment, such as cleaner petrol or alternative fuels? Such

E
developments might not be the cheapest alternative.

Environmental legislation is a major influence in many countries. This includes limitations on where
operations may be located and in what form, and regulations regarding waste products, noise and
physical pollutants.

PL
All of these issues have received considerable publicity and attention in recent years. Environmental
pressure groups are prominent in many countries; companies are now producing social and
environmental accounting reports, and/or corporate social responsibility reports. Companies
increasingly have multiple objectives that address some or all of these three issues. In the short term
non-financial, ethical and environmental issues might result in a reduction in shareholder wealth; in the
longer term it is argued that only companies that address these issues will succeed.

Answer 3 COST OF CAPITAL

(a) Cost of debt (pre-corporation tax)

M
Annual interest payment $10
(i) = = 10%
Issue proceeds (or market price) $100

$10
(ii)  11.76%
$85

(iii) The method is to find the IRR of the following cash flows:
SA

t0 t1 t2 t3
$(74) $10 $10 $110

By trial and error, NPV of the four cash flows at:

25% NPV = – $74 + 1.440 × $10 + 0.512 × $110 = – $3.28

20% NPV = – $74 + 1.528 × $10 + 0.579 × $110 = $4.97

4.97
Therefore: kd = 20% + × (25% – 20%) = 23%
4.97  3.28

$10
(iv) As redeemable at current market price, then  10%
$100

$0.05
(v) Irredeemable,  7.7%
$0.65

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 ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

(b) Cost of debt (post-corporation tax)

(i) 10% (1 – 0.35) = 6.5%

(ii) 11.76% (1 – 0.35) = 7.64%

(iii) The method is to find the IRR of the following cash flows:

t0 t1 t2 t3
$(74) $6.5 $6.5 $106.5

By trial and error:

E
15% NPV = – $74 + 1.626 × $6.5 + 0.658 × $106.5 = $6.646

20% NPV = – $74 + 1.528 × $6.5 + 0.579 × $106.5 = – $2.405

6.646
Therefore: kd = 15% + × (20% – 15%) = 19%
6.646  2.405

(c)
(iv)

(v)

Cost of equity

(i) ke
PL
10% × (1 – 0.35)

=
7.5
150
= 6.5%

7.7% (no corporation tax relief on preference share dividend).

× 100 = 5%

15
(ii) ke = × 100 = 10%
165  15
M
24  (1  0.05)
(iii) ke = × 100 + 5 = 26%
120
1 .5
(iv) ke = × 100 = 15%
10

(d) Dividend valuation model

SA

D $0.10  50,000
(i) No growth, hence P0 = = = $50,000
ke 0.1

$50,000
Per share P0 = = $1.00
50,000

$500
(ii) No growth, hence P0 = = $3,333
0.15

$3,333
Per share P0 = = $3.33
1,000

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 STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

D 0 (1  g)
(iii) Constant growth P0 =
(ke  g)
$0.10  1m  (1.05)
= = $1.05m
(0.15  0.05)
Per share = $1.05

(iv) P0 = PV of future dividends

$0.10  10,000  (1.05)
= $0.10 × 10,000 × 3.352 + × 0.497
(0.15  0.05)

E
= $8,570

Per share ≈ $0.86

Answer 4 GADDES

(a)


PL
Possible reasons for upward sloping yield curve

 Future expectations. If future short-term interest rates are expected to increase then
the yield curve will be upward sloping.

Liquidity preference. It is argued that investors seek extra return for giving up a
degree of liquidity with longer-term investments. Other things being equal, the
longer the maturity of the investment, the higher the required return, leading to an
upward sloping yield curve.

 Preferred habitat/market segmentation. Different investors are more active in

different segments of the yield curve. For example banks would tend to focus on
M
the short-term end of the curve, whilst pension funds are likely to be more
concerned with medium and long term segments. An upward sloping curve could in
part be the result of a fall in demand in the longer term segment of the yield curve
leading to lower bond prices and higher yields.

(b)(i) Market price

SA

Current market prices

$100
(1) Zero coupon = $41·73
(1·06)15

(2) 12% gilt with a semi-annual coupon

1 - (1·03)-30
PV of an annuity for 30 periods at 3% is = 19·6004
0·03
$
PV of interest payments $6 × 19·6004 = 117·60
1
PV of redemption using $100 × 0·4120 = 41·20
(1  0·03)30
———
158·80
———

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 ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

(a) If interest rates increase by 1%

$100
(1) Zero coupon = $36·25, a decrease of $5·48 or 13·1%
(1·07)15

(2) 12% gilt

1 - (1·035)-30
PV of an annuity for 30 periods at 3·5% is = 18·3920
0·035
$
PV of interest payments $6 × 18·3920 = 110·35
1

E
PV of redemption using $100 × 0·3563 = 35·63
(1  0·035)30
———
145·98
———
This is a decrease of $12·82 or 8·1%.

(b)

(1)

(2)
PL
If interest rates decrease by 1%

Zero coupon
$100
(1·05)15
= $48·10, an increase of $6·37 or 15·3%

12% gilt with a semi-annual coupon:

PV of an annuity for 30 periods at 2·5% is

1 - (1·025)-30
0·025
= 20·9303

$
M
PV of interest payments $6 × 20·9303 = 125·58
1
PV of redemption using $100 × 0·4767 = 47·67
(1  0·025)30
———
173·25
———
This is an increase of $14·45 or 9·1%.
SA

(ii) Expected price movements

The price/yield relation is not linear; it has a convex shape. There is a bigger absolute
movement in bond prices when interest rates fall than when they rise. The percentage
movement is also higher for low coupon bonds than high coupon bonds. Other things being
equal, a financial manager would prefer to hold high coupon bonds if interest rates are
expected to increase and low or zero coupon bonds when interest rates are expected to
decrease.

(iii) Bond investment strategy

If interest rates are expected to rise, and the gap between yields on short and long dated bonds
to widen, the financial manager would not want to hold longer dated bonds as these would
suffer a larger fall in price than short dated bonds. Short dated bonds, probably with high
coupons, would be preferred.

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 STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Answer 5 STOCK MARKET EFFICIENCY

The efficient market hypothesis is often considered in terms of three levels of market efficiency:

(1) Weak form efficiency;

(2) Semi-strong form efficiency;
(3) Strong form efficiency.

The accuracy of the statement in the question depends in part upon which form of market efficiency is
being considered. The first sentence states that all share prices are correct at all times. If “correct”
means that prices reflect true values (the true value being an equilibrium price which incorporates all
relevant information that exists at a particular point in time), then strong form efficiency does suggest
that prices are always correct. Weak and semi-strong prices are not likely to be correct as they do not

E
fully consider all information (e.g. semi-strong efficiency does not include inside information). It might
be argued that even strong form efficiency does not lead to correct prices at all times as, although an
efficient market will react quickly to new relevant information, the reaction is not instant and there will
be a short period of time when prices are not correct.

The second sentence in the statement suggests that prices move randomly when new information is

PL
publicly announced. Share prices do not move randomly when new information is announced. Prices
may follow a random walk in that successive price changes are independent of each other. However,
prices will move to reflect accurately any new relevant information that is announced, moving up when
favourable information is announced, and down with unfavourable information. If strong form
efficiency exists, prices might not move at all when new information is publicly announced, as the
market will already be aware of the information prior to public announcement and will have already
reacted to the information.

Information from published accounts is only one possible determinant of share price movement. Other
include the announcement of investment plans, dividend announcements, government changes in
monetary and fiscal policies, inflation levels, exchange rates and many more.
M
Fundamental and technical analysts play an important role in producing market efficiency. An efficient
market requires competition among a large number of analysts to achieve “correct” share prices, and
the information disseminated by analysts (through their companies) helps to fulfil one of the
requirements of market efficiency (i.e. that information is widely and cheaply available).

An efficient market implies that there is no way for investors or analysts to achieve consistently
superior rates of return. This does not say that analysts cannot accurately predict future share prices.
SA

By pure chance some analysts will accurately predict share prices. However, the implication is that
analysts will not be able to do so consistently. The same argument may be used for corporate financial
managers. If, however, the market is only semi-strong efficient, then it is possible that financial
managers, having inside information, would be able to produce a superior estimate of the future share
price of their own companies and that if analysts have access to inside information they could earn
superior returns.

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 ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

Answer 6 REDSKINS

(a) Post-tax weighted average cost of capital

The following calculations are based on the capital structure of the Redskins group which is
deemed to be more appropriate for determining a discount rate to evaluate the projects
available to Redskins and its subsidiaries.

Cost of debt

Interest (1 - T)
For irredeemable stock, kd =
Ex - interest market value

E
$3.00  (1 - 0.30)
Cost of 3% irredeemable stock = = 7.34%
$(31.60 - 3.00)

For redeemable stock, to calculate kd it is necessary to compute the internal rate of return of
the after-tax cash flows:
Cash PV PV

Time 0

Time 10
PL
Ex-interest market price
Time 1–10 Interest (post-tax)
Repayment of capital

Net present values

flows
$
(94.26)
6.30
100.00
at 5%
$
(94.26)
48.65
61.40
———
15.79
———
at 10%

———
$
(94.26)
38.71
38.60

(16.95)
———

 $15.79 
Cost of 9% debt = 5% +    5% = 7.41%
 $(15.79  16.95) 
M
After-tax cost of bank loan = (11% + 2%) × ($1 – 0.30) = 9.10%

Cost of 6% unquoted stock:

The value of the stock is the present value of the pre-tax cash flows discounted at 10%, i.e.
SA

($6.00 × 6.145) + ($100 × 0.386) = $75.47

The after-tax cost is the discount rate which equates the after-tax cash flows to a present value
of $75.47, i.e.
Cash PV PV
flows at 5% at 10%
$ $ $
Time 0 Current value (75.47) (75.47) (75.47)
Time 1–10 Post-tax interest 4.20 32.43 25.81
Time 10 Repayment 100.00 61.40 38.60
——— ———
Net present values 18.36 (11.06)
——— ———

18.36
By linear interpolation IRR = 5% + × 5% = 8.12%
29.42

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 STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Cost of equity = 18% (given)

The values of the various sources of finance are as follows:

$000 $000
Equity 8,000 × 1.1 8,800
3% debt 1,400 × 0.286 400
9% debt 1,500 × 0.9426 1,414
6% debt 2,000 × 0.7547 1,509
Bank loan 1,540

(0.18  8,800)  (0.0734  400)  (0.0741  1,414)  (0.0812  1,509)  (0.0910  1,540)
WACC =
8,800  400  1,414  1,509  1,540

E
1,981
= = 14.5%
13,663

(b) Problems in estimating WACC

(i)

PL
Where bank overdrafts are used as sources of long-term finance

Theoretically bank overdrafts are repayable on demand and therefore are current liabilities.
However, it is undoubtedly true that many firms run more or less permanent overdrafts and
effectively use them as a source of long-term finance. Where this is true, a case can be made
for incorporating the cost of the overdraft into the calculation of the weighted average cost of
capital. To do this it is necessary to know the interest rate and the size of the overdraft.

The first of these variables, the interest rate, presents no special problems. Overdraft rates are
known and the quoted rate is the “true” rate. As with other interest payments, overdraft
M
interest is an allowable expense for tax purposes and this must be incorporated in the
calculation. Interest on overdrafts fluctuates through time and this presents a problem.
However, it is not a problem unique to overdrafts as other interest rates are also likely to vary.
The particular problem in incorporating the cost of an overdraft into the WACC is
determining its magnitude for weighting purposes. By their very nature overdrafts vary in
size on a daily basis. It would be necessary to separate the overdraft into two components.
The first is the underlying permanent amount which should be incorporated into the WACC.
The second component is that part which fluctuates on a daily basis with the level of activity.
SA

A technique similar to that used to identify the fixed and variable elements of semi-variable
costs could be used to separate these two component parts.

(ii) Where convertible loan stocks are used as sources of long-term finance

The formula for determining the cost of a convertible loan stock derives from the basic
valuation model for convertibles which is as follows:
n
I(1 - T) MV
Vc =  (1  kc)t  (1  kc)n
t 1

where I = Interest payable

T = Rate of corporation tax
n = Years to conversion
MV = Market value of shares at the time of conversion
kc = Cost of convertible stock
Vc = Market value of convertibles

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 ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

In principle the calculation of kc is a simple IRR computation. In practice the difficulty is in

knowing whether the investor will exercise his conversion right, which will depend upon the
market value of the shares at the time of conversion. Therefore, to compute kc requires a
prediction of future share prices which obviously poses severe problems.

(c) Use of WACC as a discount rate

It can be shown that, in a perfect capital market in which the market value of an ordinary
share is the discounted present value of the future dividend stream, acceptance of a project
which has a positive NPV when discounted at the WACC will result in the share price
increasing by the amount of the NPV. It is this relationship between the NPV and the market
value which is the basis of the rationale for using the WACC in conjunction with the NPV
rule. However, the use of the WACC in this way depends upon a number of assumptions:

E
 The objective of the firm is to maximise the current market value of the ordinary
shares. If the firm is pursuing some other objective (e.g. sales maximisation subject
to a profit constraint) some other discount rate may be more appropriate.

 The market is perfect and the share price is the discounted present value of the


PL
dividend stream. Market imperfections may undermine the relationship between
NPV and the market value, and cast doubt upon the usefulness of WACC as a
discount rate. Furthermore, if the market values shares in some other way (earnings
multiplied by a P/E ratio?), then the link will also be broken.

The current capital structure will be maintained and the existing capital structure is
optimal.

The risk of projects to be evaluated is the same as the average risk of the company
as a whole. The discount rate has two components, namely the risk-free rate and a
premium for risk. The weighted average cost of capital incorporates a risk premium
M
which is appropriate to the risk of the company as a whole (i.e. the average risk of
all its existing assets and projects). Where a project is to be considered which has a
different level of risk, then the WACC is not the appropriate rate.

Answer 7 BERLAN

(a) Weighted average cost of capital

SA

Cost of equity
$000
Earnings before interest and tax 15,000
Interest 23,697 × 16% (3,791)
11,209
——–
Corporation tax @ 35% (3,923)
Available for dividend to equity 7,286
——–
7,286  100
Dividend per share = 14.57
12,500  4

D 14.57
ke = = = 0.182
P0 86.6

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 STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Cost of debt

31 Dec 20X1 31 Dec 20X2 31 Dec 20X3 31 Dec20X4

Year 0 1 2 3
(105.50) 16(1 – 0.35) 16(1 – 0.35) 16(1 – 0.35) + 100

The cost of debt is found by discounting the above cash flows, using trial discount rates.

Try 6%: – 105.5 + (10.4 × 2.673) + (100 × 0. 84) = 6.3

Try 10%: – 105.5 + (10.4 × 2.487) + (100 × 0.751) = (4.5)

6.3

E
Post-tax cost of debt = 6+ × (10% – 6%) = 8.3%
6.3  4.5

Weighted average cost of capital

$000
Market value of equity = E = 12,500 × 4 × (0.86 – 0.06) 40,000
Market value of debt = D = 23,697 × 105.5/100 25,000

(b)
PL
Cost of capital = WACC = (0.182 × 40/65) + (0.083 × 25/65) = 14.4%

Analysis of Canalot

(i) Market value

––––––
65,000
––––––

Vg = Vu + Dt
M
= 32.5 + (5 × 0.35)

= $34.25m (i.e. an increase of $1.75m).

Tax relief is available on the interest on debt. Hence introduction of debt instead of equity
reduces the company’s tax liability. The present value of tax relief to perpetuity is Dt and this
increase in value accrues to the equity shareholders.
SA

(ii) Cost of equity

Vd
ke = kei + (1 – T) (kei – kd)
Ve

5
= 0.18 + (1 – 0.35) (0.18 – 0.13) ×
32.5  5  1.75

= 18.56% (i.e. an increase of 0.56%).

The introduction of debt increases the risk borne by the equity shareholders – this increase in
risk is referred to as financial risk. This increase in risk (which is systematic) results in the
equity holders demanding a higher return on their investment. Hence the cost of equity rises
which, according to Modigliani and Miller (M&M) is at a linear rate.

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 ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

(iii) WACC

WACC = (0.1856 × 29.25 ÷ 34.25) + (0.13 × 0.65 ×5 ÷ 34.25)

= 0.171 (i.e. 17.1%)

This is a decrease of 0.9%.

The introduction of debt has three effects:

 it increases the cost of equity;

 the cost of debt is less than the cost of equity which results in a saving;
 tax relief is available on debt interest.

E
M&M argue that the first two effects cancel out. The net effect of introducing debt is the
benefit of tax relief which reduces the company’s overall cost of capital.

(c) Effect of financial gearing

The traditional theory suggests that at “low” levels of gearing the benefits (i.e. cost of debt <

PL
cost of equity and tax relief) from increasing debt outweigh the disadvantages (i.e. the
increase in financial risk to the equity shareholders) and therefore the average cost of capital
decreases. However, at “high” levels of gearing the costs start to outweigh the benefits
causing the cost of capital to increase. Hence a “U” shaped cost of capital curve and an
“optimum” level of gearing (i.e. the level of gearing can directly affect the value of the firm).
This is not based on a theoretical model and no guidance is given how to identify this
optimum. Therefore, the theory is of limited practical use although it suggests that managers
should attempt to achieve a balance between the amount of debt and equity finance used.

M&M theory with corporate tax suggests that a company should gear up as much as possible
since the benefits of debt always exceed the cost. This implies a gearing level approaching
M
100% which is clearly unrealistic in practice.

The reasons for the model being unrealistic are the assumptions on which it is based and the
costs which are excluded from the model:

(i) Assumptions

(1) Individuals and companies borrow at the same interest rate for all levels of debt;
SA

(2) Personal gearing is viewed by shareholders as equivalent in risk terms to corporate

borrowing;

(3) There are no transaction costs and that information is freely available.

(ii) Costs excluded

(1) Bankruptcy costs. At high levels of gearing the probability of bankruptcy occurring
increases and with it the expected cost of bankruptcy which can be a very
significant amount from the shareholders’ point of view.

(2) Debt capacity. There is a restriction on the amount of debt that a company is able to
raise. Lenders will not be prepared to lend beyond certain levels – often determined
by the level of security required for a loan. This capacity will vary from company
to company.

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 STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

(iii) Personal tax

In a more recent article Miller argued that when personal tax is taken into account the
introduction of debt has no effect on the value of the firm.

(iv) Tax relief

At high levels of debt the firm may reach a stage where it has insufficient taxable profits
against which to set off debt interest (i.e. it would not be able to utilise the tax relief and
hence no cash benefit from introducing more debt). This is sometimes referred to as “tax
exhaustion”.

(v) Agency costs

E
The managers of the company may impose limits on the level of debt to suit their
requirements rather than the best interests of shareholders. Similarly providers of debt may
restrict the actions of management.

These costs/restrictions tend to counteract the beneficial effect (tax relief) of introducing more

(a)
PL
debt. The impact of these various costs is to restrict the level of gearing below the 100%
suggested by the M&M model, indicating again that an optimal level of gearing may exist.

Answer 8 KULPAR CO

Impact of capital structure on cost of capital and corporate value

The company’s existing gearing is $458 million equity to $305 million debt, or 60% equity,
40% debt.

A change in gearing will result in a change in the equity beta. Assuming the beta of debt is
M
zero, the equity beta with no gearing may be estimated by:

E 60
β ungeared = β geared × or 1·4 × = 0·9545
E  D(l - t) 60  40(1 - 0·3)

If gearing was 80% equity, 20% debt by market values, the “ungeared” beta may be
“regeared” to find the new equity beta:
SA

E  D(l - t) 80  20(1 - 0·3)

β geared = β ungeared × or 0·9545 × = 1·122
E 80

Using CAPM, ke = Rf + β (Rm – Rf) or 5·5% + 1·122(14% – 5·5%) = 15·04%

If gearing was 40% equity, 60% debt by market values, this may be “regeared” to find the
new equity beta:
E  D(l - t) 40  60(1 - 0·3)
β geared = β ungeared × or 0·9545 × = 1·957
E 40

Using CAPM, ke = Rf + β(Rm – Rf) or 5·5% + 1·957 (14% – 5·5%) = 22·13%

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 ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

The cost of debt depends on interest cover and the credit rating.

80%E, 20%D 40%E, 60%D

Net operating income 110 110
Depreciation 20 20
Earnings before interest and tax 90 90
Interest 12·21 (approx $152·6m debt) 50·36 (approx $457·8m debt)
Interest cover 7·37 1·79
Cost of debt 8·0% 11·0%

The interest payable is found by examining different interest rate and interest cover
possibilities.

E
80% equity 20% debt must fall into the AA rating (if the interest rate was 9%, interest would
be $13·73 million and cover 6·55, still AA cover)

40% equity, 60% debt must fall into the BB rating (interest of 9% would be $41·20 million,
and cover 2·18 still in the BB rating).

PL
WACC at 80% equity, 20% debt = 15·04% × 0·80 + 8·0% (1 – 0·3) 0·20 = 13·15%

WACC at 40% equity, 60% debt = 22·13% × 0·40 + 11·0% (1 – 0·3) 0·60 = 13·47%

Existing cost of equity is: 5·5% + (14% – 5·5%) 1·4 = 17·4%

Existing WACC is 17·4% × 0·60 + 9% (1 – 0·3) 0·40 = 12·96%

The two alternative capital structures are expected to increase the cost of capital from its
current level.
M
Corporate value

Using the suggested equation, company cash flow = 90 (1 – 0·3) + 20 – 20 = 63

The growth rate is unknown. However, existing corporate value, company cash flow and
weighted average cost of capital are known, allowing the growth rate to be estimated.

63 (1  g)
SA

763 = Solving g = 0·043 or 4·3%

0·1296 - g

Assuming this growth rate remains unchanged corporate value with different gearing levels is
estimated to be:
63 (1  0·043)
80% equity, 20% debt = $742m
0·1315 - 0·043
63 (1  0·043)
40% equity, 60% debt = $717m
0·1347 - 0·043
Altering the capital structure to either of the two suggested levels is expected to reduce
corporate value from its current level of $763 million. It is recommended that the capital
structure is kept at its current level of 60% equity, 40% debt.

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 STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

(b) Possible reasons for errors in the estimates of corporate value

The estimates of corporate value are only approximations and may be incorrect for many
reasons including:

 The assumption of constant growth may be incorrect.

 Corporate value in this model is sensitive to the level of capital spending which
might alter considerably from period to period.

 The model ignores the cash flow impact of any changes in working capital.

 Corporate cash flow would be better estimated by:

E
(EBIT – depreciation)(1 – t) + depreciation – capital spending + or – change in
working capital

 Any change in gearing would involve transactions costs as shares were repurchased
or issued, and debt was issued or redeemed.


PL
Repurchases of shares might not be possible at the current market price.

The corporate tax rate might change

Credit rating agencies use other factors in addition to interest cover when deciding a
company’s rating, such as the quality of the company’s management, or the
volatility of a company’s cash flows.

Operating cash flow might itself be affected by a change in debt rating.

The valuation does not take account of any additional costs that might exist at high
M

levels of gearing such as direct and indirect bankruptcy costs.

 Tax exhaustion might exist at high gearing levels whereby the company can no
longer benefit from tax relief on interest paid on incremental debt issues.

 Corporate debt is not risk free and does not have a beta of zero. A positive beta will
alter the cost of capital estimates.
SA

Answer 9 MALTEC

In theory, a well-diversified investor will not place any extra value on companies that diversify. On the
contrary, as corporate diversification is expensive, and might move companies away from their core
competence, a diversified company might have a relatively low market value. However, not all
investors are well diversified, and even well diversified investors might benefit from a diversified
company. A diversified company might have a less volatile cash flow pattern, be less likely to default
on interest payments, have a higher credit rating and therefore lower cost of capital, leading to higher
potential NPVs from investments and a higher market value.

If the diversification is international the benefits of diversification will depend upon whether the
countries where the investments take place are part of any integrated international market, or are largely
segmented by government restrictions (e.g. exchange controls, tariffs, quotas). If markets are
segmented international diversification might offer the opportunity to reduce both systematic and
unsystematic risk. An integrated market would only offer the opportunity to reduce unsystematic risk.

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 ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

Most markets are neither fully integrated nor segmented meaning that international diversification will
lead to some reduction in systematic risk, which would be valued by investors.

It is to be hoped that risk reduction is not the only objective of Maltec; returns and shareholder utility
are also important.

Answer 10 WEMERE

(a) Errors of principle and revised estimates

The first error made is to suggest using the cost of equity, whether estimated via the dividend
valuation model or the capital asset pricing model (CAPM) as the discount rate. The
company should use its overall cost of capital, which would normally be a weighted average

E
of the cost of equity and the cost of debt.

Errors specific to CAPM

 The formula is wrong. It wrongly includes the market return twice. It should be:


PL
E(ri) = Rf + βi(E(rm)–Rf)

The equity beta of Folten reflects the financial risk resulting from the level of
gearing in Folten. It must be adjusted to reflect the level of gearing specific to
Wemere. It is also likely that the beta of an unlisted company is higher than the
beta of an equivalent listed company.

The return required by equity holders (i.e. the cost of equity) already includes a
return to allow for inflation.

Errors specific to the dividend valuation model

M
D1
 The formula is wrong. It should be: +g
P0

 Treatment of inflation – as for CAPM.

 Again the impact of the difference in the level of gearing of Wemere and Folten on
the cost of equity has not been taken into account.
SA

Revised estimates – CAPM

CAPM: required return = Rf + βi(E(rm)–Rf)

For Folten

Vd = 4,400

Ve = 1.38 × 1,800 × 4 = $9,936,000

Assume the debt of debt = 0

 Ve 
βa =  βe 
 Ve  Vd 1  T  

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 STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

9,936
βa = × 1.4 = 1.087
9,936  4,400(1  0.35)
For Wemere
10,600
1.087 = × βe
10,600  2,400 (1 - 0.35)

1.087 = 0.872 βe
βe = 1.25

Cost of equity = 12 + 1.25 (18 –12) = 19.5%

E
10,600 2,400
WACC = 19.5% × + 13(1 – 0.35) × = 17.5%
10,600  2,400 10,600  2,400

Revised estimate – Dividend valuation model

Folten
ke =
D1
P0
+q

Dividend growth rate:

PL
9.23 (1+g)4
(1+g)4
1+g
g
= 13.03
= 1.412
= 1.09
= 9%
D1 = 13.03 (1 + 0.09) = 14.20 cents
M
14.20
ke = + 0.09 = 0.193 (i.e. 19.3%).
138
Vd
ke = kei + (1 – T) (kei – kd)
Ve

4,400
19.3 = ke ungeared + (1 – 0.35) (ke ungeared – 13)
SA

9,936

ke ungeared = 17.9%

Wemere

2,400
ke geared = 17.9 + (1 – 0.35) (17.9 – 13) = 18.6%
10,600
10,600 2,400
WACC = 18.6% × + 13(1 – 0.35) × = 16.7%
10,600  2,400 10,600  2,400

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 ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

(b) Which estimate should be used as discount rate

Both methods result in a discount rate of approximately 17%. They are both based on
estimates from another company which has, for example, a different level of gearing. The
cost of equity derived using the dividend valuation model is based on Folten’s dividend
policy and share price and not that of Wemere. The dividend policy of Wemere (e.g. the
dividend growth rate) is likely to be different.

CAPM involves estimating the systematic risk of Wemere using Folten. The beta of Folten is
likely to be a reasonable estimate, subject to gearing, of the beta of Wemere.

CAPM is therefore likely to produce the better estimate of the discount rate to use. However,
this will be incorrect if the projects being appraised have a different level of systematic risk to

E
the average systematic risk of Folten’s existing projects or if the finance used for the project
significantly changes the capital structure of Wemere.

(c) Use of discounted cash flow techniques in small unlisted companies

Discounted cash flow techniques allow for the time value of money and should therefore be

PL
used for all investment appraisal including that carried out by small unlisted companies. It is
important for all managers to recognise that money received now is worth more than money
received in the future. Discounting enables future cash flows to be expressed in terms of
present value and for net present value to be calculated. A positive net present value indicates
that the return provided by the project is greater than the discount rate.

One non-discounting method – accounting rate of return – is used because it employs data
consistent with financial accounts, but it is not theoretically sound and is not recommended as
a final decision arbiter. Nevertheless it registers appreciation of the impact of a new project
on the financial statements and thus likely impact on users of these statements.
M
Discounted payback measures how long it takes to recover the initial investment after taking
account of the time value of money. It is a useful initial screening method but should not be
used alone since it ignores cash flows outside the payback period. A problem for all
companies, not only small unlisted companies, is estimation of the discount rate. This can be
partly overcome by calculating the IRR (i.e. the discount rate at which the NPV is zero). This
provides a “break-even” cost of capital (i.e. a yield which is then acceptable provided the
capital cost of the business “could not be lower”).
SA

Answer 11 CRESTLEE

(a) Appropriate discount rate

The discount rate should reflect the systematic risk of the individual project being undertaken.
Unless the risk of the textile expansion and the diversification into the packaging industry are
the same, their cash flows should not be discounted at the same.

The discount rate to be used should not be the cost of the actual source of funds for a project,
but a weighted average of the costs of debt and equity which is weighted by the market values
of debt and equity. It is possible to estimate an existing weighted average cost of capital for
Crestlee, but the rate cannot be applied to new projects unless the following assumptions are
complied with:

(i) The project is marginal (i.e. it is small relative to the size of the company). Taken
together the two projects are not marginal, but this is not a crucial assumption as
long as the costs of debt or equity do not alter because of the size of the financing
required.

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 STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

(ii) All cash flows of the project are level perpetuities. This is unrealistic for “real
world” projects, but again makes little difference to the validity of the estimated
weighted average cost of capital.

The remaining two assumptions are more important:

(iii) The project should be financed in a way that does not alter the company’s existing
capital structure. The net present value investment appraisal method cannot handle
a significant change in capital structure; if such a change occurs the adjusted present
value method (APV) should be used.

Crestlee’s existing capital structure using market values is:

E
$m %
30 million ordinary shares at 380 cents 114.00 66
$56 million debentures at $104 58.24 34
_____
172.24
_____

PL
If the two investments are considered as a “package”:

New finance being raised

$56 million debentures at $104
$m
9.275 equity
4.725 debt
_____
14.000 m
_____
%
66
34

The company’s capital structure does not change as a result of these two
M
investments.

(iv) The project should have the same level of systematic risk as the company’s existing
operations. As the textile investment is an existing operations it is reasonable to
assume that it has the same systematic risk. The diversification into packaging
could have very different risk characteristics. The company’s existing weighted
average cost of capital should not be used as a discount rate for the diversification.
SA

Textile expansion

The discount rate may be based upon the company’s weighted average cost of
capital (given that assumptions (iii) and (iv) are not violated).

E D
WACC = Ke + Kd (1 – t)
E+D E+D

Using the capital asset pricing model ke may be estimated by

ke = 6% + 1.2 (14% – 6%) = 15.6%

kd is taken as the current cost of loan stock, 11% (alternatively a rate could have
been estimated using the redemption yield of the debenture).

WACC = 15.6%  66/100 + 11% (1 – 0.33) 34/100= 12.8%

This is the suggested discounted rate for the expansion.

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 ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

Packaging diversification

The systematic risk of diversifying into the packaging industry may be estimated by
referring to the systematic risk of companies within that industry. However, the
equity beta is influenced by the level of financial risk (gearing). Unless the market
weighted gearing of Canall and Sealalot is the same as Crestlee, it is necessary to
“ungear” the equity beta of these companies (to remove the effect of financial risk)
and regear to take account of Crestlee’s financial risk.

Gearing Canall ($m) % Sealalot ($m) %

Equity 72.0 81 138 91
Debt 16.8 19 13 9
____ ___

E
88.8 151
____ ___

These are both significantly different from Crestlee.


βa =  PL
Ungearing Canall (assuming debt is risk free and d = 0):

Ve

Ungearing Sealalot:

a =
138
138  13(1  0.33)

βe  =
 Ve  Vd 1  T  
72
72  16.8(1  0.33)

 1.2 = 1.129
 1.3 = 1.124
M
These are very similar. The ungeared equity beta of the packaging industry will be
assumed to be 1.125.

Regearing for Crestlee’s capital structure:

Ve + Vd (1 - t) 114  58.24(1  0.33)

e = a  = 1.125  = 1.51
Ve 114
SA

ke is estimated to be:

6% + 1.51(14% – 6%) = 18.08%

WACC = 18.08%  66/100 + 11% (1 – 0.33) 34/100 = 14.4%

15% is not an appropriate discount rate for either of these projects. The less risky
textile expansion has an estimated discount rate of 12.8%, and the diversification
14.4%.

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 STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

(b) Validity of the directors’ views

The marketing director might be correct. If there is initially a high level of systematic risk in
the packaging investment before it is certain whether the investment will succeed or fail, it is
logical to discount cash flows for this high risk period at a rate reflecting this risk. Once it
has been determined whether the project will be successful, risk may return to a “more
normal” level, and the discount rate reduced commensurate with the lower risk.

The other board member is incorrect. If the same discount rate is used throughout a project’s
life the discount factor becomes smaller and effectively allows a greater deduction for risk for
more distant cash flows. The total risk adjustment is greater the further into the future cash
flows are considered. It is not necessary to discount more distant cash flows at a higher rate.

E
Answer 12 HOTALOT

(a) Explanation of terms

The equity beta measures the systematic risk of a company’s shares. A beta of 0.95 suggests
that Hotalot is slightly less risky than the market as a whole.

(b)
PL
The alpha value measures the abnormal return on a share. Hotalot’s shares are currently
earning 1.5% more than would be expected from the firm’s beta. The average alpha for the
market is zero. An investor should buy Hotalot’s shares until the price rises and the alpha
falls to zero. The alpha of 1.5% will only be temporary.

Estimation of discount rate

Hotalot’s diversification into freezer production will change the company’s risk profile. The
systematic risk of freezer production can be estimated from the betas of the firms already
producing freezers. As all the companies listed have a similar market value, the weighted
M
average equity beta is:

1.1  1.25  1.30  1.05

= 1.175
4

The equity beta reflects the financial gearing of the companies in the industry. It is therefore
necessary to degear the equity beta of the freezer industry, and re-gear to take account of
Hotalot’s gearing.
SA

Gearing of freezer industry (MV): Equity $192m Debt $40.1m

To de-gear industry beta:

E
βu = βe
E  D (I T)

192 192
= × 1.175 = 1.175 = 1.035
192  40.1(0.65) 218

Gearing of Hotalot (MV) Equity $33.92m Debt $1 7.4m

To re-gear for Hotalot;

D 74(0.65)
βe = βu (1 + (1 – t) ) = 1.035 (1 + ) = 1.38
E 33.92

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 ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

Required return = Rf + β(Rm – Rf) = 9% + 1.38(16% – 9%)

= 9% + 1.38(7%) = 9% + 9.66% = 18.66%

This is the required rate of return for Hotalot’s equity investment in freezers.
E D
The WACC required is therefore ke + kd (l – t)
ED ED
33.92 17.4
18.66% + 9.5%(1 – 0.35) = 12.33 + 2.09 = 14.43%
51.32 51.32

Hotalot should use a discount rate of 14.43% for the appraisal of its diversification into

E
freezer production.

(c) Risk associated with corporate debt

It is not realistic to assume that corporate debt is risk-free. Companies may default on both
the interest payments and the principal repayments. If corporate debt is not entirely risk-free,

PL
then ungeared betas will be underestimated, and geared betas will be overestimated.

Research by the Bond Investors Association says the default rate in “junk bonds” during the
1980s was running at 11.2%. Between 1980 and 1989, 631 corporate bond issues worth
$30.1 billion defaulted.

As Hotalot only pays 9.5% compared with a risk-free rate of 9% Hotalot debt can be assumed
to have a beta value of 0.06, say.

The asset beta (ungeared) is determined by:

E D(1 - t)
M
βu = βe + βd
E  D (1 - t) E  D (1 - t)

192 40 (1 0.35)
βu =1.175 × + 0.06 ×
192  40 (1 - 0.35) 192  40 (1 - 0.35)
Re-gear: solve for βe using Hotalot’s gearing:
SA

E D(1 - t)
βu = βe + βd
E  D (1 - t) E  D (1 - t)
33.92 17.4 (1 0.35)
1.04 = βe + 0.06
33.92  17.4 (1 - 0.35) 33.92  17.4 (1 - 0.35)

1.04 = βe (0.75) + 0.015

βe = 1.367

ke = 9% + (16% – 9%) 1.367 = 18.57%

33.92 17.4
WACC = 18.57% + 9.5% (1 – 0.35)
51.32 51.32

= 12.27 + 2.09 = 14.36%

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 STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

This compares with the previous WACC of 14.43%, which as stated above was
overestimated.

(d) Systematic and unsystematic risk

The Capital Asset Pricing Model assumes that shareholders are well diversified, and therefore
only concerned with systematic risk. However, Hotalot’s shareholders may not all be well
diversified, and may be concerned with the specific risk applicable to Hotalot.

Even well diversified shareholders should not completely ignore unsystematic risk. The total
risk of a company, both systematic and unsystematic risk, determines the probability of
bankruptcy, which can incur significant costs for equity investors.

E
Answer 13 AMBLE

(a) IRR

Relevant cash flows ($000s)

Year
Direct labour
Material Z

Depreciation
Selling expenses
Head office costs
Rental
Interest
PL 0

Components P & Q & variable costs

Management salaries

–
1
354
102
275
67

166

120
–

–
2
552
161
421
72

174

126
–

–
3
608
174
454
77

183

132
–

–
4
669
188
490
82
–
192
–
139

Other overhead 50 53 55 58
M
1,134 1,559 1,683 1,818
Sales 1,320 2,021 2,183 2,356
Net cash flows 186 462 500 538
Tax allowable depreciation 213 213 213 213
Taxable profit (27) 249 287 325
Tax payable (9) 87 100 114

Cash flows for calculation of IRR

SA

Net cash flow (above) 186 462 500 538

Taxation 9 (87) (100) (114)
New machinery (864)
Salvage value 12
Cash flows (864) 195 375 400 436
Calculate IRR by trial and error NPV
0% (864) 195 375 400 436 542
20% factor 1.0 0.833 0.694 0.579 0.482
(864) 162 260 232 210 0

Therefore IRR is 20%

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 ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

Notes:

Year 1 Year 2 Year 3 Year 4

(i) Sales price 110 115.5 121.27 127.34
Units 12,000 17,500 18,000 18,500
$000 1,320 2,021 2,183 2,356

(ii) Direct labour cost 29.5 31.56 33.77 36.14

Units 12,000 17,500 18,000 18,500
$000 354 552 608 669

(iii) Material Z, 72,000 kilos are required in the first year. The relevant cost is 70,000
kilos in inventory, opportunity cost $99,000 plus 2,000 kilos at $1.46 giving a total

E
cost of $101,920.

(iv) Only incremental management salaries are relevant, the two new managers plus the
replacement deputy manager.

(v) The opportunity rental of $120,000 is the relevant cost.

(vi)

Tax:
PL
Other fixed overhead – the apportionment of rates is not a relevant cost.

Sales less cash costs

Tax allowable depreciation
Taxable
Tax (35%)
Year 1
$000

186
213
(27)
(9)
Year 2
$000

462
213
249
87
Year 3
$000

500
213
287
100
Year 4
$000

538
213
325
114
M
Year 1 assumes the company has other profits.

When calculating IRR by trial and error, the use of 0% is a simple calculation, which gives
some idea of the next percentage figure to try. As interpolation is usually more accurate than
extrapolation the highest available percentage was tried. It was good fortune that this proved
precisely correct.)

(b) Asset beta

SA

An asset beta is the weighted average of the beta of equity and the beta of debt. It reflects the
company’s business risk. The difference between the company’s asset beta and its equity beta
reflects the company’s financial risk. Only systematic risk is considered in an asset beta.

Using the CAPM, the required return is Rf + β(Rm – Rf).

8% + 1.2(15% – 8%) = 16.4%

Since the product returns 20%, which is considerably more than the required return of 16.4%,
the product should be introduced.

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 STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

However:

 There may be non-financial factors which affect this decision.

 The new product may have a higher systematic risk than the company as a whole.
 Systematic risk is an appropriate measure only if either the company or the
shareholder is well diversified.
 The CAPM is subject to criticism, both at the theoretical level, and regarding the
practical problems of data collection. The figure of 16.4% calculated, may
therefore not be the appropriate rate.

(c) NPV using 17% discount rate

E
NPV
Year $000 17% $000
0 (864) 1.000 (864)
1 195 0.855 167
2 375 0.731 274
3 400 0.624 250
4

Year
1
2
PL $000
(9)
87
436

PV of tax at 35%
17%
0.855
0.731
(8)
64
0.534

The product will cease to be viable when the PV of the tax paid increases by $60,000.

PV($000) $000
(13)
125
233
60

PV of tax at 50%
17% PV($000)
0.855
0.731
(11)
91
3 100 0.624 62 143 0.624 89
4 114 0.534 61 162 0.534 87
M
179 256

The increase in the tax rate from 35% to 50% increases the PV of tax paid by 256 – 179 =
$77,000. By interpolation it can be calculated that the PV of tax will increase by $60,000 at a
tax rate of just under 47%. If tax rates rose to 47%, the project would not be viable.

Answer 14 PROGROW
SA

(a) Report on new machine purchase or expansion of garden tool production

From a financial perspective the alternative investments may be compared by using the
expected net present values of their incremental cash flows. On this basis expansion of
garden tool production would be the favoured alternative as its expected NPV is $277,200,
compared with $38,100 from introducing the new jack production process. The two
investments have been discounted at different rates as they are of different risk.

Before making a decision we would draw your attention to a number of factors. Investment
decisions should not be made purely on financial grounds. In this case the new process will
involve making 50 workers redundant which could adversely affect the working relationships
and motivation within your company.

Your concern about the possible effect on your share of the jack market may be well founded.
If your competitors adopt the new process and are able to cut their prices you could lose
market share unless you are able to cut your prices, which will reduce profitability and cash
flow. Information is needed on your likely price of jacks if you do not introduce the new
process.

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 ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

The likely future developments in the garden tool markets and jack markets should be
considered. If one market is likely to have better future opportunities then this should
influence your decision. The likely cash flows after the initial five-year period will be
important.

The expected NPVs are subject to a margin of error. As long as the technical specification
and reliability of the new jack production process is well proven, the projections for the jack
process are likely to be more accurate as you are not expanding sales. The garden tool
projections assume that you can sell the extra 70,000 units at the same price, which may not
be possible.

A major concern is the lack of any data about the need for extra working capital to
accompany the increase in production, or information about whether any additional

E
management or supervisory staff will be required, or if there are incremental overheads
associated with the production process. The existing data might under-estimate the cash
outflows associated with the expansion.

As both investments produce positive expected net present values might it not be possible to
construct an extension to your existing premises to create enough space to undertake both?

Year
PL
Obviously the cost of this would need to be taken into account, but it might also give the
company the flexibility to take advantage of future opportunities.

Appendix

Incremental cash flows from the introduction of the new jack process

Direct labour saved

0 1
271.6
2
287.9
$000
3
305.2
4
323.5
5
342.9
6

Redundancy costs (354)

M
Retraining (15)
Maintenance (46.8) (48.7) (50.6) (52.6) (54.7)
_____ _____ _____ _____ _____ _____
Incremental taxable
income (369) 224.8 239.2 254.6 270.9 288.2
Incremental tax 92.2 (56.2) (59.8) (63.6) (67.7) (72.0)
Taxed saved from the
depreciation allowance 66.9 16.7 12.5 9.4 7.1 11.2
SA

Cost of machines (535)

Sale of machines 125.0 40
_____ _____ _____ _____ _____ _____
Net incremental
cash flows (904) 508.9 199.7 207.3 216.7 267.6 (60.8)
_____ _____ _____ _____ _____ _____ _____

Discount factors (16%) 1 0.862 0.743 0.641 0.552 0.476 0.410

Present values (904) 438.7 148.4 132.9 119.6 127.4 (24.9)
_____ _____ _____ _____ _____ _____ _____

The expected NPV of incremental cash flows from the introduction of the new jack
production process is: $38,100

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 STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Expansion of garden tool production

Incremental cash flows:

$000
Year 0 1 2 3 4 5 6
Sales 573.3 602.0 632.1 663.7 696.8
Less: Labour 244.9 259.6 275.1 291.6 309.1
Materials 178.1 188.8 200.1 212.1 224.8
_____ _____ _____ _____ _____
Incremental contribution 150.3 153.6 156.9 160.0 162.9
Tax (37.6) (38.4) (39.2) (40.0) (40.7)
Tax saved from the
depreciation allowance 25.0 6.2 4.7 3.5 2.6 4.4

E
Capital equipment (200) 14
_____ _____ _____ _____ _____ _____ _____
Net cash flows (200) 175.3 122.2 123.2 124.3 139.5 (36.3)
_____ _____ _____ _____ _____ _____ _____
Discount factors
(12.39%) 1 0.890 0.792 0.704 0.627 0.558 0.496
Present values

PL
Expected net present value is: $277,200

Notes


(200)
_____
156.0
_____
96.8
_____
86.7
_____
77.9
_____
77.8
_____

7It is assumed that the company has sufficient profits to fully benefit from the tax
allowable depreciation.
(18.0)
_____

 Depreciation allowances:
M
As investment is in the current tax year (year 0) it is assumed that tax saving from
the depreciation allowances commences in year 1.

Jack manufacture
Allowance Tax saved
Year 1 535.0 267.5 66.9
Year 2 267.5 66.9 16.7
SA

Year 3 200.6 50.2 12.5

Year 4 150.5 37.6 9.4
Year 5 112.9 28.2 7.1

Tax book value at date of disposal = 112.9–28.2 = 84.7

Balancing allowance:

84.7 – 40 = 44.7 × 25% = 11.2, tax saved in year 6

Garden tool manufacture

Allowance Tax saved
Year 1 200.0 100.0 25.0
Year 2 100.0 25.0 6.2
Year 3 75.0 18.7 4.7
Year 4 56.2 14.1 3.5
Year 5 42.2 10.5 2.6

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 ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

End balance 31.7 Balancing allowance:

31.7 – 14 = 17.7 × 25% = 4.4, tax saved in year 6

 The company’s current weighted average cost of capital should not be used. The
discount rate should allow for the different systematic risk of jack production and
garden tool manufacture.

The discount rates may be estimated as follows:

Assuming the systematic risk of garden tool production is accurately reflected by

the beta equity of other producers, this risk may be estimated by ungearing the beta
of the other companies, and regearing it to take into account the different gearing

E
level of Progrow.

As corporate debt is assumed to be risk free, the debt beta = 0

E 50
β asset = β equity × = 1.4 ×  0.8
E  D1  t  50  501  0.25

PL
Regearing for Progrow’s capital structure, market value of equity $4.536 million
and of debt $1.650 million.

β equity = 0.8 

Using CAPM,
4.536  1.651  0.25
4.536
 1.018

ke = Rf + β(Rm – Rf)
ke = 7% + 1.018(14% – 7%) = 14.13%

The post-tax cost of debt may be estimated by finding the post-tax IRR of the bond,
M
although this may differ from the cost of the term loan.

Tutorial note: The cost of debt cannot be assumed to be at the risk free rate; the
examiner only allows this assumption when de-gearing/re-gearing betas as above.

After tax interest = $15 (1 – 0.25) = $11.25

SA

At 7% interest
$
Discounted value of $11.25 for 10 years 11.25 × 7.024 79.02
Present value of $100 in 10 years’ time 100 × 0.508 50.80
Market price (125.00)
______
Net present value 4.82
______
At 8% interest
$
Discounted value of $11.25 for 10 years 11.25 × 6.710 75.49
Present value of $100 in 10 years’ time 100 × 0.463 46.30
Market price (125.00)
______
Net present value (3.21)
______

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 STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

By interpolation the cost of debt is approximately:

4.82
7%   7.6%
4.82  3.21

Using this estimate the weighted average cost of capital for garden tool production
is:

4,536 1,650
WACC = 14.13% ×  7.6%   12.39%
6,186 6,186

This will be used as the discount rate.

E
For jack manufacture

If the overall beta equity of Progrow is 1.3, and the beta equity of garden tools is
1.018, with garden tools representing 60% of the value of the company, the beta
equity of jacks is estimated by:

Using CAPM,
PL
WACC = 19.06% 
1.3 = 1.018 × 0.6 + β equity jacks × 0.4

βequity jacks = 1.723

4,536
6,186
 7.6% 
ke = Rf + β(Rm – Rf)
ke = 7% + 1.723(14% – 7%) = 19.06%

1,650
6,186
 16%
M
 Apportioned salaries and head office overhead are irrelevant.

 Interest costs are not a relevant cash flow as the costs of any financing are
encompassed within the discount rate.

(b) Validity of comments

(i) NPV
SA

The managing director’s daughter is correct that NPV does not take into account any future
options arising from investment decisions. Such options could lead to additional NPVs and
could influence the decision process. The valuation of options from capital investments that
might occur in several years’ time is, however, extremely difficult and is known as real
options pricing theory For most companies it is enough to have an awareness of the nature of
the possible options that might exist, and to use this qualitative information in the decision
process.

NPV is not a perfect method of investment appraisal, but in a reasonably efficient market
where the results of the investment decisions of managers (i.e. the expected NPVs) are
quickly and accurately reflected in changes in a company’s share price it is a valid technique
to use as part of the strategic investment decision process. Non-financial factors are also
important.

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 ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

(ii) Betas

The capital asset pricing model does have theoretical and practical weaknesses. These
include:

 The basic model is single period whereas most investment decisions are multi-
period.

 It is based upon perfect capital market assumptions.

 The use of historic data to estimate beta assumes that the future beta will be the
same as the past which may not be the case.

E
 The required data may be difficult to obtain. What is the appropriate risk free rate?
How can the risk and return of the market as a whole be established?

 Evidence suggests that CAPM does not provide a satisfactory measure of risk
against return for small companies, low P/E ratio companies, very high or low beta
securities, and the returns in certain months of the year and days of the week.


PL
The model considers the level of return required by shareholders but ignores any
preference that they might have for income in the form of dividends and capital
gains, which may be subject to different tax treatment.

It assumes that shareholders are well diversified and are only interested in
systematic risk.

Other factors besides systematic risk are likely to influence the required returns of
shareholders. The arbitrage pricing theory does not suffer from many of the theoretical
weaknesses of CAPM, and suggests that the required return is a function of a number of
M
factors, such as interest rates, inflation rates and growth in industrial production.
Unfortunately identifying the nature or number of relevant factors is extremely difficult, and
the model has not been developed in a form that can be easily applied to aid practical capital
investment decisions.

Despite its limitations, CAPM provides a simple and reasonably accurate way of expressing
the relationship between risk and return, and offers a practical means of estimating the
discount rate to be used in the appraisal of capital investments.
SA

Answer 15 TAMPEM

(a) NPV and IRR

The tax saving from capital allowances are:

Year Written down value Capital allowance (25%) Tax saving (30%)
1 4,400 1,100 330
2 3,300 825 248
3 2,475 619 186
4 1,856 464 139

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 STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

NPV
Year 0 1 2 3 4
$000 $000 $000 $000 $000
Operating cash flows 1,250 1,400 1,600 1,800
Taxation (30%) (375) (420) (480) (540)
Tax saving 330 248 186 139
Investment cost (5,400)
Realisable value 1,500
––––– ––––– ––––– ––––– –––––
Net cash flows (5,400) 1,205 1,228 1,306 2,899
Discount factors (10%) 0·909 0·826 0·751 0·683
Present values (5,400) 1,095 1,014 981 1,980

E
The expected NPV is $(330,000)

The investment does not appear to be financially viable.

The weighted average cost of capital using CAPM is:

WACC = ke

APV
ED
PL
ke = 4% + 1·5 (10% – 4%)= 13%

E
+ kd(1 – t)
D
ED
= 13% (0·6) + 8%(1 – 0·3)(0·4) = 10·04%

The relevant cash flows for APV are the same as for the NPV, except for the issue costs
which are treated separately as a financing side effect.

Year 0 1 2 3 4
M
$000 $000 $000 $000 $000
Net cash flows (5,000) 1,205 1,228 1,306 2,899
Discount factors (9%) 0·917 0·842 0·772 0·708
Present values (5,000) 1,105 1,034 1,008 2,052

Expected base case NPV is $199,000

Tutorial note: The discount rate for the base case NPV is the ungeared cost of equity.
SA

Assuming corporate debt to be risk free (which is unlikely at 8%).

 Ve  2,700
βa =  βe  = 1·5 = 0·882
 Ve  Vd 1  T   2,700  2,700(1  0.3)

Keu = 4% + (10% – 4%) 0·882 = 9·29%

Financing side effects:

Annual tax saving on interest payments on $2·7 million debt

$2,700,000 × 8% × 0·3 = $64,800

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 ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

The present value of tax saving over four years discounted at the cost of debt is:

$64,800 × 3·312 = $214,618

$
The estimated APV is:
Base case NPV 199,000
Tax savings 214,618
Issue costs (400,000)
–––––––
13,618

The investment appears to be marginally viable based upon the APV method.

E
(b) Validity of managers’ views

Manager A advocates the use of NPV which is used by many companies worldwide. In an
efficient market a positive NPV, in theory, should lead to a commensurate increase in the
value of the company and share price. However, the use of the weighted average cost of

PL
capital (WACC) in NPV is only appropriate if there is no significant change in gearing as a
result of the investment, the investment is marginal in size, and the operating risk of the
company does not change. If WACC is estimated using the capital asset pricing model, it
also relies upon the accuracy of this model which has many unrealistic assumptions.

The adjusted present value model, advocated by manager B, treats the investment as being
initially all equity financed and then directly adjusts for the present value of any cash flow
effects associated with financing. As gearing is expected to change as a result of the
investment, APV might be better suited to the evaluation of this investment. However, it is
not always easy to identify all of the relevant financing side effects, or the discount rate that
used be used on each of the financing side effects. APV also relies upon unrealistic
M
assumptions with respect to ungearing beta and the existence of perpetual risk free debt.

Both NPV and APV do not consider the potential value of real options (e.g. the abandonment
option and the option to undertake further investments) that might exist as a result of
undertaking the initial investment.

Answer 16 PROJECT REVIEW

SA

(a) Corrected project evaluation and sensitivity analysis

The project cash flow contains a number of errors of principle which should be corrected. As
the project cash flows are shown after tax, the corrections should be made net of tax by either
adding back or deducting the change required.

 Interest has been deducted and should be added back as this finance charge is
properly charged through the application of the discount rate.

 Depreciation should be added back as this is not a cash flow.

 The indirect cost charge should be added back as this does not appear to be a
decision relevant cost.

 Infrastructure costs should be deducted as these have not been included in the
original projection.

 Site clearance and reinstatement costs of $5 million have been included net of tax.

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 STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

 The unclaimed balancing allowance is calculated as follows:

0 1 2 3 4 5 6
Capital investment 150·00 50·00
Deduct FYA at 50% –75·00 –25·00
Deduct WDA
at 25% of residual –18·75 –20·31 –15·23 –11·43 –8·57 –6·43
–––––– –––––– –––––– –––––– –––––– –––––– ––––––
Pool 75·00 81·25 60·94 45·71 34·28 25·71 19·28
–––––– –––––– –––––– –––––– –––––– –––––– ––––––
Proceeds of sale 7·00
Unclaimed BA 12·28

E
This will generate a positive tax benefit in year six of $3·68 million at the tax rate of 30%.

Tutorial notes: the examiner appears to be making several assumptions (i) that the capital
expenditure occurs at the end of a tax year, leading to an instant claim of the first year
allowance (ii) that the draft appraisal had claimed a writing down allowance in the year of
disposal (which would technically be incorrect) (iii) that the $7m disposal proceeds had been

PL
included pre-tax in the draft appraisal.

The initial CAPEX is 150, initial allowance of 50% takes the tax book value down to 75.
However after one year there is another 50 CAPEX, giving 25 initial allowance, plus 25%
WDA on the tax book value of the initial CAPEX (75 × 25% = 18.75). At the end of the first
year the total tax book value = 150 -75 – 18.75 + 50 – 25 = 81.25 which is then used to find
further WDAs at 25% reducing balance. At the end of the last year the remaining tax book
value is compared to sale proceeds and a balancing allowance claimed due to the loss on
disposal.

The adjusted project cash flow and net present value calculation for this project are:
M
0 1 2 3 4 5 6
Project after tax
cash flow –127·50 –36·88 44·00 68·00 60·00 35·00 20·00
Add back net interest 2·80 2·80 2·80 2·80 2·80
Add back depreciation (net of tax) 2·80 2·80 2·80 2·80 2·80
Add back ABC charge (net of tax) 5·60 5·60 5·60 5·60 5·60
Less corporate infrastructure costs –2·80 –2·80 –2·80 –2·80 –2·80
SA

Estimate for site clearance –3·50

Tax benefit of unrecovered
balancing allowances 3·68
–––––– –––––– –––––– –––––– –––––– –––––– ––––––
Adjusted cash flow –127·50 –36·88 52·40 76·40 68·40 43·40 28·58
–––––– –––––– –––––– –––––– –––––– –––––– ––––––
Discount factor 1·0000 0·9091 0·8264 0·7513 0·6830 0·6209 0·5645
Discounted cash flow
at 10% –127·50 –33·52 43·31 57·40 46·72 26·95 16·14
Net present value 29·48

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 ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

The sensitivity of the project to a 1% increase in capital expenditure is as follows:

Sensitivity to a $1 million
increase in CAPEX 0 1 2 3 4 5 6
at year 0
Equipment purchase/
written down value 1 0·50 0·37 0·28 0·21 0·16 0·12
FYA –0·5
WDA –0·13 –0·09 –0·07 –0·05 –0·04 –0·03
–––– –––– –––– –––– –––– –––– ––––
Balance 0·5 0·37 0·28 0·21 0·16 0·12 0·09
–––– –––– –––– –––– –––– –––– ––––

E
Impact upon CAPEX –1
Tax saving due to
WDA and FYA 0·15 0·039 0·028 0·021 0·015 0·012 0·009
Unrecovered allowance 0·027
–––– –––– –––– –––– –––– –––– ––––
Net impact –0·85 0·039 0·028 0·021 0·015 0·012 0·036

(b)
Discount factor

PL –––– –––– –––– –––– –––– –––– ––––

1·0000 0·9091 0·8264 0·7513 0·6830 0·6209 0·5645
Discounted cash flow –0·85 0·0355 0·0223 0·0158 0·0102 0·0075 0·0203
Net present value –0·63

Thus an increase in CAPEX by $1 million results in a loss of NPV of $0·63 million due to the
benefit of the capital allowances available discounted over the life of the project.

Discounted payback and duration

0 1 2 3 4 5 6
Discounted cash flows
M
from project –127·50 –33·52 43·31 57·40 46·72 26·95 16·14
Cumulative discounted
cash flow –127·50 –161·02 –117·72 –60·32 –13·60 13·35 29·48
Payback (discounted) 4·50

The duration of a project is the average number of years required to recover the present value
of the project.
SA

Duration 0 1 2 3 4 5 6
Discounted cash flow
at 10% 43·31 57·40 46·72 26·95 16·14
Present value
of return phase 190·52
Proportion of present
value in each year 0·2273 0·3013 0·2452 0·1415 0·0847
Weighted years 0·4546 0·9039 0·9809 0·7073 0·5082
Duration (= sum of the
weighted years) 3·55

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 STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Payback, discounted payback and duration are three techniques that measure the return to
liquidity offered by a capital project. In theory, a firm that has ready access to the capital
markets should not be concerned about the time taken to recapture the investment in a project.
However, in practice managers prefer projects to appear to be successful as quickly as
possible. Payback as a technique fails to take into account the time value of money and any
cash flows beyond the project date. It is used by many firms as a coarse filter of projects and
it has been suggested to be a proxy for the redeployment real option. Discounted payback
does surmount the first difficulty but not the second in that it is still possible for projects with
highly negative terminal cash flows to appear attractive because of their initial favourable
cash flows. Conversely, discounted payback may lead a project to be discarded that has
highly favourable cash flows after the payback date.

Duration measures either the average time to recover the initial investment (if discounted at

E
the project’s internal rate of return) of a project, or to recover the present value of the project
if discounted at the cost of capital as is the case in this question. Duration captures both the
time value of money and the whole of the cash flows of a project. It is also a measure which
can be used across projects to indicate when the bulk of the project value will be captured.

Its disadvantage is that it is more difficult to conceptualise than payback and may not be

(c)
employed for that reason.

Report on project appraisal

Report to Management
Prepared by: D Obbin, ACCA
PL
I have reviewed the proposed capital investment and after making a number of adjustments
have estimated that the project will increase the value of the firm by approximately $29·48
million. The project is highly sensitive to changes in the level of capital investment.
Increases in immediate capital spending on this project will lead to a concomitant loss in the
M
overall project value less the tax saving resulting from the increased capital allowances.
However, given the size of the net present value of the project, it is unlikely that an adverse
movement in this variable would lead to a significant reduction in the value of the firm.

The analysis of the payback on this project using discounted cash flows suggests that the
value of the capital invested will be wholly recovered within four years of commencement.
The bulk of the cash flow recovery occurs early within the life cycle of the project with an
average recovery of the total present value occurring 3·55 years from commencement.
SA

On the basis of the figures presented and the sensitivity analysis conducted, I
recommend the Board approves this project for investment.

For many years the Board has used payback as one technique for evaluating investment
projects. The Board has noted concerns that (i) the method chosen does not reflect the cost of
finance either in the cash flows or in the discount rate applied and (ii) it fails to reflect cash
flows beyond the payback date. Discounted payback surmounts the first but not the second
difficulty. I would recommend that the Board considers the use of “duration” which measures
the time to recover either half the value invested in a project or, by alternative measurement,
half the project net present value. Because this measure captures both the full value and the
time value of a project it is recommended as a superior measure to either payback or
discounted payback when comparing the time taken by different projects to recover the
investment involved.

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 ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

As part of its review process the Board has asked for sensitivities of the project to key
variables. Sensitivity analysis demonstrates the likely gain or loss of project value as a result
of small changes in the value of the variables chosen. Unfortunately, some variables (e.g.
price changes and the cost of finance) are highly correlated with one another and focusing
upon the movement in a single variable may well ignore significant changes in another
variable. To deal with this and given our background information about the volatility of input
variables and their correlation, I would recommend that a simulation is conducted taking these
component risks into account. Simulation works by randomly drawing a possible value for
each variable on a repeated basis until a distribution of net present value outcomes can be
established and the priority of each variable in determining the overall net present value
obtained. Furthermore, the Board will be in a position to review the potential “value at risk”
in a given project.

E
I recommend that the Board reviews a simulation of project net present values in future
and that this forms part of its continuing review process.

Answer 17 DARON

(a) Report for the managers of Daron

PL
Any recommendation regarding the sale of the company to a competitor for $20 million
should be made in the best interests of the shareholders. An offer of $20 million is an 8.7%
premium over the current share price.

Estimates of the present values of future cash flows suggest that if party A wins the election
the company’s equity value will be $16.3 million and only $7 million if party B wins. In this
light the offer of $20 million appears very attractive. .

However, these estimates are by no means precise. Inaccuracy could exist due to:
M
 Incorrect inflation estimates.
 Errors in sales volume and cost projections.
 Inaccurate discount rate estimates.
 The assumption of a constant 30% corporate tax rate.

Sensitivity analysis is recommended to analyse the significance of changes in key variables.

The cash flow estimates do not incorporate any value for options relating to opportunities that
might exist between now and 20X6 if operations continue. Nor is there data on the expected
SA

realisable value of the company at year 20X6. Even if further investment was not undertaken
at that time, the present value of the realisable value of land, buildings and cash flow released
from working capital needs to be considered. This would increase the above present value
estimates.

Appendix 2 shows the financial estimates of the hotel purchase. An APV of $0.56 million
suggests that the hotel investment is financially viable. However, this estimate is also subject
to many of the possible inaccuracies noted above. The base case NPV is heavily influenced
by the realisable value of $10 million in 20X1. Future hotel values could vary substantially
from this estimate.

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 STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Investment in the hotel industry is a strategic departure from the company’s core competence.
If the objective is primarily to diversify activities to reduce risk this may not be in the
shareholders’ best interest as they can easily achieve diversification of their investment
portfolios, through unit trusts or similar investments. As the company is in a declining
industry, in the long term diversification may be essential for survival. A medium to long
term strategic plan should be formulated examining alternative strategies, and alternative
investments which may offer better financial returns than the hotel investment, and/or be
closer to the company’s existing core competence.

(i) Appendix 1

Present value estimates

$million

E
Political party A wins the election

20X7 20X8 20X9 20Y0 20Y1 after 20Y1

Sales 28.0 29.0 26.0 22.0 19.0 19.0
Variable cost 17.0 18.0 16.0 14.0 12.0 12.0
Fixed costs 3.0 3.0 3.0 3.0 3.0 3.0
Depreciation

Taxable
Taxation (30%)

Add back depreciation

Working capital
PL 4.0
____
4.0
1.2
____
2.8
4.0
____
3.0
____
5.0
1.5
____
3.5
3.0
1.0
____
3.0
____
4.0
1.2
____
2.8
3.0
2.0
____
2.0
____
3.0
0.9
____
2.1
2.0
3.0
____
1.0
____
3.0
0.9
____
2.1
1.0
3.0
____
____
4.0
1.2
____
2.8
–
–
____
–

Net cash flow 6.8 7.5 7.8 7.1 6.1 2.8

Discount factors (13%) 0.885 0.783 0.693 0.613 0.543 3.517 × 0.543
M
Present values 6.0 5.9 5.4 4.4 3.3 5.3
____ ____ ____ ____ ____ ____

Expected total present value, up to year 20X6 = $30.3 million. We have discounted ‘free cash
flow to the firm’ (i.e. cash available to both equity and debt investors) at the average required
return of equity and debt investors (i.e. WACC). This gives the theoretical total value of the
company to its investors (i.e. market value of equity + market value of debt). We need an
equity valuation to compare to the $20 million offered for the company’s shares
SA

Equity value = total value – market value of debt = 30.3–14 = $16.3 million

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 ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

$million
Political party B wins the election

20X7 20X8 20X9 20Y0 20Y1 after 20Y1

Sales 30.0 26.0 24.0 20.0 16.0 16.0
Variable costs 18.0 16.0 15.0 12:0 11.0 11.0
Fixed costs 3.0 3.0 4.0 4.0 4.0 4.0
Depreciation 40 3.0 3.0 2.0 1.0 –
____ ____ ____ ____ ____ ____
Taxable 5.0 4.0 2.0 2.0 0 1.0
Taxation (30%) 1.5 1.2 0.6 0.6 – 0.3
____ ____ ____ ____ ____ ____
3.5 2.8 1.4 1.4 0 0.7

E
Add back depreciation 4.0 3.0 3.0 2.0 1.0 –
Working capital (1.0) 2.0 2.0 3.0 3.0 –
____ ____ ____ ____ ____ ____
Net cash flow 6.5 7.8 6.4 6.4 4.0 0.7
Discount factors (18%) 0.847 0.718 0.609 0.516 0.437 3.127 × 0.437
Present values 5.5 5.6 3.9 3.3 1.7 1.0

PL ____ ____ ____

Expected total present value, up to year 20X6 = $21 million

Equity valuation = 21 – 14 = $7m

Notes:

Discount rates
____ ____ ____

 Political party A wins

M
$m
Market value of equity 20 million shares at 92c= 18.4
Debt 14.0
____
32.4
____

The risk free rate including inflation is (1.04) (1.05) =1.092 or 9.2%
SA

The market return including inflation is (1.10) (1.05) = 1.155 or 15.5%

Using CAPM, Ke = RF + (Rm – RF) βe
Ke = 9.2% + (15.5% – 9.2%) 1.25 =17.075%

18.4 14
WACC = 17.075% × + 10% (1 – 0.3) = 12.72% or approximately 13%.
32.4 32.4

 Political party B wins

The risk free rate including inflation is (1.04) (1.10) = 1.144 or 14.4%
The market return including inflation is (1.10) (1.10) = 1.21 or 21%
Ke = 14.4% + (21% – 14.4%) 1.25 = 22.65%

18.4 14
WACC = 22.65% × + 15.5% (1 – 0.3) = 17.6% or approximately 18%.
32.4 32.4

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 STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Tutorial note: This is only a rough estimate as the share price is likely to fall with
higher inflation, leading to higher gearing.

Both Ke and Kd could alter because of these factors.

The use of the current share price in both WACC estimates is problematic. In an
efficient market this price will reflect the present uncertainty about the forthcoming
election. Once this uncertainty is resolved the share price is likely to change,
leading to new market weighted gearing levels. Fortunately the investment decision
is not highly sensitive to marginal changes in the discount rate.

Expected values

E
The use of expected values is not recommended as it does not reflect a situation that is likely
to occur in reality.

(ii) Appendix 2

$million

Turnover
Variable costs
Fixed costs

Taxable
Taxation (30%)
PL Cash flows, possible hotel purchase

20X7
9.0
6.0
2.0
____
1.0
0.3
____
20X8
10.0
6.0
2.0
____
2.0
0.6
____
20X9
11.0
7.0
2.0
____
2.0
0.6
____
20Y0
12.0
7.0
2.0
____
3.0
0.9
____
20Y1
13.0
8.0
2.0
____
3.0
0.9
____
0.7 1.4 1.4 2.1 2.1
M
Working capital (1.0) – – (1.0) –
Realisable value 10.0
____ ____ ____ ____ ____
Net cash flows (0.3) 1.4 1.4 1.1 12.1
Discount factors
(14%) 0.877 0.769 0.675 0.592 0.519
Present values (0.3) 1.1 0.9 0.7 6.3
____ ____ ____ ____ ____
SA

Base case NPV = ($9.0) m + $8.7m = ($0.3) m

Tutorial note: For APV the base case NPV is required, which is estimated from
the ungeared cost of equity.

Assuming corporate debt is risk free

E
βe ungeared = βe geared
E  D1  t 

18.4
= 1.25 ×  0.82
18.4  141  0.3

Ke ungeared = 9.2% + (15.5% – 9.2%) 0.82 = 14.4% or approximately 14%

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 ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

Financing side effects for the five year period:

9m
Including issue costs, the gross sum required will be = $9,184,000.
0.98

$9.18m × 10% × 30% per year tax saving = $275,520 per year

Discounted at 10% over 5 years gives a present value of 3.791 × $275,520 =

$1,044,000

Tutorial note: This assumes that an extra $9.184 million debt capacity is created
by the hotel investment. If less debt capacity is created the present value of the tax
shield attributable to the investment will be reduced.

E
The 10% coupon is assumed to correctly reflect the risk of the convertible, and is
used as the discount rate for the tax savings.

The estimated APV is the base case NPV plus the financing side effects:

(b)
APV
PL
Base case NPV
Issue costs
PV of tax saving

Implications of financing with convertible debentures

$m
(0.30)
(0.18)
1.04
_____
0.56
_____

Daron’s current gearing, measured by the book value of medium and long term loans to
M
14
equity is: or 63.6%
22

No information is provided about short-term loans which would increase this figure further.
A $9 million convertible debenture issue would initially increase gearing to

23
or 104.5%
SA

22

a level that involves “high” financial risk especially for a company in a declining industry.
The coupon rate of 10%, or $918,400 interest per year would have to be paid for five years or
more. Convertible debentures normally carry lower coupon rates than straight debt. Daron
can borrow long term from its bank at 10% per year, and the 10% coupon on the convertible
appears to be expensive. However, this could be explained by the market seeking a relatively
high return because of the size of the loan.

If conversion takes place the gearing level will fall, but this is not possible for at least five
$100
years. At the $100 issue price the effective conversion price is or 167 centos per share
60

This represents an average share price increase of 12.7% per year over five years, which is
possible if market prices in general increase, but is by no means guaranteed.

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 STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

The existence of the call and put options has potentially significant implications for Daron.
The call option allows the company to limit the potential gains made by debenture holders. If
the share price reaches 200 centos between 1 January 20X2 and 31 December 20X4 the
company can force the debenture holders to convert, giving maximum capital gains on
conversion of 33 centos per share (relative to the $100 issue price). This is a small gain and
may not be popular with investors. If the share price falls below 100 centos between the same
dates, the debenture holders can ask the company to redeem the debentures at par, forcing the
company to find $9 million for repayment of the debentures. If the market price of the shares
has only moved by a maximum of eight centos over five years, the company might experience
difficulty refinancing the $9 million, leading to severe problems in finding the cash for
redemption.

Answer 18 MERCURY TRAINING

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(a) Cost of equity and weighted average cost of capital

Tutorial note: the key is to build-up Mercury’s asset beta as a weighted average of the asset
beta of training (using Jupiter as a proxy) and the asset beta of the financial services sector.
Theoretically the weighting should be according to the relative value of Mercury’s training

βa = 
Ve
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and financial services assets but, as we don’t know this, we use the fact that financial services
accounts for one-third and Mercury’s revenues and hence training two thirds.

De-gear Jupiter’s equity beta:

   Vd 1  T 
βe  + 

βd 
 Ve  Vd 1  T    Ve  Vd 1  T  

 88 
βa =  1.50 = 1.39
 88  121  0 .4  
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De-gear the equity beta of financial services sector:

 75 
βa =  0.90 = 0.75
 75  251  0.4  

Mercury’s combined asset beta = (1.39 × 2/3) + (0.75 × 1/3) = 1.18

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Re-gear to Mercury’s equity beta:

 70 
1.18 =  βe 
 70  301  0.4 

βe = 1.48

Cost of equity geared = 4.5% + (1.48 × 3.5%) = 9.68%

WACC = (9.68% × 0.7) + ((4.5% + 2.5%) × (1 – 0.4) × 0.3)) = 8%

The equity cost of capital is used for valuing flows to equity investors (such as dividends or
Free Cash Flow to Equity).

The weighted average cost of capital is for valuing flows attributable to the entity i.e. to all
classes of long-term capital (such as project cash flows or Free Cash Flow to the Firm).

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 ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

(b) Likely range of issue prices

At the low end the firm’s net assets at fair value would be the realisable value of the equity
between a willing buyer and seller. This is 650c per share which would represent the lower
end of any negotiating range.

Using the dividend valuation model we estimate the share price at the upper end using the
latest DPS of 25c per share and the cost of equity capital of 9·68%. Three potential growth
rates present themselves: the historic earnings growth which at 12% is greater than the firm’s
equity cost of capital and is therefore not sustainable over the very long run, the anticipated
growth rate of the two sectors weighted according to the firm’s revenue from each (0·67 × 6%
+ 0·33 × 4% = 5·33%) and the rate implied from the firm’s reinvestment:

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(100  25)
g = bre = × 0.0968 = 7.26%
100

Value of the firm using the growth model and the higher of the two feasible growth rates:
D0 1  g 
P0 

P0 
re  g

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25  1.0726
0.0968  0.0726
= $11.08 per share

In addition, the share price gives a spot estimate of the value of a dividend stream in the hands
of a minority investor. If the option to float is taken then a share price of $11·08 could be
achieved especially if a portion of the equity and effective control are retained. However, if a
sale is made to a private equity investor then it may be appropriate to value the firm taking
into account the benefits of control which can be substantial if the purchaser is able to
generate significant synergistic benefits either in terms of revenue enhancement, cost
efficiency or more favourable access to the capital market. Control premiums can be as much
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as 30–50% of the spot price of the equity. In this case an opening negotiation may start with
a share price of $16·62.

(c) Public listing versus private equity finance

The two principal sources of large-scale equity finance are either through a public listing on a
recognised stock exchange or through the private equity market. The former represents the
traditional approach for firms who have grown beyond a certain size and where the owners
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wish to release, in whole or in part, their equity stake within the firm, or where they wish to
gain access to new, large scale equity finance. The procedure for gaining a public listing is
lengthy and invariably requires professional sponsorship from a company that specialises in
this type of work. Depending upon the jurisdiction there are three stages that may have to be
fulfilled before a firm can raise capital on a stock exchange:

(1) Formalise the company’s status as a public limited company with rights to issue its
shares to the public. In some jurisdictions this requires re-registration and in others
it is implicit in the conferment of limited liability.
(2) Seek regulatory approval for admission to a public list of companies who have met
the basic criteria required for entry to a stock exchange (in the UK this process is
under the jurisdiction of the Financial Services Authority).
(3) Fulfil the requirements of the exchange concerned which may entail the publication
of a prospectus which is an audited document containing, among other things,
projections of future earnings and profitability.

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 STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

The disadvantage of public listing is that a company will be exposed to stake building by
other companies, regulatory oversight by the stock exchange and greater public scrutiny.
Stock exchanges require that quoted companies comply with company law as a matter of
course but also that they adhere to various codes of practice associated with good governance
and takeovers. They must also comply with stock exchange rules with respect to the
provision of information and dealing with shareholders.

Private equity finance is the name given to finance raised from investors organised through a
venture capital company or a private equity business. As the name suggests these investors
do not operate through the formal equity market but they operate within the context of the
wider capital market for high risk finance. Because of its position, PEF does not impose the
same regulatory regime as the public market. Transaction costs tend to be lower and there is
evidence to suggest that private equity finance offers companies the ability to restructure and

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take long term decisions which have adverse short term consequences. In some jurisdictions
there are favourable tax advantages to private equity investors.

Answer 19 BIGUN

(a) Report on acquisitions

To
From
Date

Contents

1
Anna Liszt
Today PL
The Directors, Klein Co

Subject Cost of acquisitions to Klein Co

Terms of reference
2 Summary
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3 Klein Co
4 PTT Co
5 Conclusions
6 Appendix

1 Terms of reference

The following report estimates the values of Klein Co and PTT Co.
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2 Summary

The following table gives some estimates of the possible value of the two companies.

Valuation basis Klein Co PTT Co

P/E ratio $10.15m $10.28m
Dividend valuation $16m $12.96m
Net asset value $6.3m $6.5m

Because these valuations are based on estimates they must be seen as a guide only. Details of
these calculations are given in the appendix.

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 ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

3 Klein Co

The P/E ratio approach for Klein is the best estimate available; being based on actual earnings
and the observed P/E ratio it gives the actual market value at March 20Y3. Note, however,
that the situation of Klein might have changed significantly since that date. The dividend
valuation approach gives a higher valuation for Klein, but the assumption that investors
expect past growth to continue into the future is questionable.

The asset valuation is of little worth, no indication being given of current values, goodwill,
etc.

4 PTT Co

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PTT is not a quoted company and therefore any estimate of its value will be somewhat
arbitrary.

The dividend valuation of $12.96m is probably the best estimate but, once again, caution must
be exercised due to the difficulty in estimating growth.

PL
The P/E ratio approach is suspect as the multiple of Klein (a quoted company) has been used.
It is usually considered that non-quoted firms should have much lower P/E ratios and a
reduction of up to 50% on this valuation is possible.

For similar reasons as those given for Klein the asset value of PTT is of limited use.

5 Conclusions

All of the above figures should be seen as educated guesses. The final price paid will depend
upon how much each party wishes to sell and how strongly Bigun wishes to buy. The
estimates of $10.15m and $12.96m for Klein and PTT respectively are probably the best
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guide but premiums of up to 25% on opening market price are not uncommon, rising to 50%
plus if the bid is contested.

6 Appendix

Klein

(1) P/E ratio approach

SA

EPS × P/E ratio = Market value per share

($1.5m - ($6m  11%))  0.65

Current EPS =
5m shares

= $0.1092 per share

P/E ratio = 18.6 : 1 (given)

Market price per

share on historic EPS = $0.1092 × 18.6 = $2.03

Total value of Klein equity = $2.03 × 5m shares

= $10.15m

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 STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

(2) Dividend valuation

Do = EPS × Proportion paid out as dividend

= $0.1092 × 40% = $0.04368

D 0 (1  g) 0.04368  1.105
P0 = = = $3.22 per share
ke  g 0.12  0.105

Therefore, total value: = $3.22 × 5m = $16.1m

PTT

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(3) Dividend valuation

($1.4m - ($5.5m  10%))  0.65  0.75

Do =
2.8m shares

P0 =

=
ke  g PL
= $0.14799 per share

D 0 (1  g)

0.14799  1.095
0.13  0.095

= $4.63 per share

Total value of PTT equity

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= $4.63 × 2.8m

= $12.96m

(4) P/E valuation – using P/E ratio for Klein

EPS = $0.19732
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1 1
(i.e. Do × = 0.14799 × = 0.19732)
0.75 0.75

$0.19732 × 18.6 = $3.67 per share

Total value of equity of PTT

= $3.67 × 2.8m

= $10.28m

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 ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

(b) Packages to be offered by Bigun

The packages that may be offered partly depend upon the sum of money involved. Let us
assume that both companies are bid for at a total cost of $10.2m + $13.0m + a premium, say,
$26 million.

The following packages could be used.

A cash offer

This has the advantage that all parties are assured of the sum received. However, it could put
the shareholders in the victim companies in a capital gains tax paying position. Further,
Bigun has only $5m of cash, and borrowing or an equity issue would be required to raise the

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remainder of the cash.

A loan stock for share exchange

Bigun could offer to exchange loan stock in return for the shares of the victim companies.
This would give the victim shareholders a fairly safe income stream and not expose them to

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immediate capital gains tax. It would, however, prevent them from participating in future
profit growth and this might not be popular.

From the viewpoint of Bigun it would cause a significant increase in gearing which might be
of concern to existing investors.

A share-for-share exchange

Bigun could offer to exchange new shares for the existing shares in Klein and PTT. At a
current market price of $2.98 (EPS 16.21 cents × P/E ratio 18.4), and a bid of $26m, this
would require the issue of approximately 8.7m shares. The current EPS of Bigun is 16.21
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cents, whereas the incremental EPS on the new shares is only

Current equity of Klein and PTT $1,098,500

= = 12.6 cents
8.7m shares 8,700,000

This would result in a reduction in EPS (and possibly market value) of Bigun shares.

Overall each of the various packages presents problems. Bigun shareholders might not be
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happy with a cash offer because of liquidity problems, whereas the use of loan stock could
drive gearing to an unacceptable level. An equity issue could result in a reduction in EPS
though much would depend upon the combined earnings of the three companies. A
compromise solution often adopted would be to use a mixture of the above packages, for
example a cash and equity offer.

Answer 20 DEMAST

(a) Advantages and disadvantages of growth by acquisition

Growth by acquisition is said to allow companies to expand much more rapidly than by
organic growth. Rapid increases in size may offer:

 Economies of scale in production, marketing, R & D and finance. A reduction in

the company’s risk, and cost of capital.

 Greater market share and market power. In some markets to operate effectively
requires the achievement of a “critical mass” size.

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 STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Additionally acquisitions may allow:

 Improvements in gearing.

 Purchase of patents, brands or skilled management.

 Synergistic effects.

 Entry into a new market quickly.

 Acquisition of undervalued assets or companies, as is the stated strategy of BZO

International. This may encompass the removal of relatively inefficient
management.

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However, there is evidence that many acquisitions are financially unsuccessful. There is
often some abnormal return for the shareholders of the target company (in the form of high
prices received for their shares), but very little for the bidding company’s shareholders.
Acquisitions often experience difficulties in integrating the operations of the companies
concerned (unless asset-stripping is the motive for the acquisition).

(b) Financial prudence of bids

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Demast is an unlisted company, with no market price. Ideally the valuation of the company
should be based upon the expected net present value of future cash flows, but accurate
estimates of this value will rarely be available in an acquisition situation. Valuation could in
practice be based upon either assets or earnings. For Nadion, which is likely to be purchasing
Demast as a going concern, an earnings valuation is appropriate. BZO International has a
strategy of acquiring what are perceived to be undervalued companies. If the intention is to
quickly dispose of all or part of the company, the realisable value of Demast’s assets would
provide a useful guide, but if asset stripping is not to occur an earnings-based valuation would
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once again be recommended.

Asset valuations

No precise estimate of the realisable value of assets is possible. Net asset value, adjusted for
a 10% decrease in the value of inventory, is $5,950,000 or 149 cents per share. This,
however, ignores important factors including:
SA

(i) Land and buildings have not been revalued since 20X0. In the light of the
subsequent recession and fall in commercial property prices, the realisable value
could be less than the book value of $4 million.

(ii) No information is provided regarding the difference between book and realisable
values of other tangible assets.

(iii) The patents are not valued in the Statement of Financial Position. These could have
substantial value if they have a number of years to run.

Earnings valuations

Two common methods of “earnings” based valuations are the P/E ratio and the dividend
valuation model.

P/E – As Demast is not listed a P/E valuation must be based upon the P/E of a similar
company. The only available information for a company in the same industry is for Nadioli, a
much larger company.

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 ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

The EPS of Demast is 80.5 cents

EPS of Nadion is 58 cents

320
P/E of Nadion is = 5.52
58

If this is used for Demast the estimated value per share is

5.52 × 80.5 cents = 444 cents

Although Nadion is listed and much larger than Demast, the much higher growth rates of
Demast might justify the use of the similar P/E to Nadion.

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Dividend valuation model

D1
P=
Ke  g

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Current DPS of Demast is
1,500
4,000
= 37.5 cents

At 9% growth the expected net dividend is 37.5 (1.09)

P=
40.875
0.16  0.09
= 584 cents per share
= 40.875 cents

All of these estimates are subject to considerable margins of error.

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Value of the bids

7 September – BZO bids 7 1 0 × 2/3 = 473 cents per share

2 October – Nadion bids 170 cents plus effectively $4 per share ($100 debenture at par for
$6.25 nominal value or 25 ordinary shares), total 570 cents per share plus the conversion
opportunity.
SA

$100
The conversion is currently at an implied price of = 385 cents per share.
26

This is only 14.9% above the current share price of Nadion (335 cents), and the opportunity
for substantial capital gains on conversion exists as there are up to five years before the final
conversion date. A rise in stock market price could mean that Nadion issues new shares on
conversion at well under market price to Demast’s old shareholders.

19 October – BZO cash offer of 600 cents per share.

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 STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Commentary

Although all offers are significantly above the estimated asset valuation, the final successful
bid is only 16 cents above the dividend valuation model figure. If this is accurate, the bid
would seem to be financially prudent. However, BZO’s strategy is to acquire undervalued
companies. Unless BZO has knowledge of how to significantly increase the value of Demast
(e.g. by disposing of part of the operations, or land) the acquisition of Demast does not appear
to be in line with this strategy. Additionally financing the 600 cents cash offer with a $24
million term loan increases the book value of BZO’s gearing (measured by loans and
30  35
overdraft to shareholders’ funds) from its already high level of = 94%.
69

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If the stock market is efficient the significant fails in BZO’s share price on the occasions of
both of the company’s bids illustrate that the acquisition is not regarded as financially
beneficial by the company’s shareholders.

(c) Problems of corporate governance

Knowledge is required of the nature of corporate governance, and discussion of possible

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conflicts between the objectives of directors and shareholders of both the acquiring and
acquired company using specific information on an acquisition.

Corporate governance is the system by which companies are run. The board of directors
should act on behalf of the shareholders of the company, taking note of other interest groups
such as the government, creditors, customers and employees.

In an acquisition situation the actions of directors are constrained by the City Code on
Takeovers and Mergers, a set of self-regulatory rules administered and enforced by the Panel
on Takeovers and Mergers. The directors of both the bidding and bid for companies should
disregard their own personal interests when advising shareholders.
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It is questionable whether BZO’s directors’ actions are in the best interests of the company’s
shareholders, given the market reaction to the bid and the likely adverse effects on the
company’s gearing and interest cover. The company appears short of liquidity (current ratio
0.79:1), and may be trying to maintain its high growth in turnover through acquisitions.

The directors of Demast advised shareholders to reject the bid of Nadion worth 570 cents plus
a likely capital gain on conversion, and accept the bid from BZO of 600 cents, which also
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offered them seats on subsidiary boards within BZO. It could be argued that the directors
were acting in their own interests to retain well-paid employment, and not in the interests of
the owners of the 75% of the shares not controlled by the directors and their families,
although the value of the conversion option is difficult to quantify. Acceptance of the bid by
BZO might also affect the operations and employment levels of Demast, if part of the
operation were to be sold, or the patents sold. Continuity of current operations would be
more likely under the ownership of Nadion, a company in the same industry, although some
cost-saving rationalisation might occur, with loss of employment.

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 STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Another ratio that would need investigating is the asset turnover. At around one this is
relatively low. Unless the industry is very capital intensive, management should consider if
assets could be utilised more efficiently to improve this ratio, and with it the return on capital
employed.

As previously mentioned, managers might also review the company’s dividend policy.
Paying a constant level of earnings could lead to volatile dividend payments which might not
be popular with investors, including financial institutions, that rely upon dividends for part of
their annual cash flow.

Wurrall proposes to finance any new capital needs with increases in the overdraft. Overdraft
finance is not normally considered to be appropriate for long term financing, and the company
should consider longer term borrowing or equity issues for its long-term financing

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requirements.

PL
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SA

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 ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

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PL
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• Question practice for every topic

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• Tutorial notes

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