CORPORATE FINANCIAL MANAGEMENT NOVEMBER 2009 SUGGESTED ANSWERS AND EXAMINER S COMMENTS

Transcription

1 IMPORTANT NOTICE CORPORATE FINANCIAL MANAGEMENT NOVEMBER 2009 S AND EXAMINER S COMMENTS When reading these suggested answers please note that the answers are intended as an indication of what is required rather than a definitive right answer. In many cases there is more than one approach to a question, and different answers may be possible. The suggested answers given here may also be rather longer and more detailed than the answers that most candidates could expect to write in an unseen, time constrained examination. EXAMINER S GENERAL COMMENTS The pass rate in this examination was higher than in the June 2009 examination, lower than in the November 2008 examination and broadly in line with the average for recent examinations. Answers were generally well presented and, almost without exception, candidates attempted the right number of questions. There were possible signs in a few scripts of poor examination technique: one or two earned very good marks in Question 1 which was usually answered first, and very few marks were awarded for the questions answered last. This could be due to poor time management in the examination. It could also be due to failure to prepare a wide enough range of topics in sufficient depth to answer the longer questions. As in other examinations, discursive questions were more popular than calculation questions, with the exception of Question 2, on net present value and investment appraisal, which involved both discussion and calculations with which candidates are usually familiar. Some candidates wasted time or lost marks (in particular in Questions 3, 4 and 6) by failing to answer the question as set. In Questions 3 and 6, some answers gave comments or explanations when only identification was required. In Question 4, some answers simply listed sources where the question asked for comments as well. These points are expanded below. Time is likely to be at a premium even for the best prepared candidates. But time spent on reconnaissance, in the form of a brief initial reading of the paper, and in checking exactly what is needed to answer a question before starting to write, is rarely wasted. Page 1 of 24

2 SECTION A (Compulsory answer all parts of this question) 1. (a) Suggest reasons why a large institutional investor may choose to buy shares direct from another institution rather than through an intermediary such as a broker. (4 marks) Intermediaries charges can be avoided. The institution is likely to be able to identify potential vendors by itself using its contacts and knowledge of the market. The institution may have access to sufficient expertise in evaluating investments not to need the professional investment advice of brokers or other intermediaries. The institution may be well placed to assess the risk of non-delivery, and to be able to choose vendors where this risk is minimised, and be willing and able to take on the risk without needing to rely on the reassurance that dealing through a broker provides to smaller investors. If there is a possibility of further purchases later, the institution may wish to avoid giving any more than the minimum unavoidable publicity to the deal, and may believe that avoiding a market purchase through a broker may help in this respect. In some kinds of transactions, such as placements, shares may be sold directly by one corporate entity to another without involving a broker. EXAMINER S COMMENT Most answers identified the cost of brokers' fees, but far fewer mentioned: situations such as placements where purchases might be made directly, or the ability of institutional investors to make investment decisions without third party advice on the merits of investments or the technical aspects of share transactions. Page 2 of 24

3 (b) A company s balance sheet includes the following information about its long term capital: Loan stock 44m Preference shares 15m Ordinary shares 5m Retained profits 65m Calculate the capital gearing on a book value basis as a percentage correct to one decimal place. Give reasons for the way in which you use the figures for (i) preference shares and (ii) retained profits. (4 marks) Gearing = ( 44m + 15m)/( 5m + 65m) = 84.3% Or ( 44m + 15m)/( 44m + 15m + 5m + 65m) = 45.7% Preference shares, together with debt, are part of prior charge capital, which has to be dealt with before any returns can be made to ordinary shareholders. Retained profits, together with ordinary share capital, are part of shareholders funds. They belong to ordinary shareholders, and represent part of the ordinary shareholders risk capital investment in the company. EXAMINER S COMMENT This question was well answered by most candidates. The most frequently found reason for losing a mark was not treating preference shares as prior charge capital. (c) The Capital Asset Pricing Model depends on the concept of the efficient frontier. Explain what the efficient frontier is. (4 marks) If investments are characterised by risk and return, a rational investor makes a choice about the balance between risk and return in selecting investments. Other things being equal, if two investments have the same return then the investment with the lower risk is preferred. The efficient frontier divides the set of feasible investments (in terms of risk and return) from the set of infeasible investments. Every point on the efficient frontier represents an investment that is ideal, in the sense that it represents an efficient combination of risk and return: it is not possible to find an investment with the same return as this investment without increasing the risk, and it is not possible to find an investment with a lower risk than this investment without reducing the return. Each investment corresponding to a point inside the efficient frontier is inefficient: it is possible to find another investment with the same risk and a higher return, or the same return and Page 3 of 24

4 a lower risk. Investments corresponding to points outside the efficient frontier are not feasible: they have an unachievable combination of risk and return. EXAMINER S COMMENT While the relationship between the efficient frontier and the Capital Asset Pricing Model (CAPM) is relevant, more needs to be said. Many answers dwelt mainly or wholly on the CAPM, and did not really explain the efficient frontier at all. Few answers earned full marks. (d) If a government increases the rate of corporation tax paid by companies, without changing the rates of tax paid by investors on their investment returns, explain what this will do to the relative attractiveness of debt and equity as sources of capital. (4 marks) Companies receive tax relief on debt interest, so the net (after tax) cost of debt capital to the company is reduced by a corporation tax increase. If personal taxes do not change, the return to investors (of interest after income tax, together with any capital gain) is not affected. If, in competitive capital markets, companies transfer some of this benefit to investors by increasing the rate of interest paid, they can still have a lower after-tax cost of debt capital. Since dividends are paid out of taxed profits, the amount available for dividends from a given level of earnings is reduced, and equity capital tends to become less attractive for companies and investors. Consequently, debt becomes relatively more attractive than equity as a result of the tax change. EXAMINER S COMMENT This question was reasonably well answered by most candidates though, for full marks, answers needed to comment on the effects of a corporation tax increase on both debt and equity, and on the effect of tax rates on both the company and investors. Few answers did all these things. Page 4 of 24

5 (e) An investor has used the Arbitrage Pricing Model to calculate the expected return on a share over the coming year, using forecasts of variables such as the expected change in the size of the national economy, consumer expenditure, inflation and interest rates, and has found a figure of 12.4%. He has made an alternative estimate of the return on the share based on projections of future dividends and the current share price. The alternative estimate is a return of 8%. Comment on possible reasons for the difference between the estimates. (4 marks) The Arbitrage Pricing Model relates the return on a security to a range of factors such as economic activity, industrial production and interest rate trends. It has to be calculated separately for each security, since the factors that affect the returns on different companies shares vary. Its validity depends on the accuracy with which it explains past results, and on the relationships between the explanatory variables and the return on the share remaining the same as over the past period of time for which data were collected to develop the model. The alternative estimate of the return on the share is based on the present value of future dividends. It takes into account changes in circumstances, as far as these have informed the projections of future earnings, dividend policies and dividends. However, it does not take into account some factors that may be represented, explicitly or indirectly through the explanatory variables used, in the Arbitrage Pricing Model. One such factor could be risk. Since all models are only approximate representations of what has happened in the past, it is to be expected that two projected returns produced using the two models will be different. If the investor believes that either of his models represents factors or relationships that are not publicly known, then that model may offer a forecast that is not reflected in the market price, offering an opportunity to beat the market. EXAMINER S COMMENT Most answers to this question were less than complete. Few pointed out that, as well as incorporating different variables, both models are only approximations to the truth, and therefore cannot be expected to give the same results. Page 5 of 24

6 (f) A company is making a one-for-three rights issue of ordinary shares at a price of 4.60 per share. The current market price of the ordinary shares is Calculate the value of the rights per existing share before the issue. (4 marks) Value of 3 shares before the rights issue (3 x 6.00) Amount subscribed for one new share 4.60 Total amount of investment by holder of 3 shares before issue (= value of 4 shares after issue) Value of 1 share after issue 5.65 Value of rights per new share ( ) 1.05 Value of rights per existing share ( 1.05/3) 0.35 EXAMINER S COMMENT Only a minority of answers (though quite a large minority) were complete and correct. A fair number of answers earned two marks for calculating the ex-rights share price, but went no further. Some answers correctly calculated the value of rights per existing share as ( )/4 = 0.35 without giving the couple of lines of working to show why this formula is correct. Since the question did not ask for the full detail of the working, such answers earned full marks. Answers that used a different, and therefore incorrect, formula without justification and reached the wrong answer earned no marks. Answers that showed more detail of the working earned some marks even if they were not completely correct. Showing details to justify working is a sensible safety measure, even when it is not specified in the question. (g) Compare and contrast two sources of short term funding for a public limited company. (4 marks) Possible sources include: bank overdraft, factors, invoice discounters, forfaiters, trade creditors, and other creditors including, possibly, tax creditor. Possible factors giving rise to similarities or differences include: Amount available, time period for which capital is provided, flexibility with which capital can be obtained, flexibility of repayment, security required by lenders and the significance of a good credit rating, interest rates, fees. Page 6 of 24

7 EXAMINER S COMMENT This question was well answered by most candidates, but some quoted sources of long term funding such as ordinary shares and debentures. (h) Explain why, after the global financial crisis started at the end of 2007, higher risk corporate borrowers found it much harder to raise capital. (4 marks) The global financial crisis that started at the end of 2007 arose as a result of the unwillingness of banks to lend to each other. This lack of trust was precipitated by the failure of loans based on lending for house purchase in the United States to people who had poor credit ratings, and of financial instruments based on the securitisation of such lending, or whose value was related to this kind of lending. The operation and risks of these derivatives were not fully understood by the managers of the institutions that used them, or by regulators. As part of the developing crisis, corporate lenders became more aware of the risks attached to some lending. At the same time, the lack of reliable information about how far other institutions were exposed to these risks meant that uncertainty was increased. Lending rates between banks increased to reflect this risk. Institutions and investors became more risk averse. In particular, they avoided high-risk investments such as private equity investments and hedge funds. EXAMINER S COMMENT Most answers noted that uncertainty associated with the financial crisis increased perceptions of risk and required returns. Fewer answers gave details of the nature of the risk in this particular case, and why it had such a drastic effect on lenders perceptions and actions. (i) A company has a market valuation of 440 million. The ordinary share price is 275 pence. The pre-tax profits are 20 million. The company pays corporation tax at 28% on profits. Calculate the earnings per share and the P/E ratio. (4 marks) Shares in issue = 440m/ 2.75 = 160 million Earnings after tax = 20 million x (1 0.28) = 14.4 million Earnings per share = 14.4m/160m = 9 pence P/E ratio = 275 pence/9 pence = 30.6 Page 7 of 24

8 EXAMINER S COMMENT A good number of answers were complete and correct. Some answers did not correctly calculate the number of shares in issue, and some did not use the corporation tax rate to find earnings from pre-tax profits. (j) Explain why companies give share options to directors and senior managers, and how such incentives are affected at times of financial crisis. (4 marks) The agency problem means that the objectives of the directors, who are managing the company on behalf of its owners, the shareholders, may be different from those of the shareholders. One way of achieving goal congruence is to reward executive directors and other senior managers if they achieve objectives that match those of the shareholders. Rewards based on profits or share price performance are designed, in part at least, to do this. Another reason given for rewards of this kind is identical to that given for paying high salaries: to attract able managers. The principles involved in devices such as this, to align the interests of managers and shareholders, apply in both good times and bad. But an additional factor comes into play when share prices are depressed, either as a result of general market sentiment related to the economic situation or because of factors having a more local effect on an individual company. If the share price is well below the exercise price of options, the prospects of executive options proving profitable becomes more remote. There may then be pressure from managers to rebase options, by reducing the exercise price, or by setting up a new option scheme in conjunction with corporate reorganisation that allows managers to claim that there is in fact, and possibly in law, a new company. EXAMINER S COMMENT A large number of answers correctly explained the reasons for giving executive share options. Not all answers noted the effect of lower share prices on the value of options, and still fewer commented on moves to rebase options or change reward mechanisms. Page 8 of 24

9 SECTION B (Answer THREE questions from this section) 2. (a) Explain the advantages of net present value over accounting rate of return as a method of evaluating capital investments. (5 marks) Net present value (NPV) is based on cash flows, whereas, accounting rate of return is calculated using profit and asset figures. Cash flows avoid the scope for variation that exists in the accounting policies used to derive the profit and balance sheet figures used in accounting rate of return. There is also scope for variation in the way that accounting rate of return is calculated, whereas, there is one generally accepted definition of NPV. NPV is calculated by discounting future cash flows using the cost of capital as a discount rate. It, therefore, gives a direct indication of whether an investment gives a surplus or deficit after allowing for the cost of capital. Since it is an absolute measure (in ), it shows by how much shareholders wealth will be changed as a result of an investment. Accounting rate of return needs to be compared with a target rate of return to determine whether a project should be accepted. The target rate of return does not necessarily represent the shareholders cost of capital, so accounting rate of return does not directly indicate whether an investment is in the shareholders interest. When choices have to be made between investments that are alternatives, or where there is a limit on the funds available for investment, the net present value makes it possible to determine the most profitable way to invest funds. Accounting rate of return gives a relative measure as a percentage return on capital. It gives an approximate indication of which projects give a higher return on each pound invested, but does not indicate which investment projects give the largest surplus over the cost of capital, as does net present value. Page 9 of 24

10 (b) Gulf Private Investment Capital Ltd (GPIC) is an investment company based in the Channel Islands and owned by investors in a Gulf state. Its brief is to make the most profitable use of its owners capital. To do this, it manages a diversified portfolio of investments with different levels of risk and return. GPIC is currently considering five possible investment projects. Projects 1, 2, 3 and 4 have been evaluated, and their Net Present Values have been calculated, using GPIC s target return of 13 % per annum for investments of the kind represented here as a discount rate, as follows: Capital Investment NPV US$ million US$ million Investment Investment Investment Investment Projects 1, 2, 3 and 4 all have payback periods of less than three years (GPIC does not accept investment projects in this category unless they pay back in three years or less). Project 5 is still being evaluated. Its cash flows have been projected as follows: US$ million Year 0 (initial investment) (80.000) Year Year Year Year Year REQUIRED (i) Calculate the Net Present Value of Project 5. (4 marks) (ii) Do further calculations to show what investment GPIC should make in Project 5 (GPIC has up to US$200 million available for investment in these projects, which should all be considered to be divisible). (6 marks) Page 10 of 24

11 (i) Project 5 Cash flow $m Present Value of Cash flow $m Cumulative Cash flow $m Year 0 (80.000) (80.000) (80.000) Year (59.608) Year (31.516) Year Year Year NPV (ii) Project 5 payback period = 2 years / years = 2.79 years < 3 years Therefore, Project 5 is acceptable in terms of payback period. Project Initial Investment $m PV of inflows $m = NPV + Initial investment Profitability Index = PV of inflows/ Initial investment Priority The total available funds of 200m are allocated in order of priority: Project Initial Investment m Cumulative Investment m (Fraction 69/80) Page 11 of 24

12 (c) Suggest why it is good practice to review the success of capital investment projects after they have been implemented. (5 marks) There may be inaccuracies in the assumptions and projections used in evaluating an investment. When the investment has been implemented, and there is sufficient operating experience to form a judgment about the success or otherwise of the project and the reasons for it, a review will allow the organisation to check the correctness and accuracy of its assumptions and projections. This may help financial managers to learn to avoid weaknesses in the process, and to do future evaluations better. It may also help to discourage deliberately optimistic assessments of projects that are favoured for reasons other then those that are declared when the project is proposed, since deliberate distortions can be brought to light. Part of good practice in evaluating projects after implementation is to make the cost of doing this commensurate with the benefits derived. To do this, it may be wise to assess a sample of projects, so as to limit costs, with a larger proportion of larger projects subject to post-implementation evaluation and a smaller proportion of small projects. Good practice along the lines outlined above is relevant in an organisation where enquiries into the success or failure of investment projects can be carried out in a constructive atmosphere, where the focus is on learning for the future rather than apportioning blame for shortcomings. EXAMINER S COMMENT This was a very popular question and was well or very well answered by most candidates who attempted it. Part (a) was well answered by most candidates. For part (b), the Net Present Value was correctly calculated by almost all candidates. Most answers also correctly calculated the order of priority based on profitability indices, and the amount to be invested in Project 5. Some answers used the cash flows for Project 5 instead of the capital investments for Projects 1 to 5 to calculate profitability indices. Not all answers checked the payback period of Project 5; some calculated the discounted payback, which led to an incorrect conclusion that the project should not be undertaken. A few answers did not use the fact that the projects are divisible to find the amount to be invested in Project 5. Part (c) was reasonably well answered by most candidates. Page 12 of 24

13 3. (a) Identify the factors that affect the parity of a country s currency. (6 marks) The factors that affect the parity of a country s currency include: (b) Domestic expenditure on imports, which depends in turn on the level of domestic demand and the amount of spare productive capacity. The level of exports. The levels of foreign investment by companies or individuals, influenced by economic conditions, government policies and the availability of resources. The amount of inward investment. The balance of payments (resulting from the factors above). Differences between domestic and foreign interest rates. Differences between domestic and foreign inflation rates. The growth of money supply at home and abroad. Government operations in foreign exchange markets. Other government policies that affect demand and investment, as well as expectations concerning these policies. From time to time, a business-oriented news magazine publishes the results of its hamburger index survey, on which it bases estimates of which countries currencies are over- or under-valued in relation to other currencies. The survey involves finding the price of a hamburger in the local currency, and comparing the prices in different currencies. The hamburger for which prices are found in the countries surveyed is one that is sold by a global fast food company, and the specification is almost identical in all countries. REQUIRED (i) Name the theory of exchange rate parity that underlies the hamburger index and state what the theory says, giving a formula in support of your answer. (4 marks) (ii) The price of a hamburger in the currency of country R is R4.50, while the price of a hamburger in the United States of America is US$2.00. The market exchange rate is R3.20:US$1.00. On the basis of the hamburger index, explain what conclusions you reach about the market exchange rate of R. (3 marks) Page 13 of 24

14 (i) The exercise is based on the theory of the law of one price or purchasing power parity, which says that, in conditions of free trade, an item should cost the same in all countries. So the exchange rate between two currencies should be the ratio of the hamburger prices in the two countries. The model for exchange rates is usually expressed in terms of inflationary expectations, since expected changes in exchange rates should depend on expected changes of the prices of the item or items in the two countries that are being compared. A higher rate of inflation in one country leads to a depreciation of its currency in terms of other. This is expressed by the following formula: S t 1 i = f So 1+ i d Where: S o = The spot (current) rate of the domestic currency against the foreign currency. S t = The spot rate at time t. i f = The expected rate of inflation in the foreign country to time t. i d = The expected domestic rate of inflation to time t. (ii) Purchasing power parity of R against US$ = R4.50:$2.00 = R2.25:$1.00 Market exchange rate = R3.20:$1.00 The purchasing power of currency R is greater than what is indicated by the market exchange rate. Ratio of PPP to market rate = 2.25:3.20 =.703 = So on the basis of purchasing power parity, the R is undervalued in the market against the US$ by 29.7% Page 14 of 24

15 (c) A company based in the United Kingdom is due to make a payment of Euro 80 million to an Italian supplier in six months time. The current spot exchange rate of the Euro against the is , and the six months forward is A six month call option for Euro 10,000 with a strike price of 8010 has a premium of 370. The company currently has a cash surplus, and is receiving interest at the rate of 1.6% per annum on sterling deposits. REQUIRED Calculate the sterling cost in six months time of making the payment of Euro 80 million, and state in each case how the hedge affects the variability of the amount to be paid, if the company uses: (i) A forward contract. (2 marks) (ii) Options. (5 marks) (i) A forward contract Cost Euro 80 million Euro / = million The exchange risk is fully hedged. The amount to be paid is fixed in advance at the amount shown above (but the forward contract does not affect the commercial risk associated with the underlying transaction). (ii) Options Purchase call options for Euro 80 million at an exercise price of 8010/Euro 10,000 with a premium of 370/Euro 10,000 Cost of premium Euro 80 million x 370/Euro 10,000 = million Cost of exercising option Euro 80 million x 8010/Euro 10,000 = million Total cost if option is exercised = million Loss of interest on premium paid now 6 months at 1.6% = million Total cost including loss of interest = million The risk of loss if the Euro strengthens against the is fully hedged. If the company buys options, it eliminates the downside risk, but there is a possibility of a profit if the Euro weakens against the. If at the settlement date the Euro is worth less than 0.801, the company can let the option lapse and buy Euro at a lower rate on the spot market. Page 15 of 24

16 EXAMINER S COMMENT This question was not very popular, and the marks on the whole were not as high as for Question 2. Part (a) was well answered by most candidates. Some answers wasted time by discussing or explaining, when all that was required was identification. For question 3(b), part (i) was reasonably well answered by most candidates (though not all answers mentioned purchasing power parity). Answers to part (ii) were mixed. Most noted that the market exchange rate undervalues currency R, as compared with its purchasing power parity. Most supported this conclusion either by calculating the $ price of a hamburger in country R, or by finding the price in currency R, in country R, if the market exchange rate is in accordance with purchasing power parity. Very few answers used either of these calculations to find the amount by which currency R is undervalued. For part (c), most answers correctly calculated the amount to be paid in 6 months' time with a forward contract. Some did not comment on the effect of the hedge. Most answers also calculated correctly the cost of the option premium and the cost if the option is exercised. Not all answers expressed the cost of the option premium (paid now) as an amount paid in 6 months' time by including the (relatively small) cost of 6 months' interest on the premium - this is the only interest cost needed in a complete answer to question 3(c). 4. (a) Discuss what factors a company should take into account in deciding what level of cash balances to hold. (8 marks) A company needs sufficient cash to pay liabilities as they fall due. These include payments for day-to-day transactions, and for regular and repeated payments such as dividends and interest. Cash also needs to be available for capital investments. The amount needed will depend on the predictability and size of capital investments, which in turn will depend on the nature of the business and the company s plans for growth. Subject to these needs, the level of cash balances should be minimised, since there are costs and risks associated with holding cash and other short term assets (though companies should take into consideration shareholders expectations concerning dividends and other distributions). The cost of cash is the cost of short term capital, which may vary depending on the maturity dates of borrowings, but is related to and contributes to the company s average cost of capital. Page 16 of 24

17 Risks associated with holding cash and short term investments include: Security risk. Risk of bank or borrower default. Inflation risk. Interest rate risk for medium to long term lending. Liquidity risk for non-cash short term investments. Exchange rate risk for foreign currency. A company should aim to achieve a satisfactory balance between the cost of capital, the returns available from short term investments that can be turned easily into cash and the risks of these investments. Suitable investments, apart from bank current account balances and currency, could include: bank time deposits, commercial paper and company promissory notes, treasury bills and short dated government stocks. The availability and suitability of such investments will influence how much of a company s short term funds are held in cash. Companies that are willing to back their judgment about foreign exchange rate changes may hold cash for speculative purposes. (Other valid comments could have been made on, for example, factors affecting the level of cash in relation to the other components of working capital.) (b) Identify and comment on the effectiveness of possible sources of information for assessing the creditworthiness of a company. (6 marks) Options include: Ratings from credit agencies, which are generally reliable but for which there is a charge. Sales force reports and other reports from trade contacts, which may be anecdotal, but may be up-to-date and take account of unpublished information. Analysis of financial statements, which by their nature are not up-to-date, though a lender who is entitled to have access to management accounts can get more upto-date information. Press comment, which may be topical but may not be comprehensive. Trade associations, which can provide information that has a bearing on a company s reputation, but may not be up-to-date. Bankers references, though bankers may only be willing to provide these if authorised by the potential debtor. Page 17 of 24

18 (c) Suppliers references, which may be informative but may not give a balanced view if they are provided by a supplier named by the potential debtor, who may have ensured that some suppliers are paid promptly for this purpose. The economic order quantity model for the calculation of order sizes depends on assumptions about the cost of placing and receiving an order and the cost of holding stock. State what these assumptions are, and comment on how realistic they are. (6 marks) The assumption about the cost of holding stock is that this is proportional to the number of units of stock held. Some costs are more or less proportional to the number of units, for example, the cost of capital invested in stock, and the cost of insurance if the insurance premium reflects the value of stock. However, insurance premiums may adjust only slowly to changes in stock values, and may include fixed administration costs. Some other costs, such as space-related costs, heating and security, may be partly fixed, so they do not increase in proportion to the number of units in stock. Costs of deterioration, wastage, pilferage and handling tend to increase with the volume, units or value of stock held, but the relationship may not be proportional. When stocks become very large, costs such as handling or damage to stock may increase disproportionately. The assumption about placing and receiving orders is that the cost of an order is fixed irrespective of the size of the order. The time taken to place an order or to record the order in the accounting system may vary little if at all if the order size is increased. But if handling or checking is involved, the cost of receiving an order and putting it into the stores or moving the goods directly onto the factory floor may vary with volume. EXAMINER S COMMENT This question was popular. The completeness of answers varied, and answers to parts (a) and (b) were generally more complete than answers to part (c). Most answers to part (a) were reasonably good. Credit was given to answers that put more emphasis on cash in the context of working capital management than in the answer above. Most answers to part (b) gave fairly complete lists of sources, though not all went beyond identification and provided comments on effectiveness. Most answers to part (c) made some comments on the assumptions and their validity, and earned some marks. Few identified the assumptions that are crucial to the model: that the cost of placing and receiving an order is constant, whatever the size of the order, and that the cost of holding stock is directly proportional to the level of stock. Consequently, few answers earned very high marks. Page 18 of 24

19 5. (a) A company has 160 million ordinary shares in issue. The ordinary share price is 68 pence. This year s earnings are 27.0 million. The company s dividend cover is 2.5 times. The dividend per share three years ago was 3.8 pence. Calculate this year s dividend per share and the cost of ordinary share capital using the dividend growth model. (4 marks) EPS = 27m/160m = pence Dividend = pence/2.5 = 6.75 pence Dividend growth rate: (1 + g) 3 = 6.75/3.8 = (1 + g) = = g = = % = do (1 + g)/p + g k e = (6.75 x )/ =.331 = 33.1% (b) The same company has preference share capital (in 5% preference shares of 50 pence each) with a nominal value of 40 million. The market price of the preference shares is 27.5 pence. Calculate the cost of preference capital. (2 marks) Preference dividend = 5% of 50 pence = 2.5 pence k p = 2.5/27.5 =.091 = 9.1% Page 19 of 24

20 (c) The company has just issued 60 million nominal of 8% loan stock with a market price of 99 per 100 nominal. The stock will be redeemed at par 6 years from now. Interest is paid annually, and the next interest payment is due one year from now. REQUIRED By discounting the cash flows related to 100 nominal of loan stock, and equating the present values of these cash flows to the issue price, calculate the cost of loan capital up to the redemption date as an annual percentage figure. (10 marks) Cash flows and present values for 100 nominal of 8% loan stock Year Capital Interest Present value factor (8%) Present value (8%) Present value factor (9%) Present value (9%) Proceeds of issue Interest 1 (8.00) (7.408) (7.336) Interest 2 (8.00) (6.856) (6.736) Interest 3 (8.00) (6.352) (6.176) Interest 4 (8.00) (5.880) (5.664) Interest 5 (8.00) (5.448) (5.200) Capital 6 (100.0) (8.00) (68.04) (64.368) redemption and interest NPV (0.984) NPVlow rate IRR = low rate + (high rate - low rate) (NPVlow rate - NPVhigh rate) = 8% + (9% 8%) ( ) = 8.2% Page 20 of 24

21 (d) Using market values, calculate the company s weighted average cost of capital. (4 marks) Capital and WACC Market Value Proportion Cost % Proportion x Cost Equity 160m x 68 pence 108.8m 57.2% 33.1% 18.93% Preference shares ( 40m/ 0.50) x 27.5 pence 22.0m 11.6% 9.1% 1.06% Debt 99% of 60m 59.4m 31.2% 8.2% 2.56% Total 190.2m 100.0% WACC= 22.55% =22.6% to 1 d.p EXAMINER S COMMENT This question was the least popular, and few answers were completely correct. For part (a), few answers reached the correct answer. Common mistakes were using the earnings per share instead of the dividend in the dividend growth model, using the wrong number of years to find the dividend growth rate, and inserting figures incorrectly in the dividend growth model formula. Part (b) was correctly calculated in most answers, though a fair number of calculations used 5 pence, instead of 5% of 50 pence, as the dividend. For part (c), a fair number of answers gave correct DCF calculations. Some answers used the nominal value of 100 instead of the market value of 99 as the initial cash flow, or used figures based on the total 60 million nominal of stock in part but not all of the calculation. Answers that were based throughout on 60 million nominal of stock were accepted. Errors in parts (a), (b) and (c) meant that many calculations in part (d) were incomplete. Calculations in part (d) based on incomplete answers to earlier parts of the question earned some marks. Page 21 of 24

22 6. (a) `A is a rapidly growing software company. It was started three years ago using capital provided by the founder s family. It now needs further long term capital to fund its continuing growth. The chairman does not wish to raise equity in the market because he is aware of the scale of fees charged by the professional advisers and others involved in equity issues, and is considering raising a long term loan from the company s bankers. REQUIRED Identify the advisors and other participants who would be responsible for the fees that the chairman does not wish to pay. Explain why it might be advisable, despite his reservations, for the chairman to consider an equity issue. (10 marks) Advisors and other participants in equity issues include the following: Investment banks or other lead advisors. Stockbrokers. Underwriters. Bankers. Merchant banks. Legal advisers. Accountants. Corporate communications advisors. Financial advertising agencies. Security printers. Regulatory authorities (UKLA). An equity issue is likely to be a suitable way of raising capital for this company. It appears that family sources are not now adequate, so external sources of capital are needed. The essential choice is between equity and borrowing. Borrowing could be in the form of debt, including bank loans, or an overdraft. Overdrafts are in principle short term capital, though many companies rely on them to provide long term capital. However, banks may require security for short term lending (or in the absence of security may charge interest at rates that reflects the level of risk of the company and its business). The business risk of the company may be high, since it is operating in a rapidly changing environment where there is likely to be uncertainty about the size and nature of the market and of competitors, and where there may be technical risks in the development of new products. The company will be investing heavily in intangible assets, and may have few marketable assets to offer as security. The company may not be generating profits, and if it is growing rapidly and investing in innovation, it may not have surplus cash. It is likely to be poorly placed to service debt capital, and the risk related to the repayment of debt may be high. Debt capital is, therefore, unlikely to be suitable. Page 22 of 24

23 Given the likely unattractiveness of debt, equity is probably to be preferred. Equity investors attitudes to risk vary. Not all are keen on taking high risks in the hope or expectation of large returns at some future date, but some are. As a relatively new (and perhaps still small) company, with little in the way of track record, the company may not be well placed to get a quotation on the Main Market. But it is likely to be a very good candidate for a quotation on the Alternative Investment Market (AIM), where investors who are not risk averse are interested in investing in companies like this one. Some of the regulatory requirements for an AIM listing are less demanding than for the main market, so that some of the costs that the chairman wishes to avoid will be slightly lower. But the costs will still not be negligible, and may still represent a significant proportion of the capital raised by a fairly small equity issue. The company may have little choice but to opt for an AIM or other alternative market quotation. If the ordinary shares issued by the company are quoted, advantages include a higher public profile for the company, increased prestige, a greater ability to attract able managers (partly because quoted shares can be used for option schemes) and greater ability to raise further capital in future, both equity and debt. (b) Discuss how far the published annual report and accounts of a United Kingdom-based public limited company show what the company s financial management policies are, what decisions it has taken in furtherance of these policies, and what it is in a position to do in relation to the three main areas of corporate financial management. (10 marks) Readers of published annual reports and accounts who need information about a company s corporate financial management are interested in the company s sources of capital, its investment decisions and the results of these investments and its dividend policies. The balance sheet shows the makeup of the company s capital structure, and itemises ordinary share capital, preference share capital, reserves (in categories which indicate whether the reserves are distributable or not) and borrowing, classified by maturity date. It also shows current financial liabilities. The income statement shows the cost of capital in the form of dividends paid and proposed and interest payable on different categories of debt. The picture of the capital structure and cost of capital is not complete, since financial statements show book values but do not show market values of shares or loan stocks, and the cost of equity in particular depends on expectations concerning growth in earnings and dividends. Something about future prospects may be inferred from the past history of dividend payments, which is available from past financial statements. Information on capital investments from the financial statements is not very detailed. Broad general classifications of non-current assets, including land and buildings, showing freehold and leasehold assets, plant and equipment, computers and vehicles should be provided. Amounts of new investment in and disposals of non-current assets are also shown, and the cash flow statement shows investment and disposals. There is no separate information on the cash flows or profits attributable to specific investments, except where businesses are acquired or sold. Page 23 of 24

24 The past history of dividend payments, which may be related to past earnings, may give some indications of dividend policies as well as some basis for predicting the future trend of dividends. Some of the information mentioned above, for example details of interest payments, can be found in the notes that form part of the financial statements. Some further detail may be added to this picture of corporate financial management by qualitative statements that do not form part of the financial statements but appear in the annual report and accounts. The directors report has to comment on the business and its prospects, as well as stating what dividend is proposed. Other items, such as chairman s or chief executive s statement or review, which are not required by law but frequently found in the annual report and accounts, may add detail to this picture of corporate financial policies. They may, for example, state what the company s dividend policy and objectives are, possibly quoting quantitative growth targets. EXAMINER S COMMENT This question was popular but few answers earned very high marks. Most answers to part (a) gave a reasonably full list of advisors and participants. Many wasted time in commenting on what the advisors and participants do, when the question only asked for identification. On the whole, adequate or good reasons were given for issuing equity. Most answers provided justifications for equity that apply in principle to all companies, and some went further to explain why ordinary shares would be appropriate for this company in particular. Part (b) was generally less well answered than part (a). Most answers earned marks for identifying the three main areas of corporate financial management. Many went on to explain what corporate financial management involves under these headings, but said less about what information is given in the annual report and accounts (though some said what they ought to give). Very few answers discussed how far the information in the annual report and accounts provides what the question specifies. It is possible that answers to this part were less complete than they might have been because candidates did not make sure that they answered the question as set, or perhaps did not have at their fingertips what they might expect to find in the annual report and accounts. The scenarios included here are entirely fictional. Any resemblance of the information in the scenarios to real persons or organisations, actual or perceived, is purely coincidental. Page 24 of 24