ESSAY Questions 1. Share buybacks are sometimes motivated by the desire to increase earnings per share. Baery Ltd recorded an operating profit of $2.7 million in the last financial year. It has 3 million shares on issue and the market price of the shares is $6 each. Baery announces that it will repurchase 10% of each shareholder’s shares at $6 per share. a) Calculate Baery’s price-earnings ratio before the buyback b) An observer comments as follows: ‘Baery’s buyback should boost its earnings per share from 90 cents to 95 cents, so with the price-earnings ratio remaining the same, the share price should increase’. i. If the observer’s argument is correct, what will Baery’s share price be after the buyback? ii. Critically evaluate the observer’s argument. (chapter 11) 2. LGC Ltd converting preference shares have a face value of $20 and are due to convert to ordinary shares on 31 July 2019. Each converting preference share will convert to a number of ordinary shares that is determined by dividing $20 by: i) An amount equal to the price of LGC ordinary shares on the 31 July 2019, less 5 per cent; or ii) $20, whichever yields the greater number of ordinary shares How many ordinary shares will be received by the holder of one converting preference share if the price of an LGC ordinary share is: i) $7.50 ii) $10 iii) $15 iv) $20 v) $25? (chpt 10) 3. The chief executive of Caster Ltd, a young company that has just been set up, says: ‘we decided to borrow most of the funds needed to establish our operations because high leverage would signal to the markets that we were confident and fully committed to making this business succeed.’ Evaluate this strategy, assuming that Caster produces: a) Security software systems b) Shampoos and conditioners (chapter 13) 4. Pirexes Ltd has a fixed-rate term loan of $3 million at an interest rate of 8.50% per annum. The company has earnings before interest and tax (EBIT) of $1.8 million per annum. A covenant in the loan agreement specifies that EBIT must be at least 3.5 times greater than the total interest paid on the company’s debt. The directors of Pirexes are planning to raise additional debt by borrowing at a variable rate, initially 7.0% per annum. What is the maximum amount that Pirexes can borrow on these terms? (chpt 10) 5. Use the following information to calculate the cost of capital for Lexco Ltd, assuming that investors can remove all systematic risk by diversification. i) The systematic risk of Lexco Ltd’s equity is 0.6 ii) The risk-free interest rate is 8% per annum iii) The expected rate of return on the market portfolio (including the franking premium) is 13% per annum iv) The various sources of funds used by Lexco Ltd and their respective market values are as follows: Source of funds Market value ($m) Debt (face value $100) 1 Equity 3 v) The interest rate on the debt is 10% paid annually. The debt, which is due to mature in 8 years’ time, has a current market price of $120 vi) The statutory company income tax rate is 30 cents in the dollar vii) The proportion of the tax collected from the company that is claimed by shareholders is 0.60 Under what assumptions is the cost of capital you have calculated for Lexco Ltd in the above appropriate for a proposed project? (chpt 14) 6. Ztak Pty Ltd is a well-established company whose directors have decided to convert to public company status, make a public share issue and list on the stock exchange. The company needs to raise $8,920,000 to expand its operations. Its prospectus forecasts a dividend of 25 cents per share in its first year as a public company and dividends are expected to grow at 5% per annum indefinitely. Shareholders require a return of 15% per annum and the cost of listing amounts to 11% of the gross proceeds from the issue. How many shares must Ztak issue? (chapt 9) 7. The ABC Company has a history of rapid growth, with a rate of return on assets of about 20% per annum. For the past 5 years its dividend-payout ratio has been approximately 60%. A high payout has been justified on the grounds that the company is operated in the shareholders’ interests and dividends paid by the company have a beneficial effect on the company’s share price. What factors would you take into consideration when deciding on the appropriate dividend policy for the company? Is the current dividend policy justified? (chpt 11) 8. Kerry Ltd has commenced operations with the following capital structure: Kerry Ltd: statement of financial position as at date of incorporation ($) Assets Sundry assets 2,000,000 Liabilities and shareholders’ funds Debentures, 8% (10 years) 600,000 Preference shares, 9% 400,000 Ordinary shares, issued and paid-up, 500,000 at $2 1,000,000 2,000,000 The company’s prospectus contains estimates that it will earn $200,000 in the first year and pay dividends of 15 cents per share. Brokers anticipate that dividends will grow at 6% per annum. The shares are currently selling at $3. The statutory company income tax rate is 30 cents in the dollar and the proportion of the tax collected from the company that is claimed by shareholders is 0.60. Calculate the cost of capital for Kerry Ltd. (chapter 14)