Question 1A few years ago, Innovy Pty Ltd commenced business in the renewal energyindustry. The company is unlevered. Currently, the company possesses very...

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Question 1






































A few years ago, Innovy Pty Ltd commenced business in the renewal energy


industry. The company is unlevered. Currently, the company possesses very few


capital


assets.


By


the


nature


of


its


business,


the


company


has


been


investing,


and


will


continue


to


so,


in


research


and development projects


every


year.









Hence, the company is operating at a loss. It is only expected to turn profitable in


four years. After that, profits are expected to increase at a rate of 30 percent for a


period of six years. Thereafter, growth will moderate at 4 percent per annum into


the foreseeable


future.


The


directors are


optimistic


about


the


forecasts.












Required:











a.








Advise


the


directors of


Innovy


Pty


Ltd


the capital


structure


policy


the


company


should


adopt


for


the


next


four,


ten


and


fifteen


years.


Your


answer


must


apply


and


explain


the


relevant


capital structure


theories.





















Word


count


limit


:


250


words.


To


provide


the


word


count


at


the


beginning


of


your


answer.







(15


marks)


















b.








Explain


clearly


Modigliani


and


Miller’s


Proposition


I


in


a


perfect


world.


What


adjustments


must


be


made


to


this


proposition


if


corporate


taxes


and


bankruptcy risk exist? Your answer must include the explanation of the


appropriate cost curves and


value


graphs.





















Word


count


limit :


300


words.


To


provide


the


word


count


at


the


beginning


of


your


answer







(25


marks)


















c.








According


to


Graham


(2011),


the


two


most


popular


debt


policy









factors


listed


were


financial


flexibility


and


credit


rating.


Critically


discuss


this


finding.









(10


marks)
































































Question 2






































Delcron








plc








issued








debentures








two


years


ago.


Currently,


the


debentures


are


valued


at £2.5 million with a yield of 6 percent per annum. Its shares are listed on the


London


Stock


Exchange


with


a


market


capitalization


of


£6


million.


Analysts


estimate the


equity


beta


to


be


at


2.17. The tax


rate


is


25 percent.









The firm plans to invest in either project P or Q, which will not change the risk


profile


of


the


firm.


The


two


projects’


cashflows are


estimated


as


follows:






































































































Project











Today











Year


1












Year


2












Year


3












Year


4












P














Outflow








£200,000











Inflow








£10,000











Inflow








£40,000











Inflow








£140,000











Inflow








£70,000











Q














Outflow








£150,000











Inflow








£70,000











Inflow








£60,000











Inflow








£100,000











Inflow








£80,000





























The


FTSE


350


Index


is


expected


to


earn


a


return


of


15


percent


per


annum.


The


UK


T-bill rate is at


5


percent


per annum.












Required





:

















(a)








Calculate the cost of equity and the after-tax weighted average cost of


capital


of Delcron plc. (10


marks)









(b)








Which


project


should


Delcron


plc


accept


using


the


net


present


value


rule?









(12 marks)








(c)








Assume that Delcron plc has yet to issue the debentures, with the same


equity beta as above. Which project should be accepted using the net


present


value rule? (12


marks)









(d)








Assume that the general inflation rate has risen by 30 percentage points.


Discuss the impact on the cost of equity, the after-tax weighted average


cost


of


capital


and


on


project


selection.


No


calculations


are


required


here.









(16 marks)







































Question 3






































In the year 2015, weaker demand from a slower-growing Chinese economy was





putting








the








global








freight








industry





through


rough


water.


Apart


from


China,


the


freight


market is also plagued by a chronic overcapacity of ships ordered during the


heydays


of


the industry.


















Assume today is January 2015. Mega Machines plc manufactures winches on


freight vessels. Currently it has credit sales at £456,000 and the average debtor


collection period is 47 days. It is considering the introduction of a new policy on


debtor management to shorten the collection period to 30 days. Customers are


expected


to


react


adversely,


resulting


in


a


reduction


in


sales


by


£20,000.





Incremental








enforcement








cost








of








the








new





policy


are


expected


to


be


£1,000.


Mega’s


bank


charges


an


overdraft


rate


of


15


percent.


Mega’s


sales


contribution


to


profit


is


10 percent.


















You are the finance manager of Mega. The Board of Directors has tasked you to


appraise


the above


proposal.





















Required:









































a.








Calculate


the


net


benefit


for


the


company


if


it


introduces


the


new


policy.


Provide


your


recommendation.


What


would


be


the


necessary


cautions?









(30


marks)









b.








Conduct


sensitivity


analysis


on


sales


and


comment


on


the


result.


How


should


the


company safeguard its


position


on sales?









(20


marks)

















































































































































































Question


4






























The Great Flying Pterosaur Company (GFP) currently produces drones for


commercial use. This product is expected to be in use for the foreseeable


future, GFP's annual net profit after tax are expected to be $400,000 per


annum. Capital allowances (straight-line) are $20,000 per annum for the


company's


existing


non-current


assets.





















GFP issued preference shares (perpetual) with face value $1 million and a


dividend rate is 5 percent. GFP is expected to pay its investors. There are


2,000,000


ordinary


shares


outstanding.


GFP's


cost


of


capital


is


10


percent.





















GFP is considering to put aside $270,000 to purchase a machine to produce


an additional line of drones. This machine will operate for three years. At the








end of its useful life, it be disposed for zero value. The risk level of the company


will remain unchanged.


The expected demand is 10,000 new drones per year.


Each new drone will be priced at $40 and thereafter rise at 8 percent per year.


Total variable costs are expected to be $20 per drone in the first year and


thereafter


rise


at


5


percent


per


year.


The


corporate


tax


is


at


33


percent.


















Required:











1.








Compute


the


value


of


the


firm


before


taking


on


the


investment


opportunity.












(10


marks)












2.








Compute


the


value


added


to


the


firm


if


the


investment


opportunity


is


undertaken.












(35


marks)












3.








What


is


the


price


per


share


of


GFP


if


the


investment


opportunity


is


undertaken?












(5


marks)
































































Question


5






















































The


following


information


applies


to


ATO


Inc.:






























Number


of


ordinary


shares : 30 million





Irredeemable








debentures





at


12%


(book


value)


:


£58


million


Bank


loan


at


8% :


£7


million





















Market


price


of


ordinary


shares :


£6


per


share












Market


value


of


debentures :


£120


per


£100


debenture






























Dividends








(recently


paid) :


15p


per


share












Dividend


growth


rate :


4%


in


the


foreseeable


future












Tax


rate :


30%





















Required:











a.








Compute


the


company's


cost


of


equity.












(5


marks)












b.








Compute


the


company's


after-tax


cost


of


the


two


debt


components.












(10


marks)












c.








Compute


the


company's


weighted


average


cost


of


capital


(WACC).












(15


marks)












d.








Discuss


three


situations


when


the


WACC


may


be


used


to


assess


the












company's


project.












(10


marks)












e.








The


company


used


the


WACC


to


appraise


a


project


when


the


required


return


is


higher.


Discuss


the


impact


of


this


on


shareholder


value.












(10


marks)














































Question


6







































BF109








Ltd








and








ME262








Ltd








operate








in








the








same








industry.








BF109








is








contemplating








to











launch








a








takeover








of








ME262.








BF109's








earnings








multiple








is








15








times.





























ME262








Ltd








is








expected








to








pay








its








annual








dividend








soon,








based








on








the








proposed








retention ratio of 27 percent. Recently, the announced earnings were $0.50 per


share.


ME262's


management


maintains


a


policy


of


steadily


increasing


dividends


where


dividend


per


share


were


$0.30,


$0.32,


$0.34,


$0.35


and









$0.365


for


the


last


five


years.






























ME262


Ltd


has


8


million


shares


outstanding


where


each


share


is


priced


at












$4.00 on an ex-dividend basis. The beta of ME262's stock is 1.8. The market








risk








premium








on








the








country's








stock








index








was








7








percent








the








last








10








years.








The








T-bill








rate


is


2


percent.





















Required:









































a)








Compute the total share value of ME262 as a takeover target using the


Price/earnings


ratio


method.


Discuss


the


significance


of


the


difference


between


the


PERs


of


the


two


companies. (20


marks)


















b)








Compute the value of ME262's shares using the Dividend Discount


Model.




(20


marks)


















c)








For


the


takeover,


what


would


be


the


range


of


share


values


for


negotiation?




(10


marks)





































































Question 7A



































A company intends to upgrade its machine for a 10-year project, which just passed its sixth year. The new machine is of higher precision which is estimated to reduce defect costs of $80,000 per year and warranty claims by customers by $100,000 per year for the remaining life of the project. The applicable corporate tax rate is 17% and the cost of capital for similar risk projects is 15 percent. More details on the existing and new machines are available:



































































































































Existing Machine











New Machine











Depreciable sum











$1,000,000











$700,000











Depreciation method











Straight line











Straight line











Current salvage value











$500,000














--












Salvage value in 4 years’ time











$ 0











$ 100,000











Maintenance fee











$ 0











Year 2: $40,000























Required:











i.








Compute the incremental net present value of for the new machine.











(25 marks)


















ii.








Should the new machine be purchased? (5 marks)












































Question 7B



































Swords Enterprise dividend has been growing at a rate of 25% and it is expected to grow at the same rate for the next two years. After that, Swords Enterprise dividend growth is expected to stay at the rate of 3% perpetually. The company beta is 1.6, the market risk premium is 5%, and the risk-free rate is 3%. It just paid a dividend of $2.00 per share recently.




















Required:


























i.








What is the intrinsic value of Swords Enterprise’s stock based on the dividend discount model?








(15 marks)

















ii.








If the required rate of return on the market portfolio is increased by 2%, what is the required rate of return on Swords Enterprise’s stock?








(5 marks)








































































































































































































































































































































































































































































































Question 8A



































Discuss three factors, according to Miller & Modigliani (1961) theorem, that impact on firm value arising from the level of dividends that may be paid by a company.








(25 marks)























Question 8B



































Samantha currently owns a diversified portfolio worth $800,000. She intends to increase her investment by $200,000 and is considering Hill Corporation’s stock. Her financial advisor provided her with some financial information given below. Assume risk free rate of 2% and market risk premium of 5%.






















































































Expected Return











Beta











Original Portfolio











9.0%











1.40











Hill Corporation











11.2%











1.80























Required:


























i.








According to Capital Asset Pricing Model (CAPM), what is the required return on the Hill Corporation’s stock? Would you recommend Samantha to invest in the stock of Hill Corporation?








(10 marks)

















ii.








Calculate the expected return and beta of the new portfolio if Samantha invests in Hill’s stock. Evaluate the risk-return performance of the new portfolio.








(15 marks)



















































































































































































Question 9A



































‘A hedger is involved in two markets: the cash/underlying asset market and the derivatives market’.











Required:











Explain this statement in terms of how a hedge is achieved with a put option contract for a payer of foreign currency sometime in the future.




(25 marks)




































































Question 9B



































Critically evaluate the major sources of long-term finance.














(25 marks)


















































































































































Answered 2 days AfterNov 30, 2022

Answer To: Question 1A few years ago, Innovy Pty Ltd commenced business...

Sandeep answered on Dec 02 2022
40 Votes
Ans 1 a
Capital Structure policy is the mix of the debt and Equity invested by the firm in order to fund its operations and finance its purchase of assets. It’s also known as the Debt-Equity ratio. There are basically the following ways of raising the finance:
Issue Debt and Repurchase the Equity – Increase the Debt base and reduce the Equity base.
Issue debt and Pay huge Dividends to Equity Investors – Raise funds to pay a One-Time special dividend.
Issue Equity and Redeem Debt – Fresh Equity to raise funds to Redeem Debt and reduce outside liability.
These are used to fund Business operations, Capex expansion, Acquisitions and other long-term Investments and come with a Trade-off for Optimal Capital structure.
1-4 Years – The firm can afford to go with raising funds by Issuing fresh Equity Capital and retain ownership/stake in the management and decisi
on-making of the firm. Although equity is more expensive than debt more so when the Interest rate is low. But Equity does not need to be redeemed or returned after a fixed period of time with regular servicing. The company is heavily capital-intensive being in the vertical of renewal energy and initially require huge machinery, cutting edge Knowledge transfers, know-how and Environment-friendly ideas to grow. Directors of Innovy Pty Ltd are advised to go for the Equity capital to fund operations as risk is high and Equity investor like taking that risk. The company is heavily investing in R&D every year and currently operating at loss.
5-15 Years Scenario – The Company’s profit is expected to increase at a rate of 30 percent for 6years and thereafter moderate to 4%. Director can adopt a mix of Debt and Equity capital structure to reap benefits of “Trading on equity/Leverage “which comes within the form of Tax benefits and Interest tax deductibility. A firm targeting high growth ration chooses an aggressive Capital portfolio. An optimal Capital structure is only a Mirage which every firm chases and few can realize on a Sustainable basis. Renewal energy firm the world over employs more debt and less capital. Choice of Optimal capital has direct bearing on WACC.
Ans 1 b)
Modigliani and Miller’s Proposition I in a perfect world means that:
· There are no Taxes
· No Transaction cost
· Both Individuals and corporate can borrow at the same rate
· No Inequalities exist due to the same level of knowledge in society.
Hence V(L) = V (U).
In the perfect capital market, Firms value is independent of the capital structure.
M&M I (No Taxes): Individuals and Corporate borrow at the same rate implying that:
Leveraged firms are priced > Unleveraged firms, Investor can invest in UL firms on margin and Arbitrage.
Investors promote and artificially cause spikes in the value of Leveraged firms and thus maximizing shareholder’s earnings.
MM II (No Taxes):
· The Cost of debt is usually lower than the cost of Equity for the obvious reason that Equity investors bear the maximum burden of risk with no return promised nor the return of investment guaranteed.
· Hence if the firm is returning a 5% yield on returns on debt, then it will have to earn 9% on Equity and this leads to investors to utilize the opportunity to borrow debt to take advantage of a cheaper rate.
· MM II implies that by increasing borrowing at debt at a cheaper rate, increases the amount you will have to pay on your equity and effectively both will have the effect of offsetting/neutralizing each other. Thus, overall WACC will remain same and a zero-sum game.
· Thus, WACC cannot be lowered by trading debt for equity.
MM I (With Taxes):
· If the taxes are introduced, the firm can increase value by financing its operations through debt since it allows the firm to reduce its tax liability in form of Interest payment and tax shield. The firm cannot benefit from financing through debt in long term without the aid of tax benefits afforded by the law.
· In the case of Perpetual debt, the value of the levered firm is:
· Therefore, in the absence of taxes the firm’s capital structure is irrelevant, and with taxes introduced firms’ the Cost of capital WACC can only be lowered through the issue of debt.
· Debt offers tax shield benefits.
Ans 1 c
Graham’s debt policy states the 2 most important fact as financial flexibility and credit rating since only the entities which have the financial muscle and Balance sheet strength think of raising the funds from 3rd parties or creditors. The fund’s raising exercise is subject to completing certain compliance processes of credit rating approval from professional agencies who do a thorough due diligence of these firms and submit a report to the lending institution on whether:
· The company will not default on their debt
· Their funds and returns are secure with the borrowing firms.
· Endorsement of the project’s viability that it will succeed and not run into losses.
· Small firms who cannot approach these credit rating agencies because of exorbitant cost associated benefit from this exercise as such companies with good fundamentals are always on target of overseas investors.
Therefore, the financial flexibility and credit rating can also go against the firm’s ability to raise debt funds which are preferred for long-term and capital-intensive projects. These 2 factors may act as a barrier to achieving the long-term growth prospects of its firm. Since a lot of debt lending institutions strictly insist on the credit rating of the firm meeting certain criteria and if it does not fund are not released which adversely affects their expansion and growth plans. While no doubt these are important but should act as a deterrent to the growth of the organization.
A good debt policy is desirable, but it should not become a tool to blackmail or hold entities hostage to unreasonable demands of the lenders.
Ans 2 (a)
Cost of Equity (Ke) = Rf + β(E(Rm) – Rf)
Where Ke =??
Rf (Risk Free Rate) = 5%
Rm (Risk premium rate) = 15%
Β (Beta risk) = 2.17
Tax Rate = 25%
Ke = 5% + 2.17(15% - 5%)
Ke = 26.70%
Delcron plc Cost of Equity (Ke) = 26.70%
After Tax WACC of Delcron plc:
WACC = (E/V x Re) + (D/V x Rd x (1-Tc))
where     E = Market value of firm’s Equity
    D = Market value of firm’s Debt
    Tc = Corporate Tax rate
    Re = Cost of Equity
    Rd = Cost of Debt
    V = E +D
E = £ 6 Mn
D = £ 2.5 Mn
Tc = 25%
Re = 26.70%
Rd = 6%
V = £ 6 Mn + £ 2.5 Mn = £ 8.5 Mn
WACC = (6 /8.5 x 26.70%) + (2.5/8.5 x 6% x (1-25%))
WACC    = 20.17%
Ans 2 b)
Net Present Value (P) = -Co + CF1/ (1+r) + CF2/(1+r) ² + CF3 /(1+r) ³ + CF3 /(1+r) ⁴
Where Co = Initial Investment
CF 1 = Incremental Cash Inflows in each year
r = Risk-adjusted discount rate / WACC
t = Time (years)
Co (P project) = (£ 2,00,000))
CF 1 = £ 10000
CF 2 = £40,000
CF 3 = £140,000
CF 4 = £70,000
r =20.17%
NPV (P) = (200000) + 10000/ (1 + 20.17%) + 40000 / (1 + 20.17%) ^ 2 + 140000 / (1 + 20.17%) ^ 3 +70000 / (1 + 20.17%) ^ 4
NPV (P) = (£49737)
NPV (Q) = -Co + CF1/ (1+r) + CF2/(1+r) ² + CF3 /(1+r) ³ + CF3 /(1+r) ⁴
Where Co = Initial Investment
CF 1 = Incremental Cash Inflows in each year
r = Risk-adjusted discount rate / WACC
t = Time (years)
Co (P project) = (£ 1,50,000))
CF 1 = £ 70000
CF 2 = £60,000
CF 3 = £100,000
CF 4 = £80,000
r =20.17%
NPV (Q) = (150000) + 70000/ (1 + 20.17%) + 60000 / (1 + 20.17%) ^ 2 + 100000 / (1 + 20.17%) ^ 3 +80000 / (1 + 20.17%) ^ 4
NPV (Q) = £45787
Therefore, Delcron pl should accept Project Q as its Net present value is positive and returns will add value to the overall growth of the company.
While Project P should be rejected for negative returns / NPV.
Ans 2 c
In the absence of the debt being raised to finance the Investment, the Company’s over cost of capital will be Equity funded, and hence Cost of funds will all be Equity only. Since Delcron plc has yet to issue the Debenture, hence there will be no Cost of debt incurred.
Discount Rate = Cost of Equity
Net Present Value (P) = -Co + CF1/ (1+r) + CF2/(1+r) ² + CF3 /(1+r) ³ + CF3 /(1+r) ⁴
Where Co = Initial Investment
CF 1 = Incremental Cash Inflows in each year
r = Risk-adjusted discount rate / WACC
t = Time (years)
Co (P project) = (£ 2,00,000))
CF 1 = £ 10000
CF 2 = £40,000
CF 3 = £140,000
CF 4 = £70,000
r =20.17%
NPV (P) = (200000) + 10000/ (1 + 26.70%) + 40000 / (1 + 26.7%) ^ 2 + 140000 / (1 + 26.70%) ^ 3 +70000 / (1 + 26.70%) ^ 4
NPV (P) = (£71193)
NPV (Q) = -Co + CF1/ (1+r) + CF2/(1+r) ² + CF3 /(1+r) ³ + CF3 /(1+r) ⁴
Where Co = Initial Investment
CF 1 = Incremental Cash Inflows in each year
r = Risk-adjusted discount rate / WACC
t = Time (years)
Co (P project) = (£ 1,50,000))
CF 1 = £ 70000
CF 2 = £60,000
CF 3 =...
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