Beruflich Dokumente
Kultur Dokumente
PROBLEM 1 & 2:
1. There is a potential conflict of interest between shareholders and managers which give
rise to what are known as 'agency problems'
(a) Give examples of some of the 'agency problems' that can arise as a result of this
potential conflict of interest.
(b) In theory, shareholders are expected to exercise control over managers through the
annual meeting or the board of directors.
What other mechanisms are used in order to reduce potential agency problems?
2. There are some corporate strategists who have suggested that firms focus on
maximizing market share rather than market value. What is your view of such a
suggestion?
SOLUTION 1 & 2:
See textbook.
PROBLEM 3:
(a) What is the present value of 10,000 arising in 1 year's time, assuming a
discount rate of 12%?
(b) What is the present value of an annuity of a stream of 10 annual cash flows of
10,000 each, assuming a discount rate of 12%, with the first cash flow
arising in 1 year's time?
(c) What is the present value of an annuity of a stream of 10 annual cash flows of
10,000 each, assuming a discount rate of 12%, with the first cash flow
arising in 2 years' time?
(d) What is the present value of an annuity of a stream of 10 annual cash flows of
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10,000 each, assuming a discount rate of 12%, with the first cash flow
arising today?
(e) What is the present value of perpetuity of 10.000 per annum, assuming a
discount rate of 12%, with the first cash flow arising in 1 year's time?
(f) What is the present value of perpetuity of 10,000 per annum, assuming a
discount rate of 12%, with the first cash flow arising in 2 year's time?
(g) What is the present value of perpetuity of 10.000 per annum, assuming a
discount rate of 12%, with the first cash flow arising today?
SOLUTION 3:
This is a 10-year annuity but starting 1 year late. Therefore, the value of the annuity is as
at Year 1 and we need to discount back to give the PV.
This is-effectively a 9-year annuity of 10,000 plus 10,000 today (ie already in PV
terms),
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G ROUP 2 E XERCISES
PROBLEM 1:
A company has 100m of debentures with a 10% coupon rate, which are redeemable at a
10% premium in 5 year's time. The rate of corporation tax is 30%.
Required
Calculate the market value of these debentures assuming debenture holders require a rate of
return of 8% per annum before tax.
SOLUTION 1:
Market value of debt is found using the dividend valuation model: future cash receipts for
the debenture holders are discounted at the debenture holders' required rate of return. (The
rate of corporation tax is irrelevant). The amount of interest per annum is 10% x 100m =
10m. There is also a redemption premium of 10% (i.e. 10% 100m = 10m) in 5 years'
time. Therefore the total cash received by debenture holders in year 5 is 120m.
1 2 3 4 5
Cash flow 10m 10m 10m 10m 120m
Discount
factor 0.926 0.857 0.794 0.735 0.681
PV 9.26 8.57 7.94 7.35 81.72
Total PV 114.84
PROBLEM 2:
ABC plc is a medium sized company that is listed on the stock market. The company has
a year-end of 31st December. The company's earnings per share (EPS) and dividends per
share (DPS) for the last 5 years are as follows:
Dividends are paid on 31st December each year. If the current dividend policy is maintained,
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the directors estimate that annual growth in earnings and dividends will be no better than
the average compound growth in earnings over the past 5 years.
ABC plc is reluctant to take on debt at the present time to finance further growth. The
company is therefore contemplating a change in its dividend policy and total investment
plans to allow for 50% of its earnings to be retained for identified capital expenditure
projects, which are estimated to have a post-tax return of 15%. The cost of equity for the
company is 12%.
Required
(a) Using the dividend valuation model, calculate the share price which might be
expected by the market:
(Note: For both parts (i) and (ii), you should assume that dividends will grow from their
current level of 82p per share).
(b) Comment on the limitations of the models you have used in part (a).
(c) Discuss the reasons why the share price might react differently from the market's
expectations.
SOLUTION 2:
ABC plc
(a)
= 998.5p
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(ii) New dividend policy
= l,958.9p
PROBLEM :
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PA plc is all equity financed and has 1 million shares in issue. The following financial
information is relevant (all values in pence):
Investment analysts have re-evaluated the company's prospects and estimate the
company's earnings and dividends will grow at 25% for the next 2 years. Thereafter,
earnings are likely to increase at a lower annual rate of 10%. If this reduction in earnings
growth occurs, the analysts consider it likely that the dividend payout ratio will be
increased to 50%.
Required
Using the dividend valuation model, calculate the estimated share price which the analysts
now expect for PA plc.
SOLUTION 3:
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PA plc
= 53.28.
(0.18-0.1)
= 666p
Therefore, need to discount at year 2 discount factor for cost of equity of 18%:
= 478.19
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G ROUP 3 E XERCISES
PROBLEM 1:
Hick Limited is considering investing in a new project, for which the following
information is available:
000
Year 1 150
Year 2 300
Year 3 100
Year 4 100
Residual value 30
Required:
Evaluate the financial viability of the above project using the following techniques:
i) payback
ii) the accounting rate of return
iii) net present value (assuming a cost of capital 10%)
iv) internal rate of return
SOLUTION 1:
a.
Time value of money relates to the idea that 1 today is not equal in value to 1 in the
future
Time value of money is said to have three components
o The impatience to consume or pure time value of money
o Inflation
o Risk
Therefore it is not appropriate to simply add or compare s from different time periods
Future s are therefore translated into present value
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b.
(ii)
(iii)
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(iv)
Rearranging gives:
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PROBLEM 2:
A project requires an initial investment of 120,000 and is expected to produce the following
net cash inflows:
Year 1 50,000
Year 2 25,000
Year 3 25,000
Year 4 25,000
Year 5 30,000
Evaluate the financial viability of this project using the following methods:
a) payback
b) accounting rate of return
c) net present value
d) internal rate of return
SOLUTION 2:
a.
(i) Cash flow Cumulative
Investment = (120,000) (120,000)
Year 1 = 50,000 (70,000)
Year 2 = 25,000 (45,000)
Year 3 = 25,000 (20,000)
Year 4 = 25,000 5,000 payback
Therefore payback = 3.8 years (3 years + 20,000/25,000)
(ii)
(iv)
Rearranging gives:
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G ROUP 4 E XERCISES
PROBLEM 1:
Project Poldavia
The amount of sustaining capital expenditure required is estimated to be equal to the amount
of depreciation charged per annum.
The Poldavia plant will initially impact on the business of the Company's plant in nearby
Polgaria. It is estimated that the lost exports to Poldavia will result in lost contribution
(before tax) to the Polgarian plant of 8m in year 1, 8m in year 2 and 3m in year 3.
The investment will partly be financed by a 10-year bank loan of 30m at an interest rate of
5% before tax.
In addition to the 40m capital investment required, a number of feasibility and market
research studies have already been carried out at a total cost of 2m.
Requirement
Calculate the net present value of this investment. (You may assume that the new
Poldavia plant will have an infinite life, even though it will be depreciated over 20 years
for accounting and tax purposes).
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SOLUTION 1:
Project Poldavia
Net Present Value Analysis
Initial investment
(40,000)
Add depreciation 2,000 2,000 2,000 2,000 2,000 2,000
Less sustaining capex, (2,000) (2,000) (2,000) (2,000) (2,000) (2,000)
(working 1)
Free cash flow
Terminal value (working 2) (50,000) (500).. (175) 3,666 7,745 8,810 8,810
103,647
Total amount to discount (50,000) (500) (175) 3,666 7,745 112,457
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Workings:
2. Terminal value
Terminal value = stabilized cash flow x (1 + growth rate) / (discount rate - growth rate)
Therefore:
ECF can invest 5 million in a new plant for producing invisible makeup. The plant has
an expected life of 5 years, and expected sales are 6 million jars of makeup a year. Fixed
costs are 2million a year, and variable costs are 1 per jar. The product will be price at 2
per jar. The plant will be depreciated straight-line over 5 years to a salvage value of zero.
The opportunity cost of capital is 10%, and the tax rate is 40%.
c. What is NPV if fixed costs turn out to be 1.5 million per year?
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SOLUTION 2:
ECF
After tax cash flow = profit after tax + depreciation = 1.8m + 1 m = 2.8m
d. NPV = -5 million + [2.8 million x annuity factor (10%, 5 years)]
= -5 + (2.8 3.791) = 5.6 million
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PROBLEM 3:
Diamond Ltd
Diamond Ltd has 1m to invest and have identified the following four projects:
Required
Assuming each project is infinitely divisible and the projects are not mutually exclusive,
in which projects should Diamond Ltd invest?
SOLUTION 3:
Diamond Ltd
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G ROUP 5 E XERCISES
Problem 1: (QUIZ)
Consider the following data for the returns on shares of the swimming pool owned by Splash
plc and that of the Ice Cream Manufacturing Company (ICMC):
Required:
b. What is the standard deviation of the returns of each of the two shares?
d. Draw a risk-return line using the data you have generated from a, b and c. (In addition,
you may also assume that the minimum standard deviation possible from a portfolio of
Splash and ICMC shares is 0.62, which gives an expected return of 14.5%).
(QUIZ)
SOLUTION 1:
a.
R i (%) R s (%) p i or p s Ri P i Rsps
30 5 0.2' 6.0 1.0
15 15 0.6 9.0 9.0
2 20 0.2 0.4 4.0
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Expected E(R i )= E(R S ) = 14.0%
return 15.4%
b.
(R i - E(R i ))2 p i (R s - E(R S ))2p s
42.63 16.2
0.10 0.6
35.91 7.2
2 = 78.64 = 24.0
= 8.87% = 4.9%
c.
[R i - E(R i )] [Rs - E(R S )] p i
-26.28
-0.24
-16.08
-42.60
Portfolio A:
Expected return: 0.8 15.4 + 0.2 14 = 15.12%
Standard deviation:
(0.82 78.64 + 0.22 x 24 + 2 x 0.8 x 0.2 -42.6)I/2 = 6.1%
Portfolio B:
Expected return: 0.5 15.4 + 0.5 14 = 14.7%
Standard deviation:
(0.52 78.64 + 0.52 x 24 + 2 x 0.5 0.5 -42.6) =2.1%
Portfolio C:
Expected return: 0.25 15.4 + 0.75 14 = 14.35%
Standard deviation:
(0.252 78.64 + 0.752 24 + 2 0.25 0.75 -42.60) =1.56%
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d.
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G ROUP 6 E XERCISES
PROBLEM 1:
Delaware plc
Extracts from Delaware plc's most recent balance sheet are as follows:
000
12% Irredeemable Debentures 4,000
An annual ordinary dividend of 20p per share has just been paid. In the past, ordinary
dividends have grown at a rate of 10% per annum and this rate of growth is expected to
continue. Annual interest has recently been paid on the debentures. The ordinary shares
are currently quoted at 2.75 and the debentures at 80 per cent (i.e. 80 per 100 nominal
value).
Required
SOLUTION 1:
Delaware plc
Dividend in 1 year's time
Cost of equity = +g
P0
20p 1.1
= + 0.1
275p
= 18%
Interest (1 - tax rate)
Cost of irredeemable debt =
Market value
12 (1 - 0.3)
=
80
= 10.5%
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WACC:
PROBLEM 2:
Herbert plc
You have been called in as a consultant for Herbert plc, a sporting goods retail firm,
which is examining its debt policy. The firm is currently has a balance sheet as flows;
All amounts in m
Revenues 250
Cost of goods sold 175
Depreciation 25
EBIT 50
Long term interest 10
Earning before tax 40
Taxes 16
Net Income 24
The firm currently has 100m shares outstanding, selling at a market price of 5 per share
and the bonds are selling at their book value. The firm's current beta is 1.12, the rate of
return on government treasury bonds is 7% and the market risk premium is 5.5%.
b. What is the firm's current cost of debt? (You may assume the rate of
corporation tax is 40%).
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the interest rate on the company's debt to 15% and the beta of equity is
expected to increase to 2.8.
SOLUTION 2:
Herbert plc
c. The firms current cost of capital (WACC) = D/V r debt (1 - T) + E/V r equity
Where r debt is the pre-tax cost of debt and r debt (1 - T) is the after-tax cost of debt.
Thus WACC = 13.16% (500/600) + 6% (100/600) = 11.97%.
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PROBLEM 3:
West Ltd
West Ltd is an unquoted company. The recently appointed Finance Director has asked for
your assistance in obtaining a cost of capital that West Ltd can use to appraise its long-
term investment opportunities.
The annual dividend of 180,000, which represents 70% of the amount that was available
for distribution, has just been paid. The company expects to achieve a rate of return of
26% on its retained profits.
Required
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SOLUTION 3:
West Ltd
= 26%30% =7.8%
180 1.078
= + 0.078
1470
= 19.0%
9,000
=
(80,000 - 9,000)
= 12.7%
(e) WACC:
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G ROUP 7 E XERCISES
A Ltd wishes to buy B Ltd for lm. The current balance sheet positions of both companies
are as follows:
A Ltd B Ltd
000 000
Fixed Assets
Factory 450 -
Machinery 250 400
700 400
750 600
1,450 1,000
Financed By
Share Capital 150 100
Reserves 1,300 900
1,450 1,000
A Ltd makes pre-tax profits of 200,00 per year. The owner of A Ltd has 150,000 of cash,
lives in a house worth 600,000 subject to a mortgage of 250,000, and has life assurance
policies and investments worth 180,000. After the takeover it is estimated that the
combined companies will produce a cash flow of 250,000 for the service of debt, besides
providing the owner with a salary and dividends.
Requirement
SOLUTION 1:
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The owner of A Ltd should only really consider using his own funds and re-
mortgaging his own property after he has exhausted all opportunities for raising
finance via the company
A Ltd currently has no gearing, has 700,000 of fixed assets to offer as security
on debt, and has cash flows of 250,000 per annum to service the debt. The
company therefore has the ability to raise a significant amount of debt.
Assuming lm required, then a possible finance mix could be 250k of cash
(ideally from working capital or alternatively from the owner of A Ltd's own
funds plus re-mortgage of house), then 750k of debt secured on assets of A Ltd
and B Ltd combined
PROBLEM 2:
A group intends to sell off a division. The division is run by two managers (one in
production and one in marketing) and has been breaking even. However, the managers
reckon that it could produce profit of 100,000 a year if head office charges were removed;
they also foresee substantial growth. The group is prepared to sell the division for 400,000
to existing management. Net assets are 600,000 including a freehold factory valued at
320.000. The managers can raise 100,000 through second mortgages and savings.
Requirement
SOLUTION 2:
MBO
Management Buy Out's (MBO's) generally involve a substantial amount of cash
injection from the managers to show commitment and obtain ownership
May need to raise more than 400,000 to help finance the future growth
There is a gap between what the managers can raise (100,000) and the minimum
amount required (400,000)
Managers may be reluctant to bring in new equity as this will dilute their control of the
new company
The freehold factory may provide security for senior debt. The company should be
able to raise around 80% of the market value of the factory's market value (80% x
320,000 = 256,000)
The profit forecasts suggest that the company will generate sufficient cash flows to
service the debt interest
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The managers may look to Venture Capital finance to help fill the financing gap and
strengthen the management team.
Assuming 400,000 will be sufficient initially, suggestion is for the managers to input
100,000, VC's to input 50,000 in exchange for a place on the board, and for senior
debt of 250.000
PROBLEM 3:
A medium-sized company wants to expand, but is held back by high gearing. The planned
expansion is forecast to raise pre-tax profit from 600,000 to 900,000, but initial tooling
costs for the increased manufacturing capacity will amount to 800,000. Bank overdraft
facilities of 1,400,000 are currently fully used. The current position is as follows:
000 000
Requirement
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SOLUTION 3:
EXPANSION
PROBLEM 4:
Rights Issue (he discussed, but cannot remember whether it was in the exam or not)
RI plc has 100 million shares in issue. It wishes to raise 25m via rights issue. Its shares
are currently trading at a price of 120p in the stock market.
RI has decided to raise the 25m by issuing 25m additional shares at a subscription price
of 1 per share.
Fred currently owns lm shares in RI plc and has lm of cash in the bank.
Requirement
(a) Calculate the theoretical ex-rights share price.
i. Do nothing
ii. Take up the rights
iii. Sell the rights
(c) What effect, if any, does the level of price discount decision have on the wealth of
shareholders? (For example, would it make any difference if 50m shares were
sold at a subscription price of 50p?).
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SOLUTION 4:
RIGHTS ISSUE
(a) Given 25m shares to be issued relative to the 100m shares already in issue, this means
this will be a 1 for 4 rights issue.
= (1.20x 100m) + 25
125m
= 1.16
This assumes the new funds raised by the company will be invested at zero Net Present Value.
Before After
Shares (lm1.2) 1.2m (lm1.16) 1.16m
Cash 1.0m Cash 1.00m
2.2m 2.16m
Before After
Shares (lm1.2) 1.2m (l.25m1.16) 1.45m
Cash 1.0m Cash (1-0.25) 0.75m
2.2m 2.20m
Before After
Shares (lm1.2) 1.2m (lm1.16) 1.16m
Cash 1.0m Cash (1+(0.2516p*) 1.04m
2.2m 2.20m
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*Value of the rights = Ex-rights price - subscription price = 1.16- 1.00 = 16p per share
(c) There will be no effect on shareholders' wealth if a different combination of price and
number of shares is issued to raise the required 25m. (This can be proved by re-working
(b) above for a 50m share issue at a subscription price of 50p).
The price discount is only relevant where there is concern that after the rights issue is
announced but before it takes place, the share price might fall beneath the subscription
price. In such circumstances, the rights issue would fail as no-one would take up the rights
offer
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G ROUP 8 E XERCISES
PROBLEM 1:
MSP LTD
MSP is a private limited company with intentions of obtaining a stock market listing in the
near future. The company is wholly equity financed at present but the directors are
considering a new capital structure prior to it becoming a listed company.
MSP operates in an industry where the average asset beta is 1.2 (i.e. beta with zero gearing).
The company's business risk is estimated to be similar to that of the industry as a whole. The
current level of earnings before interest and tax is 400,000. This earnings level is expected
to be maintained for the foreseeable future.
The rate of return on risk less assets is at present 10% and the return on the market portfolio
is 15%. These rates are post-tax and are expected to remain constant for the foreseeable future.
MSP is considering introducing debt into its capital structure by one of the following methods:
(1) 500,000 10% debentures at par, secured on the company's land and buildings
(2) 1,000,000 12% unsecured loan stock at par
The rate of corporation tax is expected to remain at 33% and interest on debt is tax
deductible.
Required
(i) values of equity and the total market value of the firm
(ii) debt/equity ratios
(iii) the cost of equity
(b) List the main problems and costs which might arise for a company experiencing a
period of severe financial difficulties.
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SOLUTION 1:
(a)
We will use V g = V u + DT
Estimated cash flow after tax (to perpetuity) = 400,000 x (1-0.33) = 268,000
V u = 268,000/0.16 = 1,675,000
500,000 debenture
1,000,000 debenture
Answers to part (b) are well covered in the textbook and lecture notes.
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PROBLEM 2:
Capital Structure
Discuss this statement and comment briefly on the practical factors which a company might
take into account when determining its capital structure.
PROBLEM 3:
Dividend Policy
Discuss this statement and comment briefly on the practical factors which a company might
take into account when determining its dividend policy.
SOLUTION 2 & 3:
Answers to problem 2 and 3 are well covered in the textbook and lecture notes.
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