CIMAF3 QBank2015 Watermark PDF

Question Bank 2015 Syllabus
CIMA
Paper F3
Financial Strategy
ii I n t r o d u c t i o n
CIMA F3 Question Bank (2015 Syllabus)
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No part of this publication may be reproduced, stored in a retrieval system

or transmitted, in any form or by any means, electronic, mechanical,
photocopying, recording or otherwise, without the prior written permission
of First Intuition Publishing Ltd.
Any unauthorised reproduction or distribution in any form is strictly

prohibited as breach of copyright and may be punishable by law.
We are grateful to the Chartered Institute of Management Accountants for
permission to reproduce past examination questions and model answers.
Additional comments and guidance have been prepared by First Intuition
Publishing Ltd.
First Intuition Publishing Ltd, 2015
CIMA F3 Question Bank (2015 syllabus)
Introduction
iii
Contents
Topic
Question numbers
Page ref
Q
A
Chapter questions and answers

1 Business objectives
1 - 42
85
2 Sustainability and integrated reporting
43 - 50
10
90
3 Financial strategy
51 - 61
12
91
4 Hedge accounting
62 - 72
14
93
5 Equity finance
73 - 134
17
95
6 Debt finance
135 - 184
30
104
7 Capital structure
185 - 235
41
113
8 Dividend policy
236 - 249
52
122
9 Business valuations
250 - 299
55
124
10 Mergers and acquisitions
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300 - 359
67
132
360 - 370
81
141
CIMA Pilot paper (60 questions to be answered in 90 mins)
145
165
Maths tables and Formulae
173
11 Business reorganisations
Pilot paper questions and answers
iv I n t r o d u c t i o n
CIMA F3 Question Bank (2015 Syllabus)
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1: Business objectives
Chapter questions
Chapter 1: Business objectives

1
Company X and Company Y operate in the same industry but have different price earnings (P/E)
ratios as follows:
Company X
Company Y
P/E ratio
7
13
Which of the following is the most probable explanation of the difference in the P/E ratios
between the two companies?
Company Y has a greater profit this year than Company X.

Company Y is higher risk than Company X.
Company Y has higher expected growth than Company X.
Company Y has higher gearing than Company X.
Extracts from company Z's accounts are as follows:

Turnover
Operating profit
Interest payable
Profit before tax
Profit after tax
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$m
200
50
10
40
20
What is company Z's interest cover?
20 times
5 times
4 times
2 times
WKs profit or loss account contains the following:

Gross profit
Operating profit
Interest payable
Taxation
The nominal value of the ordinary shares is $1 and their market value is $8.
The issued share capital is 10 million shares.
What is the price/earnings ratio?
0.63
1.6
2.67
5
$m
50
30
6
8
2 1: Business objectives
4
Shareholder wealth maximisation is most consistent with
Profit maximisation
Sales maximisation
Maximisation of the present value of future cash flows
Maximisation of future growth
During 20X5, HN's price-earnings ratio fell from 12 to 9. Which of the following could be a
reason why this might have happened?
Interest rates in the economy have risen.

Prospects for future profits have improved.
HN has performed better than other companies in its industry.
The earnings yield on HNs shares has risen.
Which of the following is most likely to benefit from strategies that increase the risk and return
of a company?
Equity shareholders
Preference shareholders
Trade receivables
Debentureholders
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7
Which of the following is not a valid difference between the objectives of for-profit and not-for
profit entities?
For-profit entities primary aim is maximisation of long-term value, not-for profit entities
primary aim is achieving value for money.
For-profit entities have financial objectives, not-for-profit entities dont.
For-profit entities are primarily responsible to their shareholders, not-for-profit entities
are responsible to a wide range of stakeholders.
For-profit entities will be concerned about the balance between capital gain and
dividends, whereas this is not an important concern for not-for-profit entities.
Complete the sentence below by placing one of the following options in each of the spaces.
High
Low
The same
The agency problem arises because managers have

accountability to shareholders and access to
information as shareholders.
Better
Worse
RJ Coaches was a nationwide coach company, which had experienced financial difficulties. Five
years ago the government of Earland bought out the shareholders and now own all of the
company. The target for the company is to earn a return each year of 5% on the amount that
the government invested.
What kind of entity is RJ Coaches?
10
Private sector, not-for-profit entity

Private sector, for-profit entity
Public sector, not-for-profit entity
Public sector, for-profit entity
Littlekit is listed on its local stock exchange. It has $20 million nominal value of share capital and
$4 million worth of bonds. The nominal value of each ordinary share is $2. The shares are
currently trading at $1.25 and the bonds are currently trading at $95 per cent.
What is the gearing ratio of Littlekit, using market values and calculated as debt/equity?
11
15.2%
20.0%
30.4%
40.0%
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Dandys share price rose from $7.20 to $7.60 during 20X4. During 20X4 Dandy paid out a
dividend of $0.60 per share.
What was the annual return to Dandys investors in 20X4?
12
Which of the following figures should be used in the calculation of return on capital employed?
13
2.6%
2.8%
13.2%
13.9%
Gross profit
Profit before interest and tax
Profit before tax
Profit after tax
Louies current dividend yield is 9% and its dividend payout ratio is 12%.
What is the P/E ratio of Louie?
0.75
1.03
1.22
1.33
14
Dewies current P/E ratio is 8 and it retains 75% of after-tax earnings.

What is the dividend yield of Dewie?
15
2.0%
3.1%
6.0%
9.4%
Dans current P/E ratio is 5 and its dividend yield is 8%.

What is Dans dividend payout ratio?
16
1.6%
5.4%
40%
62.5%
The accounting ratios for Oldbear for 20X4 included the following:
Gross profit margin 40%

Operating profit margin 15%
Return on capital employed 16.0%
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What was the asset turnover for Oldbear in 20X4?
17
0.40
0.94
1.07
2.50
Sydneys Return on capital employed for 20X6 was 25% and its asset turnover was 2.
What was the operating profit margin for Sydney Co in 20X6 to the nearest 0.1%?
%
18
Achieving value for money is most likely to be the prime objective of a:
Private sector, for profit entity

Private sector, not for profit entity
Public sector, for profit entity
Public sector, not for profit entity
Use the following data to answer the next two questions.

CSs accounts for the year ended 31 December 20X5 included the following information.
$000
200
100
50
20
30%
Revenue
Cost of sales
Other operating expenses
Finance costs
Tax rate
19
What is the operating profit margin and the margin of profit before tax to revenue?
20
What is the interest cover?
21
10
7.5
5
2.5
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All other things being equal, a firms sensitivity to swings in the business cycle is lowest when:
22
50%:25%
25%:15%
50%:15%
25%:10.5%
The firm has a high beta factor.

The firm has high operating leverage.
Variable and fixed costs are roughly equal.
Variable costs are the highest proportion of its expenses.
What is the effect on the prices of German imports and exports when the Euro appreciates?
Import prices
Export prices
23
Decrease
If the $/ exchange rate moves from $/0.80 ($1 = 0.80) to $/ 0.90 ($1 = 0.90), then:
24
Increase
The has depreciated and European buyers will find US goods to be cheaper.
The has depreciated and European buyers will find US goods to be more expensive.
The has appreciated and European buyers will find US goods to be cheaper.
The has appreciated and European buyers will find US goods to be more expensive.
Post-tax earnings of RJ were $5.2 million 4 years ago. RJ has just announced post-tax earnings of
$7.4 million. What is RJs compound annual growth rate in earnings to the nearest 0.01%?
%
25
AW has paid the following dividend per share in the last few years:
$
0.30
0.29
0.27
0.34
20X1
20X2
20X3
20X4
What is AWs compound annual rate of dividend growth between 20X1 and 20X4 to the nearest
0.01%?
%
26
HJ is based in Denmark where the functional currency is the Krone. The current spot rate of the
Krone to the Euro is Kr/ 0.1400 (Kr1 = 0.1400). Expected interest rates in Denmark and
Europe for the next year are 3% and 5% respectively.
What is the forecast forward rate of exchange to 4 decimal places in one years time using
interest parity theory?
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27
KP is based in the USA. The current spot rate of the $ to the is $/ 0.6200 ($1 = 0.6200).
Expected interest rates in UK and the US for the next year are 2% and 4% respectively.
What is the forecast forward rate of exchange to 4 decimal places in 1 years time using
expectations theory?
28
The current /$ exchange rate is 1.2500 (1 = $1.2500). The Euro is expected to depreciate by
4% each year over the next few years. What is the expected exchange rate in 3 years time, to
4 decimal places?
29
The current /Kr exchange is 9.2000 (1 = Kr9.2000). UK interest rates are expected to be 2%
over the next few years, Danish interest rates are expected to be 5%.
What is the expected exchange rate in 2 years time, to 4 decimal places?
30
RP is based in South Africa and is planning to make purchases of 600,000 in Japan in a years
time. RP is trying to estimate the foreign exchange rate in a years time so that it can estimate
the likely expenditure in Rand.
The current R/ exchange rate is 9.7000 (R1 = 9.7000) and interest rates over the next year are
expected to be 4% in South Africa, 6% in Japan.
What is the expected value of the purchases in Rand in a years time to the nearest R100?
R
31
SS Co is based in Australia and is looking to buy goods in the UK in three months time.
The current /Aus$ exchange is 1.8000 (1 = Aus$ 1.8000) and the value of goods is 280,000.
Interest rates over the next three months are expected to be 2.5% in the UK and 4% in Australia.
What is the expected value of the purchases in Aus$ in three months time to the nearest
Aus$100?
$
32
Improving the welfare of beneficiaries is most likely to be the objective of:
33
A public sector organisation

A private limited company
A public limited company
A charity
NW has produced the following forecast data for the next year.
Sales revenue (cash sales)
Purchases (90 days credit)
Other costs (settled immediately)
$000
10,000
5,400
4,000
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In the previous year prior to the forecast, purchases were also $5,400,000 and on 90 day credit
terms.
NW has a current overdraft balance of $200,000. The agreed overdraft facility is $1,000,000.
Sales and purchases will arise evenly over the year. Assume 360 days in the year.
If all suppliers were to withdraw credit at the end of the year, would the overdraft figure still be
adequate?
34
Yes, the bank account would not be overdrawn.

Yes, approximately $250,000 of the facility would still be available for withdrawal.
No, the overdraft limit would be exceeded by $550,000.
The following data has been taken from the annual accounts of CC.
Year ended
Earnings ($m)
Number of shares in issue
20X6
200
50
20X7
220
50
20X8
250
60
20X9
270
60
CC undertook a 1 for 5 rights issue on 2 January 20X8.

What is the compound average growth rate in earnings per share, to the nearest 0.01%,
achieved between 20X6 and 20X9?
%
35
CH is a publicly-owned bus company which runs routes over many areas of Larland, including
rural routes with few passengers. LG is a publicly-listed coach company that runs routes
between the major towns and cities in Larland.
Which of the following statements concerning the objectives of the two companies are true?
Select ALL that apply.
36
Which of the following definitions is incorrect in relation to value for money?
37
The objectives of CH will be more difficult to define.

The management of CH will have more impact over its objectives.
CH will have to demonstrate value for money.
The level of service provided is more likely to be an objective of LG.
Value for money means providing an economical, efficient and effective service.
Economy means seeking the minimum cost of inputs.
Efficiency means doing things as quickly as possible.
Effectiveness means doing the right thing.
Which of the following is not generally an effect of inflation?
Companies increase their level of inventory.

The level of uncertainty for companies increases.
The exchange rate of a company with high inflation falls against countries with lower
inflation.
Interest rates fall.
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38
Which of the following would lead to an increase in the general level of interest rates? Select
ALL that apply.
39
A reduction in the rate of inflation

A rise in the level of government borrowing
Government relaxing constraints on growth in the money supply
Greater demand for borrowing from businesses
AK has 1 million ordinary $0.50 shares in issue with a market price of $2.50. The following
figures are taken from AKs latest accounts.
$000
5,000
(1,500)
3,500
(400)
3,100
Profit before tax

Tax
Profit after tax
Dividend
Retained profits
What is the dividend yield of AK, to the nearest %?

%
40
Which of the following ratios would be least appropriate for comparing the profitability of two
companies?
Price-earnings ratio
Return on capital employed
Return on shareholders funds
Earnings per share
41
The current market price of SSs shares is $2.40. SS has a dividend yield of 5% and the shares
have a P/E ratio of 12. What is the dividend cover to 2 decimal places?
42
KY has 4 million ordinary S1 shares in issue at a current market price of $1.50. The following
figures are taken from KYs latest accounts.
Profit before tax
Tax
Profit after tax
Dividend
Retained profits
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What is the earnings yield of KY, to the nearest %?

%
$000
2,000
(500)
1,500
(600)
900
10 2 : S u s t a i n a b i l i t y a n d i n t e g r a t e d r e p o r t i n g
Chapter 2: Sustainability and integrated reporting

43
Fluted is preparing a sustainability report, following Global Reporting Initiative guidelines.

Which of the following headings would appear in the General Standards section of the report?
44
Which of the following is an objective of Integrated Reporting, according to the International

integrated Reporting Council?
45
Stakeholder Engagement
Employee Welfare
Impact on Society
Externalities
Disclose economic, environmental and social performance

Increase quantity of information available to stakeholders
Improve quality of information available to providers of financial capital
Ensure consistency between the different reports that make up the annual report
Which of the following are Principles for Defining Report Quality according to the Global
Reporting Initiative? Select ALL that apply.
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46
Danl has recently won an important legal case in its home country, enforcing its patent over its
biggest selling product and preventing copies being made. Where would information about this
case be disclosed in Danls integrated report?
47
Sustainability
Clarity
Completeness
Comparability
Social and relationship capitals

Intellectual capitals
Manufactured capitals
Natural capitals
Identify whether the following statements are true or false.

Capitals in integrated reporting can be defined as resources
and relationships
Integrated reporting is part of sustainability reporting.
True
False
48
A company has no obligation to state that it has omitted information.

If information is unavailable, no disclosure is required.
Information can be omitted if it is subject to confidentiality constraints.
If information is omitted due to legal restrictions, the company does not need to explain
what has happened.
Which of the following is not a principle for defining report content under the Global Reporting
Initiative?
50
11
VV has adopted the Global Reporting Initiative and issued an annual sustainability report in
accordance with the guidelines. Which of the following statements relating to incomplete
disclosure is correct?
49
2: Sustainability and integrated reporting
Materiality
Completeness
Accuracy
Stakeholder inclusiveness
Which of the following is not a category under the Specific Standard Disclosures in the Global
Reporting Initiative guidance?
Economic
Ethical
Social
Environmental
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12 3 : F i n a n c i a l s t r a t e g y
Chapter 3: Financial strategy

51
52
Would either or both of the following actions increase the wealth of shareholders in an allequity financed company?
Paying out a dividend
Yes
No
Making a bonus issue
Would either or both of the following actions increase the wealth of shareholders in a currently
all-equity financed company?
Raising new equity finance
Raising new debt finance
53
Yes
No
Which of the following are generally objectives of regulatory bodies? Select ALL that apply.
Promotion of social objectives

Promotion of relationships with stakeholders
Protection of customers from full competition
Protection of customers from monopoly power
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54
AJ has an A credit rating from a credit rating agency, while BF has a BB credit rating.
Will BF find it easier or harder to raise debt finance than AJ and is the rate of interest that BF is
pays likely to be higher or lower than that paid by AJ?
55
Which of the following are valid reasons for holding cash? Select ALL that apply.
56
Easier Higher
Easier Lower
Harder Higher
Harder Lower
Meet future needs

Maintain sufficient balances to be able to complete day-to-day transactions
Maintain gearing levels
Take advantage of opportunities in short-term financial markets
Oldted has $2 million net assets. Oldted is all equity-financed, and its earnings before interest and
tax are $400,000. If Oldted changes its capital structure so that its current level of net assets is
financed by 75% equity, 25% debt, what is the return on equity before and after the change?
The tax rate is 20% and the interest rate on debt is 8%.
100% equity - 20%, 75% equity - 24%

100% equity - 20%, 75% equity - 12.6%
100% equity - 16%, 75% equity - 24%
100% equity - 16%, 75% equity - 19.2%
57
3: Financial strategy
13
Pipshirl has the following objectives:
Achieve an annual dividend growth rate of at least 8% per annum

Keep gearing (debt to equity, measured in market value) below 50%
In the last 4 years the dividend paid by Pipshirl has increased from $0.8 million to $1.1 million.
Pipshirl has 5 million $2 shares currently trading at $2.62 and $6 million of bonds with a current
market value of $115 per cent.
Which of the objects has Pipshirl achieved?
58
Which of the following strategies are likely to enhance shareholder wealth? Select ALL that
apply.
59
Neither objective
Both objectives
The dividend objective only
The gearing objective only
Paying a constant dividend

Making directors remuneration partly dependent on increases in share price
Investing in projects with a positive net present value
Purchasing shareholders shares with surplus cash
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AA has been generally successful in the last few years, although its cash flows have varied
considerably over time, following no clear pattern.
Which of the following may be motives why AA would wish to hold surplus cash? Select ALL that
apply.
60
Which of the following payments could be made as an earn-out arrangement?
61
Income
Transaction
Precautionary
Hedging
Golden handcuffs for directors

Share options for directors
Incentive payments for staff
Consideration for the sale of a business
A small, recently-established, private company requires funding for a long-term investment and
does not wish to take out bank loan finance.
Which of the following sources of finance is most likely to be suitable?
Commercial paper
Eurobond
Funds already generated from operations
New equity subscribed by the directors
14 4 : H e d g e a c c o u n t i n g
Chapter 4: Hedge accounting

62
Which of the following is not a condition that must exist for hedge accounting to be permitted
for a cash flow hedge under IAS 39 Financial Instruments: Recognition and Measurement?
63
The effectiveness of the hedge can be reliably measured.

The forecast transaction that is the subject of the hedge must be highly likely to occur.
The hedge is assessed on an ongoing basis.
The hedge is expected to be at least 90% effective.
Pravtank is a UK company. It has partly funded an investment of $100 million in the USA with a
loan of $80 million taken out on 1 April 20X4. The /$ exchange rate on 1 April 20X4 was 1.6000
(1 = $1.6000) and the /$ exchange rate on 31 March 20X5 was 1.6500.
The hedging requirement satisfies the requirement for offset in IAS 39 Financial Instruments:
Recognition and Measurement.
What is the effectiveness of the net investment hedge at 31 March 20X5 to the nearest 0.1%?
%
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64
The directors of Tomcat are considering investing in a foreign subsidiary, funding the
investment with a foreign currency loan and using hedge accounting.
What standard will apply to this arrangement?
65
Which of the following statements futures and forwards contracts is true?
66
IAS 39 whenever the hedge is set up

IFRS 7 whenever the hedge is set up
IAS 39 up to 31 December 2017, IFRS 9 thereafter
IFRS 7 up to 31 December 2017, IFRS 9 thereafter
Counterparty risk for a forward contract can be avoided by trading on a recognised exchange.
Once entered, futures contracts must be closed out at the due date.
Futures contract terms can always be tailored to the purchasers exact requirement.
Futures contracts require a margin deposit.
JB Energy owns 5,000 barrels of oil that cost $200,000 on 1 January 20X4. To reduce market risk,
JB Energy took out futures contracts to sell 5,000 barrels of oil at $250,000 on 31 March 20X5.
At JB Energys year-end on 31 December 20X4, the market value of oil was $42 per barrel and
the futures price was $52 per barrel.
Under the hedge accounting rules of IAS 39 Financial Instruments: Recognition and
Measurement, what is the accounting entry at 31 December 20X5 to reflect the change in the
value of the oil?
Credit statement of profit or loss gain of $10,000

Debit statement of profit or loss loss of $10,000
Debit statement of other comprehensive income loss of $10,000
No entry should be made until the date the contract is due to be closed out, on 31 March
20X5
67
Net investment in a foreign operation

Changes in the value of assets or liabilities
Variability in cash flows
Unrecognised firm commitment
Identified part of an asset, liability or firm commitment that is attributable to a particular
risk and could affect profit or loss
Which of the following should a company that sells in its home country and overseas and also
sources its supplies from its home country and overseas consider disclosing under IFRS 7
Financial Instruments: Disclosures? Select ALL that apply.
69
Management of political risk affecting the value of overseas operation

Maximum exposure to credit risk
Management of liquidity risk
Maturity analysis of financial liabilities
Sensitivity analysis to currency risk
Which of the following would not need to be disclosed under IFRS 7 Financial Instruments:
Disclosures by a company that trades and sources all of its supplies in its home country and has
a mix of equity and debt finance?
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Sensitivity analysis to interest rate risk

Information about financial assets that are overdue
Details of how customers are credit checked
Exposure to losses of goods in transit
Use the following information to answer the next two questions.
NA accepted an export order on which it expected to make a profit of $5,000 in its local currency.
It took out a forward contract to hedge this transaction.
On NAs year-end date, 31 December 20X2, two months before the order was due to be delivered, its
Finance Director calculated that the expected profit on the contract was $4,500 due to movements in
the spot rate. The forward contract had been revalued and its value had fallen by $500.
70
What profit or loss figure would be shown in NAs accounts for the year ended 31 December
20X2 in respect of the export contract plus forward contract if hedge accounting was not used
(show a loss as a negative number using a minus sign ())?
$
71
15
Which of the following could be the subject of a fair value hedge? Select ALL that apply.
68
4: Hedge accounting
What profit or loss figure would be shown in NAs accounts for the year ended 31 December
20X2 in respect of the export contract plus forward contract if cash flow hedge accounting was
used (show a loss as a negative number using a minus sign ())?
$
16 4 : H e d g e a c c o u n t i n g
72
Average
Closing
Historic
Profit or Loss
Other Comprehensive
Income
If a business is using hedge accounting in relation to a net investment in a foreign operation,

both the investment and the borrowing must be translated at
rate at each year end and gains or losses
on both items should be offset in
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5: Equity finance
17
Chapter 5: Equity finance

73
SO has 4 million $1 ordinary shares in issue with a current market price of $4 per share.
It decides to make a 1 for 4 rights issue at $3. What is the theoretical ex-rights price of the
shares following the issue?
74
HF has 3 million $1 ordinary shares in issue with a current market price of $3 per share.
It decides to make a 1 for 3 rights issue at $2.40. What is the value of a right per new share?
75
$2.40
$0.60
$0.45
$0.15
HD has 5 million $0.50 ordinary shares in issue with a current market price of $0.60 per share.
It decides to make a 1 for 4 rights issue at $0.40. The rate of return on existing funds is 8%, but
the rate of return on the new funds is expected to be 10%. What is the yield adjusted
theoretical ex-rights price?
76
$3.00
$3.50
$3.80
$4.00
$0.40
$0.50
$0.56
$0.58
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AL has 4 million $1 ordinary shares in issue with a current market price of $5 per share.
It decides to make a 1 for 5 rights issue at $3.80.
Calculate the value of a right per new share to the nearest $0.01.
$
77
PM has 3 million $0.75 ordinary shares in issue with a current market price of $1.32 per share.
It decides to make a 1 for 4 rights issue at $0.80. The rate of return on existing funds is 5%, but
the rate of return on the new funds is expected to be 7%.
Calculate the yield adjusted theoretical ex-rights price to the nearest $0.01.
$
78
LW has 4 million $1 ordinary shares in issue with a current market price of $4.40 per share.
It decides to make a 2 for 5 rights issue at $3.35 per share.
Calculate the theoretical ex-rights price of the shares following the issue to the nearest $0.01.
$
18 5 : E q u i t y f i n a n c e
79
AS has 5 million $0.50 ordinary shares in issue with a current market price of $1.50 per share.
It decides to make a 1 for 4 rights issue at a 20% discount on current market price.
Calculate the theoretical ex-rights price of the shares following the issue to the nearest $0.01.
$
80
BS has 10 million ordinary shares in issue with a nominal value of $1 and a market value of $3.
BS is intending to make a one-for-four scrip issue. Helen holds 100 shares in the company. How
much would Helen have to pay BS for her new shares?
81
$300.00
$240.00
$100.00
$Nil
A listed company makes a rights issue. Which of the following rankings of prices is most valid?
(Note: the symbol '<' below means 'is less than')
Ex rights < Cum rights < Issue price

Ex rights < Issue price < Cum rights
Cum rights < Ex rights < Issue price
Issue price < Ex rights < Cum rights
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A company currently has 10 million $1 shares in issue with a market value of $3 per share. The
company wishes to raise new funds using a 1 for 4 rights issue. If the theoretical ex-rights price
per share turns out to be $2.80, how much new finance was raised?
83
A company makes a 2 for 3 rights issue at an issue price of $2. The cum-rights price is $4.
The theoretical ex-rights price is:
84
$2,500,000
$4,000,000
$5,000,000
$7,000,000
$2.50
$2.80
$3.00
$3.20
Identify whether the following statements are True or False.

True
False
Following a rights issue, a companys share price is likely to fall.
Following a rights issue, the total value of a companys ordinary

shares is likely to fall.
85
5: Equity finance
19
A company makes a rights issue at an issue price of $5 per share. The cum-rights price is $8 per
share. The theoretical ex-rights price is $7 per share.
What were the terms of the rights issue?
86
1 for 3
3 for 1
1 for 2
2 for 1
Greater
Smaller
Uncertainty
Certainty
The providers of equity finance face
risk
than the providers of debt finance, because of greater

about their return and
variability of their return. As a result
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providers of equity finance will require a
level of return on their investment than providers of debt.
87
TS has 1 million ordinary shares in issue with a nominal value of $2 and a market value of $3.
TS is proposing to make a 1 for 4 bonus issue.
What will be the effect of the issue on the share capital and reserves figures in the statement of
financial position?
88
Share capital will increase by $500,000, reserves will be unchanged.

Share capital will increase by $750,000, reserves will be unchanged.
Share capital will increase by $500,000, reserves will decrease by $500,000.
XX has 200,000 shares at a nominal value of $2 and a market value of $3.50. It proposes to
make a 1 for 4 rights issue at a 30% discount.
Calculate the proceeds from the rights issue.
$
89
QQ has just achieved a stock market listing and is making a public issue of shares by an offer for
tender.
QQ has received the following tenders.
Number of shares
applied for at price
000
500
800
1,200
1,700
2,400
3,300
9,900
$
4.00
3.90
3.80
3.70
3.60
3.50
QQ has decided to issue 4 million shares and that partial acceptance would mean allotting to
each of the applicants an equal proportion of shares for which they have applied.
How much money will QQ raise from the issue to the nearest $0.1m?
$
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JS has recently undertaken a 2 for 5 rights issue. Its share price fell by $0.30 as a result. What is
the theoretical market value of a right to the nearest $0.01?
$
91
The ordinary share price of AE is currently 150c. Dividends are paid once a year, and the
dividend for the previous year has very recently been paid. The net dividend for the year was 3c
and 15% annual growth is expected for dividend payments for the foreseeable future.
Using the dividend growth model, what is the cost of equity for AE?
92
2.4%
15.0%
17.0%
17.3%
A company has a cost of debt of 5%, a weighted average cost of capital of 8% and a debt: equity
ratio of 1:2. What is its cost of equity?
3%
7%
9.5%
14%
93
5: Equity finance
21
ZZ is all equity financed. For each $1 of earnings, it consistently pays 30c in dividend and retains
70c for reinvestment. It expects to earn a rate of return of 14% on capital employed.
According to the Gordon Growth Model, what would the rate of earnings growth be in future?
Ignore tax.
94
95
4.2%
7%
9.8%
14%
Examine the validity of each of the following statements with respect to the dividend valuation
model. Each statement should be considered separately and in each case all other factors stay
constant.
True
False
An increase in the dividend growth rate would result in a lower

share price.
An increase in the cost of equity would result in a lower share price.
Complete the sentences below by placing one of the following options in each of the spaces.
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Dividends paid
Retained profit
adjusted for dividends
Nominal
Market
Current dividend
Dividend expected
next year
If dividends are expected to grow, the
should be used in the calculation. If a realistic cost of equity is to be calculated, it is necessary to

know the
96
value of shares.
The equity shares of LH are quoted at $4.00 ex div with a dividend of 50 cents per share that has
just been paid. The expected growth rate of dividends is 4% per year.
Calculate the cost of equity using the dividend model to the nearest 0.1%.
%
97
The equity shares of SH are quoted at $4.70 cum div with a dividend of 40 cents per share that
is due to be paid. SH aims to pay a constant dividend each year.
%
98
The equity shares of MW are quoted at $9.40 ex div. The directors wish to pay a dividend of
$1.20 per share in one years time and maintain an expected growth rate of dividends of 4%.
%
99
The equity shares of RC are quoted at $4.20 cum div, with a dividend of $0.20 per share about
to be paid. RCs return on capital employed is 40% and the directors aim to retain 30% of aftertax earnings in the business.
Calculate the cost of equity, using the dividend model, to the nearest 0.1%.
%
100
The equity shares of RW are quoted at $2.60 ex div, with RW having just paid a dividend of
$0.20 per share. RWs return on capital employed is 10% and the directors aim to pay 40% of
earnings after tax each year as dividend.
%
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101
The equity shares of JP are quoted at $10.30 ex div, with JP having just paid a dividend of $0.45
per share. Details of JPs dividend payments over the last few years are as follows:
$ per share
20X5
0.28
20X6
0.34
20X7
0.39
20X8 (current year)
0.45
%
102
The $2 preferred shares of JH are quoted at $2.50 ex div, with JH having just paid a dividend of
5% of the nominal value of the shares.
Calculate the cost of the preferred shares to the nearest 0.1%.
%
103
YM has just paid a dividend of $0.60 per share, with dividends expected to grow at 8%. YHs cost
of equity is 12%.
Calculate the market value per share of YMs shares to the nearest $0.01.
$
104
5: Equity finance
23
AS has 5 million $1 ordinary shares and 1 million 7% $1 preferred shares currently in issue.
The ordinary shares are currently trading at $1.20 cum div and the preferred shares are
currently trading at $1.12 cum div. The expected dividend growth rate is 9%.
Calculate the cost of the preferred shares to the nearest 0.1%.
%
105
Which of the following statements are correct if a companys cost of equity capital falls? Select
ALL that apply.
106
The weighted cost of capital would increase.

The cost of debt capital would not change.
The share price would go up.
More investment projects would be worth undertaking.
The price of a companys shares is currently $8 and the latest dividend is $1.25. The cost of
equity is 18%.
Calculate the dividend growth rate to the nearest 0.1%.
%
107
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TF plans to pay a dividend next year of $0.80 per share, with dividends expected to grow at 7%
in subsequent years. TFs cost of equity is 11%.
Calculate the market value per share of TFs shares.
$
108
The equity shares of CJ are quoted at $6.00 cum div with a dividend of $1 per share that is
about to be paid. However because CJ is expecting to make some major investments in the next
years, dividends are expected to fall by 5% per annum for the foreseeable future.
%
109
The Stock Exchange may grant a quotation where shares in a large company are already widely
held, so that a market can be seen to exist. No shares are made available to the market. What is
this process called?
Placing
Introduction
Share split
Bonus issue
110
An arrangement where most of the shares in a share issue are bought by a small number of
institutional investors is known as:
111
Introduction
Offer for sale
Underwriting arrangement
Placing
Which of the following reasons is the least likely reason for seeking a stock market listing?
112
Enhancing the existing shareholders control over the company

Making the shares more marketable
Improving the companys image
Attracting a wider range of investors
JP obtained a stock market listing six months ago and offered its shares to investors by an offer
for sale. Not all the shares were purchased by the public. The unsold shares were purchased by
a number of financial institutions under an agreement with JP.
This type of arrangement is known as:
Placing
Tender offer
Underwriting
Introduction
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113
The current annual risk-free rate of return is 6% and the required annual rate of return on a
security with a beta of 1.2 is 15.6%. Using the capital asset pricing model, what is the required
annual rate of return on the market portfolio?
114
11.52%
13.00%
14.00%
17.52%
SB has a published equity beta of 1.4. The expected return on three-month Treasury bills is 6%.
The expected return on the market is 11%.
The cost of equity for SB may be estimated as:
11%
12.4%
13%
15.4%
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5: Equity finance
25
Using the capital asset pricing model (CAPM), the beta of company X's shares is 1.6, the risk free
rate is 5% and the required return of company X's shares is 16.2%. Company Y is quoted in the
same stock market, but has a beta of 1.4.
What is the required rate of return on company Y's shares?
116
12.0%
13.0%
13.2%
14.8%
TT has a published equity beta of 1.5. The risk-free rate is 3% and the excess return on the
market is 8%.
The cost of equity for TT may be estimated as:
117
10.5%
12.0%
15.0%
16.5%
Primary
trade on an initial offering and
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Secondary
Primary and secondary
markets are where shares and bonds
markets are where shares and bonds trade after their initial offering.
118
VB is considering an initial public offering of shares, but is concerned that the share offering will
not be fully taken up.
To whom should VB go to make arrangements to ensure that all the shares are taken up?
119
A merchant bank
The stock exchange
A stockbroker
An underwriter
Which of the following are reasons for discounting a rights issue? Select ALL that apply.
Maintain control by existing shareholders

Make the shares attractive to existing shareholders
Safeguard against a fall in the market value during the offer period
Maximise revenue from the issue
120
Nominal
Market
Less than
The same as
Greater than
A company is financed entirely by equity. It is about to invest in a project with a positive net
present value, using a new issue of shares to finance the project. The directors are concerned
that current shareholders will object to the issue, as it will dilute the value of their shareholding.
In order to ensure that the current shareholders gain all the benefits of the new project, the
issue price of each share must be
the
value of each share.

HG is financed by equity of 2 million $1 ordinary shares. The current market value is $4 per share. HG
is planning to make a share issue to the general public in order to raise funds to invest in a new project
that will cost $2.66 million and give a positive net present value of $1.49 million. The issue will be
priced at a 5% discount to the current market price.
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To the nearest $, what will be the total gain accruing to existing shareholders?
$
122
To the nearest $0.01, what will be the total gain per share for new shareholders?
123
WD wishes to invest $10 million in a project with a positive net present value of $6 million.
WD is financed by 20 million $1 shares with a market value of $4.00 per share. Funds for the
new project will be raised entirely from new investors.
To the nearest $0.01, at what price should new shares be issued if all the gains from them are to
go to existing shareholders?
$
124
NX is financed entirely by equity, comprising 5 million ordinary $1 shares at a current market

price of $2.50 per share.
NX is planning to make a share issue to the general public in order to raise funds to invest in a
new project that will cost $5.4 million and give a positive NPV of $8 million. The share issue will
be priced at a 10% discount to the current share price.
What percentage of the gain from this project will go to existing shareholders, to the nearest
0.1%?
%
125
5: Equity finance
27
The directors of TD are considering raising finance of $1 million to fund a new investment. They
expect earnings to increase by $200,000 each year. TD has 5 million $1 shares, currently trading
at $1.20. TDs price/earnings ratio is 7.5.
If TD uses a 1 for 4 rights issue to fund the investment, what is the expected earnings per share
to the nearest $0.01 after the rights issue has taken place and the project has generated the
forecast earnings?
$
126
TV offered 50 million shares to the public by tender offer. Interested parties were invited to bid
for the shares in the range of $2.00 to $2.50. Partial acceptance would mean allotting to each of
the applicants an equal proportion of shares for which they have applied.
The results of the tender were as follows:
Price offered
$
2.00
2.10
2.20
2.30
2.40
2.50
127
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How will the shares be allocated?
Number of share
bids received at
price
m
5
15
35
40
30
15
5m @ $2.00, 15m @ $2.10, 30m @ $2.20

50m @ $2.20
50m @ $2.30
5m @ $2.30, 30m @ $2.40, 15m @ $2.50
KL wishes to raise $10 million from a rights issue to finance a new investment. The investment
has a return equal to KLs weighted average cost of capital.
Under the rights issue 2 million new shares will be issued at $2.40 on the basis of 1 new share
for every 4 shares held. Any shareholder who does not wish to take up their rights will be able
to sell them to the company at $0.12 for each share held.
The day after the rights issue KL had 10 million $1 shares in issue at a market price (cum rights)
of $3.00 and a theoretical ex-rights price of $2.88.
Better off than
Worse off than
In the same position as
Assuming an efficient market, shareholders who take up their rights can expect to be financially
shareholders who sell their rights to the
company.
128
Falls initially and then
levels off
Continues to fall
Rises initially and then

levels off
Continues to rise
Stays constant
As the number of shares held increases, the level of portfolio risk

, the level of unsystematic risk
and the level of systematic risk
.
129
YH currently has a WACC of 10%, 200 million $0.25 shares in issue, and a current market price of
$0.80. YH has just announced a 1 for 3 rights issue at a discount of 20% to the current share
price to finance a project that has a yield of 12.5%.
Calculate the yield adjusted theoretical ex-rights price to the nearest $0.01.
$
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LY is to undertake a $50 million rights issue to raise funds for a new investment.
Which of the following would not be affected by the amount of discount on current share price
at which the shares are issued?
131
Number of shares issued

Earnings per share
Share premium account
Amount raised
YH is just about to pay a dividend of $0.50 per share, with dividends expected to grow at 12%.
YHs cost of equity is 15%.
Calculate the market value per share of YHs shares to the nearest $0.01.
$
132
A portfolio consisting of entirely of risk-free securities will have a beta factor of:
0
0.5
1
-1
133
5: Equity finance
29
NMs current post-tax earnings per share are $3.5 million and it has 5 million $0.50 shares in
issue. The current market price per share is $2.00. The directors are considering a project that
will increase pre-tax earnings by $1 million. The project will cost $2 million and be funded by a
rights issue at a 20% discount to the current market price.
Calculate the increase in earnings per share to the nearest $0.01 if the investment is
undertaken.
$
134
Anna has recently invested $50,000. $20,000 of this investment was in DS with an expected
return of 6%, $18,000 was in RL with an expected return of 8% and $12,000 was in a risk-free
asset with an expected return of 2%.
Calculate, to the nearest 0.01%, the expected return on Annas portfolio.
%
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30 6 : D e b t f i n a n c e
Chapter 6: Debt finance

135
HO has made an issue of 6% convertible loan stock with a par value of $100. The stock can be
redeemed in four years time at $129, or converted into shares at the rate of 30 shares per $100
loan stock.
Calculate, to the nearest $0.01, the share price at which an investor would be indifferent
between conversion and redemption.
$
136
Which one of the following lists of securities is ranged in order of increasing risk to the investor
(commencing with the lowest risk)?
137
Warrant; unsecured loan; preferred share

Unsecured loan; preferred share; warrant
Preferred share; unsecured loan; warrant
Warrant; preferred share; unsecured loan
The redemption yield on a redeemable bond can be defined (ignoring tax) as
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The annual interest payment divided by the nominal value of the bond
The annual interest payment divided by the market value of the bond
The rate of interest at which the total discounted value of future interest payments and
capital repayments is equal to the current market value of the bond
The rate of interest at which the total discounted value of future interest payments is
equal to the current market value of the bond
A bond has a coupon rate of 6% per annum and will repay its face value of $100 on its maturity
in four years time. The yield to maturity on similar bonds is 4% per annum. The annual interest
has just been paid for the current year.
Calculate the expected market value of the bond at todays date to the nearest $.
139
A $100 bond has a coupon rate of 8% per annum and is due to mature in four years time. The
next interest payment is due in one years time. Similar bonds have a yield to maturity of 10%.
Calculate the expected purchase price of the bond at todays date to the nearest $.
$
140
A $100 bond has a yield-to-maturity of 6% per annum and is due to mature in three years time.
The next interest payment is due in one years time. Todays market value of the bond is
$108.06.
Calculate the coupon rate on the bond to the nearest %.
%
141
6: Debt finance
31
An investor is considering purchasing a bond with a par value of $100 and a coupon rate of 8%
payable annually. The bond is redeemable at par in six years time. Bonds with the same level of
risk have a yield to maturity of 7%.
Calculate the price the investor should pay for the bond to the nearest $ if the first interest
payment will be paid one year after the date of purchase.
$
142
A bond has a coupon rate of 8% and will repay its nominal value of $100 when it matures after
four years.
The bond will be purchased today for $103 ex-interest and held until maturity.
The current tax rate is 25%, with tax savings occurring in the same year that the interest
payments arise.
Calculate, to the nearest 0.1%, the post-tax cost of debt of the bond.
%
143
An unquoted bond has a coupon rate of 6% per annum and will repay its face value of $100 on
its maturity in 4 years time. The yield to maturity on similar bonds is estimated to be 3% per
annum. The annual interest has just been paid for the current year.
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Calculate the current expected market value of the bond to the nearest $.
$
144
A $1,000 bond has a coupon rate of 10% per annum and will repay its face value in 5 years
time. Similar bonds have a yield to maturity of 8% per annum.
Calculate the current expected market value of the bond to the nearest $.
$
145
A $1,000 bond has a coupon rate of 8% and will repay its nominal value when it matures in
4 years time.
The bond will be purchased today for $900 ex interest and held until maturity.
Calculate, to the nearest 0.1%, the yield to maturity for the bond based on todays purchase
price.
%
146
DK is considering investing in government bonds. The current price of a $100 bond with 10
years to maturity is $88. The bonds have a coupon rate of 6% and repay face value of $100 at
the end of the 10 years.
Calculate the cost of debt of the government bond to the nearest 0.1%.
%
32 6 : D e b t f i n a n c e
147
PG has issued $1 million of irredeemable debt having an annual rate of interest of 9%.
The current market value of the debt is $1.22 million. The tax rate is 30%.
Calculate the post-tax cost of the debt to the nearest 0.1%.
%
148
NE has $5 million 5% convertible bonds in issue. The market value of the bonds after the recent
payment of interest is $110 per $100 nominal. The bonds will be convertible into $1 equity
shares in three years time, at the rate of one share per $5 bond. The shares are expected to
have a market price of $6.50 each when conversion takes place, and all bondholders are
expected to convert their bonds.
Calculate the cost of the convertible securities to the nearest 0.1%.
%
149
JL has $10 million 8% convertible bonds in issue. The current market value of the bonds after
the payment of interest in the last few days is $95 per $100 nominal. The bonds will be
convertible into $0.50 equity shares in five years time, at the rate of one share per $4 bond.
The current market price of the shares is $2.80, but the market price is expected to have risen
by 50% by the time conversion takes place. All bondholders are expected to convert their
bonds. The tax rate is 30%, with tax savings occurring in the same year that the interest
payments arise.
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Calculate the post-tax cost of the convertible securities to the nearest 0.1%.
%
150
JS has in issue $200 million of long-dated bonds issued at par and paying a coupon rate of 11%.
The bonds are currently trading at $105 per $100 nominal. The tax rate is 20%.
Calculate the post-tax cost of debt for JS to the nearest 0.1%

%
151
6: Debt finance
33
The projected profit or loss account of SD for the year to 30 June 20X1 shows the following figures.
$000
100
40
Operating profit
Interest payable
60
18
42
Profit before tax

Corporation tax (30%)
Profit after tax
The directors of SD estimate that the additional purchase of new equipment on 1 July 20X0 for
$140,000 would increase the projected profit for the year by $18,000. The machine would be
financed by a loan raised on 1 July 20X0 with a coupon rate of 5%.
What would the projected interest cover for the company become if the directors purchased
the new machine?
152
Which of the following is not true for a financial lease?
153
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The lessee receives capital allowances for the asset.

The lease has a primary period which covers all or most of the useful economic life of the
asset.
The lessee is responsible for servicing and maintenance of the asset.
The lessee records the leased asset as a non-current asset in statement of financial position.
The cost of purchasing a machine is $100,000 payable immediately. Its disposal value is
expected to be $10,000 in five years' time. The same asset can be leased for a period of five
years with rentals of $25,000 payable annually in advance. The asset is returned to the lessor at
the end of the lease period. What is the net present value (to the nearest $10) to the lessor
company if it purchases the machine, then leases it to the user on the above terms if it applies
an annual discount rate of 10%? (Ignore tax.)
154
0.66
0.94
2.13
2.51
$990
$10,460
($1,960)
($11,440)
A companys Financial Director is deciding whether to purchase or lease an asset. The asset has
a ten-year life with a zero residual value. It can be purchased for $120,000. If the asset is
purchased it would be paid for in cash on the day the asset is acquired. Alternatively, it can be
leased for ten payments of $18,000 per annum payable each year in advance.
The cost of capital is 10% per annum. Ignore taxation.
Calculate whether the asset should be
Select an option from the drop down box:
Option 1 Purchased
Option 2 Leased
34 6 : D e b t f i n a n c e
155
A companys Financial Director is deciding whether to purchase or lease an asset. The asset has
a five-year life. It can be purchased for $51,000 and will have a residual value of $20,000 after
five years. If the asset is purchased it would be paid for in cash on the day the asset is acquired.
Alternatively, it can be leased for five payments of $10,000 per annum payable each year in
arrears. If leased, the asset will remain the property of the lessor and will be returned at the
end of the five-year contract.
The cost of capital is 10% per annum. Ignore taxation.
Option 1 Purchased
Option 2 Leased
156
A company is considering whether to buy an asset that has a 10-year economic life with a zero
residual value. It can be purchased for $80,000 payable immediately. Alternatively, it can be
leased for 10 lease rentals of $12,000 per annum payable annually in advance.
The required rate of return is 10% per annum. Ignore taxation.
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Option 1 Purchased
Option 2 Leased
157
A company is considering whether to buy an asset that has a five-year economic life. It can be
purchased for $81,000 payable immediately, and will have a residual value of $40,000 after five
years. Alternatively, it can be leased for five lease rentals of $14,000 per annum payable
annually in arrears, and the asset will be handed back to the lessor at the end of this five-year
contract.
The required rate of return is 10% per annum. Ignore taxation.
Option 1 Purchased
Option 2 Leased
158
A companys Finance Director is considering whether the company should purchase a machine
for $100,000, payable immediately, with a residual value of $10,000 after five years. It can be
leased for six annual rentals of $20,000, the first one being payable immediately. The companys
cost of capital is 10%.
Option 1 Purchased
Option 2 Leased
159
6: Debt finance
35
A companys Finance Director is considering whether the company should purchase a machine
for $48,000, payable immediately, with a zero residual value. It can be leased for five annual
rentals of $14,500, the first being payable in two years time. The companys cost of capital is
10%.
Option 1 Purchased
Option 2 Leased
160
The interest rate risk of a bond is:
161
The market yield of CDs bonds is 9%, but its cost of debt is 7%. What is the most likely reason
for this difference?
162
The risk that interest will not be paid in a particular year

The risk of bankruptcy due to changes in interest rates
The risk of changes in a bonds return due to changes in interest rates over time
The risk that the bondholder is passing up the chance of an investment with a higher
return by investing in the bond
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The cost of issuing new debt has become more expensive.

The market rate of interest has increased.
Interest is allowable for tax purposes.
The market yield reflects market expectations of future value, the cost of debt does not.
RR issued convertible bonds five years ago. Bondholders have the option of converting each
bond to 32 shares or receiving $100 cash on the redemption date.
Todays date is 1 January 20X3. The share price is $2.80 and it is expected to grow by 5% per
annum.
At what date would conversion be worthwhile?
163
31 December 20X3
31 December 20X4
31 December 20X5
31 December 20X6
Which of the following statements regarding subordinated debt are correct? Select ALL that
apply.
Subordinated debt has a higher ranking than senior debt.

In the case of default, subordinated debtholders will be paid before shareholders.
In the case of default, subordinated debtholders will be paid before senior debtholders.
In the case of default, subordinated debtholders will be paid after statutory creditors.
36 6 : D e b t f i n a n c e
164
In a lease vs buy decision, the discount rate used in the net present value calculation for the
lease versus buy option is:
165
The companys weighted average cost of capital

The companys cost of equity
The companys cost of debt
The implied interest rate in the lease payment
ST is considering acquiring an asset that will cost $600,000 to purchase. ST is considering a lease
arrangement where the lessor will charge $132,000 per annum in arrears for five years. What
will be the interest charge in Year 4, using the sum of the digits method?
$
166
RC is considering acquiring an asset that will cost $350,000 to purchase. RC is considering a

lease arrangement where the lessor will charge $95,000 per annum for four years in arrears.
Tax relief at 25% is available on the interest elements of lease payments in the year that they
are made.
Using the sum of the digits method, what is the tax relief on the interest paid in Year 2?
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$
Use the following information to answer the next two questions

LW is looking to acquire new equipment. If purchased, the equipment will cost $100,000 and attract
capital allowances on a reducing balance basis at 20% per annum. The life of the equipment is
expected to be three years, with no residual value. A balancing allowance or charge will be made at
the end of the assets life.
If the equipment is leased, the lease charge will be $40,000 per annum payable in arrears, with the full
lease payment qualifying for tax relief.
LW can borrow from its bank at 12% per annum. Tax at 25% is payable one year in arrears.
167
To the nearest $000, what is the present value of the purchase option?
168
To the nearest $000, what is the present value of the lease option?
$
169
Which of the following are advantages of using an interest rate swap? Select ALL that apply.
Reduction in finance cost

Elimination of uncertainty about the levels of finance cost
Avoidance of counterparty risk
Changing the profile of debt without changing the underlying instruments
Protection of the market value of issued debt
170
6: Debt finance
37
SS has floating rate borrowing at an interest rate of LIBOR + 2%. SSs directors wish to fix the
finance costs, and have instructed the bank to arrange an interest rate swap. The bank has
quoted a swap rate of 6% versus LIBOR.
If SS enters the swap, what net interest rate will it end up paying?
171
LIBOR
6%
7%
8%
TT has fixed rate borrowing at a rate of interest of 7%. The directors wish to take advantage of
favourable movements in interest rates and so have approached the bank to discuss the
possibility of entering an interest rate swap. The bank has quoted an interest rate of 5.5%
against LIBOR.
If TT enters the swap arrangement, what interest rate will it pay?
172
5.5%
LIBOR
LIBOR 1.5%
LIBOR + 1.5%
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DD and EE are contemplating new investment projects. DD would like to pay a fixed rate of
interest on loan finance for its investment, EE would like to pay a floating rate.
The two companies have been quoted the following rates of interest:
DD
EE
Fixed
Floating
7%
LIBOR + 1%
6%
LIBOR + 0.4%
What rate of interest will the companies end up paying if they choose the arrangement that is
most advantageous to both of them? Assume that if they enter into a swap arrangement, the
gains will be shared equally.
DD 6.8% EE LIBOR + 0.2%

DD 6.8% EE LIBOR + 0.6%
DD 7% EE LIBOR + 0.6%
DD 7% EE LIBOR + 0.4%
38 6 : D e b t f i n a n c e
173
JJ and KK are contemplating new investment projects. KK would like to pay a fixed rate of
interest on loan finance for its investment, JJ would like to pay a floating rate.
The two companies have been quoted the following rates of interest:
Fixed
Floating
JJ
6%
LIBOR
KK
7%
LIBOR + 1.5%
What rate of interest will the companies end up paying if they choose the arrangement that is
most advantageous to both of them? Assume that if they enter into a swap arrangement, the
gains will be shared equally.
174
KK 7.25% JJ LIBOR + 0.25%

KK 7% JJ LIBOR
KK 6.75% JJ LIBOR - 0.25%
KK 6.5% JJ LIBOR - 0.5%
ER has 5 million $1 shares in issue and 50,000 6% coupon bonds with a par value of $100.
ER made an operating profit of $850,000 last year.
ERs directors are contemplating issuing $1 million of 4% coupon bonds.
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What will be the interest cover to 2 decimal places if the new bonds are issued, assuming
operating profit remains constant?
175
TT has profit before interest and tax of $98 million. It has borrowed $200 million from the bank
at 8% interest. TT has an interest cover covenant (based on profit before interest and tax) of
5 times.
TT proposes to borrow an additional $40 million from another bank to buy out minority
shareholders. The interest rate on this loan would be 10%.
6.13
5.10
Be breached
Not be breached
4.90
4.08
If the additional borrowing is undertaken, the interest cover would be

and the interest cover covenant would
.
176
6: Debt finance
39
PP has entered into 5-year borrowing with its bank at a floating rate of LIBOR plus 1.5%. To fix
its interest rate, it has also had the bank arrange a 5 year swap with another customer of bank Y
of 4.5% fixed against LIBOR.
Complete the sentence below by placing one of the following options in the space.
LIBOR
LIBOR plus 3%
3% fixed
4.5% fixed
6% fixed
The hedged rate, taking the borrowing and swap into account, is
.
177
Are the following statements relating to convertible bonds TRUE or FALSE?

Companies can claim tax relief on interest paid on the bonds.
Bondholders must convert the bonds into shares on the
conversion date.
178
False
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Which of the following bonds would not be issued by a company?
179
True
Fir
Deep discount bonds

Irredeemable bonds
Bonds with warrants attached
Scrip bonds
A bond has a nominal value of $50 million. It pays annual interest of $4 million in the form of
two equal payments on 30 June and 31 December. The bond is trading at $115 per $100
nominal on 1 January 20X2 and is redeemable at a 10% premium on 31 December 20X3.
How much in $m must the issuer pay the bondholder on 31 December 20X3?
$
180
Which of the following are reasons why an organisation may prefer to acquire an asset under a
finance lease rather than purchase it? Select ALL that apply.
The lease might give the organisation the chance to upgrade the asset during the terms
of the lease.
The organisation may not wish to take on the commitment to maintain and repair the
asset.
The organisation may only want the asset for a short time.
The organisations tax position may mean that it cannot benefit from the tax allowances
that are available for purchasing the asset.
40 6 : D e b t f i n a n c e
181
Which of the following statements does not apply to operating leases?
182
The lessor retains the risk and rewards of ownership

The asset appears on the statement of financial position of the lessor.
The lease is for most or all of the life of the asset.
The lessor is responsible for maintaining and servicing the asset.
Are the following statements about thin capitalisation rules TRUE or FALSE?
Interest on the part of a loan that an independent third party
would be prepared to lend the company is disallowable.
Only the borrowing capacity of the individual company and
its subsidiaries is considered, not the whole group.
183
True
False
YE is an American firm that is looking to expand in the Eurozone and is looking to raise 32
million. It can borrow in the USA at 8% and in the Eurozone at 6.7%. NH is a company located in
the Eurozone that is looking to expand in America and wants to borrow $40 million. It can
borrow in the USA at 8.5% and in the Eurozone at 6.4%. The two companies decide to enter
into a currency swap for one year. The $/ exchange rate is currently $1 = 0.8, and this is
expected to stay the same for the foreseeable future.
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Calculate the saving in $ that YE will achieve by entering the swap.

$
184
NE is a wholly-owned subsidiary of TY. At 31 December 20X6, NEs last year-end, its share
capital and reserves were $28 million, it had a bank loan of $8 million and a loan from TY of
$30 million. The loan from TY was 50% more than NE could have raised from the bank at that
time. The interest rate on both loans is 6%.
The tax authorities in the country in which NE is locates consider a company to be thinly
capitalised if its debt:equity ratio is above 75%.
Calculate the amount of interest on the loan from TY that will be eligible for tax relief to the
nearest $0.1m.
7: Capital structure
41
Chapter 7: Capital structure

185
DH has 5 million $2 shares in issue currently trading at $4.00. It also has $4 million 10%
irredeemable debenture stock currently trading at $125 per $1. The post-tax cost of debt has
been calculated as 7.5% and the cost of equity at 10.5%.
Calculate the weighted average cost of capital of DH to the nearest 0.1%.
%
186
NQ has 5 million $1 shares in issue currently trading at $3.60 cum div. NQ is about to pay a
dividend of $0.40 a share and aims to pay a constant dividend each year. It also has $10 million
7% irredeemable debenture stock currently trading at par. The post-tax cost of debt has been
calculated as 4.9%.
Calculate the weighted average cost of capital of NQ to the nearest 0.1%.
%
187
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The statement of financial position of RT shows that its financing mix consists of 15% ordinary
shares, 50% reserves and 35% debt capital. Ordinary shares consist of 7.5 million $1 shares
trading at $3.50 per share and debt capital consists of 17.5 million bonds trading at $150 per
$100 nominal. The cost of the equity capital is 14% and the cost of the debt capital is 9%.
Fir
Which is the best method of calculating the weighted average cost of capital?
188
The traditional theory of gearing states that, as gearing increases, a company's weighted
average cost of capital:
189
(30% 14%) + (70% 9%)

(50% 14%) + (50% 9%)
(65% 14%) + (35% 9%)
(66% 14%) + (34% 9%)
Rises initially then falls

Remains constant
Falls consistently
Falls initially then rises
If the financial gearing of a company increases, then
The required return on equity increases.

The required return on debt decreases.
The level of dividend decreases.
Market interest rates increase.
42 7 : C a p i t a l s t r u c t u r e
190
A company has a cost of debt of 5%, a weighted average cost of capital of 8% and a debt: equity
ratio of 1:2. What is its cost of equity?
191
3%
7%
9.5%
14%
BL is deciding whether to raise debt or equity to finance a new investment. Which of the
following factors is least likely to persuade the company to choose debt?
192
Gearing is low.
Interest rates are falling.
BL is expected to make a profit in the next year.
BL has aimed to increase dividends by 5% per annum over the last few years.
Under traditional theory, a companys target capital structure is consistent with:
Minimum cost of debt

Minimum cost of equity
Minimum weighted average cost of capital
Minimum payments to finance providers
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193
Does an entitys capital structure affect or not affect the following?

Default risk
194
Not affect
Which of the following factors might cause a company to increase the proportion of debt in its
capital structure?
195
Affect
A fall in the corporate tax rate

An increase in economic uncertainty
A fall in the base rate of interest
A fall in the market value of its shares
Which of the following is not an assumption of Modigliani and Millers 1963 gearing theory?
The capital market is strongly efficient.

Debt is risk-free.
The cost of debt varies according to the level of gearing.
Investors and companies can borrow at the same rate of interest.
196
Do the Modigliani and Miller (1963) and traditional theories of capital structure conclude that
there is an optimum capital structure at which the weighted average cost of capital is minimised
and company value is maximised?
Traditional
Optimum
level
No optimum
level
Modigliani and Miller
197
According to Modigliani and Miller, the cost of equity will always rise with greater gearing
because:
198
Interest cover is greater.

The returns to shareholders become more variable.
The tax shield on debt increases the value of equity.
The cost of debt will be falling.
EF has identical operating and risk characteristics to GH, but their capital structures differ. EF
has 20 million $1 shares, total value $80 million. GH has 10 million shares and $45 million debt.
The tax rate is 30%.
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What is the value per share of GHs equity, to the nearest $0.01?
$
199
TD and LP are identic al companies except that TD is financed entirely by equity and LP has a 1:1
debt:equity ratio. TDs cost of equity is 16% and LPs pre-tax cost of debt is 9%. Tax is payable at
30%.
What is LPs cost of equity to the nearest 0.01%?
%
200
43
PD and SJ are identical companies except that PD is financed entirely by equity and SJ has a
2.25:1 equity:debt ratio. SJs cost of equity is 18% and its pre-tax cost of debt is 6%. Tax is
payable at 25%.
What is PDs cost of equity to the nearest 0.01%?
%
201
Keeps rising
Keeps falling
Eventually rises
Falls then rises
Rises then falls
Stays the same
Eventually falls
Under the traditional view of gearing, increasing gearing will mean that the cost of equity
, the cost of debt
, the weighted average cost of capital
and the value of the company
.
202
WC has a gearing ratio of 40% (based on market values and measured as debt/debt + equity)
and a weighted average cost of capital of 11%. The tax rate is 25%.
Calculate to the nearest 0.01%, using Modigliani and Millers theory with tax, the theoretical
WACC for WC if its gearing changes to 70%.
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%

DD is currently financed solely by equity. Its shares have a market value of $40 million. DDs cost of
capital is 14% and the corporate tax rate is 25%.
DD plans to replace $16 million of equity with 8% irredeemable debt.
203
What will be DDs new value in $m?
204
What will be DDs new weighted average cost of capital, to the nearest 0.01%?
%
205
FX is an all-equity financed company with a cost of capital of 17%. Its directors wish to issue
debt and reduce its cost of capital to 15%. The tax rate is 20%.
If the cost of capital fell to 15%, what would be the gearing ratio (debt/debt + equity, using
market values) to the nearest 0.01%?
%
206
45
DP currently has 10m equity shares with a market value of $25 million and a 10% $15million
bank loan. Its directors wish to issue more shares to pay off the bank loan but are unsure of the
impact that this will have. DPs cost of equity is currently 15% and the tax rate is 25%.
Calculate the new cost of capital to the nearest 0.1% if the bank loan is paid off by the share
issue.
%
207
FC currently has a gearing ratio of 30% (based on market values and measured as debt/debt +
equity) and a weighted average cost of capital of 10.8%. The tax rate is 25%.
Calculate to the nearest 0.01%, using Modigliani and Millers theory with tax, the relative
percentage change in the weighted average cost of capital if gearing was to increase to 50%
%
208
Using the traditional model of capital structure theory, GKs weighted average cost of capital is
at its lowest when gearing = 35%.
Match the following levels of gearing to their descriptions.
209
A
B
C
D
20%
35%
60%
100%
Theoretical
Conservative
Aggressive
Wealth-maximising
Which of the following statements in relation to Modigliani and Millers 1963 with tax
hypothesis are true? Select ALL that apply.
210
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The rate of interest at which investors and companies borrow is irrelevant.

Capital structure influences the weighted average cost of capital and the value of the
entity.
Investors are indifferent between personal and corporate gearing.
Tax relief on debt causes the weighted average cost of capital to fall initially and then rise
as gearing increases.
Which of a companys sources of capital normally has the highest cost?
Preference shares
Ordinary shares
Bonds
Mezzanine debt
211
YS is currently all equity-financed and its cost of capital is 12%. It is planning to issue
irredeemable bonds with a coupon rate of 6% and have a debt:equity ratio of 1:2. The tax rate is
25%.
What will be YSs weighted average cost of capital, to the nearest 0.01%?
%
212
WY has equity with market value of $1,200 million and debt with market value of $600 million.
WY plans to issue $250 million of new shares and use the proceeds to pay off part of the debt.
WYs current cost of equity is 16% and XZ (an equivalent ungeared company operating in the
same business sector) has a cost of equity of 15%. WYs current weighted average cost of capital
is 14% and the tax rate is 25%.
According to Modigliani and Millers theory with tax, if the new share capital was issued and the
debt was paid off, WYs weighted average cost of capital would move to:
13.32% = 14% [1 (
15.03% = 16% [1 (
14.27% = 15% [1 (
0.25 350
)]
1,450
0.25 350
)]
1,800
0.25 350
1,800
0.25 350
)]
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213
14.09% = 15% [1 (
1,450
)]
YW is an ungeared company with a cost of capital of 12%. It is planning to issue 7% bonds with a
yield of 8%, so that its debt:equity ratio will be 1:3. The tax rate is 30%.
According to Modigliani and Millers theory with tax, YWs cost of equity will become:
3
0.7
13.17% = 12% + [(12% - 7%)(
13.33% = 12% + [(12% - 8%)( )]
214
13.67% = 12% + [(12% - 7%)( )]
12.93% = 12% + [(12% - 8%)(
3
1
)]
3
0.7
3
)]
Modigliani and Millers 1963 theory of capital structure with tax assumes that:
The cost of debt is zero.

The cost of equity will rise as gearing increases.
Financial distress costs will mean that the weighted average cost of capital will eventually
rise.
Investors are indifferent between dividends and capital gains.
215
47
LM has a geared cost of equity of 12% , an ungeared cost of equity of 11.53% and a WACC of
10.95%. The market value of equity is $200 million and the market value of debt is $50 million.
LM plans to redeem $25m of debt by a new share issue.
According to Modigliani and Millers theory with tax, WACC would move to:
216
18.75
11.10% = 12% [1 (
11.70% = 12% [1 (
10.67% = 11.53% [1 (
11.24% = 11.53% [1 (
250
6.25
)]
)]
250
18.75
250
6.25
250
)]
)]
KL operates in a no-tax country with the following structure:
Equity
Debt
Annual payments to investors

$m
64
12
76
Dividends
Interest
Market value
$m
400
100
500
KL plans to change its debt: equity ratio to 1:7 by the redemption of debt by the issue of new
shares. As a result the cost of equity will fall by 2%. The cost of debt will remain unchanged.
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Assuming the traditional view of gearing is correct, what will be the new market value to the
nearest $m of KL, if gearing is changed as planned?
$
217
LO is an ungeared company with a cost of equity of 11%. KT is identical in all respects to LO

except that it is financed 75% by equity and 25% by debt using market values. The tax rate is
20%.
According to Modigliani and Miller, what will be the weighted average cost of capital of the
geared company, to the nearest 0.01%?
%
218
JC makes an annual profit before interest of $8 million. Its weighted average cost of capital is
16%. JC has a total market valuation of $50 million, 80% of which is equity and $10 million of
which is 7% bonds, valued at par. JC proposes to redeem $5 million of bonds by issuing
additional share capital.
Assuming Modigliani and Millers net operating income view of capital structure is correct, what
will be the cost of equity after the reorganisation to the nearest 0.01%? Assume no tax.
%
219
LB is a ungeared company with a cost of capital of 9%. The risk-free cost of debt is 4% and the
tax rate is 20%.
According to Modigliani and Miller, what would be the cost of equity to the nearest 0.01% in a
similar geared company that was 70% equity financed and 30% debt financed?
%
220
LR is financed by a combination of equity valued at $150 million and debt capital at $40 million.
According to Modigliani and Miller, what would be the market value of an ungeared company
that was identical in all other respects to LR?
$
221
NS is an ungeared company that has a market capitalisation of $80 million and a cost of capital
of 10%. It plans to raise $20 million of fixed rate debt at 5%. The business risk profile of NS will
remain unchanged and tax can be ignored.
According to Modigliani and Millers theory, what would the new cost of equity be to the
nearest 0.01%?
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222
KT has 100 million $0.50 shares in issue, with a market price of $2.40 per share. It has 50 million
9% irredeemable debt in issue, with a current market value of 108 per cent. The cost of equity is
12% and the tax rate is 25%.
Calculate KTs weighted average cost of capital, to the nearest 0.01%.
%
223
BW is currently financed by $50 million of equity and $30 million of debt. It has a cost of equity
of 12% and a pre-tax cost of debt of 6%. The tax rate is 25%.
Calculate the cost of equity to the nearest 0.1% if BW changes its debt:equity ratio to 40%.
%
49

The following information is taken from the most recent accounts of KS.
Statement of financial position
$m
33
18
51
Non-current assets
Current assets
Total assets
Equity and liabilities
Share capital
Irredeemable preferred shares
Reserves
Long-term 8% bank loan
Trade payables
Bank overdraft
Total equity and liabilities
7
2
19
12
8
3
51
Statement of profit or loss

Operating profit
Finance costs
Profit before tax
Tax at 25%
Profit after tax
3.1
0.7
2.4
0.6
1.8
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KS is planning to raise $4 million additional debt finance at 11%. Operating profit is expected to remain
constant. Indications are that KSs bank intends to renew its overdraft facility for the indefinite future.
224
Calculate the interest cover if the new finance is raised to 2 decimal places.
225
Calculate the gearing level if the new finance is raised to the nearest 0.01%, measuring gearing
as (debt/debt + equity) and using book values.
%
226
SA has a debt/equity ratio of 1 to 3 and equity beta of 0.7. Risk free debt has a pre-tax cost of
4% per annum. The expected return on the market portfolio is 9% and tax is 25%.
What is SAs geared cost of equity to the nearest 0.1%?
%
227
The Finance Director of KH, an unlisted company, is trying to derive its cost of equity. A similar
listed company in the same sector has an equity beta of 1.35 and a debt:equity ratio of 40:60.
KHs debt:equity ratio is 20:80.
The expected return on the market portfolio is 9% and the current return on a risk-free asset is
3%. The tax rate is 25%. Debt can be assumed to be risk-free.
Calculate KHs cost of equity to the nearest 0.1%.
%
228
TRs directors are currently considering replacing all the companys debt with equity and want
to know what the new cost of capital will be. TR currently has a debt-equity ratio of 25:75 and
an equity beta of 1.6. The current return on a risk-free investment is 3% and the market risk
premium is 7%. The tax rate is 20%.
Calculate TRs ungeared cost of equity to the nearest 0.1%.
%
229
YT is looking at a potential acquisition, KS, which is an unlisted company. KS has a debt/equity

ratio of 25:75.YT needs to identify an appropriate cost of capital to be used in this calculation
and therefore it needs to identify a suitable equity beta for KS.
The following information is available about three companies that have similar business risk to
KS, but different capital structures.
Debt/equity
ratio
Equity beta
XP
30:70
1.6
ZW
15:85
1.3
QL
45:55
2.0
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Which of the following is likely to be the best estimate of KSs equity beta?
230
1.0
1.25
1.5
1.75
JM is looking to diversify and is considering the acquisition of UN, a company in a different

market sector. JM needs to calculate the cost of equity of UN as part of a valuation exercise. JM
has a debt:equity ratio of 20:80 and UN has a debt:equity ratio of 25:75.
JM has obtained information about a similar company to UN in the same business sector.
This company has a debt:equity ratio of 40:60 and an equity beta of 1.7.
The current return on a risk-free investment is 2% and the return on the market portfolio is 9%.
The tax rate is 30% and debt is assumed to be risk-free.
Calculate, to the nearest 0.1%, the cost of equity that should be used as part of the valuation of
UN.
%
231
The directors of MK are about to undertake a new investment and need to carry out an
investment appraisal. They have decided to use the Adjusted Present Value approach and
therefore need to calculate an ungeared cost of equity. MK has a debt/equity ratio of 40% and
an equity beta of 1.2. The return on risk-free assets is 5% and the expected return on the
market portfolio is 10%. The tax rate is 25%.
Calculate, to the nearest 0.1%, the cost of equity that should be used as part of the adjusted
present value calculation.
%
232
51
The directors of PN are currently considering raising debt finance to fund a new investment.
PN is currently an all-equity financed company with a Beta factor of 1.05. Taking on the debt
finance will result in a debt-equity ratio of 25:75. Debt can be assumed to be risk-free and have
a pre-tax cost of 4%. The return on the market portfolio is 12% and the tax rate is 30%.
Calculate, to the nearest 0.1%, PNs cost of equity if it uses the debt to fund the investment.
%
233
LL has a debt:equity ratio of 35% and an asset beta of 1.3. Debt has a beta of 0.2. The return on
the market portfolio is 11% and the return on a risk-free investment is 5%. The tax rate is 25%.
Calculate, to the nearest 0.1%, LLs geared cost of equity.
%
234
JN is an unlisted company with a debt/equity ratio of 30:70. JNs Finance Director wishes to
calculate its geared cost of equity, using a proxy listed company, XR, in the same industry. XRs
debt:equity ratio is 45:55 and its equity beta is 1.85. The tax rate is 30% and the beta of debt is
0.15.
Which of the following shows the correct formula for regearing XRs asset beta and hence
obtaining an equity beta for JN?
235
g = 1.18 + (1.18 0.15)
g = 1.23 + (1.23 0.15)
g = 1.18 + (1.18 0.15)
g = 1.23 + (1.23 0.15)
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45 (10.3)
55
45 (10.3)
55
30 (10.3)
70
30 (10.3)
70
The directors of ZX are considering whether to acquire BQ, an unlisted company. They are
looking to value BQ by discounting its future earnings and hence need to compute its weighted
average cost of capital.
BQ currently has a debt:equity ratio of 22:78. Its debt can be assumed to be risk-free and have a
pre-tax cost of 4%.
A similar quoted company to BQ has an equity beta of 1.4 and a debt:equity ratio of 35:65.
The expected return on the market portfolio is 11% and the tax rate is 25%.
Calculate, to the nearest 0.1%, the weighted average cost of capital of BQ.
%
52 8 : D i v i d e n d p o l i c y
Chapter 8: Dividend policy

236
Which of the following factors are company directors least likely to take into account when
setting the level of dividends for the year?
237
Which of the following is true of Modigliani and Millers theory on the relevance of dividend
policy?
238
The law on distributable profits

The previous level of dividends
The liquidity position
The level of other liabilities
The value of equity depends on the investments that the firm has selected.
Higher retentions will mean lower dividend growth.
In a perfect capital market, shareholders will prefer dividends to capital gains.
The impact of dividend policy will depend on the tax rate on investment income.
Which of the following arguments could not be used to justify a policy of not paying any
dividends?
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239
For which of the following reasons are interest costs lower than dividend costs, according to
Modigliani and Miller? Select ALL that apply.
240
Pecking order theory suggests that companies should use retained earnings as their first
source of finance.
The tax regime for capital gains is more favourable than the tax regime for dividends.
Shareholders who need cash can sell their shares rather than rely on dividend payments.
A policy of no dividends gives shareholders greater control over management.
Redemption of debt is certain.

Dissatisfied shareholders who sell their shares will be liable to transaction costs.
Dividends are paid out of pre-tax earnings.
Dividends need not be paid if a company makes a loss.
If a company reduces dividend payments, which of the following is least likely to be a reason
why its market price might fall?
Investors who need cash will sell their shares.

The market will see lower dividends as indicating poor expected performance.
Investors who do not regard dividend levels as acceptable will sell their shares.
The company is using retained earnings rather than debt to finance projects with positive
net present values.
241
8: Dividend policy
53
FT currently has a cash balance of $3 million and earnings per share of $0.60.
FT has 10 million $0.50 shares in issue but its directors are planning to repurchase 2 million
shares at a price of $0.70.
What will be the cash balance and earnings per share after the repurchase?
242
Cash $2 million EPS $0.50

Cash $2 million EPS $0.75
Cash $1.6 million EPS $0.50
GG has $5 million cash that is surplus to requirements. GGs directors have decided to
repurchase some of its shares at market value. GG has 20 million $1 shares in issue trading at
$1.25 and $10 million of bonds in issue trading at $96 per cent.
What will be the new gearing level of GG after the repurchase to the nearest 0.1%, and
measuring gearing as debt/(debt + equity) using market values?
%
243
For which of the following reasons might a scrip dividend be preferable to a normal dividend?
244
In which of the following situations is a residual dividend policy most likely to be appropriate?
245
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Keeping cash to finance investments

Increasing earnings per share
Making shares more marketable
Improving the price/earnings ratio
A large publicly listed company

A small, privately-owned and managed company where dividends are taken instead of
salaries
In a tax regime where individuals pay more tax on dividends than capital gains
A private company that has expanded over recent years, with increases in earnings and
dividends, and which is just about to be listed on its local stock exchange
PP plans to pay a special cash dividend to its shareholders. PP is funded by a mix of debt and
equity.
Which of the following is the most likely consequence of this plan?
Shareholder wealth will decrease by the value of cash paid.

Gearing levels will improve.
Shareholders will believe that PP lacks profitable opportunities for investing cash.
Earnings per share will improve.
54 8 : D i v i d e n d p o l i c y
246
Which of the following statements is consistent with Modigliani and Millers dividend
irrelevancy policy?
247
Shareholder wealth can be maximised by a residual dividend policy.

Dividend policy will have no impact on share price.
Shareholder wealth can only be increased by increases in the share price.
Shareholder return is equal to dividends plus growth in the share price.
GH is a company located in the Eurozone. GH has a foreign subsidiary, IJ, in Earland, where the
functional currency is the E$. The exchange rate is expected to be stable and currently is 1 =
E$4.
IJ has surplus cash of E$20 million. GH wishes to use these funds to pay a special dividend to its
shareholders.
The tax rate on corporate profits in Earland is 25% and there is also a 10% withholding tax on
profits remitted to overseas parent companies. GH would pay tax of 20% on profits received
from IJ.
What is the maximum after-tax amount that GH could receive in ?
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248
Which of the following are valid reasons why directors may decide to retain cash surpluses
rather than pay them as dividends? Select ALL that apply.
249
Finance from retained cash surpluses has no cost.

Using retained cash surpluses means directors can undertake investment projects
without involving shareholders.
Using retained cash surpluses avoids possible changes of control that may result from a
share issue.
Tax rates on capital gains are higher than the tax rates on dividends.
What is the residual theory of dividend policy?
A company should pay a fixed proportion of post-tax earnings as dividends each year, and
use remaining funds to finance investments.
A company should adopt a smooth dividend policy, ensuring dividends are never lower
than the previous year, and use remaining funds to finance investments.
A company should invest all available funds in projects that have positive net present
values, and only pay out dividends if no such projects are available.
Companies should prefer debt finance to equity finance if possible, as tax relief is
available on interest paid.
9: Business valuations
55
Chapter 9: Business valuations

250
The following information relates to the ordinary shares of BC.

Earnings per share
Dividend cover
Published dividend yield
50c
2.5
3.2%
The price of BC's ordinary shares implied by the data above is:
251
78c
153c
625c
3,906c
HP has 5 million $1 ordinary shares in issue, at a market value of $2.40 per share.
A proposed investment is expected to have a net present value of $1.6 million and require an
initial investment of $3 million.
If the market is efficient and the share price moves immediately to reflect this information
when the investment is announced, what is the new share price to the nearest $0.01?
$
252
The prices quoted on a stock exchange are observed to reflect only historical share price
information and other historical information about a company. Which of the following best
describes this form of market efficiency?
253
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No efficiency
Weak form efficiency
Semi-strong form efficiency
Strong form efficiency
NO is planning to acquire ON. The directors of the two companies have been involved in secret
talks with no public announcements being made. However the market price of ONs shares has
risen on the local stock exchange on the assumption that NO will make a bid for ON.
The local stock market is exhibiting what form of efficiency?
No efficiency
56 9 : B u s i n e s s v a l u a t i o n s
254
KS has 50 million $1 shares in issue. The current share price is $2.30.

A proposed investment requires initial expenditure of $25 million. The present value of net cash
flows generated by this investment is $40 million and KS does not need to raise any extra funds
to finance it.
If the stock market is efficient and the share price moves to reflect this information on the day
that the investment is announced, what is the share price likely to be at the end of the day?
255
$2.30
$2.60
$2.80
$3.10
The following data relates to CC for the year ended 31 December 20X4.
Operating profit
Depreciation and amortisation
Finance costs paid and due
Capital expenditure to sustain operations
Tax paid
Repayment of borrowings
Equity dividend paid
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$m
240
60
20
75
45
55
25
The best estimate of free cash flow to equity in $m is:

$
256
The following data relates to DF for the year ended 31 December 20X5.
Profit before tax

Finance costs paid and due
Tax paid
The best estimate of free cash flow to equity in $m is:

$
$m
360
85
25
120
80
65
40
257
57
LK is using the Calculated Intangible Value method of company valuation to value its intangible
assets.
LKs average profit before tax is $50 million. The industry average return on tangible assets is
12%. LKs tangible assets are $35 million. The tax rate is 30%. LKs cost of equity is 11%, its
WACC is 9% and its cost of debt is 6%.
Complete the calculation of CIV by placing one of the following numbers in each of the spaces.
0.09
0.11
0.70
0.30
1.09
CIV = ($50 million (12% $35 million))

258
1.11
HM is using the Calculated Intangible Value method of company valuation to value its intangible
assets.
HMs average profit before tax is $70 million. The industry average return on tangible assets is
10%. HMs tangible assets are $40 million. The tax rate is 25%. HMs cost of equity is 13%, its
WACC is 10% and its cost of debt is 6%.
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Calculate the value of the intangible assets in $m.

$
259
Fir
Companies BC and DE operate in the same industry. They have the same level of earnings but
company BC has a lower P/E ratio.
Which of the following can be deduced from the information about the two companies?
260
Company BC has higher growth prospects.

Company BC has lower market capitalisation.
Company BCs shareholders are exposed to lower risk.
Company BC has a lower share price.
The following data is available about three companies.
A
B
C
Rank the companies in descending order of market capitalisation.

A
B
C
Earnings
for the
year
$m
50
60
70
P/e ratio
10
8
7
261
Zoe is an investor in Parkinson Co, holding 250 shares in the company, worth $565 at the cum
div market price. Parkinson Co has just declared a dividend of $0.14 per share.
What is the ex-dividend value of Zoes shareholding?
$
262
LB would like to purchase AT, which is a private company. The latest accounting data for AT is as
follows.
Assets (book value)
Assets (realisable value)
Liabilities (excluding borrowings)
Borrowings (book value)
Borrowings (fair value)
Equity (book value)
$m
300
340
60
70
90
170
What is the minimum purchase price for AT in $m on an asset valuation basis?

$
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263
Which of the following is a description of the free cash flows to equity method that can be used
to value a companys equity?
264
Deduct interest and dividends to arrive at the free cash flow and then discount at the
companys WACC.
Deduct interest and dividends to arrive at the free cash flow and then discount at the
companys cost of equity.
Deduct interest but not dividends to arrive at the free cash flow and then discount at the
companys WACC.
The following data relates to GF for the year ended 31 December 20X7.
Interest
Investment in non-current assets
Dividends
Operating profit
Investment in working capital
Depreciation

Calculate GFs free cash flow.
$
$m
150
500
180
890
70
230
265
59
MW is an all-equity financed company. Its forecast post-tax cash flows before finance costs for
the next few years are expected to be as follows:
Year 1
$m
340
Year 2
$m
380
Year 3
$m
440
Year 4
$m
510
The forecast has assumed that year 4 tax cash flows will be constant into perpetuity.
MW has a cost of capital of 10%.
What is the value of MW to the nearest $100m?
$
266
The forecast post-tax cash flows of PL before finance costs for the next few years are expected
to be as follows:
Year 1
$m
400
Year 2
$m
420
Year 3
$m
450
Year 4
$m
480
The forecast cash flows are expected to grow by 5% after Year 4 into perpetuity. PL looks to
maintain a gearing ratio of 50% (measured as debt/debt + equity). PL has a cost of equity of 10%
and a weighted average cost of capital of 8%.
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What is the value of PLs equity to the nearest $100m?

$
267
YHs accounts show that it has made a retained profit of $470m, after deducting finance costs of
$40m and dividends paid of $150m. Tax allowable deprecation was $15m. YH expects profits
after tax to grow at 4% indefinitely.
YH reinvests cash to a value equal to tax allowable depreciation. YHs cost of equity is 14% and
its weighted average cost of capital is 11%.
Assuming profits are equivalent to cash flows, what is the value of YHs equity capital in $m?
$
268
SR has 50 million $0.10 shares in issue. It generated $35m free cash flow last year and this figure
is forecast to grow by 5% per annum each year.
SRs cost of equity is 15% and its weighted average cost of capital is 12%. It has 5 million bonds
in issue, trading at $90 per cent.
What is the estimated value of a share in SR to the nearest $0.01?
$
269
UJ has 1 million $0.50 ordinary shares and 200,000 $0.50 preferred shares. Its ordinary shares
are currently trading at $0.84. Its profit before tax was $240,000 and it paid tax at 25%, an
ordinary dividend of $40,000 and a preference dividend of $20,000.
What is UJs price-earnings ratio to two decimal places?
270
A low P/E ratio normally indicates:
271
Dividend payments are high.

The companys growth prospects are poor.
The share is over-priced.
The companys earnings have temporarily fallen.
YH has earnings per share of $1.80, a dividend cover of 5 and a dividend yield of 4%.
To the nearest $0.01, what is the current price of YHs ordinary shares?
$
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272
HD has earnings per share of $0.39, a dividend cover of 3 and a dividend yield of 4%. It has 2
million $0.50 equity shares in issue.
What is the current market capitalisation of HDs ordinary shares?
$
273
TH has a P/E ratio of 8 and dividend cover of 4. Its share capital is 5 million $0.50 shares and its
dividend is $0.10 per share.
What is the market price per share of TH, to the nearest $0.01?
$
274
MK has a P/E ratio of 12 and dividend cover of 2. Its share capital is 1 million $2 shares and its
dividend is $0.40 per share.
What is the market capitalisation of MK?
$
275
61
YY is a listed company. The following information is taken from its latest accounts.
$m
1,000
2,400
500
6,200
600
$0.50 ordinary shares

Share premium
$1 preferred shares
Reserves
5% bonds
The ordinary shares are trading at $1.90 and the preferred shares are not traded. The bonds are
currently trading at $103 per cent.
What is the current equity market capitalisation of YY in $m?
$
276
The operating profit in BGs latest set of accounts was $9.4m and its profit before tax was $8m.
The tax rate is 25%. BGs P/E ratio is 15. BG has nominal share capital of $0.25 shares with a
value of $2m.
What is the value per share of BG to the nearest $0.01?
$
277
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ASs current P/E ratio is 14. It has just paid a dividend of $4m and has a dividend cover of 5.
What is the market capitalisation of AS in $m, based on a P/E valuation?
$
278
NBs current P/E ratio is 10. It has just paid a dividend of $2m, following its normal practice of
retaining 80% of its earnings after tax .
What is the market capitalisation of NB in $m, based on a P/E valuation?
$
Use the following information to answer the next two questions

MH is a private company with the following financial data.
Issued share capital $0.50 shares
Profit after tax
Dividends
Cost of equity
$5m
$10.5m
$8.4m
10%
You are aware that -KJ, which is a listed company but otherwise similar in profile to MH, has recently
made profits after tax of $15m and has a market capitalisation of $120m. When valuing a private
company, it can be assumed that its value is 75% of an equivalent listed company.
279
What is the value of MH in $m, based on a P/E valuation, to the nearest $m?
$
280
What is the value of MH in $m, based on the dividend valuation model, to the nearest $m?
$
281
HG is about to undertake an initial public offering of its shares on the stock exchange. It intends
to list 25% of its 6 million shares.
HGs Finance Director has prepared the following schedule of equity valuations per share:
Nominal value
Net assets book value
Net assets net realisable value
Dividend valuation model
$
1.00
1.65
1.78
2.10
Based on this data, what will be the most likely proceeds from the share issue?
$
282
Rachel has been left a legacy of $50,000 which she plans to invest on the local stock exchange.
She understands that the stock exchange shows strong-form efficiency.
If the stock market is strong-form efficient, which of the following investment strategies should
Rachel follow?
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283
Study the financial press and invest in shares that appear to be undervalued.
Invest in three or four stable companies and hold the shares long-term.
Invest in several different companies across a number of industry sectors.
Study the financial press for company announcements and invest in companies that have
good growth prospects.
Share prices on a stock exchange are regularly observed to move when companies make
announcements about the dividends they intend to pay out.
Which of the following best describes this form of market efficiency?
284
No efficiency
JWs share capital consists of $0.25 shares with a nominal value of $2.5 million and a market
capitalisation of $45 million. JW has just announced plans for a new investment that is expected
to generate an NPV of $12 million.
Assuming strong form market efficiency, what will be the impact on the share price of JW?
No change
Increase by $0.30
Increase by $1.20
Increase by $4.80
285
63
AJ is jointly owned by its three directors, who have taken no salary from the company but have
drawn dividends. AJs latest profits after tax are $700,000. KJ, a larger company, has made an
offer for 100% of AJs share capital. KJ intends to pay the new directors of AJ $100,000. The tax
rate is 25% and KJ is using a P/E ratio of 8 to value AJ.
What is the value of AJ, based on a P/E valuation?
$
286
YE has earnings per share of $0.80, dividend cover of 2 and dividend yield of 5%. What is the
price of YEs shares implied by this data to the nearest $0.01?
$
287
Which of the following are valid criticisms of the dividend valuation model? Select ALL that
apply.
288
The cost of equity is difficult to establish with accuracy.

The model assumes that retained earnings will be reinvested to earn a return equal to
the cost of equity, which may not be true.
The model assumes shareholders have no control over the level of dividends.
The model assumes that companies have sufficient earnings to maintain dividend growth
levels, which may not be true.
The model assumes that the dividend growth rate exceeds the discount rate.
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STs cost of equity is 11%, as calculated by the dividend growth model. ST has just paid a
dividend of $0.60 per share. The market price of STs shares is $6.80.
Calculate the expected annual growth rate in dividends to the nearest 0.01%.
%
289
The following figures are taken from ONs latest set of accounts.
$000
6,000
1,400
430
180
325
Sales
Operating profits
Depreciation
Finance costs paid
Tax
ON repaid $300,000 of debt during the year and spent $750,000 on tangible assets to replace
obsolete assets. ONs working capital fell by $210,000 during the year.
Calculate ONs free cash flow.
$
290
TR intends to pay a constant dividend of $0.84 on its $1 shares for the indefinite future. The
cost of capital is 11%.
Assuming a dividend has just been paid, what is the current market value of the shares, to the
nearest $0.01?
$
291
The following figures are taken from FTs statement of financial position.
Goodwill
Non-current tangible assets
Current assets
$0.25 ordinary shares
6% $1 preferred shares
Retained profits
8% bank loan
Mezzanine debt
Current liabilities
$m
60
260
140
10
20
540
130
90
36
To the nearest $0.01, what is the value of an ordinary share in FT using the net assets basis?
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$
292
BX has paid the following dividends over the last few years, with the dividend for 20X8 having
just been paid. BXs cost of capital is 13% and the number of shares in issue over the period has
remained constant.
20X4
20X5
20X6
20X7
20X8
$
0.60
0.64
0.71
0.79
0.90
Using the dividend valuation model and the information above, what is the market value per
share of BXs shares to the nearest $?
$
293
XG looks to achieve constant growth of dividend each year, as well as retaining 40% of after-tax
earnings for future investment. XG has just paid a dividend of $0.75. It can invest the funds it
earns at 11%, which is also its cost of capital.
Using the dividend valuation model and the information above, what is the market value per
share of XGs shares to the nearest $0.1?
$
294
65
The shares of CT have a market price of $1.60. The dividend in a years time is expected to be
$0.12 per share. The required return is 14%. The board of CT wishes to increase dividends at a
constant rate each year.
Using the dividend valuation model, what is the expected growth rate of dividends each year to
the nearest 0.01%?
%
295
LZ is an all-equity financed company with a cost of capital of 14%. It is forecast to make constant
post-tax profits of $2 million. LZ pays all its profits out as dividends. LZ has 4 million shares in
issue. LZ is considering a project that would cost $4 million and generate additional earnings
before interest and tax of $1.2 million. The project would be financed by an 8% bond. The cost
of equity would rise to 15% but all earnings would continue to be paid out as dividends. The tax
rate is 20%.
Assuming the market shows semi-strong efficiency, by how much to the nearest $0.01 would
the market price per share increase when the project is announced?
$
296
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NB is an all-equity financed company with a cost of equity of 10%. It is considering raising

$12 million to finance a new investment that will carry the same business risk as NBs current
operations. NBs directors are considering raising this finance either in the form of a rights issue
or an 8% bond. The tax rate is 25%.
Fir
Excluding interest on the bond, forecast post-tax earnings for NB would be predicted to be $20
million in the first year after the new investment and remain constant after that.
What would be the valuation of NBs equity according to Modigliani and Millers theory with tax
if it issued the bond and undertook the investment?
$
297
GG is all-equity financed and has 2 million shares in issue with a market value of $7.50. GG is
considering issuing $5 million worth of debt and using the proceeds to repurchase some of the
share capital. The tax rate is 25%.
What would be the market value per share of the remaining shares, to the nearest $0.01?
$
298
MJ has 2 million $1 shares in issue. MJ paid a dividend of $100,000 last year and some of its
shareholders have indicated that they expect this dividend level to be maintained this year.
However MJ is currently suffering from a temporary shortage of cash and its directors are
considering offering shareholders a 1 for 20 scrip dividend. Profits after tax are expected to be
$150,000 and the current market price of MJs shares is $3.50 per share. MJ has accumulated
reserves of $840,000.
What is the expected market price of MJs shares after the scrip issue?
$
299
The following data is available about HJ.

Tangible assets
Industry return on tangible assets
Profit before tax
Tax rate
Weighted average cost of capital
Cost of equity
$120m
16%
$36m
25%
10%
15%
Using the Calculated Intangible Value method, calculate the value of HJs intangible assets.
$
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10: Mergers and acquisitions
67
Chapter 10: Mergers and acquisitions

300
If a company believes that it can raise its earnings per share by acquiring another company, this
is known as:
301
Bootstrapping
Economy of scale
Economy of integration
Asset stripping
Are the following statements TRUE or FALSE?

A reverse takeover is the acquisition of a smaller company by
a larger company.
Asset stripping is buying the share capital of a business and
then selling off its assets.
302
True
False
C Coffee is a nationwide chain of coffee shops in Earland. M Milk is a chain of cafes based in
Earlands capital city.
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C Coffee has made an offer to acquire M Milk.

What is this type of acquisition called?
303
What is the main role of regulators in merger and acquisition activity?
304
Horizontal integration
Vertical integration
Diversification
Market integration
Deciding whether mergers and acquisitions should be allowed

Intervening if a fair price is not being offered for the shares of the target company
Intervening if the combined company is likely to have monopoly power
Intervening to prevent directors of a target company frustrating a takeover bid
LP intends to bid for TD. TDs directors do not believe that the bid is in TDs best interests and
wish to take action before the bid is made.
Which of the following courses of action can TD take before the bid is made?
Pacman
White knight
Refer the bid to the competition authorities
Revalue non-current assets
68 1 0 : M e r g e r s a n d a c q u i s i t i o n s
305
Which of the following benefits generated from a merger is a synergy from financial economics?
306
Economies of scale
Economies of vertical integration
Economies of horizontal integration
Bootstrapping
An increase
A decrease
Higher
Bootstrapping is
Lower
in value generated
when a company acquires a company with a

P/E ratio.
307
Which of the following best describes the role of competition authorities?
Approving mergers and takeovers

Protecting the public interest by ensuring that competition is not undermined
Ruling on whether competitive behaviour is ethical
Advising the government on the operation of competition law
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308
PV is planning to acquire a new subsidiary in a different market sector. PV is using a proxy

company to derive an appropriate discount rate to use when valuing the potential acquisition
using a discounted cash flow approach.
Which of the following characteristics of the proxy should be the same as the potential
subsidiary?
309
Strategic risk
Operational risk
Business risk
Financial risk
JH is valuing a possible acquisition XV using a bootstrapping calculation.

Which of the following would not be used in a bootstrapping calculation? Select ALL that apply.
JHs earnings
XVs earnings
JHs P/E ratio
XVs P/E ratio
310
69
Which of the following strategies could not be used as a defence when a hostile takeover bid
has been received?
311
Pacman strategy
White knight strategy
Changing the companys constitution to increase the % of votes required to approve a
takeover
Appeal to the competition authorities
N Bank is about to take over Q Bank, another retail bank which has been in financial trouble in
recent years. As part of the acquisition N Bank would take over all of Q Banks property portfolio
and assume responsibility for all of Q Banks staff contracts.
Which of the following would not be a synergistic benefit of N Bank purchasing Q Bank?
312
Reduction in staff costs due to elimination of duplicated functions

Cash flow benefits due to shutting branches and disposing of property in places where
branches are duplicated
Greater profitability due to less competition in the banking sector
Reduction of business risk due to diversification achieved through the acquisition
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TH wishes to acquire LP and is deciding how best to finance the bid offer. Both companies are of
a similar size. THs directors wish to fund the acquisition by a share exchange.
Fir
Which of the following would not be a consequence of funding the acquisition by a share
exchange?
THs current shareholders would have their control diluted.

LPs shareholders would be able to participate in the future growth of TH.
THs gearing ratio would fall.
THs earnings per share would rise.
Use the following data to answer the next two questions.
PU has agreed to purchase TR at a cash price of $220 million and estimates that there will be
synergistic benefits of $50 million arising from the acquisition. PU has a market capitalisation of
$750 million and a debt/equity ratio of 40%. TR is equity-financed and has a market capitalisation of
$200 million.
313
How much can PUs shareholders expect to gain from the takeover?
$
314
How much can TRs shareholders expect to gain from the takeover?
$
315
WB is considering making a bid to buy the equity shares of PL. PL is a listed company with
50 million $1 shares in issue. WB wishes to make the minimum offer possible but wants to make
an offer that PLs shareholders would be expected to accept.
WB has valued PL in a number of different ways. The results are shown below.
Valuation method
Net assets (book value)
Net assets (market value)
Market capitalisation
P/E ratio applied to forecast earnings for next year
Value
$m
400
450
600
700
What is the minimum price per share that WB should offer PLs shareholders?
$
316
HJ is planning to acquire DL. The net present value of after-tax, after-financing, cash flows are as
follows:
NPV of HJs cash flows without the acquisition
NPV of DLs cash flows without the acquisition
NPV of the combined groups cash flows with the acquisition
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$m
200
50
280
What is the maximum price that HJ should offer for the equity of DL?
$
317
JK is a listed company that is seeking to purchase the entire share capital of an unlisted
company, MB. JK has offered to buy the shares at a price that is 25% higher than the price that
5% of MBs share capital was sold for three months ago.
Which of the following are reasons why JK has offered to pay a higher price for MBs shares?
The cash flows of the combined group are likely to be higher than the sum of the cash
flows of the two companies if they remain separate.
JK has used a cash flow method to value MB, whereas the purchaser of the 5%
shareholding used a net assets method.
JK has to pay a premium to acquire a controlling interest.
The combined group will have lower diseconomies of scale.
318
71
JD is a manufacturer of computers. It has just made a bid for GT, a manufacturer of mobile
phones based in the same country. On the day that the bid was announced, the share prices of
both companies rose.
Which of the following are explanations why the rises in share price may have occurred? Select
ALL that apply.
319
The stock markets are weakly efficient.

Synergies are forecast to be generated as a result of the takeover.
The combined group is believed to have a stronger competitive position than the two
companies individually.
The combined group is forecast to have a higher Beta factor than either of the two
companies by themselves.
The Minister for Business in Earland has asked the countrys competition authorities to
investigate the takeover by V Bank of another retail bank, H Bank.
Which of the following are possible outcomes of the referral? Select ALL that apply.
320
The takeover is blocked.

The takeover is allowed to proceed.
V Bank is forced to pay a higher price for the shares of H Bank.
V Bank is required to give a guarantee that all H Banks branches will remain open.
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Three bus companies, R, S and T operate in the Eastern region of Earland. R, the largest of the
three companies, has just made a bid for T, the smallest of the companies.
Which of the following issues are likely to be of concern to the competition authorities? Select
ALL that apply.
321
The combined group will undertake a rationalisation programme and cease operating on
some socially necessary routes.
A majority of the directors of T are opposed to the bid.
A minority of the shareholders of R is opposed to the bid.
The combined group will use its increased market power to start a price war and force S
out of business.
The combined group will use its increased market power to charge higher prices.
HH is intending to take over JU. HH has a P/E ratio of 12 and post-tax earnings of $8m, and JU
has a P/E ratio of 9 and post-tax earnings of $6m.
HHs directors have forecast that there would be synergies of $2m if the companies were
combined and that the P/E ratio of the combined company would be 10.
On the basis of these forecasts, what is the maximum that HH should pay for the equity of JU?
$
322
GF is looking to acquire RT and is deciding what consideration to use. GF does not currently
have surplus cash, and is considering raising cash from a debt issue or using a share exchange.
Using a debt issue to provide cash rather than a share-for-share exchange is least likely to have
the effect of:
323
Increasing GFs earnings per share

Increasing GFs gearing
Diluting GFs shareholders control of the company
Increasing GFs cost of equity
HG has taken over UP having paid a price that was above UPs current market price. HG is a
geared company and the purchase consideration was a share-for-share exchange.
Which of the following are likely consequences of the takeover? Select ALL that apply.
324
An increase in HGs gearing

An increase in HGs share price
A dilution of earnings of HG
A reduction in the control of HG by its existing shareholders
HY is contemplating a bid for the share capital of JI. HY currently has significant cash reserves
but a gearing level that is higher than the industry average.
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Which of the following would be the least suitable method of consideration for purchasing HY?
325
What is an earnout?
326
Cash offer, funded from current cash balances

Cash offer, funded by a rights issue
Share for share exchange
Debt for share exchange
Valuation of a company using the price-earnings ratio

A situation where a company has no suitable investments in which to invest excess
earnings
Sale of a business, where part of the consideration received by the owners is linked to
the performance of the business after the sale
A company having insufficient earnings to maintain dividend levels
HE intends to purchase TW and is reviewing the post-acquisition value of the combined group
using bootstrapping.
The method it will use will be:
Discounting future cash flows at an adjusted weighted average cost of capital

Ungearing and regearing the cost of equity that is applied to returns to shareholders
Applying the current price-earnings ratio of HE to the combined post-tax earnings of the
new group
Adjusting the combined market capitalisation of the two companies for the synergies
that the acquisition will generate.
327
73
The directors of YI are about to make a bid for a smaller company. KJ. The directors see much of
the value of KJ as being due to the strong business relations that its directors have built up with
major customers and wish to retain this goodwill in the merged company.
From the viewpoint of YI, which of the following methods of consideration would be most
suitable?
328
Cash offer
Share for share exchange
Earnout
HG has bid for 100% of the share capital of LV, and intends to use a share for share exchange as
consideration for the purchase. The shares of HG are trading at a P/E ratio of 15 and the shares
of LV are trading at a P/E ratio of 11. The profits of both companies are expected to remain the
same after the takeover and no synergies are expected from the takeover.
What will happen to the earnings per share of the combined group after the takeover?
329
Earnings per share will rise.

Earnings per share will fall.
Earnings per share will remain the same
We cannot tell from the information provided what will happen to earnings per share.
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IK is negotiating to buy RT and has made a bid of $10 million, which RTs directors have rejected.
IK has proposed an amended offer, adding an earnout arrangement, as follows.
If average annual operating profits of RT exceed $2 million, additional consideration will be

payable at the following rates:
40% of operating profits for the three years if average annual operating profits exceed
$2 million, up to a maximum of $2.5 million.
$2.5 million, up to a maximum of $3 million.
$3 million, up to a maximum of $5 million.
The probabilities associated with these profit levels are 0.25, 0.15 and 0.1 respectively.
Calculate the minimum consideration that IK will have to pay to the nearest $0.01m.
$
330
KH has made an offer to buy the share capital of MM on a P/E ratio of 12. The purchase
consideration will be half in new shares of KH and half in cash. The value of KH shares will be
taken at their current market price.
The following information is available about the two companies.
Annual earnings
P/E ratio
KH
$10 million
25 million
10
MM
$5 million
10 million
12
What is the share exchange element of the purchase consideration?
331
1 KH share for 2 MM shares

2 KH shares for 1 MM share
3 KH shares for 4 MM shares
Which of the following defences against a hostile takeover bid are open to the directors of the
target company? Select ALL that apply.
Refer the bid to the competition authorities

Refuse to pass on details of the bid to shareholders
Launch a publicity campaign against the bid
Issue a forecast of attractive future profits to persuade shareholders that the bid is too
low
Find an alternative buyer
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332
JKs shares are being quoted at a market price of $6.00 and a price-earnings ratio of 12. JK has
just made a takeover bid for TY at a price of $3.00 per share with the suggested purchase
consideration being one share in JK for every two shares in TY. TYs earnings per share is $0.15
and the current market price of its shares is currently $1.96.
Which of the following methods could not be used by JK to reduce dilution in earnings per share
after the takeover?
Achieve synergies in TYs operations

Buy the shares for TY in cash rather than shares
Sell off unprofitable parts of TYs business
Revalue TYs non-current assets to a higher valuation
333
75
The most recent results of LK are as follows.

$000
5,000
400
4,600
900
3,700
350
3,350
Operating profit
Finance costs
Profit before tax
Tax
Profit after tax
Dividend
Retained profits
LK has 4 million $0.25 shares in issue. MD has agreed to buy 100% of LKs share capital on a
price/earnings ratio of 8.
Calculate the price per share offered by MD to the nearest $0.01.
$
334
Which of the following would not be an argument in favour of offering shares for a takeover
rather than cash?
335
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Which of the following are examples of poison pills in the context of mergers and acquisitions?
336
The issue of loan capital to fund a cash offer may result in unacceptably high gearing.
The owners of the acquired company will not be subject to an immediate tax liability if
the consideration is shares.
A cash offer may result in a fall in earnings per share, a share offer will not.
A share offer may persuade the shareholders of the target company to sell, by giving
them a stake in the new company.
The target company issues additional shares to existing shareholders.

The target company launches an advertising campaign denigrating the potential
purchaser.
The target company takes on large debts to make gearing too high to be attractive.
The target company revalues assets to higher values to persuade shareholders that the
bid is too low.
CK plans to acquire the share capital of ND. The terms of the offer are one share in CK for every
two shares in ND. The nominal value of CKs share capital is $0.50 per share, total value
$6 million. The nominal value of NDs share capital is $0.40 per share, total value $2 million
CKs after tax profit is $1.5 million and NDs after tax profit is $600,000. CK expects to achieve
post-tax cost savings of $300,000 as a result of the takeover.
What will be the expected earnings per share in the combined group after the acquisition, to
the nearest $0.01?
$
337
LEs bid for the shares of MA has been accepted by the shareholders of MA. LEs bid involves the
exchange of 2 shares in LE for 3 shares in MA. The takeover is expected to result in post-tax cost
savings of $5 million. As the stock market is efficient, LEs share price is expected to change to
reflect these savings but its P/E ratio is expected to remain at 12.
LEs share capital consists of 40 million $1 shares and MAs share capital consists of 30 million
$0.75 shares. LEs profit after tax is $16 million and MAs profit after tax is $12 million.
How much would a holder of 1,000 shares in LE expect to gain from the takeover, to the nearest $?
$
338
NQs directors believe that the company should lower the business risks that it faces by
diversification.
Acquisition of which of the following businesses is most likely to provide the diversification that
the directors require?
A company making complementary products

A company making substitute products
A company in a different industry sector
A significant supplier
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339
The directors of ID believe that the companys current operations do not utilise fully the skills of
its management and as a result the company is not fulfilling its potential.
Which of the following should ID acquire, in order for its managers to be able to fulfil their
potential?
340
A competitor that is operating below capacity

A company operating in a different industrial sector with high growth potential, but
which lacks strategic focus and operational efficiency
A company making complementary products
A company with a similar customer profile
UT is considering making an offer on a share-for-share exchange basis for 100% of the share
capital of YH. UTs profit after tax is $31.25 million and its price-earnings ratio is 20. YHs profit
after tax is $25 million and its price earnings ratio is 10. UT has 50 million $1 shares in issue and
YH has 20 million $1 shares in issue. To attract YHs shareholders, UT is prepared to offer a
premium of 25% on YHs current share price.
How many shares should UT issue to acquire YH?
m
341
PS intends to acquire KL and pay a price that represents a higher P/E valuation than KLs current
valuation. The purchase consideration will consist of shares in PL. There are no synergies arising
from the acquisition. PS has a debt/equity ratio of 40%.
Which of the following would not be a consequence of the acquisition?
A reduction in the % stake in PS of PSs existing shareholders

A dilution of PSs earnings per share
A reduction in PSs gearing
Lower interest costs for PS
342
77
QS is considering making an offer for the share capital of KB. QSs profit after tax is $12.5 million
and its price-earnings ratio is 12. KBs profit after tax is $6 million and its P/E ratio is 9. QS has
20 million $1 shares in issue and KB has 15 million $1 shares in issue. The offer is three new
shares in QS for every four shares in KB.
What to the nearest 0.01% is the premium being offered to the shareholders of KB?
%
343
The directors of GD are discussing with the directors of AQ the possibility of a merger between
the two companies. GDs profit after tax is $25 million and its price-earnings ratio is 18. KBs
profit after tax is $9 million and its price earnings ratio is 15. GD has 15 million $1 shares in issue
and KB has 20 million $1 shares in issue. The directors of both companies believe that the
merger will result in $3 million synergies.
The proposed terms of the merger are one share in GD for two shares in AQ.
What to the nearest $0.01 would be the dilution in earnings per share from the merger for the
current shareholders of GD?
$
344
What is the value of the bid?

$
345
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JK has made an offer for the share capital of WR. JKs profit after tax is $10 million and its priceearnings ratio is 16. WRs profit after tax is $8 million. JK has 80 million $1 shares in issue and
WR has 30 million $1 shares in issue. The offer is three new shares in JK for every four shares in
WR.
The shareholders of LQ have accepted a bid for their shares from MS. The purchase
consideration will be in the form of two shares in MS for every three shares in LQ. LQs profit
after tax is $3.8 million and it has 6 million shares in issue, share price $2.40. MSs profit after
tax is $21 million and it has 15 million shares in issue, share price $4.00. The tax rate is 25%.
The acquisition is expected to produce some synergies.
By how much must pre-tax profit increase for the shareholders of MS not to suffer any earnings
dilution? Give your answer to the nearest $0.1 million.
$
346
HW is considering making a takeover bid for MK and is planning to offer a debt for share
exchange.
In which of these circumstances would a debt for share exchange be least suitable?
HW has a higher gearing level than the industry average.

MKs shareholders want to maintain an interest in the combined company.
HWs shareholders do not want to suffer a dilution of their control.
MKs shareholders wish to defer a capital gain on the sale of shares.
347
MJ is considering acquiring HS using a share-for-share exchange. MJ currently has 30 million

$0.50 shares in issue and HS currently has 5 million $1 shares in issue. The market price of MJs
shares is $3.60 and the market price of HSs shares is $6. HSs shareholders have indicated that
they require a 20% premium on the current market price of their shares.
Calculate the number of shares in MJ that the shareholders of HS will receive as consideration.
348
What can be defined as an investor acquiring a controlling interest in a companys equity and
where a significant percentage of the purchase price is financed by borrowings?
349
Mezzanine finance
Warrant finance
Leveraged buyout
Venture capital
ES is considering raising $4 million of debt finance to fund the acquisition of BU. ESs directors
have estimated that the value of BU to the BS group, taking into account post-acquisition
synergies, is $4.8 million.
ES currently has long-term debt of $3.5 million, share capital of $6 million and accumulated
reserves of $5.7 million.
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What will be the gearing ratio, measured as (Debt/Debt+Equity) and using book values of ES, to
the nearest 0.01% if it acquires BU?
%
350
GY is planning to acquire WT. GYs post-tax earnings are $45 million and it has a P/E ratio of 12.
WTs post-tax earnings are $20 million and it has a P/E ratio of 9.
Using bootstrapping to calculate the value of the combined group, calculate the value of the
synergies that will be generated by the combination of the two groups.
$
351
HD has recently made a bid for NW and has offered the shareholders of NW 3 shares in HD for
every 4 shares in NW. After the offer was announced, the market price of HDs shares fell by 5%
and the market price of NWs shares rose.
Identify whether the following statements in relation to market opinion are true or false.
The market believes that the shareholders of HD will receive
most of the benefits from the acquisition.
The market believes that the consideration that HD is offering
for NWs shares is too low.
True
False
352
79
HW has made an offer for MQ on the basis of a one for four share exchange (one share in HW
for four shares in MQ). The directors of the two companies believe that the acquisition will
generate $4 million synergies. HW has 15 million shares, trading at $9.80 and MQ has 12 million
shares in issue, trading at $2.30.
To the nearest $0.01, what is the expected share price of the combined company after the
merger?
$
353
OR has agreed to purchase all of RVs shares for cash. ORs profit after tax is $36m, it has share
capital of 50 million $0.50 shares and its current share price is $9.00. The current share price of
RVs shares is $4.00, it has 20 million $1 shares and earnings per share of $0.40. ORs directors
believe that it can maintain its current P/E ratio once it has acquired RV.
Assuming ORs directors are correct about the companys maintaining its P/E ratio, calculate the
synergies that the combination will achieve.
$
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QA is planning to make a bid for MV. QA currently has 80 million $0.10 shares in issue with a market
price of $1.20. MV currently has 5 million S1 shares in issue with a market price of $9.00.
Fir
The directors of QA are planning to offer the shareholders of MV 8 QA shares for every 1 MV share.
They estimate that the combined company will be able to achieve synergies of $12 million.
354
Calculate the gain in wealth for the shareholders of QA if the bid is accepted.
$
355
Calculate the gain in wealth for the shareholders of MV if the bid is accepted.
$
356
JL offered 1 of its shares for every 2.5 shares in NF, a company that JL wishes to acquire. NFs
shareholders turned down this bid on the grounds that it undervalues NF as indicated by the
current market price. JLs directors are considering improving their offer, but are coming under
pressure from JLs institutional shareholders who wish JL to minimise the premium it pays for
acquiring NFs shares. The current market price of JLs shares is $4.45 and the current market
price of NFs shares is $1.90.
Which of the following offers is likely to be acceptable to the shareholders of NF and fulfil the
requirements of the institutional shareholders of JL?
1 share in JL for every 2.25 shares in NF

357
The directors of XQ are planning to make a bid for VZ. XQ currently has 20 million shares in issue
with a market price of $4.40. VZ currently has 8 million shares in issue with a market price of
$2.00.
The directors of XQ are planning to offer the shareholders of VZ one XQ share for every two VZ
shares. They estimate that the combined company will be able to achieve synergies of $8.8
million.
Calculate the % share of the synergy gain that will accrue to the shareholders of VZ, to the
nearest 0.1%.
%
358
The directors of MN are planning to make a bid for DX, offering a cash offer of $4.50 per DX
share. MN currently has 20 million shares in issue at a current share price of $7.30. DX currently
has 5 million shares in issue at a current share price of $4.10. The directors of MN estimate that
the acquisition will result in synergistic benefits of $12 million.
Calculate the increase in wealth of MNs shareholders if the bid is accepted.
$
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359
ML and FR recently merged. Prior to the merger the market capitalisation of ML was $25 million
and the market capitalisation of FR was $15 million. The merger was by means of a share
exchange with MLs shareholders holding 60% of the shares of the merged company.
The directors of the merged company decided to sell off $5 million of surplus assets which they
estimated could be sold without impacting upon the continuing profitability of the merged
company. The sale proceeds were used to make an investment with an expected net present
value of $7 million.
Calculate the increase in wealth of FRs shareholders to the nearest $0.1m.
$
11: Business reorganisations
81
Chapter 11: Business reorganisations

360
Which of the following are reasons for undertaking a sell-off? Select ALL that apply.
361
Which of the following are reasons why a management buyout of a subsidiary may be
successful? Select ALL that apply.
362
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Venture capitalist funding generally consists of 100% equity finance to give the venture
capitalist control of the company.
Venture capitalist funding generally consists of 100% debt finance as equity is too risky.
Venture capitalist funding generally consists of 100% debt finance to gain tax relief on
interest.
Venture capitalist funding consists of a mixture of equity and debt, to avoid taking
control of the company, but to gain the benefit of high returns on equity.
Which of the following are reasons why a company might undertake a spin-off? Select ALL that
apply.
364
Managers are more motivated

Loss of inter-group synergies
Managers can make changes quicker if they dont need parent company approval
The business is no longer involved in transfer pricing arrangements
Which of the following explanations generally apply to venture capitalist funding of a

management buyout?
363
Reduce the risk of a takeover

Generate cash to overcome liquidity problems
Dispose of a less profitable business
Clarify the management structure
Increase economies of scale

Raise cash
Reduce the risk of a takeover bid
Comply with legal and regulatory requirements
SS Co is seeking finance from a venture capitalist. The venture capitalist is considering whether
the finance should take the form of debt or convertible preference shares.
For which of the following reasons is a venture capitalist likely to prefer debt?
The venture capitalist will be forced to convert the preference shares into ordinary equity
shares.
The % dividend on the convertible preference shares will be lower than the % interest on
debt.
Debt interest is paid ahead of preference share dividends.
Preference shares are less marketable than debt.
82 1 1 : B u s i n e s s r e o r g a n i s a t i o n s
365
DD is about to sell one of its divisions as it is making lower profits than the rest of the DD group.
Which of the following valuation approaches is the seller likely to use when negotiating the
selling price?
366
The directors of the LK group wish to dispose of one of its subsidiary companies. The directors
of the subsidiary are interested in a management buy-out. There is a potential conflict of
interest if, during the negotiation phase of the management buyout, the directors of the
subsidiary company were to:
367
Net asset approach

Discounted cash flow analysis at purchasers cost of equity
Discounted cash flow analysis at DDs weighted average cost of capital
Discounted cash flow analysis at purchasers weighted average cost of capital
Employ more staff

Factor receivables
Use surplus cash for a major investment with a positive present value
Make a general provision against the value of assets
Sue and Jo founded a new company a few years ago, owning 100% of the share capital between
them. They now wish to realise the full value of their investment but will not be able to obtain a
stock exchange listing.
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Which of the following methods would not be an appropriate method for Sue and Jo to realise
their investment?
368
Placing
Management buy-out
Private equity buy-in
Trade sales
MD is selling off an unprofitable subsidiary called KJ to TH. TH intends KJ to become a division of

TH, and expects this division to generate higher profits than it did as a subsidiary of KJ.
Which of the following are explanations of why TH may be able to generate greater returns out
of KJ? Select ALL that apply.
TH will apply a lower cost of capital to assess KJs cash flows.

Diseconomies of scale will be higher.
TH can apply economies of scope to KJs operations.
There will be strategic synergies between TH and KJ.
369
11: Business reorganisations
83
HN has been struggling in recent years and its directors are currently deciding whether to
continue in business.
The following figures are taken from its latest accounts.
$000
780
420
240
680
210
Non-current assets
Inventory
Trade receivables
Trade payables
Bank overdraft
HNs directors have valued its non-current assets and estimate that their realisable value is 75%
of their book value. The inventory would have to be written down by 15% if disposed of on an
immediate sale. A debt factor has valued trade receivables at $205,000.
Calculate the net cash available to shareholders if HN did not continue as a going concern.
$
370
BN has agreed to sell an under-performing business unit to the managers of that business unit
for $720 million. The managers have agreed a financing package for the management buyout
with the bank and a venture capitalist. The managers have agreed to subscribe $100 million for
share capital and the venture capitalist has agreed to subscribe $300 million for share capital.
The remaining finance will consist of 2 loans of $160 million, one from the venture capitalist,
one from the bank. The venture capitalist expects a return of at least 20% on the equity portion
of its investment over the first 4 years of the management buyout.
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What is the minimum total equity value of the management buyout after 4 years, to the nearest
$0.01m required to satisfy the venture capitalist?
$
84 1 1 : B u s i n e s s r e o r g a n i s a t i o n s
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Answers to 1: Business objectives
85
Answers to chapter questions
Chapter 1: Business objectives

1
Company Y has higher expected growth than Company X.
5 times
Interest cover =
P/E ratio =
=
Profit before interest, here operating profit

= 50/10 = 5
Interest payable
Market valuation of shares

Operating proft Interest Tax
(8 10)
(30 6 8)
=5
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Maximisation of the present value of future cash flows
Shareholders will be more concerned about future cash flows than about profit maximisation in
the present.
Interest rates in the economy have risen.
Equity shareholders
For-profit entities have financial objectives, not-for-profit entities dont.
The agency problem arises because managers have low accountability to shareholders and
access to better information as shareholders.
Public sector, for-profit entity
10
30.4%
(4 0.95)/(20 0.5 1.25) = 30.4%
86 A n s w e r s t o 1 : B u s i n e s s o b j e c t i v e s
11
13.9%
((7.60 7.20) + 0.60)/7.20 100% = 13.9%
12
Profit before interest and tax
13
1.33
P/E ratio = Dividend payout ratio/Dividend yield = 12/9 = 1.33
14
3.1%
Dividend yield = Dividend payout ratio/P/E ratio

Dividend yield = 25/8 = 3.1%
15
40%
Dividend payout ratio = Dividend yield P/E ratio = 8% 5 = 40%
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16
1.07
Asset turnover = ROCE/Operating profit margin = 16/15 = 1.07
12.5
17
Operating profit margin = ROCE/Asset turnover = 25/2 = 12.5%
18
Public sector, not-for-profit entity
19
25%:15%
Operating profit margin: ($200,000 $100,000 $50,000)/$200,000 = 25%

Profit before tax to revenue: ($200,000 $100,000 $50,000 $20,000)/$200,000 = 15%
20
2.5
($200,000 $100,000 $50,000)/$20,000 = 2.5
21
Variable costs are the highest proportion of its expenses.
87
22
23
Import prices
Increase
Decrease
Export prices
The has depreciated and European buyers will find US goods to be more expensive.
9.22
24
4(7.4/5.2) 1 = 9.22%
4.26
25
3(0.34/0.30) 1 = 4.26%
0.1427
26
0.1400 (1.05/1.03) = 0.1427
0.6081
27
0.6200 (1.02/1.04) = 0.6081
1.1059
28
1.2500 0.963 = 1.1059
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9.7491
29
9.2000 (1.05/1.02)2 = 9.7491
30
60700
Exchange rate in a years time = 9.7000 (1.06/1.04) = 9.8865

Purchases = Y600,000/9.8865 = R60,689, here R60,700
31
505800
Value of purchases = 280,000 1.800 (1.04/1.025)0.25 = $505,834, here $505,800
88 A n s w e r s t o 1 : B u s i n e s s o b j e c t i v e s
32
A charity
33
O/D= 200,000 (10,000,000 5,400,000 4,000,000) + (5,400,000 90/360) = $950,000

Available facility = $1,000,000 - $950,000 = $50,000
4.00
34
20X6 EPS = 200/50 = $4

20X9 EPS = 270/60 = $4.50
Growth rate = 3(4.5/4) 1 = 4.00%
35
The objectives of CH will be more difficult to define.
CH will have to demonstrate value for money.
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36
Efficiency means doing things as quickly as possible.
Efficiency does not necessarily mean doing things as quickly as possible. It means getting the
best use out of the money spent, looking at the input/output ratio.
37
Interest rates fall.
Interest rates are likely to rise, to counter the effect of inflation.
38
A rise in the level of government borrowing
Greater demand for borrowing from businesses
16
39
Dividend yield = Dividends/Market capitalisation = $400,000/(1m $2.50) = 0.16, 16%
40
Earnings per share
This will partly depend on the number of shares each company has issued, which is not an
indication of profitability.
41
89
1.67
Dividend per share = $2.40 0.05 = $0.12
Earnings per share = $2.40/12 = $0.20
Dividend cover = $0.20/$0.12 = 1.67
42
25
Earnings yield = Profits after tax/Market capitalisation = ($1.5m/4m $1.50) = 25%
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90 Answers to 2: Sustainability & integrated reporting
Chapter 2: Sustainability and integrated reporting

43
Stakeholder Engagement
44
Improve quality of information available to providers of financial capital
45
Clarity
Comparability
Intellectual capitals
46
47
Capitals in integrated reporting can be defined as resources
and relationships
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Integrated reporting is part of sustainability reporting.
48
49
r
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50
True
False
Information can be omitted if it is subject to confidentiality constraints.
Accuracy
Ethical
Answers to 3: Financial strategy
91
Chapter 3: Financial strategy

51
Paying out a dividend
Yes
No
Making a bonus issue
Yes
No
52
Raising new equity finance
Raising new debt finance
53
Promotion of social objectives
Protection of customers from monopoly power
54
Harder Higher
55
Meet future needs
Maintain sufficient balances to be able to complete day-to-day transactions
100% equity - 16%, 75% equity 19.2%
56
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EBIT
Finance cost ($2m 25% 8%)
Profit before tax
Tax
Profit after tax
100%
$
400
400
80
320
ROE 100% = 320/2,000 = 16%

ROE 75% = 288/1,500 = 19.2%
57
The dividend objective only
Dividend growth rate = 4(1.1/0.8) 1 = 8.29%

Gearing = (6 1.15)/(5 2.62) = 52.7%
58
Making directors remuneration partly dependent on increases in share price
Investing in projects with a positive net present value
75%
$
400
40
360
72
288
92 A n s w e r s t o 3 : F i n a n c i a l s t r a t e g y
59
Transaction
Precautionary
60
61
New equity subscribed by the directors
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Answers to 4: Hedge accounting
93
Chapter 4: Hedge accounting

62
The hedge is expected to be at least 90% effective.
The requirement is that the hedge must be highly effective.
80.4
63
%
Investment
$m
$m
100/1.6
62.50
100/1.65
60.61
1.89
1 April 20X4
31 March 20X5
Difference
$m
80/1.6
80/1.65
Loan
$m
50.00
48.48
1.52
Hedge effectiveness = 1.52/1.89 = 80.4%
64
IAS 39 up to 31 December 2017, IFRS 9 thereafter
65
Futures contracts require a margin deposit.
66
Credit statement of profit or loss gain of $10,000
67
Changes in the value of assets or liabilities
Unrecognised firm commitment
Identified part of an asset, liability or firm commitment that is attributable to a particular

risk and could affect profit or loss
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Variability in cash flows and net investments in foreign operations are subject to separate
hedging rules.
68
Maximum exposure to credit risk
Management of liquidity risk
Maturity analysis of financial liabilities
Sensitivity analysis to currency risk
69
Exposure to losses of goods in transit
70
(500)
94 A n s w e r s t o 4 : H e d g e a c c o u n t i n g
71
The two losses would cancel each other out.
72
If a business is using hedge accounting in relation to a net investment in a foreign operation,

both the investment and the borrowing must be translated at closing rate at each year end and
gains or losses on both items should be offset in other comprehensive income.
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Answers to 5: Equity finance
95
Chapter 5: Equity finance

73
$3.80
TERP =
4+1
74
[(4 $4) + $3] = $3.80
$0.45
TERP =
3+1
[(3 $3) + $2.40] = $2.85
Value of right = TERP Issue price = $2.85 $2.40 = $0.45
75
$0.58
1
10
Yield-adjusted price = 4+1 [(4 $0.60) + (( 8 ) $0.40) ] = $0.58

76
1.00
$
TERP =
5+1
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[(5 $5) + 3.80] = $4.80
Value of right = TERP Issue price = $4.80 $3.80 = $1.00
77
1.28
Yield-adjusted price =
78
4+1
4.10
[(4 $1.32) + (( ) $0.80)] = $1.28
[(5 $4.40) + (2 $3.35)] = $4.10
1.44
79
1
TERP = 4+1 [(4 $1.50) + (1.50 (1 0.2)] = $1.44

80
$Nil
81
Issue price < Ex rights < Cum rights
The issue price is less than the other prices to make the shares attractive, and shares with the
benefits of rights will be more attractive than those without.
96 A n s w e r s t o 5 : E q u i t y f i n a n c e
82
$5,000,000
TERP =
+1
$2.80 =
((N cum rights price) + issue price)
4+1
((4 $3.00) + issue price)
Issue price = ($2.80 5) (4 $3.00) = $2.00

Issue proceeds = (10 million/4) $2.00= $5 million
83
$3.20
TERP =
3+2
[(3 $4) + (2 $2)] = $3.20
84
True
False
Following a rights issue, a companys share price is likely to fall.
Following a rights issue, the total value of a companys ordinary

shares is likely to fall.
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85
1 for 2
TERP =
$7 =
+1
+1
((N cum-rights price) + issue price)
((N $8) + $5)
7(N+1) = 8N+5
7N+7 = 8N+5
N=2
86
The providers of equity finance face greater risk than the providers of debt finance, because of
greater uncertainty about their return and greater variability of their return. As a result
providers of equity finance will require a greater level of return on their investment than
providers of debt.
87
88
122500
200,000 0.25 $3.50 0.7 = $122,500

The discount must be on market value as companies are not allowed to issue shares at a
discount on nominal value.
89
14.8
97
m
Number of shares
applied for at
price
000
500
800
1,200
1,700
2,400
3,300
9,900
$
4.00
3.90
3.80
3.70
3.60
3.50
Cumulative
number of shares
applied for
000
500
1,300
2,500
4,200
6,600
3,300
9,900
At $3.70 cumulative number of applications exceeds 4 million, therefore issue price is $3.70.
Proceeds = 4m $3.70 = $14.8m
90
$0.75
Value of right = Change in share price/Number of rights per share = ($0.30/(2/5)) = $0.75
91
ke =
=
92
d1
+g
P0
3(1.15)
150
+ 0.15 = 0.173, or 17.3%
9.5%
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17.3%
V
+ kd (1 t) D
VE + VD
VE + VD
WACC = ke
8 = ke (
)+5(
2+1
ke = 9.5%
93
VE
2+1
9.8%
g = bR
g = 0.7 0.14 = 9.8%
94
True
False
An increase in the dividend growth rate would result in a lower

share price
An increase in the cost of equity would result in a lower share price.
95
If dividends are expected to grow, the dividend expected next year should be used in the
calculation. If a realistic cost of equity is to be calculated, it is necessary to know the market
value of shares.
12.5
96
ke =
d
P0
0.50
= 12.5%
(4.00)
9.3
97
ke =
d
P0
0.40
(4.70 0.40 )
16.8
98
d1
0.40
4.30
= 9.3%
%
1.20
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ke =
P0
+ g=
+ 0.04 = 0.168 16.8%
9.40
17.6
99
ke =
d0 [1+ g]
P0
+g
g = 0.4 0.3 = 0.12

ke =
0.20 (1+0.12)
+ 0.12 = 0.176 17.6%
(4.200.20)
14.2
100
ke =
d0 [1+ g]
P0
+g
g = 0.1 (1 0.4) = 0.06

ke=
0.20 (1+0.06)
2.60
+ 0.06 = 0.142 14.2%
22.2
101
ke =
d0 [1+ g]
99
+g
P0
0.45
g = (3(0.28)) 1 = 17.1%
ke =
0.45 (1+0.171)
10.30
4.0
102
kpref =
103
+ 0.171 = 0.222 22.2%
d
P0
0.05 2
2.50
= 0.04 4%
16.20
$
P0 =
d0 [1+ g]
ke - g
0.60 (1+0.08)
(0.120.08)
6.7
104
kpref =
d
P0
%
0.07
(1.120.07)
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Fir
= $16.20
= 0.067 6.7%
The growth rate only applies to the ordinary shares, not the preferred shares.
105
The cost of debt capital would not change.
The share price would go up.
More investment projects would be worth undertaking.
2.1
106
ke =
d0 [1+ g]
0.18 =
P0
+g
1.25 (1+)
(8.00)
8 0.18 = 1.25 + 1.25g + 8g

9.25g = 0.19
g = 0.021 or 2.1%
107
21.40
$
P0 =
d1
ke - g
0.80 (1+0.07)
(0.110.07)
14.0
108
ke =
d0 [1+ g]
P0
+ g=
109
Introduction
110
Placing
= $21.40
%
1.00 (10.05)
(6.001.00)
0.05 = 0.14 14%
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111
Enhancing existing shareholders control over the company
A listing is likely to mean that a company attracts a wider range of shareholders, which is likely
to dilute the control of existing shareholders.
112
Underwriting
113
14.00%
ke = Rf + [Rm Rf]
15.6 = 6 + [Rm 6]1.2

1.2 Rm = 16.8
Rm = 14%
114
13%
ke = Rf + (Rm Rf)
ke = 6% + (11% 6%) 1.4 = 13%
115
14.8%
Using CAPM, for X ke = Rf + [Rm Rf]

16.2 = 5 + (Rm 5) 1.6
Rm = 12%
For Y ke = 5 + (12 5) 1.4 = 14.8%
116
101
15.0%
Rm Rf = excess return
ke = 3% + (8%) 1.5 = 15.0%
117
Primary markets are where shares and bonds trade on an initial offering and secondary
markets are where shares and bonds trade after their initial offering.
118
An underwriter
119
Make the shares attractive to existing shareholders
Safeguard against a fall in the market value during the offer period
120
A company is financed entirely by equity. It is about to invest in a project with a positive net
present value, using a new issue of shares to finance the project. The directors are concerned
that current shareholders will object to the issue, as it will dilute the value of their shareholding.
In order to ensure that the current shareholders gain all the benefits of the new project, the
issue price of each share must be greater than the market value of each share.
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121
$
1000000
Existing market value 2m $4

NPV
Issue proceeds
New value of company
Number of shares = 2m + (2.66m/$4 0.95) = 2.7m

Value per share = 12.15m/2.7m = $4.50
Gain per share = $4.50 - $4.00 = $0.50
Total gain = $0.50 2m = $1m
122
0.70
Gain = $4.50 ($4 0.95) = $0.70
$000
8,000
1,490
2,660
12,150
123
4.30
$000
80,000
6,000
86,000
Existing market value 20m $4

NPV
For gain to go to existing shareholders,

Issue price = New value/current number of shares = $86m/20m = $4.30
62.5
124
%
$000
12,500
8,000
5,400
25,900
Existing market value 5m $2.50

NPV
Issue proceeds
Number of shares = 5m + (5.4m/$2.50 0.9) = 7.4m
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Value per share = 25.9m/7.4m = $3.50
Market value per share

Existing market value/cost
Gain
No of shares
Total gain
Existing
$
3.50
2.50
1.00
5m
5m
New
$
3.50
2.25
1.25
2.4m
3m
% gain to existing shareholders = (5m/5m + 3m) = 62.5%
125
0.16
Earnings = (5m $1.20)/7.5 = $0.8m
Share capital after rights issue = 5m 1.25 = 6.25m

EPS = $0.8m + $0.2m/$6.25m = $0.16
126
50m @ $2.30
Price offered
$
2.50
2.40
2.30
Cumulative number of share bids received at price

m
15
45
85
More than 50 million bids were received for a price of $2.30 or more, therefore shares are
allocated at $2.30.
127
103
Assuming an efficient market, shareholders who take up their rights can expect to be financially
in the same position as shareholders who sell their rights to the company.
Shareholders who take up the issue can buy 1 share at $2.40 for every 4 shares they currently
own and can therefore make a profit on each share purchased of $2.88 - $2.40 = $0.48
Shareholders who sell their rights can make a profit of 4 $0.12 = $0.48, in return for giving up
the right to purchase each new share.
128
As the number of shares held increases, the level of portfolio risk falls initially and then levels
off, the level of unsystematic risk falls initially and then levels off and the level of systematic
risk stays constant.
129
0.80
1
12.5
Yield-adjusted price = 3+1 [(3 $0.80) + (( 10 ) $0.80 80%)] = $0.80

130
131
$
P0 =
Amount raised
d0 [1+ g]
ke - g
0.50 (1+0.12)
0.150.12
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19.17
= $18.67
However, this is the ex-rights price
Cum-rights price = $18.67 + $0.50 = $19.17
132
There is no risk premium, so the beta factor is zero.
133
0.02
Current EPS = $3.5m/5m = 0.70

Number of shares required to finance new investment = $2m/($2.00 0.8) = 1.25m
New EPS = ($3.5m + $1m)/5m + 1.25 m = $0.72
Change in EPS = $0.72 - $0.70 = $0.02
134
5.76
Return = (6 % 20/50) + (8% 18/50) + (2% 12/50) = 5.76%
104 A n s w e r s t o 6 : D e b t f i n a n c e
Chapter 6: Debt finance

135
4.30
Price per share $129/30 = $4.30
136
Unsecured loan; preferred share; warrant
Interest on a loan has to be paid, the dividend on a preferred share is for a certain amount,
whereas the capital gain on a warrant is uncertain.
137
138
The rate of interest at which the total discounted value of future interest payments and
capital repayments is equal to the current market value of the bond
107
Yield to maturity of similar bonds is 4% therefore use 4% as the discount rate.
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Year(s)
Description
1-4
4
0
Interest
Redemption
Market value
Cash flow
$
6
100
Discount Factor
4%
3.630
0.855
1
Present Value
$
21.78
85.50
107.28
The current expected market value of the bond is therefore $107.28

Or alternatively:
139
Year(s)
Description
1-3
4
0
Interest
Redemption & Interest
Market value
Cash flow
$
6
106
Discount Factor
(4%)
2.775
0.855
1
Present Value
$
16.65
90.63
107.28
94
Yield to maturity of similar bonds is 10%, therefore use 10% as the discount rate.
Year(s)
Description
1-4
4
0
Interest
Redemption
Purchase price
Cash flow
$
8
100
Discount Factor
10%
3.170
0.683
The current expected purchase price of the bond is therefore $93.66
Present Value
$
25.36
68.30
93.66
Answers to 6: Debt finance
105
Alternatively:
Year(s)
Description
1-3
4
0
Interest
Redemption
Purchase price
140
Cash flow
$
8
108
Discount Factor
10%
2.487
0.683
Present Value
$
19.90
73.76
93.66
The yield to maturity is 6%, therefore the net present value of the cash flow when discounted at
6% will be equal to zero.
Year(s)
Description
0
1-3
3
NPV
Purchase
Interest
Redemption
Cash flow
$
(108.06)
X
100
Discount Factor
6%
1.000
2.673
0.840
Present Value
$
(108.06)
Y
84.00
0
To achieve a NPV of zero the present value of the total interest paid has to be $108.06 - $84.00
= $24.06. Interest paid = PV/Cumulative discount factor = $24.06/2.673 = $9, which is a coupon
rate of 9%.
141
105
$
Year(s)
Description
1-6
6
0
Interest
Redemption
Purchase price
5.2
Year(s)
Description
Cash flow
0
1-4
Purchase
Interest 8
(1-0.25)
Redemption
142
4
NPV
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Fir
Cash flow
$
8
100
103
6
Discount
Factor
3%
1.000
3.717
100
0.888
Discount Factor
7%
4.767
0.666
Present
Value
$
(103.00)
22.30
By interpolation: 3% + (($8.10 /($8.10 + $3.01)) 3) = 5.2%
88.80
8.10
Present Value
$
38.14
66.60
104.74
Discount
Factor
6%
1.000
3.465
0.792
Present
Value
$
(103.00)
20.79
79.20
(3.01)
143
111
144
Year(s)
Description
1-4
4
Market value
Interest
Redemption
Cash flow
$
6
100
Discount
factor
3%
3.717
0.888
Present
value
$
22.30
88.80
111.10
1080
Year(s)
Description
1-5
5
Market value
Interest
Redemption
Cash flow
$
100
1,000
Discount
factor
8%
3.993
0.681
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11.3
145
Present
value
$
399.30
681.00
1,080.30
Interest is 80/900 i.e. 89% plus capital gain at maturity of $100 therefore discount initially at
10%.
Year(s)
Description
0
1-4
4
NPV
Purchase
Interest
Redemption
Cash flow
$
900
80
1,000
Discount
factor
10%
1.000
3.170
0.683
Present
value
$
(900.00)
253.60
683.00
36.60
Discount
factor
12%
1.000
3.037
0.636
Present
value
$
(900.00)
242.96
636.00
(21.04)
Discount
factor
10%
1.000
6.145
0.386
Present
value
$
(88.00)
36.87
38.60
(12.53)
By interpolation: 10% + (2% (366/(366 + 21.04))) = 113%
7.8
146
Year(s)
Description
0
1-10
10
NPV
Purchase
Interest
Redemption
%
Cash flow
$
(88)
6
100
Discount
factor
7%
1.000
7.024
0.508
By interpolation: 7% + (3% (4.94/(4.94 + 12.53))) = 7.8%
Present
value
$
(88.00)
42.14
50.80
4.94
5.2
147
i[1 - t]
kd net =
P0
9 (10.3)
122
= 0.052 or 5.2%
Year(s)
Description
0
1-3
3
Purchase
Interest
Conversion
1
( $650)
Discount
Factor
7%
1.000
2.624
0.816
Cash flow
$
(110.00)
5.00
130.00
NPV
107
10.0
148
Present
Value
$
(110.00)
13.12
106.08
Discount
Factor
10%
1.000
2.487
0.751
9.20
Present
Value
$
(110.00)
12.44
97.63
0.07
By interpolation: 7% + (3% (9.20/(9.20 0.07))) = 10.02%
8.3
149
Year(s)
Description
0
1-4
Purchase
Interest
8(1 0.3)
1
Conversion (
4
$280 1.5)
4
NPV
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Fir
Cash flow
$
(95.00)
5.60
105.00
Discount
Factor
6%
1.000
3.465
0.792
Present
Value
$
(95.00)
19.40
83.16
7.56
By interpolation: 6% + (3% (7.56/(7.56 + 2.52))) = 8.25%
8.4
150
kd net =
151
i[1 - t]
P0
%
11 (10.2)
105
= 8.38%
2.51
Operating profit will increase by $18,000

Interest payable will increase by $140,000 5% = $7,000
Interest cover =
Profit before interest payable $118,000

=
= 2.51
Interest payable
$47,000
Discount
Factor
9%
1.000
3.240
0.708
Present
Value
$
(95.00)
18.14
74.34
(2.52)
152
The lessee receives capital allowances for the asset.
153
$10,460
Year
Item
0
0-4
5
Cost of purchase
Rentals
Disposal value
Net cash flow

$
(100,000)
25,000
10,000
Discount Factor
10%
1.000
*4.170
0.621
Present Value
$
(100,000)
104,250
6,210
10,460
* Yr 1 4 Annuity factor + 1
154
Purchased
Present value of purchase cost = $120,000

Present value of lease cost = $18,000 + ($18,000 5.759) = $121,662
The asset should be purchased as the present value of the purchase cost is lower.
155
Leased
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Present value of purchase cost = $51,000 ($20,000 0.621) = $38,580

Present value of lease cost = $10,000 3.791 = $37,910
The asset should be leased as the present value of the lease payments is lower.
156
Purchased
Cost of purchase: $80,000

Leasing
Year
0-9
Rental
Net cash flow

$
(12,000)
Discount Factor
10%
6.759
Present Value
$
(81,108)
Decision: Purchase
157
Leased
Purchase
Year
0
5
Purchase
Residual value
Net cash flow

$
(81,000)
40,000
Discount Factor
10%
1.000
0.621
Present Value
$
(81,000)
24,840
(56,160)
Lease
Year
1-5
Rental
Decision: Lease
Net cash flow

$
(14,000)
Discount Factor
10%
3.791
Present Value
$
(53,074)
158
109
Purchased
Lease $20,000 (1+3.791) = $95,820

Purchase
Year
0
5
Cash flow
$
(100,000)
10,000
Purchase
Residual value
Discount Factor
10%
1
0.621
Present Value
$
(100,000)
6,210
(93,790)
Decision: Purchase
159
Purchased
Lease $14,500 (4.355 0.909) = $49,967

Purchase = $48,000
Decision: Purchase
160
The risk of changes in a bonds return due to changes in interest rates over time
161
Interest is allowable for tax purposes.
162
31 December 20X5
20X3: 32 $2.80 1.05 = $94.08

20X4: 32 $2.80 1.052 = $98.78
20X5: 32 $2.80 1.053 = $103.72
163
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In the case of default, subordinated debtholders will be paid before shareholders.
In the case of default, subordinated debtholders will be paid after statutory creditors.
164
The companys cost of debt
165
8000
Payments = $132,000 $5 = $660,000

Interest = $660,000 - $600,000 = $60,000
Denominator = 5 (5 + 1/2) = 15
Year 1: $60,000 (5/15) = $20,000
Year 2: $60,000 (4/15) = $16,000
Year 3: $60,000 (3/15) = $8,000
166
2250
Payments = $95,000 4 = $380,000

Interest = $380,000 - $350,000 = $30,000
Denominator = 4 (4 + 1/2) = 10
Year 1: $30,000 (4/10) 0.25 = $3,000
Year 2: $30,000 (3/10) 0.25 = $2,250
167
81000
Discount at after-tax cost of debt 12% (1 0.25) = 9%

Year
$
(100,000)
20,000 0.25
16,000 0.25
64,000* 0.25
* (100,000 20,000 16,000)
0
2
3
4
Discount Factor
9%
1.000
0.842
0.772
0.708
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168
78000
Year
$
(40,000)
40,000 0.25
3.240 0.917
1-3
2-4
169
170
Discount Factor
12%
2.531
2.323*
Present Value
$
(101,240)
23,230
(78,010)
Reduction in finance cost
Elimination of uncertainty about the levels of finance cost
Changing the profile of debt without changing the underlying instruments
8%
Interest paid = LIBOR + 2% + 6% - LIBOR = 8%
171
Present Value
$
(100,000)
4,210
3,088
11,328
(81,374)
LIBOR + 1.5%
Interest paid = 7% + LIBOR 5.5% = LIBOR + 1.5%
172
111
DD 6.8% EE LIBOR + 0.2%

Fixed
Floating
DD
7%
LIBOR + 1%
EE
6%
LIBOR + 0.4%
1%
0.6%
Gain = 1% - 0.6% = 0.4%, 0.2% each

DD will pay 7% - 0.2% = 6.8%
EE will pay LIBOR + 0.4% - 0.2% = LIBOR + 0.2%
173
KK 7% JJ LIBOR
JJ has comparative advantage in floating rate finance (pays 1.5% less than KK, compared with
1% less than KK for fixed rate finance), meaning that KK has comparative advantage in fixed rate
finance. Since both have comparative advantage in the type of finance that they want, it is not
worth undertaking the swap and the companies will pay the rates quoted.
2.50
174
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New finance cost = (50,000 100 6%) + (1,000,000 4%) = $340,000

Interest cover = 850,000/340,000 = 2.50
175
If the additional borrowing is undertaken, the interest cover would be 4.90 and the interest
cover covenant would be breached.
($200m 0.08) + ($40m 0.1) = $20m
Interest cover = $98m/$20m = 4.9
176
The hedged rate, taking the borrowing and swap into account, is 6% fixed.
Rate = LIBOR + 1.5% + 4.5% - LIBOR = 6%
177
Companies can claim tax relief on interest paid on the bonds.
Bondholders must convert the bonds into shares on the
conversion date.
178
Scrip bonds
True
False
179
57
Payment = ($50m 1.1) + ($4m/2) = $57m
180
The lease might give the organisation the chance to upgrade the asset during the terms
of the lease.
The organisations tax position may mean that it cannot benefit from the tax allowances
that are available for purchasing the asset.
A finance lease is likely to be for a longer period of time, and the lessee is likely to be
responsible for maintaining the asset.
181
The lease is for most or all of the life of the asset.
182
Interest on the part of a loan that an independent third party
would be prepared to lend the company is disallowable.
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Only the borrowing capacity of the individual company and

its subsidiaries is considered, not the whole group.
True
False
Interest on the loan by a willing third party would be allowable.
183
120000
Interest costs without swap

Interest costs with swap
Saving
YE
000
2,144
2,048
96
Saving in $ = 96,000/0.8 = $120,000
184
1.2
Debt : equity ratio = (30 + 8): 28 = 135.7%, so thin capitalisation rules apply.
Interest on TY loan = 6% $30m = $1.8m
Interest disallowed = $1.8m 50/150 = $0.6m
Allowable interest = $1.8m - $0.6m = $1.2m
NH
$000
3,400
3,200
200
Answers to 7: Capital structure
113
Chapter 7: Capital structure

9.9
185
MV debt = $4m 1.25 = $5m

MV equity = 5m $4= $20m
Market
value
$m
20
5
25.0
Equity
Debt
Cost
10.5
7.5
Market value
Cost
210
37.5
247.5
WACC = (247.5/25) = 9.90%
9.6
186
ke =
d
P0
= 0.125 or 12.5%
MV equity = 5m $3.2= $16m
Equity
Debt
WACC = (249/26) = 9.58%
187
Co
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Fir
(50% 14%) + (50% 9%)
Market
value
$m
16
10
26
Cost
12.5
4.9
Ignore reserves. Weight by market value of share and debt capital

MV of share capital = 7.5m $3.50 = $26.25m
MV of debt capital = 17.5m $1.50 = $26.25m
Market value are equal, therefore 50% weighting for each
188
Falls initially then rises.
189
The required return on equity increases.
The return on equity will increase because of the greater level of financial risk.
Market value
Cost
200
49
249
114 A n s w e r s t o 7 : C a p i t a l s t r u c t u r e
190
9.5%
+ kd (1 t) D
VE + VD
VE + VD
WACC = ke
VE
2
1
+5
2 + 1
2 + 1
8 = ke
ke = 9.5%
191
BL Co has aimed to increase dividends by 5% per annum over the last few years.
192
Minimum weighted average cost of capital
193
Affect
Not affect
Optimum level
No optimum
level

Default risk
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194
A fall in the base rate of interest
195
The cost of debt varies according to the level of gearing.
196
Traditional
Modigliani and Miller
197
198
The returns to shareholders become more variable.
4.85
Vg = Vu + TBc = $80m + ($45m 0.3) = $93.5m

Value of equity = $93.5m - $45m = $48.5m
Value per share = $48.5m/10m = $4.85
20.90
199
115
keg = keu + [keu kd]
VD [1 - t]
VE
15.00
200
= 16 + [16 9]
1(10.3)
1
= 20.90%
VD [1 - t]
VE
1(10.25)
18 = keu + [keu 6]
2.25
1(10.25)
18 - keu= [keu 6]
54 - 3keu= [keu 6]
2.25
4 keu = 60
keu = 15%
201
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Under the traditional view of gearing, increasing gearing will mean that the cost of equity keeps
rising, the cost of debt eventually rises, the weighted average cost of capital falls then rises and
the value of the company rises then falls.
10.08
202
kadj = keu[1 tL]

At 40% 11 = keu[1 (0.25 0.4)] = 0.9 keu
keu = 12.22%
At 70% kadj = 12.22[1 (0.25 0.7)] = 10.08%
203
44
Vg = Vu + TBc = 40 + (0.25 16) = $44m
204
12.73
%
16
kadj = keu[1 tL] = 0.14 (1 ( )0.25) = 12.73%

44
58.82
205
kadj = keu[1 tL]

0.15 = 0.17[1 0.2L)
0.2L = 1 (0.15/0.17)
L = 0.5882, 58.82%
13.4
206
%
VD [1 t]
VE
15(10.25)
0.15 = keu + [keu 0.10]

25
11.25
25
[0.15 keu] = keu 0.10
0.33 + 0.10 = 3.22 keu

keu = 13.4%
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5.37
207
kadj = keu[1 tL]
0.108 = keu[1 (0.25 0.3)]

keu = 0.1168
kadj = 0.1168[1 (0.25 0.5)] = 10.22%
% change =
10.810.22
10.8
= 5.37%
208
A2 B4 C3 D1
209
Capital structure influences the weighted average cost of capital and the value of the
entity.
Investors are indifferent between personal and corporate gearing.
Ordinary shares
210
211
11.00
kadj = keu[1 tL] = 12 [1 0.25(
)] = 11.00%
1+2
212
14.27% = 15% [1 (

0.25 350
117
)]
1,800
Substitute into kadj = keu[1 tL] , using the proxy companys cost of equity of 15%
213
12.93% = 12% + [(12% - 8%)(
0.7
3
Substitute into keg = keu + [keu kd]
)]
VD [1 t]
VE
, with kd being 8%
214
The cost of equity will rise as gearing increases.
215
11.24% = 11.53% [1 (
6.25
250
)]
Substitute into kadj = keu[1 tL]
216
553
Co
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Fir
Current cost of equity = 64/400 = 16%

New cost of equity = 16% - 2% = 14%
Cost of debt = 12/100 = 12%
WACC under new gearing = (7/8 14%) + (1/8 12%) = 13.75%

Market value = $76m/0.1375 = $553m
217
10.45
kadj = keu[1 tL] = 11 [1- (0.2 0.25)] = 10.45%
218
17.00
Market value of company irrespective of gearing = $8m/0.16 = $50m

Post the refinancing debt will be $5m, equity $45m
Earnings after interest = $8m - (7% $5m) = $7.65m
Cost of equity = $7.65m/$45m = 17%
219
10.71
%
VD [1 t]
VE
= 9 + ([9 4] [(30 0.80/70] = 10.71%
220
178
Vg = Vu + TBc
$190m = Vu + (0.3 $40m)
Vu = $178m
11.25
221
Ignoring tax, WACC is assumed to be constant at all levels of gearing under this theory.
0.1 = 0.8r + (0.2 0.05)
0.8r = 0.09
r = 0.1125, 11.25%
9.14
222
Cost of irredeemable debt = (9/108) 0.75 = 6.25%
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Market
value
$m
240
54
294
Equity
Debt
WACC = 294/3,217.5 = 9.14%
223
11.38
VD [1 - t]
12 = keu + ([keu - 6] [
VE
30 (10.25)
12 = keu + 0.45 keu - 2.7
50
])
14.7 = 1.45 keu

keu = 10.14%
keg = 10.14 + ([10.14 - 6] [
224
2.72
3.1/(0.7 + (4 0.11)) = 2.72
0.4 (10.25)
1
]) = 11.38%
Cost
12
6.25
Market
value Cost
2,880
337.5
3,217.5
40.43
225
119
As the preferred shares are irredeemable they are counted as part of equity and as the bank
overdraft appears to be permanent, it is counted as part of debt.
Gearing = (12 + 3 + 4)/((12 + 3 + 4) + (7 + 2 + 19)) = 40.43%
7.5
226
Simple CAPM can be used.

ke = Rf + [Rm Rf] = 4 + [9 4] 0.7 = 7.5%
9.4
227
Degear
60
= 1.35 (
) = 0.9
60+40 (10.25)
VE + VD (1 t)
u = g
Regear
VE
g = u + (u d)
VD (1 t)
Substitute in CAPM
VE
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Fir
= 0.9 + 0.9 (
20 (10.25)
80
)= 1.069
ke = Rf + [Rm Rf] = 3 + [9-3]1.069 = 9.4%
11.8
228
Degear
75
= 1.6 (75+25 (10.2)) = 1.263
+
(1
t)
V
V
E D
u = g
VE
Substitute in CAPM
ke = Rf + [Rm Rf] = 3 + [7]1.263 = 11.8%
229
1.5
KSs debt/equity ratio lies between the ratios of ZW and XP, so the equity beta will be between
1.3 and 1.6.
12.0
230
Degear
60
= 1.7 (
) = 1.159
60+40 (10.3)
VE + VD (1 t)
u = g
Regear
VE
g = u + (u d)
VD (1 t)
VE
= 1.159 + 1.159
25 (10.3)
75
Substitute in CAPM
= 1.429
ke = Rf + [Rm Rf] = 2 + [9-2]1.429 = 12.0%
9.6
231
Degear
100
= 1.2 (
) = 0.923
100+40 (10.25)
VE + VD (1 t)
u = g
VE
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Substitute in CAPM
ke = Rf + [Rm Rf] = 5 + [10 5]0.923 = 9.6%
14.4
232
g = u + (u d)
VD (1 t)
VE
= 1.05 + 1.05
Substitute in CAPM
25 (10.3)
75
= 1.295
ke = Rf + [Rm Rf] = 4 + [12-4]1.295 = 14.4%
14.5
233
Gear
g = u + (u d)
VD (1 t)
VE
= 1.3 + (1.3 0.2)
35 (10.25)
Substitute in CAPM
ke = Rf + [Rm Rf] = 5 + [11 5]1.589 = 14.5%
100
= 1.589
234
g = 1.23 + (1.23 0.15)
Degear XRs equity beta
121
30 (10.3)
70
V (1 t)
55
45 (10.3)
+ D D
= 1.85 (
) + 0.15 (
) = 1.23
55+45 (10.3)
55+45 (10.3)
VE + VD (1 t)
VE + VD (1 t)
u = g
VE
Regearing should then be done at JNs gearing ratio.
10.4
235
Degear
65
= 1.4 (
) = 0.997
65+35 (10.25)
VE + VD (1 t)
u = g
Regear
VE
g = u + (u d)
VD (1 t)
Substitute in CAPM
VE
= 0.997 + 0.997 (
22 (10.25)
78
)= 1.208
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ke = Rf + [Rm Rf] = 4 + [11-4]1.208= 12.46%
WACC = (0.78 12.46%) + (0.22 4% (1 0.25)) = 10.4%
122 A n s w e r s t o 8 : D i v i d e n d p o l i c y
Chapter 8: Dividend policy

236
The level of other liabilities
237
The value of equity depends on the investments that the firm has selected.
238
A policy of no dividends gives shareholders greater control over management.
239
Dissatisfied shareholders who sell their shares will be liable to transaction costs.
Dividends need not be paid if a company makes a loss.
The company is using retained earnings rather than debt to finance projects with positive
net present values.
240
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241
Cash = $3m (2m 0.70) = $1.6m

Earnings = 0.60 10m = $6m
EPS = $6m/(10m 2m) = $0.75
32.4
242
Number of shares = 20m ($5m/$1.25) = 16m
Gearing = (10 m $0.96)/((10m $0.96) + (16m $1.25)) = 32.4%
243
Keeping cash to finance investments
244
In a tax regime where individuals pay more tax on dividends than capital gains
245
Shareholders will believe that PP lacks profitable opportunities for investing cash.
246
Shareholder return is equal to dividends plus growth in the share price.
247
3600000
Maximum receipt = 20m 0.9 0.8/4 = 3.6m
248
Answers to 8: Dividend policy
Using retained cash surpluses means directors can undertake investment projects
without involving shareholders.
Using retained cash surpluses avoids possible changes of control that may result from a
share issue.
123
Although using retained cash surpluses avoids transaction costs, their cost is the cost of equity.
If the tax rate on capital gains is higher, shareholders will prefer dividends. The directors may
have to ask shareholder approval at a general meeting if a new share issue rather than retained
cash is used to fund investments.
249
A company should invest all available funds in projects that have positive net present
values, and only pay out dividends if no such projects are available.
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124 A n s w e r s t o 9 : B u s i n e s s v a l u a t i o n s
Chapter 9: Business valuations

250
625c
Dividend cover =
Earnings per share

Dividend per share
Dividend per share =

Dividend yield =
50
= 20c
2.5
Dividend per share

Market price per share
Market price per share =
251
20
= 625c
0.032
2.72
New share price = $2.40 + ($1.6m/5m) = $2.72
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253
254
$2.60
New share price = $2.30 + (($40m - $25m)/50m) = $2.60
255
105
Free cash flow = 240 + 60 20 75 45 55 = 105
256
180
Free cash flow = 360 + 85 120 80 65 = 180
257
CIV = ($50 million - (12% $35 million))
258
495
0.70
CIV = ($70 million - (10% $40 million)) (0.75/0.1) = $495 million
0.09
259
Answers to 9: Business valuations
125
Company BC has lower market capitalisation.
The share price will be influenced by the number of shares in issue, which is not necessarily the
same between the two companies.
260
A
B
C
261
1
3
2
$50 m 10 = $500m
$60 m 8 = $480m
$70 m 7 = $490m
530
Cum div value per share = 565/250 = $2.26

Ex div value per share = $2.26 - $0.14 = $2.12
Value of shareholding = $2.12 250 = $530
262
210
Price = 340 60 70 = $210m
263
264
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215
Operating profit
Interest
Profit before tax
Tax
Depreciation
Investment in non-current assets
Investment in working capital
$m
890
(150)
740
(185)
230
(500)
(70)
215
265
4800
m
Year 1
$m
340
0.909
309
Discount factor
Present value
Year 2
$m
380
0.826
314
Year 3
$m
440
0.751
330
Year 4
$m
510
(1/0.1) 0.751
3,830
Present value = $4,783m, so $4,800m
266
6900
m
Year 1
$m
400
0.926
370
Discount factor 8%
Post year 4 cash flows = (
Year 2
$m
420
0.857
360
Year 3
$m
450
0.794
357
480 (1+0.05)
0.080.05
) 0.735 = $12,348m
Sum of cash flows = $13,788m
Value of equity = 50% $13,788m = $6,894m, so $6,900m
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267
6448
Value of equity =
268
(470+150)(1+0.04)
0.140.04
= $6,448m
7.35
Value of equity =
Value per share =
35(1+0.05)
0.150.05
367.5
50
= $367.5m
= $7.35
5.25
269
Earnings in earnings per share calculation = Profit after tax Preference dividends
= ($240,000 0.75) - $20,000 = $160,000
EPS = $160,000/1m = 0.16
P/E ratio = 0.84/0.16 = 5.25
270
The companys growth prospects are poor.
Year 4
$m
480
0.735
353
271
127
9.00
Earnings as a % of share price = Dividend yield Dividend cover = 4% 5 = 20%

Share price = $1.80/20% = $9.00
272
$
6500000
Earnings as a % of share price = Dividend yield Dividend cover = 4% 3 = 12%

Share price = $0.39/12% = $3.25
Market capitalisation = 2m $3.25 = 6,500,000
273
3.20
Earnings per share = Dividend per share Dividend cover = $0.10 4 = $0.40
Price = P/E ratio EPS = $0.40 8 = $3.20
274
9600000
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Earnings per share = Dividend per share Dividend cover = $0.40 2 = $0.80
Price = P/E ratio EPS = $0.80 12 = $9.60
Market capitalisation = 1m $9.60 = $9,600,000
275
3800
Market capitalisation = (1,000m/$0.50) $1.90 = $3,800m
276
11.25
Profit after tax = $8m 0.75 = $6m

Market capitalisation = $6m 15 = $90m
Market price per share = $90m/(2m/0.25) = $11.25
277
280
Earnings = $4m 5 = $20m

Market capitalisation= $20m 14 = $280m
278
100
Earnings = $2m/(1 0.8) = $10m

Market capitalisation= $10m 10 = $100m
279
63
Value = Profit after tax P/E ratio Private co adjustment = 10.5 (120/15) 0.75 = $63m
280
107
Growth rate in calculation = bR

r = 10%
b= (10.5 8.4)/10.5 = 0.2
g= 10% 0.2 = 2%
P0 =
d0 [1 + g]
ke g
8.4 (1 +0.02)
0.10.02
= $107.1m, $107m
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281
3150000
Use dividend model, as market will expect dividend payments.

Valuation = 6m 0.25 $2.10 = $3,150,000
282
Invest in several different companies across a number of industry sectors.
283
The stock market is responding to a public announcement.
284
No change
If the stock market is strongly efficient, it will have already anticipated JWs expansion plans.
285
5000000
Need to use sustainable profits, which are $700,000 ($100,000 0.75) = $625,000
Valuation = $625,000 8 = $5,000,000
286
129
8.00
Dividend per share = EPS/Dividend cover = $0.80/2 = $0.40

Market price per share = Dividend per share/Dividend yield = $0.40/0.05 = $8.00
287
The cost of equity is difficult to establish with accuracy.
The model assumes that retained earnings will be reinvested to earn a return equal to
the cost of equity, which may not be true.
The model assumes that companies have sufficient earnings to maintain dividend growth
levels, which may not be true.
The model assumes dividend levels are determined by shareholder expectations, the issue of
control is irrelevant. The model assumes that the discount rate exceeds the dividend growth
rate.
2.00
288
ke =
d0 [1 + g]
0.11 =
P0
+g
0.60 (1+)
6.80
+g
0.11 = 0.0882 + 0.0882g + g
0.0218 = 1.0882g
g = 2.00%
289
485
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m
Free cash flow = 1,400 + 430 180 325 300 750 + 210 = $485m
290
7.64
0.84/0.11 = $7.64
291
3.10
Valuation = 260 + 140 20 130 90 36 = $124m

Valuation per share = ($124m/(10/0.25)) = $3.10
292
28
Growth rate = 4(0.9/0.6) 1 = 10.67%, using a geometric progression

The growth rate over the last year of (0.9/0.79) 1 = 13.92% exceeds the cost of capital, so
cannot be used in the calculation.
P0 =
293
d0 [1 + g]
ke g
0.6 (1+0.1067)
0.130.1067
= $28
11.9
Growth rate = bR = 0.4 0.11 = 0.044

P0 =
d0 [1 + g]
ke g
0.75 (1+0.044)
0.110.044
6.05
294
= $11.9
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P0 =
d0 [1 + g]
ke g
$1.60 =
0.12 (1+)
0.14
0.14 g = 0.075 + 0.075g

1.075g = 0.065
g = 6.05%
295
0.94
Current market price per share = ($2m/0.14)/4m = $3.57
Profit before interest and tax (($2m/0.8) + $1.2m)

Interest ($4m 0.08)
Profit before tax
Tax
Profit available for distribution
New market price per share = ($2.704m/0.15)/4m = $4.51

Increase in market price = $4.51 - $3.57 = 0.94
$000
3,700
320
3,380
676
2,704
296
191
131
Value of NB if it remains ungeared = $20m/0.1 = $200m

Vg = Vu + TBc = $200m + (0.25 $12m) = $203m
Value of equity = $203m - $12m = $191m
297
8.44
Vg = Vu + TBc
Vu = 2m $7.50 = $15m
Vg = $15m + (0.25 5m) = $16.25m
Veg = $16.25m - $5m = $11.25m
Number of shares = 2m ($5m/7.50) = 1.33m
Market price per share = $11.25/1.33) = $8.44
298
$
3.33
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Company value will be unchanged
Market capitalisation before the scrip issue = 2m $3.50 = $7m
Market value per share after the scrip issue = $7m/(2m 1.05) = $3.33
299
126
Current pre-tax profit generated from intangibles = $36m (16% $120m) = $16.8m
Assuming this is a perpetuity and discounting at WACC
Value of intangibles = $16.8m (1 0.25)/0.1 = $126m
132 A n s w e r s t o 1 0 : M e r g e r s a n d a c q u i s i t i o n s
Chapter 10: Mergers and acquisitions

300
Bootstrapping
301
A reverse takeover is the acquisition of a smaller company by
a larger company.
Asset stripping is buying the share capital of a business and
then selling off its assets.
True
False
302
Horizontal integration
303
Intervening if the combined company is likely to have monopoly power
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304
Revalue non-current assets
305
Bootstrapping
306
Bootstrapping is an increase in value generated when a company acquires a company with a

lower P/E ratio.
307
Protecting the public interest by ensuring that competition is not undermined
308
Business risk
309
JHs earnings
XVs P/E ratio
310
Changing the companys constitution to increase the % of votes required to approve a

takeover
311
Reduction of business risk due to diversification achieved through the acquisition
312
THs earnings per share would rise.
313
30
Answers to 10: Mergers and acquisitions
133
Gain = 200 + 50 220 = $30m
314
20
Gain = 220 200 = $20m
315
12
Price per share = 600/50 = $12
316
80
Offer price = 280 200 = $80m
317
318
319
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The cash flows of the combined group are likely to be higher than the sum of the cash
flows of the two companies if they remain separate.
JK has to pay a premium to acquire a controlling interest.
Synergies are forecast to be generated as a result of the takeover.
The combined group is believed to have a stronger competitive position than the two
companies individually.
The takeover is blocked.
The takeover is allowed to proceed.
Fir
The competition authorities will not intervene to regulate the price to be paid and are more
likely to insist that some branches are disposed of, because the combined group may be seen as
having excessive market power if all the branches remain open.
320
The combined group will undertake a rationalisation programme and cease operating on
some socially necessary routes.
The combined group will use its increased market power to start a price war and force S
out of business.
The combined group will use its increased market power to charge higher prices.
321
64
Value of HH = $8m 12 = $96m

Value of combined group = (8 + 6 + 2) 10 = $160m
Maximum payment = 160 96 = $64m
322
Diluting GFs shareholders control of the company
323
A dilution of earnings of HG
A reduction in the control of HG by its existing shareholders
324
A debt for share exchange would increase gearing levels, which are already high, further.
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325
Sale of a business, where part of the consideration received by the owners is linked to
the performance of the business after the sale
326
Applying the current price-earnings ratio of HE to the combined post-tax earnings of the
new group
327
Earnout
This should encourage KJs directors to join the combined company, and gives them an
incentive to contribute to its future performance.
328
Earnings per share will rise.
If a company buys another company with a lower P/E ratio by means of a share exchange, the
EPS will rise if total profits stay the same.
329
10.00
The probabilities add to less than 1 (0.5), so there is a possibility that no extra consideration will
be payable.
330
135

KH
$10 million
25 million
$0.40
10
$4.00
Annual earnings
Earnings per share
P/E ratio
Share price
MM
$5 million
10 million
$0.50
12
$6.00
Total purchase consideration = $6.00 10m = $60m

Consideration to be paid in new KH shares = $60m 0.5 = $30m
Number of new shares to be issued $30m/$4 = 7.5m
10m shares, therefore offer is 3 KH shares for 4 MM shares
331
Launch a publicity campaign against the bid
Issue a forecast of attractive future profits to persuade shareholders that the bid is too low
Find an alternative buyer
Directors can lobby the competition authorities but they cannot refer the bid themselves. Not
passing on details of the bid breaches their duty of transparency to shareholders.
332
333
7.40
EPS = 3.7m/4m = $0.925

Offer price = $0.925 8 = $7.40
334
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Revalue TYs non-current assets to a higher valuation
A cash offer may result in a fall in earnings per share, a share offer will not.
A share offer may result in a fall in earnings per share.
335
336
The target company issues additional shares to existing shareholders.

The target company takes on large debts to make gearing too high to be attractive.
0.17
Number of CK shares pre-acquisition = 6m/0.5 = 12m

Number of shares in ND = 2m/0.4 = 5m
Number of shares issued in CK = 5m/2 = 2.5m
Total number of shares in CK after the acquisition = 14.5m
Earnings = 1.5 + 0.6 + 0.3 = $2.4m
Earnings per share = 2.4/14.5 = $0.17
337
1800
LE EPS = 16/40 = $0.40

LE share price = $0.40 12 = $4.80
Number of new shares = (2/3) 30 m = 20m
New share capital = 40m + 20m = 60m
Earnings = S16m + $12m + $5m = $33m
EPS = $0.55
New share price = $0.55 12 = $6.60
Increase in share price = $6.60 - $4.80 = $1.80
Gain = 1,000 $1.80 = 1,800
338
A company in a different industry sector
339
A company operating in a different industrial sector with high growth potential, but
which lacks strategic focus and operational efficiency
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25
340
Market value of UTs shares = $31.25m 20 = $625m

Market value per share = $625m/50m = $12.50
Market value of YHs shares = $25m 10 = $250m
Market value of shares to be issued to YH shareholders = $250m 1.25 = $312.5m

Number of shares to be issued = $312.5m/$12.50 = 25m
341
Lower interest costs for PS
The acquisition will have no impact on interest costs.
342
56.25
EPS QS = $12.5m/20m = $0.625

Share price QS = $0.625 12 = $7.50
EPS KB = 6/15 = $0.40
Share price KB = $0.40 9 = $3.60
Offer 3 shares in QS = $7.50 3 = $22.50
4 shares in KB = $3.60 4 = $14.40
Premium = ($22.50 - $14.40)/$14.40 = 0.5625
343
137
0.12
Profits of merged company = $25m + $9m + $3m = $37m

Number of shares = 15m + 20m/2 = 25m
EPS of merged company = $37m/25m = $1.48
Existing EPS = $25m/15m = $1.60
Dilution = $1.60 - $1.48 = $0.12
344
45
JK EPS = $10m/80 = $0.125

JK share price = $0.125 16 = $2
No of JK shares to be issued = 30m = 22.5m
Value of bid = 22.5m $2 = $45m
345
2.4
MS EPS = $21m/15m = $1.40
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Number of shares issued to acquire LQ = 6m 2/3 = 4m

New number of shares = 15m + 4m = 19m
Total earnings required to avoid dilution = 19m $1.40 = $26.6m

Combined earnings = $21m + $3.8m = $24.8m
Increase in post-tax earnings required = $26.6m - $24.8m = $1.8m

Increase in pre-tax profit required = $1.8m/0.75 = $2.4m
346
HW has a higher gearing level than the industry average.
A debt for share exchange would increase gearing, which may already be excessive.
10000000
347
Value of consideration = 5m $6 1.2m = 36m

No of shares = 36m/$3.60 = $10m
348
Leveraged buyout
Venture capitalists may use this method, but it is not a definition of venture capital.
31.25
349
New debt = $3.5m + $4m = $7.5m

New equity = S6m + $5.7m + $4.8m = $16.5m
New gearing = 7.5/(7.5 + 16.5) = 31.25%
350
60
Value GY = $45m 12 = $540m

Value WT = $20m 9 = $180m
Pre-acquisition value = $540m + $180m = $720m
Post-acquisition value = ($45m + $20m) 12 = $780m
Synergy gains = $780m - $720m = $60m
351
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The market believes that the shareholders of HD will receive

most of the benefits from the acquisition.
The market believes that the consideration that HD is offering
for NWs shares is too low.
352
9.92
HW current market value = 15m $9.80 = $147m
MQ current market value = 12m $2.30 = $27.6m
Value post merger = $147m + $27.6m + $4m = $178.6m

Number of shares = 15m + (12/4)m = 18m
Market price per share = $178.6/18 = $9.92
353
16
OR current market value = 50m $9 = $450m

RV current market value = 20m $4.20 = $84m
Value post merger = $450m + $84m = $534m
OR EPS = $36m/50m = 0.72
OR P/E ratio = 9/0.72 = 12.5
PAT after merger = $36m + ($0.40 20m) = $44m
Value using ORs P/E ratio = $44m 12.5 = $550m
Synergies = $550m - $534m = $16m
True
False
354
139
QA current market value = 80m $1.20 = $96m

MV current market value = 5m $9.00 = $45m
Value post merger = $96m + $45m + $12m = $153m
Number of shares in issue = 80m + (5m 8) = 120m
QA shareholders have 80/120 (2/3) of merged group, value = $153m 2/3 = $102m
Gain = $102m - $96m = $6m
355
MV current market value = $45m

Value post merger = $153m
Number of shares in issue = 120m
MV shareholders have 40/120 (1/3) of merged group, value = $153m 1/3 = $51m
Gain = $51m - $45m = $6m
356
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Ratio of prices = 4.45/1.90 = 2.34. The shareholders of NF will not accept exchanging more than
2.34 shares for each JL share, but JLs shareholders want JL to pay the minimum premium.
357
31.8
XQ current market value = 20m $4.40 = $88m

VZ current market value = 8m $2.00 = $16m
Value post merger = $88m + $16m + $8.8m = $112.8m

Number of shares in issue = 20m + (8m/2) = 24m
Share price = $112.8m/24m = $4.70
VZ shareholders hold 4m shares, value $18.8m
Gain = $18.8m - $16m = $2.8m
Share of total gain = $2.8m/$8.8m = 31.8%
358
MN current market value = 20m $7.30 = $146m

DX current market value = 5m $4.10 = $20.5m
Value post merger = $146m + $20.5m + $9m = $175.5m
Cash paid to DX shareholders = 5m $4.50 = $22.5m
MNs shareholders value = $175.5m - $22.5m = $153m
Increase in wealth = $153m - $146m = $7m
359
3.8
Value of merged group = $25m + $15m + $7m = $47m

Share of FRs shareholders = 40% $47m = $18.8m
Gain = $18.8m - $15m = $3.8m
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Answers to 11: Business reorganisations
141
Chapter 11: Business reorganisations

360
Generate cash to overcome liquidity problems
Dispose of a less profitable business
Managers are more motivated
Managers can make changes quicker if they dont need parent company approval
362
Venture capitalist funding consists of a mixture of equity and debt, to avoid taking
control of the company, but to gain the benefit of high returns on equity.
363
Reduce the risk of a takeover bid
Comply with legal and regulatory requirements
364
Debt interest is paid ahead of preference share dividends.
365
Discounted cash flow analysis at purchasers weighted average cost of capital
366
Make a general provision against the value of inventory
367
Placing
368
TH can apply economies of scope to KJs operations.
There will be strategic synergies between TH and KJ.
361
369
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257000
Cash available = (75% 780) + (85% 420) + 205 680 210 = $257,000
370
829.44
VC investment will need to grow by 20% each year to satisfy its requirement, so after 4 years
= $300m 1.204 = $622.08
Venture capitalist investment = 300/(300 + 100) = 75% of equity, so
Total equity value = $622.08/0.75 = $829.44m
142 A n s w e r s t o 1 1 : B u s i n e s s r e o r g a n i s a t i o n s
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143
Pilot Paper
Fir Cop
s
t In yrig
(2015 Syllabus)
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144
CIMA F3
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145
CIMA
Pilot Paper (2015 Syllabus)

Paper F3
Financial Strategy
Time allowed: 90 minutes
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All questions are compulsory and MUST be attempted
146 P i l o t p a p e r q u e s t i o n s ( 2 0 1 5 s y l l a b u s )
CIMA F3
ALL questions are compulsory and MUST be attempted
In which THREE of the following circumstances is a scrip dividend most likely to be preferable to
a normal dividend?
For a bank wishing to increase its capital adequacy ratios

To retain cash in the business to finance investment
For a company facing liquidity problems
To reward shareholders after many years of not declaring a dividend
To split the shares in order to make them more marketable
A fair value hedge is defined in IAS 39: Financial Instruments: Recognition and Measurement as:
Place the words below to complete the following statement.

cash flow
asset or liability
derivative
fair value
firm commitment
A hedge of the exposure to changes in highly probable
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of a recognised
; an unrecognised
, or an identified portion of an asset,
liability or firm commitment that is attributable to a particular risk and could affect profit or
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3
loss.
A steady increase in earnings is MOST likely to be a financial objective of:
A charity
A public listed company
A public sector enterprise
A not-for-profit company
Modigliani and Millers 1963 Theory of Capital Structure with Tax assumes that:
the cost of equity remains constant regardless of gearing level.

financial distress does not carry any cost.
companies can borrow at zero cost.
a company is liable to tax but not its shareholders.
CIMA F3
Pilot paper questions (2015 syllabus)
147
A company has:
Profit before interest and tax of $120 million
A borrowing of $300 million at 5% interest from Bank A with an interest cover covenant
(based on profit before interest and tax) of 5
The company plans to borrow an additional $100 at 5% interest from Bank B without an interest
cover covenant to finance the repurchase of shares.
Complete the following sentence:
If this plan is carried out, interest cover would then be
and
therefore the interest cover covenant with Bank A would

Option 1 be breached
Option 2 not be breached
6
A public sector college receives government sponsorship for certain courses which teach skills
which are needed locally in the form of a fixed fee for each student completing such courses to
a satisfactory level. The college operates within very tight budgetary cash constraints.
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Which THREE of the following would be the MOST important in a value for money review of this
college by the government.
In which of the following situations is a residual dividend policy most likely to be appropriate?
Number of students enrolled

Cost of providing tuition
Student achievement level
Student satisfaction with facilities
Cash deficit avoided
A large publicly listed company

A small family-owned private company where the majority of the shareholders use
dividend income to pay household expenses
A small company listed on a small company stock exchange and owned by investors
seeking maximum capital growth on their investment
In a tax regime where individuals pay less tax on income than on capital gains
Which of the following best describes the role of competition authorities?
To ensure that new businesses can grow and become successful despite high levels of
competition
To promote fair and ethical competitive behaviour
To prevent monopoly situations developing in essential service industries
To ensure healthy levels of competition and safeguard public interest
9
CIMA F3
A company plans to return surplus cash to shareholders by paying a special dividend, making it
clear to investors that this is a one-off event. The company is funded by a mix of debt and equity
and there are no unused bank facilities.
Which of the following is the MOST likely consequences of this plan?
10
The company would become more vulnerable to a hostile takeover bid.

Shareholder wealth would decrease by the value of cash paid as a special dividend.
The company would become less able to respond promptly to new business
opportunities.
The share price would rise due to the signalling effect of the special dividend.
A company has bank borrowings with Bank A.

The directors of the company wish to accept additional finance offered by a venture capitalist.
Bank A has asked that the venture capitalist's finance is structured in the form of convertible
preference shares rather than a borrowing in order to reduce risk to Bank A.
What is the best explanation of why convertible preference shares are considered to reduce the
risk to Bank A?
Lower gearing throughout the life of the convertible preference shares

Debt interest is paid ahead of preference share dividends
Greater interest cover due to higher profit before tax and interest
Preference dividends can be waived if there is insufficient cash available
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11
A UK company:
Enters into a 3 year borrowing with bank A at a floating rate of Libor plus 2%; and
In order to fix the interest rate for the 3 years, simultaneously enters into an interest rate
swap with bank B at 3.5% fixed against Libor.
The hedged borrowing rate, taking both the borrowing and swap into account, is
Complete the above sentence by placing one of the following options into the highlighted box.
Libor
12
3.5% fixed
2% fixed
5.5% fixed
2.0% fixed
Libor plus 2%
Share prices quoted on a stock exchange are observed to reflect historical share price
information and other historical information about a company, but also respond to other
information about the company immediately it becomes publicly available.
Which of the following best describes the form of market efficiency?
Weak form
Semi-weak form
Strong form
Semi-strong form
CIMA F3
13
149
A company has 100 million $1 ordinary shares in issue and the current share price is $2.40.
A proposed new project requires an initial investment of $40 million and is expected to have an
Internal Rate of Return of 20% and Net Present Value of $24 million.
If the market is efficient and the share price moves to reflect this information on the day that
the project is announced, what is the theoretical movement in the share price on that day?
14
No change
$0.24 increase
$0.48 increase
$0.64 increase
A company wishes to raise $4 million from a rights issue to finance a new project. The project
has a return equal to the companys Weighted Average Cost of Capital.
Under the rights issue, 1 million share will be issued at $2.80 each of the basis of 1 new share
for every 5 shares held. Any shareholder who does not wish to take up their rights will be able
to sell them to the company at $0.15 for each share held.
The day after the announcement of the project and rights issue, the company has:
5 million $1 shares in issue

Market share price (cum rights) of $4.00
Theoretical ex-rights price (TERP) of $3.80
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Assuming an efficient market, shareholders who take up their rights can expect to the
financially
rights to the company.
shareholders who sell their

Option 1 better off than
Option 2 worse off than
Option 3 in the same position as
15
A company adopts the Global Reporting Initiative (GRI) and issues an annual sustainability
report in accordance with the guidelines. Which of the following statements relating to
incomplete disclosure is correct?
Where legal restrictions prohibit, no further disclosure is required

Where information is unavailable, it is sufficient to state that this is the case
Where information is omitted due to confidentiality constraints, these should be
explained
Information may only be omitted if it is subject to either legal prohibitions or
confidentiality constraints
16
CIMA F3
A parent company is planning to dispose of a subsidiary company that operates in a different

market sector to the rest of the group. The parent company is using a proxy company to derive
an appropriate discount rate to use for valuing the subsidiary company using a discounted cash
flow approach.
Which of the following characteristics of the proxy company should be the same as the
subsidiary company?
17
Which THREE of the following strategies are MOST likely to enhance shareholder wealth?
18
Foreign exchange risk

Product risk
Financial risk
Business risk
Investment in projects with a positive Net Present Value

Increasing the rate of dividend growth
Enhancing brand reputation and recognition
Increasing director bonuses
Moving profitable operations to low tax regimes
A company uses currency A$ as its functional currency but will receive payment in respect of
foreign income of B$300 in 2 years time.
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Foreign exchange data:
A$/B$ spot is currently 1.300 (that is, A$ 1 = B$1.300)

A$ interest rate is 3% a year
B$ interest rate is 5% a year
What is the best estimate of the A$ value that the company will obtain for the B$300 receipt in
2 years time?
19
A$222
A$235
A$240
A$405
The following data relates to a company

Operating profit
Finance charges paid
Tax paid
The best estimate of free cash flow for equity is:
$40 million
$70 million
$90 million
$120 million
$million
200
70
15
90
45
50
30
CIMA F3
20
151
The following statements in respect of convertible bonds issued by a company are either true or
false.
True/False
On conversion date, the ordinary shareholders of the company have the option to
choose whether or not the bonds should be converted into shares
The bondholder can normally claim tax relief on interest paid on the bond up to
conversion
Place one of the following options in each of the boxes highlighted above.
True
False
21
YY is valuing a potential acquisition target, company ZZ, using a bootstrapping approach.

Which of the following items of data would be used in a bootstrapping valuation calculation?
22
YYs earnings
ZZs earnings
YYs P/E ratio
ZZs P/E ratio
ZZs debt
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Company ABC has achieved rapid growth by acquiring new business units. Some of the new
business units are making losses and have failed to achieve the synergistic benefits expected.
The cash flows of ABC vary considerably from month to month.
Which THREE of the following are most likely to be motives for ABC to hold surplus cash?
23
Speculative
Value for money
Transaction
Economies of scale
Precautionary
A company has:
A geared cost of equity of 12%

An ungeared cost of equity of 10%
A WACC of 9.25%
Market value of equity of $210 million
Market value of debt of $70 million
A tax rate of 30%
The company plans to raise $20 million of debt and use these funds to repurchase shares.
According to Modigliani and Millers theory with tax, WACC would move to:
83
9.30% = 12% 1 280

83
7.75% = 10% 1
280
27
9.04% = 10% 1 280

27
10.84% = 12% 1
280
24
A division of a company is being sold. Which of the following valuation approaches is likely to be
the most useful to the seller when negotiating the sales price?
25
Bootstrapping
Asset basis
Discounted cash flow analysis discounted at the sellers WACC
Discounted cash flow analysis discounted at the sellers cost of equity
Which of the following could be used as defence on receipt of a hostile takeover bid?
26
CIMA F3
Poison pill strategy

Change the Articles of Association to increase the percentage of shareholder votes
required to approve a takeover
White Knight strategy
Declare a special dividend
50 million ordinary shares are to be offered to the general public by tender offer. Interested
parties were invited to bid for shares in the range $2.20 to $2.60 per share. The results are as
follows:
Price offered
$
2.20
2.30
2.40
2.50
2.60
Number of share bids received at that price
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5
35
55
44
25
Which of the following options shows how the shares will be allocated?
Number of shares
issued at each
price (millions)
Number of shares
issued at each
price (millions)
Number of shares
issued at each
price (millions)
Number of shares
issued at each
price (millions)
2.20
2.30
35
2.40
10
50
2.50
50
25
2.60
25
Price
offered
CIMA F3
27
153
NN operates a number of retail stores in a particular region of the country. NN is in the process
of acquiring QQ, a company that also operates retail stores in this region. Post-acquisition NN
would become the largest retailer in the region, NN and QQ have highly positively correlated
cash flow streams because they operate in the same business sector and location.
As part of the purchase agreement, NN would take over all staff contracts and ownership of the
store properties owned by QQ.
Which THREE of the following would be MOST likely to be synergistic benefits to NN of
purchasing QQ?
28
Cost savings due to economies of scale in purchasing activities

Reduction in staff costs due to elimination of duplicated administration roles
Cash benefit by sale and leaseback of retail store property acquired
Enhanced profit due to reduced competition in the region
Diversification due to owning a larger portfolio of retail outlets
A listed company has 10 million $0.50 shares in issue. The company is planning to repurchase 1
million of these shares at a price of $1.50 each.
The impact of this plan on the cash balance and earnings per share is:
Earnings per share ($)
After the share

repurchase
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Cash ($ million)
Before the share

repurchase
2.00
0.20
Complete the table above by placing one of the following options in each of the highlighted
boxes.
0.18
29
0.20
0.22
0.50
1.50
2.00
A carpet retail outlet has produced the following forecast data for the next 6 month (183 day)
period to show its bank.
Sales revenue (cash sales)
Purchases (60 days credit)
Other costs (settled immediately)
$000
8,600
4,200
4,000
In the previous 6 months, (183 day) period to the forecast the purchases were also $4,200,000
and on 60 day credit terms.
The company has an overdraft balance of $100,000. The agreed overdraft facility is $900,000.
Sales and purchases can be assumed to arise evenly over the period.
If all suppliers were to suddenly withdraw credit at the end of month 6, would the overdraft
facility be adequate?
Yes, the bank account would not be overdrawn

Yes, approximately $510,000 of the overdraft facility would still be available for
drawdown
No, the overdrawn facility would be exceeded by approximately $180,000
No, the overdraft facility would be exceeded by approximately $1,080,000
30
Which of the following statements is consistent with Modigliani and Millers dividend
irrelevancy theory?
31
CIMA F3
A policy of steady growth in dividend is preferable to a residual dividend policy

Shareholder return can be measured as the aggregate of dividends plus growth in share
price
The share price is NOT affected by a dividend payment
Shareholder wealth can be maximised by retaining a high percentage of earnings
Complete the statement below by placing one of the following options in each of the
highlighted spaces.
equity
controlling
noncontrolling
a lender
an investor
borrowings
A leveraged buyout occurs when

typically a private equity firm, acquires a
interest in a companys equity and where a significant percentage of the purchase price is
financed through
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AA is a company which manufactures vacuum cleaners and sells them to retail outlets in its
home country, which has A$ as its currency.
Sales are on 90 day terms.
AA sources most goods and services locally buy also imports some large value items from a
neighbouring country which has N$ as its currency.
AA is funded by a combination of ordinary shares and fixed rate bank borrowings denominated
in A$. It has no surplus cash.
Which THREE of the following should AA consider disclosing in its financial statements according
to IFRS 7 Financial Instruments: Disclosures?
Capital management policy

Credit risk management policy
Aged debtor analysis
The impact of adverse exchange rate movements on reported profit
Business recovery risk policy
CIMA F3
33
155
Company ABC is using the Calculated Intangible Value (CIV) company valuation method to value
its intangible assets.
Relevant data:
Average profit before tax for ABC is $40 million

Industry average return on tangible assets is 11%
ABCs tangible assets are $30 million
Corporate income tax is 35%
ABC has a WACC of 10%, cost of debt of 8% and cost of equity of 12%
Complete the following CIV calculation by placing the numbers into the boxes below.
CIV = [ $40 million (11% $30 million) ]
0.10
34
0.12
1.10
/
1.12
0.35
0.65
Company AQ is purchasing a foreign company, TT, which will be set up as a subsidiary.

Consideration for TT will include sufficient funds to enable TTs directors to repay TTs
borrowings in full.
AQ wishes to finance the new subsidiary with maximum possible gearing.
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Which of the following is most likely to reduce the optimum gearing level for the new
subsidiary?
35
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Thin capitalisation rules

Political risk
The extent to which the foreign company tax rate is lower than the parent company tax
rate
Parent company dividend policy
A wholly equity financed companys financial objectives are:
To achieve earnings growth of 4% a year; and

To meet on invested funds of 9%.
The company forecasts free cash flow of $110 million and earnings of $80 million in the current
financial year.
Based on the forecast data above and assuming the financial objectives are achieved, what is
the best prediction of the dividend for the current financial year?
$36 million
$44 million
$49 million
$61 million
36
CIMA F3
A bond:
has a nominal value of $300 million;

pays interest of $15 million twice a year in arrears;
is trading at $103 per $100 nominal on 1 July 20X1; and
is redeemable at par on 31 December 20X1
How much must the issuer pay to the bondholders on 31 December 20X1?
37
$15 million
$300 million
$309 million
$315 million
A company has:
Equity beta of 1.8

Pre-tax cost of debt of 3.8%
Gearing (D/D+E) of 40%
Corporate income tax rate of 30%
The risk free rate is 2% and the market risk premium is 3%.
The companys debt beta is:
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Place one of the following options in the highlighted box above.

0.1
38
0.7
1.8
Which THREE of the following are types of bonds issued by a company?
39
0.2
Bond with warrants attached

Revolving credit bond
Redeemable bond
Equity bond
Convertible bond
The directors of a company wish to dispose of one of its subsidiary companies. The directors of
the subsidiary company are interested in purchasing the subsidiary company by means of a
management buy-out. There is a potential conflict of interest if, during the negotiation phrase
of the management buy-out, the directors of the subsidiary company were to:
employ more staff in the subsidiarys administration office

accept projects with high Net Present Values
delay a revaluation of assets
sell and leaseback office buildings
CIMA F3
40
Which of the following payments would be made, based upon a pre-agreed formula relating to
the financial performance of a business, through an earn-out arrangement?
41
Management bonus incentive payment

Contractual payment on redundancy
Incentive payment to salespersons
Complete the above share portfolio risk chart by placing one of the following options in each of
the highlighted boxes.
Beta value
Systematic risk
Number of shares held
Unsystematic risk
Average time to maturity
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42
A long-established unlisted medium sized company requires 10 year funding and wishes to
reduce its dependence on bank finance.
Which of the following sources of finance is most likely to be suitable?
43
157
Convertible bond
Commercial paper
Private placement of bonds
Retained earnings
A company is evaluating the decision whether to lease an asset or to buy it outright using newly
borrowed funds.
Which of the following is the BEST discount rate to use for the evaluation?
Pre-tax cost of debt

Post-tax cost of debt
Cost of equity
WACC
44
CIMA F3
Companies GG and HH operate in the same industry. They have the same level of earnings buy
Company HH has a higher P/E ratio.
What does this information tell us about the difference between Company HH and Company
GG?
45
Company HH has lower growth prospects

Company HH has a higher share price
Company HHs shareholders are exposed to greater risk
Company HH has a higher market capitalisation
Company A is planning to sell wholly owned subsidiary B on 1 January 20X1 and is preparing a
valuation for B as at that date using a discounted cash flow method.
Additional information:
Bs net operating cash flow is forecast to be $250 million in the year to 31 December
20X1 and is expected to remain at this level every year in perpetuity
New equipment costing $200 million will need to be paid for on 1 January 20X1. Tax
depreciation allowances can be claimed over 4 years on a straight line basis in respect of
this equipment
The corporate income tax rate is 30%. Tax is paid a year in arrears
Assume all cash flows arise at the end of the year unless stated otherwise
B has a financial year end of 31 December
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The trainee accountant has produced the following analysis of forecast project cash flows to be
used in the valuation. All figures are in $ million.
Click on the TWO grid squares that contain an error.
Time
Net operating cash flow (NOCF)

Tax on NOCF
New equipment
Tax relief on new equipment
3-5
6+
250
250
250
250
250
(75)
(75)
(75)
(200)
50
15
CIMA F3
46
159
EE is a company located in country E, whose functional currency is E$. EE has a foreign

subsidiary, FF, in country F, whose functional currency is F$. The exchange rate is reasonably
stable and today, E$ 1 = F$ 2.
FF has F$ 4 million of surplus cash EE wishes to use these funds to pay a special dividend to its
shareholders.
Tax regime:
FF has already paid 25% corporate income tax on profits and would need to pay
withholding tax of 15% on any cash remitted to the parent company.
EE would pay tax of 10% on cash received from FF.
The maximum level of special dividend that could be paid by EE is approximately:

Option
Value of dividend
Workings
E$ 1.15 million
4 million x 75% x 85% x 90%
E$ 1.53 million
4 million x 85% x 90% / 2
E$ 3.06 million
4 million x 85% x 90%
E$ 6.12 million
4 million x 85% x 90% 2
47
Option A
Option B
Option C
Option D
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Company ST wishes to acquire company VZ and is considering how best to structure the bid
offer. Both companies are of a similar size.
ST currently has gearing (debt/debt+equity) of 40% and would fund any cash offer by raising
additional debt finance.
Structuring the bid offer for the acquisition of VZ as a cash offer funded by debt rather than a
share exchange is MOST likely to have the effect of:
Diluting ST shareholders control

Lowering STs gearing (debt/debt+equity)
Enabling VZs shareholders to participate in future growth in ST
Increasing ST shareholders earnings per share
CIMA F3
48
Earnings for the year

($ million)
100
160
200
Company AAA
Company BBB
Company CCC
P/E ratio
12
10
7
Rank the companies in order of market value by placing them into the highlighted boxes below.
Company CCC
Company AAA
Company BBB
Options:
Highest value
Lowest value
49
A company currently has:
WACC of 12%
Corporate income tax rate of 30%
400 million $1 ordinary shares in issue
Current market share price of $2.60
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The company announces a 1 for 4 rights issue at a discount of 20% to the current share price to
finance a project that has a yield of 15%.
The yield adjusted TERP is:
$
50
(give your answer to 2 decimal places)
Mr A and Mr B established a new company five years ago. The company has grown extremely
quickly but is not yet sufficiently large to be able to obtain a listing on the local stock exchange.
Mr A and Mr B still own 100% of the share capital in the company and wish to realise the full
value of their investment in the coming year.
Which THREE of the following exit strategies could Mr A and Mr b consider?
51
Management buy-out
Trade sale
Initial public offering
Spin-off
A company declares a dividend of $0.09 per share.

Mr A holds 120 shares in a company, worth a total of $184.80 at the cum div market price.
What is the theoretical ex div value of Mr As shares? Give your answer to 2 decimal places.
$
CIMA F3
52
161
A company has gearing of 50% (debt/debt+equity) and plans to:
Issue $1.00 ordinary shares under a rights issue at a 20% discount to the current market
price of $2.00 a share
Reinvest the funds raised immediately in a project with an Internal Rate of Return (IRR)
equal to WACC
Show how this plan is likely to affect gearing and the share premium account by placing one of
the available options in each of the following boxes:
Gearing (debt/debt+equity)
Increase
Stay the same
Decrease
53
Data for private company MM:

Assets (book value)
Assets (realisable value)
Liabilities (excluding borrowings)
Borrowings (book value)
Borrowings fair value)
Equity (book value)
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A company wishes to purchase MM.
$ million
250
300
90
60
70
100
The minimum purchase price for MMs equity on an asset valuation basis is:
$
54
million (round your answer to the nearest whole number)
A rights issue is to be used to raise $100 million. The funds are required to finance a new
project.
Which THREE of the following are affected by the choice of discount at which shares are issued?
Wealth of a typical shareholder

Cost of underwriting
Value raised
Earnings per share
55
CIMA F3
Company RS has agreed to purchase company TS at a cash price of $120 million and estimates
that there will be synergistic benefits of $30 million arising from the purchase.
RS has 50% gearing (debt/debt+equity) and a market capitalisation of $300 million.
TS is wholly equity financed and has a market capitalisation of $110 million.
RSs shareholders and lenders can expect to gain from the deal as follows.
Place one of the following options in each of the highlighted boxes below.
0
15
Gain (in $ million)
RSs shareholders
RSs lenders
56
Company W is considering making a bid to buy the equity shares of company XX.
XX is a listed company with 100 million shares in issue.
W has valued the acquisition target in a number of different ways. The results are shown below:
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Valuation method
Net assets (book value)
Net assets (market value)
P/E ratio applied to forecast earnings for next year
Market capitalisation
Value of XX in $ million
250
420
580
500
Note that net assets are defined here as assets less all liabilities except borrowings.
W should offer shareholders at least:
$
per share. Give your answer to the nearest whole number.
CIMA F3
57
163
A company is located in country A and uses the A$ as the functional currency. To date, all sales
and purchases have been in A$.
The companys first export order was received in 20X1 and a forward contract was taken out to
hedge the A$ value of the order. No hedge accounting was applied.
Details of the export order are as follows:
Date
Action
1 December 20X1
The company accepted an export order. When converted at spot, the

export sale showed an exported gross profit of $100.
31 December 20X1
The forward contract showed a loss on revaluation of $10.

The expected gross profit on the order fell by $10 to $100 due solely to
movements in the spot rate.
1 February 20X2
Goods delivered and invoice raised.
How would the use of cash flow hedge accounting have affected the financial statements for
the year ended 31 December 20X1?
Place one of the following options in each of the highlighted boxes.
Profit before tax in respect of the
export sale plus forward contract
No hedge accounting
$10 loss
58
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Cash flow hedge accounting applied
$ nil
$90 profit
$100 profit
The following data has been taken from the annual reports of a single company:
Year ended 31 December
Earnings ($million)
Number of shares in issue at the end
of the year (million)
20X1
120
100
20X2
160
150
20X3
180
150
20X4
210
150
The company issued 50 million new shares by means of a rights issue on 3 January 20X2.
The latest annual report lists growth in earnings per share as a financial objective.
The compound average annual growth rate in earnings per share achieved between 20X1 and
20X4 is approximately:
5.3%
5.6%
20.5%
25.5%
59
CIMA F3
The following statements in respect of finance leases are either true or false.
True/False
A bank can offer a low rate of interest on a finance lease than on a bank loan
because the lease is supported by an asset.
Under a finance lease, an unprofitable lessee can still benefit from tax
depreciation allowances passed on by the lessor
Place one of the options below in each of the highlighted boxes above.
True
60
False
Company Y is acquiring company Z. The net present value (NPV) of after-tax, after-financing
cash flows for each company and the combined group are as follows:
NPV of Ys cash flows without the acquisition
NPV of Zs cash flows without the acquisition
NPV of the combined group YZs cash flows with the acquisition
Value (in $ million)

100
40
170
The maximum price that Y should offer for the equity of Z is:
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$
million. Give your answer to the nearest whole number.
165
CIMA
Pilot Paper (2015 Syllabus)

Paper F3
Financial Strategy
Answers
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166 P i l o t p a p e r a n s w e r s ( 2 0 1 5 S y l l a b u s )
CIMA F3
A hedge of the exposure to changes in highly probable fair value of a recognised asset or
liability; an unrecognised firm commitment, or an identified portion of an asset, liability or firm
commitment that is attributable to a particular risk and could affect profit or loss.
A public listed company
financial distress does not carry any cost.
If this plan is carried out, interest cover would then be 6.0 and therefore the interest cover
covenant with Bank A would not be breached
Cost per student of providing tuition

Student achievement level
Cash deficit avoided
A small company listed on a small company stock exchange and owned by investors
seeking maximum capital growth on their investment.
To ensure healthy levels of competition and safeguard public interest.
The company would become less able to respond promptly to new business
opportunities.
10
Debt interest is paid ahead of preference share dividends
11
The hedged borrowing rate, taking both the borrowing and swap into account, is 5.5% fixed.
12
Semi-strong form
13
$0.24 increase
14
Assuming an efficient market, shareholders who take up their rights can expect to the
financially better off than shareholders who sell their rights to the company.
For a bank wishing to increase its capital adequacy ratios.

To retain cash in the business to finance investment.
For a company facing liquidity problems
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CIMA F3
Pilot paper answers (2015 Syllabus)
15
Where information is omitted due to confidentiality constraints, these should be

explained.
16
Business risk
17
Investment in projects with a positiveNet Present Value

Enhancing brand reputation and recognition
Moving profitable operations to low tax regimes
18
A$222
19
$70 million
167
20
True/False
On conversion date, the ordinary shareholders of the company have the option to
choose whether or not the bonds should be converted into shares
The bondholder can normally claim tax relief on interest paid on the bond up to
conversion
False
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21
ZZs earnings
YYs P/E ratio
22
Speculative
Transaction
Precautionary
23
9.04% = 10% 1
280
24
Discounted cash flow analysis discounted at the sellers WACC
25
White Knight strategy
27
False
CIMA F3
26
Price
offered
27
Number of shares
issued at each
price (millions)
2.20
2.30
2.40
50
2.50
2.60
Cost savings due to economies of scale in purchasing activities.

Reduction in staff costs due to elimination of duplicated administration roles.
Enhanced profit due to reduced competition in the region.
28
After the share
repurchase
Cash ($ million)
2.00
0.50
Earnings per share ($)
0.20
0.22
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30
Before the share

repurchase
No, the overdraft facility would be exceeded by approximately $ 180,000.
Shareholder return can be measured as the aggregate of dividends plus growth in share
price.
31
A leveraged buyout occurs when an investor, typically a private equity firm, acquires a
controlling interest in a companys equity and where a significant percentage of the purchase
price is financed through borrowings.
32
33
CIV = [ $40 million (11% $30 million) ]
34
Thin capitalisation rules
35
$44 million
Credit risk management policy

Aged debtor analysis
The impact of adverse exchange rate movements on reported profit
0.65
0.10
CIMA F3
36
37
The companys debt beta is: 0.6
38
Bond with warrants attached

Redeemable bond
Convertible bond
39
delay a revaluation of assets.
40
Consideration for the sale of a business.
169
$315 million
41
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Unsystematic risk
Systematic risk
Number of shares held
42
Private placement of bonds
43
Post-tax cost of debt
44
Company HH has a higher market capitalisation.
45
Time
Net operating cash flow (NOCF)
Tax on NOCF
New equipment
Tax relief on new equipment
46
(Option B) E$ 1.53 million
3-5
6+
250
250
250
250
250
(75)
(75)
(75)
(200)
50
15
47
CIMA F3
Increasing ST shareholders earnings per share
48
Highest value
Company BBB
Company CCC
Lowest value
Company AAA
49
50
51
2.60
Management buy-out
Trade sale
174.00
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Gearing (debt/debt+equity)
Decrease
Increase
53
54
150
million
Cost of underwriting
Earnings per share
55
Gain (in $ million)
56
RSs shareholders
20
RSs lenders
per share
CIMA F3
171
57
Profit before tax in respect of the
export sale plus forward contract
$10 loss
No hedge accounting
$ nil
Cash flow hedge accounting applied
58
5.3%
59
True/False
60
A bank can offer a low rate of interest on a finance lease than on a bank loan
because the lease is supported by an asset.
True
Under a finance lease, an unprofitable lessee can still benefit from tax
depreciation allowances passed on by the lessor
False
70
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million
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CIMA F3
Maths tables & Formulae
173
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174 M a t h s t a b l e s & F o r m u l a e
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175
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176 M a t h s t a b l e s & F o r m u l a e
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Question Bank 2015 Syllabus

CIMA F3 Question Bank (2015 Syllabus)

No part of this publication may be reproduced, stored in a retrieval system

Any unauthorised reproduction or distribution in any form is strictly

First Intuition Publishing Ltd, 2015

CIMA F3 Question Bank (2015 syllabus)

Chapter questions and answers

2 Sustainability and integrated reporting

10 Mergers and acquisitions

CIMA Pilot paper (60 questions to be answered in 90 mins)

Maths tables and Formulae

Pilot paper questions and answers

CIMA F3 Question Bank (2015 Syllabus)

CIMA F3 Question Bank (2015 syllabus)

Chapter 1: Business objectives

Company Y has a greater profit this year than Company X.

Extracts from company Z's accounts are as follows:

What is company Z's interest cover?

WKs profit or loss account contains the following:

Shareholder wealth maximisation is most consistent with

CIMA F3 Question Bank (2015 syllabus)

Interest rates in the economy have risen.

The agency problem arises because managers have

CIMA F3 Question Bank (2015 syllabus)

Private sector, not-for-profit entity

CIMA F3 Question Bank (2015 syllabus)

Dewies current P/E ratio is 8 and it retains 75% of after-tax earnings.

Dans current P/E ratio is 5 and its dividend yield is 8%.

Gross profit margin 40%

Achieving value for money is most likely to be the prime objective of a:

Private sector, for profit entity

CIMA F3 Question Bank (2015 syllabus)

Use the following data to answer the next two questions.

What is the interest cover?

The firm has a high beta factor.

CIMA F3 Question Bank (2015 syllabus)

CIMA F3 Question Bank (2015 syllabus)

Improving the welfare of beneficiaries is most likely to be the objective of:

A public sector organisation

Yes, the bank account would not be overdrawn.

CC undertook a 1 for 5 rights issue on 2 January 20X8.

CIMA F3 Question Bank (2015 syllabus)

Which of the following definitions is incorrect in relation to value for money?

The objectives of CH will be more difficult to define.

Which of the following is not generally an effect of inflation?

Companies increase their level of inventory.

A reduction in the rate of inflation

Profit before tax

What is the dividend yield of AK, to the nearest %?

CIMA F3 Question Bank (2015 syllabus)

What is the earnings yield of KY, to the nearest %?

CIMA F3 Question Bank (2015 syllabus)

Chapter 2: Sustainability and integrated reporting

Fluted is preparing a sustainability report, following Global Reporting Initiative guidelines.

Which of the following is an objective of Integrated Reporting, according to the International

Disclose economic, environmental and social performance

Social and relationship capitals

Identify whether the following statements are true or false.

CIMA F3 Question Bank (2015 syllabus)

A company has no obligation to state that it has omitted information.

2: Sustainability and integrated reporting

CIMA F3 Question Bank (2015 syllabus)

Chapter 3: Financial strategy