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Exam FM 3

Exam Question Answer FM

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19 views2 pages

Exam FM 3

Exam Question Answer FM

Uploaded by

natinael Tsegaye
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOCX, PDF, TXT or read online on Scribd
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(a) Cost of equity

Using the CAPM, ke= 4 + (1.25 × 5.6) = 11.0%


Cost of capital of 10% irredeemable preference shares
Preference share dividend = 0.1 × $0.5 = $0.05 per share
Cost of preference shares = $0.05/$0.55 × 100 = 9.1%
Cost of debt of loan notes
After-tax interest cost = $8 × 0.8 = $6.40 per $100 loan note
Year Cash flow $ 5% discount PV ($) 6% discount PV ($)
0 market value (108.29) 1.000 (108.29) 1.000 (108.29)
1–6 interest 6.40 5.076 32.49 4.917 31.47
6 redemption 105.00 0.746 78.33 0.705 74.03
2.53 (2.79)
–––––– ––––––
After-tax kd = IRR = 5+ (2.53)/(2.53+ 2.79) = 5+ 0.5 = 5.5%
Cost of debt of bank loan
The after-tax interest cost can be used as kd, i.e. 7 × 0.8 = 5.6%.
Alternatively, the after-tax cost of debt of the loan notes can be used as a substitute.
Appropriate values of the sources of finance
$000
Market value of equity = $6.35 × ($8m/$0.2) = 254,000
Market value of preference shares = $0.55 × ($2m/$0.5) = 2,200
Market value of loan notes = $108.29 × ($6m/$100) = 6,497
Book value of debt 2,000
Total market value of sources of finance 264,697
–––––––
Calculation of WACC
WACC = [(11 × 254,000/264,697) + (9.1 × 2,200/264,697) + (5.5 × 6,497/264,697) +
(5.6 × 2,000/264,697)] = 10.8%
(b) Business risk in financial management relates to the variability of shareholder
returns
which arises from business operations.
It can be measured from a statement of profit or loss perspective by operational
gearing, which considers the relative importance of fixed and variable operating costs
in relation to operating profit (PBIT). One definition of operational gearing is
contribution/profit before interest and tax or PBIT. Business risk is not influenced by
the way in which a company is financed, that is, it is not influenced by the capital
structure of a company.
Financial risk relates to the variability of shareholder returns which arises from the
way in which a company finances itself, that is, from its capital structure. It can be
measured from a balance sheet perspective by gearing (financial gearing, debt/equity
ratio, debt ratio) and from a statement of profit or loss perspective by interest cover
and income gearing.
The combination of business risk and financial risk is referred to as total risk.
(c) Pre-emptive right of shareholders
In order to preserve the balance of ownership and control in a company, existing
shareholders have a right to be offered new shares before they are offered to other
buyers. This is known as the pre-emptive right and an offer of new shares to existing
shareholders is consequently referred to as a rights issue.

Rights issue price and cum rights price


The price at which the new shares are offered to existing shareholders is called the
rights issue price. The share price following the announcement of the rights issue is
called the cum rights price and the rights issue price is at a discount to this price.
Theoretical ex rights price
The share price after the rights issue has taken place is called the theoretical ex rights
price. This is a weighted average of the cum rights price and the rights issue price.
The weighting arises from what is called the form of the rights issue, e.g. a 1 for 5
issue would allow an existing shareholder to buy one new share for every five shares
already held.
Neutral effect on shareholder wealth
If issue costs and the use or application of the rights issue funds is ignored, then,
theoretically, rights issue have a neutral effect on shareholder wealth. The rights
issue transfers cash from existing shareholders to the company in exchange for
shares, so the shareholder will see cash wealth replaced by ordinary share wealth.
The theoretical ex rights price, rather than the cum rights price, is therefore a
benchmark for assessing the effect on shareholder wealth of the use or application to
which the rights issue funds are put.
Balance of ownership and control
Providing existing shareholders buy the shares to which they are entitled, there is no
change in the balance of ownership and control in a company. Relative voting rights
are therefore preserved.
Underwriting
In order to ensure that a company receives the funds it needs, rights issues are
underwritten as a form of insurance. Shares which are not taken up by existing
shareholders will be taken up, for a fee, by the underwriters.

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