Sample Test 2018, answers PDF

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Department of Accounting and Finance M.Sc. Finance M.Sc. Investment and Finance M.Sc. International Banking and Finance M.Sc. International Accounting and Finance M.Sc. Economics and Finance M.Sc. Finance and Management And LLM Law and Finance

AG915: Advanced Corporate Finance and Applications1 AG917: Topics in Corporate Finance2 SAMPLE TEST (45 minutes) Instructions for Candidates – Please Read Carefully Answer ALL Questions (in the spaces provided) 1. Financial calculators are not allowed. 2. Calculators must not be used to store text and/or formulae nor be capable of communication. Invigilators may require calculators to be reset. 3. All answers are to be written in the spaces provided in ink. If more space is required the answer can be continued on the back of the page where the question appears. 4. This question paper is to be returned along with your examination answer booklet, you should accurately complete the information below. Under no circumstances is a copy of this paper to leave the exam room. 5. Failure to follow these requirements will lead to a deduction of marks. To Be Completed by Student (please write clearly)

Surname Forename Registration Number 2016 Course (please indicate by ticking appropriate box) Finance

Invest & Fin.

Economics & Fin.

Banking & Fin

Accounting & Fin

Finance & Management

Law & Finance

For Examiners Use Only

SOLUTIONS MARKS AWARDED 1

This test accounts for 15% of you final mark in this class This test accounts for 30% of your final mark in this class M.Sc. Finance (A4)

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Q1.

Two companies, U and G, have identical business operations and expected annual earnings of £60m, but are financed differently. U is financed totally by equity and this is valued in the market at £400m. G is financed by debt and equity, its equity is valued at £340m and its debt is valued £120m and the interest rate on the debt is 6 per cent. There are no taxes and the capital market is perfectly competitive. An investor holds 10 per cent of the shares of G. Determine the increase in income this investor can achieve by selling her shares in G, undertaking some borrowing, and investing the funds in the shares of U. a) b) c) d)

+0.72m +0.90m +0.32m +0.10m

(9 marks) The investor holds 10 per cent of the shares of G and these will be worth £34m. This will produce earnings of £5.28 a (X  k i BG ) 0.10(£60m  0.06x £120m ) £5.28m

The investor can sell the shares for £34m and borrow to obtain the same debt equity ratio as company G: £120m/£340m or 6/17. This will give borrowing worth 6/17 times £34m or £12m. The investor now has £46m to invest in company U. This will generate income, net of interest on the borrowing of £12m, of £6.18m: a * X  k i B *G 

£46m £60m  0.06x £12m  £6.18m £400m

The investor is exposed to the same risk as in her original investment in G, as a result of personal borrowing, but obtains higher income of £6.18m - £5.28m = £0.90m. According to MM (without tax investors) will recognise this type of opportunity and sell the shares in the geared company (G) and buy shares in (U) until the valuation differential disappears. Q2.

Consider the following statements and determine which of them is incorrect If there are no taxes and the expected rate of return on capital employed is higher than the interest rate the use of some debt financing will lead to a) b) c) d)

an increase in expected earnings per share. an increase in the value of the company. (INCORRECT) an increase in the expected rate of return on equity. An increase in the shareholders’ expected rate of return on their investment.

(9 marks) These statements, apart from (b) are based on the M-M model without tax. EPS(G) will exceed EPS(U) as long as ROCE>k(i), but this will not create any increment in value as the risk of the geared EPS will exceed the risk of the ungeared EPS. The same reasoning applies to ROE: ROE (G)> ROE(U), but will not create any increment in value as ROE(G) is riskier than ROE(U). Finally, investors will recognise that E(RG) is riskier than E(RU)and will consequently require a higher value for E(RG) than E(RU). The following information should be used in answering Questions 3 and 4 Weston plc financed entirely by equity, but is considering the use of debt to fund a major expansion of the company’s business. This expansion will required an investment of £8 million. Presently the company has 6 million shares outstanding trading at £4.00 per share. It could fund the proposed investment by issuing 2 million shares at the current market price or issue bonds for £8m at an interest rate of 9 per cent. The level of expected earnings after the expansion is £5.20 million and the tax rate is 25 per cent.

M.Sc. Finance (A4)

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Q3.

Determine the difference between the expected EPS with gearing to that of the EPS if the company continues to only employ equity in its financing. a) b) c) d)

£0.0542 £0.0790 £0.0620 £0.0725 (9 marks)

Q4.

Continuing with the choice of financing for Weston outlined above determine the level of earnings before interest and tax that will produce the same earnings per share for both the financing options. a) b) c) d)

£2.88 million £3.20 million £2.16 million £1.72 million (9 marks)

EPS(U )  EPS( G) X (1  t C ) ( X  k i B )(1  t C )  N (U ) N (G ) ( X  0.09 x8) X  8 6 6X  8X  8(0.09x 8) 2 X 5.76 X *  2.88

The following information should be used when answering Questions 5 and 6 Branton plc is planning a rights issue to raise £45m. The company has 75 million shares outstanding and its current share price is £4.00. The subscription price for the issue is going to be set at a discount of 25 per cent. Q5.

Determine the value of a right.

M.Sc. Finance (A4)

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a) b) c) d)

3.75 0.83 3.00 2.80 (8 marks)

PS = 4.00 (1 – 0.25) ΔN = 45m/3.00 Terms → 15 for 75 Px = 1/6 x 3.00 + 5/6 x 4.00 V0 = P0 x N = 4.00 x 75m Px = (V0 + F)/(N + ΔN) V(R) = Px – Ps = £3.83 - £3.00

Q6.

= 3.00 = 15m = 1 for 5 = £3.83 = £300m = (£300m + £45m)/(75m + 15m) = £3.83 = £0.83

If an investor owns 500 shares and decides to sell the rights to the proposed issue for cash. Determine how the total value of Branton’s shares held in his portfolio will change as a result. a) b) c) d)

54.56 90.21 83.33 85.64 (8 marks)

Initial investment Investment post issue Difference Sale of rights (1 for 5) Q7.

500 x £4.00 = £2,000 500 x £3.8333 = £1916.67 = £83.33 100 x £0.8333 =£83.33

Which of the following statements is not correct a) A right can be viewed as a call option. b) The average discount offered on equity issues on cash offers in the USA is lower than the average discount employed in rights issues in the UK, making the real cost of the issues in the USA are lower than those in the UK. c) As underwriting provides a certification role it is likely to cost more than its value as a put option. d) Rights issues are designed to protect the interests of a company’s shareholders. (8 marks) A right can be viewed as a call option as the shareholders in a rights issue are given a right to subscribe to the new shares at the subscription price, but are not obliged to do so. In principle the size of the discount in a rights issue does not have an effect on the wealth of the shareholders. But if shares are sold to new or outside investors, as would be the case for cash offers in the USA, the interests of the existing shareholders are diluted. For new issues made at a discount in the USA a cost is imposed on the existing shareholders, and the greater the discount offered to the new shareholders the greater the real cost. The statement made in (b) is therefore incorrect. Underwriting gives the company the right but not the obligation to sell shares to the underwriters at the subscription price – and therefore has the same properties as a put option. But the underwriters are lending their reputation the issuing company, this is referred to as a certification role, and this carries an element of risk for which the underwriter will require compensation that will push the cost above that of a simple put option. Rights issues were designed to protect shareholders from the dilution that would occur if managers were to sell shares to outsiders at a discount. (An action that would dilute the interests of the shareholders.)

The following information should be used when answering Questions 8, 9, 10 and 11 M.Sc. Finance (A4)

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Garfield plc is financed entirely by equity and the company’s expected earnings before tax is £180 million and this is not expected to change over time. The corporate tax rate is 30 per cent and the ungeared company’s equity is valued at £840 million. Q8.

Determine the company’s cost of equity. a) b) c) d)

0.12 0.15 0.16 0.14 (8 marks)

kU 

Q9.

X (1  t C ) 180(1  0.30) 0.15  VU 840

The company is considering buying back £340 million of its equity and financing this by issuing debt at 8 per cent. If the company implements this financial restructuring determine the overall value of the company.

a) b) c) d)

£840 million £904 million £942 million £1,080 million (8 marks)

VG VU  t C BG 840  0.30 * 340 942

Q10.

Determine the company’s cost of equity if the restructuring is implemented. a) b) c) d)

0.1457 0.1805 0.1623 0.1777 (8 marks)

( X  k iB G )(1  t C ) ke  SG SG VG  BG  942  340  602 (180  0.08 x340 )(1  0.30) 106.96   0.1777 602 602 B 340  0.1777 k e k U  (k U  k i )(1  t C ) G 0.15  (0.15 - 0.08)(1 - 0.30) 602 SG Determine the weighted average cost of capital for the company assuming the restructuring takes place. ke 

Q11.

a) b) c) d)

0.1421 0.1500 0.1338 0.1356 (8 marks)

X (1  tC ) 180(1 0.30)  0.1338 WACC k 0  VG 942  w B x k i (1 t C )  (1 w B )k e 340 340 x 0 .08x (1  0.30)  (1  )0.1777  942 942  0.0202  0.1136 0.1338 M.Sc. Finance (A4)

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[ 8 marks] Q12. Selkirk plc is financed entirely by equity and is valued at £360 million. It is considering restructuring its capital and introducing some debt capital into its financing. It has been established that it can borrow £120 million at 8 per cent and that the additional funds will be used to buy-back shares, worth £120 million. The corporate rate is 30 per cent, the personal tax rate on equity income is 8 per cent and the personal tax rate on interest income is 20 per cent. Use Miller’s Debt and Taxes model to determine the overall value of the company following the implementation of the restructuring.

a) b) c) d)

143.4 million 396.0 million 480.0 million 383.4 million. (8 marks) [TOTAL 100 MARKS]

M.Sc. Finance (A4)

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