1 f9 Revision Mock June 2013 Answers Version 6 Final

7/22/2019 1 f9 Revision Mock June 2013 Answers Version 6 Final

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ACCAPaper F9

Financial Management

Revision Mock ExaminationJune 2013

Answer Guide

Health Warning!

How to pass Attempt the examination under exam conditionsBEFORE looking at these suggested answers.Then constructively compare your answer,identifying the points you made well andidentifying those not so well made.If you got the basics wrong: re-revise by re-writing them out until you get them correct.

How to fail Simply read or audit the answers congratulatingyourself that you would have answered thequestions as per the suggested answers.


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Answer 1 Pep Co

Tutorial help and key points

(a)

NPV should be calculated as the present value of future relevant cash flows(discounted using the appropriate cost of capital) less the initialinvestment.

The $8,000,000 development and testing cost is sunk as it has alreadybeen incurred and irrelevant cash flow. It should be ignored.

Initial market research cost of $2,500,000 is a committed cost andirrelevant cash flow. It should be ignored.

Fixed costs represent incremental fixed production overheads which arewholly attributable to the project, hence relevant to cash flow.

Selling price, variable cost and fixed costs are all in current prices andshould be adjusted by their respective inflation rates from year oneonwards.

Tax is payable one year in arrears. Working capital should be included in year zero subject to general inflation

increase and the total should be recovered in year four.

The appropriate cost of capital should be the nominal (after inflation) asthe cash flows are already inflated. Convert the real cost of capital tonominal using the Fisher equation (1 + M) = (1 + R)(1 + I)

Comment on the acceptability of the project based on the NPV figure.(b)

Internal rate of return (IRR) is the discount rate that makes the NPV equalto zero.

To calculate IRR, you need two NPVs using two different discount rates,ideally one positive and other negative NPV.

Having calculated one positive NPV at 11% in (a), you need to calculate anegative NPV using a higher discount factor.

Substitute the two NPVs and their corresponding rates in the IRR formula. Comment on the acceptability of the project by comparing the IRR to the

cost of capital

(c)

Discuss the key issues in capital investment projects process:

identifying, evaluating,


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authorising, monitoring and controllingMarking scheme

Marks

(a)

NPVSales 1Variable cost 1Fixed costs 1Tax on operating profit 2Tax saved on capital allowances 3Residual value 1Working capital 2

Nominal/(money discount factor 1Discount factors 1Net present value 1Comment on the acceptability of the project 1_______

Max 13

(b)

IRRSecond NPV 1IRR calculation 2Comment on the financial acceptability of the project 1

_______

4(c)

2 marks each for the discussion of each stage(identifying, evaluating, authorising, monitoring andcontrol) up to a maximum of 8

Total marks 25 marks


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(a)

Net present value

Years 0 1 2 3 4 5$000 $000 $000 $000 $000 $000

Sales 42,000 169,820 231,500 36,460Variable cost (18,720) (75,740) (143,375) (23,860)Fixed costs (10,500)______ (11,025)______ (11,576)_______ (12,155)______

12,780 83,055 76,549 445Tax 30% (3,834) (24,917) (22,965) (134)

Tax savings oncapital allows 9,000 6,750 5,063 12,188Equipment cost (120,000)Resale value 10,000Working capital (20,000)_______ (600)______ (618)______ (637)_______ 21,855______

Net cash flows (140,000) 12,180 87,603 57,745 14,398 12,054

DF (11%) 1_______ 0.901______ 0.812______ 0.731_______ 0.659______ 0.593______Present values (140,000)_______ 10,974______ 71,134______ 42,212_______ 9,488_______ 7,148______

Net presentvalue $956

Since the net present value is positive the project is financially acceptable.

Workings

(1) Sales

Years 1 2 3 4

$000 $000 $000 $000

Selling price 2,000 2,200 1,600 1,500

Inflation 1.051______ 1.052______ 1.05

3______ 1.054______

Inflated selling price 2,100 2,426 1,852 1,823

Units (000) 20______ 70_______ 125_______ 20_______

Sales ($000) 42,000______ 169,820_______ 231,500_______ 36,460_______

(2) Variable cost

Years 1 2 3 4

$000 $000 $000 $000

Variable cost per unit 900 1,000 1,020 1,020

Inflation 1.041______ 1.042______ 1.04

3_______ 1.044______

936 1,082 1,147 1,193

Units (000) 20______ 70______ 125_______ 20______

Total variable cost ($000) 18,720______ 75,740______ 143,375_______ 23,860______


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(3) Fixed costs

Years 1 2 3 4

$000 $000 $000 $000

Fixed costs ($000) 10,000 10,000 10,000 10,000Inflation 1.051______ 1.05

2______ 1.053______ 1.05

4______

Inflated fixed cost 10,500______ 11,025______ 11,576______ 12,155______

(4) Tax savings on capital allowances

Year Tax saved

$000

1 120,000 x 0.25 x 0.3 9,000

2 0.75 x 9000 6750

3 0.75 x 6750 50634 Difference 12,187______

(120,000 - 10,000) x 30% 33,000______

(5) Working capital

Years 0 1 2 3 4

$000 $000 $000 $000

Total working capital(1.03) 20,000

______20,600

______21,218

______21,855

______Increase in workingcapital cash flows 20,000 600 618 637 21,855

(6) Nominal/money discount factor

(1 + M) = (1 + R)(1 + I)

Money discount factor = (1.078)(1.03) 1 = 11.034% say 11%

(b)

Net cash flows (140,000) 12,180 87,603 57,745 14,398 12,054

DF (13%) 1_______ 0.885______ 0.783______ 0.693______ 0.613______ 0.543______

Present values (140,000)_______ 10,779______ 68,593______ 40,017______ 8,826______ 6,545______

NPV = (5,240)

IRR = 11% + (956/956 + 5240) x (13% -11%) = 11.31%

The IRR is marginally higher than the cost of capital and the project is financiallyacceptable.


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(c)

Investment decisions can be seen as comprising of the following key stages:

Determining the funds available

The funds available may be determined either by the external market or by themanagement of the business. In practice, it is usually the latter that will set a limitto the level of investment funds. Feasible investment opportunities are those thatfall within the agreed limit.

Identify profitable investment opportunities

Arguably the most important stage in the process is the search for suitableinvestment opportunities. This may be done in various ways. It can involve asystematic search of the environment, taking into account factors such as changesin technology, consumer tastes and market conditions. It can also involve a searchwithin the business to identify opportunities for efficiencies. The search for suitableopportunities may involve senior managers, project teams and individual

employees.Evaluate the investment opportunities

Each opportunity identified should be the subject of formal screening. For largerprojects, a business case may have to be prepared which sets out various aspectsof the investment such as its relation to the objectives of the business, the marketopportunities to be exploited, the degree of risk, the technical feasibility, theresources required to support the investment and so on. Information concerningthe time scale of the investment, the key investment stages and the costs of notpursuing the investment should also be considered. The key estimates andassumptions underpinning the business case should be clearly identified andevaluated. The investment opportunity must be subject to financial evaluation.Where the objective of the business is to maximise shareholder wealth, the NPVmethod of appraisal is most suitable. The risks of the investment should also betaken into account through techniques such as sensitivity analysis, scenarioanalysis and so on.

The investment may have promoters within the business and their ability to see theinvestment through to a successful conclusion must also be evaluated.

Authorisation of the investment

The level of authorisation required will normally vary according to the scale of theinvestment.

Large investments are likely to require the authorisation of senior management.Where the funds available are insufficient to cover all of the opportunities proposed,some ranking of proposals will have to be carried out. Not all the investmentopportunities identified are likely to be authorised. Some may be postponed toawait further developments, or further information, and some may be rejected.Where an investment opportunity is rejected, the likely effect on the business andstaff morale must be considered.

Monitoring the investment

Once a decision is made to go ahead, the investment must be carefully monitored.For large investments, regular progress reports should be produced which trackvariances between actual and forecast figures. Where necessary, revisions may

have to be made to forecast outcomes, completion dates or other critical variables.At the end of the investment, a post-completion audit may be carried out. This


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should try to identify where things did not go according to plan and what lessonsmay be learned for the future. The audit should also help to ensure that futureinvestment proposals are not overly optimistic. Managers involved in thepreparation of investment project proposals will know that their estimates andforecasts will be scrutinised at the end of the project.


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Answer 2 - WLF


(a)

(i) Net asset using book value

Net asset (book value) method values the ordinary shares as thedifference between total assets and total liabilities (both current andnon-current liabilities) from the statement of financial position given.

The share price is therefore the total net assets divided by thenumber of ordinary shares.

(ii) Net asset using net realisable values

Net asset (net realisable value) method values the ordinary shares asthe difference between the total net realisable value of assets andtotal net realisable value of liabilities (both current and non-currentliabilities).

Therefore, adjust the statement of financial position values to theirrealisable values before calculating the net assets.

Any asset or liability without realisable value, simply assume that itnet realisable value is equal to its book value.

The share price is therefore the total net realisable value of netassets divided by the number of ordinary shares.

(iii) Dividend growth valuation method

The dividend valuation model values the ordinary share as thepresent value of the future dividend using the cost of equity as thediscount factor.

Dividend is growing and therefore need to use the growth formula:Po = Do(1 + g)/(r g)

(iv) Price Earnings Ratio method

The price-earnings ratio method values ordinary shares as: Po = P/Eratio x Earnings per share (EPS).

The price earnings ratio used should be a proxy price-earnings ratiofrom a similar company.

The earnings per share should be the earnings of the company to bevalued and should be calculated as the earnings divided by thenumber of ordinary shares.


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(b)

WACC is calculated as the weighted average of cost of equity andcost of debt using market values of equity and debt as the weighting.

The company has raised capital from equity, bank loan andredeemable loan notes, hence calculate the cost and value of each ofthese sources of capital.

Cost of equity is given, so just calculate the market value of equityas the number of ordinary shares multiplied by the ordinary shareprice.

Calculate the cost of bank loan as the net interest: I x (1-t). Thevalue of bank loan is simply the book value.

Calculate the cost of the redeemable loan notes as the internal rateof return and calculate the market value of the loan notes.

Finally, calculate the WACC.(c)

Explain the term efficient in the context of stock markets Discuss the three levels of market efficiency:

o Weak form,o Semi-strong form,o Strong form.

Marking scheme

Marks

(a)

(i) Net assets (book value method) 1(ii) Net assets (liquidation method) 3(iii) Dividend growth valuation method 3(iv) Price earnings ratio method 1_______

8

(b)

Market value of equity 1Cost of bank loan 1Cost of redeemable loan notes (internal rate of return) 4Market value of loan notes 1WACC 2

_______

9


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(c)

Explanation of efficiency 2Weak form 2Semi-strong form 2

Strong form 2_______

8


(a)

(i) Net assets (book value method)

Po = Net assets from statement of financial position values/No of ordinary shares

= $762/200= $381

(ii) Net assets (liquidation method)

Po = Net assets at realisable values/No. of ordinary shares

= [(876 + 24 + 52 + 408 + 330) 590]/200

= $550

(iii) Dividend growth valuation method

Po = Do(1 + g)/(r g)

Where:

Do = current dividend

g = expected annual growth in dividends

r = required rate of return

= $030 (1 + 003)/(007 003)

= $773

(iv) Price Earnings Ratio method

Po = P/E ratio x Earnings per share (EPS)

= 9 x 108*

= $972

*EPS is calculated as follows:

EPS = $216/200

= $108

(b)

Equity

Cost of equity (given) = 7% Market value of equity = (200/1) x $8.3 = $1,660


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Bank Loan

Cost of bank loan = 6% ( 1 0.25) = 4.5% Value of bank loan (given) = $105Loan notes

Cost of Loan notes ( calculate internal rate of return)The annual after-tax interest payment = 7 x (1 0.25) = 7 x 0.75 = $5.25 peryear

Year Cash flow 5% Discount Present($) factor value ($)

0 Market price (103.50) 1.000 (103.50)16 Net interest 5.25 5.076 26.656 Redemption value 100 0.746 74.60_______

(2.25)_______

Year Cash flow 4% Discount Present($) factor value ($)

0 market price (103.50) 1.000 (103.50)16 net interest 5.25 5.242 27.526 redemption value 100 0.790 79.00______

3.02______

After-tax cost of debt (IRR) = 4 + [(1 x 3.02)/(3.02 + 2.25)] = 4 + 0.57 = 4.6%

Market value of Loan notes = (180/100) x 103.5 = $186.30WACC

= (keVe + kBLVBL + kd(1 T)Vd)/ (Ve + Vp + Vd)

= (7% x 1,660 + 4.5% x 105 + 4.6% x 186.3)/1,951.3 = 6.6%

(c)

The term efficient in the context of stock markets refers to the way in whichinformation is processed by investors. A stock market is regarded as being efficientwhere relevant information is absorbed quickly and accurately by investors andwhere this information is faithfully reflected in share prices. The fact that newinformation is processed quickly and accurately means that, in an efficient market,

it is not possible for an investor to make abnormal gains over the long term byswiftly responding to new information. It also means that there is no prospect ofspeculative bubbles as share prices will always faithfully reflect the informationavailable.

Three levels of market efficiency have been identified. These are the weak form,the semi-strong form and the strong form. Each of these forms is consideredbelow.

Weak form

Weak-form efficiency is said to occur when current share prices reflect all relevantpublished information relating to the past share price and trading performance.

New information relating to companies, however, is not anticipated by the market.As new information concerning companies will arise on a random basis, and will not


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be anticipated by the market, changes in share prices will occur on a random basis.This means that it is not possible for investors to make abnormal gains over thelong term by trying to detect trends or patterns in share prices.

Semi-strong form

Semi-strong form efficiency is said to occur when share prices quickly andaccurately reflect all publicly available information. This will include informationrelating to future prospects as well as past performance and may include newsrelating specifically to the company (such as the published annual reports, takeoverspeculation, boardroom changes etc), news relating to the industry within which thecompany operates (such as changing levels of demand, competitive pressures etc),and news relating to the economy as a whole (such as interest rate changes,inflation etc). Where a semi-strong level of efficiency exists, investors will beunable to make abnormal gains on a consistent basis by studying fundamentalssuch as company news, reported profits, industry reports and future prospectsbecause this information is already incorporated in share prices.

Strong form

Where strong-form efficiency exists, share prices will reflect all information,whether publicly available or not, that is relevant to deriving the true value of ashare. This means that it is not possible for investors to make abnormal gains evenif they have access to inside information. The stock market is considered to be a

fair game, insofar that no investor has an information advantage over others.


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Answer 3 FAQ plc


(a)

Identify liquidity and profitability as the twin objectives of working capitalmanagement.

Explain the meaning of liquidity. Explain the meaning of profitability. Give one conflict between profitability and liquidity. Conclude that the company should try to achieve a balance between

liquidity and profitability.

(b)

The best policy (discount or factoring) depends on which policy will resultin the highest net benefit.

Calculate the costs and benefits associated with the settlement discountas:

o Cost discount allowed.o Benefits collection cost saved and the interest saved on the cash

received early as a result of the discount.

o Compare the total cost to total benefits to calculate the net cost orbenefits.

Calculate the costs and benefits associated with the factoring as:o Cost factors fee and interest and overdraft interest.o Benefits collection cost saved and overdraft interest saved.o Compare the total cost to total benefits to calculate the net cost or

benefits.

Finally, select the policy with the highest net benefit.(c)

Discuss the advantages of just-in-time inventory management policy. Discuss the disadvantages of just-in-time inventory management policy.(d)

The best ordering policy is the order size that minimises the total inventorycost. Therefore calculate the total cost for each order size.

There are three order sizes in the question: at the EOQ (no discount willbe given), 200 units or 400 units.


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At EOQ level:o Calculate the EOQ using the formula (2 x CoD)/Ch.o Calculate the total purchase cost.o Calculate the total holding cost.o Calculate the total ordering cost.

At 200 level:o Calculate the total purchase cost (removing the discount from the

purchase price).

o Calculate the total holding cost.o Calculate the total ordering cost.

At 400 level:o Calculate the total purchase cost (removing the discount from the

purchase price).

o Calculate the total holding cost.o Calculate the total ordering cost.

Select the order size with the minimum total cost.Marking scheme

Marks

(a)

Explanation of profitability and liquidity 2Explanation of conflicts between profitability and liquidity 2_______

4

(b)

Early payment discountDiscount allowed 1Collection cost saved Interest saved 1Decrease in receivables 1Net benefits 1

Factoring servicesFactors fees 1Factors interest 1Overdraft interests 2Collection cost savings Net benefits 1Conclusion 1

_______

Max 10

(c)

Arguments for the implementation of a just-in-time approach 2-3Arguments against the implementation of a just-in-time approach 2-3_______

Max 5


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(d)

EOQCalculation of EOQ 1Purchase cost

Total ordering cost Total holding cost

If 200 units are orderedPurchase cost 1Total ordering cost Total holding cost

If 400 units are orderedPurchase cost 1Total ordering cost Total holding cost _______

Max 6



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(a)

The objectives of working capital management are profitability and liquidity.

Profitability is to ensure that reasonable returns are given to shareholders in linewith the primary objective of maximizing shareholders wealth. Liquidity is toensure that the company is able to meet it liabilities when they fall due.

The two objectives are in conflict because liquid assets such as bank accounts earnvery little return or no return, so liquid assets decrease profitability which is met byinvesting over the longer term in order to achieve higher returns.

The objective of working capital management is therefore to achieve a balancebetween profitability and liquidity.

(b)

Early payment discount

$CostsDiscount allowed (12,000,000 x 80% x 2%) 192,000_______

BenefitsCollection cost savings (140,000 - 40,000) 100,000Interest saved (800,000* x 15%) 120,000_______

220,000_______

Net benefits (220,000 - 192,000) 28,000_______

*

Receivables without discount = (60/360) x 12,000,000 2,000,000

Receivable with discount:

(30/360) x 12,000,000 x 80% + (60/360) x 12,000,000 x 20% = 1,200,000________

Decrease in receivables *800,000________

Factoring

CostsFees (2% x 12,000,000) 240,000

Factor interest (20/360 x 12,000,000 x 80% x 10%) 53,333Overdraft interest (20/360 x 12,000,000 x 20% x 15%) 20,000________

313,333________

Benefits

Collection cost saved (140,000 5,000) 135,000Overdraft interest saved (60/360 x 12,000,000 x 15%) 300,000_______

435,000_______

Net benefits (435,000 313,000) 121,667_______

Factoring is preferable on financial grounds as it offers the highest net benefit.


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(c)

The just-in-time (JIT) approach to inventory management requires that inventorybe delivered to the customer at the moment they are required to enter theproduction process. Such a precise approach to inventory delivery means that thecustomer and supplier must have a close working relationship. The supplier must

be aware of the production requirement of the customer in advance and so thecustomer must be prepared to divulge potentially sensitive information to thesupplier. In addition, the customer must be confident that the appropriate quantityand quality of inventory will be delivered at the right time. The efficiency of theproduction process becomes highly vulnerable to any delivery problems.

The JIT approach is not necessarily a means of reducing overall costs, even thoughstockholding costs may be reduced. This approach effectively transfers thestockholding problem, along with the associated costs, to the supplier. This is likelyto mean that the supplier will charge the customer higher prices in order tocompensate. The close relationship between customer and supplier may also meanthat it is not possible to reduce costs by taking advantage of cheaper sources of

supply easily.

The JIT approach is closely associated with Japanese companies where it isembraced as part of an overall commitment to excellence and the elimination ofinefficiency. It is seen as contributing towards an ideal manufacturing environmentwhere there are no defects, no waste or production inefficiencies, and wheresupplies are delivered on time. Whilst this environment may be impossible toachieve in practice, it does provide the business with demanding goals that itshould seek to achieve.

(d)

The economic order quantity (EOQ) without discounts can be calculated as follows:

EOQ = (2 x 8,000 x 50)/80 = 100 units

If the EOQ approach is used, the total annual costs associated with the item is:

$

Annual purchases (8,000 x $60) 480,000Annual ordering costs [(8,000/100) x $50] 4,000Annual holding costs [(100/2) x $80] 4,000_______

488,000_______

The discounts will only apply to orders above the economic order quantity. Thus, if

200 items are ordered, the total annual costs of the item will be:

$

Annual purchases [8,000 x ($60 x 975%)] 468,000Annual ordering costs [(8,000/200) x $50] 2,000Annual holding costs [(200/2) x $80] 8,000_______

478,000_______


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If 400 items are ordered, the total annual costs of the item will be:

$

Annual purchases [8,000 x ($60 x 96%)] 460,800Annual ordering costs [(8,000/400) x $50] 1,000

Annual holding costs [(400/2) x $80] 16,000_______477,800_______

Thus, it seems that it would benefit the company if 400 units were ordered on eachoccasion. However, there is little to choose between the two discount options.


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Answer 4 SGT plc


(a)

Theoretical ex-rights price is calculated as the weighted average of thecurrent market price and the issue price.

The current market price was not given. Calculate it using the price-earnings ratio method as the P/E ratio times EPS.

The issue price is 70% of the current share price. The rights issue is madeat a discount of 30%.

To calculate the TERP, multiply the number of shares before the rightsissue by the current market price and add to the issue price multiplied bythe rights issue shares. Divide the sum by the number of shares afterrights issue.

(b)

The options available to the shareholder of 10,000 shares were given inthe question as:

o Take up rights offero Sell all the rightso Allow rights offer to lapse (do nothing).

Effect on wealth can be assessed by comparing the current wealth (value)to the revised wealth (value after the rights issue and the option theshareholder will take).

Calculate the current wealth as the current market price multiplied by the10,000 shares.

Calculate the wealth after rights issue as follows:o Market price after rights issue is the TERP calculated in (a).o Calculate the value of the rights per the new share as the difference

between TERP and the issue price.

o Calculate the rights shares as the number of shares he will receiveunder the rights issue.

o Calculate the wealth for each of option take up rights up offer, sellall the rights and do nothing.

(c)

The effects on EPS, interest cover and gearing is assessed by comparingthe current to the revised EPS, interest cover and gearing.

By raising equity capital through rights issue to pay of some debt:


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o debt capital will reduce by the proceeds from the rights issue,o interest will also reduce by the interest saved on the amount of debt

paid,

o Profit will therefore increase by net interest saved = interest savedless tax,o Equity capital will increase by the proceeds from rights issue,o Number of shares will also increase by the shares issued under the

rights issue.

Calculate current and revised EPS separately using the current/revisedearnings divided by the current/revised number of shares respectively.

Calculate current and revised interest covers separately as thecurrent/revised profit before interest and tax divided by thecurrent/revised interest respectively.

Calculate current and revised gearing ratios separately as thecurrent/revised debt divided by the current/revised equity respectively.

Comment on your findings by comparing the current figures and therevised figures.

(d)

Assuming that the price earnings ratio remained constant, the marketprice after the redemption of some of the debt will be estimated as: theprice earnings ratio multiplied by the revised earnings per share.

Comment on your findings as follows:o The current market price of the company is 5 and after the rights

issue the price (TERP) reduced to 4.75. The reduction in marketprice of the shares does not reduce the shareholders wealth as thereduction is compensated by increased number of shares. Afterredemption of some of the debt, the share price is 4.87 andtherefore increases shareholders wealth by 0.12 (4.87 4.75) pershare.

(e)

Discuss the factors to consider in formulating dividend policy such as:o Liquidity positiono Profitabilityo Restrictive covenantso Signalling effectso Clientele effectso Rate of expansion.


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Marking scheme

Marks

(a)

Current market price 1Rights issue price 1Terp 1_______

3

(b)

Take up the rightValue of shares after rights issue 1Purchase cost 1

Sell all the rights

Value of shares after rights issue 1Sale of rights 1

Allow rights to lapseValue of shares after rights issue 1

Comment 1_______

6

(c)

Current EPS

Revised EPS 1Current interest cover Revised interest cover 1Current debt/equity ratio Revised debt/equity ratio 1Comment 2_______

7

(d)

Market price after redemption of debt 1Comment 2_______

3(e)

1 mark per point discussed Max 6



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(a)

Theoretical ex rights price

Earnings per share (75m/240m) 0.3125_______

Market value per ordinary share (16 x 0.3125) 5.00_______

Original shares 5 x 5.00 25.00Rights share 1 x (5.00 x 0.7) 3.50_ _______

6 shares 28.50_______

Theoretical ex rights price (TERP) 28.50 /6 4.75_______

(b)

Value of rights per new shares (TERP issue price)

TERP 4.75Issue price 3.50_______

Value of rights per new share 1.25_______

Evaluation of options

Current market value of the 10,000 share holdings = 10,000 x 5.00 = 50,000

Take up rights offer

Value of shares following rights issue [(10,000 + 2,000) x 4.75] 57,000Less: Cost of purchasing rights shares (2,000 x 3.50) (7,000)_______

50,000_______

Sell rights

Value of shares following rights issue (10,000 x 4.75) 47,500Add: Sale of rights (2,000 x 1.25) 2,500

_______50,000_______

Allow rights offer to lapse (do nothing)

Value of shares after rights issue (10,000 x 4.75) 47,500_______

The calculations indicate that the wealth of the investor will be unaffected whethera decision is made to take up the rights offer or to sell the rights. The onlydifference will be in the form that the investors wealth will take. However, if theinvestor allows the rights offer to lapse, there will be a loss of wealth of 2,500.Thus, there is an incentive for the investor not to allow the offer to lapse. Inpractice, the business may sell the rights on behalf of the investor and then pass on

the proceeds. However, it is under no obligation to do this.


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(c)

Number of rights shares = 240/5 = 48 shares

Number of shares after rights issue (revised number of shares) = 240 + 48 = 288shares

Proceeds from rights issue = 48 shares x 3.5 (issue price) = 168 = Amount ofdebt redeemed

Revised equity capital = 520 + 168 = 688

Remaining debt amount (revised debt) = 550 - 168 = 382

New interest payable (revised interest payable) = 382 x 10% = 38.2

(i) Earnings per share

Current EPS = 75/240 = 0.3125

Revised Earnings = 75 + (168 x 10% x 0.75) = 87.6

Revised EPS = 87.6/288 shares = 0.3042(ii) Interest cover

Current interest cover = 155/55 = 2.82 times

Revised interest cover = 155/38.2 = 4.06 times

(iii) Gearing (debt/equity)

Current gearing = (550/520) x 100% = 105.8%

Revised gearing = (382/688) x 100% = 55.5%

The redemption of some of the debt has decreased the earnings per share due toproportional increase in shares being more than the proportional increase inearnings due to net savings of interest on the debt paid. However, the payment ofdebt has improved the gearing position (financial risk) of the company as indicatedby increase in interest cover above the industry average and reduction of debtequity ratio below the industry average.

(d)

Assuming that the price earnings ratio remained constant, the market price afterthe redemption of some of the debt will be estimated as: price earnings ratiomultiplied by the revised earnings per share:

MP = 16 x 0.3042 = 4.87

The current market price of the company is 5 and after the rights issue the price(TERP) is reduced to 4.75. The reduction in market price of the shares does notreduce the shareholders wealth as the reduction is compensated by increasednumber of shares. After redemption of some of the debt, the share price is 4.87and therefore increases shareholders wealth by 0.12 (4.87 4.75) per share.

(e)

In deciding a companys dividend policy the following factors should be considered:

Liquidity

To pay dividend sufficient liquid funds should be available. Even very profitable

companies might sometimes find it difficult to pay dividend if resources are tied upin other forms of asset, especially if bank overdraft facilities are not available.


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Repayment of debt

Dividend payout may be made difficult if debt is scheduled for repayment and thisis not financed by a further issue of funds.

Restrictive covenants

The articles of association may contain agreed restrictions on dividends. Inaddition, some forms of debt may have restrictive covenants limiting the amount ofdividend payments or the rate of growth that applies to them.

Rate of expansion

Growth companies faced with many investment opportunities may prefer to financetheir expansion by retaining a large proportion of their profit instead of distributingthe profit by way of dividend and asking the existing shareholders to provide extramoney for expansion through rights issues which will incur issue cost.

Stability of profit

All other things being equal, a company with stable profits is more likely to be able

to pay out a higher percentage of earnings than a company with fluctuating profits.

Control

The use of retained earnings to finance new projects preserves the companysownership and control.

Policy of competitors

Dividend policies of competitors may influence corporate dividend policy. It may bedifficult, for example, to reduce a dividend for the sake of further investment, whencompetitors follow a policy of higher distribution.

Signalling effect

This is the information content of dividend. Dividends are seen as signals from thecompany to the financial markets and shareholders. Investors perceive dividendannouncements as signals of future prospects for the company.

Legal restrictions

For example, in the UK the Companies Act 2006 imposes restrictions on thedistribution of profit by companies. It should be noted that the purpose of the lawis to determine the maximum allowable distribution.

Taxation

In some countries dividends and capital gains are subject to different marginal

rates of taxation, usually with capital gains being subject to lower level of taxationthan dividend. This distortion in the personal tax system can have an impact oninvestors preference. The preference would very much depend on the tax positionof investors. This is the clientele effect.

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