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| Section | Weight | Objectives |
|---|---|---|
| Business Valuation | 40% | - Impairment testing and value management - Investment appraisal
|
| Sources of Long-term Funds | 25% | - Debt finance
- Capital structure theories and WACC
|
| Financial Policy Decisions | 15% | - Strategic financial objectives and stakeholder impact
|
| Financial Risks | 20% | - Risk measurement and assessment
- Types of financial risk
|
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NEW QUESTION # 169
On 1 January 20X1, a company had:
* Cost of equity of 10 0%.
* Cost of debt of 5.0%
* Debt of $100Mmilion
* 100 million $1 shares trading at $4.00 each.
On 1 February 20X1:
* The company's share police fell to $3.00.
* Debt and the cost of debt remained unchanged
The company does not pay tax.
Under Modigliani and Miller's theory without lax. what is the best estimate of the movement in the cost of equity as a result of the fall in ne share price?
Answer: A
Explanation:
At 1 Jan:
Cost of equity, ke=10%k_e = 10\%ke=10%
Cost of debt, kd=5%k_d = 5\%kd=5%
Debt D=100D = 100D=100
Shares = 100m @ $4 # Equity E0=400E_0 = 400E0=400
Total value V0=D+E0=500V_0 = D + E_0 = 500V0=D+E0=500.
WACC under Modigliani & Miller (no tax):
k0=E0V0ke+DV0kd=400500#10%+100500#5%=8%+1%=9%k_0 = \frac{E_0}{V_0}k_e + \frac{D}{V_0} k_d = \frac{400}{500} \cdot 10\% + \frac{100}{500} \cdot 5\% = 8\% + 1\% = 9\% k0=V0E0ke+V0Dkd=500400#10%+500100#5%=8%+1%=9% k0k_0k0 stays constant.
After the share price falls to $3:
Equity E1=100m×3=300E_1 = 100m \times 3 = 300E1=100m×3=300
Debt still 100 # D/E1=100/300=0.3333D/E_1 = 100/300 = 0.3333D/E1=100/300=0.3333 MM no-tax formula:
ke=k0+(k0#kd)DE=9%+(9%#5%)#100300=9%+4%#0.3333#9%+1.33%=10.33%k_e = k_0 + (k_0 - k_d)\frac
{D}{E} = 9\% + (9\% - 5\%) \cdot \frac{100}{300} = 9\% + 4\% \cdot 0.3333 \approx 9\% + 1.33\% = 10.33
\%ke=k0+(k0#kd)ED=9%+(9%#5%)#300100=9%+4%#0.3333#9%+1.33%=10.33%
Rounded # 10.3%.
NEW QUESTION # 170
A large, quoted company that is all-equity financed is planning to acquire a smaller unquoted company that is also all-equity financed.
The acquiring company's directors are using the dividend valuation model to value the target company before making an offer.
Relevant data for the target company:
* Dividends paid in the last financial year $2 million
* Book value of net assets $15 million
* Shares in issue 1 million
The acquiring company's cost of capital is 10%.
Its directors believe they can improve the target company's performance in the long term.
They estimate there will be no growth in the first year of the acquisition but from year 2 onwards there will be a 4% growth each year in perpetuity.
What is the maximum price the acquiring company should offer for each of the shares in the target company?
Answer: A
NEW QUESTION # 171
M is an accountant who wishes to take out a forward rate agreement as a hedging instrument but the company treasurer has advised that a short-term interest rate future would be a better option.
Which of the following is true of a short-term interest rate future?
Answer: D
Explanation:
Short-term interest rate futures (STIRs) are:
Standardised, exchange-traded contracts
Not tailored exactly to one company's needs (that's FRAs)
Traded on an exchange, so you can close out early by taking an opposite position If interest rates fall, futures prices rise (since price # 100 - interest rate) Now check each statement:
A). "Tailored to exact needs" # False (that's an FRA)
B). "If interest rates go down the price will have fallen" # False (it rises)
C). "Must be kept for whole duration" # False
D). "Date is flexible and the position can be closed quickly and easily" # True (you choose the contract month and can close out any time before expiry)
NEW QUESTION # 172
Company A is identical in all operating and risk characteristics to Company B, but their capital structures differ.
Company B is all-equity financed. Its cost of equity is 17%.
Company A has a gearing ratio (debt:equity) of 1:2. Its pre-tax cost of debt is 7%.
Company A and Company B both pay corporate income tax at 30%.
What is the cost of equity for Company A?
Answer: B
NEW QUESTION # 173
A company is funded by:
* $40 million of debt (market value)
* $60 million of equity (market value)
The company plans to:
* Issue a bond and use the funds raised to buy back shares at their current market value.
* Structure the deal so that the market value of debt becomes equal to the market value of equity.
According to Modigliani and Miller's theory with tax and assuming a corporate income tax rate of 20%, this plan would:
Answer: D
Explanation:
According to Modigliani and Miller with tax, the value of a levered firm is:
VL=VU+Tc×DV_L = V_U + T_c \times DVL=VU+Tc×D
where TcT_cTc is the corporate tax rate and DDD is the market value of debt. With corporate income tax, interest is tax-deductible, so increasing debt creates a tax shield and increases total firm value.
Initially:
Debt = 40
Equity = 60
Total value = 100
Tax rate = 20%.
If the company increases debt and uses the proceeds to buy back shares until debt equals equity, then:
New structure: D=ED = ED=E
Total firm value rises because Tc×DT_c \times DTc×D increases.
The extra value (PV of the additional tax shield) accrues to shareholders, even though the accounting market value of equity after the buyback may fall in absolute terms; shareholders have also received cash from the buyback, so their total wealth increases.
Business risk (and therefore asset beta) is unchanged; however equity beta would rise, not fall, because of higher financial leverage. Therefore the only correct statement is that the plan would increase shareholder wealth - answer C.
NEW QUESTION # 174
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