220 Tufa Co (Sep/Dec 17) 36 mins

The following statement of financial position information relates to Tufa Co, a company listed on a large stock
market which pays corporation tax at a rate of 30%.
$m $m
Equity and liabilities
Share capital 17
Retained earnings 15
Total equity 32
Non-current liabilities
Long-term borrowings 13
Current liabilities 21
Total liabilities 34
Total equity and liabilities 66

The share capital of Tufa Co consists of $12m of ordinary shares and $5m of irredeemable preference shares.
The ordinary shares of Tufa Co have a nominal value of $0.50 per share, an ex dividend market price of $7.07 per
share and a cum dividend market price of $7.52 per share. The dividend for 20X7 will be paid in the near future.
Dividends paid in recent years have been as foIlows:
Year 20X6 20X5 20X4 20X3
Dividend ($/share) 0.43 0.41 0.39 0.37
The 5% preference shares of Tufa Co have a nominal value of $0.50 per share and an ex dividend market price of
$0.31 per share.
The long-term borrowings of Tufa Co consists $10m of loan notes and a $3m bank loan. The bank loan has a
variable interest rate.
The 7% loan notes have a nominal value of $100 per loan note and a market price of $102.34 per loan note. Annual
interest has just been paid and the loan notes are redeemable in four years' time at a 5% premium to nominal value.
Required
(a) Calculate the after-tax weighted average cost of capital of Tufa Co on a market value basis. (11 marks)
(b) Discuss the circumstances under which it is appropriate to use the current WACC of Tufa Co in appraising
an investment project. (3 marks)
(c) Discuss THREE advantages to Tufa Co of using convertible loan notes as a source of long-term finance.
(6 marks)
(Total = 20 marks)

221 Tin Co (Mar/Jun 18) 36 mins

Tin Co is planning an expansion of its business operations which will increase profit before interest and tax by 20%.
The company is considering whether to use equity or debt finance to raise the $2m needed by the business
expansion.
If equity finance is used, a 1 for 5 rights issue will be offered to existing shareholders at a 20% discount to the
current ex dividend share price of $5.00 per share. The nominal value of the ordinary shares is $1.00 per share.
If debt finance is used, Tin Co will issue 20,000 8% loan notes with a nominal value of $100 per loan note.

BPP Tutor Toolkit Copy Questions 77

 Financial statement information prior to raising new finance:
$’000
Profit before interest and tax 1,597
Finance costs (interest) (315)
Taxation (282)
Profit after tax 1,000

$’000
Equity
Ordinary shares 2,500
Retained earnings 5,488
Long-term liabilities:
7% loan notes 4,500
Total equity and long-term liabilities 12,488

The current price/earnings ratio of Tin Co is 12.5 times. Corporation tax is payable at a rate of 22%.
Companies undertaking the same business as Tin Co have an average debt/equity ratio (book value of debt divided
by book value of equity) of 60.5% and an average interest cover of 9 times.
Required
(a) (i) Calculate the theoretical ex rights price per share. (2 marks)
(ii) Assuming equity finance is used, calculate the revised earnings per share after the business
expansion. (4 marks)
(iii) Assuming debt finance is used, calculate the revised earnings per share after the business expansion.
(3 marks)
(iv) Calculate the revised share prices under both financing methods after the business expansion.
(1 mark)
(v) Use calculations to evaluate whether equity finance or debt finance should be used for the planned
business expansion. (4 marks)
(b) Discuss TWO Islamic finance sources which Tin Co could consider as alternatives to a rights issue or a loan
note issue. (6 marks)
(Total = 20 marks)

78 Questions BPP Tutor Toolkit Copy

4 KQK Co wants to raise $20 million in order to expand its business and wishes to evaluate one possibility, which is
an issue of 8% loan notes. Extracts from the financial statements of KQK Co are as follows.
$m
Income 140·0
Cost of sales and other expenses 112·0
––––––
Profit before interest and tax 28·0
Finance charges (interest) 2·8
––––––
Profit before tax 25·2
Taxation 7·6
––––––
Profit after tax 17·6
––––––
$m $m
Equity finance
Ordinary shares ($1 nominal) 25·0
Reserves 118·5 143·5
––––––
Non-current liabilities 36·0
Current liabilities 38·3
––––––
Total equity and liabilities 217·8
––––––
It is expected that investing $20 million in the business will increase income by 5% over the first year. Approximately
40% of cost of sales and other expenses are fixed, the remainder of these costs are variable. Fixed costs will not be
affected by the business expansion, while variable costs will increase in line with income.
KQK Co pays corporation tax at a rate of 30%. The company has a policy of paying out 40% of profit after tax as
dividends to shareholders.
Current liabilities are expected to increase by 3% by the end of the first year following the business expansion.
Average values of other companies similar to KQK Co:
Debt/equity ratio (book value basis):(shareholders wealth) 30%
Interest cover: (financial risk) 10 times
Operational gearing (contribution/PBIT):(financial risk) 2 times
Return on equity:(shareholders wealth) 15%

Required:
(a) Assess the impact of financing the business expansion by the loan note issue on financial position, financial
risk and shareholder wealth after one year, using appropriate measures. (10 marks)

(b) Discuss the circumstances under which the current weighted average cost of capital of a company could be
used in investment appraisal and indicate briefly how its limitations as a discount rate could be overcome.
(5 marks)

(15 marks)