Financial Management QB

The Institute of Chartered Accountants of Bangladesh
FINANCIAL MANAGEMENT
Professional Stage Application Level
Question Bank
www.icab.org.bd
Financial Management
The Institute of Chartered Accountants of Bangladesh Professional Stage
These learning materials have been prepared by the Institute of Chartered Accountants in England and Wales
ISBN: 978-1-84152-844-1
First edition 2009
All rights reserved. No part of this publication may be reproduced or

transmitted in any form or by any means or stored in any retrieval system, or
transmitted in, any form or by any means, electronic, mechanical, photocopying,
recording or otherwise without prior permission of the publisher.
ii © The Institute of Chartered Accountants in England and Wales, March 2009

Contents
Time Page
allocation
Title Marks Mins Questions Answers
Objectives and investment

appraisal
1 Stakeholders 17 25 3 101
2 Highseas Ltd 25 38 3 103
3 Profitis Ltd 17 25 4 106
4 Global Power Ltd 19 29 5 108
5 Sarajevo Ltd 8 12 6 110
6 Quattro Air Ltd 16 24 6 112
7 Clearchannel Dredging Ltd 20 30 7 113
8 Broadham Hotels Ltd 22 33 8 116
9 Roberto Ltd 16 24 9 118
10 Henwood Green Ltd 18 27 9 120
11 Farmshoppers Ltd 13 19 10 121
12 CAPM and project appraisal 18 27 11 122
13 Starr Chemicals Ltd 18 27 12 124
14 Holden Ltd 19 29 12 126
15 Maritime Specialists Ltd 12 18 13 129
16 Zola Holdings Ltd 18 27 14 130
17 Beaters Ltd 16 24 15 132
18 Maxtherm Ltd 10 15 16 134
19 Investment portfolios 12 18 16 134
20 Sunday newspaper article 19 28 16 135
21 Daniels Ltd 25 38 17 137
22 Pretorius Ltd 17 25 18 139
23 Headington Ltd 19 29 19 140
24 Channel 14 Ltd 24 36 20 142
© The Institute of Chartered Accountants in England and Wales, March 2009 iii
Time Page
allocation
Finance and capital structure

25 Oxfield Ltd 24 36 23 145
26 Yollo Ltd 22 33 23 148
27 Navarac Ltd 24 36 24 151
28 Terry Ltd 17 25 25 153
29 Ellis Ltd 12 18 26 155
30 Personal investment 14 21 26 156
31 Sheridan Ltd 12 18 27 158
32 Nash Telecom 19 29 27 160
33 Zimba Ltd 20 30 28 162
34 Genesis Ltd 16 24 29 164
35 Educare Ltd 17 25 30 165
36 Saddlebrook Ltd 15 23 31 167
37 Quigley Industries Ltd 22 33 32 168
38 Philpot Ltd 18 27 32 170
39 Efficient markets hypothesis 12 18 33 172
40 Abydos Ltd 20 30 34 173
Business plans, dividends and

growth
41 Newton Pearce Ltd 22 33 35 177
42 Wentworth Ltd 22 33 36 179
43 Krenn Ltd 16 24 37 180
44 Duofold Ltd 17 25 38 182
45 Portico Ltd 16 24 38 183
46 Biojack Ltd 14 21 39 185
47 Safeway Ltd 16 24 39 186
48 Sunnydaze Ltd 29 44 40 188
49 Tinkler’s Stores Ltd 12 18 41 190
50 Bill Jackson Haulage Ltd 24 36 42 192
51 Megagreat Ltd 17 25 42 195
52 Thebean Ltd 25 38 43 196
53 Fituup Ltd 25 37 44 198
54 Narmer Ltd 17 26 46 201
iv © The Institute of Chartered Accountants in England and Wales, March 2009

Time Page
allocation
Risk management
55 Plutocrat Ltd 17 25 47 203
56 Snowdrop Ltd and Fortensia Ltd 20 30 47 205
57 Thersk Ltd 18 27 48 207
58 Precision Specifications Ltd 12 18 48 210
59 Treasurer 20 30 49 212
60 Haining Ltd 14 21 49 214
61 Westgarth Ltd 25 38 50 215
62 Xylophone Ltd 25 37 51 217
63 Verriana Ltd 18 27 51 220
64 Duvall Ltd 15 23 52 221
65 Atkins Ltd 17 25 52 223
66 Formosa Ltd 20 30 53 225
67 Dubois Ltd 20 30 54 226
Additional Exam-standard
questions
68 Illumin8 Ltd 28 42 55 229
69 Viogen Inc 26 39 56 231
70 York Ltd 26 39 57 233
Objective test questions

Objectives and investment appraisal 59 237
Finance and capital structure 73 243
Business plans, dividends and growth 83 247
Risk management 87 249
Appendix
Formulae and discount table 255
© The Institute of Chartered Accountants in England and Wales, March 2009 v

vi © The Institute of Chartered Accountants in England and Wales, March 2009
Question Bank
Your exam will consist of
Part one – 5 – 15 objective test questions 20 marks

Part two – 3 questions 80 marks
Time available 2 ½ hours
© The Institute of Chartered Accountants in England and Wales, March 2009

1
2 © The Institute of Chartered Accountants in England and Wales, March 2009
QUESTION BANK
Objectives and investment appraisal
1 Stakeholders
Requirements
(a) In the following situations, identify the stakeholders that could be involved in potential conflicts.
(i) A large conglomerate 'spinning off' its divisions by selling them or setting them up as separate
companies.
(ii) A private company converting into a public company.
(iii) A Japanese car manufacturer building new plants in other countries. (9 marks)
(b) 'I get paid to make the owners of the Coca-Cola Co. increasingly wealthy with each passing day.
Everything else is just fluff.' Roberto Goizueta, Former CEO of Coca-Cola.
Discuss the argument that maximisation of shareholder wealth should be the only objective of a
company. (8 marks)
(17 marks)
2 Highseas Ltd
The Finance Director shifted uneasily in his seat, looked at the other Board members of Highseas Ltd
(Highseas), then defended his position – 'Financial managers need only concentrate on meeting the needs of
shareholders – no other group matters. As a company our main financial objective should be to increase
dividends each year.'
The discussion of Highseas' board then continued to consider the company's objectives. Its only non-
financial objective was to treat all stakeholders in the organisation with 'even-handedness'.
Company background:
 Privately-owned boat manufacturer.
 It has a large number of shareholders with a combination of both major and smaller investors.
 Financed with 70% equity and 30% debt (based on book values).
 The debt is a mixture of secured and unsecured bonds carrying interest rates of between 6% and 7.5%
and repayable in 5 to 10 years' time.
 Revenue and assets equivalent in amount to some public listed companies.
 Global market for inputs and output.
Company strategy
Highseas has been a reasonably profitable company for a number of years and the directors and
shareholders are unwilling to adopt strategies that they think might involve a substantial increase in risk.
Some of its competitors for example, have set up manufacturing facilities in low cost countries. Highseas
accepts its growth rate will be relatively low as a result of this 'play it safe' approach, compared with some
of its competitors.
Inflation in Bangladesh can be assumed to be near zero and interest rates are low and possibly falling.
© The Institute of Chartered Accountants in England and Wales, March 2009 3

Requirements
(a) You are a consultant to the Board. Evaluate the appropriateness of the Finance Director's statement
and Highseas' current objectives. Discuss the issues that the Board should consider when determining
the new corporate objectives. Conclude with a recommendation. (15 marks)
(b) Highseas has a small treasury department. Discuss the factors that it should consider when
determining financing, or re-financing strategies in the context of the economic environment described
in the scenario and explain how these might impact on the determination of corporate objectives.
(10 marks)
(25 marks)
3 Profitis Ltd
Profitis Ltd has a continuing need for a machine. At the level of intensity of use by the company, after four
years from new the machine is not capable of efficient working. It has been the company's practice to
replace it every four years. The production manager has pointed out that in the fourth year the machine
needs additional maintenance to keep it working at normal efficiency. The question has therefore arisen as
to whether to replace it after three years instead of the usual four years.
Relevant information is as follows.
(1) The machine costs CU80,000 to buy new. If it is retained for four years, it will have a zero scrap value
at the end of the period. If it is retained for three years, it will have an estimated disposal value of
CU10,000.
The machine will attract tax depreciation. For the purposes of this analysis assume that it will be
excluded from the general pool. This means that it will attract a 25% (reducing balance) tax
depreciation in the year of acquisition and in every subsequent year of being owned by the company,
except the last year. In the last year the difference between the machine's written-down value for tax
purposes and its disposal proceeds will either be allowed to the company as an additional tax relief if
the disposal proceeds are less than the written-down value, or be charged to the company if the
disposal proceeds are more than the tax written-down value.
Assume that the machine will be bought and disposed of on the last day of the company's accounting
year.
(2) The company's corporation tax rate is 30%. Tax is payable on the last day of the accounting year
concerned.
(3) During the first year of ownership the supplier takes responsibility for any necessary maintenance
work. In the second and third years maintenance costs average CU10,000 a year. During the fourth
year these rise to CU20,000. Maintenance charges are payable on the first day of the company's
accounting year and are allowable for tax.
(4) The company's cost of capital is estimated at 15%.
Requirements
(a) Prepare calculations to show whether it would economically be more desirable to replace the machine
after three years or four years. (13 marks)
(b) Discuss any other issues that could influence the company's replacement decision. This should include
any weaknesses in the approach taken in (a). (4 marks)
(17 marks)

QUESTION BANK
4 Global Power Ltd

Global Power Ltd (Global) is a Bangladeshi power-generating company with a financial year end of
31 March. It is considering investing in a new power station, the 'GP 12', which would increase its capacity
to supply electricity to its customers. If the investment were to go ahead, construction of the GP 12 would
be completed by 31 March 20X6 and supply would commence at the start of the financial year 20X6/X7.
You have been asked to advise Global on the investment.
Future cash flows will be affected by inflation. Unless stated to the contrary, all figures below are given in
money terms.
The power station would cost CU1,200 million to build. Global's management has estimated that the
incremental revenues and costs arising from the investment will be as follows.
Year to Year to Year to Year to
31 March 31 March 31 March 31 March
20X7 20X8 20X9 20Y0
CUm CUm CUm CUm
Revenue 694 840 938 882
GP 12 costs incurred 190 255 286 452
Fixed costs re-allocated (Note 1) 6 8 9 9
Variable costs saved (Note 2) 28 32 37 39
Notes:
(1) GP 12 will enable Global to reduce its levels of activity in two of its older power stations. Accordingly,
central management fixed costs have been re-allocated by the company from those two stations to
GP 12.
(2) In addition, it is estimated that the two older stations referred to in Note 1 will be able to save
variable costs because of this reduction in activity level.
Because of the pace of technological development in power supply, Global's management is unwilling to plan
ahead further than a maximum of four years from commencement of production, i.e. to 31 March 20Y0.
When GP 12 is taken out of production, its scrap value will be negligible and, indeed, decommissioning
costs will be incurred. Estimates of these costs for two possible dates of closure for GP 12 are as follows.
Closure at 31 March 20X9 – decommissioning costs = CU90 million
Closure at 31 March 20Y0 – decommissioning costs = CU370 million
The tax implications of these decommissioning costs should be ignored.
The investment will attract tax depreciation, but will be excluded from the general pool. This means that it
attracts 25% (reducing balance) tax depreciation in the year of expenditure and in every subsequent year of
being owned by the company, except the last year. In the last year, the difference between the equipment's
written down value for tax purposes and its disposal proceeds will be
either (i) allowed to the company as an additional tax relief, if the disposal proceeds are less than the
tax written down value
or (ii) charged to the company, if the disposal proceeds are more than the tax written down value.
You should assume that all cash flows occur on the last day of each financial year. Global pays a corporation
tax rate of 30% on its taxable profits – payable at the end of the financial year in which profits are earned.
It will be necessary to support GP 12 by investing in an additional CU120 million of working capital once its
supply of electricity to the market commences. At the end of the project all the working capital will be
recovered. The rate of inflation for the working capital is estimated at 5% per annum.
Global's management has followed accepted practice in calculating the company's cost of capital.
Accordingly, it uses a money cost of capital figure of 10% for the appraisal of capital projects.

Requirements
(a) Advise Global if it should undertake the investment into GP 12 and, if so, which, if either, of the two
closure dates should be chosen for the GP 12. Your advice should be based on a calculation of net
present values at 31 March 20X6. (12 marks)
(b) Calculate the decommissioning costs at 31 March 20Y0 that would make Global's management
indifferent as to which of the two possible closure dates for GP 12 to choose. (2 marks)
(c) Explain how Global's management will have calculated the cost of capital figure. Make clear any
assumptions that you have made. (5 marks)
(19 marks)
5 Sarajevo Ltd
Sarajevo Ltd has identified five investment opportunities. The cash flows associated with the projects are as
follows.
Project t0 t1 t2 t3
CU'000 CU'000 CU'000 CU'000
A (15) (15) 20 25
B (30) – – 60
C (35) 10 10 20
D (10) (20) 20 26
E – (25) 50 –
Requirements
(a) Rank the projects according to their desirability on the assumption that they are mutually exclusive
and funds are freely available to Sarajevo Ltd at a cost of capital of 10%. (4 marks)
(b) Assume that the projects are independent and divisible, and that capital available for investment at t0 is
restricted to CU50,000. Thereafter funds are expected to be freely available at the cost of capital.
Re-rank the projects. (2 marks)
(c) Now assume that the projects are independent and divisible, and investment funds are only limited at
t1 to CU40,000.
Which projects should be accepted and what is the total NPV available to the firm? (2 marks)
(8 marks)
6 Quattro Air Ltd

Quattro Air Ltd is a small, growing airline company. In the past, as well as carrying out maintenance on its
own aircraft, the company has also carried out some maintenance work for other airlines. Recently,
however, the directors have been concerned at the rather cramped nature of the maintenance facilities.
Last month the company was asked by a Spanish airline to undertake a maintenance contract for four years,
from which Quattro Air would receive estimated revenues of CU4.8m per annum based on current
exchange rates with the euro. In order to assess the project Quattro Air has carried out an extensive
feasibility study that has cost CU308,000. This indicates that the preferred option would be to build new
maintenance facilities on land already owned but not used by the company.
The total capital investment in the new facilities would be CU9.5m payable in advance. There would be no
pre-tax cash flows or efficiency savings in the year following the initial CU9.5m payment while the facility is
constructed, except for a CU1.2m receipt from the sale of the old maintenance facility at the end of the
year. There are no tax depreciation considerations in respect of this CU1.2m receipt in Year 1. Thereafter,
the new facilities would bring efficiency benefits that would save CU250,000 per annum in carrying out
Quattro Air's existing level of maintenance work. In addition to current work and the Spanish contract, the
directors of Quattro Air are confident that they can generate additional revenue from maintenance work

QUESTION BANK
totalling CU700,000 in the first year of operations and increasing by CU500,000 per annum over the
remaining three years of the expected four-year operating life of the new facility.
At the end of Year 4 of operations it is expected that the maintenance facility could be sold for CU1m, with
the proceeds being received immediately. The directors have estimated annual incremental costs during the
operating life of the facility of 50% of sales revenue, and also intend to allocate existing head office overhead
costs of CU600,000 per annum to the project.
The company uses a cost of capital of 10% in appraising such projects. Tax depreciation allowances of 25%
on a reducing basis are immediately available on the initial CU9.5m investment in the plant. Assume that
there are sufficient profits available elsewhere in the business to utilise all tax benefits in full and at once.
Corporation tax is assumed to be paid at a rate of 30% for the whole period under consideration. All tax
payments are assumed to be made at the end of the year to which they relate. The working capital impact
of the project is deemed to be negligible.
Requirements
(a) Calculate the net present value of the proposed investment. (11 marks)
(b) Describe what other factors should be considered by the directors of Quattro Air Ltd before they
make a final decision on this project, and advise the directors whether or not they should proceed.
(5 marks)
(16 marks)
7 Clearchannel Dredging Ltd

Clearchannel Dredging Ltd ('the company') has recently won a contract with the Avon River Authority ('the
authority') to keep a stretch of the river Avon in a condition such that it can be navigated by small vessels.
This contract runs from 1 January 20X8 to 31 December 20Y1. This follows on from a similar contract the
company currently has with the authority which comes to an end on 31 December 20X7.
The company uses its own dredging equipment on the current contract. This could continue to be used on
the new contract for its full duration. Alternatively, the company could buy new equipment which would
yield savings on fuel, maintenance and labour costs.
The existing equipment cost CU2 million when it was bought new during 20X6. It could be sold at
31 December 20X7 for an estimated CU500,000. Alternatively, it could be leased out to another company
for two years from 1 January 20X8 for an annual rent of CU250,000, payable in advance. By December
20X9 it is estimated that this existing equipment would have no disposal value and it would be scrapped.
Under the leasing contract the user would take responsibility for all maintenance.
The new equipment would be bought on 31 December 20X7 for CU5 million. It would be expected to be
kept for the duration of the new contract and disposed of on 1 January 20Y2 for an estimated CU1 million
(at 1 January 20Y2 prices).
Assume that the expenditure can be treated as a short-life asset and excluded from the 'pool' (assume that
're-pooling' does not apply). This means that the plant would attract a 25% (reducing balance) tax
depreciation allowance in the year of acquisition and in every subsequent year of its being owned by the
company, except in the last year. In the last year the difference between the plant's written down value for
tax purposes and its disposal proceeds (zero) will be allowed to the company as an additional tax relief.
The annual cost savings from operating the new equipment, compared with operating the existing
equipment, are estimated to be as follows (at 1 January 20X8 prices).
CUm
20X8 1.0
20X9 1.1
20Y0 1.2
20Y1 1.3
The company finds that working capital equal to 10% of the operating costs is required for dredging
operations. This needs to be in place by 1 January of the year concerned.

The company's accounting year end is 31 December. The relevant rate of corporation tax is expected to be
30%. Tax is payable at the end of the accounting period.
The annual general rates of inflation are expected to be as follows.
%
20X8 4
20X9 4
20Y0 and thereafter 5
The annual operating cost savings are expected to alter in line with the general level of inflation.
The company's directors have as a target an annual 'real' after-tax return of 10%.
Requirement
Prepare a schedule of relevant annual cash flows and use it to assess whether or not the new equipment
should be acquired. (20 marks)
8 Broadham Hotels Ltd

Broadham Hotels Ltd (BH) owns and manages a hotel in a major Midlands city. The hotel has 500 identical,
twin-bedded rooms for which a standard rate of CU50 per night is charged, whether the room is occupied
by one or two people. Occupancy rates have fallen below those which was envisaged when the hotel was
built five years ago.
Septo, a Japanese-owned business, which is shortly to open a local manufacturing plant, has approached the
hotel's management with a proposal that it takes over 100 of the rooms, in effect the whole of the top two
floors of the hotel, to accommodate its staff and guests when they visit the plant. Septo wishes to take over
the rooms for a five-year period starting on 1 July 20X2. Septo would employ its own staff to service and
manage the rooms.
On the basis of past experience and taking account of future developments in the market, the hotel's
management believes that future average nightly demand will be as follows.
Rooms Probability (%)
380 20
400 20
420 30
440 20
460 10
The hotel is open for 360 nights each year.
It is estimated that the variable costs of having a room occupied is on average 10% of the room rate. All
staff costs are effectively fixed costs, and no staff cost savings are expected to be made by the hotel should
the Septo proposal be accepted. The total fixed costs of running the hotel are estimated at CU4 million a
year.
Under the proposal Septo would pay a fixed fee annually on 1 July from 20X2 to 20X6 inclusive.
There is expected to be a general annual rate of inflation of 3% throughout the five-year period. This will
affect the room rate, the variable costs and the fixed costs, all of which are stated above at 1 July 20X2
prices.
BH has a corporation tax rate of 30% and an accounting year ending on 30 June. Tax will be payable on the
last day of the accounting year in which the relevant transactions occur. You should assume that all
operating cash flows occur on the last day of the relevant accounting year, except for any receipt from
Septo, which will be received on the first day.
BH's cost of capital, in real terms, is 10% per annum.

QUESTION BANK
Requirements
(a) Determine, on the basis of net present value and the information given in the question, the minimum
fixed annual payment that Septo must make so that BH is as well off in expected value terms as it
would be without the Septo proposal.
Notes:
(1) Work in 'money' terms.
(2) Assume for this requirement that neither Septo's new plant nor the proposal to BH would affect
the projected nightly demand figures given in the question. (13 marks)
(b) State and explain any other items of information, not mentioned in the question, that should have been
brought into the determination of the minimum annual payment in (a). (4 marks)
(c) Discuss briefly whether in principle from Septo's perspective the planned provision of accommodation
seems a good idea. (5 marks)
(22 marks)
9 Roberto Ltd
Roberto Ltd has CU6 million investment finance available. Four possible projects have been identified. Each
involves an immediate outflow of cash and is seen as having two possible outcomes as regards the net
present value (NPV). The required initial investment, possible NPVs and their probabilities are as follows.
Investment Initial outlay NPV Probability
CUm CUm
A 6.0 3.0 (positive) 0.5
1.5 (negative) 0.5
B 2.0 1.0 (positive) 0.5
0.5 (negative) 0.5
C 2.0 1.0 (positive) 0.5
0.5 (negative) 0.5
D 2.0 1.0 (positive) 0.5
0.5 (negative) 0.5
The outcomes of each project are completely uncorrelated.
Requirements
(a) Compare the results of an investment in project A alone with an investment in all three of projects B,
C and D. (5 marks)
(b) (i) State, with reasons, which of the two investment strategies you would recommend to the
directors.
(ii) State and explain the assumptions which you have made about the company, the directors and
the shareholders in making your recommendation. (11 marks)
(16 marks)
10 Henwood Green Ltd

Henwood Green Ltd (Henwood) is a medium-sized, family controlled, fruit canning business and has a year
end date of 31 July. Its main customers are major supermarket companies. Henwood operates in a very
competitive market and in recent months its sales have been decreasing. The company's management is
aware that this is because competitors have developed more efficient production lines. As a result,
Henwood's management is planning a major investment (CU3 million) in new equipment, but because of its
inability to attract that level of long-term funding at present, this will not occur for at least two years, i.e.
the summer of 20X6.
However, Henwood's management has also been considering how it might improve trading (on a smaller
scale) during the next two years. Henwood can afford to fund a major refurbishment of its existing

production line – this would cost CU340,000 and would be payable in July 20X4. The refurbishment would
mean that the trade-in value of the existing production line (to be realised in July 20X6) would increase
from CU30,000 to CU70,000. Henwood has commissioned market research which is summarised in the
table below. That research has concluded that the refurbishment would improve the company's net cash
flows from trading as follows.
Year 1 (20X4/X5) Year 2 (20X5/X6)
Increase in Probability Increase in Probability
net cash flows (CU) net cash flows
CU
(If Year 1 net cash flows increase by CU150,000)
50,000 25%
150,000 40% 100,000 25%
150,000 50%
(If Year 1 net cash flows increase by CU220,000)

150,000 20%
220,000 60% 200,000 20%
300,000 60%
The refurbishment will attract tax depreciations, but will be excluded from the general pool. This means
that it attracts 25% (reducing balance) tax depreciation in the year of expenditure and in every subsequent
year of being owned by the company, except the last year. In the last year, the difference between the
equipment's written down value for tax purposes and its disposal proceeds will be
either (i) allowed to the company as an additional tax relief if the disposal proceeds are less than the
tax written down value
or (ii) be charged to the company if the disposal proceeds are more than the tax written down
value.
You should assume that all cash flows occur on the last day of each trading year. Henwood pays
corporation tax at a rate of 30% on its taxable profits, payable at the end of the year in which profits are
earned.
Henwood's management has agreed that a discount rate of 8% per annum would be reasonable for
appraising the investment. However, the Production Director would rather a lower rate were used as '(i)
this is more prudent and would help us to take better account of the riskiness of the project and (ii) it will
make the project's internal rate of return more accurate'.
Requirements
(a) Advise Henwood's management whether it should proceed with the proposed refurbishment of the
equipment, using a discount rate of 8% per annum. Your advice should be supported by workings and
include any reservations that you might have. (15 marks)
(b) Comment on the views of the production director. (3 marks)
(18 marks)
11 Farmshoppers Ltd
You have been recently appointed as the accountant/finance manager of Farmshoppers Ltd, a firm of
agricultural suppliers located in Herefordshire. You are the only member of the staff with any real
understanding of accounting and financial issues. The directors are considering making a major investment in
providing a new service for their farmer customers. You have helped with estimating the potential cash
flows from this investment. You have also, with the help of the directors, looked at the range of feasible
outcomes for each of the items of input data and ascribed probabilities to various outcomes for each of
these input data. Using all of this information you have
 Carried out a net present value (NPV) assessment of the best estimates of the cash flows and have
found a significant positive outcome

QUESTION BANK
 Carried out a sensitivity analysis on the positive NPV

 Derived the expected NPV using the expected values of each of the items of input data.
You are due to present this information to the directors, but you feel that it would be a good idea to
include some notes for them.
Requirement
Draft the notes for the directors explaining why you have used the NPV approach, what a sensitivity
analysis is and what the expected value means. Your notes should also discuss how useful the results of
these three analyses are in helping the directors to make a decision and how the analyses might be
extended to provide more useful information. (13 marks)
12 CAPM and project appraisal

You were recently appointed by a major manufacturing company as the senior accountant at one of the
divisions of the company, which is located in Cardiff. You have received the following memorandum from
the divisional manager.
'I tried to see you today, but you were tied up with the auditors.
I have to go to a meeting at head office on Friday about the robotics project. We sent head office the
projected cash flow figures for it before you arrived.
Apparently one of the head office finance people has discounted our figures, using a rate which was
calculated from the capital asset pricing model. I do not know why they are discounting the figures, because
inflation is predicted to be negligible over the next few years – I think that this is all a ploy to stop us going
ahead with the project and let another division have the cash.
I looked up capital asset pricing model in a finance book which was lying in your office, but I could not make
head nor tail of it, and anyway it all seemed to be about buying shares and nothing about our project.
We always use payback for the smaller projects which we do not have to refer to head office. I am going to
argue for it now because the project has a payback of less than five years, which is our normal yardstick.
I am very keen to go ahead with the project because I feel that it will secure the medium-term future of our
division.
I will be tied up all day tomorrow, so again I will not be able to see you. Could you please make a few notes
for me which I can read on the train on Friday morning?
I want to know how the capital asset pricing model is supposed to work, plus any other things which you
feel I ought to know for the meeting. I do not want to look a fool or lose the project because they blind me
with science.
As you have probably discovered I do not know much about finance, so please do not use any technical
jargon or complicated maths.
Requirements
(a) Prepare notes for the divisional manager which will provide helpful background for the meeting.
(14 marks)
(b) Critically comment on the following statement, explaining the reasons for your comments and clearly
defining any technical terms that you use.
'The capital asset pricing model is a device for deriving the guaranteed return for an equity share in a
particular company. Some people misguidedly seek to use it to estimate the cost of capital to be used
in a net present value assessment of an investment in a non-current asset.' (4 marks)
(18 marks)

13 Starr Chemicals Ltd

Starr Chemicals Ltd, an all-equity finance company, has developed a new type of industrial cleaning material,
code named CL5.
Developing CL5 cost CU1 million. It is company policy to write off such expenditure in equal instalments
over the sales life of the product developed.
If it is decided that CL5 is commercially viable, production will start on 1 January 20X0, the first day of the
company's accounting year. Sales revenues from CL5 are estimated as follows.
CUm
20X0 4
20X1 8
20X2 8
20X3 4
It is estimated that variable costs of 30% of sales value will be incurred. In addition, there will be
incremental fixed costs of CU1 million per annum.
Manufacture of CL5 will require an investment of CU4 million in additional plant. This would be purchased
and paid for on 1 January 20X0 and disposed of for an estimated CU1 million on 31 December 20X3, with
the cash expected to be received on the same date. This asset would be treated as a 'short-life' asset
(excluded from the 'pool') and attract tax depreciation allowances of 25% per annum reducing balance.
CL5 would be expected to have an adverse effect on sales of one of the company's other products to the
extent of 25% of the sales value of CL5. The other product has variable costs of 40% of its sales value. Any
reduction in sales of the other product will have no effect on fixed costs.
Working capital items would be involved with CL5 and the existing product as follows.
Trade receivables 15% of sales value
Inventory 20% of variable costs
Trade payables 10% of variable costs
Working capital would need to be in place by the start of the year concerned. Changes in working capital
would not have any tax effect.
The directors are seeking a minimum return on capital of 15% per annum after tax.
Assume a corporation tax rate of 30%, with tax being paid at the end of the accounting year to which it
relates.
Requirements
(a) Prepare a schedule which shows the annual relevant net cash flows associated with a decision to go
into production with CL5, and use it to recommend a decision on the basis of net present value.
(13 marks)
(b) Assess and discuss the sensitivity of the decision reached in (a) to the assumed corporation tax rate.
(5 marks)
Note: Ignore inflation. (18 marks)
14 Holden Ltd (S04)

Holden Ltd (Holden), an all equity financed company, has recently won a three year contract from 1
October 20X4 for the production of plastic bottles for a large supermarket chain. Holden will need to
dedicate one injection moulding machine to the contract for its duration.
The initial proposal was to use a machine already owned by Holden, but which is currently idle with no
foreseeable alternative use and for which the directors recently received an offer from a dealer of CU3m.
This offer will lapse at the end of September 20X4. The machine was originally purchased on 30 September

QUESTION BANK
20X2 at a cost of CU5m and it is anticipated that it could be sold at the end of the contract for CU1m.
Estimates for the contract using this machine indicate that operating costs will be CU4.8m per annum.
However, a visit from one of Holden's machine suppliers has prompted a re-appraisal of the contract based
on the purchase of a brand new machine on 30 September 20X4 at a cost of CU10m. If the new machine is
purchased the old machine could be sold simultaneously, with the new machine expected to have a sale
value of CU4m on completion of the contract on 30 September 20X7. Use of the new machine would
reduce operating costs to CU2.3m per annum.
In order to fulfil this contract the company will also need to invest in working capital equal to 5% of one
year's operating costs. The working capital will need to be in place at the start of the contract, with release
being achieved in full upon its completion.
The company uses the dividend growth model to calculate its cost of equity, which it then employs as a
discount factor in appraising investment projects. Using this method, the finance director has recently
formulated the following estimates of the company's cost of equity for the period of the contract.
For the year ended 30 September 20X5 10%
The current corporation tax rate is 30% and it is anticipated that this rate will be the same throughout the
contract. You can assume that tax is paid at the end of the year to which it relates.
Both machines attract 25% reducing balance tax depreciations in the year of acquisition and in each
subsequent year of ownership by the company, except the final year, when the difference between the
machine's written down value for tax purposes and its disposal proceeds will create either a balancing
charge or a balancing allowance. You can assume that there are sufficient profits elsewhere in the company
to utilise all tax benefits in full and at once.
Requirements
(a) On the basis of net present value and showing all calculations
(i) Advise the directors whether to retain the old machine for use on this new contract or to
purchase the new machine
(ii) Identify for the directors what you consider to be the key sensitivities and assumptions involved
in the analysis you have undertaken. (14 marks)
(b) Advise the directors of the advantages of using the capital asset pricing model, as opposed to the cost
of equity used in part (a), to derive a suitable discount factor for use in capital investment decisions
such as this and of the practical problems that might be encountered in doing so.
(5 marks)
Note: Ignore inflation. (19 marks)
15 Maritime Specialists Ltd

Maritime Specialists Ltd undertakes a range of work, including contracts to build sailing boats to customers'
specifications. Recently, as the company completed a particular boat for a customer, it received information
that he had gone bankrupt with no possibility of any payment to suppliers seen as likely. The total contract
price was CU75,000. The contract specified that payment must be made in stages as the building of the boat
progressed. The company had received CU30,000 in progress payments for the boat. This amount is not
returnable according to the contract. It is estimated that the boat could be sold, as it stands, for CU40,000.
A potential French customer has been identified for the boat, but she would require alterations to it.
Details of the alterations are as follows:

(1) Material A. The required quantity is held in inventory. This cost CU3,000 when it was bought. It would
cost CU3,200 to replace it. The material is hazardous and would cost the company CU500 to scrap it.
The company uses it constantly.
(2) Material B. By coincidence, the appropriate quantity of this material was ordered six months ago for
another job that was subsequently abandoned because the material was not delivered in time. The
company does not normally use this material and its scrap value is CU2,000. The original cost price
was agreed at CU5,000. Though the contract to buy this material is binding, the supplier will accept
CU4,000 to compensate for the late delivery. The current market buying price is now CU3,500.
(3) Material C. 20 units of this material will be required. This is in general use in the company. An order
for 35 units is shortly to be placed for another job. The price for this material is CU65 per unit, but
the supplier allows a bulk discount of CU5 per unit, for the entire order, for orders of 50 units and
above.
(4) Labour. 50 hours of labour will be required for the alterations. Labour is a fixed cost to the company,
because members of staff are paid in full the normal CU12 an hour whether there is work for them to
do or not. 20 hours, of the required 50 hours, can be provided by members of staff who currently
have no work to do. The remaining 30 hours can be provided only by taking staff off other work. This
other work is charged out to customers at CU30 an hour.
Requirements
(a) Determine, with supporting explanations, the minimum price that the company could charge the
French customer for the altered boat, such that the shareholders would be no worse off as compared
with selling the boat as it stands.
Note: Ignore the time value of money. (10 marks)
(b) Explain why it would be strictly incorrect to ignore the time value of money in your answer to (a).
(2 marks)
(12 marks)
16 Zola Holdings Ltd

Over the past twenty years Zola Holdings Ltd (Zola), a listed company financed by a mix of debt and equity,
has grown organically and through acquisition into a conglomerate involved in a range of different
businesses. Many of these are in the aeronautical engineering sector, but some are involved in areas
unrelated to this core business.
One such subsidiary is Murray Health Ltd (Murray), which manufactures one product, a special syringe.
There are just three years left to run on a six-year contract with what is currently its only customer,
Borthwick Ltd, which operate a group of private hospitals. Renewal of the contract is not due for discussion
for two more years and is, therefore entirely uncertain, as is the possibility of other business with new
customers.
Concerns among the management team of Murray regarding the long-term commitment of the parent
company have led them to consider the possibility of a management buy-out of the business. They have now
approached the directors of Zola to commence negotiations on a purchase of the business. Zola's directors
are keen to divest but are somewhat uncertain of the economic value of the business, given its insecure
future. They have approached you, as a financial consultant, to advise them and have provided the following
information regarding the projected finances of the company over the next three years.
Under the Borthwick contract, revenues (in current terms) are variable depending on demand, but
estimates for Year 1 are CU3.5m (60% probability) or CU3.7m (40% probability). In Year 2, if the lower
Year 1 figure is achieved, then estimates are for sales of CU2.5m (80% probability) or CU2.9m (20%
probability), although if the higher Year 1 figure is achieved, the estimates are for sales of CU2.5m (20%
probability) or CU2.9m (80% probability). In Year 3, whatever happens in previous years, the estimated
sales are CU2.2m.
Variable production costs are expected to be stable at 40% of sales revenue each year, and avoidable fixed
costs will be CU1.2m per annum at today's prices.

QUESTION BANK
The corporation tax rate is expected to be 30% for the entire period under consideration. Tax is assumed
to be payable at the end of the year in which the related cash flows occur.
Inflation is expected to average 4% per annum for the entire period and will impact on all cash flows during
that period.
The group's money cost of capital is 10% per annum.
All cash flows are assumed to be at year end.
Requirements
(a) Using net present value and the information available, calculate the current economic value of Murray
and explain to the directors of Zola the assumptions implicit in your calculation. (11 marks)
(b) Justify to the directors of Zola the method of valuation employed in part (a) and identify for them any
reservations you think the shareholders of Zola might have concerning the valuation. (7 marks)
(18 marks)
17 Beaters Ltd
Beaters Ltd makes plastic kits for building model sailing ships. The company's designer has just developed a
new product, a kit for making a model of the Golden Hind, the ship in which Drake circumnavigated the
world. To make the kits a new plastic moulding machine will have to be bought for CU50,000.
A net present value appraisal has been carried out that indicates a positive net present value (NPV) of
CU2,983. This appraisal was followed up with an assessment of the riskiness of the project. This was
achieved by taking each of the input factors in turn and estimating the value for it at which the project
would have a zero NPV. In looking at each input factor it was assumed that the other factors would be as
originally estimated.
Date on the original estimates and on the values of each of them that generate a zero NPV are as follows.
Original Value to generate
estimate a zero NPV
Cost of moulding machine CU50,000 CU52,983
Selling price (per unit) CU20 CU19.60
Material cost (per unit) CU6 CU6.40
Labour cost (per unit) CU5 CU5.40
Variable overheads (per unit) CU2 CU2.40
Sales life 6 years 5.5 years
The above assessment is based on the assumptions of a discount rate of 15% and of constant sales of 2,000
units per annum. It has been reliably established that the new production would not affect fixed costs or
working capital to any significant extent. There are no other input factors for the decision.
The risk-free rate of interest over the six years has been estimated to be 6%.
Requirements
(a) To generate a zero NPV estimate the values for
(i) the discount rate, and
(ii) the annual sales volume (5 marks)
(b) Comment on the results of both the NPV appraisal and the subsequent quantitative analysis. Discuss
how the managers might proceed to put themselves in a position to reach a decision on whether to go
ahead with the new product. Your discussion should include some consideration of the usefulness of
the quantitative analysis already undertaken and how this might usefully be extended. (11 marks)
Note: Ignore taxation and inflation. (16 marks)

18 Maxtherm Ltd
Maxtherm Ltd is an energy company which is considering building a power station which would supply the
National Grid. The alternatives under consideration are a gas fuelled power station, or a new type of
nuclear power station.
Both types of power station are expected to generate similar annual revenues at current prices. Both types
of power station have an expected operating life of 25 years, and both would start to produce power in
four years' time.
Requirement
Explain how the concepts of real options could be relevant to Maxtherm's capital investment decision,
giving examples of real options that might apply to the power station decision process. (10 marks)
19 Investment portfolios
In connection with the selection and holding of investments, discuss each of the following points of view.
(a) An investor holding only one security need be concerned only with the unsystematic risk of that
security.
(b) However, an investor who holds a number of securities should take account of total risk.
(c) An investor should never add to a portfolio an investment that yields a return less than the market
rate of return. (12 marks)
20 Sunday newspaper article

Recently a director of a client company said the following to you.
'Over the weekend I was reading an article on finance in a Sunday newspaper. It said that as
shareholder wealth maximisation is the generally accepted corporate objective, net present value is
the most logical approach to investment appraisal. It then went on to say that the 'capital asset pricing
model' is the best way to find the appropriate discount rate to use. This is apparently because you can
use the average rate of return from other businesses; also it ignores the specific risk of the investment
concerned.
This all seems nonsense to me. These days corporate management needs to be concerned with more
than just the shareholders. What about all of the other groups who contribute to the business? They
can't be ignored. Even if shareholders' wealth were the key issue, I don't see how NPV fits in. Surely
internal rate of return is more to the point because it favours investments that get the best returns
and cover financing costs. Those investments will make the shareholders richer. As for CAPM, it
seems to defy all logic. It can't be correct to ignore the returns that the investing business seeks and
just concentrate on other businesses. Risk must be taken into account. In our business we compare
weighted average cost of capital with the IRR and this seems more logical than using CAPM.'
The director went on to say
'The article also said that, in theory, it doesn't make any difference to the shareholders whether new
finance is raised from a share issue or a loan stock issue as they both cost the same. We raise all of
our new finance from retained earnings, which doesn't cost anything, but loan finance has a cost.'
Requirement
Draft a reply to the director, bearing in mind that he is clearly not very well informed on finance.
(19 marks)

QUESTION BANK
21 Daniels Ltd
Daniels Ltd (Daniels) is a large civil engineering company and it has a financial year end of 31 May. Much of
Daniels' work involves long-term contracts for the railway industry. You work for Daniels and have been
asked for advice by the board on the following problems:
Problem 1
Daniels is considering a major investment involving five possible projects in the West of England and South
Wales which have been put out to tender. Daniels' board of directors has prepared the following estimated
cash flows (and resultant net present values at 31 May 20X7) for the five projects:
Project LLocation Investment on Year to 31/5/X8 Year to 31/5/X9 Year to 31/5/Y0 NPV
31/5/X7
CU'000 CU'000 CU'000 CU'000 CU'000
B Bristol (4,150) (1,290) 530 7,270 577
C Cardiff (3,870) (1,310) 3,130 1,550 (1,309)
G Gloucester (6,400) 1,770 2,160 3,160 (632)
S Swansea (5,000) (2,610) 6,450 6,520 2,856
T Tiverton (4,600) 1,290 2,870 3,620 1,664
You can assume that the net present values shown in the table above are accurate.
Due to financial constraints, the company, if successful with its tenders, would be unable to take on all five
projects. The board is prepared to release CU8 million for initial investment (on 31 May 20X7) into one or
more of the projects, but might increase this figure to CU9 million if there are grounds for doing so. An
alternative scenario which has been considered would be to make available sufficient funds to start all five
projects in May 20X7, but this would limit the capital available in the year to 31 May 20X8 to a maximum of
only CU500,000.
Problem 2
Daniels runs a fleet of vans to support its operations. Currently it replaces those vans every three years,
but the board is not sure whether this is in the company's best interests. Vans cost, on average, CU12,400
each. Daniels' transport manager has prepared the following schedule of costs and resale values for the
vans:
Maintenance and Resale value
running costs
In first year of van's life CU4,300 After one year CU9,800
In second year of van's life CU4,800 After two years CU7,000
In third year of van's life CU5,100 After three years CU5,000
Problem 3
About a year ago (March 20X6) Daniels completed construction of a factory for Kithill Ltd (Kithill). This
cost Daniels CU720,000 to construct and Kithill is paying CU190,000 a year for eight years. Daniels will,
therefore, ultimately make a profit of CU800,000, which gives a return on the investment of over 100%.
When Kithill sent its first annual instalment last week, it indicated that rather than make annual payments it
would prefer to settle the outstanding balance by making a one-off payment of CU925,000 in a year's time
(March 20X8). One of Daniels' directors is keen on this proposal stating 'I know that this is less than we
would receive over the full eight years, but my calculations show that the internal rate of return would be
much better.'
General information
(1) Daniels uses a cost of capital of 10% when appraising possible investments.
(2) You should assume that all cash flows take place at the end of the year in question.
(3) All projects are independent.

Requirements
(a) For Problem 1, assuming that all of the projects are divisible and
(i) assuming that Daniels has no capital rationing, advise its directors as to which projects should be
accepted (2 marks)
(ii) assuming that the directors are prepared to spend a maximum of CU8 million on 31 May 20X7,
advise them as to which projects should be accepted (3 marks)
(iii) assuming that the directors are prepared to make available sufficient funds to start all five
projects on 31 May 20X7, but only CU500,000 on 31 May 20X8, advise them as to which
projects should be accepted. (5 marks)
(b) For Problem 1, assuming that none of the projects are divisible and that the directors are
prepared to spend a maximum of CU9 million on 31 May 20X7, advise them as to which projects
should be accepted. (4 marks)
(c) For Problem 2, advise the directors as to the optimal replacement period for Daniels' vans and
comment on the limitations of the approach used. (6 marks)
(d) For Problem 3, advise the directors as to whether they should accept Kithill's proposal. (5 marks)
(25 marks)
Note: Ignore taxation.
22 Pretorius Ltd
Pretorius Ltd expects to have spare production capacity during the coming year and its directors are
considering whether to undertake a contract for a fixed price of CU100,000. Their objective is to maximise
the net cash inflows to the company. Work on the new contract would have to start immediately and
would take 48 weeks to complete. The company's cost accountant has submitted the following statement
to the directors and advises rejection of the contract:
CU CU
Materials:
A (100 tonnes at CU140 per tonne) 14,000
B (130 tonnes at CU50 per tonne) 6,500
C (80 tonnes at CU45 per tonne) 3,600
24,100
Labour:
4 employees at CU300 each per week 62,400
Supervisor (CU17,000 plus overtime at CU500) 17,500
79,900
Overheads:
20% of total labour cost 15,980
Total cost 119,980
Mark-up:
10% of total cost 11,998
131,978
Contract price 100,000
Deficit 31,978
As a financial consultant to the company, you have made further enquiries regarding this contract and have
ascertained the following information:
(1) 40 tonnes of material A are already in stock at an original cost of CU100 per tonne. The current
replacement cost of material A is CU140 per tonne and existing stocks would realise CU110 per
tonne net of selling costs. There is no alternative use for material A within the company for the
foreseeable future.
(2) The company has no stocks of material B, nor is it committed to buying any. The current purchase
price of material B is CU50 per tonne.

QUESTION BANK
(3) The required quantity of material C was purchased last year at CU45 per tonne. In its present form it
has no alternative use in the company. If the contract was not undertaken, material C could be sold at
a price of CU30 per tonne. However, the company would have to pay transportation costs of CU10
per tonne. Alternatively, material C could be used as a substitute for material D which is in regular use
in the company. Material D currently costs CU35 per tonne. In order to use material C as a substitute
for material D, the company would have to pay conversion costs of CU5 per tonne.
(4) Four skilled employees would be needed for the contract at a weekly wage of CU300 each. Three of
these could be transferred from other departments. However, this would require hiring three less
skilled employees at a wage of CU250 per week to fill the gaps created. The fourth would have to be
specially recruited for the contract and would require one week of initial training (at a cost of CU300)
before the contract commenced. The company operates a 48 week working year but is also
committed to paying full wages to all staff during their four weeks of annual holiday.
(5) The supervisor is a member of the permanent staff of the company and, if the contract were accepted,
he would be required to work overtime costing CU500.
(6) Overhead costs are currently allocated to contracts on the basis of 20% of total labour cost. If this
contract is undertaken, it is envisaged that overhead costs will increase by CU5,000 in the forthcoming
year.
(7) The machine needed for the contract is seldom used and it has a book value of CU5,000. It was
previously decided to scrap it in the forthcoming year and the costs of dismantling it at any time are
expected to absorb its sale proceeds. The production manager has pointed out that, over the
forthcoming year, the company could use the machine for sub-contract work yielding net cash inflows
of CU4,000.
(8) It is company policy to apply a mark-up of 10% of total costs to all contracts.
Requirements
(a) Determine whether or not the directors of Pretorius Ltd should accept the contract. (13 marks)
Note: You must show all calculations and also provide an explanation for your treatment of each
item and state any assumptions made.
(b) Discuss any other considerations that you think the directors should take into account when deciding
whether or not to accept the contract. (4 marks)
(17 marks)
23 Headington Ltd
Headington Ltd operates a private members' club, known as the Eaton Club, in central London. The
directors of the company have, for some time, been conscious of the increasing age profile of its fee-paying
membership. Recently, therefore, the directors have been considering a number of potential strategies for
attracting and retaining younger members. One such strategy is the possible installation of gymnasium
facilities in a part of the club's premises which is currently rented out to a financial recruitment company at
an annual rent, receivable in arrears, of CU85,000 (at 20X6 prices).
The club's income is made up primarily of membership fees and revenues from bar and restaurant facilities.
As part of their consideration of this potential new strategy, the directors commissioned a market research
firm, at a cost of CU7,500 (paid in full last month), to assess the likely impact of the installation of
gymnasium facilities on the club's income. The summarised findings of the market researchers were
somewhat inconclusive. Whilst it was felt that the most likely impact would be an increase in annual
revenues of CU760,000 (0.6 probability), the researchers also suggested that, dependent on the prevailing
economic climate, additional annual revenue could be as high as CU1m (0.2 probability) or as low as
CU608,000 (0.2 probability). The club generates a contribution of 50% on revenues. The market
researchers have also suggested that all costs and revenues associated with this project (other than the
initial investment) are likely to be subject to an inflation rate of 5% per annum from the start of the first
year that the facilities will be operational, i.e. from 1 January 20X7.

In order to pursue this strategy the company would need to spend CU750,000 on building costs and
gymnasium equipment in 20X6. It is also expected that the equipment will be disposed of for CU100,000 (at
20X6 prices) after five years of use. In addition, the directors estimate that the operation of the gymnasium
will add CU85,000 per annum (at 20X6 prices) to the company's fixed costs.
The company has also made the following assumptions:
 The corporation tax rate will be 30% for the next five years
 The company's money cost of capital will be 10% for the next five years
 The capital cost of the project will qualify for tax depreciation allowances at the rate of 25% per
annum on a reducing balance basis. The allowances will commence in the year in which the initial
investment is made. As at 31 December 20Y1, a balancing charge or allowance will arise equal to the
difference between any residual value and the written down value
 All cash flows will arise at the end of the year to which they relate.
Requirements
(a) Use the net present value model to assess the project over a five-year assessment horizon and, on the
basis of this, make a suitable recommendation to the directors. (11 marks)
(b) Calculate the sensitivity of the net present value of the project to changes in the expected annual
contribution. (5 marks)
(c) Describe any reservations you might have concerning the figures used in assessing the project in (a)
above. (3 marks)
(19 marks)
24 Channel 14 Ltd
Channel 14 Ltd (C14) is a large commercial television company based in London, with a year end of
31 December. Its senior management is considering relocating the company's production operations at the
end of 20X7 to a site in Bolton, in the North of England, where, it is hoped, C14's capacity could be
increased and its running costs lowered.
The majority of C14's main administration functions would continue to be carried out in London for the
foreseeable future and the Bolton site would commence its full-time operations from 1 January 20X8. The
financial implications of the move are being considered by C14's board of directors and the key figures
available are shown below.
Equipment at the new site
Were C14 to relocate its production to Bolton, it could either buy new equipment or transfer its existing
equipment from London. New equipment would cost CU65 million, payable on 31 December 20X7, and
because of the fast rate of technological change, would be worth CU30 million by the end of 20Y0.
Alternatively, the transfer (from London) and installation (in Bolton) of its existing equipment on
31 December 20X7 would cost CU7 million (which would not attract tax depreciations, but would be
treated as tax deductible revenue expenditure). This equipment was purchased in 20X5 for CU50 million,
could be sold on 31 December 20X7 for CU25 million and will have zero scrap value at the end of 20Y0.
The new equipment, having advanced technological capabilities would enable C14 to make annual savings of
CU5 million.
The new equipment will attract tax depreciations, but will be excluded from the general pool. This means
that it attracts 25% (reducing balance) tax depreciation in the year of expenditure and in every subsequent
year of ownership by the company, except the final year. In the final year, the difference between the
machinery's written down value for tax purposes and its disposal proceeds will be either (i) allowed to the
company as an additional tax relief, if the disposal proceeds are less than the tax written down value, or (ii)
be charged to the company, if the disposal proceeds are more than the tax written down value.

QUESTION BANK
Staffing
20% of employees have already indicated that were C14 to move to Bolton then they would stay in the
London area and seek another job. As a result redundancy payments (with an estimated total value of
CU1.5 million) would have to be made on 31 December 20X7. Relocation costs for employees moving to
Bolton would total CU2 million on 31 December 20X7, but there would be an annual wage saving of CU1m
per annum resulting from the move.
Property
C14 currently pays CU3 million a year to rent its properties in London. These rental agreements are
binding on C14 until the end of 20X8. By moving to the north, C14 would incur an annual total rental cost
(from 20X8) of CU2.2 million in Bolton. The company would retain properties in London with an annual
rental cost (from 20X9) of CU0.8m. If the move to Bolton does not go ahead then the annual London
rental charge will total CU5 million from 20X9.
Capacity
By moving to Bolton, C14 will enhance its production capacity. This means that it will be able to (i) make
more programmes using its own facilities, thereby saving CU1.1 million annually and (ii) hire out those
facilities to independent programme makers, generating an annual income of CU1.9 million.
The company's Marketing Director feels that the proposed move to Bolton is an ideal opportunity for the
board to employ Shareholder Value Analysis (SVA). He is concerned that the stock market is undervaluing
the company at present and that, in his words, 'using SVA would, at least, give us an accurate figure of its
real worth.'
The corporation tax rate is 30% per annum and is payable in the same year as the investment/income/costs
to which it relates.
C14 uses a cost of capital figure of 8% when assessing investments.
All cash flows will take place at the end of each relevant trading year outlined above.
Note: Ignore inflation.
Requirements
(a) Assuming it were to proceed with the relocation of facilities to Bolton, advise C14's management
whether it would be more beneficial, in net present value terms, to acquire the new equipment and
dispose of the existing equipment or to transfer the existing equipment to Bolton. (11 marks)
(b) Advise C14's management whether it is worth, in net present value terms and based only on a
planning period 31 December 20X7 to 31 December 20Y0, proceeding with the relocation of facilities
to Bolton. (8 marks)
(c) Explain what you understand by Shareholder Value Analysis and comment on the Marketing Director's
views. (5 marks)
(24 marks)


QUESTION BANK
25 Oxfield Ltd
Oxfield Ltd, a listed industrial company, is considering a major investment. The company's investment
projects team needs an appropriate rate at which to discount the estimated after-tax cash flows for the
investment. Following the company's normal practice this is to be based on the weighted average cost of
capital (WACC).
Figures relating to long-term financing included in the company's most recent balance sheet are as follows.
CUm
160 million ordinary shares of CU0.50 each 80
Share premium account 27
Revaluation reserve 26
Retained earnings 9
7.2% loan stock 67
The loan stock interest for the current year has just been paid. Interest is payable at the end of each of the
next three years, and all of the loan stock is to be redeemed in cash at a 5% premium at the end of three
years.
A dividend of 18p per share has just been paid. Dividends have shown an average annual growth rate of 7%
over recent years.
The current share price is 210p and the loan stock has a market value of CU97 (per CU100 nominal).
The corporation tax rate is expected to be 30% for the foreseeable future.
Requirements
(a) Calculate the company's WACC. Explain your workings and any assumptions which you have made.
Justify the basis of the weightings which you have used. (7 marks)
(b) Explain any criticisms which could be made of using the figure calculated in (a) as the discount rate for
assessing the investment under consideration by the company. (7 marks)
(c) Explain how the capital asset pricing model (CAPM) could be used as an alternative means of
determining a suitable discount rate for the assessment of the investment. Your explanation should
include an outline of the strengths and weaknesses of the model. (5 marks)
(d) Explain what would have been the effect on the WACC, in theory and in practice, of the company
having a different debt: equity ratio. (5 marks)
(24 marks)
26 Yollo Ltd
Yollo Ltd is a listed company which manufactures zip fasteners. Over 90% of its sales are to clothing
manufacturers, based upon long-term contracts which have provided relatively stable profits over many
years.
Yollo Ltd has 4 million 50p ordinary shares in issue with a market value at 31 August 20X0 of CU1.50 per
share. The annual dividend of CU240,000 just paid represented 60% of the current year's profit available for
distribution. The company expects to achieve an annual return of 25% on its retained earnings.
There are also 1 million 10% irredeemable preference shares of CU1 in issue with a market value of
CU1.10 per share cum div at 31 August 20X0. The preference dividend is paid in one instalment each year.

Current debt financing consists of CU2 million of 8% debentures 20X2 which are redeemable at a premium
of 5% on 31 August 20X2. Interest is payable on 31 August annually and has just been paid. These
debentures are known to have an after-corporation tax cost of 9% per annum.
The corporation tax rate is 30%. Ignore taxes on the redemption premium.
Yollo Ltd intends to expand its activities into a new type of product called 'Super-Velcon'. This expansion
would involve a considerable initial outlay and a significant degree of uncertainty. The company intends to
use net present values to assess its viability. There is some confusion, however, as to the most appropriate
rate to use for discounting.
The company's new accountant argues 'We are probably going to use debt finance for this new project, so
we should use the cost of debt for discounting. If the project earns more than the cost of the interest paid
on this debt we make a profit, if it earns less we make a loss.'
The company’s finance director was more uncertain. 'I agree that we will probably use debt to finance the
new project if it goes ahead, but I still favour using the current weighted average cost of capital for
discounting as it applies our overall cost of finance.'
Requirements
(a) Calculate Yollo Ltd's weighted average cost of capital at 31 August 20X0. (11 marks)
(b) Examine how Yollo Ltd should arrive at an appropriate discount rate to use for calculating the net
present value of the new project.
In so doing
(i) Assess in detail the comments of the accountant and the finance director
(ii) Examine the possible consequences for the cost of each type of capital and for the weighted
average cost of capital arising from accepting the new project. Refer where appropriate to your
calculations in (a) above, but further calculations are not required. (11 marks)
(22 marks)
27 Navarac Ltd
On 31 December 20X0 Navarac Ltd, an unlisted, all equity-financed company, invested in some machinery
and started to manufacture a new product, WX14. The decision was based on the machinery being capable
of producing WX14s until the end of 20X6 and sales continuing until that time.
Actual sales have not been as buoyant as projected when the investment was being appraised during 20X0.
As a result, the company's management is considering abandoning the project at the end of 20X3, the
earliest date at which it would be feasible to do so. You, as the company's finance expert, have been asked
to prepare calculations and recommend whether to abandon the project at that time or to continue as
originally projected until the end of 20X6.
You have discovered the following.
(1) The machinery was bought on 31 December 20X0 for CU400,000. Were production to be abandoned
at the end of 20X3, the machinery would be disposed of for CU150,000, either late in December
20X3 or in early January 20X4, whichever were to be the more economically beneficial. Should the
project continue, it would be disposed of in late December 20X6 for zero proceeds.
Expenditure on the machinery has attracted, and would continue to attract, tax depreciation. For the
purposes of this analysis, the expenditure can be assumed to attract 25% (reducing balance) tax
depreciation in the year of acquisition and in every subsequent year of being owned by the company,
except the last year. In the last year the difference between the machinery's written down value for
tax purposes and its disposal proceeds will either be allowed to the company as an additional tax relief
if the disposal proceeds are less than the tax written down value, or be charged to the company if the
disposal proceeds are more than the tax written down value.

QUESTION BANK
(2) Following discussions with the marketing director, it has been agreed that the most likely volume of
sales for the remaining three years of the project are as follows.
Year Units of WX14
20X4 2,400
20X5 2,400
20X6 1,500
(3) WX14s are sold for CU200 each. This produces a contribution of CU80 per unit.
(4) The variable costs include CU90 per unit of WX14 for materials. The only other element of variable
operating cost is labour.
(5) The company also has a longstanding product, the AP25, for which the market is very buoyant. This
uses the same manufacturing labour, paid at the same rate, as the WX14s. As a result of a shortage of
this labour, unit sales of AP25s are lost when WX14s are produced. A higher-than-planned output of
AP25s has occurred since 20X1, due to the labour released by the WX14 sales shortfalls.
AP25s generate a contribution of CU50 each, with a variable labour element of CU30.
(6) All production requires the support of working capital. This needs to be in place at the beginning of
each year and is entirely released at the end of production. The amount of working capital required is
expected to be equal to 10% of the contributions.
(7) It is believed that there are no other incremental cash flows associated with the decision.
(8) The capital asset pricing model (CAPM) is to be used to derive a cost of capital for the project. The
project's beta is estimated at 1.25, the risk-free rate is 5% pa and the return on the market is 13% pa.
(9) The company's corporation tax rate is 30%. Its accounting year end is 31 December. Tax can be
treated as being payable on the last day of the accounting year to which it relates.
Assume that all operating cash flows arise on the last day of the accounting year concerned.
Requirements
(a) Show calculations that indicate, on the basis of net present value at 31 December 20X3, whether
Navarac Ltd should abandon WX14 production at the end of 20X3 or continue until 20X6. You
should also indicate whether, if production were to end in 20X3, the machinery should be disposed of
in late 20X3 or in early 20X4. (17 marks)
(b) Explain the nature and purpose of CAPM. This explanation should include the logic of using it to
derive the project's cost of capital, how the company may have derived the input values for using in
the model and any reservations that you may have about using CAPM in that context. (7 marks)
(24 marks)
28 Terry Ltd
Terry Ltd is financed by 1m CU1 ordinary shares currently valued at CU1.725 cum div. The company has
paid a constant dividend of CU225,000 for many years. The directors are considering investing in a project
which is expected to yield CU56,000 per annum in perpetuity, commencing in one year's time. The
immediate initial investment required is CU225,000 and the project could be financed
either (1) by a rights issue of 7 for 20, priced to raise CU225,000
or (2) by a new issue
(i) either priced so as to give all the gain on the project to the current shareholders
(ii) or at CU1.25 per share.

Requirements
(a) For (1) calculate the gain to the ordinary shareholders and the NPV of the project. (4 marks)
(b) For (2)(i) calculate the issue price and the number of shares to be issued. (3 marks)
(c) For (2)(ii) calculate the gains or losses to the current and the new shareholders. (4 marks)
(d) Discuss the factors which directors of a company should consider in determining the pricing and
timing of a rights issue. (6 marks)
(17 marks)
29 Ellis Ltd (M03)

Ellis Ltd provides a range of office services to medium-sized businesses. The Ellis family has a 55% holding in
the company, which is unlisted and medium-sized. Most of the family members do not take part in the
management of the company. They rely on income from the business, but have limited understanding of
financial matters. Three of the company's directors have put forward different proposals for the business as
follows.
Director A (the new finance director) has proposed a strategy of expansion, taking advantage of depressed
market conditions to buy rivals relatively cheaply. He has assured the family that it would be possible to
raise venture capital by using his contacts.
Director B (a family member) has argued for organic growth, based on limited bank borrowings. He
contends that this is the lowest risk and the most cost effective strategy for the family.
Director C (the sales director) has suggested a series of short-term measures which she believes would
increase sales and profitability, as a prelude to selling the company to a bigger rival in the medium term. She
has urged that a major marketing campaign should be mounted, financed by a sale and leaseback
arrangement of the company's offices.
You have been asked by the Ellis family to advise them on the three proposals outlined.
Requirements
Prepare notes for an initial briefing for the family which
(i) Explain the meaning of the terms 'venture capital', 'organic growth' and 'sale and leaseback'
(ii) Review critically the risks and relative merits of the three proposals. (12 marks)
30 Personal investment (J03)

A friend has recently spoken to you about personal investment. She said
'I've always played safe and put my savings into bank and building society savings accounts, but recently
the interest rates have been so tiny that it doesn't seem worth it. Everyone seems to be saying that
investing in companies' shares is a much better bet. I must admit that I can't really see the difference
between the two.
I think that I am right in saying that, with shares you get dividends instead of interest, but I was reading
the other day that sometimes companies don't pay a dividend for a particular year. Surely they have to
or no one will invest money with them. How do they decide on the size of each year's dividend?
My newspaper says that shares in Sainsco, the supermarket, are cheap at the moment and I'm thinking
about taking my money out of the savings accounts and buying Sainsco shares. I do most of my food
shopping at Sainsco and I find them very good, so I can believe that their shares are pretty good value.'
You have made it plain that you are not in a position to offer advice about specific investments, but that you
will try to clarify the issues that she has raised and to warn her of any risks inherent in her plans.

QUESTION BANK
Requirement
Draft some notes of the points that you will make in reply to your friend. You should bear in mind, as is
obvious from what she has said, that she has little understanding of financial matters. (14 marks)
Note: Ignore taxation.
31 Sheridan Ltd
Sheridan Ltd (Sheridan) is a listed company involved in the commercial carpet and floor-covering market. It
is presently financed by a mix of ordinary share capital and loan stocks, and has grown rapidly since its
flotation two years ago.
During that period, retained earnings have consistently been ploughed back into the business to fund its
growth, but this has left Sheridan short of funds at the present time, although its current debt to equity
ratio of 60% is below the 75% average for firms in this market.
The company has recently identified an investment opportunity involving the acquisition of a competitor
company, Vernon Ltd (Vernon). Negotiations have been successfully concluded with the directors of
Vernon for a cash purchase at a price which amounts to approximately 35% of Sheridan's current market
capitalisation.
A board meeting has been called to consider the question of financing the purchase of Vernon. Sheridan has
already ruled out the possibility of a further public issue of new shares so soon after its flotation, but the
following short list of other possibilities has been drawn up.
(1) A rights issue
(2) A further issue of loan stock
(3) Bank loan finance
Before the board meeting various comments have been made by some of the directors.
Director A: 'We do not want to make a rights issue at the present time, given the current low level of our
share price which will mean issuing a relatively high number of shares to raise the funds required.'
Director B: 'I would not favour a further issue of loan stock as that would increase financial gearing in
excess of the sector average and would not, therefore, help our share price.'
Director C: 'I seem to remember from my business school days that it doesn't make any difference to the
existing shareholders whether new finance is raised from a share issue or from some form of borrowing.'
Director D: 'I am not keen on going to our bankers for loan finance. We have done well to avoid
dependence on bank lending and all the restrictions that the bank may impose on us.'
Requirement
You have been asked to prepare briefing notes for the board meeting that will address all the relevant
issues regarding the potential funding arrangements for the acquisition, as well as the specific points made
by each of the four directors. None of the directors is a financial expert, so your notes should be expressed
in language that will be understood by them. (12 marks)
32 Nash Telecom
An uncle of yours, who has a comparatively small holding of shares in Nash Telecom, has sent you a
newspaper report that contains the following commentary.
'Nash Telecom raised a record €9 billion after the banks underwrote a rights issue intended to resolve
concerns about the €40 billion debt mountain. Shareholders will be able to buy 16 new Nash Telecom
shares at €15.5 each for every 20 existing Nash Telecom shares held.
Nash Telecom's share price fell 1.5% to €20. Shares will start trading on an ex-rights basis today with
a theoretical ex-rights price of €18.'

Requirements
(a) Explain the terms 'rights issue', 'ex-rights' and 'underwriting'. (3 marks)
(b) Explain how the 'theoretical ex-rights price of €18' is calculated and why the actual price might be
different. (4 marks)
(c) Explain to your uncle the effect on his wealth of:
(i) subscribing, or
(ii) not subscribing for the rights issue. (4 marks)
(d) Explain to your uncle two other ways in which Nash Telecom might raise money in order to reduce
its debt mountain, setting out the differing impacts on the shareholders and debt holders involved.
(5 marks)
(e) Discuss the possible effects on Nash Telecom's weighted average cost of capital of increasing equity
and reducing borrowings in this way. (3 marks)
(19 marks)
33 Zimba Ltd
Zimba Ltd is a listed, all-equity financed company which makes parts for digital cameras. It is a relatively
small operator in a rapidly changing market with high fixed costs. The company pays out all available profits
as dividends.
Zimba Ltd has a share capital of 150 million CU1 ordinary shares. On 30 September 20X0 it expects to pay
an annual dividend of 20p per share. In the absence of any further investment the company expects the next
three annual dividend payments also to be 20p, but thereafter a 2% per annum growth rate is expected in
perpetuity. The company's cost of equity is currently 15% per annum.
The marketing director is proposing a new investment in plant and equipment to manufacture equipment
for digital televisions. This would require an initial outlay of CU50 million on 30 September 20X0. If this
investment were financed by a 1 for 3 rights issue it would enable the annual dividend per share to be
increased to 21p on 30 September 20X1 and all further dividends would be increased by 4% per annum.
The new investment is, however, more risky than the average of existing investments, as a result of which
the company's overall cost of equity would increase to 16% per annum were the company to remain all-
equity financed.
The finance director argues, however, to the contrary. 'It is nonsense to continue to be all-equity financed. I
believe that we could finance the new investment by an issue on 30 September 20X0 of 8% irredeemable
debentures. Debt would be far cheaper than equity and the interest is available for tax relief.'
The company accountant has reservations. 'New debt finance would add financial risk on top of the existing
high operating risk, which is a particular concern due to the uncertainty of future sales. I believe that we
should continue to use equity finance, particularly with the additional risk of this new investment; a rights
issue is the best way of doing this.'
The managing director was unsure. 'I seem to recall that it should not really matter whether we use debt or
equity finance. Moreover, most of our shares are owned by large, well-diversified investors and they do not
view risk from the perspective of an individual company, as we do. I am sure that this must have
implications for the way in which we assess this investment and decide on its financing.'
Assume a corporation tax rate of 30%.

QUESTION BANK
Requirements
(a) Assuming that Zimba Ltd remains all-equity financed, and using the dividend valuation model, calculate
the expected ex-dividend price per share at 30 September 20X0 on each of the following bases.
(i) The new investment does not take place
(ii) The new investment takes place
Based on the above computations, determine whether the new investment should be undertaken.
(8 marks)
(b) As an external consultant to the company, write a report to the directors which, so far as the
information permits, advises them on the implications of the new investment and the most appropriate
method of financing.
Your report should include an analysis of the concerns expressed by the directors and the company
accountant. (12 marks)
(20 marks)
34 Genesis Ltd
Genesis Ltd, a listed company operating in the leisure industry, has recently appointed a new finance
director who is about to consider the merits of a potential investment opportunity in one of the company's
existing market sectors. The company has grown rapidly in recent years, with dividends (paid annually)
growing at a rate of 8% per annum for the past two years. The finance director has been advised that such a
rate of growth in dividends is expected to continue in the foreseeable future.
In the past, when undertaking net present value appraisals of such investment opportunities, the company's
financial analysts have used the rate of interest on the company's long-term debt as a discount rate. The
new finance director believes that it would be more accurate to use the company's weighted average cost
of capital as a discount rate.
Information regarding the capital structure of the company is as follows.
(1) The ordinary shares of Genesis Ltd are currently quoted at CU1.50 ex-dividend. The recently paid
dividend was 5p per share.
(2) The company has issued 20m 8.4% preference shares, each with a nominal value of CU1. The current
ex-dividend market value of these preference shares is CU0.80 per share.
(3) The company has also issued CU40m of 5% irredeemable debentures, which have a current market
price of CU50%.
The finance director is satisfied that if the new investment goes ahead, then the funding for it will be such
that the historic financing mix of the company will remain unchanged.
The finance director also has the following summarised opening balance sheet for 20X3 for Genesis Ltd.
Balance sheet as at 31 December 20X2
CUm CUm
Net assets 410 Ordinary CU1 shares 200
Preference shares 20
Irredeemable debentures 40
Reserves 150
410 410
Profit after tax, interest and preference dividends for the year ended 31 December 20X3 was CU30m.
Dividends for the year ended 31 December 20X3 were CU10m.
Corporation tax is 30%.

Requirements
(a) Calculate the company's weighted average cost of capital (using the company's dividend growth
forecast). (5 marks)
(b) The finance director has explicitly assumed that the current capital structure will be maintained.
Discuss and evaluate the other assumptions that are implicitly being made when using the weighted
average cost of capital as the discount rate for appraising investment projects. (6 marks)
(c) Use the version of the Gordon growth model based on earnings retention (g = r × b) to calculate an
alternative dividend growth rate for the company. (2 marks)
(d) Identify the major limitations of the version of the Gordon growth model used in © above.
(3 marks)
(16 marks)
35 Educare Ltd
You are a member of the finance staff of Educare Ltd, whose shares are listed on the London Stock
Exchange. You have been asked to derive a weighted average cost of capital (WACC) for use in assessing a
major investment in a training facility in China.
The company's balance sheet at 31 August 20X3 showed the following long-term financing.
CUm
120 million ordinary shares of 25p each 30
Reserves 55
85
9% loan stock 20X5 30
On 31 August 20X3 the shares were quoted at 121p cum div, with a dividend of 5.2p per share due very
shortly. Over recent years, dividends have increased at the rate of about 5% a year. The general view in the
company is that this rate has been, and will continue to be, the target dividend growth rate.
The loan stock is not listed. It is due to be redeemed at par on 31 August 20X5. Interest is payable annually
on 31 August. You have looked at the current prices of similar, but listed, loan stocks of comparable
companies and you have concluded that the cost of Educare Ltd's loan stock is 5.5% pa, after corporation
tax. This takes account of the fact that this loan stock is not listed.
After looking at your workings for WACC, a colleague expressed the view that since the cost of equity is
linked to dividends, and the cost of debt is lower than that for equity, a company can reduce its WACC by
paying smaller dividends. She went on to say that she finds it odd that the company should have a target
dividend growth rate and that this contrasts with what she has read about dividend policy. She also asked
why account needed to be taken of the loan stock not being listed.
The company's corporation tax rate is 30%.
Requirements
(a) Determine the company's WACC at 31 August 20X3. (6 marks)
(b) Discuss the points made by your colleague. (5 marks)
(c) Outline reasons why the WACC determined in (a) may not be suitable for assessing the investment in
China. (6 marks)
(17 marks)

QUESTION BANK
36 Saddlebrook Ltd
Saddlebrook Ltd is a company which intends to raise floating rate finance in order to establish a new
production plant in the Czech Republic. Saddlebrook Ltd evaluates its investments using NPV, but the
Finance Director is not sure what cost of capital to use in the discounting process.
The company is also proposing to increase its equity finance in the near future for expansion, resulting
overall in little change in the company's market weighted capital gearing.
Financial data for the company before the expansion are shown below.
Profit and loss account for the year ending 31 March 20X6
CUm
Turnover 2,112
Gross profit 488
Profit after tax 86
Dividends 37
Retained earnings 49
Balance sheet as at 31 March 20X6

CUm
Non-current assets (net) 856
Working capital 380
1,236
Medium and long-term loans 210
1,026
Shareholders' funds
Issued ordinary shares (50 pence par) 225
Reserves 801
1,026
Medium- and long-term loans include CU75m 14% fixed rate bonds due to mature in five years' time and
redeemable at CU100. The current market price of these bonds is CU119.50. Other medium- and long-
term loans are floating rate bank loans at base rate plus 1%.
The corporate tax rate may be assumed to be 30%. The market price of the company's ordinary shares is
currently 376 p.
Saddlebrook Ltd's equity beta is estimated to be 1.18. The systematic risk of debt may be assumed to be
zero. The risk free rate is 7.75% and market return 14.5%. Bank base rate is currently 8.25%.
The estimated equity beta of the main Czech competitor in the same industry as the new proposed plant is
1.5, and the competitor's capital gearing is 35% equity, 65% debt by book values, and 60% equity, 40% debt
by market values. The Czech corporate tax rate may be assumed to be 30%.
Requirement
Estimate the CU cost of capital that Saddlebrook Ltd should use as the discount rate for its proposed
investment in the Czech Republic. State any assumptions that you make. (15 marks)

37 Quigley Industries Ltd

Quigley Industries Ltd is a listed manufacturer whose principal product is 'Qboard'. Qboard is widely used
in the building trade, particularly in residential properties. The company has several manufacturing plants.
Qboard manufacture is a highly capital intensive activity. The company's other products, which account for
only a small part of revenue are also supplied to the building trade.
Recently demand for Qboard has been very buoyant and the directors have decided to open a new
manufacturing plant in Staffordshire to supply the local market and save on transport costs. A net present
value assessment of the projected plant shows a substantial positive outcome. The cost of establishing this
plant will be significant for the company, representing about 15% of its current stock market value.
The company is financed by a combination of equity and loan stock. Since the company's funds are all tied
up in operations, establishing the new plant will require that the company raises additional finance. The
directors generally have open minds on the source or sources of finance.
You are the company's finance director and have had some conversations with your colleagues, when the
following points were made.
Director A
'This is not a good time to be issuing equity. I have a small share portfolio of my own and I plot the monthly
prices of each share on graphs. I have done this for some years now and I can tell you that the patterns
clearly show that we are heading for a major downturn in share prices. If we went for equity finance, by the
time that we could get it organised the bear market would be with us and we would need to issue a large
number of shares to raise the necessary cash.'
Director B
'We must pay attention to financial gearing. If we get that wrong, the stock market will probably savage our
share price. By the way, are we going to make the financing decision without outside advice and are we
going to handle the practicalities? If not, who is going to do it for us?'
Director C
'People only seem interested in equities these days; the evidence all shows that average returns are higher
than you get from lending. We'll struggle to raise loan finance.'
Director D
'Everyone seems to be talking about external finance, but I'm not so sure that it's necessary. We make good
profits and have done for some time; can't we use some of the retained earnings for this?'
Requirement
Draft notes for the directors, addressing the whole question of the financing decision, as well as picking up
the points raised by the directors. The notes should use language that you expect the directors to
understand and should explain any technical terms. (22 marks)
38 Philpot Ltd
Philpot Ltd is a large, listed manufacturing company that is currently considering how best to raise new
equity finance. One option is to undertake a public issue of new shares, a course of action that was recently
approved by shareholders. Alternatively, the company is considering a 1 for 4 rights issue at a 10% discount
to the current market price of CU5.00 per share.
The company has spoken to a number of investment banks regarding the potential new rights issue and
public issue. During these discussions one investment bank has stated that whilst, in their opinion, the
precise timing of a rights issue would be of no consequence, they are adamant that a public issue of new
shares should not be undertaken at the present time. The bank has recommended that if the company
wishes to pursue a public issue then it should be deferred for a minimum of six months. The bank has
explained that it feels that at the present time the stock market is significantly undervaluing the company's

QUESTION BANK
shares and, as a result, the company would have to issue far more shares to raise the required amount of
finance than it would have to do in six months.
The finance director of Philpot Ltd, however, is uncertain about this and at a recent board meeting when
these matters were being discussed she made the following statement:
'According to the efficient market hypothesis all share prices are correct at all times, with prices
moving randomly when new information is publicly announced. The analysts at investment banks are
unable to predict future share prices.'
Requirements
(a) Calculate the theoretical ex-rights price per share and the value of the rights per existing share should
the company choose this option. (2 marks)
(b) Discuss the alternative courses of action open to the owner of 500 shares in Philpot Ltd as regards the
rights issue, in each case determining the effect on the wealth of the investor. (4 marks)
(c) Discuss the factors that will influence the actual ex-rights price per share. (4 marks)
(d) Discuss the meaning and significance of the three forms of the efficient market hypothesis and, with
specific reference to these, discuss both the recommendation that the company waits for six months
before undertaking a public issue and the finance director's statement. (8 marks)
(18 marks)
39 Efficient markets hypothesis

You are presented with the following different views of stock market behaviour.
(1) If a company publishes an earnings figure higher than the market expects, the shares of that company
will usually experience an abnormally high return, both on the day of the earnings announcement and
over the two or three days following.
(2) The return on professionally managed portfolios of equities is likely to be no better than that which
could be achieved by a naive investor who holds the market portfolio.
(3) Share prices usually seem to rise sharply in the first few days of a new fiscal year. However, this can be
explained by the fact that many investors sell losing stocks immediately prior to the fiscal year end in
order to establish a tax loss for capital gains tax purposes. This causes abnormal downward pressure
which is released when the new fiscal year begins.
Requirements
(a) Briefly describe the three forms of the efficient markets hypothesis. (4 marks)
(b) Consider what each of the above three statements tells you about the efficiency of the stock market.
Where appropriate, relate your comments to one or more forms of the efficient markets hypothesis.
(8 marks)
(12 marks)

40 Abydos Ltd
Abydos Ltd is considering a large strategic investment. The scale of the new venture is such the significant
injection of CU12.5 million of new capital will be required. The new capital is estimated to give rise to a
new gearing level of 60% equity and 40% debt by market value.
The new project will require outlays immediately as follows:
CU'000
Plant and equipment 10,000
Working capital 1,500
Equity issue costs 700 (not tax allowable)
Debt issue costs 300 (not tax allowable)
12,500
Other details are as follows:
(i) Estimates of relevant cash flows and other financial information associated with the possible new
investment. These are shown below.
Year 1 2 3 4
CU'000 CU'000 CU'000 CU'000
Pre-tax operating cash flows 3,000 3,400 3,800 4,300
(ii) The investment equity beta is 1.4, assuming gearing at 60% equity, 40% debt by market values.
(iii) The risk free rate is 5% and the market return 12%
(iv) Debt finance for the investment will be an 8% fixed rate debenture.
(v) Tax depreciation is at 25% per year on a reducing balance basis.
(vi) The corporate tax rate is 30%. Tax is payable in the year that the taxable cash flow arises.
(vii) The after tax realisable value of the investment as a continuing operation is estimated to be CU4m
(including working capital) at the end of Year 4.
(viii) Working capital may be assumed to be constant during the four years.
The board of directors of Abydos Ltd is discussing how the company should appraise the new investment.
There is a difference of opinion between two directors.
The sales director believes that net present value should be used as positive NPV investments should be
quickly reflected in increases in the company's share price.
The finance director states that NPV is not good enough as it is only valid in potentially restrictive
conditions, and should be replaced by APV (adjusted present value).
Requirements
(a) Calculate the expected NPV and APV of the proposed investment. (14 marks)
(b) Discuss briefly the validity of the views of the two directors. Use your calculations in (a) to illustrate
and support the discussion. (6 marks)
(20 marks)

QUESTION BANK
Business plans, dividends and growth
41 Newton Pearce Ltd

Newton Pearce Ltd (NP) is a well established retailer of gymnasium equipment. The company's key market
is in southern and central England. Extracts from the company's most recently published annual report (as
at 31 December 20X6) are shown below:
CU'000 CU'000 CU'000
Non-current assets 3,518
Current assets
Inventories 3,780
Trade receivables 3,668
7,448
Total assets 10,966
Ordinary shares (50p) 980

Retained earnings 1,954
Total equity 2,934
Non-current liabilities
8% Debentures (redeemable in 20Y1) 2,550
Current liabilities
Trade payables 2,870
Other payables 372
Short-term borrowings 2,240
5,482
Total liabilities 8,032
10,966
NP's finance director has calculated that the company needs to raise CU1,827,777 of additional long-term
funds to provide finance for the following three matters.
 Over the past three years, NP's annual revenue has changed very little and so its senior management is
now considering extending operations into northern England and Scotland. This would necessitate
expenditure of CU950,000 on new buildings and vehicles at the company's existing distribution centre.
 NP's short-term borrowings comprise only a bank overdraft and the company is under pressure from
its bank to reduce that overdraft (which has stayed close to its current level for the past eighteen
months) to CU2 million.
 Its trade suppliers are unhappy that they have to wait, on average, 45 days to receive payment and
would like this figure reduced by ten days.
You are a member of NP's finance team and have been asked to prepare workings that would aid
management in their decision. Other information relevant to the situation is:
NP's total revenue (20X6) CU28.5m
NP's net margin (20X6) – before interest costs 3%
Bank overdraft interest rate (fixed) 17.5%
Dividends per share (20X6) 5p
Earnings per share (20X6) 9.25p
Gearing using book values: debt / (debt + equity) (20X6) 46.5%
NP's marketing director believes that the expansion into northern England and Scotland will generate
additional revenue of CU6m in 20X7 and, because of the impact of fixed costs, it is estimated that the net
margin on these extra sales (before interest costs) would be 5%. NP's management estimates that the 20X6
dividend per share will be maintained in 20X7.

You have been advised that, for the additional long-term funds, senior management wishes to use either
(i) A rights issue, with the new shares priced at about 20% below the current market value of
CU1.55 per share; or
(ii) An issue of irredeemable debentures with a coupon rate of 10%. Currently investors expect a
12% return on similar debentures in the market.
The corporation tax rate is 30%. NP's management has assumed that there will be no additional working
capital requirements associated with the additional revenue.
Requirements
(a) Demonstrate how NP's finance director calculated the long-term funding requirement of
CU1,827,777. (1 mark)
(b) Assuming that NP needs to raise CU1,827,777, calculate:
(i) Its projected earnings per share figure for 20X7 if it raises those funds by (a) a rights issue
or (b) a debenture issue. (7 marks)
(ii) NP's projected gearing figure at the end of 20X7 if it raises those funds by (a) a rights issue
or (b) a debenture issue. (5 marks)
(c) Based on your workings in (b) above, recommend, with reasons, which, if either, method of long-term
funding NP's senior management should choose. (5 marks)
(d) Comment on the assumption made by NP's management that there would be no additional working
capital requirements associated with the additional revenue. (4 marks)
(22 marks)
42 Wentworth Ltd
The shares of Wentworth Ltd are listed on the London Stock Exchange. The current distribution of the
company's shareholders is as follows:
Institutional investors 60%
Directors 30%
Private individuals 10%
Wentworth Ltd is a long established printing company operating in the highly competitive magazine market.
In recent years growth has been steady rather than spectacular, although the company has maintained its
high dividend pay-out ratio.
Competitive pressures in the industry demand that players keep pace with technological developments in
printing processes if they are to survive. The company currently has the opportunity of tendering for a large
contract with a national publishing company, but in order to tender the company will need to purchase a
new laser-based printing machine at significant cost in terms of purchase price, installation and staff training.
At the present time, the company is unlikely to be able to raise further external finance. The finance
director has, therefore, highlighted the fact that this significant investment will place some immediate
pressure on the company's liquidity and has forewarned that the current high dividend pay-out ratio may
need to be reduced in at least the next two years to allow the company to cope with the strain on its
finances.
The finance director's comments have received a mixed reception amongst the other directors. Some
directors have expressed indifference to the possible change and feel that the company's shareholders
should also be indifferent, whilst other directors have expressed grave concern that the dividend policy
might change in the way suggested and feel that many of the company's shareholders will share their
concerns.

QUESTION BANK
Requirements
(a) Discuss the potential reasons why the directors of Wentworth Ltd might choose to adopt a high
dividend pay-out policy. (5 marks)
(b) Explain the theory that might justify the opinion of those directors who feel that the shareholders
should be indifferent to the proposed change in dividend policy. (6 marks)
(c) Identify and discuss the risks faced by a company when deciding to change its dividend policy which
might justify the opinion of those directors who feel that the proposed change in dividend policy is a
cause for concern. (6 marks)
(d) Explain how shareholders who might be unhappy with any future pattern of dividend payments
adopted by the company can respond to achieve their own income preferences and explain one
dividend strategy the company might employ to address the potential liquidity issues facing it.
(5 marks)
(22 marks)
43 Krenn Ltd
Krenn Ltd is a listed company that makes a limited range of traditional British preserves and processed
food. It is financed by a mixture of debt and equity. The company's market has remained remarkably steady
over recent years and has not been under much pressure from competition. Several years ago the company
made an attempt to break into the overseas market and to expand its product range in the local market, in
both cases without success.
A good level of profits, coupled with little new investment, have led to a build-up of a significant amount of
cash. Some of the directors are concerned about this, and the board has met to discuss it. During the
meeting the following points were made.
Director A
'We have built up this cash because we are in the growth phase of our business. I believe that we should
hold on to the cash. It's safely in the bank earning a reasonable rate of interest. Our investors will surely
appreciate the fact that the company is in a strong financial state.'
Director B
'I feel that the cash mountain makes us vulnerable to a takeover attempt. We should buy up and cancel
some of our shares. That will get rid of the cash and improve our share price, without any side effects.'
Director C
'We should use the cash to redeem a lot of our loan finance. There's enough cash to redeem most of it.'
Director D
'A large dividend to the equity holders is the answer. This would be a way to reward the investors. It would
improve market sentiment towards us and restrict the risk of takeover.'
Requirement
Comment critically on the points made by the directors. Your comments should include discussion of any
misunderstandings evident from the points made by the directors, and should also suggest reasons why the
directors may have taken the positions they did. (16 marks)

44 Duofold Ltd
You are a shareholder in Duofold Ltd, a listed company with an issued share capital of 10m ordinary CU1
shares with a current market price of CU1.80 per share at the close of business yesterday afternoon. Today
you are to attend the company's annual general meeting, and just before the meeting begins you are in
conversation with a number of fellow shareholders.
(1) The first shareholder is Alan Jones who owns 2,000 shares in Duofold Ltd. He expresses great
concern that before the market opened this morning the company announced its intention to pursue a
1-for-2 rights issue at CU1.00 per share to raise funds for a new project that it claimed has a net
present value of CU2m. 'This massive discount to the market price is atrocious, and the consequent
fall in the share price will be bad news for me.'
(2) The second shareholder, Peter Atkins, produces a recent investment bank report that hints at a
possible acquisition by Duofold Ltd of its principal competitor. The report states that the annual cash
flows of Duofold are currently CU4.2m and that 'an appropriate discount rate for these cash flows is
12%'. The report goes on to estimate that combined annual cash flows would total CU6.8m and that
'the appropriate discount rate for these cash flows is 10%'. Peter's concern is that he does not know
what would be a reasonable price for the directors to pay in such circumstances, as the report makes
no reference to a likely purchase price.
(3) The final shareholder is Norma Benbow, who is concerned by rumours that Duofold Ltd might be
about to cut its dividend, because she has read that a cut in dividend by another company adversely
affected that company's share price. At the same time, however, Norma mentions that a friend has
suggested that a company's dividend policy is irrelevant. She is confused.
Requirements
(a) Advise Mr Jones of his various options in such a scenario, making clear to him the expected ex-rights
price of the company's ordinary shares, how much he could reasonably sell his rights for (if he chose
to) and provide calculations to illustrate to him the effect on his wealth of each of the options available
to him. (6 marks)
(b) Calculate for Mr Atkins the maximum price the directors of Duofold Ltd should consider paying for
this acquisition, and advise him of the potential reasons why the directors of Duofold Ltd might
recommend an acquisition to their shareholders. (5 marks)
(c) Outline to Norma the theoretical and practical positions regarding the relevance or otherwise of a
company's dividend policy. (6 marks)
(17 marks)
45 Portico Ltd
Portico Ltd (Portico) has recently become a listed company. Prior to its flotation this previously family-
owned private company made dividend decisions each year to suit the particular requirements at the time
of both the company and the small number of family shareholders who held substantially all of the
company's equity. There was no long-term, stable dividend policy in place.
Following flotation, the family is no longer involved in the day-to-day management of the firm but has
retained 45% of the equity, which currently represents the largest single block of shares owned. None of
the family members is any longer a director of the firm, but one member has been retained as a non-
executive director. The new board of directors consists of a group of young professional managers who are
all keen to grow the business rapidly.
Now that it is a listed company, the question of establishing a more formal dividend policy has arisen and a
forthcoming board meeting will address the issue. As the company's finance director you have been
approached by two directors who have made the following observations.
Director A
'The value of the company's shares is tied to the level of the company's dividend, so we should pay the
maximum dividend possible. If at any time this policy places pressure on finances, then raising further equity
will be that much easier, given the policy of maximum dividends the company will have established'.

QUESTION BANK
Director B
'What strikes me is the variety of different views on this issue among our shareholders. Some shareholders
tell me they want us to maximise the dividends as they depend so much on the income and are not
primarily concerned with capital growth. Others say they would prefer the company to retain much of its
profits to invest in new projects so as to maximise the share price'.
Both these directors have limited financial knowledge.
Requirement
Prepare briefing notes for the forthcoming board meeting that
 Set out the key considerations for a company in Portico's position when formulating a dividend policy
 Address the specific points made by the two directors and how Portico might address the fact that
particular groups of investors may have different preferences in respect of dividends
 Explain to the board the relationship between a company's dividend policy and the 'agency problem' in
business finance. (16 marks)
46 Biojack Ltd
Biojack Ltd is an all-equity financed, listed company that has experienced no profit or dividend growth over
recent years. The market expects that the 13p per share dividend, which the company has paid for many
years, will continue into the future.
The company manufactures casual outdoor clothing made from natural fibres. The directors have identified
an opportunity to make an investment in plant to manufacture warm clothing for outdoor workers. The
directors are unwilling to issue additional shares or to borrow, so the only way that the new investment
could be undertaken would be by failing to pay the 13p per share dividend expected shortly and that of the
following year. Dividends are expected to be resumed in two years' time and then to remain at a constant,
higher figure.
The company's current cost of equity is 11% pa but the increased risk associated with the new venture
means that this will increase to 14% should the new investment be made. The market does not know of the
possible investment and so the current share price does not reflect it.
Requirements
(a) Calculate the amount of the dividend to be paid in two years' time that should, in theory, maintain the
share price at its present level, were the company to announce its intention to go ahead with the new
investment. (5 marks)
(b) Identify and discuss any factors that could mean that an announcement of forecast resumed dividends,
of the amount calculated in (a), may not be sufficient to maintain the current share price. (9 marks)
(14 marks)
47 Safeway Ltd
A takeover battle for Safeway Ltd (Safeway), the UK supermarket chain, included three potential bidders.
(1) WM Morrison Supermarkets Ltd (Morrisons), also a UK supermarket chain, offered shares in its
company in exchange for Safeway shares. The two businesses would be merged and Safeway's head
office closed. Morrisons had previously expanded through organic growth.
(2) Wal-Mart Stores Inc is a major international retailing company. Its funds available for a takeover bid
were generated by organic growth. It was expected to operate the Safeway stores as part of its
'ASDA' UK operations, under the latter's management. A significant number of Safeway stores would
be sold off to meet regulatory requirements (for competition in the UK).
(3) J Sainsbury Ltd (Sainsbury's), a UK supermarket chain, would have needed to borrow funds to finance
such an acquisition strategy. It was expected to reduce the Safeway head office function and sell off
some stores.

Requirements
(a) Explain the risks involved in the contrasting strategies of organic growth and acquisition such as
adopted by Morrisons. (4 marks)
(b) Explain the difference between 'financial gearing' and 'operational gearing', and suggest how Sainsbury's
financial gearing and operational gearing might be affected by its bid as outlined in (3) above.
(4 marks)
(c) Explain to four groups of stakeholders in Safeway the potential benefits and drawbacks of the offers
described above. (8 marks)
(16 marks)
48 Sunnydaze Ltd
Sunnydaze Ltd (Sunnydaze) is a mainstream package holiday provider. The holidays that the company
provides are principally by air to popular Mediterranean destinations in hotel and self-catering
accommodation. The company also has a small division (Bienvenue) that provides holidays in tent
accommodation on campsites in three locations in France. Here the clients travel to their chosen site in
their own cars, using ferry or Channel Tunnel bookings arranged by Bienvenue. Once on the site the clients
look after themselves.
Sunnydaze's directors have been sceptical about the Bienvenue operation. It has not been very profitable. It
is believed by the directors that it would need to be expanded substantially to make it viable, but they are
reluctant to do so, preferring to expand their core air/hotel activities.
Seeing a business opportunity and a probable means of safeguarding an otherwise uncertain future, a group
of senior Bienvenue managers has approached the board with a management buy-out proposal. Since the
buy-out team has yet to look for financing and it will take time to set up a deal, the team suggested that the
buy-out, should it occur, would take place on 31 December 20X1. The board sees the buy-out proposal as
an opportunity to deal definitively with Bienvenue.
Sunnydaze has agreed to the buy-out provided that it receives, from the buy-out team, the present value, at
31 December 20X1, of the projected incremental cash flows of Bienvenue over the three years starting the
following day and discounted at Sunnydaze's weighted average cost of capital. This period of time was
selected because Bienvenue, were it to remain part of Sunnydaze, would make an investment in some new
tents and other related equipment on 1 January 20X2. These normally have a life of about three years.
You have been asked to calculate the buy-out price and you have found the following information.
(1) The investment in new tents and related equipment etc on 1 January 20X2 would total CU1 million.
At the end of 20X4 these will be disposed of for a negligible sum.
These assets will attract tax depreciation, but will be excluded from the general pool. This means that
they attract 25% (reducing balance) tax depreciation in the year of acquisition and in every subsequent
year of being owned by the company, except the last year. In the last year, the difference between the
assets' written down value for tax purposes and their disposal proceeds will either be allowed to the
company as an additional tax relief, if the disposal proceeds are less than the written down value, or
be charged to the company, if the disposal proceeds are more than the written down value.
The existing tents and related equipment would be discarded at the end of the 20X1 season,
irrespective of the buy-out proposal.
(2) Annual revenues from Bienvenue's operations are hard to predict. In the past ten years they have
twice been about CU1 million, five times about CU1.2 million and three times about CU1.4 million.
These figures showed no particular trend, with good years and less good years arriving, apparently, at
random. The Sunnydaze directors and the buy-out team agree that the past ten years are as good a
guide to the next three as is likely to be found.
All of these revenues are expressed in 1 January 20X2 prices.
(3) Variable costs tend to average about 25% of revenues.

QUESTION BANK
(4) Fixed costs, including a share of Sunnydaze's head office costs equal to CU0.2 million, average about
CU0.5 million.
(5) Operating cash flows should be assumed to occur at the end of the relevant year.
(6) The working capital tied up in Bienvenue's operations is about 10% of the sales revenue. This must be
in place by the start of the year concerned. It will be released at the end of operations.
(7) Sunnydaze pays tax at the rate of 30% and it has an accounting year end of 31 December. Assume that
tax is payable at the end of the year concerned.
(8) Inflation is expected to average 3% per annum for the foreseeable future. All financial amounts
mentioned above are expressed at 1 January 20X2 prices.
(9) Sunnydaze's annual cost of capital is 12% in real terms.
Requirements
(a) Calculate, using 'money' (or 'nominal') cash flows, the price at which Sunnydaze will offer Bienvenue to
the buy-out team. (17 marks)
(b) Explain to the buy-out team why a present value evaluation is a theoretically sound approach to
reaching a price for Sunnydaze. (4 marks)
(c) Outline the issues that the buy-out team needs to consider if it wishes to proceed to a deal, including
those concerning the calculation of the price and possible sources of finance and advice. (8 marks)
(29 marks)
49 Tinkler's Stores Ltd

Tinkler’s Stores Ltd operates a large department store in the North of England, which was founded over
100 years ago. Key figures from its financial statements for the year ended 31 May 20X4 are shown below.
CUm
Revenue 10.0
Gross profit 3.0
Net profit 0.5
Land and buildings (book value) 10.0
Land and buildings (market value) 20.0
Long-term loans 5.0
Bank overdraft 1.0
Shareholders' funds 4.0
The Tinkler family holds 40% of the ordinary voting shares of the company. The shareholdings of the family
have become widely dispersed around family trusts and individual family members. The last family members
to be a part of the management of the business retired two years ago. The family is considering the
following strategies put forward by the board for their consideration.
(1) Borrow CU1 million to develop key departments, with an estimated contribution of CU200,000 per
year before interest.
(2) Sell the business in six months' time to a large rival in exchange for shares with a current market value
of CU10 million.
(3) Sell the business in a management buy out for CU10 million, one half payable immediately and the
other half in one year's time.
(4) Close down the business immediately. This would incur estimated closure costs of CU5 million.
Requirement
Prepare a report advising the Tinkler family as to the merits and risks involved with the four financial
strategies outlined above. (12 marks)

50 Bill Jackson Haulage Ltd

Bill Jackson Haulage Ltd is a family-owned, unlisted company specialising in transporting bulk materials and
waste, particularly for the local building trade, using its own fleet of lorries.
The company leases a site on which are located the company's lorry maintenance facility, a small office
building and parking space for the lorries. The lease is shortly due to expire, and the landowner wishes to
sell the site rather than renew the lease. A figure of about CU500,000 has been mentioned as a possible
price for the freehold. This represents about 20% of the value of the company's total assets less current
liabilities.
You are the partner in a local firm of chartered accountants responsible for the company's audit. You have
been speaking to Paul Jackson, the company's chief executive, about the possible purchase of the site.
During the conversation he said:
'We are very keen to buy this site. Land prices seem to rise pretty reliably round here, so there's not
much chance of it turning out to be a bad move commercially. If we don't buy it, we don't know who
will. It could be people who want to use it themselves, and then we would have to find a new site. If
we buy it, a lot of uncertainty would be taken away.
The problem is where would the cash come from? We haven't got any. We recently expanded our
fleet of lorries and that took up all our spare funds and we had to borrow a bit from the bank as well.
We could obviously borrow more – if we can find a lender, but we are not keen to overstretch
ourselves. As I understand it, some borrowing is usually regarded as a good thing, though I'm not clear
why. There must be a limit on the amount of borrowing that is wise. What is the maximum figure for
a company like ours?
Could you do us a short report on where we might get the cash, plus any related financial issues that
you feel we ought to think about? I'd be grateful if you would keep it simple, so that we can
understand it and discuss it among ourselves.'
Requirements
(a) Prepare the report requested by Paul Jackson. (16 marks)
(b) Critically comment on each of the following statements that have appeared in the press, explaining the
reasons for your comments and clearly defining all technical terms used.
(i) 'A spin-off is a corporate restructuring device, where a company sells off a set of assets which
constitute a definable part of its business to another business. The selling company's objective is
usually to raise finance either for investment in its core activity or to stave off a financial crisis.'
(4 marks)
(ii) 'Where there is 'hard' capital rationing, the business should seek to take on projects with the
highest net present value.' (4 marks)
(24 marks)
51 Megagreat Ltd
Megagreat Ltd has recently announced a takeover bid for Angelic Ltd. The offer is that for every four
Angelic Ltd ordinary shares the owner would receive three ordinary shares in Megagreat Ltd plus CU6 in
cash. Both companies are listed.
According to published estimates, if Angelic Ltd were to remain independent the company would pay its
next dividend in one year's time at 37p per share. Subsequently dividends are expected to grow by an
average 5% pa. Angelic Ltd has an equity cost of capital of 12% pa.
Estimates for Megagreat Ltd, assuming that the takeover goes ahead, suggest that a dividend of 43p per
share will be paid in one year's time and the same amount in two years' time. In three years' time the
dividend paid will be 7% higher than the 43p to be paid next year and the year after. This rate of growth is

QUESTION BANK
expected to continue indefinitely. The expanded Megagreat Ltd is expected to have a cost of equity of
11% pa.
Requirements
(a) Show calculations that indicate whether, on the basis of the published estimates, Angelic Ltd
shareholders would be advised to accept the offer from Megagreat Ltd. (6 marks)
(b) Discuss reasons why any particular shareholder might look beyond the result of the calculations in (a)
when deciding whether to accept the offer. (4 marks)
(c) Suggest the possible effect on Angelic Ltd's ordinary share price of the announcement of the bid,
stating and explaining any assumptions made in reaching your conclusion. (4 marks)
(d) Suggest and explain any other strategies that Megagreat Ltd could use to achieve growth, apart from
taking over other businesses. (3 marks)
(17 marks)
52 Thebean Ltd
Thebean Ltd (Thebean) operates a chain of mid-market coffee shops. It was established twenty years ago
and has grown rapidly benefiting from the global increase in the café society.
The most recent financial statements of Thebean are as follows.
Balance sheet CU'000

Net non-current assets 22,300
Net current assets 12,210
10% debentures 20X0 (3,500)
31,010
Ordinary shares, par value 50p 4,000

Retained profit 27,010
31,010
Income statement for the last year CU'000

Sales 60,000
Cost of sales 45,000
Gross profit 15,000
Administration costs 8,000
Profit before interest and tax 7,000
Interest 350
Profit before tax 6,650
Taxation at 30% 1,995
Profit after tax 4,655
Dividends 2,560
Thebean is currently planning to expand its existing chain of coffee shops, for which it will need to raise
CU10m. As a result of the expansion of the business it is expected to increase sales revenue by 9% in the
first year and administration costs (all fixed) will increase by 6%. Variable costs make up 75% of cost of
sales.
Thebean is faced with a choice of raising the finance for the expansion by either
 Issuing 8% debentures redeemable in 20X5,
 Or by a rights issue at CU5.00 per share.
Thebean has a policy of paying out 55% of profit after tax as dividends and has no overdraft.

Requirements
(a) Discuss the factors that should be considered by a company when choosing between debt and equity
issues. (8 marks)
(b) For each financing proposal, prepare a forecast Income Statement following the expansion. (5 marks)
(c) Evaluate and comment on the effects of each financing proposal on the following:
(i) The capital structure – i.e. the level of financial gearing measured as debt/equity
(ii) The cost structure – in particular the level of fixed costs i.e. operational gearing, measured as
contribution/profit before tax
(iii) Earnings per share
(iv) Interest cover (12 marks)
(25 marks)
53 Fituup Ltd
Fituup Ltd (Fituup) is a specialist supplier of shop fittings whose business has been very successful recently.
Extracts from the forecast Income Statement for the year ended 31 December 20X5 for
Fituup Ltd
CU'000
Revenue 53,200
Costs and expenses 39,741
Operating profit 13,459
Finance costs 4,680
Tax 2,634
Additional information:
(1) Dividends declared for 20X5 are CU2,458,000 and will be increased by 4% each year.
(2) Revenue is expected to increase by 15% per annum in each of the financial years ending 31 December
20X6 and 20X7. Costs and expenses are expected to increase by an average of 6% per annum. Finance
costs are expected to remain unchanged.
(3) The marginal rate of tax can be assumed to continue at 30%. Assume that tax is paid in the year in
which the liability arises.

QUESTION BANK
Forecast balance sheet as at 31 December 20X5

CU'000 CU'000
Total assets
Current assets
Inventories 7,893
Trade receivables 6,475
Cash 347
14,715
37,372
EQUITY AND LIABILITIES
Equity
Share capital 14,612
22,926
(secured bonds, 7% 20X8) 7,000
Current liabilities
Other payables (dividends) 2,458
7,446
37,372
The following additional information is also available.

(1) The ratios of trade receivables to revenue and trade payables to costs and expenses will remain the
same for the next two years. The value of inventories is likely to remain at 20X5 levels.
(2) The non-current assets are land and buildings, which are not depreciated by Fituup Ltd. Capital (tax)
allowances on the buildings may be ignored. All other assets used by the entity (machinery, cars and so
on) are either rented or leased on operating leases.
(3) Fituup Ltd intends to purchase for cash new machinery to the value of CU10,500,000 during 20X6,
although an investment appraisal exercise has not been carried out. It will be depreciated straight line
over 10 years. Fituup Ltd intends to charge a full year's depreciation in the first year of purchase of its
assets. Capital (tax) allowances are available at 25% reducing balance on this expenditure.
(4) Fituup Ltd's main financial objectives for the years 20X6 – 20X7 are to earn a pre-tax return on the
closing book value of equity of 35% per annum and a year-on-year increase in earnings of 10%.
Requirements
(a) Provide forecast income statements, dividends and retentions for the two years ending 31 December
20X6 and 20X7. (6 marks)
(b) Provide cash flow forecasts for the years 20X6 and 20X7. Comment briefly on how Fituup Ltd might
finance any cash deficit. (8 marks)
(Ignore the timing of cash flows within each year and you should not discount the cash flows. You
should also ignore interest payable on any cash deficit.)
(c) Discuss the main aspects and implications of the financial information you have obtained in your
answer to parts (a) and (b) of the question. In your discussion, comment on whether Fituup Ltd is
likely to meet its stated objectives using appropriate calculations to support your comments.
(11 marks)
(25 marks)

54 Narmer Ltd
Narmer Ltd is a manufacturer of bathroom fittings and decorative products. The company faces strong
competition in its existing product markets, so is considering launching a new range of up-market fittings
where there should be less pressure on prices.
The most recent abbreviated financial statements for the company are as follows.
Abbreviated income statement for the year ended 31 December 20X4
CU'000
Sales revenue 17,500
Cost of sales and expenses (15,200)
Operating profit 2,300
Interest payable (400)
Tax at 30% (570)
Profit after tax 1,330
Dividends (430)
Retained profit for the year 900
Abbreviated balance sheet as at 31 December 20X4
CU'000
Current assets 4,800
14,000
Ordinary share capital (CU1 shares) 1,500
5,800
8% debentures, redeemable in 20X9 5,000
Current liabilities
14,000
The directors believe that the cost of launching the new product range will be CU4m. The new products
should generate new sales of CU6m in the forthcoming year ended 31 December 20X5, at an operating
profit margin 2% better than was achieved by the company in 20X4.
The directors are considering how the cost of launching the new range should be raised early in 20X5
either
(a) By an issue of 10% irredeemable debentures at par, or
(b) By a rights issue at CU2.50 per share
In discussions with the stakeholders in the business, potential buyers of the new debentures have been
identified, but it seems that the proposed rights issue would only be a success if the company promised to
maintain the current dividend payout ratio in future years. The directors have publicly agreed to this
undertaking.
Requirements
(a) For each of the financing proposals:
(i) Prepare a forecast income statement for the coming year
(ii) Calculate the expected earnings per share for the coming year
(iii) Calculate the expected gearing level at the end of the coming year (12 marks)
(b) Comment on your results in (a) above, identifying the key points that the directors should bear in
mind when deciding on which financing proposal to accept. (5 marks)
(17 marks)

QUESTION BANK
Risk management
55 Plutocrat Ltd
The finance director of Plutocrat Ltd is concerned that interest rates could become more volatile for many
major trading countries following recent turmoil in credit markets.
It is now 1 March and Plutocrat is expected to need to borrow CU12,000,000 for a period of six months
commencing in six months' time.
Futures and options quotes are given below. You may assume that the company may borrow at the
3-month LIBOR rate.
LIFFE futures prices, CU500,000 contract size
June 94.54
September 94.28
LIFFE options on futures prices, CU500,000 contract size, premiums are annual %
Exercise price Calls Puts
June September June September
94.25 0.437 0.543 0.083 0.187
94.50 0.276 0.387 0.168 0.282
94.75 0.163 0.263 0.302 0.407
3-month LIBOR is currently 5.5%.
Requirements
(a) Discuss the relevant considerations when deciding between futures and options to hedge the
company's interest rate risk. (6 marks)
(b) Using the above information illustrate the possible results of hedging interest rate risk using
(i) Futures, and
(ii) Options
hedges if interest rates in six months' time increase by 0.5% and the September future is then trading
at 93.97. Recommend which hedge should be selected. (11 marks)
(17 marks)
56 Snowdrop Ltd and Fortensia Ltd

Snowdrop wishes to raise CU200 million of floating rate finance. The company's bankers have suggested
using a five-year swap. Snowdrop has an AAB rating and can issue fixed rate finance at 6.35%, or floating
rate at LIBOR + 0.5%. Fortensia has only a BBC credit rating and can raise fixed rate finance at 7.6%, or
floating rate at LIBOR + 1.25%.
A five-year interest rate swap on a CU200 million loan could be arranged with a bank acting as an
intermediary for a fee of 0.25% per annum. Snowdrop will only agree to the swap if it can make annual
savings of 0.2%. LIBOR is currently 5.75%.

Risk management
Requirements
(a) Evaluate whether or not the swap is likely to be agreed. (6 marks)
(b) Determine the net borrowing costs of Snowdrop and Fortensia and illustrate the cash flows of the
overall arrangement. (6 marks)
(c) What are the benefits and risks of interest rate swaps? (8 marks)
(20 marks)
57 Thersk Ltd
You are the financial director of Thersk Ltd (Thersk), a diversified international business. Thersk wishes to
borrow CU25 million for a period of three years. Thersk has a good credit rating and could borrow at a
fixed rate of interest at 6 per cent per annum or at a floating rate of LIBOR + 0.2 per cent per annum. You
believe that interest rates are likely to fall over the next three years, and favour borrowing at a floating rate.
Your company's bankers are currently working on raising a three-year loan for CU25 million for another of
their customers, Perturb Ltd (Perturb). Perturb is smaller and less well known than Thersk, and its credit
rating is consequently lower. Perturb could borrow at a fixed rate of 7.5 per cent per annum or a floating
rate of LIBOR + 0.5 per cent. Perturb has indicated to the bank that it would prefer a fixed rate loan and
they have suggested you engage in a swap which might benefit both companies. The bank's commission
would be 0.2 per cent of the amount borrowed in total by both parties. The financial director of Perturb
suggests that the commission fees and swap benefits should be shared equally.
Interest is to be paid annually in arrears and the principal is repaid on maturity (i.e. at the end of three years).
You have been in the post for twelve months, having been recruited from a large financial institution. You
have a keen interest in using financial derivatives (such as futures and options) to both manage risk and
generate revenue. Some board members have expressed concern that your activities may be involving the
company in unnecessary risk.
Requirements
Write a report to the board which:
(a) Explains the meaning and use of financial derivatives, in general terms, and the advantages and
disadvantages of their use for companies such as Thersk. (8 marks)
(b) Determines whether there is any benefit to be had from entering into a swap arrangement. (6 marks)
(c) Determines the net borrowing costs to each party. (4 marks)
(18 marks)
58 Precision Specifications Ltd

Precision Specifications Ltd (PS) has just fulfilled a major contract with a French oil company. The work has,
at the customer's insistence, been invoiced in euros and there will be a credit period of two months. This is
the company's first experience of a major foreign exchange transaction.
PS's accountant is rather anxious about this debt. She is totally confident that it will be paid in full (in euros)
on the due date. She is aware, however, that the volatility in exchange rates between the euro and Taka has
highlighted the extent to which those who have assets or liabilities denominated in foreign currencies are at
risk of substantial losses, should there be a significant adverse exchange rate movement during the period of
exposure.

QUESTION BANK
Requirement
Write a report to PS's accountant outlining the issues to consider relating to the problem identified in the
question and the practical approaches that could be taken.
Your report should explain each approach carefully, pointing out the nature (but not the amount) of the
cost associated with each. (12 marks)
59 Treasurer
You are currently acting in the treasurer capacity for a large UK business to manage its surplus funds. For
the last few years the UK and world economic outlooks have been quite positive and the business has
benefited from a major investment in equities and holds a portfolio worth £30m.
Recently, however, these positive signs have reduced and there is now the fear of some market volatility or
even a short downturn or market correction over the next three months. The long-term prospects for
equities are still positive however and so you do not wish to divest the share portfolio, however you do
wish to protect against a downturn over the next three months.
The current level of the FTSE 100 index is 6000 and a three-month FTSE 100 index futures contract is
currently quoted at 6020.
Options are also available on the FTSE 100 index with a strike price of 6000 and maturity of three months.
A call option has a premium of 150 points and a put option has a premium of 130 points.
Requirements
(a) Describe how you could use the FTSE 100 index future to hedge any portfolio losses arising over the
next 3 months and illustrate the outcome if the index either falls to 5800 or rises to 6200.
(10 marks)
(b) Describe how options may be used to hedge exposure to any market correction and illustrate the
outcome if the index either falls to 5800 or rises to 6200. (10 marks)
(20 marks)
60 Haining Ltd (S04)

Haining Ltd is a small Bangladesh engineering company that is today entering into a contract with an
American company to purchase an item of machinery for $0.9m. This is the first occasion on which the
company has acquired machinery from an overseas supplier. The spot exchange rate today for $/Taka is
1.60 – 1.65. However, delivery of the machine will take six months, with payment due on delivery. The
finance director has discovered today that the six month discount is 0.02 – 0.03, and a columnist in the
national press is predicting that the spot rate in six months' time may move to 1.50 – 1.55.
The company has simultaneously negotiated the sale of an old machine to a dealer in Germany. The dealer
will take delivery of the machine in six months' time and has agreed to pay 0.3m euros at that time. The
spot exchange rate today for euro/Taka is 1.30 – 1.35, and the six-month discount is 0.015 – 0.020.
The commercial director of the company has suggested that a futures contract might be employed to
reduce the transaction risk involved in both these transactions.
US interest rates are currently 3% for six months, euro zone interest rates are currently 3.5% for six
months and Bangladesh interest rates are currently 4% for six months.
Requirements
(a) Calculate the current price of the new machine based on the prevailing spot rate and explain to the
finance director how a forward exchange contract could be employed to reduce the transaction risk
involved in the purchase of the new machine. Your explanation should include figures to illustrate how
the contract would operate in practice. (5 marks)

Risk management
(b) Advise the finance director how a money market hedge could be employed to reduce the transaction
risk involved in the sale of the old machine. Your answer should include figures to illustrate how the
money market hedge would operate in practice. (5 marks)
(c) Advise the commercial director of the characteristics of a futures contract and whether or not (with
reasons) you agree with his suggestion. (4 marks)
Note: Your calculations should be to the nearest Taka. (14 marks)
61 Westgarth Ltd
You are Finance Director of Westgarth Ltd, a Bangladesh based importer/exporter which trades extensively
with customers in Europe. You are concerned about recent exchange rate volatility and are considering
different methods of hedging the exchange risk involved.
The following transactions are expected in 3 months.
Sales receipts €1,080,000
Purchases payable €600,000
The following economic data is available.
 Spot rate of exchange: €1.4540 – 1.4590
 Euro premium on the three-month forward rate of exchange: 0.72 – 0.54 cents.
 Annual interest rates for three months:
Bangladesh 5.50% – 5.75%
Europe 3.75% – 4.00%
 Option prices (cents per Tk, contract size Tk12,500):
Calls Puts
Exercise price € 3 month 6 month 3 month 6 month
1.40 – 15.20 – –
1.45 2.65 7.75 – 3.45
1.50 1.70 3.60 – 9.32
Assume that the contracts expire three months from now.
Requirements
(a) Calculate the net Taka receipts that Westgarth can expect from its transactions if the company hedges
the exchange risk using each of the following alternatives:
(i) The forward foreign exchange market
(ii) The money market
Include in your calculations a brief explanation of your approach and recommend the most financially
advantageous alternative. (8 marks)
(b) Explain the factors the company should consider before deciding to hedge the risk using the foreign
currency markets, and identify any alternative actions available to minimise risk. (5 marks)
(c) Describe (i) the characteristics of a fixed forward exchange contract and (ii) the relative advantages
and disadvantages of using foreign currency options.
Illustrate your points numerically assuming that the actual spot rate in three months' time is either
€1.40 or €1.48, and evaluate whether Westgarth would have been better advised to hedge using
options instead of a fixed forward contract. (12 marks)
(25 marks)

QUESTION BANK
62 Xylophone Ltd
You are the financial director of Xylophone Ltd, a Bangladesh company that imports mainly from Europe
and exports to the US. Xylophone is partly financed by a Taka loan and usually hedges its foreign currency
exposure by using the forward or money markets. Most customers are allowed 3 months' credit. The
company has recently sold equipment to a customer in the US for $2 million.
The following information is available.

Exchange rates $/Tk €/Tk
Spot rate 1.9600 1.4600
1 month forward rate 1.9580 1.4579
Bangladesh USA Europe
Central bank base rate per annum 5.5% 4.25% 3.75%
A recent economic forecast suggested that annual inflation over the next 12 months in Europe is expected
to be 1%, while in the USA it is expected to be 2.7%.
Requirements
Comment on the interest rate parity and purchasing power parity methods for estimating future exchange
rates and answer each of the following questions, including appropriate calculations, where relevant, to aid
your discussion.
(1) As interest rates are higher in Bangladesh than Europe, should the euro be depreciating against the
Taka, hence trading at a discount?
(2) What 3-month dollar forward rate of exchange is implied by the information given, and therefore what
Taka receipts can the company expect in 3 months' time from the US customer?
(3) If the company buys euros on the spot market as and when needed to pay for their imports rather
than taking out forward contracts, would it save them money?
(4) Would a sensible policy be to buy euros on the spot market now and place them on deposit until
Xylophone needs them?
(5) Would it be in Xylophone's interests to borrow euros and pay off their Taka loan? Would this save
money on interest payments? (25 marks)
63 Verriana Ltd
Verriana Ltd (Verriana) has short-term equity holdings in a number of companies that it considers are
currently under-priced by the market.
The equity market has recently been very volatile, and the finance director is considering how to protect
the company's investment portfolio from adverse market movements, in case some of the holdings need to
be sold, at short notice, by the end of October.
The finance director is particularly concerned about 1 million shares that are currently held in Correg Ltd
(Correg). The shares are trading at 735 p.
Assume that it is now 1 June and that option contracts mature at the month end.
LIFFE Correg Ltd Traded options (1,000 shares)
Exercise price CALLS PUTS
July October January July October January
700 39.0 54.0 63.0 1.5 25.0 37.5
750 8.0 23.5 32.5 22.5 52.5 61.5

Risk management
Requirements
(a) Illustrate how Verriana might use traded options to protect against a fall in the share price of Correg.
Evaluate the outcome of the hedge(s) if Verriana has to sell the shares at the end of October, in the
event that the price is (i) 685 p, and (ii) 770 p. (6 marks)
(b) Discuss the reasons why the January 750 call option premium is not the same as the intrinsic value of
the option. (4 marks)
(c) Explain how the value of an option is influenced by the following factors.
(i) The price of the security
(ii) The exercise price of the option
(iii) The general level of interest rates
(iv) The time to expiry of the option
(v) The volatility of the security price (8 marks)
(18 marks)
64 Duvall Ltd
Duvall Ltd is a UK-based company which has placed an order for machinery with a company in the USA.
It is currently February. The machinery will cost $1,537,500 and will be paid for in May.
 The spot exchange rate now is: $2.05/£
 The quote for June futures is: $2.02/£
Requirements
(a) You have been asked to write a memorandum for the Finance Director. Explain, with accompanying
calculations, how the company might use futures to hedge its currency risk, based on the following
illustrative scenario.
 The spot rate in May moves to $1.98
 The June futures rate is $1.95
Sterling futures contracts available on the Chicago Mercantile Exchange have a standard contract size
of £62,500. (9 marks)
(b) Explain briefly the advantages and disadvantages of using futures in comparison with forward contracts.
(6 marks)
(15 marks)
65 Atkins Ltd
Atkins Ltd (Atkins) started trading in 20X1. The company makes industrial filters and of late has been
expanding its trading links (both in terms of imports and exports) in Europe. To date it has not been
concerned with managing its foreign exchange risk. However, Atkins's board of directors now wishes to
investigate the implications of a change in that policy. You are a member of the company's finance team and
have been sent the memorandum set out below by Jacqueline Walker, Atkins's Finance Director.

QUESTION BANK
MEMORANDUM
To: A Student
From: Jacqueline Walker
Date: 21 March 20X7
I'd like you to finish off a piece of work I've been doing for the board which wants to establish if it's worth
trying to hedge our exposure to foreign exchange risk. We have three fairly large transactions to deal with
in the next six months, all of which involve buying/selling euros.
The details are as follows.
 We are due to receive €632,000 from a German customer on 20 June 20X7
 We are due to receive €560,000 from a Belgian customer on 22 September 20X7 and to pay
€1,347,500 to one of our Spanish suppliers on the following day
I have researched the relevant foreign exchange rates and interest rates and they're listed below:
Exchange rates €/Tk
Spot rates 1.412 – 1.445
Three months forward rates 0.85 – 0.81 cents premium
Six months forward rates 1.43 – 1.38 cents premium
Interest rates Lending Borrowing

Euro 3.9% pa 5.2% pa
Taka 4.8% pa 6.1% pa
Could you write a memorandum for the board which:
(a) Recommends whether we should use (i) a forward contract or (ii) a money market hedge. It would
also be advisable to show the board what the outcome would be if we didn't hedge at all (you can
assume here there would be no change in the spot rate as at 21 March 20X7 in the next six months).
(b) Explains the implications of using futures contracts or currency options instead.
Regards
Jacqueline
Requirement
Prepare the memorandum for the board as requested.
Marks will be split as follows:
Item (a) (11 marks)
Item (b) (6 marks)
(17 marks)
66 Formosa Ltd
Formosa Ltd is a company involved in the manufacture of high-technology equipment for the defence
industry. Historically the company's main customer has been the Bangladesh government, but during the
past 18 months the company has been successful in negotiating a small number of large value contracts in
mainland Europe. The board of directors has no other experience of trading outside the Bangladesh and the
company's chief executive has expressed some concern about the risks and financial implications of this
geographical expansion.
The directors are currently considering how to hedge sales revenues of 15m euros, which are due to be
received in 3 months' time. The company has been quoted the following exchange rates by one of its
relationship banks:

Risk management
Spot rate (euro/Tk) 1.4753 – 1.4780

90 day forward rate (euro/Tk) 0.0151 – 0.0161 discount
At the present time, the rate of interest for borrowing euros is 5.6% per annum, while the Taka interest
rate is 4.8% per annum.
Requirements
(a) Calculate the Taka value of the company's euro receivables if it decides to use a forward market hedge
to manage its foreign currency exposure. (2 marks)
(b) Explain to the finance director how he might use a money market hedge to manage the company's
foreign currency exposure and calculate the Taka value of the company's euro receivables using this
method. (5 marks)
(c) Identify the principal features of a forward market hedge and compare and contrast this with:
(i) A currency futures hedge; and
(ii) A currency options hedge. (7 marks)
(d) Advise the board of directors of the risks and other financial management implications of the
company's strategy to develop business in mainland Europe. (6 marks)
(20 marks)
Note: Assume there are 30 days in each month and 360 days in each year.
67 Dubois Ltd
Dubois Ltd is a consumer electronics wholesaler with a highly seasonal business.
In one half year, the business is highly cash generative but in the other half year, the company needs to
borrow to cover its costs.
Dubois will move into this borrowing period in three months' time and expects to need to borrow Tk5m
for the entire low season half year. The directors are concerned that interest rates are expected to rise
over the next few months.
Interest rates and FRAs are currently quoted as follows.
 spot 5.75 – 5.50
 3-6 FRA 5.82 – 5.59
 3-9 FRA 5.94 – 5.64
The 3-month Tk500,000 Taka future maturing in three months is quoted at 94.15.
Requirements
(a) Explain how a forward rate agreement (FRA) may be useful to the company. Illustrate this on the basis
that interest rates
(i) Rise to 6.5%
(ii) Fall to 4.5% (8 marks)
(b) Explain how the 3-month Tk500,000 Taka future may be useful to the company and illustrate its
usefulness under the same two interest rate scenarios of a rise to 6.5% or a fall to 4.5%. (9 marks)
(c) Explain how interest rate guarantees or short-term interest rate caps could be used. (3 marks)
(20 marks)

QUESTION BANK
Additional Exam-standard questions
68 Illumin8 Ltd
Illumin8 Ltd specialises in the sale of lighting systems used in the entertainment industry, principally by
theatres, concert halls, galleries and exhibition centres. In recent years the Bangladesh entertainment
industry has experienced strong growth in large-scale outdoor music concerts staged at venues such as
football grounds, parks and other outdoor locations. These events typically need to hire large, complex
lighting systems for short periods ranging from two days to two weeks.
New lighting system
The directors of Illumin8 Ltd have decided to move into this area of the market and are considering the
purchase of a new lighting system that would cost Tk180,000 on 31 December 2007, have an estimated
useful life of four years and have estimated disposal proceeds of Tk50,000 on 31 December 2011. The
directors estimate that the lighting system could be hired out for Tk1,500 per day and in addition to the
lighting system itself the company would also supply two trained staff who would be available to help with
installation, operation and removal of the lighting system during the hire period. Illumin8 Ltd would pay the
two staff Tk220 each per day out of the hire charge and the company estimates that other operating costs
of Tk160 per day would also have to be covered out of the hire charge.
The capital cost of the lighting system would qualify for tax depreciation allowances at the rate of 25% per
annum on a reducing balance basis. The allowances would commence in the year in which the lighting
system was acquired. As at 31 December 2011, a balancing charge or allowance would arise equal to the
difference between any disposal proceeds and the lighting system's tax written down value.
Corporate hospitality
Whilst the company has a good reputation in the sales market for smaller lighting systems, the directors
realise that they may need to invest in marketing the company's new service to raise awareness amongst
the relatively small number of firms that promote the outdoor concerts.
The company's marketing director has, therefore, suggested hosting a small number of corporate hospitality
events every year from 2008 – 2011 inclusive to support the company's hire service.
The budget for such events would be set at Tk12,500 per annum.
The directors initially estimated that the lighting system could be hired out for 60 days per annum for a
period of four years, but the marketing director is confident that if the programme of corporate hospitality
is undertaken then the estimate for hire days could realistically be increased to 75 in each of the four years.
The expenditure on the corporate hospitality would qualify for corporation tax relief in the year of the
expenditure.
The finance director has advised the board that he estimates that inflation will be 2.5% in 2008, 3% in 2009,
2.5% in 2010 and 2% in 2011. All the cash flows associated with the new lighting system are expressed in 31
December 2007 prices and are all expected to increase at these rates of inflation.
The finance director also estimates that the company's real minimum required rate of return will be 7% in
2008, 6% in 2009, 6% in 2010 and 5% in 2011. The finance director has used the capital asset pricing model
(CAPM) to derive these figures. The company's accounting year end is 31 December and, unless otherwise
specified, all cash flows can be assumed to occur on 31 December of the year to which they relate. The
directors assume that the company's corporation tax rate will be 30% for the next four years and that tax
will be payable at the end of the accounting year to which it relates.

December 2007 exam questions
Requirements
Prepare a response to the following points raised in the e-mail:
(a) Identify the relevant incremental cash flows relating specifically to the four year programme of
corporate hospitality and, by calculating their net present value, indicate whether or not the company
should proceed with the corporate hospitality. (8 marks)
(b) Taking account of the decision reached in (a), use net present value principles to show whether the
new lighting system should be purchased. (10 marks)
(c) Calculate the sensitivity of the net present value of the investment to a fall in the number of days for
which the lighting system will be hired out to customers. (4 marks)
(d) Critically evaluate the use of CAPM as the means of establishing the discount factors used in appraising
this investment. (6 marks)
(28 marks)
Note: Your answers to (a), (b) and (c) should be provided in money terms.
69 Viogen Inc
Viogen Inc (Viogen) is a US company that manages the licensing of pharmaceutical products for production
by companies throughout the world. Last month, a former colleague of yours, Mark Vaughan, was
appointed chief financial officer of the company. This is his first senior appointment.
Mark understands that the finances of Viogen are dominated by the receipt of funds, often from outside the
US, in respect of royalty payments. In addition, he notices that the previous chief financial officer did not
make any attempt to hedge the company's foreign exchange transaction exposure. Mark is particularly
concerned about a receipt of Tk1.25m that is due to be received by Viogen in 30 days from a Bangladesh
licence holder. He feels that steps should be taken to hedge this exposure (although other directors
disagree with him) and is aware that both option contracts and futures contracts may be potential means of
achieving this. However, he lacks detailed knowledge of these instruments and has contacted you urgently
by e-mail for advice.
In his e-mail to you he has included the following information. The company's bankers have advised him that
he could either use 30-day Taka futures at a price of $1.6513/Tk (contract size Tk62,500) or he could buy
Taka options with a strike price of $1.6612/Tk at a premium of 2 cents per Taka (contract size Tk31,250).
The spot exchange rate is currently $1.6560/Tk and market commentators in the US are currently
suggesting that the Taka is expected to trade in a range from $1.6250/Tk to $1.7010/Tk for the next
month. His e-mail has raised a number of issues that he would like you to clarify.
Requirements
Prepare a response to the following points raised in the e-mail:
(a) (i) Advise Mark whether put or call options should be purchased and calculate the number of option
contracts that the company would need to enter into in order to hedge its Taka receipts
(ii) Advise Mark whether to buy or sell Taka futures contracts and calculate how many futures
contracts would be required. (2 marks)
(b) Calculate how much Viogen would gain or lose (in $s) on the option contracts and on the futures
contracts if, in 30 days' time, the $/Tk spot rate was:
(i) 1.6250
(ii) 1.6513
(iii) 1.6612; and
(iv) 1.7010 (6 marks)

QUESTION BANK
(c) Calculate how much the total cash flow to Viogen will be in 30 days' time for each of the future spot
rates listed in (b) above, if the company decided
(i) to leave its position unhedged
(ii) to hedge its Taka receipts using option contracts; and
(iii) to hedge its Taka receipts using futures contracts.
Comment on the comparative cash flow outcomes of using either option contracts or futures
contracts. (8 marks)
Note: In part (c) you should provide a full breakdown of how the actual cash flow has arisen.
(d) Calculate Viogen's break-even future spot rate on the option contracts and on the futures contracts
(2 marks)
(e) Discuss the general theoretical arguments for and against a firm hedging its foreign exchange
exposure. (8 marks)
(26 marks)
70 York Ltd
York Ltd operates a regional railway service in the north-west of Bangladesh and is a listed company.
The company's services and passenger numbers have expanded significantly in the last few years and as a
result the company has recently decided to purchase three additional passenger trains at a total cost of
Tk20m. After much discussion between the directors regarding the financing decision, it has finally been
decided that these new trains will be financed in full by an 8% per annum fixed rate bank loan which will be
secured on the new trains, drawn down on 1 January 2008 and repaid over a five year term. A number of
directors had, however, expressed a strong preference for raising new equity to finance the new trains.
The company's budgeted balance sheet as at 31 December 2007 includes the following figures:
Tkm
Ordinary Tk1 shares 100
Reserves 60
9% Debentures 2010 (at nominal value) 200
360
9% debentures 2010
 Expected market value at 1 January 2008 Tk101.50 (ex-interest) per Tk100 nominal
 Due to be redeemed at par on 31 December 2010
 Interest is payable annually in arrears on 31 December and is allowable for tax purposes
 Tax is payable at the end of the year in which the taxable profits arise
 It can be assumed that the company pays corporation tax at a rate of 30%
Ordinary Tk1 shares
 In recent years dividends have grown by 2.5% per annum
 The company's expected dividend on 31 December 2007 is Tk1 per share
 Dividends are expected to grow at a rate of 4% per annum from 1 January 2008
 The price per share is currently Tk13.50 (ex-dividend) and this is not expected to change before
31 December 2007
At one recent meeting, during which the proposed new bank loan was being discussed, one of the
company's directors had queried why there was a difference between the cost to the company of the
proposed new bank loan and the cost to the company of the existing debentures, given that they were both
forms of debt finance.

Requirements
(a) Calculate the company's expected weighted average cost of capital at 31 December 2007. (4 marks)
(b) Discuss the factors that the directors need to consider when making the financing decision between
debt and equity. (10 marks)
(c) Assuming that the 8% bank loan is selected as the source of finance, discuss (without further
calculations) the likely impact of the new bank loan on the company's
(i) cost of equity
(ii) cost of debt; and,
(iii) weighted average cost of capital. (7 marks)
(d) Explain to the directors the principal differences between debentures and bank loans and the factors
that may cause the cost of these two types of debt to differ. (5 marks)
(26 marks)

QUESTION BANK

1 In company finance, which of the following provides the best definition of the primary financial
objective of a firm?
A To maximise the level of annual profits
B To maximise the level of annual dividends
C To maximise the wealth of its ordinary shareholders
D To achieve long-term growth in earnings
2 Which of the following are stakeholder groups for a listed company?

1 Employees
2 Ordinary shareholders
3 The board of directors
4 Trade creditors
A Groups 2, 3 and 4 only
B Groups 1, 2 and 3 only
C Groups 1, 2, 3 and 4
D None of these particular groups
3 Financial management focuses on financial objectives. Which of the following are financial objectives?
1 Earnings growth
2 Maximisation of market share
3 Achieving a target level of customer satisfaction
4 Sales revenue growth
5 Achieving a target level of return on capital employed
A 1 and 5 only
B 2 and 4 only
C 1, 4 and 5 only
D 1, 2, 3 and 4 only

Objectives and investment appraisal: objective test questions
4 The directors of Tandoori Ltd are contemplating undertaking a project, which will require the
purchase of new machinery at a cost of CU49,500. It is expected that this will lead to an increase of
CU33,000 in annual sales for the next eight years. Tandoori Ltd prices its products using a mark-up of
40% on cost and has a required return of 11%. No inventories are held, and all sales and purchases are
for cash.
Assuming that cash flows arise at the end of the year to which they relate, what is the net present
value of the project?
A CU121,391
B CU52,470
C CU48,559
D CU(978)
5 A machine is to be purchased now at a cost of CU100,000. It has a life of five years during which it will
produce 10,000 items per annum at a cost of CU10 each for materials and CU8 each for other
variable costs. The machine has no residual value, and depreciation is to be calculated on a straight-line
basis over the five-year life. Each item produced can be sold for CU30, the sales revenue being
receivable annually in arrears. Material costs are payable annually in advance and other variable costs
are payable annually in arrears. The discount rate is 10% per annum.
What is the net present value of this investment (to the nearest CU1,000)?
A CU241,000
B CU279,000
C CU317,000
D CU355,000
6 A company is evaluating a project that requires three types of material (Q, R and T). All material is
required at the commencement of the project. Data relating to the material requirements are as
follows.
Material type Quantity Quantity Original Current Current
needed for currently in purchase purchase resale
the project inventory price of price price
inventory
Tonnes Tonnes CU/tonne CU/tonne CU/tonne
Q 200 300 19 22 20
R 700 200 26 36 32
T 400 100 10 14 12
Material types Q and T are used regularly by the company in normal production. Material type R is not
currently used but it could be a substitute for other material in another project that is about to
commence. The other material for which R could be substituted would otherwise cost the company
CU34 per tonne to purchase.
What is the total relevant cost of materials that should be included in the evaluation of the project?
A CU33,800
B CU34,400
C CU34,800
D CU35,200

QUESTION BANK
7 A company has been asked to manufacture and supply 200 units of a specified product. The
manufacture of each unit requires four hours of skilled labour and two hours of semi-skilled labour.
The company has a limited number of skilled labour operatives available and they are fully occupied on
other production work. No additional supplies of skilled labour are available. Semi-skilled labour has
sufficient spare capacity to undertake this additional work.
The company's current labour rates per hour are as follows.
Skilled CU9
Semi-skilled CU5
If skilled labour operatives are transferred to the production of these 200 units, they will have to be
taken off work to which the following data refer.
CU/unit
Selling price 60
Variable cost of manufacture (including CU27 for skilled labour) 54
What is the total labour cost which is relevant to the appraisal of the production of the 200 units of
the specified product?
A CU8,800
B CU8,400
C CU6,600
D CU12,000
8 A company is considering investing in a two-year project. Machine set-up costs will be CU150,000,
payable immediately. Working capital of CU4,000 is required at the beginning of the contract and will
be released at the end.
Given a cost of capital of 10%, what is the minimum acceptable contract price (to the nearest CU100)
to be received at the end of the contract?
A CU150,700
B CU154,000
C CU182,400
D CU186,340
9 A company has 31 December as its accounting year end. On 1 January 20X5 a new machine costing
CU2,000,000 is purchased. The company expects to sell the machine on 31 December 20X6 for
CU300,000.
The rate of corporation tax for the company is 30%. Tax depreciation allowances are obtained at 25%
on the reducing balance basis, and a balancing allowance is available on disposal of the asset. The
company makes sufficient profits to obtain relief for tax depreciation as soon as it arises.
If the company's cost of capital is 15% per annum, what is the present value of the tax depreciation at
1 January 20X5 (to the nearest CU1,000)?
A CU350,000
B CU397,000
C CU403,000
D CU494,000

10 A project has the following cash flows:

Cash flow Timing of cash flow Value
Purchase of equipment Now CU150,000
Sale of equipment Four years from now CU25,000
Sales revenue At the end of each of the next four years CU300,000 pa
Variable costs At the end of each of the next four years CU210,000 pa
Taxation on revenue profit At the same time as net revenue is generated 30%
The equipment costs are not allowable as a deduction from profit and no tax depreciation is available.
An increase in fixed overheads of CU15,000 will occur at the end of each of the next four years as a
result of undertaking this project.
What is the net present value (to the nearest CU1,000) of the project cash flows using an after-tax
cost of capital of 15% pa?
A CU14,000
B CU25,000
C CU78,000
D CU228,000
11 A company has a 'money' cost of capital of 21% per annum. The inflation rate is currently estimated at
9% per annum.
What is the 'real' cost of capital?
A 21%
B 12%
C 11%
D 9%
12 Data of relevance to the evaluation of a particular project are given below.

Cost of capital in real terms 10% per annum
Expected inflation 5% per annum
Expected increase in the project's annual cash inflow 6% per annum
Expected increase in the project's annual cash outflow 4% per annum
Which one of the following sets of adjustments will lead to the correct NPV being calculated?
Cash inflow Cash outflow Discount percentage
A Unadjusted Unadjusted 10.0%
B 6% pa increase 4% pa increase 15.5%
C 6% pa increase 4% pa increase 15.0%
D 5% pa increase 5% pa increase 15.5%

QUESTION BANK
13 A company is commencing a project with an initial outlay of CU50,000 on 1 January 20X1. It is

estimated that the company will sell 1,000 items on 31 December 20X1 and at the end of each
subsequent year until 31 December 20X3. The contribution per unit on 31 December 20X1 will be
CU33, and is expected to rise by 10% pa over the life of the project.
At the end of the project scrap sales are expected to realise a cash amount of CU15,000. This will be
received by the company on 31 December 20X3. At an inflation rate of 10% pa the real cost of capital
is 10% pa.
To the nearest CU1,000, what is the net present value of the project's cash flows at 1 January 20X1?
A CU43,000
B CU41,000
C CU36,000
D CU33,000
14 Paisley Ltd plans to purchase a machine costing CU13,500. The machine will save labour costs of
CU7,000 in the first year. Labour rates in the second year will increase by 10%. The estimated average
annual rate of inflation is 8% and the company's real cost of capital is estimated at 12%.
The machine has a two-year life with an estimated actual salvage value of CU5,000 receivable at the
end of Year 2. All cash flows occur at the year end.
What is the NPV (to the nearest CU10) of the proposed investment?
A CU1,150
B CU970
C CU770
D CU550
15 A firm finds that the internal rate of return (IRR) of a project is 20%, assuming that all cash flows are
subject to uniform inflation at a rate of 6% pa.
What would be the internal rate of return if all cash flows were subject to uniform inflation at a rate of
5%?
A 21.0%
B 19.8%
C 19.0%
D 18.9%

16 Moore has estimated the following cash flow pattern for the purchase and maintenance of a piece of
equipment which he expects to use for the foreseeable future.
Time 0 1 2 3 4
CU'000 CU'000 CU'000 CU'000 CU'000
Capital cost 150
Maintenance 20 30 40 60
Scrap proceeds (40)
He anticipates purchasing a replacement machine every four years.
Moore has been approached by a leasing company offering to provide a maintenance-free machine for
as long as he wishes for a fixed annual sum payable in advance.
If Moore has a 10% cost of capital, what is the maximum annual sum (to the nearest CU100) he should
be prepared to pay the leasing company?
A CU74,700
B CU67,900
C CU65,000
D CU59,200
17 A machine costing CU150,000 has a useful life of eight years, after which time its estimated resale
value will be CU25,000. Annual running costs will be CU5,000 for the first three years of use and
CU8,000 for each of the next five years. All running costs are payable on the last day of the year to
which they relate.
Using a discount rate of 20% per annum, what is the annual equivalent cost (to the nearest CU100) of
using the machine if it were bought and replaced every eight years in perpetuity?
A CU21,100
B CU43,300
C CU43,900
D CU46,600
18 A project consists of a series of cash outflows in the first few years followed by a series of positive
cash inflows. The total cash inflows exceed the total cash outflows. The project was originally
evaluated assuming a zero rate of inflation.
If the project were re-evaluated on the assumption that the cash flows were subject to a positive rate
of inflation, what would be the effect on the payback period and the internal rate of return?
Payback period Internal rate of return
A Increase Increase
B Decrease Decrease
C Decrease Increase
D Increase Decrease

QUESTION BANK
19 A company is about to quote a price for manufacturing a special machine which will require 1,500 kg
of material X and 2,000 kg of material Y. The following information is available about these resources.
Type of material Amount in inventory Original cost price Current purchase Net realisable value
now per kg price per kg now per kg
Kg CU CU CU
X 1,000 5 6 4
Y 2,000 8 10 7
The inventory of X cannot be used by the company for any other purpose, whereas material Y is used
frequently.
What is the relevant cost of the materials for the manufacture of the special machine?
A CU21,000
B CU24,000
C CU27,000
D CU29,000
20 The following data apply to a non-current asset.

CU
Net realisable value 5,000
Historic cost 6,000
Net present value in use 7,500
Replacement cost 10,000
What is the deprival value of the non-current asset?
A CU10,000
B CU7,500
C CU6,000
D CU5,000
21 The draft cost estimate for Job M includes CU8,000 spent on a chemical, for which the current
replacement cost is CU8,500. The chemical cannot be sold, and if not used on Job M it will be
disposed of at a cost of CU1,000.
When evaluating Job M, what is the relevant figure to include in the cost estimate in respect of the
chemical?
A CU1,000 saving
B CU1,000 cost
C CU8,000 cost
D CU8,500 cost

22 Garfield Ltd is considering whether to enter into a new contract. The machinery which would be used
to produce the goods for the contract was purchased six-and-a-half years ago at a cost of CU80,000,
with an estimated life of ten years. Depreciation is calculated on a straight-line basis. The machinery
has been idle for some time, and if not used on this contract would be scrapped and sold immediately
for an estimated CU5,000. After use on this contract the machinery would have no value, and would
have to be dismantled and disposed of at a cost of CU1,500.
Ignoring the time value of money, what is the relevant cost of the machine to the new contract?
A CU3,500
B CU5,000
C CU6,500
D CU24,500
23 Anderson Ltd is considering a project with a life of three years. In the first year it is expected to
generate sales of CU5m, increasing at the rate of 20% per annum over the remaining two years. At the
start of each year, working capital is required equal to 10% of the sales revenue for that year. All
working capital will be released at the end of the project.
What is the net present value (to the nearest CU1,000) of the working capital cash flows of the
project, discounting at a rate of 20% per annum?
A Nil
B CU(250,000)
C CU(446,000)
D CU(1,083,000)
24 Thomas Ltd uses the net present value (NPV) approach in evaluating possible projects. Data of
relevance to the evaluation of a particular project are given below.
% pa
Cost of capital (CC) in real terms 10
Inflation expected 7
The annual cash inflow (CI) from the project expected to increase by 5
The annual cash outlay (CO) on the project expected to increase by 4
Which of the following sets of adjustments will lead to the correct NPV being calculated?
A CI and CO to be unadjusted and discounted by 10% pa
B CI and CO to be increased by 7% pa and discounted by 17% pa
C CI to be increased by 5% pa, CO to be increased by 4% pa and both discounted by 17.7% pa
D CI to be increased by 5% pa, CO to be increased by 4% pa and both discounted by 17% pa

QUESTION BANK
25 Frankell Ltd is considering investment in new labour saving equipment costing CU800,000. One major
saving is expected to be semi-skilled labour which in the current year is paid CU4 per hour, but which
the firm expects to have to increase at 5% pa into the foreseeable future. If purchased, the equipment
is expected to save 20,000 labour hours pa, and would be in place from the start of next year.
Assume that savings arise at the end of each year and that the real cost of capital is 15%.
What is the present value of the savings over a ten year planning period as at the beginning of next
year (to the nearest CU1,000)?
A CU540,000
B CU446,000
C CU402,000
D CU309,000
26 Ackford is contemplating spending CU400,000 on new machinery which will be used to produce a
revolutionary type of lock, for which demand is expected to last three years. Equipment will be bought
on 31 December 20X1 and revenue from the sale of locks would be receivable on 31 December
20X2–X4. Labour and labour-related costs for the three years, payable in arrears, are estimated at
CU500,000 per annum in current terms. These figures are subject to inflation at 10% per annum.
Materials required for the three years are currently in inventory. They originally cost CU300,000 but
would cost CU500,000 at current prices, though Ackford had planned to sell them for CU350,000.
The sales revenue from locks in the first year will be CU900,000. This figure will rise at 5% per annum
over the life of the product.
If Ackford has a money cost of capital of 15½%, what is the net present value (to the nearest CU10)
of the lock project at 31 December 20X1? (Use discount factors correct to two decimal places.)
A CU(128,100)
B CU(21,300)
C CU21,890
D CU128,700
27 Grainger Ltd wishes to replace its existing CNC lathe immediately with a new model. The new model
would be replaced by the same model in perpetuity. These new models are available as follows.
Model I II III
Purchase price CU70,000 CU56,000 CU98,000

Estimated life 5 years 4 years 6 years
Annual running costs (payable at the end of each year) CU5,600 CU8,400 CU4,900
If model I were purchased, its life could be extended to eight years by incurring repair costs of
CU49,000 after five years of use. Grainger Ltd has a cost of capital of 10% pa.
Which new model should Grainger Ltd choose, and what replacement policy should it follow if it
wishes to minimise the present value of its costs?
A Purchase model I and replace every eight years
B Purchase model II and replace every four years
C Purchase model III and replace every six years
D Purchase model I and replace every five years

28 A company is considering undertaking project X which will require 100 kg of a special material Q. The
company has 100 kg of Q in inventory but there is no possibility of obtaining any more. If project X is
not undertaken, the company could undertake project Y which would also require 100 kg of Q. The
revenues and costs associated with project Y are as follows.
CU CU
Revenues 10,000
Less Costs
Original purchase cost of 100kg of Q 3,000
Other direct costs 5,000
(8,000)
Profit 2,000
The 100 kg of Q could also be sold as it is for CU4,000.
When deciding whether to accept project X what is the relevant cost of using 100 kg of Q?
A CU5,000
B CU4,000
C CU3,000
D CU2,000
29 A company is about to quote a price for manufacturing a special machine which will require 1,500 kg
of material X and 2,000 kg of material Y. The following information is available about these resources.
Type of material Amount in inventory Original cost price Current purchase Net realisable value
now per kg price per kg now per kg
Kg CU CU CU
X 1,000 5 6 4
Y 2,000 8 10 7
The inventory of X cannot be used by the company for any other purpose, whereas material Y is used
frequently by the company.
What is the relevant cost of the materials for the manufacture of the special machine?
A CU29,000
B CU27,000
C CU24,000
D CU21,000
30 The following three values apply to a firm's asset.

CU
Net realisable value 23,000
Economic value 24,000
What will be the firm's policy with regard to the asset?
A Sell and replace for resale
B Sell and do not replace
C Use and expect to replace
D Use but do not expect to replace

QUESTION BANK
31 The following data relate to 200 kg of material ZX in inventory and needed immediately for a contract.
CU
Standard cost 2,300
Realisable value 2,000
Within the firm the 200 kg of material ZX can be converted into 200 kg of material RP at a cost of
CU100. Material RP has many uses in the firm, and 200 kg cost CU2,200.
What cost should be included for material ZX when assessing the viability of the contract?
A CU2,000
B CU2,100
C CU2,200
D CU2,300
32 In order to utilise some spare capacity, Stamp Ltd is preparing a quotation for a special order which
requires 1,000 kg of material R.
Stamp Ltd has 600 kg of material R in inventory (original cost CU5.00 per kg). Material R is used in the
company's main product Q. Each unit of Q uses 3 kg of material R, and, based on an input value of
CU5 per kg of R, each unit of Q yields a contribution of CU9.00.
The resale value of material R is CU4.00 per kg. The present replacement price of material R is
CU6.00 per kg. Material R is readily available in the market.
What is the relevant cost of the 1,000 kg of material R to be included in the quotation?
A CU4,000
B CU5,000
C CU5,400
D CU6,000
33 A project has a life of three years. In the first year it is expected to generate sales of CU400,000,
increasing at the rate of 8% per annum over the remaining two years. At the start of each year
working capital is required equal to 20% of the sales revenue for that year. All working capital will be
released at the end of the project.
What is the net present value of the working capital cash flows of the project, discounting at a rate of
15% per annum (to the nearest CU1,000)?
A Nil
B CU(29,000)
C CU(55,000)
D CU(260,000)

34 A machine is currently used to produce product alpha, each unit of which earns a contribution of
CU46. A new product, the beta, is currently under consideration. It would make use of the same
machine as the alpha; 4 hours of machine time at CU7 per hour would be required to produce one
unit of either alpha or beta.
The machine is depreciated at a rate of CU10,000 per annum, and is expected to lose CU25,000 more
in value (in current terms) over the period of producing beta rather than alpha. The maintenance cost
of the machine is charged at CU0.30 per machine hour.
Which of the following costs should not be included, in deciding whether to make the beta rather
than the alpha?
A Contribution per unit of alpha: CU46
B Variable cost per unit of using the machine: CU28
C Loss in value over the production life of the beta: CU25,000
D Maintenance cost per unit of CU1.20
35 A company is considering a project and predicts:

(i) That the wage rate paid to the necessary skilled labour will rise by 6% per year
(ii) That the annual increase in RPI (the retail price index) will be 10%
(iii) That the company's money/nominal cost of capital is 22%
What is the appropriate discount rate to apply to forecast money/nominal cash flows relating to skilled
labour?
A 6%
B 10%
C 13%
D 22%
36 Potts Ltd is considering a project that would involve buying a machine for CU120,000, to earn cash
profits before tax of CU50,000 pa for three years. At the end of Year 3, the machine would be sold
for CU50,000. The machine would qualify for tax depreciation allowances, which are at the rate of
25% on a reducing balance basis.
Taxation, at 30%, is paid in the same year as the cash flows that give rise to it. The company's cost of
capital is 20%.
What is the NPV of the project, to the nearest CU1,000?
A + CU33,000
B + CU5,000
C – CU2,000
D – CU31,000

QUESTION BANK
37 The daily demand for a perishable product has the following probability distribution.
Demand Probability
(units)
100 0.25
200 0.40
300 0.35
Each item costs CU4 and is sold for CU8. Unsold items are thrown away at the end of the day.
If orders must be placed before the daily demand is known, how many units should be purchased at
the beginning of each day in order to maximise expected profit?
A 300 units
B 210 units
C 200 units
D 100 units
38 The higher risk of a project can be recognised by decreasing

A The cost of the initial investment of the project
B The estimates of future cash inflows from the project
C The internal rate of return of the project
D The required rate of return of the project
39 Characteristics of four portfolios are shown below.

Standard deviation Expected return
% %
Portfolio A 15 11
Portfolio B 26 16
Portfolio C 8 7
Portfolio D 14 13
Which portfolio would a risk averse investor immediately reject?
A Portfolio A
B Portfolio B
C Portfolio C
D Portfolio D
40 Risk that cannot be diversified away can be described as

A Unsystematic risk
B Financial risk
C Business risk
D Systematic risk

41 When using the expected value criterion, it is assumed that the individual wants to
A Minimise risk irrespective of the level of return
B Minimise risk for a given level of return
C Maximise return irrespective of the level of risk
D Maximise return for a given level of risk
42 The CAPM is the line which represents the relationship between the expected returns on securities
and
A The overall risks of those securities
B The market risks of those securities
C The expected returns on the market
D The expected returns on the risk-free asset
43 The systematic risk of a project's return is the result of uncertainties in the return caused by
A Factors unique to the project
B Factors unique to the firm undertaking the project
C Nationwide economic factors
D Factors unique to the industry to which the project belongs
44 The equity shares of Front Ltd have a beta value of 0.90. The risk-free rate of return is 5% and the
market risk premium is 4%. Corporation tax is 25%. What is the required return on the shares of
Front Ltd?
A 7.7%
B 8.1%
C 8.6%
D 13.1%
45 Four companies are identical in all respects, except for their capital structures, which are as follows.
A Ltd B Ltd C Ltd D Ltd
Equity as a proportion of total market capitalisation 70% 20% 65% 40%
Debt as a proportion of total market capitalisation 30% 80% 35% 60%
The beta value of the equity shares of A Ltd is 0.89 and the beta of the equity of D Ltd is 1.22.
Within which ranges will the beta values of the equity of B Ltd and C Ltd lie?
A The beta of B Ltd and the beta of C Ltd are both higher than 1.22.
B The beta of B Ltd is below 0.89 and the beta of C Ltd is in the range 0.89 to 1.22.
C The beta of B Ltd is above 1.22 and the beta of C Ltd is in the range 0.89 to 1.22.
D The beta of B Ltd is in the range 0.89 to 1.22 and the beta of C Ltd is higher than 1.22.

QUESTION BANK

1 Which one of the following is not a feature of a capital market with 'strong form' efficiency?
A Share prices change quickly to reflect all new information about future prospects
B Transaction costs are not significant
C No individual dominates the market
D Individual share price movements can always be predicted from past price movements
2 Goat Ltd has 200 million shares in issue, currently priced at CU6 each on the stock market. It is
planning an investment costing CU100 million, which would be financed by a mixture of retained
profits and new debt capital. It has been estimated that the investment will have a net present value of
CU120 million.
On 3rd April, the board of directors met to approve the capital expenditure. At the meeting, the
company's advisers confirmed that the required debt capital would be available at the expected cost.
On 10th April, the company made an announcement about the investment to the stock market.
Investors welcomed the announcement and the estimated forecast of returns has been generally
accepted as credible.
There are no other factors influencing the share price in this period. If the stock market displays semi-
strong form efficiency, what will be the share price after the events of 3rd April and 10th April
respectively?
A CU6 per share after 3rd April and CU6 per share after 10th April
B CU6 per share after 3rd April and CU6.10 per share after 10th April
C CU6 per share after 3rd April and CU6.60 per share after 10th April
D CU6.60 per share after 3rd April and CU6.60 per share after 10th April
3 What is a dividend restraint covenant?

A An undertaking by a company to its shareholders to maintain dividends at or above a specified
minimum level
B A restriction on dividend payments by a company due to having insufficient free cash flow
C An undertaking by a company to a lender to keep dividend payments within a specified limit
D An undertaking by a company to a lender not to pay dividends until all outstanding interest
payment obligations have been met

Finance and capital structure: objective test questions
4 Mr Hollins has been left CU20,000 which he plans to invest on the Stock Exchange in order to have a
source of capital should he decide to start his own business in a few years' time. A friend of his who
works in the City of London has told him that the London Stock Exchange shows strong form market
efficiency.
If this is the case, which of the following investment strategies should Mr Hollins follow?
A Study the company reports in the press and try to spot under-valued shares in which to invest
B Invest in two or three blue chip companies and hold the shares for as long as possible
C Build up a good spread of shares in different industry sectors
D Study the company reports in the press and try to spot strongly growing companies in which to
invest
5 Trinity Ltd has announced a 1 for 4 rights issue at a subscription price of CU2.00. The current cum-
rights price of the shares is CU3.05.
What is the new ex-div market value of the shares?
A CU2.84
B CU3.05
C CU3.55
D CU5.05
6 Which of the following best describes the term 'coupon rate' as applied to debenture stock?
A The rate of stamp duty applicable to purchases of the stock
B The total rate of return on a stock, taking into account capital repayment as well as interest
payments
C The annual interest received divided by the current ex-interest market price of the stock
D The annual interest received on the face value of the units of the stock
7 Trout Ltd has announced a 1 for 3 rights issue at a subscription price of CU1.00. The current cum-
rights price of the shares is CU1.52.
What is the theoretical value of the right per existing share?
A CU0.52
B CU0.39
C CU0.17
D CU0.13

QUESTION BANK
8 A company's shares have gone ex-div having just declared a dividend of 20p per share, but the market
expects this dividend to decline by 2% each year in perpetuity. The annual cost of equity capital is 8%.
What is the ex-dividend price per share (to the nearest 1p)?
A CU1.96
B CU2.00
C CU2.24
D CU3.27
9 The dividend growth valuation model is based on certain assumptions that can be challenged. Which of
the following is not a valid reason for challenging the assumptions on which the model is based?
A The cost of equity is difficult to establish with accuracy
B The model assumes that shareholders have no control over dividend policy. However, future
dividends can be controlled by shareholders through voting at annual general meetings
C The model assumes that all retained earnings will be reinvested to earn a return equal to the cost
of equity, which is not necessarily correct
D The share valuation derived from the model is based on expectations of future dividends in
perpetuity, but these are not easily predictable and investors will have differing expectations
10 Sterrdrum Ltd has been achieving the following annual results.

CU
Profit before interest 1,000,000
Interest on CU2,500,000 12% loan stock 300,000
700,000
Tax at 30% 210,000
Earnings and dividends 490,000
The loan stock has a market value at par, and the cost of equity is 19.6%. There are 1,000,000 shares
in issue.
The company is now considering a project costing CU1,000,000 which would add to profits by
CU200,000 per annum in perpetuity before interest and tax.
All earnings would continue to be paid as dividends.
The share price will respond immediately to any change in expected future dividends. Tax on profits
will remain at 30%.
By how much will the share price change if the project is undertaken, financed entirely by new debt
capital, so that the cost of debt remains unchanged but the cost of equity rises to 22%?
The share price will:
A Fall by 2p
B Rise by 25p
C Rise by 43p
D Rise by 138p

11 Hake and Legge Ltd has 40 million shares in issue, and its capital structure has been unchanged for
many years.
Its dividend payments in the years 20X1 to 20X5 were as follows.
End of year Dividends
CU'000
20X1 2,200
20X2 2,578
20X3 3,108
20X4 3,560
20X5 4,236
Dividends are expected to continue to grow at the same average rate into the future.
According to the dividend valuation model, what should be the market price per share at the start of
20X6 if the required return on the shares is 25% per annum?
A CU0.96
B CU1.10
C CU1.47
D CU1.73
12 The shares of Crack Tribb Ltd have a current market price of 74 pence each, ex-div. It is expected
that the dividend in one year's time will be 8 pence per share. The required rate of return from net
dividends on these shares is 16% per annum.
If the expected growth in future dividends is a constant annual percentage, what is the expected annual
dividend growth?
A 0.4% per annum
B 3.5% per annum
C 3.8% per annum
D 5.2% per annum
13 A firm has a dividend cover of 2, a P/E ratio of 9.3 (both based on its ex-dividend price). The most
recent financial statements indicated a growth in shareholders' funds of 10%, resulting from retained
earnings.
Which of the following is the best estimate of the firm's cost of equity?
A 10.0%
B 11.5%
C 13.1%
D 15.9%

QUESTION BANK
14 The following information relates to a company quoted on the London Stock Exchange.
Balance sheet as at 31 December 20X4
CUm
Paid up share capital 36
Share premium 29
Revaluation reserve 24
Retained earnings 89
Shareholder funds 178
Five year summary

20X0 20X1 20X2 20X3 20X4
Profit after tax (CUm) 12.6 14.2 18.6 27.2 31.2
Dividends (CUm) 4.2 5.0 6.6 9.4 10.8
Shares qualifying for dividends (m) 24 24 48 60 90
In October 20X2 the company made a 1 for 1 scrip (bonus) issue. Other share adjustments arose
from rights issues. The share price on 31 December 20X4 is CU1.50.
Using the constant growth rate model and years 20X0 and 20X4, what is the cost of equity capital?
A 15.04%
B 16.88%
C 30.45%
D 36.73%
15 An all-equity financed company distributes 30% of its earnings each year and reinvests the balance. The
return on its projects is a constant 15% pa.
Assume that the company's current market capitalisation is CU1.5m and its earnings are CU125,000.
What is the required rate of return for the ordinary shareholder?
A 10.6%
B 13.3%
C 16.9%
D 19.7%
16 Hyden Ltd's irredeemable preference shares have a coupon rate of 8% and pay a dividend of CU4 per
CU100 nominal stock on 1 January and 1 July each year.
If the ex-dividend price on 1 January is CU82, what is the annual cost of the preference share capital
to the company?
A 8.00%
B 9.99%
C 10.26%
D 10.52%

17 A company issued its 10% irredeemable debentures at 95. The current market price is 90. The
company is paying corporation tax at a rate of 30%.
What is the current net cost of capital per annum of these debentures?
A 11.1%
B 10.0%
C 7.8%
D 7.4%
18 A company's capital structure is as follows.

CUm
20m 50p ordinary shares 10
Reserves 4
13% loan stock 20X4 7
21
The loan stock is redeemable at par in 20X4. Current market prices for the company's securities are:
50p ordinary shares, 280p; 13% loan stock 20X4, 100. The company is paying corporation tax at a rate
of 30%. The cost of the company's equity capital has been estimated as 12% pa.
What is the company's per annum weighted average cost of capital for investment appraisal purposes?
A 12.1%
B 11.7%
C 11.4%
D 8.5%
19 Ingham Ltd's capital structure is as follows.

CUm
50p ordinary shares 12
8% CU1 preference shares 6
12.5% loan stock 20X2 8
26
The loan stock is redeemable at par in 20X2. The current market prices of the company's securities
are as follows.
50p ordinary shares 225p
8% CU1 preference shares 92p
12.5% loan stock 20X2 CU100
The company is paying corporation tax at the rate of 30%. The cost of the company's ordinary equity
capital has been estimated at 15% pa.
What is the company's weighted average cost of capital for capital investment appraisal purposes?
A 12.66%
B 13.53%
C 13.74%
D 14.19%

QUESTION BANK
20 The following data relates to an all-equity financed company.

Dividend just paid CU50m
Earnings retained and invested 70%
Return on investments 15%
Cost of equity 23%
What is the market value of the company (to the nearest million CU)?
A CU442m
B CU400m
C CU418m
D CU218m
21 A company has just declared an ordinary dividend of 22.4p per share; the cum-div market price of an
ordinary share is 280p.
Assuming a dividend growth rate of 14% per annum, what is the company's cost of equity capital?
A 22.0%
B 22.7%
C 23.1%
D 23.9%
22 A firm has achieved an average growth in dividends over the last five years of 14% pa. It is now widely
believed that the long-run average annual dividend growth rate will be 15.6% pa. The firm's current net
dividend yield is 5.2%.
What is the cost of equity capital?
A 19.2%
B 19.9%
C 20.8%
D 21.6%
23 Shown below are recent statistics relating to the ordinary shares of Lamdin Ltd, a quoted company.
Last year's net dividend 8p
Average annual growth rate of dividends 16%
Dividend cover 3.84
Price/earnings ratio 12.8
The company calculates its cost of equity capital using the net dividend growth valuation model.
What is the cost of Lamdin's equity capital?
A 17.8%
B 18.4%
C 18.0%
D 25.0%

24 Philin Ltd's irredeemable preference shares have a coupon rate of 11.2% and pay a dividend of CU5.60
per CU100 nominal stock on 1 January and 1 July each year.
If the cum-dividend price on 1 January is CU75, what is the annual cost of the preference share capital
to the company?
A 16.79%
B 15.49%
C 14.9%
D 8%
25 The following data relate to the ordinary shares of Lye Cheese Ltd.
Current market price, 31 December 20X1 250p
Market price one year ago, 31 December 20X0 227p
Earnings per share, 20X1 57.73p
Dividend per share, 20X1 35p
Expected growth rate in dividends and earnings 10% per annum
Average market return 20%
Risk-free rate of return 13%
Basic rate of income tax 30%
Beta factor of Lye Cheese Ltd's equity 1.5
The estimated cost of Lye Cheese Ltd's equity, using the dividend growth model and market price, is:
A 24.0%
B 25.4%
C 30.0%
D 32.0%
26 Corbet Ltd has just paid a dividend of CU2.30 per share. The last accounts show that its earnings per
share were CU5.10, and that the value of its assets was CU5 million. There are 200,000 shares in
issue, currently quoted at CU12.00 ex div.
What is the cost of capital of Corbet Ltd?
A 19.17%
B 21.45%
C 30.11%
D 32.54%
27 Assuming market interest rates remain unchanged, a decrease in the coupon rate of a bond will
A Increase the yield to maturity of the bond
B Decrease the yield to maturity of the bond
C Increase the selling price of the bond
D Decrease the selling price of the bond

QUESTION BANK
28 A company uses additional debt to finance a new investment. Equity capital and the level of operating
risk are unchanged.
What is the most likely effect upon the company's cost of equity capital?
A It remains constant
B It increases
C It decreases
D It either increases or decreases
29 Which of the following statements is part of the traditional theory of gearing?

A There must be no taxes
B There must exist a minimum WACC
C Cost of debt increases as gearing decreases
D Cost of equity increases as gearing decreases
30 A company incorporates increasing amounts of debt finance into its capital structure while leaving its
operating risk unchanged.
Assuming that a perfect capital market exists with no taxation, the company's cost of equity will
A Rise
B Fall to a minimum and then rise
C Fall steadily
D Remain the same
31 If a company were to automate its production line it would expect its operating gearing (leverage) to
A Increase
B Decrease
C Remain the same
D Increase or decrease depending on the nature of the production process
32 According to Modigliani and Miller the cost of equity will always fall with decreased gearing because
A The firm is less likely to go bankrupt
B Debt is allowable against tax
C The return to shareholders becomes less variable
D The tax shield on debt increases the value of the shareholders' equity

33 Which of the following would be implied by an increase in a company's operating gearing (leverage)
ratio? The company
A Is more profitable
B Is less risky
C Has a greater proportion of costs that are variable
D Has profits which are more sensitive to changes in sales volume
34 A company incorporates increasing amounts of debt finance into its capital structure while leaving its
operating risk unchanged.
Assuming that a perfect capital market exists with no taxation, the company's weighted average cost of
capital will
A Remain the same
B Fall steadily
C Fall to a minimum and then rise
D Rise steadily
35 Which of the following events is most likely to lead to an increase in a firm's operating risk?
An increase in the proportion of the firm's operating
A Capital which is debt
B Costs which are fixed
C Capital which is equity
D Costs which are variable
36 Two all-equity financed companies have identical business risks. Company R is valued at CU40 million
and company S at CU8 million. The two companies merge via a share exchange, which results in
company R shareholders holding 80% of the shares of the new merged company.
As a result of synergy, surplus assets of CU5 million are sold immediately without affecting the future
profitability of the merged company. Half of the proceeds of the disposal are invested in a project with
a net present value of CU1 million.
What will be the gains to the shareholders of company R?
A CU4.8m
B CU3.2m
C CU1.2m
D CU0.8m

QUESTION BANK

1 Which of the following is least likely to be a benefit of a share repurchase scheme?
A Finding a use for surplus cash
B Tax advantage of receiving an immediate capital gain
C Increase in gearing to take advantage of debt capacity
D Increase in earnings per share
2 A few companies have a long-term dividend policy of paying out no dividends. A notable example has
been Microsoft, the US software corporation. Which of the following is the weakest and least likely
reason for justifying a no-dividend policy over the long term?
A Retained profits are a cheaper source of new finance than raising new capital in the markets
B The tax treatment of capital gains is more favourable than the tax treatment of dividends
C Shareholders needing cash can sell shares in the stock market at any time, and so do not need
dividends
D The company is a growth company and investors buying shares in the company recognise that all
profits will be reinvested for growth
3 Which of the following best characterises the residual theory of dividend policy?
A That the main dividend policy of a company should be to smooth dividends from one year to the
next, and reinvest only those profits that are not needed to maintain dividend payments at least
at the same level as the previous year
B That a company should have a policy of paying out a fixed proportion of earnings as dividends,
and only use what is left to re-invest long term in the company
C That share prices are determined by shareholder expectations of future dividends
D That a company should invest its post-tax profits in all projects that are available with a positive
net present value, and pay out as dividend only those profits that are left over
4 A bonus issue with perfect information

A Decreases the debt/equity ratio of the company
B Increases individual shareholder wealth
C Decreases earnings per share
D Increases the market price of the share

Business plans, dividends and growth: objective test questions
5 The dividends paid by Fraser Ltd over the past three years are as follows.
20X5 20X6 20X7
CUm CUm CUm
Dividend 54 61 68
The company had 300m issued shares entitled to dividends in 20X5, but made a scrip (bonus) issue of
1:4 in January 20X7. The ex-div price per share is CU4.50 on 1 January 20X8.
What is the expected return on the shares?
A 4.4%
B 12.3%
C 16.7%
D 27.5%
6 Which of the following statements about venture capital is correct?

A Venture capital would not be appropriate to finance a management buyout
B Venture capital organisations may provide loan finance as well as equity finance to a company
C Secured medium-term bank loans are a form of venture capital
D Companies with a stock market quotation would have no difficulty raising finance from a venture
capital organisation
7 MFW Ltd is considering a CU1,000,000 expansion of its business. The directors are considering either
a loan in the form of a 7% loan stock or issuing 400,000 ordinary shares at CU2.50 to raise the same
amount of funds. The expansion will generate CU500,000 of extra operating profit each year. Assume
tax of 25%. Ratios currently stand as follows.
Gearing = Prior charge capital / Equity = CU2,500,000 / CU7,200,000 = 34.7%
Interest cover = PBIT / Interest payable = CU2,522,000 / CU223,000 = 11.3 times
Earnings per share = Profit after tax / Number of equity shares in issue
= CU1,724,000 / 3,000,000
= 57.5p per share
Which one of the following is correct?
A Interest cover is reduced using either source of finance.
B Earnings per share are increased most by using debt.
C Equity reduces gearing and gives the best earnings per share.
D Earnings per share and interest cover both worsen using debt.

QUESTION BANK
8 An independent accountant has produced the following valuations of a private company.

CUm
(1) Historical cost adjusted for changes in general purchasing power 3.2
(2) Piecemeal net realisable value 4.1
(3) Cost of setting up an equivalent venture 5.3
(4) Economic value of the business 5.6
Assuming that the above valuations accord with the expectations and risk perceptions of the
purchaser, what is the maximum price that should be paid for the private company?
A CU3.2m
B CU4.1m
C CU5.3m
D CU5.6m
9 The following information relates to two companies, Alpha Ltd and Beta Ltd.
Alpha Ltd Beta Ltd
Earnings after tax CU200,000 CU800,000
P/E ratio 16 21
Beta Ltd's management estimate that if they were to acquire Alpha Ltd they could save CU100,000
annually after tax on administrative costs in running the new joint company. Additionally, they estimate
that the P/E ratio of the new company would be 20.
On the basis of these estimates, what is the maximum that the shareholders of Beta Ltd should pay for
the entire share capital of Alpha Ltd?
A CU6.3m
B CU5.2m
C CU4.2m
D CU2.0m
10 The following valuations relate to a private company. Where appropriate they reflect the expectations
of the owners.
CUm
Discounted future cash flows 3.0
Net realisable value of individual assets 2.8
Cost of setting up the business from scratch 2.6
Balance sheet value of assets 2.4
Assuming that the owners wish to realise their investment, what is the minimum value they should
accept for all of their share capital?
A CU3.0m
B CU2.8m
C CU2.6m
D CU2.4m

11 The directors of Hood Group have decided to sell off a loss-making subsidiary, Tucker Ltd. A
management team from Tucker has expressed interest in buying the company. For which one of the
following reasons would the parent company be likely to agree to sell Tucker to the management
team rather than an external buyer, if the MBO team and the external buyer have both offered the
same price?
A To avoid redundancy costs
B To avoid non-co-operation from management and employees hostile to the divestment
C Because the management buyout team knows more about the company than the external buyer
D To raise the cash more quickly
12 X Ltd acquires another company and pays a price that represents a higher P/E ratio valuation than the
current P/E of X Ltd shares. The purchase consideration is paid by issuing new X Ltd shares. There is
no synergy arising from the takeover. X Ltd has some debt capital in its capital structure.
Which of the following would not be a likely consequence of the takeover?
A A reduction in gearing of X Ltd
B A dilution of earnings for X Ltd
C An increase in the share price after the takeover
D A reduction in the proportionate stake in the company of existing X Ltd shareholders
13 The shares of Fortunate Ltd are currently valued on a P/E ratio of 6. The company is considering a
takeover bid for Seed Ltd, but the shareholders of Seed have indicated that they would not accept an
offer unless it values their shares on a P/E multiple of at least 8.
Which of the following is not a reason which might justify an offer by Fortunate Ltd for the shares of
Seed on a higher P/E multiple?
A Seed has better growth prospects than Fortunate
B Seed has better-quality assets than Fortunate
C Seed has a higher gearing ratio than Fortunate
D Seed is in a different industry from Fortunate, where average P/E ratios are higher
14 A scrip issue with perfect information

A Decreases earnings per share
B Decreases the debt/equity ratio of the company
C Increases individual shareholder wealth
D Increases the market price of the share

QUESTION BANK
Risk management

1 What is the purpose of hedging?
A To protect a profit already made from having undertaken a risky position
B To reduce costs
C To reduce or eliminate exposure to risk
D To make a profit by accepting risk
2 Which of the following is correct?

A If interest rates rise, the market price of bond futures will fall.
B If interest rates rise, the value of put options on bond futures will rise.
C If interest rates rise, the yield curve will become steeper.
D If interest rates rise, the value of a swap for the receiver of the fixed interest payments will rise.
3 Which of the following is not a method for dealing with international credit risk?
A Multilateral netting
B Documentary credits
C Forfaiting
D Export factoring
4 Which of the following is the best description of interest rate risk?

A The risk from borrowing
B The risk from not being able to meet interest payments on debt obligations
C The risk that interest rates will rise
D The risk to profit, cash flow or a company's valuation from changes in interest rates
5 Which of the following instruments is most similar to an interest rate guarantee?

A Forward rate agreement
B Interest rate option
C Interest rate future
D Interest rate swap

Risk management: objective test questions
6 As company treasurer, you will be borrowing cash (Taka) in November and are worried that interest
rates will soon rise. Which of the following would be an appropriate hedging transaction?
A Sell December short Taka futures
B Buy September short Taka futures
C Buy December short Taka futures
D Sell September short Taka futures
7 A company can borrow at a fixed rate by issuing five-year bonds at 9.4% or can borrow at a variable
rate of LIBOR + 0.6%. It has been quoted rates of 8.50% – 8.55% for a five-year plain vanilla swap. The
company wants to borrow at a floating rate of interest. How much would it save by borrowing fixed
and arranging a swap, compared with borrowing at a floating rate?
A It would be cheaper to borrow at a floating rate
B 0.15%
C 0.30%
D 0.90%
8 Three-month sterling June futures are quoted on LIFFE at 93.50. Call options on three-month sterling
June futures at 93.00 are quoted at 0.66. This premium of 0.66 represents
A 0.66 intrinsic value
B 0.66 time value
C 0.50 intrinsic value and 0.16 time value
D 0.16 intrinsic value and 0.50 time value
9 You are expecting to borrow $20 million in four months' time, for a period of nine months. Which of
the following instruments would enable you to hedge against the risk of an increase in interest rates in
the next four months?
A Forward exchange rate
B Interest rate cap
C Buying an interest rate put option over the counter
D Forward rate agreement
10 A company wants to secure minimum earnings on deposits of Tk10 million it will be making in four
months' time (mid-December) for an investment period of three months (to mid-March). Which of
the following would be suitable methods of hedging the exposure to a fall in interest rates over the
next four months?
A Buying a 4 – 7 FRA
B Selling September Taka futures
C Buying a put option on September Taka futures
D Buying December Taka futures

QUESTION BANK
11 A company wants to create a hedge against the risk of a rise in three-month interest rates during the
next four months, when the interest rate on its CU6 million floating rate bank loan will be re-set.
Which of the following would provide a suitable hedge?
A Buy a 3 – 7 FRA
B Sell a 4 – 7 FRA
C Buy a 4 – 7 FRA
D Sell a 3 – 7 FRA
12 The diagram below shows the profit or loss for a participant in the market for options on the shares
of Farrar Ltd, depending on the share price on the exercise date of the options, which is in three
months' time.
Which of the following market participant's position is best represented by the diagram?
A Call option holder
B Call option writer
C Put option holder
D Put option writer
13 Which of the following statements about the value of an option is incorrect?

A 'Out of the money' options have an intrinsic value of zero
B A rise in interest rates will generally lead to share call option prices increasing
C More volatile securities will generally attract higher option prices
D As time passes, the time value of an option increases

14 X buys a put option on shares in Mightiliner Ltd. The current share price is 260p. The exercise price
of the option is 300p, and the premium is 15p per share. On expiry of the option, the share price rises
to 350p.
Which of the following correctly states X's position on expiry of the option?
A X will exercise the option and has made an overall profit on the option
B X will exercise the option and has made an overall loss on the option
C X will abandon the option and has made an overall profit on the option
D X will abandon the option and has made an overall loss on the option
15 It is now mid-August. In about two or three months' time JLH Ltd will need to borrow £6,000,000 for
six months and wishes to obtain protection against the possibility of rising interest rates. JLH has been
advised to sell the 'three-month sterling' £500,000 interest rate contracts traded on LIFFE.
JLH should:
A Sell 24 of the December contracts
B Sell 12 of the December contracts
C Sell 24 of the September contracts
D Sell 12 of the September contracts
16 In three months' time you will have Tk6 million to put on deposit for four months. You are concerned
that interest rates will fall and wish to arrange an FRA to hedge the risk and fix an effective interest
rate for the future deposit. What will you do to hedge the exposure?
A Sell a 3 – 7 FRA
B Sell a 3 – 4 FRA
C Buy a 3 – 4 FRA
D Buy a 3 – 7 FRA
17 The current US dollar/Taka spot rate is $1.50 to CU1, and the dollar is at a premium against Taka for
forward exchange contracts.
What would happen to the spot rate and forward rates if interest rates went up in Bangladesh on Taka
but not in the USA on the dollar?
Spot rate Forward premium
A Dollar would weaken Would increase
B Dollar would strengthen Would increase
C Dollar would strengthen Would get smaller
D Dollar would weaken Would get smaller

QUESTION BANK
18 A Bangladesh based manufacturing company with spare capacity imports a considerable proportion of
its materials and components from abroad, and exports about 20% of its output. The foreign exchange
value of Taka declines by 10%.
What will be the consequence for the company's revenues and unit variable cost respectively?
Revenues and variable costs, respectively
A Will fall Will fall
B Will rise Will rise
C Will rise Will fall
D Will fall Will rise
19 The spot rate of exchange is Tk1 = $1.4400. Annual interest rates are 4% in Bangladesh and 10% in the
US. Assume three months to be exactly one quarter of a year. The three-month forward rate of
exchange should be:
A Tk1 = $1.5231
B Tk1 = $1.4616
C Tk1 = $1.5264
D Tk1 = $1.4614
20 Suppose that annual inflation levels are currently 4% in Japan and 6% in Bangladesh. If the levels of
inflation move during the next year to 3% in Japan and 8% in Bangladesh, what effect are these changes
in inflation likely to have on the relative value of the yen and the Taka by the end of the next year,
according to the purchasing power parity theory of long-term exchange rates?
The Taka will decline in value against the yen by
A 2.8%
B 3.0%
C 4.6%
D 5.0%
21 Chocshop distributes exotic chocolates from around the world. It buys chocolates from Ruritania
which cost Ruritanian $130,000 and the goods are resold in Bangladesh for Tk42,500. At the time of
importation, the Tk/R$ rate is 3.4050 – 3.6000.
What is the expected profit or loss on the resale of the chocolates in Bangladesh?
A Tk6,898 loss
B Tk5,384 loss
C Tk6,389 profit
D Tk4,321 profit

22 A company based in Bangladesh acquires 50% of its resources in Bangladesh and the other 50% from
suppliers in Continental Europe (the eurozone countries). It sells nearly all its output to North
America. It is strategically exposed to the risk of a rise in the value of the euro, and to a fall in the
value of the dollar against Taka. What is the term for this type of currency exposure?
A Transaction
B Translation
C Economic
D Strategic
23 Lytham Ltd is a Bangladesh company, trading in South-East Asia and remitting profits to Bangladesh.
The directors are considering methods that they can use to minimise their exposure to foreign
exchange risk.
Which of the following will not protect them from exchange risks?
A Matching
B Forward contracts
C Invoicing in Asian local currencies
D Leading and lagging
24 The spot Taka exchange rate against the currency of country X is quoted at 197.05 – 197.95 ($X per
Taka). The three-month forward rate is quoted as 190c – 191c premium. This implies that:
A Bangladesh three-month interest rates are about 4% per annum lower than X three-month rates
B Bangladesh three-month interest rates are about 4% per annum higher than X three-month rates
C Bangladesh three-month interest rates are about 1% per annum lower than X three-month rates
D Bangladesh three-month interest rates are about 1% per annum higher than X three-month rates
25 Beta Ltd is a Bangladesh trading company which is a subsidiary of Mann GmbH, a German company. It
is group policy that all invoices are issued in euros.
Which of the following is a disadvantage of such a policy?
A Accounts consolidation will all be in euros
B Beta's customers now settle their bills with a Bangladesh company in euros
C Trade between group companies is all in euros
D Prices are transparent throughout the group
26 What does the term 'matching' refer to?

A The coupling of two simple financial instruments to create a more complex one
B A mechanism whereby a company balances its foreign currency inflows and outflows
C The adjustment of credit terms between companies
D Contracts not yet offset by futures contracts or fulfilled by delivery

QUESTION BANK
27 Edted Ltd has to pay a Spanish supplier 100,000 euros in three months' time. The company's Finance
Director wishes to avoid exchange rate exposure, and is looking at four options.
(1) Do nothing for three months and then buy euros at the spot rate
(2) Pay in full now, buying euros at today's spot rate
(3) Buy euros now, put them on deposit for three months, and pay the debt with these euros plus
accumulated interest
(4) Arrange a forward exchange contract to buy the euros in three months' time
Which of these options would provide cover against the exchange rate exposure that Edted would
otherwise suffer?
A Option 4 only
B Options 3 and 4 only
C Options 2, 3 and 4 only
D Options 1, 2, 3 and 4
28 The treasurer of Gordonbear Ltd wishes to sell 200,000 Swiss francs that the company will receive in
three months' time from a customer in Berne. The SF/Tk exchange rates are:
Spot 2.23 – 2.24
3 months forward 3.25 – 3c premium
If the company took out a forward exchange contract, what would it receive in Taka in 3 months' time
from the exchange of its Swiss franc income?
A Tk88,106
B Tk88,398
C Tk90,498
D Tk91,013
29 Plane Tiff Ltd has just purchased goods from Sweden costing 200,000 Swedish krona. It is now 1 April
and the supplier must be paid on 15 June. Plane Tiff Ltd's finance director wishes to hedge against
foreign currency transaction exposure. Exchange rate details are:
On 1 April 9.90
2 months forward 1.25 ore pm
3 months forward 1.75 ore pm
On 15 June 9.92
(Note: there are 100 ore per krona)
How much would Plane Tiff Ltd pay on 15 June to obtain the Swedish currency that it requires, on the
assumption that measures were taken on 1 April to hedge against the currency exposure?
A Tk20,161
B Tk20,228
C Tk20,233
D Tk20,238

30 Calculate the forward per annum premium or discount given the following information:
Spot Tk1 = $1.40000; 3 month forward Tk1 = $1.4200
A The $ is at a premium of 5.71 percent
B The $ is at a discount of 5.71 percent
C The $ is at a discount of 1.43 percent
D The $ is at a premium of 1.43 percent
31 Are the following statements correct or incorrect?

Statement 1 A company is only exposed to currency risk if it exports or imports goods or
services, or borrows or invests in a foreign currency.
Statement 2 When interest rates on the euro are lower than interest rates on the Taka, a
Bangladesh company with no cash flows in euros will not save money by borrowing
in euros.
A Statement 1 only is correct
B Statement 2 only is correct
C Both statements are correct
D Both statements are incorrect
32 In April, a company arranged a forward exchange contract to sell $650,000 that it expected to receive
from a US customer in three months, in July. During May, the company is notified that its US customer
has filed for Chapter 11 bankruptcy protection, and will not be able to pay the money due in June.
What should the company do to avoid any exposure to currency risk?
A Arrange a forward contract to buy $650,000 in July
B Notify the bank that it is cancelling the forward contract
C Buy Taka/US dollar options for expiry in July
D Do nothing
33 Pohl Leese Witneys Ltd has entered a transaction that will involve a yen payment exposure arising in
six months' time. The company's treasurer decides to cover the exposure by means of foreign
currency options, and buys a 6-month yen call/Taka put option.
Forward exchange rate 240 yen = Tk1
Option strike price 240 yen = Tk1
Option premium 1.2%
What is the worst case exchange rate that the company will have to pay, and what would it do in
6 months' time if the spot rate is 245 yen = Tk1?
Worst case rate Decision in 6 months' time
A 237.1 Exercise the option
B 242.9 Exercise the option
C 237.1 Let option lapse
D 242.9 Let option lapse

QUESTION BANK
34 The Taka/US dollar spot rate is 1.7770 – 1.7860 and the forward rate is quoted as 0.35 – 0.36
discount. At what forward rate will the bank sell US dollars?
A 1.7724
B 1.7735
C 1.7805
D 1.7896
35 The treasurer of HRR Ltd wishes to sell 120,000 euros that the company will receive in two months'
time from a customer in Frankfurt. The bank's euro/Taka exchange rates are:
Spot 2.73 – 2.74
2 months forward 3.25 c – 3 c pm
If the company took out a forward exchange contract, what would it receive in two months' time from
the exchange of its euro income?
A Tk43,321.30
B Tk43,360.43
C Tk44,280.44
D Tk44,568.25
36 Which one of the following is true?

A As the majority of futures contracts are never taken to delivery, a futures contract is not legally
binding
B Delivery dates on futures contracts are specified by the futures exchange and not by the buyer
and the seller
C The margin requirement is a purchase cost of the future
D The quantity in a futures contract is agreed between the buyer and the seller
37 Swaps could be used for a number of different purposes. Which of the following would not be a
reason for entering a swap transaction?
A To reduce net borrowing costs through credit arbitrage
B To benefit from favourable interest changes during the term of the swap
C To switch net interest obligations out of one currency and into another currency
D To alter the mix of fixed and floating rate debt obligations in the organisation's debt structure

38 Williamson Ltd, a Bangladesh based firm, is about to tender for an overseas contract. Williamson's
internal budgets for the tender indicate the following.
%
Sales value – US Dollar ($) 100
Costs: Taka (Tk) 65
US Dollar ($) 25
90
10
The dollar costs include the costs of short-term US finance and it is intended to pay for these dollar
costs out of the dollar receipts. The total amount of the tender is $25 million and, if the tender is
successful, the work will be carried out in the next seven months with payment due to be received in
full in ten months.
The budgeted figures are all based on the current Tk/$ exchange rate and there is concern that the
project is vulnerable to exchange rate fluctuations. Action is proposed to protect the firm against
exchange rate fluctuations.
To protect itself, Williamson should:
A Purchase an option to sell $25 million in ten months
B Sell forward $18.75 million for settlement in ten months
C Purchase an option to sell $18.75 million in ten months
D Sell forward $25 million for settlement in ten months
39 Consider the following statements concerning currency risk:

1. Leading and lagging is a method of hedging transaction exposure.
2. Matching receipts and payments is a method of hedging translation exposure.
Which of the above statements is/are true?
A Statement 1 True; Statement 2 True
B Statement 1 False; Statement 2 True
C Statement 1 True; Statement 2 False
D Statement 1 False; Statement 2 False
40 A Bangladesh company is bidding for a contract with the Thai government, but will not know for three
months if the bid has been accepted. The company will need Thai currency (the Thai Baht) to cover
expenses but will be paid in Taka by the Thai Government if it is awarded the contract.
In order to minimise its exposure to currency risk, what should the Bangladesh company do?
A Buy Thai Baht put options
B Buy Thai Baht call options
C Buy Thai Baht futures
D Sell Thai Baht futures

QUESTION BANK
41 The following information is provided.

Spot 63.15 – 63.25 Utopian escudos/Taka
Three-month forward 19 cents pm – 6 cents dis
At what rate will the bank contract to buy Utopian escudos in three months' time?
A 62.96 Utopian escudos/Tk
B 63.19 Utopian escudos/Tk
C 63.31 Utopian escudos/Tk
D 63.34 Utopian escudos/Tk
42 A Bangladesh company will purchase new machinery in three months for $4.5 million. The current
spot exchange rate is Tk1 = $1.7920 – 1.7930 and the three-month forward premium is quoted at
0.22 – 0.24c.
What is the appropriate three-month forward rate at which the company should hedge this
transaction?
A $/Tk1.7954
B $/Tk1.7942
C $/Tk1.7906
D $/Tk1.7898


Answer Bank
© The Institute of Chartered Accountants in England and Wales, March 2009

99
ANSWER BANK
1 Stakeholders
(a) (i) A large conglomerate spinning off its divisions
Large conglomerates may sometimes have a market capitalisation which is less than the total
realisable value of the subsidiaries ('conglomerate discount'). This arises because more synergy
could be found by the combination of the group's businesses with competitors than by running a
diversified group where there is no obvious benefit from remaining together.
For many years, Hanson Trust was the exception to this situation, but subsequently it decided to
break up the group.
The stakeholders involved in potential conflicts are as follows.
(1) Shareholders
They will see the chance of immediate gains in share price if subsidiaries are sold.
(2) Subsidiary company directors and employees
They may either gain opportunities (e.g. if their company becomes independent) or suffer
the threat of job loss (e.g. if their company is sold to a competitor).
(ii) A private company converting into a public company
When a private company converts into a public company, some of the existing
shareholder/managers will sell their shares to outside investors. In addition, new shares may be
issued. The dilution of ownership might cause loss of control by the existing management.
Stakeholders involved in potential conflicts
(1) Existing shareholder/managers
They will want to sell some of their shareholding at as high a price as possible. This may
motivate them to overstate their company's prospects. Those shareholder/managers who
wish to retire from the business may be in conflict with those who wish to stay in control –
the latter may oppose the conversion into a public company.
(2) New outside shareholders
Most of these will hold minority stakes in the company and will receive their rewards as
dividends only. This may put them in conflict with the existing shareholder/managers who
receive rewards as salaries as well as dividends. On conversion to a public company there
should be clear policies on dividends and directors' remuneration.
(3) Employees, including managers who are not shareholders
Part of the reason for the success of the company will be the efforts made by employees.
They may feel that they should benefit when the company goes public. One way of
organising this is to create employee share options or other bonus schemes.
(iii) Japanese car manufacturer building new car plants in other countries
The stakeholders involved in potential conflicts are as follows.
(1) The shareholders and management of the Japanese company
They will be able to gain from the combination of advanced technology with a cheaper
workforce.
(2) Local employees and managers engaged by the Japanese company

They will gain enhanced skills and better work prospects.
(3) The government of the local country, representing the tax payers
The reduction in unemployment will ease the taxpayers' burden and increase the
government's popularity (provided that subsidies offered by the government do not
outweigh the benefits!).
(4) Shareholders, managers and employees of local car-making firms
These will be in conflict with the other stakeholders above as existing manufacturers
lose market share.
(5) Employees of car plants based in Japan
These are likely to lose work if car-making is relocated to lower wage areas. They will
need to compete on the basis of higher efficiency.
(b) The concept that the primary financial objective of the firm is to maximise the wealth of
shareholders, by which is meant the net present value of estimated future cash flows, underpins
much of modern financial theory.
Achievement of this goal can be pursued, at least in part, through the setting of specific subsidiary
targets in terms of items such as return on investment and risk adjusted returns.
A widely adopted approach is to seek to maximise the present value of the projected cash
flows. In this way, the objective is both made measurable and can be translated into a yardstick for
financial decision making. It cannot be defined as a single attainable target but rather as a criterion for
the continuing allocation of the company's resources.
There has been some recent debate as to whether wealth maximisation should or can be the only true
objective, particularly in the context of the multinational company. The stakeholder view of
corporate objectives is that many groups of people have a stake in what the company does. Each of
these groups, which include suppliers, workers, managers, customers and governments as well as
shareholders, has its own objectives, and this means that a compromise is required.
The firm has responsibilities towards many groups in addition to the shareholders, including:
(i) Employees: to provide good working conditions and remuneration, the opportunity for
personal development, outplacement help in the event of redundancy and so on
(ii) Customers: to provide a product of good and consistent quality, good service and
communication, and open and fair commercial practice
(iii) The public: to ensure responsible disposal of waste products.
There are many other interest groups that should also be included in the discussion process.
Non-financial objectives may often work indirectly to the financial benefit of the firm in the long term,
but in the short term they do often appear to compromise the primary financial objectives.
For example, in the case of the multinational firm with a facility in a politically unstable third world
economy, the directors may at times need to place the interests of local government and
economy ahead of those of its shareholders, in part at least to ensure its own continued stability
there.
Conclusion
It is very difficult to find a comprehensive and appropriate alternative primary financial objective to
that of shareholder wealth maximisation but the definition of non-financial objectives should also
be addressed in the context of the overall review of the corporate plan.
ANSWER BANK
Marking guide
Marks
(a) (i) Explanation 3

(ii) Explanation 3
(iii) Explanation 3
1289
(b) 1 – 2 marks per argued point max 8
17
Tutorial notes
The answer to (a) shows some of the major stakeholders that you will encounter in questions. Don't forget
shareholders are stakeholders (the most important stakeholders) and managers' interests will normally be
significant. If the business is likely to undergo significant changes, employees will also be important, and if the
business is highly geared think about lenders. Before you finish, think always how the wider community
might be affected by the business's actions.
You may not get a full question on the areas covered in this question. They are more likely to form part of
a larger question involving other areas of the syllabus. Wider stakeholder interests will often be relevant to
discussion questions.
(b) is carefully structured, starting off with the concept of maximising shareholder wealth. A discussion-
based answer such as this needs to be planned before you begin to write. This answer shows the sort of
length paragraphs will be in a well-constructed answer.
2 Highseas Ltd
(a) Corporate objectives for Highseas
Highseas has two main objectives at present:
 To treat all stakeholders with even-handedness
 To increase dividends each year
(i) Even-handedness
Stakeholders
There will always be a number of stakeholder groups interested in a company's operations,
including shareholders, loan creditors, directors and managers, other employees, customers,
suppliers, government (including tax authorities), and the communities in which the company is
based.
Shareholders
The primary stakeholders are the shareholders, who are the owners of the company. They
appoint directors as agents to run the company on their behalf. In a private company like
Highseas the directors will almost invariably also be shareholders. Thus private sector companies
must have a primary objective that is related to the needs of shareholders.
Stakeholders with legal rights
Some of the stakeholder groups (e.g. loan creditors and the national and local tax authorities)
have clear legal rights to payments by the company, and the concept of 'even-handedness' will
not really apply. For the most part these are stakeholders whose sole need is for the law to be
satisfied, that is they expect to be paid on time, and any negotiations start from this premise.
Other stakeholders
For the other stakeholders, the concept of even handedness is a good general approach to adopt.
Even those who assert that a company's sole objective should be to benefit shareholders will
agree that this is best done by considering the needs of other stakeholder groups. For example:
(1) Customers should not be cheated on the quality of goods (or they will buy elsewhere).
(2) Suppliers should not be made to wait unduly for payment (or they will increase their
prices).
(3) Directors and key managers should be given fair rewards for their successes (or they
will lose motivation, divert benefits to themselves or leave the company); however they
should not be allowed to take the same rewards if they are unsuccessful.
(4) Other employees should not only be paid fair market rates but also encouraged to
participate in company plans.
(5) The local community should not be subjected to unnecessary noise or pollution,
and can provide powerful good publicity for the company.
(ii) Increasing dividends each year
Although it correctly focuses on shareholders, the objective of increasing dividends each year is
unsatisfactory as a primary objective for Highseas. This is because the pattern of dividends may
need to be varied to take advantage of investment opportunities. In some years it may be
wise to restrict dividends in order to reinvest in the company for growth.
Finance Director's statement
The FD stated that 'As a company our main financial objective should be to increase dividends each
year'. As stated above, the primary objective of a private sector company must be to benefit
its owners, taking into consideration the fact that this cannot be properly done without also satisfying
the legal needs of other shareholders and treating them with equity and fairness. Whether or not
equity and fairness is viewed as a set of objectives or conditions is not particularly important in
practice, provided it is acknowledged.
It should be noted that increasing dividends each year is not necessarily the same as profit
maximisation. Dividends are, of course, paid from distributable profits and profit maximisation will lead
to shareholder wealth maximisation. If, as the FD's comments suggest dividends need to increase every
year this will not necessarily lead to profit maximisation as large investment projects, for example, may
mean a reduction in dividends in the short term in exchange for even higher dividends in the future.
The question then turns to whether 'maximisation of shareholder wealth' is something that can
actually be achieved, and if so, how? Some writers would say that 'satisficing' (i.e. paying a minimum
required rate of return) is the closest that can be achieved, with surpluses generated by the
company being the subject of bargaining between stakeholders. Also, in a private company like
Highseas, where the boundary between shareholders and directors is blurred, the remuneration
paid to directors usually contains some element of shareholder rewards.
A range of performance objectives
The other directors propose a range of 'objectives' which are probably best described as targets,
designed to help achieve the main objective of shareholder wealth creation. Thus a target return on
investment is a way of trying to increase shareholder wealth. In setting these financial targets,
however, it is vital to recognise the relationship between risk and return and to put boundaries on
risks taken in pursuit of the targets.
The problem with financial targets is that they depend on non-financial actions, such as increases in
sales or productivity. Hence non-financial performance improvement measures are vital as a
component of the set of targets the company should seek.
Strategic plan
This leads to the most important criticism of all. The company appears to have no strategic plan,
but appears to working on the basis that its current success will continue unchanged. In particular it
ANSWER BANK
is likely to be outflanked by some of its competitors that have relocated production facilities to low
cost countries.
Conclusions
The company's main objective should be to pay shareholders a minimum rate of return
consistent with the risk they are prepared to accept. The company should investigate attitudes to risk
among its main shareholders.
The main objective should be presented in conjunction with statements that the company will fulfil its
legal obligations and will treat other stakeholders with equity and fairness.
The main objective should then be accompanied by a set of financial and non-financial targets,
based on the strategic plan.
(b) Financing or refinancing strategies
The treasury department should develop a financing strategy based on its ongoing business and
investment plans, and the cash requirements forecasts that come out of these plans. The financing
strategy should consider:
(i) Debt or equity
Treasury should evaluate the project plans in conjunction with the gearing ratio and decide
whether it is worthwhile taking out more debt or redeeming it with surplus cash
instead of paying dividends. Some investments will provide good security for borrowing and
may allow gearing to be increased without taking undue financial risk. Other investments are less
certain in the development stage and are better financed with equity. The directors may
also wish to consider ownership implications, the tax shield effects of debt, and the interest
commitment made if debt is taken out.
(ii) Short- and long-term debt
It is best to obtain a satisfactory mix of short- and long-term debt, in order to manage
financing risk at the minimum interest cost. In general long-term debt will be more secure
but more expensive because the lender does not have the option to withdraw it so soon. The
policy should consider financing assets out of funds from the same type of duration. For
example non-current assets and the permanent part of working capital can be financed from
equity and longer-term loans, whereas fluctuating working capital should be financed from
overdraft or other short-term funds.
(iii) Fixed or floating rate loans
Interest on fixed rate debt is easier to forecast but may be more expensive in the long run
than floating rate debt. The fact that interest rates are predicted to fall is an indicator that floating
rate debt may be beneficial at the moment but interest rate risk must be acknowledged. There
may be cash flow problems in the event of rising interest rates.
(iv) Foreign currency loans
A foreign currency loan should probably only be considered as a hedge against income
received in that currency. For example a euro loan can be matched against expected euro
receipts. Foreign currency loans should not be taken out simply because the interest rate
appears cheap, because unhedged exchange rate movements can cause significant losses.
Financing and overall strategy
Financing strategies will be reflected in the company's overall strategic plan. In general the aim should
be to trade off the cost and risks of finance. The decisions taken on financing will be reflected in
some of the target figures accompanying the corporate objectives – for example gearing, cost of
capital and duration of finance.
Marking guide
Marks
(a) 1 – 2 marks per paragraph 12

Conclusions 3
15
(b) 2 – 3 marks per paragraph 10
25
Tutorial notes
This question requires detailed analysis of stakeholders but also a realisation that the primary objective
must be maximisation of shareholder wealth. Hopefully you discussed the lack of a strategic plan. Make sure
that your discussion is applied to the specific circumstances of Highseas. You may feel that you could
produce a fuller answer to part (b) after you have studied later parts of the study text.
3 Profitis Ltd
(a) Derivation of the equivalent annual cost: Net present value
Time 3 years 4 years
PV @ 15% PV @ 15%
CU CU CU CU
0 Cost (80,000) (80,000)
Tax depreciation 6,000 6,000
(74,000) (74,000) (74,000) (74,000)
1 Tax depreciation 4,500 4,500
Maintenance (10,000) (10,000)
(5,500) (4,783) (5,500) (4,783)
Maintenance (10,000) (10,000)
Tax on maintenance 3,000 3,000
(3,625) (2,741) (3,625) (2,741)
Maintenance – (20,000)
Tax on maintenance 3,000 3,000
Proceeds 10,000 –
20,125 13,233 (14,469) (9,514)
4 Tax depreciation – 7,594
Tax on maintenance – 6,000
13,594 7,724
Present value (68,291) (83,314)
Annuity factor 2.283 2.855
Equivalent annual cost CU29,912 CU29,182
Therefore a four-year life is marginally more economic.
ANSWER BANK
WORKING
Time @ 30%
CU CU
0 Cost 80,000
Tax depreciation allowance (25%) (20,000) 6,000
60,000
1 Tax depreciation allowance (25%) (15,000) 4,500
45,000
33,750
3 Proceeds (10,000)
23,750 7,125
or
2 Written-down value 33,750
25,312
4 Proceeds Nil
25,312 7,594
(b) Discussion of other issues
Relevant issues include the following.
 The analysis in (a) ignores price changes of all descriptions. A change in the price of a new
machine, for example, could easily alter the conclusion. The same would be true for all of the
input factors.
 The approach taken assumes that replacement will take place with an identical machine. The
machine may be technologically superseded. The company may conclude that it no longer has a
need for such a machine. In practice it seems unlikely that many such assets are replaced with
identical models on a continuing basis.
 The timing of the cash outflows on new machines could be an issue in practice, i.e. making
payments every fourth year may cause less of a cash flow problem than every third year.
Marking guide
Marks
(a) Calculations:
Time 0 1
Time 1 1
Time 2 1½
Time 3 2½
Time 4 1
PV 2
Equivalent annual cost 3
Conclusion 1
1113
(b) 1½ marks per point, maximum max max max4
17
4 Global Power Ltd

(a) Closure date
Closure 20X9
t0 t1 t2 t3
CUm CUm CUm CUm
Income 694 840 938
Expenditure (190) (255) (286)
VCs saved 28 32 37
Net income 0 532 617 689
Tax on net income (159.6) (185.1) (207)
Investment (1,200) (90)
Tax on investment (W1) 90 67.5 50.6 151.9
Working capital (W3) (120) (6) (6.3) 138.9
Cash flow (1,230) 433.9 476.2 683.1
Discount factor 1 0.909 0.826 0.751
(1,230) 394.4 393.3 513.2
NPV = CU70.9m
Closure 20Y0
t0 t1 t2 t3 t4
CUm CUm CUm CUm CUm
Income 694 840 938 882
Expenditure (190) (255) (286) (452)
VCs saved 28 32 37 39
Net income 0 532 617 689 469
Tax on net income (160) (185.1) (207) (140.7)
Investment (1,200) (370)
Tax on investment (W2) 90 67.5 50.6 38.0 113.9
Working capital (W3) (120) (6) (6.3) (7) 145.9
Cash flow (1,230) 433.9 476.2 513.3 218.1
Discount factor 1 0.909 0.826 0.751 0.683
(1,230) 394.4 393.3 385.5 149.0
NPV = CU92.2m
As the NPV of the four-year project is higher, Global's management would be advised to close the
new plant on 31 March 20Y0. Shareholder wealth will increase accordingly. However, any decision
must be subject to Global's management being satisfied that key assumptions are valid, i.e. that finance
is available and the project is worth the risks, given the relatively small return for the risks involved.
ANSWER BANK
WORKINGS
t0 t1 t2 t3 t4
CUm CUm CUm CUm CUm
(1) Investment 1,200 900.0 675.0 506.3
TDA (300) (225.0) (168.8) (506.3)
WDV/Disposal value 900 675.0 506.3 0.0
TDA × 30% 90 67.5 50.6 151.9
(2) Investment 1,200 900.0 675.0 506.3 379.7
TDA (300) (225.0) (168.8) (126.6) (379.7)
WDV/Disposal value 900 675.0 506.3 379.7 0.0
TDA × 30% 90 67.5 50.6 38.0 113.9
(3) Working capital
Money cost (5% inflation) 120.0
× 1.05 126.0
× 1.05 132.3
×1.05 138.9
× 1.05 145.9
(b) Decommissioning costs
The four-year project NPV is CU26.651m higher (CU108.545m – CU81.894m) than that of the three-
year project.
Thus the decommissioning costs would need to be CU39.020m (CU26.651m/0.683) higher. There is
no tax effect to worry about.
Thus the decommissioning costs in 20Y0 would need to be CU409.020m (CU370m + CU39.020m)
(c) Cost of capital
A firm may have a variety of sources of long-term finance, typically shares and debt. The cost of each
source can be equated with the return which the providers of capital expect on their investment. The
return can be expressed as an interest rate and this will be used as the overall measure of cost. Thus
the cost of money is the percentage return which a firm needs to pay to its investors.
The cost of ordinary (equity) shares can be calculated by
(a) Using the dividend valuation model (whereby dividends [with their growth rates] are compared
to the share's market value), and/or
(b) Using the CAPM (Capital Asset Pricing Model). This approach acknowledges that there are two
main determinants of a firm's cost of capital,
(i) The risk free rate of return, and
(ii) The reward for the risk taken by investors in advancing funds to the firm. Equity holders
take more risk than debt holders and would therefore want higher rates of return. This
(systematic) risk is measured using an index called beta. The higher the risk, the higher the
beta, and thus the higher the cost of equity.
The cost of debt can be calculated by comparing the annual interest charge to the current market price
of the debt if
(a) The debt is irredeemable, or
(b) The current market price equals the redemption price.
If the debt is redeemable at other than current market price, an IRR calculation is made.
Because of the probable variety of sources of long-term finance, it will be necessary to calculate a
weighted average cost of capital, based on the respective total market values of the constituent elements
of long-term finance. This assumes that
(a) Global's historic proportions of debt and equity do not change
(b) Global's operating risk remains the same
(c) The finance is not specific to the project

Finally, Global's cost of capital has been expressed in money terms. This means that it has been
increased by the rate of inflation in order to take account of (and negate) the effects of inflation on the
cash flows of the investment in question.
Marking guide
Marks
(a) Closure 20X9 7

Closure 20Y0 4
Conclusion 1
max 12
(b) 1 mark per point max 2
(c) 1 mark per point max 5
19
5 Sarajevo Ltd
(a) Mutually exclusive investments
The ranking should be on the basis of project NPVs as follows.
Present values NPV Ranking
CU'000 CU'000
Project A – 15 – (15  0.909) + (20  0.826) + (25  0.751) = + 6.7 4
Project B – 30 + (60  0.751) = + 15.1 2
Project C – 35 + (10  0.909) + (10  0.826) + (20  0.751) = – 2.6 5
Project D – 10 – (20  0.909) + (20  0.826) + (26  0.751) = + 7.9 3
Project E (– 25  0.909) + (50  0.826) = + 18.6 1
However, since the projects are mutually exclusive, only Project E would be accepted.
(b) Single period capital rationing
In these circumstances the projects should be ranked on the basis of their benefit/cost ratios, which
are calculated by dividing the NPV by the investment in the period in which the capital is rationed.
Benefit/cost ratio Ranking
CU'000
Project A + 6.7  15 = + 0.45 4
Project B + 15.1  30 = + 0.50 3
Project C – 2.6  35 = – 0.07 5
Project D + 7.9  10 = + 0.79 2
Project E + 18.6  0 =  1
Therefore accept projects E, D, B and 2 3 of A, given a restriction of CU50,000.
ANSWER BANK
(c) Single period rationing – inflows and outflows

The first step is to recompute the cost/benefit ratios based on the new rationing situation.
Benefit/cost ratio
CU'000
Project A + 6.7  15 = + 0.45
Project B + 15.1  0 = 
Project C – 2.6  (10) = + 0.26
Project D + 7.9  20 = + 0.40
Project E + 18.6  25 = + 0.74
The solution may be to accept projects B, E and A. The resultant NPV would be
15.1 + 18.6 + 6.7 = CU40,400
and the CU40,000 of available funds would be exhausted.
However, if the company were to accept Project C in spite of the negative NPV, an additional
CU10,000 would be made available at t1. The resultant CU50,000 could then be invested in projects C,
B, E, A and ½ of Project D.
The total NPV from this investment strategy would be
– 2.6 + 15.1 + 18.6 + 6.7 + (0.5  7.9) = CU41,800
The latter strategy is optimal.
Marking guide
Marks
(a) Ranking method ½

½ mark per line 2½
Conclusion 1
4
(b) Calculations 1½
Conclusion ½
2
(c) Calculations 1½
Conclusion ½
2
8
6 Quattro Air Ltd

(a) Net present value
Year 0 1 2 3 4 5
CU CU CU CU CU CU
Investment (9,500,000)
Spanish contract 4,800,000 4,800,000 4,800,000 4,800,000
Sales proceeds 1,200,000
Savings 250,000 250,000 250,000 250,000
Ad hoc revenue 700,000 1,200,000 1,700,000 2,200,000
Sale proceeds 1,000,000
Operating costs (2,750,000) (3,000,000) (3,250,000) (3,500,000)
Pre-tax cash
flows (9,500,000) 1,200,000 3,000,000 3,250,000 3,500,000 4,750,000
Tax (900,000) (975,000) (1,050,000) (1,125,000)
Tax saved on
TDA (W) 712,500 534,375 400,781 300,586 225,440 376,318
Net cash flow (8,787,500) 1,734,375 2,500,781 2,575,586 2,675,440 4,001,318
Discount factor 1 0.909 0.826 0.751 0.683 0.621
PV of cash flows (8,787,500) 1,576,547 2,065,645 1,934,265 1,827,326 2,484,818
NPV = CU1,101,101
WORKING: TDAs
CU CU
t0 9,500,000
TDA (2,375,000) × 30% = 712,500
t1 7,125,000
TDA (1,781,250) × 30% = 534,375
t2 5,343,750
TDA (1,335,938) × 30% = 400,781
t3 4,007,812
TDA (1,001,953) × 30% = 300,586
t4 3,005,859
TDA (751,465) × 30% = 225,440
t5 2,254,394
Proceeds 1,000,000
BA 1,254,394 × 30% = 376,318
(b) Other factors
The appropriateness of the discount factor and the impact of this new venture on risk profile (financial
and/or business).
The accuracy of the estimates employed across the board and the potential impact of inflation.
Whether, given the commercial risks involved, the company really needs to do this work itself.
The potential impact of exchange rate fluctuations on the project: this suggests that the whole issue of
managing such risks needs to be addressed by the directors, and the cost of any such actions needs to
be considered.
The directors must note that a large proportion of the positive NPV is dependent on the final sale
proceeds.
The advice to the directors should be to proceed with the investment in view of the positive NPV,
subject to satisfaction with regard to the issues raised above.
ANSWER BANK
Marking guide
Marks
(a) Investment 1
Spanish contract 1
Sales proceeds (Y1) 1
Savings 1
Ad hoc revenue 1
Sales proceeds (Y5) 1
Operating costs 1
Tax 1
TDA (W1) 2
NPV 1
11
(b) One mark per point max 5
16
7 Clearchannel Dredging Ltd
Relevant cash flows

t0 t1 t2 t3 t4 t5
1 Jan 31 Dec 31 Dec 31 Dec 31 Dec 31 Dec
20X8 20X8 20X9 20Y0 20Y1 20Y2
CU'000 CU'000 CU'000 CU'000 CU'000 CU'000
Cost savings (W1) 1,040 1,190 1,363 1,550
Tax consequences @ 30% (312) (357) (409) (465)
TDs (W2) re new equipment 375 281 211 158 119 56
Purchase of new equipment (5,000)
Disposal proceeds 1,000
Disposal of old equipment (W4) 500
Tax consequences (W4) 300
TDs forgone by not using
existing equipment (W6) (113) (84) (63) (47) (143)
Working capital (W5) 104 15 17 19 (155)
Net relevant cash flow (3,834) 940 998 1,084 1,906 56
Discount factors (W3) 1 0.874 0.764 0.662 0.573 0.496
PV (3,834) 822 762 718 1,092 28
NPV = CU(412,000)
The NPV is negative, indicating that the new equipment should not be purchased. Existing equipment should
be used.
Explanation of method
Money cash flows have been discounted at the money cost of capital.
Assumption
Tax depreciation on equipment are calculated at 25% per reducing balance.
WORKINGS
(1) Annual cost savings in money terms
CU'000
20X8 1,000  1.04 = 1,040
20X9 1,100  (1.04)2 = 1,190
20Y0 1,200  (1.04)2  1.05 = 1,363
20Y1 1,300  (1.04)2  (1.05)2 = 1,550
(2) Tax depreciation on new machinery
CU000 Tax effect @ 30% Timing
20X7 Purchase 5,000
TD @ 25% (1,250)  375 t0
20X8 3,750
TD @ 25% (938)  281 t1
20X9 2,812
TD @ 25% (703)  211 t2
20Y0 2,109
TD @ 25% (527)  158 t3
20Y1 1,582
TD @ 25% (396)  119 t4
20Y2 1,186
Disposal proceeds (1,000)
Bal allowance (186)  56 t5
(3) Discount factors/rates

Rates 1 + m = (1 + r) (1 + i)
20X8, 20X9 1 + m = 1.10 x 1.04 = 1.144 m = 14.4%
20Y0, 20Y1, 20Y2 1 + m = 1.10 x 1.05 = 1.155 m = 15.5%
1
t1 DF = = 0.874
1.144
1
t2 DF = = 0.764
(1.144)2
1 1
t3 DF = 2
 = 0.662
(1.144) 1.155
1 1
t4 DF = 2
 = 0.573
(1.144) (1.155)2
1 1
t5 DF = 2
 = 0.496
(1.144) (1.155)3
1 1
t6 DF = 2
 = 0.429
(1.144) (1.155) 4
(4) Options re old machinery

(a) Sell on 31 December 20X7 for CU500,000
Tax consequences
CU'000
20X6 Bought for 2,000
TD @ 25% (500) SUNK
20X7 B/f 1,500
Disposal proceeds (500)
Bal allowance (1,000) tax saving of 300 at t0
 NPV if sell at t0 = 500 + 300 = CU800,000
ANSWER BANK
(b) Keep and lease

Tax consequences (TDs)
CU000
20X7 B/f 1,500
TD @ 25% (375)  tax saving of 113 at t0
20X8 B/f 1,125
TD @ 25% (281)  tax saving of 84 at t1
20X9 B/f 844
Scrapped –
Bal allowance (844)  tax saving of 253 at t2
PV of relevant flows
t0 t1 t2
Lease payments 250 250
Tax effect (75) (75)
TDs (above) 113 84 253
363 259 178
DF (W3) 1 0.874 0.764
PV 363 226 136
NPV = CU725,000
Conclusion: existing equipment should be sold if not needed on the 'Avon' project.
(5) Working capital
t0 t1 t2 t3 t4
1 January 20X8 20X9 20Y0 20Y1 20Y2
Working capital reduction required (104) (119) (136) (155) 0
Working capital reduction in place 0 (104) (119) (136) (155)
Relevant CF 104 15 17 19 (155)
(6) Tax re tax depreciation forgone by not using existing equipment
t0 113
see W4(b)
t1 84
20X9 B/f 844

TD @ 25% (211)  tax effect 63 at t2
20Y0 B/f 633
TD @ 25% (158)  tax effect 47 at t3
20Y1 B/f 475
Scrapped –
Balancing allowance (475)  tax effect 143 at t4
Marking guide
Marks
Cost saving (W1) 1

Tax 1
TDs (W2) / new equipment 2
Disposal (W4) ½
Options re old equipment:
Sell 2
Keep and lease 3
TDs forgone (W6) 3
Working capital (W5) 3
Net relevant cash flow 2
Discount factors 2
NPV ½
20
8 Broadham Hotels Ltd

(a) Determination of the minimum annual payment
Expected value of the loss of the rooms
Since at the two lowest levels of demand occupancy would not be affected by the Septo proposal, the
expected value of lost bookings will be as follows.
[(420 – 400)  0.3] +[(440 – 400)  0.2] + [(460 – 400)  0.1] = 20 rooms per night
Annual cost (at 1 July 20X2 prices) = 20  50 (1 – 10%)  360 = CU324,000
In 'money' terms
Year ending Net of Factor PV
tax
30 June CU CU (see below) CU
20X3 CU324,000  1.03 = 333,720 233,604 0.883 206,272
20X4 CU324,000  = 343,732 240,612 0.779 187,437
1.032
20X5 CU324,000  = 354,044 247,831 0.688 170,508
1.033
20X6 CU324,000  = 364,665 255,266 0.607 154,946
1.034
20X7 CU324,000  = 375,605 262,924 0.536 140,927
1.035
Present value of expected cost 860,090
Let F = Annual Septo fee
F + 2.957F – (3.493F × 0.3) = 860,090
F = CU295,655
(The annual fee is receivable on 1 July 20X2 and on 1 July of each of the four subsequent years. Tax is
payable on 30 June 20X3 and on 30 June of each of the four subsequent years.)
ANSWER BANK
WORKING
Discount factors 1+m = (1 + r)  (1 + i)
m = (1.10  1.03) – 1
= 0.133
Factor for 1 year 1 = 0.883

1.133
Factor for 2 years 1 = 0.779

1.1332
Factor for 3 years 1 = 0.688

1.1333
Factor for 4 years 1 = 0.607 2.957 = 4 year annuity factor

1.1334
1
Factor for 5 years  = 0.536
1.1335
3.493 = 5 year annuity factor
(b) Information that should have been brought into the annual payment determined in (a)
Possible information that could have been brought into the determination of the annual payment
includes the following.
 The possible effect on room sales of the loss of the top floors (view and security etc).
 The possible loss of sales as a result of customers not attempting to book a room because of the
likelihood that the hotel will be full.
 The possible room sales to Septo if the proposal does not go ahead; Septo's staff will have to stay
somewhere locally.
 The likely loss of ancillary sales, e.g. restaurant sales.
(c) Discussion of the advisability of the proposal from Septo's perspective
Septo is seeking to have 'in house' an activity that most businesses would 'outsource'. It involves Septo
in an activity that seems well outside its core activity and, presumably, its area of expertise.
This could be expensive and risky as it turns a variable type of cost (paying by room/night as needed)
into a fixed cost. How often will Septo need all 100 rooms?
Five years is a long time to commit to use a facility like this.
It also has an adverse cash flow profile, since the annual fee is payable in advance.
On the other hand, Septo has the opportunity to control quality and style. It could prove to be much
cheaper than taking rooms by the night, provided that Septo were able to make good use of the
facility.
Marking guide
Marks
(a) Annual cost 4

Money terms 2
PV of expected cost 1
Annual fee 2
Workings 4
13
(b) 1 per point max 4
(c) 1 per point max 5
22
9 Roberto Ltd
(a) NPVs of project – using expected values
Investment Working (NPV)
EV
CUm
A (3m × 0.5) + (– 1.5m × 0.5) 0.75
B (1m × 0.5) + (– 0.5m × 0.5) 0.25
C (1m × 0.5) + (– 0.5m × 0.5) 0.25
D (1m × 0.5) + (– 0.5m × 0.5) 0.25
Results of investments
(i) Project A (alone)
CUm Probability
Expected value 0.75
Possible outcomes 3.00 0.5
(1.50) 0.5
1.0
(ii) Projects B, C and D
CUm Probability
Expected values (0.25 + 0.25 + 0.25) 0.75
Possible outcomes (1m + 1m + 1m) 3.00 0.125
(– 0.5m + – 0.5m + – 0.5m) (1.50) 0.125
(1m + 1m – 0.5m) 1.50 0.375
(1m – 0.5m – 0.5m) Nil 0.375
1.000
(b) (i) Recommendation to directors
Assuming that the objective of the company is to maximise shareholders' wealth then, since the
expected NPVs of all projects are positive when using expected values, all four projects should be
taken on if cash were not restrained.
However, as the company can only afford strategy 1 or strategy 2 (investments B, C + D), then
the preferred strategy will be decided by the directors' attitude to risk, since both strategies have
the same expected values, maximum possible outcomes and minimum outcomes.
ANSWER BANK
Using expected values as a sole criterion for choice would leave the directors indifferent
between the two strategies. However, the use of expected values is inappropriate for a one-off
decision such as this, where the expected outcomes of each strategy are not even possible.
The use of expected values ignores the attitudes of investors to risk.
The directors will need to consider the extent to which the activities of the company are
diversified.
On the assumption that the directors are risk averse and wish to minimise risk for a given return,
the second strategy is recommended. There is only a 12.5% chance of making a loss under
strategy 2, against a 50% chance under strategy 1.
(ii) Assumptions made
The company
Overall objective is to maximise shareholders' wealth.
The NPVs of the projects have been identified by discounting the cash flows with a discount rate
which reflects the levels of business and financial risk involved.
Additional funds are not available elsewhere, otherwise all four projects should be considered.
The market value of the shares will rise by the NPVs of the projects undertaken.
Directors
The NPVs of the projects should have been computed using a suitably risk-adjusted discount rate.
Shareholders
It is assumed they are risk averse and wish to maximise returns for a given level of risk.
If the major shareholders are not the directors, their preferred strategy will be dependent upon
whether or not they are well diversified.
Where directors are not shareholders it is possible for a conflict of interest to arise.
Marking guide
Marks
(a) NPVs 1
Project A (alone) 2
Projects B, C and D 2
5
(b) 1 mark per valid point max 11
16
Tutorial note
Suitable references to CAPM and systematic risk could also have been made.
10 Henwood Green Ltd

(a) NPV
t0 t1 t2
CU CU CU
Cost of refurbishment (340,000)
Increase in trade-in value 40,000
Tax relief on tax depreciation (W1) 25,500 19,125 45,375
Expected cash flows (W2) 192,000 195,000
Tax on expected cash flows (@30%) (57,600) (58,500)
(314,500) 153,525 221,875
8% Discount factor 1 0.926 0.857
Present value (314,500) 142,164 190,147
Expected net present value = CU17,811
WORKINGS
(1) Tax depreciation
t0 t1 t2
CU CU CU
Cost of refurbishment/WDV b/f 340,000 255,000 191,250
TDA (25%)/Balancing allowance (85,000) (63,750) 151,250
WDV/Extra proceeds 255,000 191,250 40,000
Corporation tax (@30%) on TDA 25,500 19,125 45,375
(2) Expected cash flows
t1 t2
CU CU
Expected cash flow (t1)
CU150,000 × 40% 60,000
CU220,000 × 60% 132,000
192,000
Expected cash flow (t2)
CU50,000 × 25% × 40% 5,000
CU100,000 × 25% × 40% 10,000
CU150,000 × 50% × 40% 30,000
CU150,000 × 20% × 60% 18,000
CU200,000 × 20% × 60% 24,000
CU300,000 × 60% × 60% 108,000
195,000
Thus the ENPV is positive, and the refurbishment should go ahead.
Reservations
This is based on probabilities and hence needs to be treated with caution.
The ENPV is only just positive and so management should consider how sensitive it is to any changes.
There is a 60% chance of a positive NPV and a 40% chance of a negative NPV. (This could be
calculated by working out the individual ENPV for each of the six possible cash flow profiles.)
(b) Production director
Production director's views – these are both wrong.
By lowering the discount rate present values would increase and so it is more likely that the scheme
would be accepted.
The internal rate of return is not affected by the discount rate – it is calculated from the profile of
cash flows of the project.
ANSWER BANK
Marking guide
Marks
(a) NPV 5
TDs 3
Expected cash flows 4
Reservations 3 15
(b) 1 mark per valid point 3
18
11 Farmshoppers Ltd
Notes on three techniques used in investment appraisal
NPV
The following points could be included.
 NPV is directly linked to the generally accepted, shareholder wealth maximisation objective
 It takes all of the relevant information into account
 The cost of financing the project is accounted for in such a way that it is only while the project uses
the funds that the cost is charged to the project
 By using the opportunity cost of capital, the project is directly compared with competing demands for
funds
 The level of risk can be accounted for in a logical way through a risk-adjusted discount rate
 It is generally accepted as the appropriate way of assessing investment projects.
Sensitivity analysis (SA)
This is a technique for assessing the riskiness of a project by asking how much each of the input factors to
the decision could vary, in an adverse direction, from the original estimate, before it would cause the
project to be non-viable (negative NPV).
The advantage of the approach is that it gives the decision-maker a feel for the input factors to which the
outcome of the project would be particularly sensitive. This could lead to a reassessment of the project.
Steps might be able to be taken to make the decision-maker more confident as to the actual outcome for
the sensitive input factors. For example, if there were fears regarding a rise in the price of a raw material, it
might be possible for some forward purchasing to take place.
The problems with the approach include the following.
 It provides only subjective signals that can be difficult to interpret in many cases.
 It is difficult to assess relative sensitivities: two factors may appear equally sensitive, yet their different
natures could easily mean that their sensitivities are not at all similar.
 It is rather a 'static' technique: only one variable is considered at a time, but in practice usually more
than one factor turns out to be different from the original estimate.
Scenario building is an extension of SA, where the possibility that various input factors could vary from their
predicted values is considered. This is most easily achieved by modelling the project on a spreadsheet.
Assessment can be made of various scenarios, including a worst case one. Scenario building does not solve
the 'subjective judgement' problem of SA, but it can certainly deal with the 'static' criticism.
Expected value (EV)

The expected value is the average of all of the perceived possible outcomes for the project, weighted
according to how likely each possible outcome is. As it is being used in this question, the weighted average
value of each input is established and one single expected value is deduced for the NPV of the project.
Decision-making can be difficult where there is a vast array of possible outcomes, some favourable, others
adverse. With a single EV the decision-maker has a single value on which to make a decision.
The problems with EV include the following.
 Difficulty in ascribing probabilities to various outcomes for each of the input factors.
 As it is being applied in the question, the EV only provides an average and, as with all averaging,
information is hidden. The decision-maker would normally find it helpful to know the range and
probabilities of the various outcomes for the project.
An alternative approach to that taken in the question would be to identify all of the possible outcomes, i.e.
all of the various combinations of outcomes for each of the input factors. This would enable the decision-
maker to know the overall expected value for the project and could also provide information on the
dispersion of the various possible NPVs, perhaps by calculating the standard deviation.
A problem here is that in real life the number of possible combinations could be vast. Simulation (Monte
Carlo) enables the decision maker to 'sample' this vast population, and to use the sample data to draw
conclusions.
Marking guide
Marks
NPV 1 mark per point

SA 1 – 2 marks per point
EV 1 – 2 marks per point max 13
12 CAPM and project appraisal

(a) Notes for the divisional manager
Discounting
Discounting of future cash flows is a technique used to place less value on cash flows which are
received further into the future. This reflects the fact that our investors would rather receive money
now than in the future. This preference for money now, which is known as the time value of money, is
increased if there is inflation in the economy, as investors also need to be compensated for the buying
power of their money being reduced in the future.
Therefore the discount rate is a combination of both the time value of money and inflation. Even if
inflation is negligible, cash flows still need discounting to reflect the time value of money.
Discount rate
Finding the correct discount rate can be a difficult exercise and this is where the capital asset pricing
model (CAPM) can be very useful.
CAPM looks at the returns paid on shares on the stock market compared to the risk or variation in
returns of those shares. Because investors in general are risk averse, they will expect a higher average
return by way of dividends and capital gains to compensate for a higher risk.
ANSWER BANK
The logic then follows that if shareholders can earn a given return on the stock market for a certain
level of risk, then any projects which we may undertake must at least satisfy that target return.
Where CAPM is special, however, is in the way it considers risk. A company or project looked at on
its own may have a very high level of risk. However, if it is added to the shareholders' portfolio of
investments, some of that risk will be removed or diversified away.
This is because two different causes of the total risk of a company can be identified.
Systematic risk – Due to the economy, such as interest rates, exchange rates, etc which affect
all companies
Unsystematic risk – Due to events specific to a company, such as new product developments,
fires, strikes, etc.
Systematic risk cannot be diversified away; however, the unsystematic risk will cancel out across
companies, as bad events in one company are evened out by good events in another.
Risk
Unsystematic risk
o
Systematic risk
o
15 – 20
Number of investments in the portfolio
Therefore as shareholders suffer only systematic risk if they hold a wide-ranging or well-diversified
portfolio, a company only needs to pay a return based on that risk.
CAPM measures the systematic risk as a beta. A beta of 1 indicates that the company has the same
level of risk as the average of all Bangladesh shares, called the market portfolio. A beta of 0.5 would
indicate that it has only half the risk of the market portfolio, and therefore does not need to give such
a high return.
This can be expressed in the following equation.
Required return = Rf +  (Rm – Rf)
where Rf = return on risk-free investments such as treasury bills
Rm = average return on the market portfolio.
The beta for this type of industry can be readily found in a book published by the London Business
School, as companies in the same industry share the same risk of economic variables.
Payback
Payback is a good technique in that it uses earlier cash flows which are more certain and useful if a
company is short of cash. However, it has the following drawbacks.
(i) It ignores the time value of money
(ii) It ignores cash flows after the payback period
(iii) It does not measure the change in shareholder wealth
(iv) Target paybacks are chosen subjectively
The technique of using discounted cash flows, although more complicated, overcomes all of these
problems.
(b) CAPM statement

CAPM is a device for deriving the expected return from an asset of any description. Though this
includes equities, it is not limited to them. CAPM takes account of the systematic risk of the asset's
returns. There is no question of CAPM providing guaranteed returns; there is no such thing except
with a risk-free asset.
Systematic risk is that part of total risk that is caused by factors that apply to all or most assets.
Using CAPM to derive a cost of capital to be used in investment decisions is entirely logical. Since
betas are typically derived from published equity performance, they reflect a market-determined
risk/return trade off for a particular type of business.
CAPM is only logical where the shareholders are well-diversified.
When using CAPM to derive a discount rate, it is the beta of the project which should be used, rather
than that of the company.
Marking guide
Marks
(a) 2 marks per paragraph max 14

18
13 Starr Chemicals Ltd

(a) NPV
1.1.X0 31.12.X0 31.12.X1 31.12.X2 31.12.X3
t0 t1 t2 t3 t4
New sales 4 8 8 4
Old sales (25%) (1) (2) (2) (1)
Net sales (A) 3 6 6 3
New variable costs (1.2) (2.4) (2.4) (1.2)
Old variable costs 0.4 0.8 0.8 0.4
Net variable costs (B) (0.8) (1.6) (1.6) (0.8)
Increased contribution (A – B) 2.2 4.4 4.4 2.2
Fixed costs (1.0) (1.0) (1.0) (1.0)
Taxable cash flows (C) 1.2 3.4 3.4 1.2
Tax @ 30% (0.36) (1.02) (1.02) (0.36)
Working capital (W1) (0.53) (0.53) – 0.53 0.53
Initial investment (4.00) 1.00
Taxed saved by tax depreciation (W2) 0.30 0.225 0.169 0.206
Net cash flow (4.53) 0.61 2.605 3.079 2.576
DF (15%) 1.00 0.870 0.756 0.658 0.572
PV (4.53) 0.531 1.969 2.026 1.473
Hence, NPV  CU1,469,000 and therefore the decision should be to go into production.
ANSWER BANK
WORKINGS
(1) Working capital
20W9 20X0 20X1 20X2 20X3
15% increase in sales (A) 0.45 0.9 0.9 0.45
10% increase in var costs (B) 0.08 0.16 0.16 0.08
0.53 1.06 1.06 0.53 0
Change 0.53 0.53 – (0.53) (0.53)

WDV Tax saved Timing
(30%)
1 January 20X0 Cost 4
31 December 20X0 TDA (1.00) 0.30 t1
3.00
31 December 20X1 TDA (0.75) 0.225 t2
2.25
31 December 20X2 TDA (0.563) 0.169 t3
1.687
31 December 20X3 Proceeds (1.000)
Bal allow 0.687 0.206 t4
(b) Sensitivity
Let x  corporate tax rate
Then, from (a):
(1) PV taxable cash flows (line 'C' in (a) above)
= 1.2(0.870 + 0.572) + 3.4(0.756 + 0.658) = 6.538
(2) PV tax on above = – 6.538(x)
(3) PV investment flows (plant + w cap)
= – 4.53 – 0.53(0.870) + 0.53(0.658) + 1.53(0.572) = – 3.767
(4) PV tax saved via tax depreciation
= 1x(0.870) + 0.75x(0.756) + 0.563x(0.658) + 0.687x(0.572) = 2.2x
Hence NPV = 6.538 – 3.767 – 6.538x + 2.2x
= 2.771 – 4.338x
To change decision (NPV = 0)
2.771 – 4.338x = 0
x = 0.639
Hence tax rate would need to increase to >63% to make the project unviable.
This is a relatively large (110%) change in the rate, and would seem unlikely.
Additionally as the project progresses, subsequent changes in the tax rate could be even larger before
the project ends up with a negative NPV.
Marking guide
Marks
(a) Net sales (A) 2

Net variable costs (B) 2
Increased contribution ½
Fixed costs ½
Tax 1
Working capital 2½
Initial investment 1
TDs (W2) 2½
DF ½
NPV ½
13
(b) Method 2
Figure 1
Discussion 2
5
18
14 Holden Ltd
(a) NPV and sensitivities
If the existing machine is retained (and the new machine not bought)
20X4 20X5 20X6 20X7
CUm CUm CUm CUm
Existing machine (W1) (3.000) 1.000
TDs
Bal charge avoided 0.056
TDAs 0.211 0.158 0.119 0.056
New machine cost/scrap avoided (W2) 10.000 (4.000)
TDs lost (0.750) (0.563) (0.422) (0.066)
Operating costs (incremental) (2.500) (2.500) (2.500)
Tax benefit @ 30% 0.750 0.750 0.750
Working capital
(5% incremental operating costs) (0.125) 0.125
6.392 (2.155) (2.053) (4.635)
Discount factor (W3) 1.000 0.9091 0.8340 0.7723
DCF 6.392 (1.959) (1.712) (3.580)
NPV = CU(0.859)m
Therefore, the new machine should be acquired.
The key sensitivities in any scenario are the various input factors to the decision, each of which could
be taken in turn, and a value determined for it that will generate a zero NPV. The key sensitivities in
this particular scenario, therefore, are the residual values of the machines, the incremental operating
costs, the working capital requirements, and the discount factors employed in the calculations.
The key assumptions underlying the earlier analysis are, inter alia, issues such as cash flows being
received at year end, working capital having no tax effect, the accuracy of the discount factor
ANSWER BANK
estimations, a stable tax rate throughout the period under review, and tax payments being made at the
end of the year to which they relate.
WORKINGS
(1) Tax depreciation – existing machine
CUm
20X2 Cost 5.000
TDA 1.250
3.750
20X3 TDA 0.938
2.812
Then either
CUm CUm
20X4 Disposal 3.000
Bal charge 0.188 @ 30% = 0.056
2.812
or
20X4 TDA 0.703 @ 30% = 0.211
2.109
20X5 TDA 0.527 @ 30% = 0.158
1.582
20X6 TDA 0.396 @ 30% = 0.119
1.186
20X7 Disposal 1.000
Bal all 0.186 @ 30% = 0.056
(2) Tax depreciation – new machine
CUm CUm
20X4 Cost 10.000
TDA 2.500 @ 30% = 0.750
7.500
20X5 TDA 1.875 @ 30% = 0.563
5.625
20X6 TDA 1.406 @ 30% = 0.422
4.219
20X7 Disposal 4.000
Bal all 0.219 @ 30% = 0.066
(3) Discount factors
20X5 1/(1 + 0.10) = 0.9091
20X6 1/(1 + 0.10)(1 + 0.09) = 0.8340
20X7 1/(1 + 0.10)(1 + 0.09)(1 + 0.08) = 0.7723
(b) CAPM
CAPM is a formula which states that the expected return from a risky investment is equal to the risk-
free rate plus a risk premium, and the risk premium is equal to the average risk premium for all risky
assets (the expected level of return for all risky assets less the risk-free rate) multiplied by the
riskiness of the particular asset concerned relative to the average level of risk (beta). It can be readily
used, therefore, by businesses to derive suitable discount rates for use in capital investment appraisal.
The advantages of using a project specific CAPM to derive a discount rate for use in capital investment
decisions are as follows.
 It clearly shows that the discount rate should be related to the project's risk.
 It is particularly appropriate where a new project has different risk characteristics from the firm's
existing operations, by looking at betas of businesses that specialise in that type of investment.
 In making a distinction between systematic and unsystematic risk, the CAPM shows how a highly
speculative project may have a lower than average required return because its risk is highly
specific.
The practical problems encountered in using a project specific CAPM for this purpose, however,
centre on the fact that there are three factors that need to be estimated for the future in order that
the logic of using CAPM to derive the discount rate can be carried into practice. These are the risk
measure (beta), the risk-free rate and the expected return of the market portfolio.
 Estimating the beta of a new capital investment project can often be problematic.
 Establishing a risk-free asset (strictly speaking there is no such thing) usually leads to the selection
of short-dated Bangladesh government bills, but establishing their future returns can often be less
straightforward, and so tends to be focused on past rather than future returns.
 The expected return on the market portfolio is a problem area – it tends to be volatile and
difficult to forecast accurately.
Marking guide
Marks
(a) Existing machine (W1) 2

TDs 1½
New machine / TDs lost / (W2) 2
Operating costs / Tax 1½
Working capital 1
Discount factor 1
Conclusion 1
Discussion (ii) 4
14
(b) 1 – 1½ marks per point 5
19
ANSWER BANK
15 Maritime Specialists Ltd

(a) Minimum price for altered boat
CU Explanation
Current value of the boat 40,000 The stage payments are irrelevant. Whether they are
repayable or not does not affect the current decision.
Material A 3,200 The cost to scrap and the historic cost are both
irrelevant, as the material will need to be replaced.
Material B 2,000 The history of this and the final buying price are both
irrelevant, because it will need to be bought
irrespective of the current need. The relevant cost is
simply the scrap value.
Material C 1,025 Price for existing order = CU65 × 35 = CU2,275
Price for new order = CU60 × 55 = CU3,300
The relevant figure is the difference between these.
Labour (see below*) 900 The work done during 'idle' time has no relevant cost.
The remainder has an opportunity cost of CU30 an
hour for 30 hours.
Total 47,125
* It could be argued that since the business seems to have some spare capacity at present, it might
be possible for the 'other' work to be delayed with no incremental cost. Where a candidate took
this line, and explained it adequately, it was accepted as a correct alternative answer.
(b) Time value of money
It seems likely that the decision in (a) will involve cash flowing at different times. For example, the
labour will be paid no later that at the end of the month of doing the work. Cash from the French
customer would probably not be received until a month or so after completion of the alterations,
assuming normal credit sales.
Strictly this point should not be ignored. Cash has an opportunity cost. The fact that it would be tied
up in financing the alterations deprives the company of investing it in some other activity, even merely
leaving it in the bank or reducing an overdraft. Tying the cash up in the alterations exposes it to risk –
the customer may renege on the contract or simply not pay. This risk could be insured against, but at
a cost.
The effective opportunity cost should reflect the interest lost (which presumably incorporates an
allowance for inflation), plus a risk premium.
Marking guide
Marks
(a) Current value of boat 2

Material A 2
Material B 2
Material C 2
Labour 2
10
(b) Explanation 2
12
16 Zola Holdings Ltd

(a) Current economic value of Murray Ltd
Using NPV and the information provided to ascertain an economic value for Murray Ltd gives the
following analysis.
Year 1 Year 2 Year 3
CU2.5m 1.0
0.8 CU2.2m
CU2.5m
0.6
0.2 CU2.2m
CU2.9m 1.0
CU2.5m 1.0
CU2.2m
0.2
0.4
CU3.7m
0.8 CU2.2m
CU2.9m 1.0
t1 t2 t3
CUm CUm CUm
0.6 × 3.5 = 2.10 0.6 × 0.8 × 2.5 = 1.20
0.4 × 3.7 = 1.48 0.6 × 0.2 × 2.9 = 0.35
0.4 × 0.2 × 2.5 = 0.20
0.4 × 0.8 × 2.9 = 0.93
Expected sales 3.58 2.68 2.20
Plus inflation @ 4% pa 3.72 2.90 2.48
Sales 3.72 2.90 2.48
Variable costs (1.49) (1.16) (0.99)
Fixed costs (1.25) (1.30) (1.35)
Pre-tax cash flow 0.98 0.44 0.14
Tax @ 30% (0.29) (0.13) (0.04)
Post-tax cash flow 0.69 0.31 0.10
DF @ 10% 0.909 0.826 0.751
PV 0.63 0.26 0.08
NPV = CU970,000
The following assumptions are implicit in the preceding analysis.
(1) Revenues and costs can be reliably predicted.
(2) Inflation and tax rate estimates prove accurate.
(3) The group's cost of capital is an appropriate rate to reflect the risk of the subsidiary's activities.
ANSWER BANK
(b) Justification
The method of valuation employed in determining the economic value of the company can be justified
on the following basis.
 Given the uncertainty concerning post-contract business, the offer price validly reflects the loss
of foreseeable revenue for the group and so measures the loss to Zola's shareholders of selling
the subsidiary.
 The NPV method uses a discount rate that incorporates risk and the time value of money.
 There may well be additional costs involved if the business is retained but has to be wound down
in three years' time (decommissioning, redundancy, etc).
However, the shareholders of Zola may well have the following reservations concerning the valuation.
 Using the group's cost of capital may be inappropriate – it may not reflect the business risk of the
subsidiary company – e.g. if a lower discount rate were appropriate to the risk profile of Murray,
a higher economic value would arise.
 The cash-flows are only estimates and are the result of the estimated value of a wide probability
distribution – the actual outcome might be substantially different.
 The projected inflation rate of 4% per annum may prove inaccurate.
 There is no mention made of a break-up valuation for the company – this should initially be
ascertained to establish a baseline valuation.
 The value is pessimistic in the sense that it selects the minimum possible time horizon and
completely ignores any upside potential from either contract renewal or the acquisition of new
business from other customers. There is, furthermore, no goodwill to reflect the long-standing
relationship with Borthwick.
 Given that a new management team might be motivated to pursue contract renewal and new
business opportunities, it might well be asked whether this valuation accurately reflects potential
under a new owner.
 No mention is made of the potential for other buyers to emerge.
Marking guide
Marks
(a) Expected sales calculations 3

Pre-tax cash flow 5
Assumptions stated 3
11
(b) ½ – 1 mark per point max 7
18
17 Beaters Ltd
(a) Estimation of the sensitivities of other factors
(i) Discount rate
NPV – 50,000 + [2,000 (20 – 6 – 5 – 2)]AF = 0
(where AF = annuity factor for zero NPV)
50,000
AF = = 3.571
7  2,000
Looking at the annuity table for six years, 3.571 falls almost exactly halfway between 15% and
20%, i.e. about 17.5%.
(ii) Annual volume
NPV – 50,000 + [V (20 – 6 – 5 – 2)]3.784 = 0
(where V = annual volume for zero NPV)
50,000
V = = 1,888 units per annum
7  3.784
(b) Comments on the NPV and the sensitivity analysis
It would be helpful to look at the sensitivities expressed as a percentage of the original estimate.
Difference expressed as a
percentage of the original estimate
52,938  50,000
Cost of machine 5.9
50,000
20.00  19.60
Selling price 2.0
20.00
6.40  6.00
Material cost 6.7
6.00
5.40  5.00
Labour cost 8.0
5.00
2.40  2.00
Variable overheads 20.0
2.00
6.00  5.50
Sales life 8.3
6.00
17.50  15.00
Discount rate 16.7
15.00
2,000  1,888
Annual sales volume 5.6
2,000
This is clearly a risky project: the NPV is positive but it is relatively small (less than 6% of the initial
investment). Though in theory an NPV above zero is enough to justify taking on the investment,
particularly when the discount rate already allows for risk, it looks particularly risky. The length of the
project (six years) raises problems of predicting cash flows in later years.
Taking each input factor in turn:
Cost of machine
Though this looks to be one of the most risky factors, in fact it is relatively risk free. If the price of the
machine were to rise above the estimate, this fact would be known before the company need commit
itself to the project.
Selling price and sales volume
ANSWER BANK
The project seems very vulnerable to either or both of these turning out to be lower than estimated,
particularly sales volume. This is a luxury product and may well be one subject to the vagaries of taste
and fashion. Management may believe that it should carefully re-examine the premises on which the
price and volume estimates were made. It might be worth undertaking some further market research
to assess the reliability of the estimates.
Material and labour costs
The project also looks vulnerable to these two factors. Again, the basis of the estimates could be re-
examined. Each of these costs involves a financial rate and a quantity of usage (e.g. grams of material,
minutes of labour). Both of these could be looked at again. In theory, it might be possible to determine
one of these variables by buying call options on the raw material or agreeing future contracts with the
supplier. This will increase costs since the counterparty to the option or the supplier will take on the
risk and will require an incentive to do so.
Variable overheads
These look fairly safe.
Discount rate
There is a reasonable margin of safety here, though real financing costs over six years could vary.
Sales life
Again a small safety margin, particularly when looking more than five years into the future.
Annual sales volume
Yet another high risk area.
Sensitivity analysis (SA) has the advantage of enabling the decision-maker to gain good insights to the
project and what could cause it to fail. It suffers from two weaknesses as a decision-making tool. It
gives the decision-maker no clear guidelines on how to proceed; and it considers only one variable at
a time.
Scenario building takes SA a stage further by considering various plausible outcomes for each input
factor in combination.
The fact that the rate used to discount the projected cash flows has a significant risk premium attached
to it, implies that the riskiness of the individual factors has already been accounted for. The risk of a
project is the risk that estimates used in the assessment of the project prove not to be as accurate.
Marking guide
Marks
(a) Sensitivities:
Discount rate 2½
Annual volume 2½
5
(b) Sensitivities as % of estimate 4
Input factors: 1½ – 2 marks each 7
11
16
18 Maxtherm Ltd
An option is a choice which need only be exercised if it is to the investor's advantage. A 'real option'
is such a choice or opportunity which exists because of a capital investment. The choice may
involve being able to change plans once the project is underway. The opportunity also may not have
been envisaged when the original plans were made, but may arise later on.
Options associated with the project
Options associated with the projects are in the main more valuable for the gas fuelled than for the
nuclear power project. They include the following:
(a) The option to abandon the project early
This may be needed for a variety of reasons, for example because of falling demand or because of
the emergence of a new technology. High decommissioning costs make this a problem for the
nuclear powered project.
(b) The option to expand if demand increases
This is easier for gas because of the lower investment costs.
(c) The option to switch power source in the future
This is more valuable for gas, because the technology could be adapted for other fossil fuels, such
as oil. Nuclear power technology has no easy power source alternatives.
The significance of these options is that they add value to the project and should be taken into
account in the investment appraisal. Although the valuation is difficult, even a rough estimate is
better than no estimate at all. On this basis, the gas fuelled project is likely to be relatively more
valuable than shown in the original calculations.
Marking guide
Marks
Real options explanation 2

Examples related to project: 2 marks each max 6
Conclusion 2
10
19 Investment portfolios
(a) Unsystematic risk
Unsystematic risk may be defined as the risk attached to a specific investment, in contrast to
systematic risk, which is the overall market risk. As such, it is possible by the compilation of a portfolio
of investments to eliminate unsystematic risk through diversification. The investor who only holds one
security will therefore bear a total risk, made up of the systematic risk of the market and the
unsystematic risk of the investment itself.
Hence it is incorrect to argue that he need only be concerned with the unsystematic risk of that
security. On the other hand, he may well be concerned about the unsystematic risk of the security,
because of the fact that it is that portion of the risk which is present simply because he holds only one,
rather than a portfolio of investments.
ANSWER BANK
(b) Total risk

In holding a portfolio of investments, the rational investor will assemble the portfolio in such a way as
to minimise the risk associated with the portfolio. This means that in a large portfolio it is possible to
diversify away the unsystematic risk completely.
The total risk to the investor under such circumstances is only the systematic risk of the market itself.
The total risk to an investor in a number of securities may therefore be made up of only systematic
risk, or systematic plus unsystematic risk, depending on the extent to which the portfolio is diversified.
(c) Market rate of return
In deciding whether to add an investment to a portfolio, the investor should determine the effect of
the extra investment on the overall risk of the portfolio. If the effect is to reduce the overall risk then,
assuming that the investor does seek to minimise risk, the investment should be undertaken.
An investment yielding a rate of return less than that of the market is one which is of relatively low
risk or possibly risk-free; it would therefore be appropriate to add such an investment to a currently
high-risk portfolio as a means of reducing the overall level of risk. It is not relative return but the effect
on risk which should determine the investment decision.
Marking guide
Marks
(a) 2 marks per paragraph max 4

(b) 2 marks per paragraph max 4
(c) 2 marks per paragraph max 4
12
20 Sunday newspaper article

It is true that management need to be concerned with all of the 'stakeholders' in the business. This may
mean that managers need to balance 'maximisation of shareholders' wealth' (MSW) with the objectives of
others.
It can be argued that the welfare of other stakeholders is not inconsistent with MSW. Normally, unless
other stakeholders are getting, at least, a fair deal from the business, this will be at odds with MSW. For
example, if suppliers are being treated unfairly by the business, they will seek ways to avoid dealing with the
business. This may not be open to them in the short-term, but in the longer-term it probably will be, and
this will be to the disadvantage of shareholders.
Once MSW is accepted as the key objective, NPV is the only totally logical approach to business investment
decision-making. This is because the NPV is the net increase in wealth caused by the investment.
Investments give rise to various outflows of cash that have the effect of reducing the shareholders' wealth
and inflows, which have the opposite effect. Were all of these flows to occur simultaneously, assessing
investments would be simple; net inflows would represent an increase in wealth and net outflows the
opposite. In practice, the various cash flows do not occur simultaneously but at various points in time, often
at points wide apart. Since investors do not view CU1 receivable next year as being as valuable as CU1
receivable today, a direct comparison between total inflows and total outflows cannot be made.
Discounting enables the various effects on wealth to be assessed on a common basis. All of the cash flows
are converted to their value at the same point in time, normally the present time, and the net effect on
wealth assessed. None of the other popular investment appraisal techniques looks specifically at wealth.
IRR is the average return on the investment over its lifetime, taking account of the fact that, typically, cash
will be flowing into and out of the investment project at various times over its life.
The key weakness of IRR is that it is a rate of return and, as such, it is not directly concerned with wealth. It
would always indicate that a large percentage return on a small investment is preferable to a smaller
percentage return on a large investment, when it is quite possible for the latter to have a more favourable
effect on shareholders' wealth. Thus using IRR does not necessarily lead to undertaking investments that
make shareholders richer, though it should not make them poorer.
It is fair to say that IRR typically gives the same signals as NPV, so its use will tend to lead to wealth
maximising investments, but NPV should always lead to the correct decision if MSW is accepted.
CAPM (capital asset pricing model) is a device for deriving investors' required returns from an investment.
It says that the expected return is the risk-free rate plus a risk premium. The risk premium depends on the
average risk premium for all risky investments and the level of risk of the investment under consideration,
relative to the average.
Theory and evidence suggest that investors can only expect a premium relating to systematic risk, i.e. the
risk arising from factors that tend to be common, though differentially severe, to most risky investments.
Specific risk, because it can be, and in practice is, diversified away, does not attract a risk premium.
It would not be correct to ignore the risks of the particular investment under consideration, but it is logical
to ignore the specific risk. Often when using CAPM to derive a discount rate for use with NPV, an average
risk premium for businesses engaged exclusively in the activity of the particular investment is used. This is
logical because all investments in a particular area of business can be expected to have a similar level of
systematic risk.
WACC and CAPM are not in conflict. WACC simply takes account of the required returns of the various
providers of a business's finance. CAPM is a means of deriving the cost of each of these elements. So
logically WACC could use CAPM-derived required returns, averaging them according to how important
they are, by value, to the business.
WACC, if it is based on the business's own data, is an average rate of return for all the business's activities,
some of which will be more risky than others. This may well provide an inappropriate rate for NPV
discounting or comparison with the IRR.
In theory (Modigliani and Miller – ignoring taxes) shareholders' wealth is not affected by the approach taken
to financing the business (equity or debt). Since debt is relatively low risk, lenders expect lower returns
than equity holders, but the existence of debt increases the shareholders' risk and the net effect on
shareholders' wealth is nil.
This theory was revised by MM who said that if account is taken of the fact that interest on debt is tax
deductible, increasing amounts of debt reduce the average cost of capital and make shareholders wealthier.
In practice there is a limit to the amount of debt finance a business can take on because high levels of debt
expose it to the risk of incurring the costs of financial distress (bankruptcy). In practice there seems to be
some level of debt financing that balances the benefits of tax relief against the potential costs of bankruptcy.
This will vary from business to business depending on such things as the nature of their commercial
activities.
It does not cost anything to retain profit, in the sense of costs of making a share issue. In that sense loan
stock issues are relatively cheap and share issues relatively expensive, particularly public issues.
Retained earnings certainly have cost in terms of returns required by the shareholders. These shareholders
incur an opportunity cost if their profits are retained instead of being paid to them as dividends. Naturally
they expect to be compensated for this cost. Since their funds are being invested in the same business as the
original share capital, they expect similar returns.
Marking guide
Marks
2 marks per paragraph max 19
ANSWER BANK
21 Daniels Ltd
(a) (i) No capital rationing, so choose all projects with a positive NPV, i.e.:
NPV
CU'000
Bristol 577
Swansea 2,856
Tiverton 1,664
Total 5,097
(ii) Capital rationing of CU8m on 31/5/X7 (t0). Rank according to NPV/CU invested:
Bristol Cardiff Gloucester Swansea Tiverton
CU'000 CU'000 CU'000 CU'000 CU'000
NPV (CU'000 ) 577 (1,309) (632) 2,856 1,664
Investment t0 4,150 3,870 6,400 5,000 4,600
NPV/CU 0.139 n/a n/a 0.571 0.362
Rank 3 1 2
Therefore choose all of Swansea (CU5m investment) and 65.2% (CU3,000/CU4,600) of Tiverton:
NPV
CU'000
Swansea (100%) 2,856
Tiverton (65.2%) 1,085
Total 3,941
(iii) No capital rationing at t0 but only CU500,000 available at t1:
Bristol Positive NPV and negative funds in t1 So consider further
Cardiff Negative NPV and negative funds in t1 So ignore
Gloucester Negative NPV and positive funds in t1 So consider further
Swansea Positive NPV and negative funds in t1 So consider further
Tiverton Positive NPV and positive funds in t1 So accept unconditionally
If Gloucester is ignored, because it has a negative NPV, then there is CU1,790,000 (CU500,000 +
1,290,000 [Tiverton]) available at t1.
Thus choose Swansea (higher ranking than Bristol) and do 68.6% (CU1,790/CU2,610) of it. Thus the
total NPV would be:
CU'000
Tiverton 1,664
Swansea (68.6%  CU2,856,000) 1,959
3,623
Alternatively, if Gloucester is considered and its positive t1 cash flow utilised then there is
CU3,560,000 capital available (CU1,790,000 + CU1,770,000) at t1.
Based on the same ranking, for t1 choose 100% Swansea and use the balance (CU950,000) to fund
Bristol, i.e. (higher ranking than Bristol) and do 73.6% (CU950/CU1,290) of it. Thus the total NPV
would be:
CU'000
Tiverton 1,664
Swansea (100%) 2,856
Bristol (73.6%  CU577,000) 425
Gloucester (632)
4,313
Thus it is preferable if the Gloucester project is taken on as this produces the higher total NPV.
(b) Capital rationing of CU9m in t0, but projects not divisible:

Only choose the projects with positive NPVs, i.e. Bristol, Swansea or Tiverton. The highest NPV is
generated from Swansea (and is higher than Bristol and Tiverton added together). Thus the NPV
would be CU2,856,000.
(c)
PV PV PV Eq. Ann
CU CU factor (CU) factor Cost
Replace vans after one year
t0 Cost of van (12,400) 1.000 (12,400)
t1 Maintenance costs (4,300)
Resale value 9,800
5,500 0.909 5,000
(7,400) 0.909 (8,140)
Replace vans after two years

t0 Cost of van (12,400) 1.000 (12,400)
t1 Maintenance costs (4,300) 0.909 (3,909)
Resale value 7,000
2,200 0.826 1,818
(14,491) 1.735 (8,352)
Replace vans after three years
t0 Cost of van (12,400) 1.000 (12,400)
Resale value 5,000
(100) 0.751 (75)
(20,349) 2.486 (8,185)
Thus the cheapest option for Daniels is to replace the vans every year as this produces the lowest
Equivalent Annual Cost (EAC). However it should be noted that this is by no means a clear decision,
as a three-year cycle produces only a slightly higher EAC.
Limitations
 Changing technology, leading to obsolescence, changes in design
 Inflation – affecting estimates and the replacement cycles
 How far ahead can estimates be made and with what certainty?
Note: A further limitation is the ignoring of taxation, which the candidates were told to do.
(d) The PV of the two investments should be considered:
Original situation Proposed change
Cash 10% PV Cash 10% PV
Flow factor Flow factor
Year 1 – 7 190,000 4.868 925,000 Year 1 925,000 0.909 840,825
The NPV is higher if Daniels maintains the current cash flow profile and so is better off not accepting
Kithill's proposal. The IRR might be higher by accepting, but the NPV is the key measure and should be
followed.
ANSWER BANK
Marking guide
Marks
(a)
(i) Reasoning: 1 Figures: 1 2
(ii) Method and figures: 2 Ranking: 1 3
(iii) Method: 1 Calculations: 2 Conclusions and reasoning: 2 5
10
(b) Reasoning: 2 Conclusion: 1 NPV: 1 4
(c) Calculations: 4 Limitations: 2 6
(d) PV calculations: 3 Conclusion and reasoning: 2 5
25
22 Pretorius Ltd
(a) Material A: 100 tonnes required CU
40 @ resale value = 40  CU110 4,400
60 @ purchase cost = 60  CU140 8,400
The relevant cost of the 40 tonnes already in stock is its net realisable value.
The relevant cost of the 60 tonnes to be purchased is its current replacement cost.
Material B: 130 tonnes required
130 @ current purchase price = 130 × CU50 6,500
The relevant cost of the 130 tonnes is its current replacement cost.
Material C: 80 tonnes required
Use as substitute for D = 80  CU30 2,400
Disposal of the 80 tonnes would yield a net CU20 per tonne, whilst use of the 80 tonnes
as a substitute for material D would yield a net CU30 per tonne. The latter is the
preferable option, so this is the opportunity cost of using it on this contract.
Skilled labour
Replacement for 3 employees
3  CU250  52 weeks 39,000
New employee – 52 + 1 week training
1  CU300  53 weeks 15,900
The incremental impact of recruiting three new employees is CU250 per week per employee.
The incremental impact of recruiting the fourth employee is CU300 per week for 53 weeks.
Supervisor – assuming he/she would be employed regardless
Overtime 500
The only incremental cost in respect of the supervisor arising from undertaking this
contract is his overtime.
Overheads (additional cost only) 5,000
The company's internal allocation of overheads is irrelevant. The only relevant cost is
the incremental impact of the new contract.
Machine
Sub-contract work (only the opportunity cost is relevant) 4,000
Total relevant cost 86,100
Profit margin – this is irrelevant and can be ignored in light of the stated objectives of
the directors.
Contract price 100,000
Surplus 13,900
Therefore, on the basis of the financial information available, the contract should be accepted as it will
generate a cash surplus for the company of CU13,900.
(b) Reliability of the data provided needs to be considered.
Availability of resources (both materials and labour – willingness to work overtime).
Likelihood of meeting deadlines – impact of any potential penalties?
Is machine sub-contract work readily available?
Potential future business opportunities
Possible consideration of the time value of money
Possible impact of finance charges/tax/cash flows and liquidity (payment by instalments?)
Possible impact on other projects or on competitiveness
Creditworthiness of other party?
Marking guide
Marks
(a) Total relevant cost calculations (1 per line): max 11 Conclusion: 2 13

17
23 Headington Ltd
(a) Year
0 1 2 3 4 5
Investment (750,000)
Opportunity cost (89,250) (93,713) (98,399) (103,319) (108,485)
Extra revenue (EV) 816,480 857,304 900,169 945,178 992,437
Variable costs (408,240) (428,652) (450,085) (472,589) (496,219)
Fixed costs (89,250) (93,713) (98,399) (103,319) (108,485)
Taxable CF (750,000) 229,740 241,226 253,286 265,951 279,248
Tax (30%) (68,922) (72,368) (75,986) (79,785) (83,774)
Tax Saved on TDAs 56,250 42,188 31,641 23,731 17,798 15,105
Residual proceeds 127,628
NCF (693,750) 203,006 200,499 201,031 203,964 338,207
df (10%) 1 0.909 0.826 0.751 0.683 0.621
DCF (693,750) 184,533 165,612 150,974 139,307 210,027
NPV 156,703
The investment is financially viable and from that perspective should proceed.
Omission of the sunk cost in respect of the market research.
ANSWER BANK
Note:
TDAs 187,500 140,625 105,469 79,102 59,326 50,350
(Bal All)
(b) The net after-tax present value of the contribution is as follows.

Contribution Tax payment C/F df PV
(30%)
Year 1 408,240 122,472 285,768 0.909 259,763
2 428,652 128,596 300,056 0.826 247,846
3 450,085 135,026 315,059 0.751 236,609
4 472,589 141,777 330,812 0.683 225,945
5 496,219 148,866 347,353 0.621 215,706
Total 1,185,869
The NPV of the investment is CU156,703, so the present value of the contribution can reduce by this
amount before the NPV becomes negative. In other words, the present value can fall by 13.2%
(156,703/1,185,869 × 100).
(c) The reservations in respect of the figures used in the calculation of the net present value of the
investment would be as follows.
 The presumed stability of the inflation rate, the discount factor and the tax rate
 The accuracy of the discount factor used – we are not told how it has been derived nor whether
the impact of this project on the firm's cost of capital has been considered
 The accuracy of the estimates for residual value of equipment and incremental fixed costs
 While the expected value of revenue calculation is based to some degree on probabilities, they
are subjective and the calculation is not based on a full probability distribution
 The presumption that the opportunity cost will be valid for a five-year term
 The presumption of a stable contribution/sales ratio throughout the five-year term
Marking guide
Marks
(a) Calculations: 1 per line. Conclusion: 1 max 11

(b) Calculations: 1 per line. Conclusion: 1 max 5
(c) I mark per point max 3
19
24 Channel 14 Ltd
(a) It would be worth purchasing new equipment – the NPV is higher (CU3.769m compared to
CU2.517m).
NPV of purchasing new equipment (see Working 1)
20X7 20X8 20X9 20Y0
t0 t1 t2 t3
CU'000 CU'000 CU'000 CU'000
Sale of old equipment 25,000.0
Tax saved on balancing allowance (W3) 937.5
Cost of new equipment (65,000.0)
Sale of new equipment 30,000.0
Tax saving/(cost) on new equipment 4,875.0 3,656.3 2,742.2 (773.4)
Annual savings of new equipment 5,000.0 5,000.0 5,000.0
Tax on annual savings (30%) (1,500.0) (1,500.0) (1,500.0)
Total cash flow (34,187.5) 7,156.3 6,242.2 32,726.6
8% discount factor 1.000 0.926 0.857 0.794
Present values (34,187.5) 6,626.2 5351.7 25,979.4
NPV 3,769.8
NPV of keeping old equipment (see Working 2)

20X7 20X8 20X9 20Y0
t0 t1 t2 t3
CU'000 CU'000 CU'000 CU'000
Tax saving on old equipment 2,109.4 1,582.0 1,186.5 3,559.6
Transfer/installation costs (7,000.0)
Tax on transfer/installation costs (30%) 2,100.0
Total cash flow (2,790.6) 1,582.0 1,186.5 3,559.6
8% discount factor 1.000 0.926 0.857 0.794
Present values (2,790.6) 1,464.8 1,017.3 2,825.7
NPV 2,517.2
WORKINGS
(1) – New equipment
20X7 20X8 20X9 20Y0
t0 t1 t2 t3
CU'000 CU'000 CU'000 CU'000
Cost/NBV b/f 65,000 48,750 36,563 27,422
TDA @ 25%/Balancing charge (16,250) (12,188) (9,141) 2,578
WDV/Disposal value 48,750 36,563 27,422 30,000
Tax on tax depreciation (30%) 4,875.0 3,656.3 2,742.2 -773.4
ANSWER BANK
(2) – Old equipment

20X7 20X8 20X9 20Y0
t0 t1 t2 t3
CU'000 CU'000 CU'000 CU'000
Cost/NBV b/f [CU50m × 75% × 28,125 21,094 15,820 11,865
75%]
TDA @ 25%/Balancing charge 7,031 5,273 3,955 11,865
WDV/Disposal value 21,094 15,820 11,865 0.0
Tax on tax depreciation (30%) 2,109.3 1 582.0 1,186.5 3,559.5
(3) – Tax saving (on balancing allowance) if old equipment sold in 2008
CU'000
NBV b/f 1/1/07 (CU50m × 75% × 75%] 28,125
Sale proceeds 2007 (25,000)
Balancing allowance 3,125
Tax saved on balancing allowance (@30%) 937.5
(b) By using the new equipment, the total net present value of the proposed move would be CU2,004,200
positive, would increase shareholder wealth and should therefore be taken on.
20X7 20X8 20X9 20Y0
t0 t1 t2 t3
CU'000 CU'000 CU'000 CU'000
Savings on programme making 1,100 1,100 1,100
Hire charges 1,900 1,900 1,900
Staff relocation costs (2,000)
Staff redundancy cost (1,500)
Bolton rental costs (2,200) (2,200) (2,200)
Savings on London rental costs 4,200 4,200
1,000 1,000 1,000
Savings on staff costs (3,500) 1,800 6,000 6,000
Total cash flows 1,050 (540) (1,800) (1,800)
Tax on cash flows (30%) (2,450) 1,260 4,200 4,200
Net cash flows 1.000 0.926 0.857 0.794
8% discount factor (2,450) 1,166.7 3,600.8 3,334.1
Present values (CU'000) 5,651.6
Net present value (CU'000) 3,769.8
New equipment NPV (CU'000) 9,421.4
less: PV costs of foregone tax

savings on
old equipment [per (a) in W2]* (7,417.2)
Total NPV (CU'000) 2,004.2
* = (2,109.4)+(1,464.8)+(1.017.3)+(2.825.7)
(c) Shareholder Value Analysis (SVA) concentrates on a company's ability to generate value and
thereby increase shareholder wealth. SVA is based on the premise that the value of a business is equal
to the sum of the present values of all of its activities. SVA posits that a business has seven value
drivers:
 Life of projected cash flows
 Sales growth rate
 Operating profit margin
 Corporate tax rate
 Investment in non-current assets
 Investment in working capital
 Cost of capital
The value of the business is calculated from the cash flows generated by drivers 1 to 6 which are then
discounted at the company's cost of capital (driver 7).
The Marketing Director's statement implies that he has superior knowledge than do those who, by
their actions (i.e. buying and selling in the stock market) influence share prices.. Evidence on the
efficiency of the capital market suggests that this is only likely to be true if the person making the
statement has 'inside knowledge'. Otherwise the evidence shows that the market knows best on
average. It is feasible that, as the market is 'semi-strong form' efficient the director and his colleagues
will have information that gives a more accurate figure of the value of C14.
Marking guide
Marks
(a)
(i) NPV for purchase of new equipment 4
(ii) NPV for keeping old equipment 4
(iii) Workings 3
11
(b) 1 mark per line max 8
(c) 2 marks per paragraph max 5
24
ANSWER BANK
25 Oxfield Ltd
(a) WACC
D1 18 (1.07)
Ke = +g= + 0.07 = 0.1617 = 16.17%
P0 210
Kd = IRR of relevant cash flows from the company's perspective.
Consider a CU100 nominal value block of loan stock.
t Narrative CF DF PV DF PV
@ 5% @ 5% @ 7% @ 7%
0 Market value 97 1 97.00 1 97.00
1-3 Interest, net of corporation tax (5.04) 2.723 (13.72) 2.624 (13.22)
3 Redemption (105.00) 0.864 (90.72) 0.816 (85.68)
(7.44) (1.90)
(  7.44)  (7  5)
Kd = IRR ~
– 5+ = 7.685%
(  7.44  1.9)
MVequity  K e  MVdebt  K d
WACC =
MVequity  MVdebt
(160m  2.10 16.17%)  (67m  97%  7.685%)

=
(160m  2.10)  (67  97%)
= 14.79%
Assumptions/explanations
(i) The formula for Ke assumes that future growth in dividends will be constant.
(ii) The use of 7% for the growth rate assumes that past growth will be continued in the future.
(iii) In the Kd calculation it has been assumed that the interest is an allowable deduction for tax and
that there is no delay on the tax. Thus the post tax interest figure used is
7.2% × 100 × (1 – 0.3) = CU5.04 pa.
(iv) Tax is assumed to remain at 30% for the next three years.
(v) That the current share price is fair and not distorted by short-term market factors.
(vi) That the dividend valuation model is valid.
Basis of weightings
(i) Both costs of capital (Ke and Kd) and the WACC have been calculated using current ex-dividend
(ex-interest) market values, rather than balance sheet/nominal values.
(ii) This is to ensure that a current market cost of finance is determined, rather than an historic cost.
Ideally a future WACC is wanted to discount future project cash flows, and the current WACC
based on current market rates is the best estimate for this.
(b) Criticisms
The existing company WACC reflects the company's current gearing level and its existing Ke and Kd.
The Ke in turn reflects the shareholders' risk perception of the company's existing activities.
Thus the existing WACC is only suitable for project appraisal if the following apply.
(i) The project has the same business risk as the company's existing activities, so that overall
business risk is unchanged
(ii) The project is financed by a mixture of debt and equity, so as to leave the company's gearing
unaltered
(iii) New debt can be issued at the same cost as the existing loan stock.
These conditions may be relaxed if the project is small, as business risk and gearing do not change
much and/or if finance is deemed to come out of the 'pool' so any change in gearing is seen to be
short-term. However, in this case Oxfield is to undertake a 'major' investment, so the above three
concerns must be addressed.
The size of the investment may be such that a public issue of shares would be required for equity
finance. These new shareholders may have a different risk perception of the company and project than
existing shareholders, so the company Ke would change, again invalidating the existing WACC.
(c) CAPM
CAPM could have been used to estimate a project–specific Ke if the project activities were different
from that of the company. This could then have been used to calculate a project specific WACC.
The method for this would have been as follows.
(i) Find a listed company with activities similar to those of the project.
(ii) Look up its beta factor.
(iii) Adjust for gearing if necessary.
(iv) Put into the CAPM equation.
Project Ke = rf + ß (rm – rf)
Note: rf could be calculated by looking at yields on Government gilts.
rm could be calculated by looking at movements on the FT all share index.
The model's strengths and weaknesses include the following.
Strengths Weaknesses
 Gives a risk-adjusted discount rate specific  Only appropriate for well-diversified
to the project's activities. shareholders.
 Books of betas are readily available.  Published betas are calculated by looking at
past share price movements. The discount
rate is thus of limited use for future project
appraisal.
(d) WACC and gearing

There are two theories linking a company's WACC and its gearing ratio.
(i) The traditional theory of gearing proposes a 'U' shaped WACC curve.
ANSWER BANK
Cost of capital
K equity
WACC
K
debt
Debt
G1 Gearing =
Equity
Thus if Oxfield is already at its optimal gearing level, G1, then any change in gearing will cause the
WACC to increase. If Oxfield is not already at optimal gearing, then were the change in gearing
to move it closer to G1 the WACC would drop, but if further away from G1 the WACC would
rise.
(ii) Modigliani and Miller ('M&M')
M&M predicted that with corporation tax, but without personal tax, firms should gear up as
much as possible.
Cost of capital
K equity
WACC
K
debt
Debt
Gearing =
Equity
Thus if Oxfield were to increase its gearing its WACC would drop, and a fall in gearing would
increase the WACC.
In practice the impact of a change in gearing would depend on market reaction.
Debt
(1) Oxfield's current gearing level =
Equity
67m  97%
=
160m  2.10
64.99
=
336
= 0.19, or 19%
This appears low.
(2) If Oxfield were to move to a gearing level higher than the industry average, the WACC
could increase as the company is perceived as being more risky.
Marking guide
Marks
(a) Calculations 3½
Assumptions/explanations 2½
Basis of weightings 1
7
(b) 1 mark per valid point max 7
(c) Explanations 1
CAPM equation 1
Strengths/weaknesses 3
5
(d) (i) 2½
(ii) 2½
5
24
26 Yollo Ltd
(a) Calculation of the weighted average cost of capital
Cost of equity
d (1  g)
Ke = +g
P
where g = rb
r = 0.25 = return on new investment
b = 0.40 = proportion of earnings retained
Thus
g = 0.25 × 0.4
= 0.1
240,000 (1.1)
 Ke = + 0.1
1.5  4m
= 0.044 + 0.1
= 14.4%
ANSWER BANK
Cost of preference shares

100,000
KP =
1,100,000 – 100,000
= 10%
Value of debt
160,000 (0.7) 160,000 (0.7) 2,100,000
Vd = + +
(1.09) 2
2
(1.09) (1.09)
112,000 2,212,000
= +
(1.09) (1.09) 2
= CU1,964,548
WACC
Market value Cost of capital Weight Weighted cost
CU % %
Equity 6,000,000 14.4 6,000,000 9.638
8,964,548
Preference shares 1,000,000 10.0 1,000,000 1.116
8,964,548
Debt 1,964,548 9.0 1,964,548 1.972
8,964,548
8,964,548 12.726
Thus WACC = 12.726%
(b) Arriving at an appropriate discount rate
(i) Accountant's comments
The cost of a particular form of finance used for a new project is not usually the appropriate rate
to use for discounting.
The providers of finance are subject to the risk of the company being unable to repay debt or
make an adequate return on equity rather than separately being repaid from the cash flows of the
project (non-recourse finance is an exception to this general rule).
As such the accountant's suggestion of merely attempting to cover interest payments is not
appropriate, as additional debt would increase the financial risk of existing equity holders both by
increasing the variability of their residual returns and by representing a prior charge over assets
in the case of liquidation. The required return of equity holders is therefore likely to increase as a
result of financing this project by debt.
In a perfect M&M world without taxes the marginal increase in equity will precisely balance the
lower cost of debt, leaving the weighted average cost of capital constant. Given this, the marginal
cost of capital would be the weighted average cost of capital, rather than merely the cost of debt
as suggested by the accountant.
Finance director's comments
The above argument would appear to suggest that the finance director is correct in proposing
that the WACC be used in NPV calculations for the new project. This needs to be qualified,
however, in a number of ways.
First, the risk of the new project appears to be substantially higher than the risk of the average of
existing projects. It is clear that the existing portfolio of projects and the profit arising from them
is stable and seems likely to continue to be so given that they are based on long-term contracts.
Conversely, however, the new project is a departure both into new markets and new production
techniques, presumably with associated capital investment up-front which may not be recoverable
if the project fails. The risk of the new project would thus demand a higher rate of return than
that of the existing projects. This is likely to raise the overall cost of capital beyond the current
level of 12.726%.
Nevertheless it would be inappropriate to use even the new cost of capital as this would be the
average overall change. What is really needed is the marginal return required as a result of the
new project.
Given that the company is listed, it may be appropriate to estimate the required return on the
new project using CAPM, as it is the stock market that sets share prices and thus prices risk.
In so doing it is not the risk of an individual project that is the main issue but the marginal impact
on the risk of a diversified portfolio of shares. Thus, project specific risk would not demand a
price as it can be diversified away. As such, it is necessary to consider the correlation of returns
of the new project with those of the stock market as a whole, i.e. the systematic risk. It is not
easy to forecast betas with respect to a prospective project but one possibility is to consider the
share prices of companies engaged solely, or largely, in a similar industry.
Another is to consider the extent to which the returns of the project vary in relation to the
macroeconomic factors that drive share prices generally (growth, interest rates, exchange rates,
inflation, fiscal policy). To the extent that these could be estimated, an approximate required
return figure could be calculated and used as a discount rate in NPV calculations.
(ii) Debt
The cost of debt may change from the current figure of 9% if the new debt is of a different risk
class to the existing debt. This may arise because of the following.
 The period to maturity and thus exposure to risk
 The seniority of the debt, e.g. does it rank equally with existing debt?
 The availability of restrictive covenants to protect lenders
 The quantity and quality of the available security on the debt
 The risk of the company's cash flows changing over time
Preference shares
New debt would rank in front of preference shares both in terms of right to income and to
terms of claims on assets on a winding up. If the amounts of a new debt were significant this
might mean the price of preference shares falling as a result of an increase in the required rate of
return. The operating risk of the project would also suggest that the cost of preference capital
would increase further.
Cost of equity
New debt would similarly rank in front of equity shares both in terms of right to income and in
terms of claims on assets on a winding up. Again, this would mean an increase in the required
cost of equity in response to the increase in financial risk. The operating risk of the project would
also suggest that the cost of equity would increase further.
WACC
In a perfect M&M world without taxes one would expect that the lower cost of debt would be
precisely offset by the increases in the cost of other forms of capital, leaving the WACC
constant. There are two major reasons why this might not be the case.
 The operating risk of the project appears to be higher than the weighted average operating
risk of existing projects which would have the effect of pushing WACC upwards.
 The tax benefit of more debt would push WACC downwards.
 The failure of any of the other M&M assumptions to apply would mean that the M&M
conclusion of constant WACC may fail to hold.
ANSWER BANK
Marking guide
Marks
(a) Cost of equity

Equation 1
rb figures 2½
g 1
Ke 1
Cost of preference shares 1
Value of debt 2½
WACC 2
11
(b) (i) 1 mark per point max 6
(ii) 2 marks per point max 5
11
22
27 Navarac Ltd
(a) NPV
Differential costs of bailing out
31 December 20X3 20X4 20X5 20X6
CU CU CU CU
Disposal proceeds 150,000
Tax depreciation 12,656 (7,031)
Tax depreciation forgone (12,656) (9,492) (7,119) (21,357)
Contributions forgone (72,000) (72,000) (45,000)
Tax on contributions avoided 21,600 21,600 13,500
Working capital 7,200 (2,700) (4,500)
157,200 (66,923) (60,219) (57,357)
Discount factor (15%) 1.000 0.870 0.756 0.658
Present values 157,200 (58,223) (45,526) (37,741)
Net present value = CU15,710
Therefore, 'bail out' of the project at the end of 20X3, disposing of the machine on 1 January 20X4.
WORKINGS
Year CU CU
20X0 Cost 400,000
TDA (25%) 100,000
20X1 300,000
TDA (25%) 75,000
225,000
20X2 TDA (25%) 56,250
168,750
Either
20X3 Disposal proceeds 150,000
Balancing allowance 18,750 @ 30% 5,625
or
20X3 TDA (25%) 42,188 @ 30% 12,656
126,562
20X4 Disposal proceeds 150,000
Balancing charge 23,438 @ 30% (7,031)
Therefore retain the machinery until 1 January 20X4 if the decision is made to bail out at the end
of 20X3. This is because, although the total cash flow relating to the tax depreciation is the same,
a 20X4 disposal gives a more beneficial timing.
CU CU
or
20X3 TDA (25%) 42,188 @ 30% 12,656
126,562
20X4 TDA (25%) 31,641 @ 30% 9,492
94,921
20X5 TDA (25%) 23,730 @ 30% 7,119
71,191
20X6 Disposal proceeds Zero
Balancing allowance 71,191 @ 30% 21,357
(2) Contributions
Labour cost per unit of WX14 = CU(200 – 80 – 90) = CU30. Thus for each WX14 produced,
one unit of AP25 as its labour cost is also CU30. Labour cost is common, so net contribution per
WX14 = CU(110 – 80) = CU30.
Year Units Contributions
CU
20X4 2,400 × CU30 72,000
20X5 2,400 × CU30 72,000
20X6 1,500 × CU30 45,000
(3) Working capital
Flows if production had continued
20X3 20X4 20X5 20X6
CU CU CU CU
Amount of working capital required 7,200 7,200 4,500 Nil
Flow (7,200) – 2,700 4,500
If production ceases, these flows are reversed.
(4) Cost of capital
5% + 1.25 (13% – 5%) = 15%.
(b) CAPM
CAPM is a device for determining the investors' required return from risky investments, both real and
financial. It is based on the assumption that investors hold 'efficient' portfolios, i.e. portfolios of
investments that have all specific risk eliminated from them through diversification.
Specific risk is that part of total business risk that relates to the particular investment concerned. This
means that CAPM assumes that investors bear systematic or market risk, i.e. the risk that all
investments bear, but not all investments bear the same amount of it.
CAPM says that investors should expect to receive the risk-free rate, plus a risk premium. The risk
premium should be based on the premium available for the average investment, scaled up or down
according to how risky the particular investment is relative to the average investment. This relative
(systematic) riskiness is measured by a factor known as beta. Thus CAPM adds (or, in theory, could
subtract) a market-derived cost of risk to the risk-free rate.
Is the use of CAPM entirely suitable in the case of Navarac Ltd's investment decision? This is an
unlisted company, so it may very well be that the shareholders are not well diversified at a portfolio
ANSWER BANK
level. On the other hand, unlisted companies have a problem with estimating their cost of capital, so
CAPM has some appeal, but the results from using CAPM need to be adjusted. Unfortunately, the
adjustment will have to be subjective.
The company would probably have found listed companies, for which there would be information on
the beta, similar to Navarac Ltd, and based the risk premium on the betas of those companies. For the
risk-free rate, probably a long-term historic rate on government securities would have been used.
Similarly, the expected return from the market portfolio (the average investment return) would
probably have been based on long-term historic equity returns. The resulting figure should probably be
adjusted upwards to recognise that smaller companies need higher returns than larger companies.
Marking guide
Marks
(a) NPV 5
Tax depreciation 6
Contributions 4
Working capital 2
Cost of capital 17
(b) 2 marks per paragraph max 7
24
28 Terry Ltd
(a) Gains for (1)
CU225,000
Required return of ordinary shareholders =  100
(1m  CU1.725)  CU225,000
= 15%
New dividend = CU(225,000 + 56,000)
= CU281,000
CU
CU281,000
New total market value of ordinary shares (ex div) 1,873,333
0.15
Less Amount raised by rights issue (225,000)
1,648,333
Less Old market value (ex div) (1,500,000)
Gain 148,333
(No reduction in current t0 dividend of CU225,000)

Project NPV
56,000
(225,000) + = CU148,333
0.15
(b) Gain to current shareholders

If all the gain goes to the current shareholders, their 1 million shares will be worth CU(1,500,000 +
148,333) = CU1,648,333, a market value of CU1.6483 per share.
Since none of the gain goes to the new shareholders and their shares will also have a market value of
CU1.6483 each, this must be the issue price. (Note that as the shares are currently valued at CU1.50
ex div, it is unlikely that the issue will succeed!)
CU225,000
The number of shares to be issued is therefore = 136,502.
CU1.6483
(c) Split gain
CU225,000
= 180,000 new shares will be issued at CU1.25 each, a total of 1,180,000 shares.
CU1.25
New total market value of ordinary shares ex div (as for (a)) = CU1,873,333
CU1,873,333
Market value per share = CU1.58757
1,180,000
Gain/loss to current shareholders
CU
New market value 1m × 1,587,570
CU1,873,333
1,180,000
Less Old market value (1,500,000)
Gain 87,570
Gain to new shareholders
CU
Market value 180,000 × 285,763
CU1,873,333
1,180,000
Less Amount raised (225,000)
Gain 60,763
Note: The total net gain is CU(87,570 + 60,763) = CU148,333 as in (a).
(d) Price and timing of a rights issue
These two factors are inter-related, but it is probably easier to discuss the timing first.
The reason for the rights issue will affect its timing. For example, funds for the overseas expansion
may be required quickly if the company is attempting to beat its competitors into a new market. In
other cases it may be less urgent, for instance if it intends to take over existing companies.
Firms usually try to make a share issue when the market price of their shares is high, reflecting good
accounting results, and when the stock market is generally rising. There are various reasons for this.
It is important that the shareholders are confident in the future prospects of the company, so that
they would all wish to subscribe if they could raise the money. It is also possible to issue fewer shares
if the price is high, thus decreasing issue costs. Furthermore, a rising stock market means that there is
less chance that the market price of the shares falls below the issue price, which would undermine the
issue.
However, the reason which is often stated, that it is better to issue at a high price because this
minimises the cost of paying dividends on the shares (i.e. fewer total shares in issue and dividend needs
to be maintained), conflicts with the theory of rights issues which suggests that the price is irrelevant.
As to the issue price, in theory the price is unimportant; however, there are opposing factors working
towards issuing at a higher or lower price.
ANSWER BANK
The main factor favouring a low issue price is that there would be very little chance of the current
market price falling below the issue price in the period between the announcement and the issue. The
factors causing a fall in market price might be a downturn in the whole market or a lack of certainty as
to the reasons for the issue if the market were surprised by the announcement.
If the issue price is low enough it may be possible to avoid underwriting, which amounts to more than
2% of the proceeds. Merchant bankers and brokers would obviously not advise this course because
they would lose their commission, but theoretically there is no need for underwriting a rights issue if
the issue price is below market price and if investors act rationally by taking up or selling their rights.
The factors favouring a higher issue price have already been mentioned in the context of the timing of
the issue. Some issue costs will be saved and, if the company wishes to maintain its dividend per share,
the cost will be less. However, there is no rational need to maintain dividend per share if the issue
price is cheap.
Marking guide
Marks
(a) Calculations 4
(b) Gain to current shareholders 3
(c) Split gain 2
Gain to current shareholders 1
Gain to new shareholders 1
4
(d) 1 mark per paragraph 6
17
29 Ellis Ltd
Notes for initial family briefing
General
 Assumes expansion is desirable for the company.
 The family's interests as shareholders may differ from those of the management.
 Needs clear understanding by family of what/how to invest in new funds; discounting; sensitivity, as this
strategy carries a risk that it may not succeed.
Director A
 Venture capital is 'the provision of risk-bearing capital, usually in the form of participation in equity, to
companies with high growth potential'. That is, the venture capitalist will often provide funds in return
for shares, a seat on the board and a clear route to sell its shares in the medium term.
 Venture capital may be difficult to raise in current market conditions; may be expensive to raise; not
easy for a medium-sized company to raise, but it is potentially cheap and flexible funding.
 It will give away control of the company (or at least provide much more information). Venture
capitalists are likely to want capital growth.
Director B
 Organic growth is the retention of profits and/or raising new finance to fund internally generated
projects, e.g. new product development. It normally implies a relatively slow rate of growth.
 Such organic growth is superficially less risky to the family but what about the company and its long-
term future? (May be risky not to innovate and/or grow.)
 Bank borrowings can be inflexible; must provide security; interest is a 'fixed' cost compared to
discretion over dividend payments.
 Strategy is one of seeking long-term dividends/income rather than capital growth (Modigliani and Miller
assumption that the shareholders can sell shares will not apply, as not easily sellable).
Director C
 Sale and leaseback is the raising of funds by selling assets of the business and then leasing them back.
Often this will involve the sale of premises to a financial institution.
 No guarantee that marketing will necessarily increase sales; needs clear plan for spend and evaluation
of proposal.
 Sale and leaseback can be a risky way to raise funds; cedes control of key assets; interaction with
other forms of borrowing restricts choices but a good way to raise significant cash, if required.
(Unlikely that this much cash would be needed merely for a marketing campaign.)
 Sale of company = capital growth strategy. Implies loss of control by family – do they want this?
Marking guide
Marks
General 2
Director A 2½
Director B 4
Director C 3½
12
30 Personal investment
Banks and building societies
When you put money into a bank (or building society), you are lending money to it. It uses this cash to
make loans to other people and businesses. The bank will pay you interest on your deposit to encourage
you to do so. It charges interest to those to whom it lends. On this aspect of its business the bank makes a
profit from this. You are a customer of the bank and the reward (interest) that you get is not linked to the
profit that the bank makes.
There are no guarantees, but the major Bangladesh banks and building societies provide a very safe deposit
for your money. At the same time the rates of interest are very low. This partly reflects the fact that
returns are safe. Risk and return tend to be linked.
Interest rates are low at present, by historical standards, but they reflect low expectations of price inflation.
In reality you are probably not worse off by having your funds in a bank deposit account now than you were
a few years ago.
Shares
When you buy shares in a company, you become a part owner of that business. The benefits that you get
from ownership depend entirely on how profitable the company is.
Shares are slices of the ownership of the company. When you buy shares through the Stock Exchange you
are buying them from some person or investing institution (like an insurance company) that has decided to
sell its stake, or part of it, in the ownership of the company. You merely replace the previous owner of the
shares as a part owner of the company.
ANSWER BANK
Sometimes companies expand by inviting investors to buy new shares that it issues. Here investors would
be buying new shares rather than 'second hand' shares from an existing shareholder.
Company profits and dividends
As already said, shareholders share in the profits made by the company in proportion to how many of the
total shares they own individually. Most companies whose shares are available to buy through the Stock
Exchange reinvest much of their profits in an attempt to generate greater future profits for their
shareholders. Most of them also pay part of the profit as a cash dividend to their shareholders, according to
how many shares each owns.
Dividends are not guaranteed. If a company makes no profit there would usually be no dividend, though
companies are allowed to pay dividends using funds generated from previous years' profits. Even where
profits are good, the directors may feel that reinvesting all of those profits and not paying any dividend will
serve the shareholders' best interests.
In theory, the dividend should be dependent on the amount of funds available and the investment
opportunities available to the business. If there are lots of profitable opportunities, no dividend would be
payable. The larger, better known companies, like Sainsco, usually pay part of their profit as a dividend,
partly because they know that many, perhaps most, of their shareholders need a regular stream of cash.
Companies seem reluctant to fail to pay any dividend. They seem to pay fairly steady dividends from one
year to the next, with relatively small increases from time to time. Whether the company pays a dividend
or not, the profits generated belong to the shareholders; so, if they are not getting a dividend, the value of
their shares should be increasing.
When you buy your shares you will have to pay the current market price. That price will depend on general
expectations of the future economic prospects for the company concerned. This, in turn, will depend on
such things as the perceived quality of the management, the future market for the product or service that
the company sells etc. No one knows what will happen in the future, but the price of a share at any
moment should represent the consensus view on what the share is worth taking account of the prospects
for the company. There is strong evidence that the price of a share at any time is a fair representation of its
fair value according to the information available.
Share prices alter on a minute-to-minute basis, according to investors' perceptions of their fair value. This
means that when you come to sell your shares, they may not be worth as much as you hope, or even as
much as you paid for them.
Risk and return
The rewards of share ownership are a combination of the dividends received plus any increases (less any
decreases) in the price of the shares. There are no guarantees. History shows that on average investing in
shares yielded significantly higher returns than putting your money in the bank. Despite this, over particular
short periods and with the shares of particular companies, investment in shares has been less rewarding
than bank interest.
Sainsco
Evidence shows that newspaper tips and advice of any 'experts', on individual shares, are not worth
following and that they will only be correct by chance. If Sainsco is a well-run company with a profitable
future, neither the newspaper tipster, nor you will be the only people to notice this. This information will
already be reflected in the share price. This is not to say that Sainsco does not represent a good
investment, but if the shares of all companies are fairly priced, then this will be equally true of all of them.
Share prices reflect expected returns.
Eggs and baskets
You would be ill-advised to put all of your money into the shares of one company. Evidence shows that
spreading your funds between 15 or more different shares can eliminate some of the risk of owning shares.
If the amount of funds that you have to invest is small, it may be uneconomic, in terms of agents' fees, to
spread your investment funds so thinly.
In this case it is possible to achieve this risk diversification by pooling your funds with those of other small
investors. Funds (unit trusts etc) are available for this. The disadvantage of this is that the managers of the
funds take a fee out of your investment for running the funds. These fees vary from fund to fund, so it may
be valuable to shop around.
Marking guide
Marks
Banks and building societies 2

Shares 3
Company profits and dividends 3
Buying and selling shares 3
Risk and return 1
Sainsco 2
Diversification 2
Maximum 16
Total available 14
31 Sheridan Ltd
Briefing notes
A substantial investment such as that proposed may be seen as increasing the business risk of the company,
despite the fact that the company being acquired operates in the same sector. This could increase the
required return of both shareholders and lenders.
Issuing more debt could reduce the average cost of capital, although an expansion of this size, funded
entirely by debt, could push up the cost of capital rather than reduce it.
The company may well be below its optimal capital gearing level at the present time and while the precise
optimal level is a matter of judgment (based on likely market response to particular capital structures),
forming that judgment must take account of Sheridan's current level of gearing as well as the sector average.
With regard to the comments by Director C, in theory gearing makes no difference to the wealth of
shareholders in the absence of taxes (M&M) – cheaper loan finance has a positive impact that is precisely
cancelled out by the higher returns required by shareholders in the face of higher risk.
However, taking account of the tax deductibility of loan interest, gearing favours shareholders, although at
higher levels of gearing the risk of non-servicing of interest commitments could impact adversely on
shareholder wealth via liquidation. Gearing policy, therefore, appears to be about striking a balance between
the benefits of tax relief and the potential costs of bankruptcy.
Rights issue
This is relatively cheap to issue and not as difficult to price compared to a public issue.
If fully taken up it will not change the control of the company and existing shareholders will retain all the
benefits of the acquisition.
There would, however, be no benefit from cheaper debt finance.
Investors need not lose out if they do not wish to participate as they can sell their rights (market efficiency
will dictate a price at which they will not lose out). Existing investors will only lose if they neither take up
nor sell their rights.
Equity is rather more expensive than loan finance as investors expect higher returns than they do for loans,
given that the returns are more risky and paid after the payments to lenders.
ANSWER BANK
The comment made by Director A is somewhat illogical – market efficiency theory (and evidence) suggests
that whatever the current share price, it represents the best unbiased estimate of a share's worth based on
available evidence.
Unlike interest, dividends are not, in theory, a fixed commitment.
Loan stock or bank loan
Either would be cheaper to raise and service relative to equity, as it offers a fixed income to providers,
which is paid ahead of equity shareholders and for which they are prepared to accept a lower level of
return. However, it is often seen as more risky than equity.
With regard to the comments of Director B, the driver of EPS or share price is not how a project is
financed but the nature of the project itself – as long as it has a positive net present value it will generate
returns for shareholders over and above their required minimum return and should therefore increase both
earnings and share price.
The use of debt finance instead of equity should result in a lower overall average required rate of return
and, correspondingly, a higher share price.
This is a large acquisition for the company, so serviceability of additional debt would be a key issue. There is
also, often, an obligation to redeem loan stocks.
High gearing may increase the perceived risk, thereby increasing the interest rate demanded by lenders and,
unlike dividends, interest is a fixed commitment.
Another issue to consider is whether the loan stock would be secured or unsecured, which could, in turn,
have an impact on the interest cost.
With regard to the comments of Director D, a bank loan may well require good security and come with a
series of restrictive covenants. This raises the question of whether the company has sufficient unused debt
capacity in its assets.
Lenders have contractual rights to interest and redemption payments, but loan interest is tax deductible,
which makes it cheaper than equity.
Recommendation
Probably a mixture of rights issue and debt – the precise balance being based on estimated calculations of
the likely impact on the overall cost of capital.
Marking guide
Marks
Introduction 3
Rights issue 4
Loan stock / bank loan 5
Recommendation 2
Maximum 14
Total available 12
32 Nash Telecom
(a) Rights issues
A rights issue is an issue of new shares for cash to existing shareholders in proportion to their existing
holdings.
The ex-rights price is the price at which the shares will settle after the rights issue has been made.
Underwriting is the process whereby, in exchange for a fee, an institution or group of institutions will
undertake to purchase at the issue price any securities not subscribed for by the public.
(b) Theoretical ex-rights price
Market value of shares pre - rights issue  rights proceeds
The theoretical ex-rights price =
Number of shares ex - rights
Calculation of the theoretical ex-rights price

€
Current holding 20 shares at €20 each 400
Rights issue 16 shares at €15.5 each 248
Total new holding 36 shares worth 648
So theoretical ex-rights price = €18 (€648 ÷ 36) as stated in the newspaper.
However, it is possible that the actual price may be higher or lower than the theoretical figure,
depending on market expectations about the prospects for the business.
(c) Effect on wealth
You should consider a number of factors in deciding whether to take up the rights issue.
 Whether you wish to continue in the company for the long term (as its recent performance has
been poor and it has run up a debt mountain).
 Whether you want to maintain your holding at the same proportionate level. (If you give up your
rights, you will effectively have half the proportionate holding).
 Whether you have the money to subscribe for the rights issue.
 The market price for selling the rights.
In theory, this is the financial effect on uncle of him subscribing or nor subscribing for the rights issue.
€ €
Uncle's current holding (say 200 shares) is worth (200  €20) 4,000
(i) If uncle takes up the rights
New holding is worth ((200 + 160)  €18) 6,480
Less Cost of new shares (160  €15.5) (2,480)
Net effect 4,000
(ii) If uncle sells the rights
Holding is now worth (200  €18) 3,600
Plus Sale of rights (160  (€18 – €15.5)) 400
Net effect 4,000
(iii) If uncle does nothing
Holding is now worth (200  €18) 3,600
Thus in situations (i) and (ii) above uncle 'breaks even', i.e. his wealth remains the same (€4,000). If he
chooses to do nothing (situation (iii)), however, he will lose €400 (€4,000 – €3,600).
However, in practice the company might well sell the rights on uncle's behalf and reimburse him with
the difference (€400).
ANSWER BANK
(d) Reducing debts

Nash Telecom seems to have considered debt-based options. Other possibilities might include the
following.
 Make a public issue of shares – this would dilute the control of existing shareholders. This would
also be expensive. However, existing lenders would be encouraged, as gearing will be declining.
 Negotiate the conversion of (substantial) loans into equity – this dilutes existing shareholders'
interests and eliminates right of lenders to repayment.
 Seek to be taken over by a large company with limited debts, i.e. to produce a combined
company with a reasonable debt to equity relationship – this reduces risks for existing
shareholders and for employees.
 Seek a venture capitalist investment – this dilutes the existing shareholders' interests; and there is
continuing uncertainty about long-term ownership for both employees and shareholders.
 Divestment, i.e. sell off assets and raise cash to reduce debt. This subsequent lack of assets might
well affect the company's performance, and a sale and leaseback arrangement might be preferred.
 Seek Government finance to re-structure the company and/or to support specific operations –
this increases the Government's stake in the future of the business.
(e) WACC
The cost of equity is generally deemed to be greater than that for debt. This is not least because of the
tax advantages of debt (since the interest payments get tax relief). In addition debt holders normally
require a lower rate of return, as the level of return is fixed and the company is obliged to pay it.
So, it is probable that the weighted average cost of capital would increase with the shift from debt to
equity, but it would depend on whether the company is close to (or even above) its optimal level of
gearing.
Interest rates are currently relatively low, but Nash Telecom would need to pay higher than market
rates due to its high level of debt.
However, Modigliani and Miller originally concluded that a company's weighted average cost of capital
should not be affected by its capital structure. They argued that, as a company's level of debt increased
the cost of equity would increase in direct proportion, thus cancelling out the effect of the cheaper
debt. Subsequently they developed their theory to show that in the presence of corporation tax it is
advantageous to issue debt.
Marking guide
Marks
(a) 1 mark per point 3

(b) 1 mark per point 4
(c) 1 mark per point 4
(d) Up to 2 marks for each reasoned point 5
(e) 1 mark per point 3
19
33 Zimba Ltd
(a) Determination of whether an investment should be undertaken
(i) The new investment does not take place
(0.2)(1.02)
Share price = 0.2  (3 year annuity factor @ 15%) + ( )  1.153
0.15 – 0.02
= 0.2  2.283 + 1.0318
= 0.4566 + 1.0318
= 1.4884, i.e. CU1.49
Value of equity excluding project = CU1.4884  150 million = CU223,260,000
(ii) The new investment takes place
0.21
Share price = = 1.75, i.e. CU1.75
0.16 – 0.04
Value of equity including project = CU1.75  200 million = CU350,000,000
CU
Difference in values 126,740,000
Initial outlay (50,000,000)
Value generated by investment 76,740,000
Thus the new investment appears to be viable.
(b) REPORT
To The Directors, Zimba Ltd
From A Jones, External Consultant
Date Today
Subject Investment and financing of digital television investment
Introduction
The new investment is significant in relation to the existing size of the company and is a departure into
a related, but new, market. The implications for returns, risk, liquidity and form of finance thus need to
be carefully considered.
The new investment
Returns
The calculations provided in Appendix 1 (part (a)) show that, using the dividend model, there is an
increase in share price and hence the project appears to be worthwhile. One minor concern is that, in
effect, profits net of taxes are distributed and thus the increase in annual dividend is an increase in
profit rather than cash flows. The information relating to cash flows of the project has not been
provided. Nevertheless, in the longer term profits are equivalent to cash and the dividend stream is
maintained in perpetuity. Therefore the two can, in this instance, be seen as more or less equivalent.
Additionally, there appears to be a significant increase in the value of the company, so there is
considerable margin for error.
Risk (company accountant and managing director)
The existing business relating to digital cameras appears to be risky in the sense of sales volatility and
in terms of cost structure (operating gearing). Nevertheless, the question of introducing some financial
gearing should not be ruled out entirely on risk grounds without considering other issues. The
problem of gearing is examined below.
ANSWER BANK
Debt financing (finance director)

The company currently has zero gearing. The introduction of debt to finance the project will produce
an advantage with respect to the value of the tax shield on interest.
The finance director is not, however, correct in stating that debt finance at 8% is necessarily cheaper
than equity at 15%. The risk of the project is greater than the average of existing projects, but if the
project were debt financed there would be further financial risk exposure for shareholders in addition
to this operating risk. In a perfect world the cost of equity would rise sufficiently to maintain the
weighted average cost of capital at 15%, but with the tax advantage of debt it would be a little lower
than this.
This point relates to the irrelevance of gearing. This concerns a perfect world (e.g. no tax, equal
borrowing and lending rates, risk averse investors, costless transactions, zero bankruptcy costs). The
tax shield generates an advantage to gearing but ultimately bankruptcy costs will create additional cost
to gearing as debt approaches high levels. Moreover, gearing will increase both company specific and
systematic risk and, in the latter case, will demand a price in the market.
A further cost of debt may be the existence of restrictive covenants, which may prevent the company
from taking certain actions, such as the issuing of further debt ranking above this issue. The
importance of financial flexibility would thus need to be considered.
A final point relates to the form of debt. The finance director argues for a publicly-issued debenture,
but consideration should also be given to privately-issued debt, e.g. from a bank. This type of debt
tends to have lower interest rates and issue costs than debentures, but more covenants and other
forms of control.
Rights issue (company accountant)
Where a company faces high operating and business risk it may be prudent to limit financial gearing.
The question of the optimal level of gearing is, however, a question of balancing costs and benefits and,
even where other types of risk are high, this does not entirely exclude the possibility of debt. The debt
financing of this new investment would give a gearing level which would not be high but would still
need to be considered after a more detailed examination and quantification of operating and business
risk.
Regarding the rights issue, its main function is to implement pre-emption rights in respect of existing
shareholders, such that they capture the value of the new project and have the opportunity to
maintain their share of equity and control in the company.
The issue costs, while smaller than a public issue of shares, and possibly debentures, are likely to be
greater with a rights issue than with privately-issued debt.
Conclusion
The project looks to be viable with a considerable margin of safety, notwithstanding the fact that it is
likely to result in an increased risk to all finance providers. The optimal form of financing is, however,
far from clear: it should be the subject of further detailed analysis and negotiation with the potential
finance providers.
Marking guide
Marks
(a) (i) Calculations 3½

(ii) Calculations 3½
Conclusion 1
8
(b) Report format 1
1 – 2 marks per paragraph 11
12
20
34 Genesis Ltd
(a) WACC
0.05 1.08
Cost of equity = + 0.08 = 0.036 + 0.08 = 11.6%
1.5
Cost of debt = 5 (1 – 0.3) / 50 = 7%

8.40
Cost of preference shares = = 10.5%
80
(300  0.116)  (20  0.07)  (16  0.105)
WACC =
300  20  16
34.8  1.4  1.68
= = 11.27%
336
(b) Use of WACC
The use of the WACC as a discount rate in investment appraisal depends upon a number of principal
assumptions.
(1) The objective of the company is to maximise the current market value of the ordinary shares.
(2) The market is perfect and the share price is the discounted present value of the dividend stream
(the dividend valuation model is correct).
(3) The project is of the same level of operating risk as the existing activities.
(4) The finance for the project comes from a pool of funds and is not project specific (and market
values are stable). There are no other forms of financing.
(5) The project is marginal, i.e. small in size relative to the size of the company.
(c) Gordon growth estimate
Gordon growth model: g = r  b
CU30m 100
r (ARR) = = 7.32%
CU410m
b (ERR) = 66.6%
g = 7.32%  66.6% = 4.9%
(d) Major limitations
The major limitations relate to the assumptions/premises on which the model is based.
(1) The assumption that r and b will be constant (inflation can substantially distort the accounting
rate of return if assets are valued on an historical cost basis).
(2) The assumption that all new finance comes from equity.
(3) Dividend growth is based on future earnings.
(4) The dubious reliance on accounting profits (the model is based on the premise that the higher
the company's level of retentions and the more effectively the funds are used, the greater is the
potential growth rate).
ANSWER BANK
Marking guide
Marks
(a) Calculations 5
(c) 2 marks max 2
(d) 1 mark per point max 3
16
35 Educare Ltd
(a) WACC
Cost of equity
D 0 (1+ g)
ke = +g
P0
0.052 (1  0.05)
= + 0.05
1.21- 0.052
= 9.7%
Cost of debt
This is given as 5.5% after tax.
Value of equity
120m  (1.21 – 0.052) = CU139m
Value of debt
(Normally given value of debt and find after tax cost. Here given after tax cost – so reverse
procedure.)
0.09 (1 - 0.30)  30 [0.09 (1 - 0.30)  30]  30
VD = +
(1  0.055) (1  0.055)2
= CU30m
WACC
(9.7% 139)  (5.5%  30)
WACC =
(139  30)
= 9.0%
(b) Discussion of colleagues' points
Dividends and WACC
The dividend valuation models do not suggest what dividends should be paid, simply that whatever
level of dividends are expected to be paid dictates the market value of the company. Assuming that
Educare were to pay a lower dividend than normal, this would mean that it would have more
investment funds available than normal and this would lead to a higher profit than normal. This must
mean either that the growth rate of dividends must increase relative to what it would otherwise be, or
funds would build up in the company and these would sooner or later be paid to the shareholders.
One way or another the shareholders would receive dividends or some other cash receipt from the
company.
Unlisted loan stock
Since the loan stock is unlisted there is no ready market for it. Any investor who wishes to liquidate
the loan may well have to wait until the redemption date before being able to do so, though a buyer
might be found. To induce investors to take up the loan stock, the company would normally have to
offer a premium rate of interest. When basing the cost of this debt on similar, but listed, loan stocks, it
would be necessary to allow for this factor. The extent of this 'allowance' would be a subjective
judgement.
Target dividend growth rate
In theory (Modigliani and Miller) dividends should only be paid where the company cannot find positive
NPV projects in which to invest. As these will not follow a regular pattern, and neither will the
available funds, a target dividend growth rate seems odd. It may be achievable, but only by risking the
possibility that wealth-enhancing investments may be overlooked. The only way in which these two
points can be reconciled is by the company raising additional finance from a share issue or borrowing
to meet the shortfall in funds.
In practice, companies seem eager to maintain steadily rising dividend levels over the years.
(c) Use of WACC
Possible reasons for the WACC determined in (a) being unsuitable for the investment in China include
the following.
 As discussed in (b), the target growth rate of dividends may well not be achievable, calling the
cost of equity into question.
 The loan stock is to be redeemed in two years. The company may not be able to negotiate a
similar loan at a similar rate. On the other hand the cost of debt is market-determined.
 The weightings may alter as a result of changes in the market values of debt and/or equity. The
investment in China may itself shift these weights, since the investment's NPV will all accrue to
the shareholders (not to the loan stock holders).
 An explicit change in the company's financial structure would cause the weights to alter.
 The tax rate may alter during the course of the project.
 The project may be in a risk class different from the generality of projects currently undertaken
by the company.
 There could be other sources of finance used by the company in future, e.g. a bank overdraft,
that has not been considered.
Marking guide
Marks
(a) Cost of equity calculation 2

Value of debt 2
WACC 2
6
(b) 2 marks per point max 5
(c) 1 – 1½ marks per point max 6
17
ANSWER BANK
36 Saddlebrook Ltd
Use of WACC
The discount rate that should be used is the weighted average cost of capital (WACC), with
weightings based on market values. The cost of capital should take into account the systematic risk of the
new investment, and therefore it will not be appropriate to use Saddlebrook Ltd's existing equity beta.
Instead, the estimated equity beta of the main Czech competitor in the same industry as the new proposed
plant will be ungeared, and then the capital structure of Saddlebrook Ltd applied to find the WACC to be
used for the discount rate.
Ungearing of Czech company beta
Since the systematic risk of debt can be assumed to be zero, the Czech equity beta can be ungeared using
the following expression.
a =  e E
×
E  D (1 t)
where:
a = asset beta
e = equity beta
E = proportion of equity in capital structure
D = proportion of debt in capital structure
t = tax rate
For the Czech company:
a = 1.5 × 60 / (60 + 40(1 – 0.3))
= 1.023
The next step is to calculate the debt and equity of Saddlebrook Ltd based on market values.
CUm
Equity: 2 × 225m = 450m shares at 376p 1,692.00
Debt: Bank loans (210m – 75m) 135.00
Bonds (75m  1.195) 89.63
Total debt 224.63
We can now apply Saddlebrook's gearing level to the asset beta to calculate the relevant equity beta.
E  D (1 – t)
e = a 
E
1,692  224.63 (1 – 0.3)
= 1.023 
1,692
= 1.118
This can now be substituted into the capital asset pricing model (CAPM) to find the cost of equity.
k e = rf +  (rm – rf)
= 7.75% + 1.118 (14.5% – 7.75%)
= 15.3%
Bank loans CU135m have a cost of (8.25% + 1%) × (1 – 0.30) = 6.475%.

Bonds CU89.63m have a cost of [CU10.5m (1 – 0.30)]/CU89.63m = 8.2%.
Then, calculate the WACC:
WACC = [(1,692  15.3) + (135  6.475) + (89.63  8.2)]/[1,692 + 224.63]

= [25,888 + 874.125 + 734.966]/1,916.63 = 14.35%
Marking guide
Marks
Use of WACC 3
Ungearing of Czech beta 3
Cost of equity 3
Debt and equity 3
WACC 3
15
37 Quigley Industries Ltd

Financing and other issues relating to a major investment
Gearing
Quigley Industries Ltd (QI) is operating in a classic cyclical industry, with high capital intensity and, almost
certainly, high operating gearing. Operating profits are susceptible to great fluctuations in the face of
fluctuations in revenue. History shows this trade to be subject to such fluctuations.
Financial gearing must therefore be approached with caution. Identifying the optimal level of gearing seems
very difficult to achieve. It can only be a matter of judgement, but forming that judgement must take
account of QI's current level of gearing and of levels of gearing in the industry, particularly with market
leaders and with companies having high operating gearing, such as QI.
In theory (Modigliani and Miller) gearing makes no difference to the wealth of the shareholders: cheap loan
finance has a positive effect that is precisely cancelled out by the higher returns required by shareholders in
the face of higher risk. If we take account of the tax deductibility of loan interest, gearing in theory favours
shareholders since, in effect, there is a transfer of wealth from the tax authorities to shareholders.
At higher levels of gearing the risk of the company being unable to meet its debt commitments of interest
and capital repayment, particularly during a period of low revenue/operating profitability, could force the
company to liquidate, to the detriment of shareholders' wealth (Director B's comment). Gearing policy
tends, therefore, to be seen as striking a balance between the benefits of tax relief and the potential costs of
'bankruptcy'.
Other factors that could come into play
Agency
Directors may be unwilling to gear the company up to a level optimum to the shareholders. This is because
gearing imposes a set of disciplines on the directors, i.e. of having to meet interest payments and arranging
continuing finance when the loan is due for redemption.
Signalling
It is believed by some that a company making a loan issue implies confidence in the future, and this could
have a favourable effect on the share price.
ANSWER BANK
Clientele effect
It is believed that particular shareholders are attracted to the shares of a particular company, because of the
level of gearing. Altering the level of gearing could have a detrimental effect on the share price as investors
move away from the company to a 'preferred habitat'. Uncertainty about the company's intentions could
also have a detrimental effect.
A large positive NPV project, such as the new plant, will affect gearing, since it will add value to the equity
of the company.
Equity
This is an obvious source of finance, subject to the gearing level. The most obvious source of equity is a
rights issue to existing shareholders. This has the advantage of being relatively cheap to issue and does not
face the company with much of a problem regarding the issue price. There is normally a right that existing
shareholders are offered new shares before a public issue can be made. Usually the shareholders would
need to vote away their 'pre-emption' rights, before the company could go for a public issue.
A public issue is much more expensive than a rights issue to achieve, because there are legally-required,
expensive procedures to be met. Public issues tend to be more likely to fail. Setting prices for public issues
tends to be difficult to judge.
Equity is rather more expensive to QI than loan finance: investors expect higher returns than they do for
loans, but their returns are distinctly more risky. (Director C's comment). Equities seem popular at present.
Loan finance
Whether a loan stock issue to the public or a term loan from a financial institution, loan finance is relatively
cheap to raise relative to equity. Lenders typically expect good security, and freehold land tends to offer the
best security. So the ability of QI is likely to be linked to the extent that it has unused 'debt capacity' in its
assets.
Lenders typically expect lower returns than equity holders, but they have contractual rights to interest and
redemption payments on the due dates. This exposes the company to risk and to discipline.
Provided that the company has sufficient taxable profits, loan interest is tax deductible and this makes it still
cheaper for the company.
Retained earnings
This is an important source of new finance to Bangladesh companies. It would not be suitable in this case,
since all of the company's available funds are already committed. There is the option of waiting, perhaps a
few years, until retained earnings build up before making the investment, but commercially this may not be a
real option.
The revenue reserves are not cash, but part of the owners' claim. Therefore they are not available as
investment funds (Director D's comment).
Retaining profit has implications for dividend policy and, possibly, for shareholder wealth.
Market efficiency
The evidence is clear, that in sophisticated stock markets charted price patterns do not repeat themselves,
except by chance. Weak form efficiency is present in such markets.
It is illogical to feel that a time of low share prices is a bad time to issue new shares. Market efficiency
theory (and evidence) suggests that whatever the share price is at any point represents the best unbiased
estimate of its worth based on available evidence (Director A's comment).
Other sources
 Leasing the plant
 Sales and leaseback
 Working capital efficiencies
 Possibility of grants from public funds
Advice
It is possible that QI has sufficient 'in-house' expertise to enable it to avoid the need for professional advice.
Raising the level of finance that we are probably considering here is not an everyday event for a commercial
company, so it is probably better to seek advice from experts.
Investment banks can typically offer advice and may well be able to put the company in touch with potential
investors, assuming that the rights-issue route is not taken.
The larger firms of chartered accountants, almost certainly QI's auditors, have close links to corporate
finance advisors.
The advice will not typically be cheap (Director B's comment).
Marking guide
Marks
Gearing 3
Other factors: 1½ marks per point 4
Equity 3
Loan finance 3
Retained earnings 3
Market efficiency 3
Other sources 3
Advice 4
Maximum 26
Total available 22
38 Philpot Ltd
(a)
The rights issue price = CU5.00 × 0.90 = CU4.50
The theoretical ex-rights price = [(4 × CU5.00) + CU4.50]/5 = CU4.90
The value of the rights per existing share = (4.90 – 4.50)/4 = CU0.10
(b)
The value of 625 shares after the rights issue = 625 × CU4.90 = CU3,062.50
The value of 500 shares before the rights issue = 500 × CU5.00 = CU2,500.00
The value of 500 shares after the rights issue = 500 × CU4.90 = CU2,450.00
The amount of cash subscribed for the new shares = 125 × CU4.50 = CU562.50
The amount of cash raised from the sale of rights = 500 × CU0.10 = CU50.00
The shareholder could do nothing, take up the rights or sell the rights (or any combination of these).
The effect on the shareholder's wealth depends on the action taken:
(1) If the shareholder takes up the rights, the rights issue will have a neutral effect on his wealth. As
an owner of 500 shares, he will purchase an additional 125 shares and the value of the total 625
shares (CU3,062.50) will be the same as the value of 500 shares before the rights issue
(CU2,500.00) plus the cash subscribed for the new shares (CU562.50). The make-up of the
shareholder's wealth will have changed (less cash, more shares), but not his total wealth.
(2) If the shareholder sells his rights, the rights issue will also have a neutral effect on his wealth. The
value of 500 shares after the rights issue (CU2,450.00) plus the cash received from selling the
rights (CU50.00) equals the value of 500 shares before the rights issue (CU2,500.00). Again, the
make-up of the shareholder's wealth will have changed (more cash, less shares), but not his total
wealth.
ANSWER BANK
(3) If the shareholder neither takes up the rights nor sells the rights, a loss of wealth of CU50 will
occur, representing the difference between the value of 500 shares before the rights issue
(CU2,500.00) and the value of 500 shares after the rights issue (CU2,450.00).
(c) Factors that may influence the actual share price following the rights issue
(1) The expectations of investors/the stock market regarding the company's future.
(2) The level of take-up of the rights issue – if the issue was not fully taken up, for example, the share
price might fall.
(3) Information regarding the use to which the proceeds will be put and the market's reaction to that
information – possibly being used to restructure finances in a way that affects the company's cost
of capital; or being used in a project with a positive net present value.
(4) General stock market conditions/sentiment at the time of the issue, or conditions/sentiment
within the company's particular sector of the stock market.
(5) The existence of specific information (positive or negative) regarding the company or its sector
at the time of the issue.
(6) It is assumed that the details of any new investment/strategy are communicated to, and believed
by, the stock market, but if this is not the case then the share price will differ from the
theoretical ex-rights price. In other words, the degree of efficiency of the market could impact
on the actual share price.
(d) The three forms of theoretical stock market efficiency are weak, semi-strong and strong.
If a stock market has weak form efficiency then only past information is currently reflected in share
prices. Weak form efficiency, therefore, implies that share prices fully and fairly reflect all past
information about the share and investors cannot, therefore, make abnormal gains by studying and
acting upon any past information.
If a stock market has semi-strong form efficiency then not only all past information but also all publicly
available current information (e.g. financial statements, press reports) is currently reflected in share
prices. Semi-strong form efficiency, therefore, implies that share prices fully and fairly reflect all past
and current publicly available information and investors cannot, therefore, make abnormal gains by
studying and acting upon any such information.
If a stock market has strong form efficiency then not only all past and current publicly available
information but also all relevant private information (e.g. board minutes) is currently reflected in share
prices. Strong form efficiency, therefore, implies that share prices fully and fairly reflect all past,
current publicly available and private information and investors cannot, therefore, make abnormal gains
by acting upon information of any sort.
The implication of all this is that if the stock market is efficient in all three forms, investors cannot beat
the market by having superior information as it does not, by definition, exist. However, if the stock
market is not strong form efficient then abnormal gains can be made from possession of private
(insider) information.
Discussion
Empirical evidence suggests that stock markets are certainly not strong form efficient, so the bank's
claim appears misguided. There is much empirical evidence, however, that stock markets are semi-
strong efficient and so it is unlikely that the company's shares are undervalued and certainly not to any
extent that might justify deferring a public issue.
Regarding the finance director's statement, its accuracy depends in part on which form of market
efficiency is evident. Strong form efficiency does suggest that share prices are 'correct' (they reflect
true values) at all times, but the other two forms of efficiency would not generate 'correct' share
prices as they do not fully consider all information. However, even with a strong form efficient market
there may be a time lag between the emergence of new, relevant information and the market reaction
to it, meaning that for a time prices will not be 'correct'.
Finally, as regards the ability of analysts to predict future share prices, if the stock market is strong
form efficient then analysts will be unable to achieve consistently superior rates of return. But that
does not mean they cannot predict share prices – by chance they may do so on occasions, but the
implication is that they will be unable to do so consistently. However, if the market is only semi-strong
form efficient, then if the analysts have access to any private information then they may be able to
predict the future share price and make superior rates of return.
Marking guide
Marks
(a) Calculation 2
(b) Calculations: 1½ ; explanations 2½ 4
(c) 1 mark per paragraph max 4
(d) 1 mark per paragraph max 8
18
39 Efficient markets hypothesis

(a) Three forms of EMH
The efficient market hypothesis considers how efficient the market is at impounding in prices
information available to investors. Three possible levels of efficiency have been postulated.
Weak form
A market is weak form efficient if all the information which has been gleaned from a security's past
price movement has been reflected in the current market value of that security.
Semi-strong form
A market is semi-strong form efficient if all publicly-known information about a company, including its
plans, together with information about the security's past price movements, is reflected in the current
market value of that security.
Strong form
A market is said to be strong form efficient if the current market value of a security reflects all
relevant information, including information which is supposedly secret to the company.
(b) Stock market efficiency
One of the principal assumptions underlying financial management is that the market value of a
security is based upon investors' expectations of future earnings derived from that security, and that
those earnings are discounted at the investors' required rate of return. Expectations of future earnings
are based upon information available in the market.
First statement
The first view given in the question is stating that having released information regarding a company's
earnings, this has resulted in a revision of investors' expectations. In this situation this has led to an
increase in the market value of the security because the information was favourable – actual earnings
being better than market expectations.
Because this high return was experienced over two or three days following the announcement, it
suggests that the market transmission mechanism is not perfect. Had it been perfect there would have
been no time delay: all investors would have received the information at the same time and acted upon it.
This scenario is characteristic of a semi-strong form efficient market, in that investors are revising
their expectations regarding future earnings as soon as the information is publicly known, although as
ANSWER BANK
stated there is a time delay. Having acted upon this information, a new equilibrium is achieved over a
period of two to three days following the announcement.
Second statement
Implicit in the second view is that a professionally-managed portfolio may give a return which is no
better than that which can be achieved by a naive investor, because both have access to the same
information.
This may accord with the view that the market is strong form efficient, all investors having access to all
relevant information. Therefore no party is in a more favourable position relative to the other party,
and neither party can make a gain.
It is also consistent with semi-strong efficiency, i.e. fund managers do not have access to better (inside)
information.
Third statement
This suggests that it is possible to earn abnormal returns by adopting a strategy ('buy just before the
fiscal year end and sell a week or so later'), which is based on information contained in the past time
series. This implies inefficiency. The fact that there is an identifiable cause does not eliminate the
inefficiency. If the market were weakly efficient, arbitrageurs would eliminate the excess return at the
start of the fiscal year by creating buying pressures for the under-priced shares being sold at the end of
the previous fiscal year.
Marking guide
Marks
(a) Explanation of the hypothesis 1

Each form of hypothesis: 1 mark × 3 3
4
(b) Max 3 marks per statement max 8
12
40 Abydos Ltd
(a) Expected NPV
The NPV is found by discounting the relevant cash flows at the weighted average cost of capital,
calculated as follows.
Cost of equity
Using CAPM
Ke = rf +  (rm– rf)
= 5 + 1.4(12 – 5) = 14.8%
Cost of debt
After tax cost of debt = 8(1 – 0.3)
= 5.6%
Weighted average cost of capital

Gearing after the investment has been financed is expected to be E = 0.6, D = 0.4
E D
WACC = Keg +K d
E +D E +D
= 14.8(0.6) + 5.6(0.4)
= 11.12%, say 11%
Tax depreciation
These are on the CU10 million part of the investment that is non-current assets (not working capital
or issue costs).
Year Value at start of year Tax depreciation Tax saving
25% 30%
CU'000 CU'000 CU'000
1 10,000 2,500 750
2 7,500 1,875 563
3 5,625 1,406 422
4 4,219 1,055 316
Year 0 1 2 3 4
CU'000 CU'000 CU'000 CU'000 CU'000
Pre-tax operating cash flows 3,000 3,400 3,800 4,300
Tax @ 30% (900) (1,020) (1,140) (1,290)
Tax savings from tax depreciation 750 563 422 316
Investment cost (11,500)
Issue costs (1,000)
After tax realisable value 4,000
Net cash flows (12,500) 2,850 2,943 3,082 7,326
Discount factor 11% 1.000 0.901 0.812 0.731 0.659
Present values (12,500) 2,568 2,390 2,253 4,828
The expected net present value is
CU(461,000)
Expected APV
To calculate the base case NPV, the investment cash flows are discounted at the ungeared cost of
equity, assuming the corporate debt is risk free (and has a beta of zero).
E
ßa = e
E +D(1– t)
0 .6
= 1.4  = 0.955
0.6  0.4(1  0.3)
The ungeared cost of equity can now be estimated using the CAPM:
Keu = 5 + 0.955 (12 – 5)
= 11.69% (say, approximately 12%)
Year 0 1 2 3 4
CU'000 CU'000 CU'000 CU'000 CU'000
Net cash flows (excl issue costs) (11,500) 2,850 2,943 3,082 7,326
Discount factor 12% 1.000 0.893 0.797 0.712 0.636
Present values (11,500) 2,545 2,346 2,194 4,659
The expected base case net present value is CU244,000.
ANSWER BANK
Financing side effects
Issue costs
CU1m, because they are treated as a side-effect they are not included in this NPV calculation.
Present value of tax shield
Debt issued by project = 40%  CU12.5m = CU5m

Annual tax savings on debt interest = CU5m × 8% × 30% = CU120,000
PV of tax savings for 4 years, discounted at the risk-free rate 5%, is CU120,000 × 3.546 = CU425,520
CU'000
Adjusted present value
Base case NPV 244
Tax relief on debt interest 426
Issue costs (1,000)
(330)
The adjusted present value is CU330,000
(b) Validity of the views of the two directors
Sales director
The sales director believes that the net present value method should be used, on the basis that the
NPV of a project will be reflected in an equivalent increase in the company's share price.
However, even if the market is efficient, this is only likely to be true if:
 The financing used does not create a significant change in gearing

 The project is small relative to the size of the company
 The project risk is the same as the company's average operating risk
Finance director
The finance director prefers the adjusted present value method, in which the cash flows are
discounted at the ungeared cost of equity for the project, and the resulting NPV is then adjusted for
financing side effects such as issue costs and the tax shield on debt interest. The main problem with
the APV method is the estimation of the various financing side effects and the discount rates
used to appraise them. For example in the calculation the risk-free rate has been used to discount the
tax effect when the cost of debt of 8% could have been used instead and produced a different result.
Problems with both viewpoints
Both methods rely on the restrictive assumptions about capital markets which are made in the capital
asset pricing model and in the theories of capital structure. The figures used in CAPM (risk-free rate,
market rate and betas) can be difficult to determine. Business risks are assumed to be constant.
Neither method attempts to value the possible real options for abandonment or further investment
which may be associated with the project.
Marking guide
Marks
(a) Tax depreciation/tax saving 2

NPV calculations 4–5
APV calculations
Base case NPV 3–4
Financing side effects 2–4
Give credit for technique max 14
(b) Reward sensible discussion. Bonus mark for mention of real options max 6
20
ANSWER BANK
41 Newton Pearce Ltd

(a) Finance to be raised CU
New assets 950,000
Reduction in overdraft (2,240 – 2,000) 240,000
Reduction in payables (2,870,000 × 10/45) 637,777
1,827,777
(b) (i)
Rights issue Debenture issue
Earnings per share (CU420,700/3,434,014) CU0.123
CU0.136
(CU267,167/1,960,000)
CU CU
Sales 34,500,000 34,500,000
Net margin (CU28.5m × 3%) 855,000 855,000
(CU6m × 5%) 300,000 300,000
1,155,000 1,155,000
Interest Current debentures (8% × CU2,550) 204,000 204,000
New debentures (12% × CU1,827,777) 0 219,333
Bank overdraft (CU2m × 17.5%) 350,000 350,000
(554,000) (773,333)
Profit before taxation 601,000 381,667
Taxation (30%) (180,300) (114,500)
Profit after tax/Earnings 420,700 267,167
WORKING 1
Rights issue (CU1,827,777/[CU1.55 – 20%]) 1,474,014 shares
Plus existing shares (CU980,000/CU0.50) 1,960,000 shares
Total 3,434,014 shares
(b) (ii)
Gearing % (see Working 2) (CU2,550,000/CU7,560, 33.7% 58.5%
777)
(CU4,377,777/CU7,480,
944)
WORKING 2
Profit after tax/earnings (part (a)) 420,700 267,167
Dividends Existing shares (5p × (980/CU0.50)) (98,000) (98,000)
New shares (5p × 1,474,014) (73,700) 0
Retained profit 249,000 169,167

Total long term funds at 31/12/X6 CU5,484,000 CU5,484,000
Plus: New long term funds raised 20X7 1,827,777 1,827,777
Plus: Retained profit 20X7 249,000 169,167
Total long term funds at 31/12/X7 CU7,560,777 CU7,480,944
Total geared funds at 31/12/X7 CU2,550,000 CU4,377,777

(CU2,550,000 + CU1,827,777)
Note: an alternative calculation in this gearing calculation, i.e. using the nominal value of the new
debentures issued (CU2,193,332 – see below), would not have been penalised.
10% Debenture issue (CU1,827,777  12%/10%) = CU2,193,332 nominal value
(c) NP's current earnings per share figure is 9.25 pence. This is significantly lower than both of the
forecast earnings per share figures for the forthcoming year.
The debentures issue will lead to a higher earnings per share figure for shareholders than the rights
issue of shares.
Debenture issue: the risks associated with this issue are greater than those associated with the rights
issue. The level of gearing under the debenture issue option might be considered far too high in
relation to the expected returns. The interest cover ratio under this option of 1.49
(CU1,155,000/773,333) is also low. From the company viewpoint, the level of interest payments under
this option will prove a burden unless profits can be maintained at a high level.
Do the existing debenture holders have any collateral, e.g. on the company's non-current assets? Will
the new debenture holders expect something similar? Is there potential conflict here? Is there
sufficient security for these borrowings – the current book value of the assets is only CU3,518,000
(plus new assets of CU950,000). What is the market value of the non-current assets?
Rights issue: although the EPS is less than for the debenture issue, it will be higher than in 20X6. The
level of gearing is much lower than under the debenture issue option. Also it gives a lower level of
gearing than the current one. The interest cover ratio of 2.08 is higher than that for the debenture
issue. Shareholders may find it difficult to raise the required finance to subscribe to the issue because
the rights issue equates to 75% (1,474,014/1,960,000) of the existing shares in issue. This may limit the
potential success of the issue.
(d) Working capital typically comprises inventories, trade receivables, bank/cash and trade payables.
Contrary to management's view, NP's expansion into northern England and Scotland is likely to affect
its level of working capital required as follows:
It would be prudent to carry sufficient additional inventory to avoid the embarrassment of a 'stock out'
(which could cause a loss of customers in the future). With inventory, NP must strike a balance
between the costs of 'stock outs', ordering costs and holding costs.
To encourage potential new customers in northern England and Scotland to buy its products, NP
would be unwise not to offer credit terms on its 'new' sales – thus the level of trade receivables will
increase.
In contrast NP should continue with its policy of purchasing goods on credit and, once the ten day
adjustment has been made to the creditors' payment period, the expansion of trade means that the
level of trade payables will increase, which will reduce NP's working capital investment.
Marking guide
Marks
(a) Calculation 1
(b) (i) Calculation: 1 mark per line max 7
(ii) Calculation: 1 mark per line max 5
(c) 1 mark per paragraph max 5
(d) 1 mark per paragraph max 4
22
ANSWER BANK
42 Wentworth Ltd
(a) The potential reasons are as follows.
(1) The existence of limited investment opportunities due, for example, to the maturity of existing
product lines or a downturn in the market for the company's goods or services
(2) Traditionally strong cash flows generated by the business
(3) To signal confidence in the future of the company, thereby raising the company's stock market
rating (and facilitating future financing) as well as impacting positively on the share price
(4) The knowledge that an actual or potential shareholder clientele prefers a high dividend payout
policy
(5) As a discipline on their managers (thereby addressing the classic agency problem), who will more
often have to seek out funds from the market to fund investment and, therefore, be called upon
to justify proposals to potential investors, rather than simply being able to rely on the use of
internally generated funds
(6) The 'bird in the hand' theory – the company may be persuaded that the market will value more
highly a firm that pays dividends and issues shares to finance a new investment, than one that uses
retentions
(b) This refers to the theory of dividend policy irrelevance, first developed by Modigliani and Miller (M&M)
in 1961. They showed the irrelevance of dividends in a world without taxes, transaction costs or other
market imperfections. M&M showed that if a company has a set investment and borrowing policy, the
source of equity finance (retained earnings or new issues of equity) had no impact on shareholder
wealth – the gain or loss to existing shareholders is the same whether a reduction in dividend
(retained earnings) or a new issue of shares was used to finance an investment. Therefore, the
dividend decision was irrelevant. In other words, if a change in dividend policy leaves the present value
of future dividends unchanged, then that policy must be irrelevant. It does not matter when the
dividends occur, provided that their present value is maximised.
(c) In practice there are a number of reasons why those directors who feel that dividend policy is not an
irrelevance may have a point. The practical risks involved in changing an established dividend policy
comprise:
(1) It is argued that companies attract a clientele of investors who favour their current dividend
policy for tax, cash flow and other reasons. Any change in policy could cause this clientele to
dispose of their shares, in turn causing the share price to fall.
(2) Dividends resolve uncertainty, such that investors may prefer high payout policies, as they regard
future capital gains as uncertain. If investors are rational they will perceive future dividends and
gains to be equally risky, but evidence suggests they tend not to be fully rational, preferring a
current dividend to a cut and the promise of future increased dividends.
(3) Similarly, in the absence of perfect information, dividends will be used as information signals by
shareholders of future earnings and dividends. In the short term, a share price might fall as a
result of a dividend cut to finance an investment, since investors might have incomplete
information regarding the new investment and may consequently revise downwards their future
dividend expectations. This may also affect the firm's cost of capital.
(4) Any change in dividend policy may adversely affect either investors (e.g. tax) or the firm (e.g.
share price fall).
(d) Shareholders who are faced with a dividend cut which is not their preference can 'manufacture' a
dividend by selling shares or conversely, can purchase shares out of dividend income to cancel out, to
a certain extent, the effect of the dividend.
The company could use the option of a scrip dividend, where shares are issued as dividend rather than
cash. This would enable the company to maintain its current level of dividend whilst conserving
liquidity, although the extent to which this might be achieved would depend on the precise terms of
the scrip dividend on offer. A scrip dividend can either be in one of two 'normal' forms 1) for example,
a 1 for 10 scrip dividend in place of the usual cash dividend – this would maximise liquidity
preservation; or 2) a choice between cash or scrip dividend – which would conserve liquidity only to
the extent that shareholders opt for the scrip dividend; or it can be undertaken in its 'enhanced' form,
where a choice would be given between a cash dividend and an enhanced scrip dividend, to encourage
uptake of the scrip option and therefore encourage liquidity preservation.
This strategy, therefore, would, to some extent, address both the risks inherent in an absolute change
(cash reduction) in dividend policy, whilst maintaining the actual level of the dividend and preserving
liquidity.
Lesser credit was also given for suggestions to pass or reduce the dividend (or to adopt a residual
dividend policy that would lead to either of these options), accompanied by clear communication to
the market of the reasons behind the decision.
Marking guide
Marks
(a) 1 mark per reason max 5

(c) 1½ marks per paragraph max 6
(d) 1½ marks per paragraph max 5
22
43 Krenn Ltd
Notes for the directors regarding a decision on a cash surplus
Director A
This business seems not to be in a growth phase: there seems to be no growth in sales. It seems to be in a
maturity phase. There is a danger that it may slip into a decline phase if something is not done to innovate.
Past experience may have been unsuccessful, but a change in consumer tastes or the entry of a competitor
could be disastrous.
Putting the cash in the bank is not using it more effectively, in terms of wealth generation, than the
shareholders could do for themselves, given the level of risk. This puts the cash on the margin for returning
to the shareholders.
The shareholders do not wish, presumably, to have their funds invested in such a low risk asset as a bank
deposit account. If so, they would have kept their funds and invested for themselves.
This director's comments may arise from a desire to have a relatively risk-free investment that would
protect the directors' position. This could be an example of an agency cost to the shareholders, with the
best interests of the shareholders conflicting with those of the directors.
Director B
It is true that a cash mountain could be a reason for a takeover attempt. A predator could see this as a way
to pick up some liquid resources cheaply.
Cancelling shares would affect the gearing ratio by increasing it. Both the traditional view of gearing and the
post-tax Modigliani and Miller position (and taking 'bankruptcy' cost into account) conclude that there is an
optimum gearing ratio. Whether such a reduction in gearing would be beneficial or detrimental depends on
the company's position relative to this optimum.
The gearing change could be seen, however, as moving back towards the position before the cash started to
build up. Having cash on interest-yielding deposit can be seen as negating the equivalent amount of gearing.
ANSWER BANK
This is because the deposit provides a fairly steady stream of income that would roughly match the servicing
of the equivalent amount of debt finance.
Altering the gearing ratio may cause some existing shareholders to want to sell their shares and reinvest
elsewhere in investments that they feel more comfortable (the 'clientele' effect). This could lead to net
reductions in shareholders' wealth.
It is argued that cancelling shares increases the share price because it lessens supply. However, this seems a
dubious conclusion in the context of capital market efficiency. Even if this were true, the effect of a shift in
gearing may well have an effect on share price.
Again, there may be an agency problem. A takeover may possibly increase the shareholders' wealth. It may
very well have an adverse effect on the directors' welfare.
Director C
This is a possibility but it would have a significant effect on gearing. All of the points made on gearing with
reference to Director B's comments apply here.
Director D
A large dividend is not necessarily the answer. According to Modigliani and Miller, dividend policy does not
in theory affect shareholders' wealth. In practice issues like tax and dealing charges are likely to have an
effect.
There appears to be a 'clientele' effect with dividend policy. Shareholders moving from one company to
another will cause wealth losses.
Thus a sudden change in dividend policy may well not improve market sentiment towards the company.
Though in theory it is always open to shareholders to negate dividends through reinvesting the proceeds in
shares, this action normally has costs attached.
Again, there could be an agency issue here, with the objective of the director to avoid a takeover.
Marking guide
Marks
Director A: 1 mark per point max 5

Director B: 1 mark per point max 5
Director C: 1 mark per point max 1
Director D: 1 mark per point max 5
16
44 Duofold Ltd
(a) Mr Jones' options
Ex-rights price of the company's ordinary shares
(10m  CU1.80)  CU5m  CU2m
= CU1.6666
10m  5m
He could reasonably sell his rights for CU1.6666 – CU1.00 = 66.66p
Option 1: Take up his rights
CU
Wealth prior to the rights issue = 2,000  CU1.80 3,600.00
Wealth post the rights issue = 3,000  1.6666 4,999.80
Less Cost of rights issue = 1,000  1.00 (1,000.00)
3,999.80
He is therefore CU399.80 better off as a result of taking up his rights.
Option 2: Sell his rights for 66.66p
CU
Wealth prior to the rights issue = 2,000  CU1.80 3,600.00
Wealth post the rights issue = 2,000  CU1.6666 3,333.20
Plus Proceeds of sale of rights = 1,000  66.66p 666.60
3,999.80
He is therefore CU399.80 better off as a result of selling his rights.
Option 3: Do nothing
CU
Wealth prior to the rights issue = 2,000  CU1,80 3,600.00
Wealth post the rights issue = 2,000  CU1.6666 3,333.20
He is therefore CU266.80 worse off as a result of doing nothing.

(b) Maximum price
The maximum that should be paid for the competitor is as follows.
CU6.8m
Value of Duofold Ltd and target combined = 68m
0.10
CU4.2m
Value of Duofold Ltd on its own = 35m
0.12
So the maximum that Duofold Ltd should pay is CU33m.
The usual justifications for an acquisition are as follows.
(1) Synergy (from issues such as administrative savings, economies of scale, shared investment, leaner
management structures and access to under-utilised assets).
(2) Risk reduction (reflected in reduced WACC).
(3) Reduction in or elimination of competition (as well as market access).
(4) Vertical protection (via acquisition of a supplier, distributor or customer).
(5) Increased shareholder wealth arising from any of the above.
ANSWER BANK
(c) Dividend policy

Dividend policy irrelevance is as follows.
 Modigliani and Miller (M&M) (1961) showed that dividends are irrelevant in a world without
taxes, transaction costs or other market imperfections.
 M&M showed that the dividend decision is irrelevant, since financing a project by either paying a
dividend and issuing shares or not paying a dividend has the same impact on shareholder wealth.
 Although the dividend decision was shown to be irrelevant, dividends themselves were not
considered irrelevant – the view is simply that if a change in dividend policy leaves the present
value of future dividends unchanged, then the dividend policy must be irrelevant.
 If a shareholder prefers income to capital gains they can 'manufacture' dividends by selling shares
with no loss of wealth (M&M).
 However, M&M's argument depends on a perfect capital market, and once the assumptions are
relaxed it can be shown that in the real world dividend policy is relevant due to the following.
(1) Transaction costs (that will reduce shareholder wealth in 'manufacturing' dividends).
(2) Taxation (which may lead to a preference on the part of individual investors for income or
capital gains).
(3) Dividends acting as information signals (in the absence of perfect information, i.e.
shareholders may not be aware of a particular positive NPV project).
(4) Dividends being (irrationally) perceived as resolving uncertainty (future capital gains are
viewed as uncertain).
(5) Dividends having a clientele effect (attracting investors who favour a particular dividend
policy for tax, cash flow or other reasons).
Marking guide
Marks
(a) Ex-rights price 1
Price to sell rights 1
Option 1 1½
Option 2 1½
Option 3 1½
Mmaxx 6
(b) Value combined 1
Value alone 1
Conclusion 1
Justifications 2
5
M&M assumptions 2
6
17
45 Portico Ltd
Notes on dividend policy for a company in Portico's position
In theory, companies should make all investments available to them that increase shareholder value (i.e. all
positive NPV investments, when discounted at the shareholders' opportunity cost of capital). Any funds
remaining after undertaking such investments should be distributed to shareholders as dividends so that the
shareholders can invest them as they see fit. The dividend decision is, therefore, a residual decision. As a
company's share price is the PV of its future dividends, shareholders should be indifferent about how the PV
is made up (i.e. the size of each year's dividend).
One point of view is that individual shareholders who dislike a particular dividend policy can adjust the cash
flows to suit their own needs. They can do this by 'creating' dividends through the sale of shares or
conversely they can buy more shares to cancel the effect of dividends. One drawback to this strategy,
however, is the question of transaction costs in the real world.
However, in practice, Portico's dividend policy will be affected by a number of other issues than purely its
own investment policy.
Dividend signalling. In reality, shareholders do not have perfect information concerning the future
prospects of the company, so the pattern of dividend payments actually functions as a key indicator of likely
future performance (increased dividends is taken as a signal of confidence which causes estimates of future
earnings to increase, so increasing the share price, and vice versa). This supports the argument for the
relevance of dividend policy and the need for a stable (and increasing) dividend pay-out.
Preference for current income (as displayed by certain of the private shareholders referred to by
Director B). This implies that many shareholders will prefer companies which pay regular dividends and will,
therefore, value their shares more highly.
Clientele effect. Investors may be attracted to firms by their dividend policy, for example, because it suits
their particular tax position. Major changes in dividend policy may well upset particular clienteles who may
then sell their shares, so pushing down the share price. While this may be off-set by other clienteles buying
the shares and boosting the share price, the climate of uncertainty concerning long-term dividend policy
often depresses the share price.
Cash. Shortage of cash can affect dividend policy, although money may be borrowed to fund a dividend
payment to avoid negative signalling effects. In summary, companies should establish a dividend policy which
is stable, which sets a stable, rising dividend per share, and which sets the dividend at a level below
anticipated earnings to provide for new investment (avoiding the need for new share issues) and to provide
a cushion if an unexpected fall in earnings is experienced. Excess earnings over investment needs and
normal dividends can be returned to shareholders via a special dividend or used to repurchase the firm's
shares.
Director A's comments reflect the dividend valuation model but overlook the issues of both the funds
available to a company and the investment calls on the company in any given year. Furthermore, Modigliani
and Miller showed that, in the absence of taxes and transaction costs, dividends are irrelevant to the value
of a company. In principle, it does not matter when dividends occur, provided that their PV is maximised.
Furthermore, transaction costs somewhat undermine the director's comments on raising new finance.
Director B's comments are illustrative of the clientele effect as discussed above.
Addressing the issue of differing shareholder preferences
The way in which a company will try to address the issue of differing preferences of different groups of
shareholders depends on the current mix of shareholders (which the company must remain aware of at all
times), what other similar companies do, and the effect that changes in dividend payout have had on the
share prices of similar companies in the past. It is vital that the company makes clear to shareholders what
its long-term dividend policy is, why any changes in dividend policy are being made and what the likely effect
will be on shareholder value of any future proposed investments.
In reality, the aspirations of the new management team may mitigate against the family shareholders' desire
for dividend payments as required and so the only way ahead is to communicate a planned, long-term
dividend policy even if this means driving away those family shareholders.
The relationship between a company's dividend policy and the 'agency problem'
This is apparent in the way that managers/directors do not necessarily act in the best interests of
shareholders. Shareholders may seek to keep some control over their money by insisting on high pay-out
ratios (in line with Director A's comments), thereby forcing managers/directors wanting new funds for
investment to justify why the investment is sound. However, there is an agency cost here in the form of the
cost of the new share issue.
Managers/directors may, therefore, be motivated to adopt a low dividend pay-out policy which circumvents
this need to justify projects by creating retained earnings which can be used to fund new projects. Even if
they do this, however, there may still be an agency cost for shareholders in that managers may invest in
ANSWER BANK
empire building projects rather than in those that maximise shareholder wealth. In addition, an over-
reliance on retentions can lead to dividend cuts which upset shareholders, depress the share price and
increase the cost of equity.
Marking guide
Marks
General points 4
Dividend policy factors 5
Director comments 3
Different preferences 3
Agency problem 3
Maximum 18
Total available 16
46 Biojack Ltd
(a) Estimation of the new dividend
CU0.13
Current share price = + CU0.13 = CU1.31
0.11
The new dividend (d) is given by
d ÷ 0.14
CU1.31 =
1+ 0.14
d = 1.31 × 1.14 × 0.14 = CU0.2091, say 21 pence

(b) Discussion of the practical effects on the share price
The analysis in (a) assumes that the assertions of Modigliani and Miller (M&M) hold true. M&M argued
that share valuation is entirely dependent on the amount, timing and perceived riskiness of future
dividends. Changing the pattern of dividends, as in the Biojack Ltd case, will not affect shareholders'
wealth. M&M made the following assumptions in reaching this conclusion.
 Frictionless capital markets
 Efficient capital markets
 Companies can issue shares without cost or restriction
 No taxes on income or capital gains for companies or individuals.
This could be a situation where shareholders might choose to create 'home-made' dividends to ease
possible cash flow problems.
The issues likely to cause the new share price not to equal CU1.31 include the following.
 Informational content of dividends. It is believed that the failure to pay a dividend could cause
shareholders' perceptions of the future to alter.
Clientele effect. This company is planning to change its pattern of dividends. This may well not
appeal to existing investors, who may react by selling their shares. The lack of appeal may stem
from the shareholders' tax position or from their need for cash. Efficient market evidence
suggests that the market will correctly value the new situation, but there will be losses of value as
a result of the change in ownership of some of the shares.
The change in the risk profile of the company's returns could also cause a clientele effect.
 A disbelief that there will be a constant level of dividend in the future. In real life such constancy
would be unusual.
Marking guide
Marks
(a) Current share price 2

New dividend 3
5
(b) M&M assumptions 4
Relevant factors 5
9
14
47 Safeway Ltd
(a) Organic growth v acquisition
Organic growth normally means relatively slow growth, financed by profits and limited amounts of
borrowing.
A business such as Morrisons remains firmly in control of the growth process as a result of such a
strategy and is not dependent on lenders.
The main risk of such a strategy is that slow growth may mean losing out to competitors in the market
place.
Growth by acquisition means buying businesses to expand group revenue.
Often this means raising or borrowing money to finance growth.
This carries the risk of dependence on borrowers or on shareholders' expectations of prompt
returns.
Wal-Mart is exceptional in generating funds to finance its own acquisition programme.
There is a risk that acquired businesses may take time and management time and effort to assimilate.
(b) Financial and operational gearing
Financial gearing is the relationship between borrowed money and shareholders' funds.
It may be represented as
Debt
Debt  Equity
Operational gearing is the relationship between fixed costs and variable costs.
Sainsbury's would need to borrow money to buy Safeway. This would represent an increase in its
financial gearing.
Sainsbury's would acquire fixed costs (for the Safeway supermarkets) and variable costs (to pay the
people to run the ex-Safeway supermarkets and to buy the products to be sold in them).
Sainsbury's sale of stores and closure of Safeway head office would reduce fixed costs and borrowings.
It would also reduce variable costs.
ANSWER BANK
(c) Stakeholders
Shareholders
Immediate 'cash' from Wal-Mart, Sainsbury's
but loss of flow of income
Shares from Morrisons offer continuing interest in business and/or sector
but there is a risk of poor performance, especially in the period of assimilation
Employees
A takeover risks redundancies for some
but it may provide secure long-term future
Customers
Safeway customers may lose their favoured brands
but they will have the convenience of their 'local supermarket' continuing
Suppliers
Some may not continue as suppliers.
Suppliers who continue may be expected to reduce prices
but continuing suppliers will have the prospects of bigger volumes and bigger overall profits
Lenders
With the Sainsbury's offer existing lenders might be concerned with the increase in debt
A larger and more diversified company is likely to meet interest payments more easily
Professional advisers and banks
Will expect increased income as a result of any takeover activity
Marking guide
Marks
(a) 1 mark per point 4

16
48 Sunnydaze Ltd
(a) Evaluation of the offer price
Year 20X1 20X2 20X3 20X4
CUm CUm CUm CUm
Tents etc (1.000)
Tax depreciation (W1) 0.075 0.056 0.169
Operating cash flows (W2) 0.633 0.652 0.672
Tax thereon (0.190) (0.196) (0.202)
Working capital (W3) (0.126) (0.003) (0.004) 0.133
(1.126) 0.515 0.508 0.772
Discount factors (W4) 1.0000 0.8669 0.7514 0.6514
Discounted values (1.126) 0.446 0.382 0.503
Net present value = CU0.205m
The price that Sunnydaze would ask is CU205,000.
WORKINGS
Year CUm CUm
20X2 Cost 1.000
TDA (0.250) @ 30% 0.075
0.750
20X3 TDA (0.188) @ 30% 0.056
0.562
20X4 Disposal –
Balancing allowance 0.562 @ 30% 0.169
(2) Operating cash flows
Real terms sales =(CU1.000m ×0.2) +(CU1.200m ×0.5) +(CU1.400m ×0.3)
= CU1.220m
Money (or nominal) operating profits
CUm
20X2 [(CU1.220m  0.75) – CU0.300]  (1.03) 0.633
20X3 [(CU1.220m  0.75) – CU0.300]  (1.03)2 0.652
20X4 [(CU1.220m  0.75) – CU0.300]  (1.03)3 0.672
(3) Working capital
Increment Cumulative
At 31 December CUm CUm
20X1 (CU1.220  1.03)  10% (0.126) (0.126)
20X2 [(CU1.220  1.032)  10%] – 0.126 (0.003) (0.129)
20X3 [(CU1.220  1.033)  10%] – 0.129 (0.004) (0.133)
20X4 0.133 zero
20X2 1[(1 + 0.12) (1 + 0.03)] = 0.8669
20X3 1[(1 + 0.12) (1 + 0.03)]2 = 0.7514
20X4 1[(1 + 0.12) (1 + 0.03)]3 = 0.6514
ANSWER BANK
(b) Justification of the PV approach to valuation

Using the NPV of the future projected cash flows to evaluate an investment is the only truly logical
approach. The financing cost is accounted for and risk can be incorporated in the discount rate.
Any economic asset only has a value because it is believed capable of producing net positive cash flows
in the future. Logically its value should depend on the magnitude of those cash flows, their riskiness
and the cost of financing them until they materialise.
Discounting appropriately takes account of the fact that chronologically more distant cash flows are
less valuable, CU for CU, than nearer flows.
(c) Further issues for the buy-out team
Generally the offer price looks generous to the buy-out team, because of the short timescale of the
projected cash flows. The team presumably believes that the Bienvenue business can continue much
further into the future, possibly with higher levels of operating profits than it has experienced in the
past ten years.
The directors' scepticism about Bienvenue could well have led to the division being overlooked and
left to stagnate. As a separate business with committed managers, this could very well breathe life into
it.
The tax rate of the new independent Bienvenue business may well be less than 30% (Sunnydaze's rate),
which means that the effective value of the cash flows will be greater.
Though correct under the valuation formula, Bienvenue's share of head office costs was ignored
(because it would not represent a saving to Sunnydaze); this would be a cost to Bienvenue. Presumably
head office provided Bienvenue with services (perhaps accounting, personnel etc) that Bienvenue
would now have to provide. The valuation method therefore overvalues the division, from the team's
perspective, in this regard.
Sunnydaze's cost of capital may well not be the same for Bienvenue. Though it is not possible to know
without further information, it seems reasonable to speculate that the latter's cost of capital would be
higher. Larger organisations tend to be able to raise cheaper finance than smaller. Moreover, if
Bienvenue's tax rate is lower than that of Sunnydaze, the interest on any loan finance would be
relieved at a lower rate.
The buy-out team needs to get a finance professional to look at the figures to assess the
reasonableness.
The team must logically look at the cost of setting up a similar operation from scratch, bearing in mind
any goodwill value of the Bienvenue name and that Bienvenue could well stay on as a competitor. If
this looks cheaper than the buy-out, the buy-out should probably not go ahead.
The team needs to realise that unless it intends to proceed after the buy-out, in a different manner to
that projected by Sunnydaze, it will need to raise not only the funds determined in (a), but enough for
new tents and working capital. This totals about CU1.33 million.
If the team wishes to proceed, it will have to raise the necessary cash. It may be able to find the funds
from its own resources. It may be able to get Sunnydaze to accept instalments, with interest at an
agreed rate on the outstanding balances.
A firm of chartered accountants or other professional accountants might be able to offer funding and
other advice or provide a link to someone who can do so. A high street bank might also be able to
help.
Venture capital might be a possibility, but venture capitalists tend to take equity interests and need an
exit route. This could come from selling the business off in a few years to another company or, if it is
very successful, through a flotation on a stock market.
A bank might be prepared to advance a term loan, but it would almost certainly want security. There
is no mention that any of Bienvenue's assets include items which banks tend to favour as security. The
only tangible asset of the new Bienvenue will probably be its tents. These are quickly depreciating and
located in France. This may not be seen as suitable security for a bank, whether in the BANGLADESH
or in France. The personal assets (e.g. houses) of the buy-out team might provide some or all of the
security.
Leasing or hire-purchasing the tents could be possibilities.
A business angel could be another possibility.
Marking guide
Marks
(a) Tax depreciation (W1) 3½

Operating cash flows (W2) 5½
Tax 1
Working capital (W3) 2½
Discount factors 2½
NPV 1
Price to ask 1
17
(b) 1 – 2 marks per paragraph 4
(c) 1 – 2 marks per paragraph 8
29
49 Tinkler's Stores Ltd

REPORT
To: The Tinkler Family
From: An Accountant
Date: Today
Subject: Financial strategies under consideration
I have outlined below the merits and risks involved with the financial strategies that you are considering.
Option 1: CU1 million borrowing to finance the development of key departments
This option could be said to represent (further) organic growth by the company, that is to say the funding
of internally-generated projects.
The merits of this strategy would be that
 The company and the family keep control of the business
 The costs of the project are spread over time
 The rate of change with the business is likely to be slower than under other options.
The main risks would be
 The risk that the project does not succeed (the 'strategy' seems to be a defensive one – what the
company can afford rather than a clear strategy to differentiate the business)
 The process may be too slow and tentative for the company to survive
 The lenders are likely to want a relatively high rate of interest, given the company's current gearing
level, bank overdraft and net current assets at zero – although the land and buildings would seem to
provide good security.
ANSWER BANK
Option 2: Sell to a rival

This option may be said to represent the disposal (or possibly acquisition) option.
The main merit of this option would be that the risks of investing in the business would be removed.
Similarly, the concentration of risk in one entity could be replaced by investment in a more balanced
portfolio.
The main risk would be that the price being offered could be deemed to be too low. (The land and buildings
are said to be worth CU20 million and the net assets are worth CU14m (CU20m – [CU5m + CU1m]). An offer of
more than CU10 million from the rival would be necessary.)
It could be deemed a risk of the offer that it is an offer of shares in the rival rather than 'cash'.
This offer has the advantage of a degree of certainty (despite the possible change in share value). The rival is
well established; this should reduce risk.
The shareholders might incur capital gains tax upon disposal of the shares.
The timing of payment (in six months' time) is likely to be at least as good as the other offers.
Option 3: Management buy-out
This is the management buy-out (MBO) option.
The main merit of this financial strategy is that it is a cheaper alternative to a close down.
Management should be familiar with the business, paying a reasonable price and having a good chance of
success.
The main risks are likely to be that
 There is no guarantee of success
 It is often difficult for MBO teams to immediately finance for a full buy-out
 Management may be concentrating on the buy-out rather than increasing current profits for the
business
 Successful MBOs can lead to big gains for management – on which the previous shareholders will have
lost out.
In this particular case, the Tinkler family would be at risk to the extent of CU5 million until the second
instalment of the consideration were paid and have no control over the operations of the business during
this period.
Again, the price of CU10 million may be deemed to be too low – the net assets are worth CU14m.
Option 4: Closing the business
Closing the business represents the liquidation option. The main merit of this approach is that it allows the
assets of the business to be converted into cash before there are (financial) losses and value is lost to
shareholders.
The main risks are that the assets fail to realise the expected values and/or costs are greater than expected.
It appears that liquidation might not be attractive an option for Tinkler.
CUm
Land and buildings at market value 20
Less Closure costs (5)
Net 15
Less Bank overdraft and long-term loans (6)
Realisable 9
This compares with CU10 million offered by the rival and by the MBO.
Marking guide
Marks
Report format 1
Option 1: I mark per point max 3
Maximum 14
Total available 12
50 Bill Jackson Haulage Ltd

(a) REPORT
To: Paul Jackson, Chief Executive of Bill Jackson Haulage Ltd (BJH)
From: J Gray, Black, White and Gray, Chartered Accountants
Date: 13 June 20X2
Subject: Financing the purchase of the company's site
Terms of reference
To advise on possible sources of finance for the purchase of the freehold of the company's site
General points
Before proceeding with plans to purchase the site the directors must be confident that purchasing the
current site represents the best prospect. Moving to an alternative site, whether leased or bought,
may provide an economically preferable option. If such a site exists, a net present value assessment
should be made of the options.
Irrespective of other sites the directors must be confident that purchase of the site at the price
expected represents an economically viable prospect. In simple terms, can BJH afford this site, given
the use to which it will be put?
Financing
General points
Broadly, financing sources fall into two categories; equity and debt. A question arises about the extent
to use debt, which tends to be (or appears to be) cheaper. For most businesses, debt is relatively
cheap because interest payments attract tax relief. It also seems cheaper because interest rates tend
to be lower than the level of returns expected by shareholders. This is because lenders' returns are
less risky than those of shareholders.
Ignoring tax for a moment, as soon as a business starts to borrow (has capital gearing) the returns of
shareholders become more risky because they have the additional burden of legally enforceable
interest payments. It has been shown that the net effect on the shareholders of borrowing is zero.
Debt is cheaper but this benefit is precisely countered by the higher returns expected by shareholders
because of the additional risk.
Thus tax is the only reason that debt is cheaper. This is significant because it represents a 30%
discount on the cost of debt. From this it might appear that businesses should raise all or almost all of
their finance from borrowing. This is not practical for one main reason: there is the danger that the
business would not be able to meet its interest or loan redemption obligations, leading to the loan
creditors forcing it into liquidation (bankruptcy). This can be very costly to the shareholders because it
ANSWER BANK
tends to lead to assets being sold off for much less than they are worth to the shareholders on a 'going
concern' basis.
Thus a balance needs to be struck between taking advantage of tax relief and avoiding the costs of
bankruptcy. Where this balance lies is very difficult to say and, in practice, a matter of managerial
judgement.
Factors that tend to be involved include the following.
 Whether the business has sufficient profits to take advantage of tax relief on interest payments –
not a problem with BJH
 Whether the business can provide security, normally in the form of suitable assets – probably not
a problem for BJH with the lorries and the land itself
 The type of assets that the business owns – if they tend to have relatively high realisable values,
bankruptcy cost would be less
 The extent to which revenues fluctuate – high gearing is not consistent with fluctuating profits;
much of your business comes from the building trade, which tends to have peaks and troughs of
demand
 The level of operating gearing (fixed costs to total costs) – high operating gearing leads to profit
fluctuations which capital gearing would add to; a business like BJH tends to have relatively high
fixed costs
 The attitude of the shareholders – if they are prepared to take more risk for higher rewards,
higher capital gearing may be appropriate.
For your size of business CU500,000 is a large loan. On the other hand, you are presently paying rent
which I presume is commensurate with prospective interest payments, with broadly the same
implications, i.e. failure to pay implies eviction from the site. Borrowing to buy the site would lower
your operating gearing, but increase your capital gearing.
Sources of finance
Equity
New issue
The most obvious source of equity is a rights issue to existing shareholders. This has the advantage of
being relatively cheap to issue and does not provide the company with much of a problem regarding
the issue price. A key issue here is the extent to which the shareholders have the funds necessary to
take up new shares. They may also lack willingness to make further investment in the company. On
the other hand, they will see the company's problem and may be prepared to help if they can.
Normally, equity is rather more expensive to the company than debt; investors expect higher returns
than for debt, but their returns are distinctly more risky. This tends to be less of an issue with a
private company.
It is possible that the directors would consider taking the company public. There are companies as
small as this listed on the Alternative Investment Market (AIM), but this is very much at the lower end.
For this size of company the fixed costs of an AIM listing are very high. Moreover, the potential loss of
control, together with the exposure to public scrutiny associated with an AIM listing, would probably
not be welcome to the company.
A more fruitful area for an equity issue might be a business angel or a venture capitalist. Such investors
tend to need the prospect of high returns and an exit route for their investment. This means that such
investors are interested only in expanding companies that can be foreseen to be likely to be taken
over or to go public within a reasonable time.
Retained earnings
This is an important source of new finance to Bangladesh companies, but it is slow. It would not be
suitable in this case, since all of the company's available funds are already committed. There is the
option of waiting, perhaps a few years, until retained earnings build up before making the investment
but, commercially, this may not be realistic.
Retaining profit normally has implications for dividend policy and, possibly, for shareholder wealth, but
this too may not be a big issue for this company.
Term loan from a bank or similar institution
Your bank may well be prepared to lend you the money, or to put you in touch with another lender.
My firm has corporate finance contacts, which may be able to advise, if necessary.
A term loan tends to be tailored to the needs of the borrower. It may involve partial repayment of the
principal (the amount borrowed) with interest payments over the period of the loan (like a repayment
mortgage) or interest only payments until the loan is due to be repaid. Term loans tend to be very
cheap to negotiate.
Interest rates tend to be low where there is good security, which there would be in this case where
the site value would provide a good basis. Lenders would tend to want a margin of safety, so would be
reluctant to lend CU500,000 on the security of an asset costing that much. It may be that other assets
could also be pledged as security, or that other sources (see below) could reduce the amount
required.
It is not unusual for lenders to impose covenants or restrictions on the borrower, e.g. insisting that it
maintains a particular current assets/current liabilities ratio.
This type of finance looks as if it may be the most appropriate for BJH and should be seriously
considered.
Loan stocks
In theory this is a possibility but, for a small family company, it is probably not very practical. Probably
the main benefit of loan stocks is their transferability, but without a listing this is probably not an issue.
Working capital
It may well be worth assessing whether there is any scope for generating some cash from the
company's working capital. For example, might it be possible for you to reduce trade receivables
and/or increase trade payables? There is clearly little scope with inventory since you hold very little.
Anything that you can obtain from working capital, provided that you are prudent, would have little or
no cost. The amounts involved here would certainly not make great inroads on CU500,000, but it
might be worth considering.
Unused non-current assets
Are there any assets that you do not use or are not used profitably? If there are, and they could be
sold, cash could be generated. As with working capital, any cash sourced from here would be relatively
little.
(b) (i) Critical comments on the spin-off statement
The statement is comprehensively wrong. A spin-off occurs where a company takes a definable
part of its activities and places it in another, subsidiary company. It then hands out the shares in
the subsidiary to the members of the original company pro rata their shareholding in the latter.
Usually a stock exchange listing is obtained for the new, spun-off company.
The reasons for doing this are typically twofold.
 A desire to give the spun-off company its own distinct identity, which might enhance overall
shareholder value.
 To avoid a takeover attempt for the whole company, by making the spun-off element more
expensive.
Thus no new finance is raised and there is no effective change in ownership of any of the assets
of the original company.
What is described in the quote is a 'sell-off'.
ANSWER BANK
(ii) Critical comments on the capital rationing statement

Capital rationing is a situation where a company does not have sufficient funds to make all of the
investments that have a positive NPV, when discounted at the investors' opportunity cost of
capital.
The capital restriction may arise from the company's inability to raise funds in the market, so-
called 'hard' capital rationing. (A company-imposed restriction on the amount of investment
finance available to managers, say, at divisional level is known as 'soft' capital rationing.)
In principle, selecting investments on the basis of the highest NPV per CU of investment finance
(not necessarily the highest NPV projects) will lead to the maximum generation of shareholder
wealth.
Marking guide
Marks
(a) Report format 1

1 – 2 marks per point 15
16
(b) (i) 1 mark per point 4
(ii) 1 mark per point 4
24
51 Megagreat Ltd
(a) Evaluation of a takeover offer
Value of an Angelic Ltd share (P0) = D1 / (ke – g)
= 0.37 / (0.12 – 0.05)
= CU5.29
 0.43 (1.07) 
 
0.43 0.43  0.11  0.07 
Value of an Megagreat Ltd share =  
1.11 1.112 1.112
= CU10.07
CU6  (3  CU10.07)
The holder of one A Ltd share will receive = CU9.05
4
Therefore, accept the bid.
(b) Discussion of the limitations of the calculations in (a) as the basis of a decision
Possible reasons include the following.
 Lack of confidence in the estimates on which the calculations are based.
 Unwillingness on the part of A Ltd shareholders to hold M Ltd shares – dividend policy, level of
capital gearing etc and the cost of share dealing charges to move out of M Ltd shares.
 It looks as if these two companies may have a different risk profile and A Ltd shareholders may
not be happy with this.
 The cash payment may not be appealing to A Ltd shareholders because of the potential capital
gains tax charge to which this may give rise.
(c) Suggestions on how a target company's share price would tend to move when a takeover
offer is announced
If the market were to accept the estimates and believe that the bid would be successful and disregard
the factors in (b), A Ltd's share price would tend immediately to move to CU9.05.
If the market were to believe that the bid would be successful, but M Ltd would have to increase its
bid to succeed, the price would tend to rise to more than CU9.05.
If the market were to believe that the bid would be unsuccessful the A Ltd share price would tend to
remain at its present level.
Changes in market perceptions during the bid period may cause the share price to move around to
reflect those changes.
(d) Suggestions for strategies for growth without making takeovers
Alternatively, growth could be achieved organically by undertaking internally-generated projects,
perhaps using retained earnings to finance them.
Another growth strategy might be to 'buy-in' parts of other businesses, perhaps large parts, without
going for a full takeover. Buy-ins tend to involve only the assets, whereas takeovers involve the whole
of the business including the liabilities.
Marking guide
Marks
(a) Value of Angelic Ltd share 1½

Value of Megagreat Ltd share 2
Amount holders receive 1½
Conclusion 1
6
(b) 1 – 2 marks per point 4
(c) 1 – 2 marks per point 4
(d) 1 – 2 marks per explanation 3
17
52 Thebean Ltd
(a) When choosing between an issue of debt and an issue of equity finance, a company needs to consider
the following factors.
(i) Risk – additional debt finance will increase the gearing of the company, and increases its financial
risk because of the commitment to meet interest payments. There is no such commitment to
make dividend payments to shareholders.
(ii) Cost – debt is cheaper than equity because of the requirement to pay interest. This interest is
deductible when calculating taxable profit. It is also less risky from an investor's perspective,
because lenders have priority over equity shareholders in the event of liquidation. Debt finance is
often secured on the assets of the company to provide security.
(iii) Maturity – debt finance will ultimately need to be repaid, whereas equity finance does not. If a
company has to pay back a large amount of debt this can severely stretch the available cash
resources if there is no method of refinancing in place.
ANSWER BANK
(iv) Availability – both equity and debt finance can be unavailable to companies for various reasons.
The terms of a share issue or loan may be unacceptable, or there may be little enthusiasm for a
rights issue.
(v) Control – both debt and equity finance have implications for the control of the company. A
large issue of new shares via an offer for sale could bring in new shareholders with a different set
of interests or objectives as well as legal rights to appoint directors and auditors. An issue of debt
may necessitate the meeting of certain covenants on the part of the company (such as a certain
level of interest cover that must be met at all times). The company will need to report on its
performance against such covenants to the lender on a regular basis.
(vi) Flexibility – debt financing is more flexible in that specific amounts can be borrowed for a range
of rates and maturities. Also, generally debt is easier to repay (depending on the terms).
(b)
Debt finance Equity finance
CU'000 CU'000
Sales 65,400 65,400 60,000  1.09
Variable cost of sales (36,788) (36,788) 45,000  75%  1.09
Fixed cost of sales (11,250) (11,250) 45,000  25%
Gross profit 17,362 17,362

Administration costs (8,480) (8,480) 8,000  1.06
PBIT 8,882 8,882
Interest (1,150) (350) Debt finance cost 8%  CU10m =
CU800k
in addition to existing CU350k
Profit before tax 7,732 8,532
Tax at 30% (2,320) (2,560)
Profit after tax 5,412 5,972

Dividends at 55% (2,977) (3,285)
Retained earnings 2,435 2,687

(c)
Financial gearing Current Debt finance Equity finance
Debt/equity ratio:
Debt 3,500 13,500 3,500
Share capital and reserves 31,010 33,445 43,697
Debt/equity ratio % 11.3% 40.4% 8.0%
Operational gearing Current Debt finance Equity finance
Contribution/PBIT
Contribution 26,250 28,612 28,612
PBIT 7,000 8,882 8,882
Operational gearing 3.8 3.2 3.2
Earnings per share Current Debt finance Equity finance
Profit after tax 4,655 5,412 5,972
Number of shares 8,000 8,000 10,000
EPS (pence) 58.2 67.7 59.7
Interest cover Current Debt finance Equity finance
PBIT 7,000 8,882 8,882
Debt interest 350 1,150 350
Interest cover 20 7.7 25.4
The debt finance proposal increases EPS, but will reduce interest cover and increase financial gearing.
Whether these changes are acceptable depends both upon sector averages and the response of
investors and managers. A decision to use equity finance would decrease financial gearing but would
increase interest cover. A decrease in operational gearing would result from both proposals.
Marking guide
Marks
(a) Up to 2 marks for each well discussed factor 8
(b) Sales and administration cost 1

Cost of sales 1
Interest 1
Profit after tax 1
Retained earnings 1
5
(c) Revised share capital and reserves 1
Financial gearing 2
Operational gearing 2
Earnings per share 2
Interest cover 2
Calculation of current values 2
Discussion 1
12
25
53 Fituup Ltd
(a) Forecast income statements
Year 20X5 20X6 20X7
CU'000 CU'000 CU'000
Revenue 53,200 61,180 70,357 Up 15%
Cash based costs and expenses (39,741) (42,125) (44,652) Up 6%
Depreciation – (1,050) (1,050) 0% straight line on CU10.5
million.
Operating profit 13,459 18,005 24,655
Finance costs (4,680) (4,680) (4,680) Unchanged
Profit before tax 8,779 13,325 19,975
Tax (2,634) (3,525) (5,717) W1
Profit after tax 6,145 9,800 14,258
Dividend (2,458) (2,556) (2,658) Up 4%; paid following year
Retained profit for the year 3,687 7,244 11,600
Retained earnings b/f 8,314 15,558
Retained earnings c/f 15,558 27,158
WORKING 1
Tax payable
20X6 20X7
CU'000 CU'000
Plant value at start of year 10,500 7,875
Tax depreciation (25% reducing balance) (2,625) (1,969)

Add back depreciation 1,050 1,050
Less tax depreciation (2,625) (1,969)
Taxable profit 11,750 19,056
Tax at 30% (3,525) (5,717)
ANSWER BANK
(b) Cash flow forecasts

Year ended 20X6 20X7
CU'000
CU'000
Cash from sales (61,180 + 6,475 – 7,446) (W2) 60,209 69,240 Up 15%
Cash on costs and expenses (42,125 + 4,988 – 5,287) (41,826) (44,336) Up 6%
Cash from operations 18,383 24,904
Finance costs (4,680) (4,680) Constant
Dividend paid (2,458) (2,556) Previous year's div.
Tax paid (3,525) (5,717)
Purchase of plant and machinery (10,500) –
Net cash flow (2,780) 11,951
Balance brought forward 347 (2,433)
Balance carried forward (2,433) 9,518
WORKING 2
Trade receivables and payables
20X5 20X6 20X7
CU'000 CU'000 CU'000
Trade receivables (grow by 15% pa) 6,475 7,446 8,563
Trade payables (grow by 6% pa) 4,988 5,287 5,604
Financing of cash deficit

The cash deficit in 20X6 could be financed by increasing the company's overdraft; by taking out
a medium-term loan; by reducing the dividend (would only finance part of the deficit); or by
using a source of short term finance based on its receivables (factoring or invoice discounting).
The deficit is not large enough and does not last long enough to consider a longer-term source of
funds such as a share issue or long-term loan. The situation may be complicated if there are
restrictive covenants in the company's borrowing based on liquidity and/or gearing levels, in
which case equity funds would be needed unless the company can renegotiate terms with its bankers.
Reducing the dividend would require careful explanation to shareholders and most quoted
companies would probably opt to increase borrowings rather than reduce the dividend when the
profitability trend is firmly upwards.
(c) Key aspects of the company's performance
Pre-tax return
The company's stated targets are concerned with profitability and growth. On the basis of above
forecasts, the pre-tax return on closing book value of equity is forecast to stay consistently above the
target of 35% pa and to show steady growth:
20X5: 8,779 / (14,612 + 8,314) = 38.3%
20X6: 13,325 / (14,612 + 15,558) = 44.2%
20X7: 19,975 / (14,612 + 27,158) = 47.8%
Growth in equity earnings
At the same time, the forecast annual growth in equity earnings (profit after tax) is much higher than
the company's target.
20X6: (9,800 / 6,145) – 1 = 59.5%
20X7: (14,258 / 9,800) – 1 = 45.5%
These results are excellent, especially as an increase in sales (or reduction in cost) specifically from
the investment in plant has not been factored into the forecasts.
Liquidity position
However, the results cannot be looked at in isolation of the company's liquidity position. The
investment and rapid growth will cause a significant drop in the cash resources during 20X6, though
this is predicted to turn round in 20X7.
The liquidity ratios will change as follows:
20X5 20X6 20X7
CU'000 CU'000 CU'000
Inventories 7,893 7,893 7,893
Trade receivables 6,475 7,446 8,563
Cash 347 9,518
14,715 15,339 25,974
Current liabilities
Trade payables 4,988 5,287 5,604
Other payables: Dividends 2,458 2,556 2,658
Overdraft 2,433
7,446 10,276 8,262
Current ratio (current assets / current liabilities) 1.98 1.49 3.14

Quick ratio ((current assets – inventory) / current
liabilities) 0.92 0.72 2.19
Although the liquidity position is only bad for one year, the company will need to make use of an
overdraft facility with its bankers, or use one of the other sources of funds mentioned in part (b) above.
The 7% bonds will need to be redeemed in 20X8 and there will probably be enough cash by then to
do this, although an alternative would be to refinance with more long-term debt at that stage.
Marking guide
Marks
(a) Calculations: ½ mark per line 6

(b) Calculations: ½ mark per line 5
Comments 3
8
(c) Pre-tax returns 3
Growth in earnings 3
Liquidity position 5
11
25
ANSWER BANK
54 Narmer Ltd
(a) (i) Forecast income statements for the year ended 31 December 20X5
Debenture issue Share issue
CU'000 CU'000
Sales revenue (17.5 + 6) 23,500 23,500
Cost of sales and expenses (bal. fig.) (20,292) (20,292)
Operating profit (W) 3,208 3,208
Interest payable (400 + 10%  4,000) (800) (400)
Tax at 30% (722) (842)
Profit after tax 1,686 1,966
430 (545) (636)
Dividends ( at = 32.33%)
1,330
Retained profit for the year 1,141 1,330
WORKING
2,300
Current operating profit margin =  100% = 13.14%
17,500
 New sales have an operating profit margin of 13.14 + 2 = 15.14%
 Operating profit in 20X5 = 2,300 + (15.14%  6,000) = 3,208
(ii)
Earnings per share 1,686 1,966
= 112.4p = 63.4p
1,500 1,500  1,600
(iii)
Debt 5,000  4,000 5,000
Gearing ratio
Debt  Equity 9,000  5,800 1,141 5,000  5,800  1,330  4,000
= 56.5% = 31.0%
5,000
(b) The company's current gearing level is = 46.3%.
5,000  5,800
The debenture proposal would increase this somewhat to 56.5%, but this is not very high. The interest
charge in the income statement is well covered, and the directors have already identified potential
buyers for the new debentures. Thus the debenture issue seems possible.
1,330
The company's current earnings per share is = 88.7p.
1,500
This falls substantially to 63.4p under the share issue proposal. The rights issue appears to be planned
to be made at a deep discount. We are not told the current share price, but the shares have a net
5,800
asset value of = CU3.87, so the share price is probably well in excess of this, and offering new
1,500
shares at CU2.50 seems unnecessarily low and dilutive. Can the new shares be offered at a higher
price, to reduce the amount by which earnings per share will be reduced?
In deciding between the two proposals in the question, the directors should consider the risk of each
proposal (additional debt will increase financial risk) and the cost of capital of each proposal (the cost
of debt is less than the cost of equity). Furthermore it will be cheaper to issue new debt than to issue
new shares, and the existing shareholders must be consulted to see if they are willing and able to take
up their rights in a rights issue.
Marking guide
Marks
(a) Calculations (i) 6
Calculations (ii) 3
Calculations (iii) 3
12
(b) Comment on results of (a) 3
Key points 2
5
17
ANSWER BANK
Risk management
55 Plutocrat Ltd
(a) Interest rate futures
Hedging
A future is an agreement on the future price of a variable. Hedging with futures offers protection
against adverse movements in the underlying variable; if these occur they will more or less be
offset by a gain on the futures market. Hedging with futures, however, also offsets any favourable
movement in the value of the variable.
Terms
The terms, sums involved and periods are standardised and hedge inefficiencies will be caused
by either not having a whole number of contracts, or by basis risk.
Deposit
Futures require the payment of a small deposit; this transaction cost is likely to be lower than the
premium for a tailored forward rate agreement or any type of option.
Timescale
The majority of futures are taken out to hedge borrowing or lending for short periods.
Interest rate options
Guaranteed amounts
The main advantage of options is that the buyer cannot lose on the interest rate and can take
advantage of any favourable rate movements in contrast to futures where both adverse and favourable
movements are hedged. An interest rate option provides the right to borrow a specified amount
at a rate less than or equal to a guaranteed maximum rate of interest. On the date of expiry
of the option the buyer must decide whether or not to exercise his right to borrow. He will
only exercise the option if actual interest rates have risen above the option rate.
Premium cost
However a premium must be paid regardless of whether or not the option is exercised, and the
premium cost can be quite high, high enough not to make an option worthwhile if interest rate
movements are expected to be marginal.
Types of option
Options can be negotiated directly with the bank (over the counter, OTC) or traded in a
standardised form on Euronext.liffe. OTC options will be preferable if the buyers require an option
tailored to their needs in terms of maturity date, contract size, currency or nature of interest.
OTC options are also generally more appropriate if the buyers require a long time to maturity or a
large contract size. Traded options will be more appropriate if the buyers are looking for options
that can be exercised at any time, are looking for a quick, straightforward deal, or might want
to sell the options before the expiry date if they are not required.
Risk management
(b) (i) Hedging the borrowing rate using futures

Setup
Since we are looking to borrow in six months' time (1 September), we should sell
September contracts.
CU12,000,000 6
Number of contracts =  = 48 contracts
CU500,000 3
(as they are 3-month contracts and we need to cover 6 months)
Outcome
The results of this are as follows.
(1) Futures market
1 Mar: Sell 48 @ 94.28
1 Sept: Buy 48 @ 93.97
Quote movement 0.31%
Profit / (Loss) 48 contracts  CU500,000  0.31%  3/12 CU18,600
(2) Net outcome
CU
Payment in spot market 6%  CU12m  6/12 (360,000)
Profit/(Loss) in futures market 18,600
Net cost of loan (341,400)
341, 400 12
Effective interest cost is   5.69%
12,000,000 6
(ii) Hedging the borrowing rate using options
Setup
Since we are looking to borrow in six months' time and are concerned that rates may
rise, we should buy September put options.
Number of contracts = 48 (as for futures above)
Option premium
94250: 48  0.187%  CU500,000  3/12 = CU11,220
94500: 48  0.282%  CU500,000  3/12 = CU16,920
94750: 48  0.407%  CU500,000  3/12 = CU24,420
Closing price of futures
93.97 as above
Outcome
(i) Option market outcome
Put option strike price (right to sell) 94.25 94.50 94.75
September futures price 93.97 93.97 93.97
Exercise option? (prefer to sell at highest price) Yes Yes Yes
Gain 0.28% 0.53% 0.78%
Option outcome (48 × CU500,000  3/12 × gain) 16,800 31,800 46,800
ANSWER BANK
(ii) Net position

94.25 94.50 94.75
CU CU CU
Actual interest cost (as above) (360,000) (360,000) (360,000)
Value of option gain 16,800 31,800 46,800
Premium (11,220) (16,920) (24,420)
Net cost of loan 354,420 345,120 337,620
Effective interest cost (Cost × 2/12m) 5.91% 5.75% 5.63%
The 94.75 option is the preferred hedging method, as it has a lower interest cost than the future.
If interest rates fall, the option can lapse or be sold and Plutocrat can take the benefit of a lower
borrowing rate.
Marking guide
Marks
(a) Futures 3
Options 3
6
(b) Futures 1
Sell September futures 1
Number of contracts 3
Hedge, with outcome
Options:
Buy 48 September puts 1
Premium costs 1
Overall costs with options 3
Conclusion 1
Comment about interest rates falling 1
For full marks all exercise prices should be considered Max 11
17
56 Snowdrop Ltd and Fortensia Ltd

(a) Compare the rates at which the two companies can borrow from the market:
Fixed Floating
Snowdrop 6.35% LIBOR + 0.50%
Fortensia 7.60% LIBOR + 1.25%
Differential 1.25% 0.75%
%
Difference between the differentials (1.25% – 0.75%) 0.50
Less bank commission 0.25
Available arbitrage gain 0.25
Gain required by Snowdrop 0.20
Gain available for Fortensia 0.05
Snowdrop has comparative advantage borrowing fixed rate, so it will gain if it borrows at fixed and
swaps into floating rate. The reverse is true for Fortensia. The arbitrage gain figures show that a
swap can be arranged which will benefit all parties, but Snowdrop gains much more than Fortensia,
who may not agree to the deal.
Risk management
(b) Overall position

Net borrowing cost
Snowdrop Fortensia
Rate achievable alone (LIBOR + 0.50%) (7.60%)
Gain from swap 0.20% 0.05%
Net borrowing cost (LIBOR + 0.30%) (7.55%)
Swap cash flows
LIBOR LIBOR
Snowdrop Bank Fortensia
6.05% 6.3%
6.35% LIBOR + 1.25%
Loan (6.35%) 0% (LIBOR + 1.25%)

Swap
Floating rate (LIBOR) 0% LIBOR
Fixed rate 6.05% 0.25% (6.30%)
Net cost (LIBOR + 0.3%) 0.25% (7.55%)
Gain 0.2% 0.25% 0.05%
Note:
 In questions like this, always set the floating rate leg of the swap to LIBOR unless specifically
instructed otherwise.
 The fixed leg of the swap is then the balancing figure needed to achieve the net position.
(c) Benefits
 Enable a switch between fixed and floating rate to hedge interest rate risk
 Low arrangement costs, typically less than terminating an old loan and taking a new one
 Achieve cash flow schedule desired (fixed/floating) at a better rate than could be achieved alone
due to the theory of comparative advantage
 Available for long periods (several years)
 Not standardised, so can be tailored to business needs with respect to amount and period.
Risks
 Counterparty may default on payments, usually covered by intermediary
 Rates may move unfavourably after entering the position leaving the net borrowing cost
uncompetitive
 Lack of clarity in accounts
ANSWER BANK
Marking guide
Marks
(a) Borrowing rates 3

Gains 3
6
(b) Net borrowing costs 2
Cash flows 4
6
(c) 1 mark per valid comment 8
20
57 Thersk Ltd
REPORT
To: Board of Directors, Thersk Ltd
From: Finance Director
Date: 1 December 200X
Subject: The use of financial derivatives and interest rate swaps
1 Introduction
1.1 The purpose of this report is to explain the nature and function of financial derivatives,
and the benefits that they could offer to Thersk. The later sections of the report deal in more
detail with methods of hedging interest rate risk, and the potential benefits of negotiating an
interest rate swap with Perturb.
2 Financial derivatives
2.1 Financial derivatives are products that have developed from the securities and currency markets.
Examples of derivative products include futures and options in currencies and interest rates.
2.2 There are two main purposes for which these products might be used:
(i) Hedging against known risks
This can best be explained by means of an example. The company might have a
commitment to make a payment in a foreign currency on a specific date in three
months' time. It knows the amount of the sum to be paid in foreign currency, but it
cannot know what the exchange rate will be at that time. It therefore faces the risk that if
the home currency depreciates against the foreign currency, the size of the payment in CU
will be greater than if the payment were made now. This risk could be hedged by using a
derivative. Such a transaction would have a commission cost associated with it, but it
would limit the risk faced by the company.
(ii) Speculation
Derivatives can also be used to gamble on expectations of movements in interest and
exchange rates. For example, the investor might believe that CU would weaken against the
dollar, and therefore buy dollars futures. These dollars would then be sold on the spot
market once the expected movement in rates had taken place. The transactions are made
purely with the motive of making a profit, and are not linked to any underlying business
transactions. They are therefore very risky.
Risk management
(iii) Use by Thersk

Since Thersk has diversified, international interests, derivative products offer significant
benefits in the management of the financial risks to which the company is exposed. The
board needs to determine the level of risk that it is prepared to accept in these areas so
that an integrated set of guidelines can be established for the effective management of these
issues.
3 Hedging interest rate risk
The main techniques available to hedge this type of risk are as follows.
3.1 Forward rate agreements
A forward rate agreement (FRA) is an OTC contract to lend or borrow a given sum of
money in the future at an interest rate that is agreed today. For currencies, the equivalent is the
forward contract: an agreement to buy or sell a given amount of currency in the future at an
exchange rate that is agreed today. These contracts can be used to 'fix' interest rates or
exchange rates on future transactions, thus removing the risk of rate movements in the
intervening period.
3.2 Interest rate futures
These operate in a similar way to forward rate agreements. However, they are not negotiated
directly with a bank but are traded on the futures market. Consequently, the terms, the
amounts and the periods are standardised. For this reason, forward rate agreements are
normally more appropriate than interest rate futures to non-financial companies such as Thersk.
3.3 Interest rate options
An interest rate option provides the right to borrow/lend a specified amount at a
guaranteed maximum/minimum rate of interest. On the date of expiry of the option, or
before, the buyer must decide whether or not to exercise the right. Thus in a borrowing
situation, the option will only be exercised if market interest rates have risen above the option
rate. Tailor made contracts can be purchased from major banks, while standardised contracts are
traded in a similar way to interest rate futures. The cost of taking out an option is generally
higher than for a forward rate agreement.
3.4 Interest rate swaps
These are transactions that exploit different interest rates in different markets for borrowing, to
reduce interest costs for either fixed or floating rate loans. An interest rate swap is an
arrangement whereby two companies, or a company and a bank, swap interest rate
commitments with each other. In a sense, each simulates the other's borrowings, although
each party to the swap retains its obligations to the original lenders. This means that the parties
must accept counterparty risk.
The main benefits of a swap as compared with other hedging instruments are as follows.
 Transaction costs are low, being limited to legal fees.
 They are flexible, since they can be arranged in any size, and they can be reversed if
necessary.
 Companies with different credit ratings can borrow at the best cost in the market
that is most accessible to them and then swap this benefit with another company to reduce
the mutual borrowing costs.
 Swaps allow capital restructuring by changing the nature of interest commitments
without the need to redeem debt or to issue new debt, thus reducing transaction costs.
4 Implications of an interest rate swap with Perturb
The proposed swap would involve one company borrowing at a floating rate, and the other at a fixed
rate. Each company would enter into an individual loan arrangement with the bank, and the interest
rate liabilities would then be swapped.
ANSWER BANK
Comparing the rates available to each company we have

Fixed Floating
Thersk 6.0% LIBOR + 0.2%
Perturb 7.5% LIBOR + 0.5%
Differential 1.5% 0.3%
%
Difference between differentials 1.20
(maximum potential gain)
Less: banks commission 0.20
Gain to counterparties 1.00
Since it is to be split up equally

Gain to Thersk 0.50%
Gain to Perturb 0.50%
Since there is a gain to each counterparty the arrangement is beneficial.
5 Net borrowing costs
Thersk has an absolute advantage in both markets (is cheaper in both fixed and floating) but has a
comparative advantage in fixed where it is a full 1.5% cheaper. Perturb has an absolute disadvantage in
both markets (more expensive in both) but a comparative advantage in floating where it is only 0.3%
more.
Therefore Thersk should borrow fixed at 6% and Perturb borrow floating at LIBOR + 0.5% and the
two counterparties should swap to their mutual benefit. The swap floating rate will be LIBOR with the
fixed rate set to achieve the desired split of the gain and consequent net borrowing costs.
The net borrowing costs will be
Thersk Perturb
Rate achievable alone LIBOR + 0.2% 7.5%
Gain from swap 0.5% 0.5%
Net borrowing cost LIBOR – 0.3% 7.0%
LIBOR LIBOR
Thersk Bank Perturb
6.3% 6.5%
6% LIBOR + 0.5%
Net position
Loan (6%) 0% (LIBOR + 0.5%)
Swap
Floating rate (LIBOR) 0% LIBOR
Fixed rate* 6.3% 0.2% (6.5%)
Net cost (LIBOR – 0.3%) 0.2% (7.0%)
*Balancing figures to get the correct net position
Risk management
Marking guide
Marks
(a) Meaning of derivatives 1

Uses of derivatives 1
Merits 3
Demerits 3
8
(b) Identify source of competitive advantage 2
Quantify extent of gain 2
Take account of costs 1
Benefit to each party 1
6
(c) Identify correct swap 1
Quantify rates for each 2
Quantify costs to each 1
4
18
58 Precision Specifications Ltd

REPORT
To: The marketing director of Precision Specifications Ltd
From: Forex analyst
Date: Today
Re: Dealing with a debt denominated in a foreign currency
Terms of reference
To report on the possible methods of dealing with a large exposure to foreign exchange rate risk arising
from a major sale on credit denominated in euros.
There are broadly four possible approaches open to the company.
Do nothing and accept the risk
This has the advantage that it costs nothing to arrange and, if the euro strengthens against the Taka during
the two-month credit period, the company will benefit.
The problem with this approach is, of course, if the Taka strengthens against the euro, the company could
lose a significant amount.
Businesses with a simultaneous exposure to many currencies, both as payables and receivables, might be
inclined to adopt this policy, but for a company in the present position, some action seems desirable.
Use a forward exchange contract
Here the euros are sold, in the foreign exchange (forex) market, immediately the work is invoiced, or even
before, but with delivery of the euros and the Taka payment not taking place until two months after the
invoice date. This guarantees the exchange rate, but it is likely be a less favourable rate because the
counterparty in this forex market will bear the risk. It is a straightforward transfer of the risk from the
company to the foreign exchange dealer.
The cost to the company is the probable less favourable rate of exchange, plus the fact that a favourable
exchange rate shift could not advantage the company. There is also the problem that the contract is binding.
If the customer fails to pay on the due date, the company will still have to produce the euros and complete
the deal. This could mean having to convert Taka to euros or borrowing euros – incurring further costs.
ANSWER BANK
Carry out a money market hedge

Here the company would immediately borrow euros of such an amount that, with interest for two months,
it will grow to the amount owed by the French customer. This amount would immediately be converted
into Taka, thus obviating the risk. When the customer pays, the euros received will exactly pay off the debt.
The cost to the company is the probably less favourable rate of rate of interest that could be earned, during
the two months, on the Taka, than the company will have to pay on the euro loan. Added to this is the fact
that a favourable exchange rate shift could not advantage the company. There is also the problem that the
euro borrowing has to be repaid, so a potentially expensive problem may ensue if the customer fails to pay
on the due date.
Buy a currency option
Here the company immediately buys an option. This gives it the right in two months' time to sell the euros
for Taka at a rate specified when the option is purchased. The counterparty to this contract would probably
be a forex dealer. When the two months have elapsed, the company can assess the position. If the Taka has
strengthened against the euro, the option would be exercised so that more Taka would be forthcoming
than if the forex transaction were to be at the spot rate ruling in two months' time. If, however, the euro
had strengthened against the Taka, the option would be ignored in favour of the current spot rate. Similarly,
if the customer fails to pay, the option need not be exercised.
Note that an option (of any description) bestows a right to deal, at the stated price, but not an obligation.
The owner of the option has the right to walk away from it if it is not beneficial to exercise that right.
The cost to the company is the price that it will have to pay for the option (the premium). The great
advantage of the option over other risk management techniques is that it leaves the company with the
opportunity to benefit from a favourable shift in exchange rates. The cost of the option, however, will
reflect the fact that the seller of the option will be denied that opportunity. The outcome for that party can
only be to exchange at an unfavourable rate relative to the spot rate ruling at the time, or nothing.
Marking guide
Marks
Report format 1
Outline approaches / no hedge 3
Forward exchange market 3
Money market hedge 3
Currency option 4
Maximum 14
Total available 12
Risk management
59 Treasurer
(a) The FTSE 100 index currently stands at 6000 and, given that the face value of the FTSE 100 index
future is CU10 per index point, this gives a contract value of CU60,000 (6000  CU10).
To hedge against a market fall we could either
 Sell shares and hold cash, or
 Sell futures
Since we do not wish to divest ourselves of the portfolio our action will be to sell FTSE 100 index
futures.
Market value of portfolio CU30,000,000
Number of contracts    500
Value of one contract CU60,000
So we should sell 500 FTSE 100 futures contracts now.
Index expiry levels
Futures gain/loss at expiry 5800 6200
Sell future at 6020 6020
Buy to close position at expiry (5800) (6200)
Gain/(loss) (pts) 220 (180)
Value per point CU10 CU10
Gain/(loss) per contract CU2,200 (CU1,800)
Number of contracts 500 500
Total futures gain/(loss) CU1,100,000 CU(900,000)
Portfolio value 5800 29,000,000 31,000,000 6200

CU30m  CU30m 
6000 6000
Futures gain/(loss) 1,100,000 (900,000)
Net value 30,100,000 30,100,000
We can see that irrespective of how the index has moved we have locked in to a value of CU30.1m
through this hedge.
(b) Hedge set-up using options
 Type of option
Our concern is that the index may fall so we could either
– Sell shares, or
– Hold the shares and take out an option to sell shares, i.e. a put option
 Number of contracts
As for the FTSE 100 index future, the option is evaluated at CU10 per index point or, based on
the current index level of 6000, CU60,000. Hence
Market value of portfolio CU30,000,000
Number of contracts    500
Value of one contract CU60,000
ANSWER BANK
 Premium payable
The premium on the 6000 put option is 130 points, so for 500 contracts that amounts to
130  CU10  500 = CU650,000.
Action and option value
Final index level
5800 6200
Action taken with option Exercise Abandon
Value of option (6000 – 5800)  CU10  0
500
= CU1,000,000
Net outcome
Final index level
5800 6200
CU CU
Portfolio value (as above) 29,000,000 31,000,000
Option value 1,000,000 0
Premium paid (650,000) (650,000)
Net position 29,350,000 30,350,000
The CU29,350,000 represents a minimum value the portfolio may have if markets fall.
Marking guide
Marks
(a) Alternatives 1
Sell future 1
Future gain/loss
– Points 2
– CU's 2
– Net gain 2
Conclusion 1
10
(b) Alternatives 1
Buy put options 1
Premium 1
Options
– Action 2
– Sell value 2
– Premium and net 2
10
20
Risk management
60 Haining Ltd
(a) Forward contract
Cost = $900,000
Therefore, in Taka, the spot cost is CU(900,000/1.6) = CU562,500
The forward exchange rate is calculated by adding the appropriate discount to the appropriate spot
rate as follows.
The forward exchange rate is 1.60 + 0.02 = 1.62
A forward exchange contract is a binding contract to buy or sell a specified quantity of a particular
currency at a pre-determined rate of exchange on a fixed future date, so, therefore, the forward
exchange rate fixes the cost at CU(900,000/1.62) = CU555,556
This compares to the predicted spot rate of 1.50 which would leave the company facing a payment of
CU(900,000/1.5) = CU600,000
(b) Money market hedge
If a company has an asset denominated in a foreign currency, it can mitigate the effect of exchange rate
movements on the value of the asset by borrowing in that currency, thus creating an equal and
opposite liability. Since interest rates on loans can be fixed in advance and all currency translation is
done at spot rates, the uncertainty is removed.
Spot rates euro/CU 1.30 – 1.35 interest Bangladesh – for six months = 4%
rates
Euro zone – for six months = 3.5%
300,000 euros to be received in six months' time. Therefore, borrow an amount of x euros now, such
that with interest 300,000 euros will be owing in six months' time
x euros  1.035 = 300,000 euros
x euros = 289,855 euros
Convert to CU immediately to remove the exchange rate risk.
289,855/1.35 = CU214,707
In six months' time the loan with interest will be 300,000 euros and will be paid off by the receipt.
(c) Futures contracts
Although similar to a forward exchange contract, in that it creates a no win/no loss position for the
purchaser of the contract with a fixed maturity date, a futures contract has some important
differences.
(1) It is sold in standardised amounts of currency, rather than at any amount required.
(2) It is traded on a currency exchange, rather than sold by banks.
The advice to the commercial director, therefore, is that it would be extremely unusual to be able to
use a futures contract to cover a precise amount of foreign currency risk, unless the risk happened to
be exactly equal to one of the standardised amounts in which the contract was sold.
That is not the case with Haining Ltd and so a forward exchange contract should be the preferred
option for managing the transaction risk the company faces with these two transactions.
ANSWER BANK
Marking guide
Marks
(a) Cost of forward contract 1

Forward exchange rate 1
Fixed contract cost 1
Company payment 2
5
(b) Discussion 2½
Calculations 2½
5
14
61 Westgarth Ltd
(a) (i) Since both the receipts and payments are expected to occur on the same date, Westgarth Ltd
need only hedge the net amount, i.e. a receipt of €480,000 (€1,080,000 – €600,000). To hedge
this transaction, a three-month forward contract to sell euros will be required. The rate that will
apply for this contract will be €1.4590 – €0.0054 = €1.4536/Tk.
The net receipt will then be Tk330,215 (€480,000  1.4536)
(ii) Since the company is expecting to receive euros, to effect a money market hedge it will need to
borrow euros now in anticipation. The sum to be borrowed must be just enough so that the
receipt in three months' time will repay the loan and the interest due for the period.
The money will be borrowed in euros at an annual rate of 4%. This equates to a three-month
rate of 1.0% (4%/4). The amount to be borrowed in euros is therefore €480,000  1.01 =
€475,248. These euros will be sold now at the spot rate of €1.4590/Tk to realise Tk325,735.
This Taka amount can now be invested in the Bangladesh at an annual rate 5.5%. This equates
to a three-month rate of 1.375%. The value of the deposit at the end of the three-month period
when the euro loan is repaid will be Tk325,735  1.01375 = Tk330,214.
Give or take Tk1, both alternatives offer the same Taka return, hence neither is advantageous.
(b) Factors to consider
(i) Any costs of the different alternatives
(ii) Your ability to manage the techniques
(iii) The attitude of the company to risk
(iv) The size of the transaction in relation to the company's overall operations, and therefore the
scale of the risks involved
(v) The perceived level of risk attached to the currencies in question
Alternative options to minimise risk
(i) Operating bank accounts in foreign currencies. This is only an option if the company has
regular transactions in the currencies in question.
(ii) The use of multilateral netting. This will only be possible if there are a large number of
foreign currency transactions.
(iii) The company could consider the use of swaps and option contracts.
Risk management
(iv) The company could consider the cost and viability of insisting that more of its contracts are
denominated in Taka.
(c) Fixed forward exchange contract characteristics
(i) An immediately firm and binding contract (for example, between a bank and its customer)
(ii) For the purchase or sale of a specified quantity of a stated foreign currency
(iii) At a rate of exchange fixed at the time the contract is made
(iv) For performance at a future time which is agreed upon when making the contract
Advantages of option contracts
Option contracts are attractive when:
(i) The date on which the transaction being hedged will take place is uncertain
(ii) There is uncertainty about the likely movement in exchange rates – the company can take
advantage of any favourable movements in exchange rates, while continuing to hedge any
unfavourable movements
Main drawbacks to option contracts
(i) They are more expensive than fixed contracts, and the premium will have to be paid,
whether or not the option is exercised
(ii) They are traded in standard amounts, and therefore it is difficult to hedge exactly the sum
required – in practice, the company will have to carry some of the risk itself, or use two different
hedges to cover the transaction fully
Option set up
(i) Contract date = 3 months
(ii) Type of option = Buy Taka call option (right to buy Taka with euros)
(iii) Strike price
We have two available strike prices on three-month calls, 1.45 and 1.50
(iv) Action
1.45 1.50
$480, 000  1.45 $480, 000  1.50
Number of contracts  26.48  25.6
£12, 500 £12, 500
Round to nearest whole number i.e. 26 i.e. 26
Taka value contracted Tk325,000 (26  Tk325,000
Tk12,500)
Euro value contracted €471,250 (325,000  1.45) €487,500 (325,000  1.5)
Premium €0.0265 €0.0170
Premium paid now (€) €8,612.50 €5,525.00
Spot rate for buying euros 1.4540 1.4540
Premium paid now (Tk) Tk5,923 Tk3,800
Received in 3 months (spot 1.40)
1.45 1.50
Exercise currency option? No No
Tk Tk
Translated at spot 342,857 342,857
Premium paid (5,923) (3,800)
Net received Tk336,934 Tk339,057
ANSWER BANK
Received in 3 months (spot 1.48)

1.45 1.50
Exercise currency option Yes No
Translated: € Tk € Tk
Option rate 471,250 325,000 –
Spot rate (Bal) 8,750 5,912 480,000 324,324
480,000 330,912 480,000 324,324
Premium paid (5,923) (3,800)
Net received Tk324,989 Tk320,524
Conclusion
If the exchange rate moves to 1.40 the options offer the best opportunity as they can be abandoned
and Westgarth can take advantage of the favourable rate move. In this situation the 1.50 option is
optimal as it has the lowest premium.
If the exchange rate moves to 1.48, the futures contract offers the highest Taka receipt though the
1.45 option is better than the 1.50.
The bottom line is that the optimal alternative cannot be determined in advance, but will only be
realised after the event when the ultimate spot rate is known.
Marking guide
Marks
(a) (i) Calculations 2

Explanations 2
(ii) Calculations 2
Explanations 2
8
(b) Factors 2½
Alternative actions 2½
5
(c) Advantages 2
Disadvantages 2
Calculations:
Option set up 3
Option market outcome 2
Net outcome 3
12
25
62 Xylophone Ltd
There are two important theories linking exchanges rates, interest rates and inflation which need to be
considered when determining strategies in this area.
Interest rate parity
Interest rate parity is based on the hypothesis that the difference between interest rates in the two
countries should offset the difference between the spot rates and the forward foreign exchange rates over
the same period. The formula is:
1+ nominal A interest rate
Forward rate currency a/b = Spot a/b 
1+ nominal B interest rate
Risk management
Purchasing power parity

Purchasing power parity predicts that the exchange value of foreign currency depends on the relative
purchasing power of each currency in its own country, and that spot exchange rates will vary over time
according to relative price changes. The formula is:
1+ A inflation rate
Forward rate currency a/b = Spot a/b 
1+ B inflation rate
Note:
(1) Euro forward rate
The forward rate between the euro and Taka is as predicted by interest rate parity.
1  0.037512
One month forward rate = 1.4600   1.4579
1  0.055012
The difference between the spot rate and the forward rate of €0.0021 represents a small premium
suggesting the euro is appreciating.
The net effect is that a Bangladesh investor can either:
 Invest in the Bangladesh at 5.5%, or
 Invest in Europe at 3.75% but also benefit from an appreciating currency giving the same overall
return.
This is the consequence of the process of currency arbitrage.
(2) Forward exchange rates
Again interest rate parity can be used to estimate the forward rate.
1  0.0425 4
Three month forward rate 1.9600   1.9540
1  0.0550 4
The company can therefore expect $2,000,000  1.9540 = CU1,023,541. This compares with a receipt
of $2,000,000  1.96 = CU1,020,408 on the spot market.
To guarantee that we receive the CU1,023,541 we should take out a forward contract for the
expected receipt at a rate of $1.9540, the contract to be performed in three months time.
(3) Buying euros on spot market
Purchasing power parity indicates that the forward rates should in real terms be the same as the spot
rates at the future date. In practice spot rates differ from forward rates and the company could make
gains from favourable spot rate movements. However the company may equally make losses if
rates move adversely.
By contrast the company's use of forward contracts allows it to limit its exposure to losses by
fixing in advance the rates it will use when it comes to pay for imports.
(4) Placing euros on deposit
The arrangement described is a money market hedge, buying the currency, putting it on deposit
and using the principal and interest to make the euro payment when it falls due.
Money market hedging may be slightly more beneficial than using the forward exchange markets, but
the difference is likely to be small, as the premium or discount on the forward exchange rates will
reflect interest rate differentials. Money market hedging is currently a strategy that the company uses.
(5) Borrowing euros to pay off the Taka loan
It is true that the company would be paying lower interest rates on a loan in euros than a loan in Taka.
However the difference in the forward rates compensates for this. As noted earlier, the lower euro
rate implies that the euro is appreciating. If the company were to switch into a euro loan, we would
ANSWER BANK
benefit from a lower interest rate, however the Taka capital value would grow if the euro appreciated
in the way implied in the forward rate resulting in zero benefit.
1.0375
The implied forward rate for one year is 1.46   1.4358
1.0550
and if one considers a CU100 loan to be repaid in one year, the two alternatives are
Now Interest 1 Year
CU € € CU
Taka loan 100  1.055 = 105.5
Euro loan 100 @ 1.46 = 146  1.0375 = 151.475 @ 1.4358 = 105.5
What can be seen is the total Taka cost is the same either way if rates move as implied by the forward
rate.
Since rates don't always move as implied by forward rates there is the potential for a gain if we
switched to a euro loan, however there is equally the possibility of a loss which may be unacceptable.
Unless the company has some expertise in currency speculation, the advice would be retaining the
loan in Taka.
Marking guide
Marks
IR parity 3
PP parity 3
Question 1 4
Question 2 3
Question 3 4
Question 4 4
Question 5 4
25
Tutorial notes
This question involves discussion of various issues raised concerning how foreign exchange markets work.
The information you are given indicates that you will need to discuss interest rate parity and/or purchasing
power parity. Since these concepts are relevant throughout the answer, our answer explains them in detail
in the introduction, and refers to them more briefly later on.
The level of detail you are given should have indicated that calculations should be used to support the
points you made as relevant.
When dealing with continuously compounded interest rates for part of a year, it is more correct to use x
to the power y calculations, but you would also have gained credit if you had adjusted the interest rates by
dividing.
You need to assume that there is no concern about the bid/offer spread on the forward exchange rates.
Risk management
63 Verriana Ltd
(a) Share options
Correg's shares are currently trading at 735 pence. To protect against a fall in share price Verriana can
purchase put options.
Purchase of put options
If put options are purchased, they will be for the October contract and can be at strike prices of 700
or 750 pence. Clearly the 750 strike price has a higher premium cost as it enables Verriana to sell the
shares at above the current market price.
(i) Share price 685p
Assuming the Correg share price falls to 685p by the end of October and Verriana must sell 1
million shares:
(1) If no options are used, the shares would be sold for 685p each: total CU6.85 million.
(2) If the 750 put option is used, it would be exercised: sale price 750p less premium 52.5p
= 697.5p: total CU6.975 million.
(3) If the 700 put option is used, it would be exercised: sale price 700p less premium 25p =
675p: total CU6.75 million.
The 750 put option gives the best hedge if the share price fell to 685p.
(ii) Share price 770p
If, on the other hand the share price had risen to 770p, the options would be abandoned
(allowed to lapse). The best result would then be to have used no option hedge. The 700
hedge would be better than the 750 hedge simply because the premium is cheaper.
(b) Intrinsic value of call option
The intrinsic value of a call option is the difference between the share price and the exercise
price, subject to a minimum of zero if the share price is below the exercise price. Thus the intrinsic
value of the January 750 call option is zero, because 750 is higher than the current share price of 735.
Full value of share option
The full value of a share option is the sum of its intrinsic value and its time value. The time value
arises because the option has time (in this case 7 months) before it expires, and in this time the share
price is likely to rise above the exercise price. The time value depends on the time to expiry, the
volatility of the option and the level of interest rates. The higher these variables, the higher the
time value of the option. For the January 750 call option, the option premium of 32.5 pence is entirely
time value.
(c) The value of the option depends on the following variables, for the reasons explained.
(i) The price of the security
A decrease in the price of the security will mean that a call option becomes less valuable.
Exercising the option will mean purchasing a security that has a lower value.
(ii) The exercise price of the option
A decrease in the exercise price will mean that a call option becomes more valuable; the profit
that can be made from exercising the option will have increased.
(iii) General level of interest rates
A general decrease in interest rates will mean that a call option becomes less valuable. The
purchase of an option rather than the underlying security will mean that the option holder has
spare cash available, which could be invested at the risk-free rate of interest. A general decrease
in interest rates will mean that it becomes less worthwhile to have spare cash available, and
hence to have an option rather than having to buy the underlying security.
ANSWER BANK
(iv) Time to expiry of the option

A decrease in the time to expiry will mean that a call option becomes less valuable, as the time
premium element of the option price has been decreased.
(v) Volatility of the security price
A decrease in volatility will mean that a call option becomes less valuable. A decrease in
volatility will decrease the chance that the security price will be above the exercise price when
the option expires.
Marking guide
Marks
(a) Illustrate use of options 2

(i) Outcome at 685p 2
(i) Outcome at 770p 2
6
(b) Explain intrinsic value of call option 2
Explain full value of share option 2
4
(c) 2 marks max per explanation max 8
18
64 Duvall Ltd
(a) MEMORANDUM
To: Finance Director
From: Accountant
Date: x-x-xx
Use of currency futures to hedge May payment
In May the company is due to pay $1,537,500 for the machinery purchase. The $/£ spot exchange rate
is currently $2.05. There is a risk that sterling could decline in value against the US dollar between
now and May.
Currency futures allow us to 'lock in' at the current exchange rate, although conversely they do not
allow the company to take advantage of any further strengthening of sterling against the US dollar.
The Chicago Mercantile Exchange (CME) trades sterling futures contracts with a standard size of
£62,500. Only whole number multiples of this amount can be bought or sold. The futures can only be
delivered on certain dates e.g. sterling futures have contract dates of March, June, September or
December. The quote for June futures is $2.02/£.
For illustrative purposes, we look below at what happens if the spot rate in May moves to $1.98 and
the June futures rate is $1.95.
$1,537,500 at the current spot rate of 2.05 is equivalent to £750,000.
Number of contracts we require: £750,000 ÷ £62,500 = 12 contracts
The company needs to sell futures (sell £s)
In February (now) – the hedge is set up by
Selling (12 contracts  £62,500) = £750,000 for June delivery at $2.02
In May – the futures position is closed by
Risk management
Buying (12 contracts  £62,500) = £750,000 for June delivery at $1.95

Summary of futures position
$
Sell £ for 2.02
Buy £ for (1.95)
Gain per £ 0.07
$0.07/£  (£62,500  12 contracts) = $52,500 gain, i.e. £26,515 at the May spot rate of 1.98.
The $1,537,500 required by the company is bought in May at the prevailing spot rate.
$1,537,500 @ $1.98 = £776,515.
In our illustration, spot rate sterling weakens over the period to May, increasing the sterling payment
required.
£
Value of $1,537,500 – in February @ 2.05 750,000
Value of $1,537,500 – in May @ 1.98 776,515
Increase in cost 26,515
Summary
£
Increase in sterling cost of payment 26,515
Gain due to futures position 26,515
The above illustration shows a perfect hedge. In reality this is unlikely to happen, due to basis risk.
(b) A futures market hedge attempts to achieve the same result as a forward contract, that is to fix the
exchange rate in advance for a future foreign currency payment or receipt.
Advantages of futures v forward contracts
 Transaction costs should be lower.
 The exact date of receipt or payment of the currency does not have to be known, because the
futures contract does not have to be closed out until the actual cash receipt or payment is made.
Disadvantages of futures v forward contracts
 Futures contracts cannot be tailored to the user's exact requirements.
 Hedge inefficiencies are caused by having to deal in a whole number of contracts and by basis risk
i.e. pricing differences between spot markets and futures markets.
 Only a limited number of currencies are the subject of futures contracts.
 Converting between two currencies if neither is the US dollar is more complex for futures
compared to a forward contract.
The overall disadvantages of futures explain why the futures market is much smaller than the currency
forward market.
ANSWER BANK
Marking guide
Marks
(a) Explanation 2
Futures position 2
Cash position 2
Summary 2
9
(b) Advantages (1 each) 2
Disadvantages (1 each) 4
6
15
65 Atkins Ltd
(a) MEMORANDUM
To: Board of Directors
From: A Student
Date: 23 March 20X7
Forward exchange contract
20 June 20X7 receipt
€632,200
= Tk439,835
(1.445  €0.0081)
Money market hedge
20 June 20X7 receipt
€632,000
1 (5.2%/4)
€632,000
= €623,889 borrowed
1.013
€623,889
= Tk431,757 received now
1.445
Note: Tk431,757 (1+(4.8%4))
= Tk436,938 in 6 months
nd rd
22 /23 September net payment
Netting off
Payment due = (€1,347,500)
Receipt due = €560,000
Net payment due = (€787,500)
€787,500
(1.412  €0.0143)
€787,500
= Tk563,425
€1.3977
Risk management
Money market hedge

22nd/23rd September net payment
€787,500
1 (3.9%/2)
€787,500
= €772,437
1.0195
€772,437 Tk547,052 paid now
=
1.412
Note: Tk547,052 (1+(6.1%/2))
= Tk563,737 in 6 months
For the June receipt Atkins would be better off with a forward exchange contract, as it would receive
more Taka than with a money market hedge.
For the September net payment, a forward exchange contract produces a lower net payment in Taka.
Tk
In summary June receipt (forward exchange contract) 439,835
September net payment (forward exchange contract) (563,425)
Net payment (123,590)
Were Atkins to ignore hedging then the situation, using the spot rates, would be:
June receipt (€632,000/1.445) 437,370
September net payment (€787,500/1.412) (557,720)
Net payment (120,350)
Based on these figures, the hedging would cost the company Tk3,240 (Tk120,350 - Tk123,590).
(b) A futures contract is similar to a forward exchange contract (FEC) as the company would be in a no
win/no loss position. However, the future is for a standardised amount, unlike an FEC, which can be
for any amount. Also the company would not be able to buy a future at the bank (as it could with an
FEC), as futures are traded on currency exchanges.
Currency options are similar to FECs, but they would give Atkins the right to buy/sell currency in
the future, whereas FECs are a contractual obligation.
There are two types of option:
 Call option to buy currency or
 Put option – to sell currency
Because the holder of the option has the right to buy/sell, the option is more flexible. As a result of
this options are more expensive and transaction charges are high.
Marking guide
Marks
(a) Forward contract / money market hedge comparison:

June receipt 4
September payment 4
Outcome with no hedge; conclusion 3
11
(b) Futures contracts implications 3
Currency options implications 3
6
17
ANSWER BANK
66 Formosa Ltd
(a) By selling the receipts forward, the company can lock in a Taka value of:
15,000,000/1.4941 = Tk10,039,489.
(b) The company can also hedge its euro receivables by borrowing €14,792,899 (the present value of
€15,000,000 at a 90-day interest rate of 1.4% (5.6%  90/360)); sell the proceeds in the spot market at
a rate of €1.4780/Tk (giving Tk10,008,727); and invest the Taka proceeds at a 90-day interest rate of
1.2% (4.8%  90/360) to produce Tk10,128,832. Using a money market hedge, therefore, the company
can lock in a Taka value of Tk10,128,832.
(c) A forward market hedge is a binding contract to buy or sell a specified sum of a particular currency
at some point in the future at a rate of exchange that is determined at the time of entering into the
contract. The company cannot allow the forward contract to lapse if the spot rate on the expiry date
of the forward contract makes it unattractive. Unlike the currency option contract, there is no
premium payable for a forward contract. This reflects the lack of flexibility in these contracts – the
company can avoid downside risk, but any upside potential is foregone. Forward contracts are
available from banks rather than through currency exchanges.
A currency futures hedge is similar to a forward contract in the sense that the company's position
can be fixed by the rate of exchange in the futures contract. However, a futures contract differs from
a forward contract in that the futures contract is for a standardised amount of currency, whereas a
forward contract can be for any amount of currency, i.e. it can be customised exactly to a customer's
circumstances. In addition, each futures contract has a fixed maturity date, usually operating to a
three-month cycle of maturity, i.e. June, September, December, March. Also, futures contracts are
traded on currency exchanges rather than being available through banks. Effectively the futures
contract works like a bet – a winning bet cancels out any actual loss on a transaction and vice versa, so
the futures contract, like the forward contract, puts the company in a no win/no loss position.
A currency options hedge is similar but different from forward contracts in that they give the
company the right, but not the obligation to buy or sell currency at some point in the future at a rate
of exchange that is determined at the time of entering into the contract. If the exchange rate moves
against the company, then the option can be used to limit the company's loss, but if rates move in the
company's favour the company can allow the option contract to lapse and profit from the exchange
rate movement by translating at the spot rate. However, an option premium is payable in return for
this level of flexibility, i.e. maintaining upside potential whilst avoiding downside risk. Options to buy
are call options, while options to sell are put options. Options are available either from banks (over
the counter options tailored to a customer's needs) or from currency exchanges (exchange traded
options).
(d) The implications for financial management comprise the following.
(1) Transaction risk – the uncertainty caused by fluctuations in exchange rates between the date
of entering into a foreign currency-denominated contract and the date of settlement of that
contract.
This gives rise to the need to decide upon an invoicing strategy – whether to invoice in Taka,
thereby removing all transaction risk but potentially putting sales in jeopardy, or to invoice in the
customer's currency (or some other acceptable currency), thereby potentially winning business
but exposing the business to transaction risk, when shareholders are unlikely to want the
company to speculate on market movements.
This gives rise to the need to develop a suitable hedging strategy in respect of the company's
export sales using potentially forward contracts, money market hedges, options and futures
contracts, foreign currency bank accounts and borrowings (which would be repaid from foreign
currency receivables) and matching/netting of foreign currency assets and liabilities.
(2) Economic risk – this is the long-term version of transaction risk and arises from variations in
the overall value of the business (the PV of future cash flows) due to unexpected changes in
exchange rates.
Risk management
(3) Credit/trading risk – selling on credit in overseas markets is often riskier than doing so
domestically and also often involves granting extended credit terms. Both of these increase the
risk of bad debts. There is also political risk (potential exchange control legislation and the like).
These risks give rise to the need to consider credit insurance covering both commercial and
political risks.
(4) Increased financial requirements – increased sales overseas will create a need for increased
working capital which gives rise to a need to consider various export credit facilities such as bills
of exchange, discounted letters of credit, and export factoring.
Credit was also given for appropriate references to cultural issues and their potential financial
management implications and for the fact that this strategy is a step into the unknown for the
firm.
Marking guide
Marks
(a) Calculation of Taka value 2

(b) Calculations 3; methodology 2 5
(c) Forward market 2½; futures 2; options 2½ 7
(d) 1½ marks per paragraph max 6
20
67 Dubois Ltd
(a) Forward rate agreement
Entering into an FRA will allow the company to effectively lock in an interest rate for a specified future
period, here for a six-month period starting in 3 months' time and ending in 9 months' time. That is,
we should use a 3 – 9 FRA which should lock us in to a borrowing rate of 5.94%.
The FRA is independent of the loan itself upon which the prevailing rate must be paid, however any
difference between the actual rate and the FRA rate will result in a cash flow from the FRA that offsets
the higher or lower interest cost.
Net outcome
Fixed Interest Rate
4.5% 6.5%
Actual rate 4.5% 6.5%
FRA rate 5.94% 5.94%
Gain/(loss) (1.44%) 0.56%
FRA Receipt/(Payment) Tk5m  1.44%  6/12 Tk5m  0.56%  6/12
(Tk36,000) Tk14,000
Interest on Tk5m for 6 months (Tk112,500) (Tk162,500)
Net payment (Tk148,500) (Tk148,500)
Net payment at 5.94% is Tk5m  5.94%  6/12 = Tk148,500
Hence the FRA has locked us in to a rate of 5.94%
(b) Interest rate futures
Interest rate futures have the same effect as FRAs, in effect locking in to an interest rate. Unlike FRAs,
however, they are standardised in terms of size, duration and term and they are tradable on exchanges
(such as Euronext.liffe).
They are generally closed out prior to maturity with any gain or loss offsetting any higher or lower
interest cost when borrowing.
ANSWER BANK
The standardisation in terms of size, duration and term may appear to make them limited compared to
FRAs, however the ability to trade them means that any hedge can be easily released at any time if
conditions change which is not the case for FRAs.
Since we, as borrowers, are concerned that rates may rise we are looking for a profit on these futures
to offset the interest cost.
If rates rise then futures prices fall (futures price = 100 – rate) hence to gain we must sell interest rate
futures.
Actual amount of loan length of loan
Number of contracts  
Contract size 3 months
Tk 5,000,000 6
   20 contracts
Tk 500,000 3
Net outcome
Fixed Interest Rate
4.5% 6.5%
Futures action
Sell to open 94.15 94.15
Buy to close 95.50 (100 – 4.5) 93.50 (100 – 6.5)
Gain/(loss) (1.35%) 0.65%
Futures cash receipt/(payment) Tk500,000  20  1.35%  Tk500,000  20  0.65% 
3 3
/12 /12
(Tk33,750) Tk16,250
Interest on Tk5m for 6 months (Tk112,500) (Tk162,500)
Net interest cost (Tk146,250) (Tk146,250)
The net payment at 5.85% (100 – 94.15) is Tk5m  5.85%  6/12 = Tk146,250, hence the interest rate
future has locked us in to a rate of 5.85%.
(c) Interest rate guarantees or short-term interest rate caps offer the opportunity to limit the impact of
any adverse movement in interest rates whilst still benefiting from any favourable rate movement.
They represent an interest rate option giving the holder the right, but not the obligation, to deal at an
agreed interest rate at a future maturity date.
This means that if rates rise the option would be exercised by Dubois, locking the rate. If rates fall,
however, Dubois would allow the option to lapse and benefit from lower than envisaged rates.
Marking guide
Marks
(a) Explanation 2
Illustration: 6.5% 3
8
(b) Explanation 3
9
(c) Explanation 3
20
Risk management
ANSWER BANK
Additional Exam-standard questions
68 Illumin8 Ltd
(a)
2008 2009 2010 2011
Tk Tk Tk Tk
Corporate hospitality (12,813) (13,197) (13,527) (13,798)
Tax 3,844 3,959 4,058 4,139
Additional contribution 13,838 14,253 14,609 14,901
Tax (4,151) (4,276) 4,383 (4,470)
718 739 757 772
Df 0.9118 0.8351 0.7686 0.7177
PV 655 617 582 554
NPV 2,408
On the basis of this positive NPV, the expenditure on corporate hospitality should be made.
WORKINGS
(1) Corporate hospitality costs in 2007 terms = Tk12,500
2008 = 12,500  (1+0.025) = 12,813
2009 = 12,813  (1+0.030) = 13,197
2010 = 13,197  (1+0.025) = 13,527
2011 = 13,527  (1+0.020) = 13,798
(2) Daily contribution = 1,500 – 440 – 160 = 900
In money terms
2008: 900.00  (1+0.025) = 922.50 ( 15 = 13,838) ( 75 = 69,188)
2009: 922.50  (1+0.030) = 950.18 ( 15 = 14,253) ( 75 = 71,265)
2010: 950.18  (1+0.025) = 973.94 ( 15 = 14,609) ( 75 = 73,045)
2011: 973.94  (1+0.020) = 993.42 ( 15 = 14,901) ( 75 = 74,505)
2008: 1/[(1+0.07)(1.0.025)] = 0.9118
2009: 0.9118  1/[1+0.06)(1+0.03)] = 0.8351
2010: 0.8351  1/[(1+0.06)(1+0.025)] = 0.7686
2011: 0.7686  1/[(1+0.05)(1+0.02)] = 0.7177
(b)
2007 2008 2009 2010 2011
Tk Tk Tk Tk Tk
Cost of lighting system (180,000)
Proceeds 55,189
Tax depreciation 13,500 10,125 7,594 5,695 529

Corporate hospitality (12, 813) (13,197) (13,527) (13,798)
Tax 3,844 3,959 4,058 4,139
Contribution 69,188 71,265 73,045 74,505
Tax (20,756) (21,380) (21,914) (22,352)
(166,500) 49,588 48,241 47,357 98,212
Df 1 0.9118 0.8351 0. 7686 0.7177
(166,500) 45,214 40,286 36,399 70,487
NPV 25,886
On the basis of this positive NPV, the lighting system should be purchased.
WORKINGS
(4) Money value of the lighting system
50,000  (1+0.025)(1+0.03)(1+0.025)(1+0.02) = 55,189.
Tax effect
@ 30%
Tk Tk
2007 Cost 180,000
TDA 45,000 13,500
135,000
2008 TDA 33,750 10,125
101,250
2009 TDA 25,313 7,594
75,937
2010 TDA 18,984 5,695
56,953
2011 Disposal 55,189
Balancing Allowance 1,764 529
(c) The net present value must fall by Tk25,886. The parts of the net present value calculation that are
affected by changes in the number of days for which the lighting system is hired out are 1.
Contribution and 2. Tax.
Contribution Tax df
Tk Tk Tk
2008 69,188 20,756  0.9118 = 44,160
2009 71,265 21,380  0.8351 = 41,659
2010 73,045 21,914  0.7686 = 39,299
2011 74,505 22,352  0.7177 = 37,430
162,548
So the sensitivity of the investment to a fall in the number of days for which the lighting system is hired
out is given by 25,886/162,548 x 100 = 15.9%.
(d) Using CAPM to derive the discounts factors in this context does have certain positive aspects:
(1) CAPM is clearly based on the idea that discount factors should be related to project risk (via the
use of an appropriate beta).
(2) CAPM recognises that the relevant risk of an individual investment is its systematic risk and it is
on this basis that investments should be judged.
However, there may well be some misgivings regarding its use in this particular context:
(1) There is a key assumption underlying the CAPM methodology that the firm's shareholders hold
diversified investment portfolios ('the market portfolio'). This may well not be the case here as it
is an unlisted, private company whose shareholders may not hold diversified investment
portfolios, which thereby renders CAPM inappropriate.
(2) Estimating the beta factor for a new venture such as this may be problematic. Comparison with
the beta of a listed company involved in a similar business may be a possible solution, but even
that presupposes that the listed company is involved only in that one particular line of business,
which may well not be likely. Also, the listed company with which comparison is made may be
financially geared to a different extent.
(3) Stakeholders other than the shareholders, such as directors and employees, are exposed to both
the systematic and specific risk of the business – they cannot diversify away their jobs, so it
would, in practice, be difficult to persuade them that they can ignore the specific risk of the
business, which the CAPM methodology suggests shareholders can.
(4) CAPM is a methodology predicated on the notion of a perfect capital market.
Marking guide
Marks
(a) Relevant incremental cash flows and NPV 8
8
(b) Show whether the new lighting system should be purchased. 10
10
(c) Calculate the sensitivity of the net present value of the investment 4
4
(d) Critically evaluate the use of CAPM 7½
6
28
69 Viogen Inc
(a) With a futures contract size of Tk62,500, Viogen would need to sell 20 Taka futures contracts to
hedge its royalty payments of Tk1.25m.
With an option contract size of Tk31,250, Viogen would need to buy 40 put option contracts to hedge
its royalty payments of Tk1.25m.
(b) Viogen would gain or lose on the option contract (strike price $1.6612/Tk) as follows:
($) 1.6250 1.6513 1.6612 1.7010
Inflow 2,076,500 2,076,500 – –
Premium (25,000) (25,000) (25,000) (25,000)

Spot value (2,031,250) (2,064,125) – –
Profit/(loss) 20,250 (12,625) (25,000) (25,000)
Alternatively:
Spot 1.6250 1.6513 1.6612 1.7010
Right 1.6612 1.6612 1.6612 1.6612
Intrinsic 0.0362 0.0099 0 0
Profit $ 45,250 12,375

Premium (25,000) (25,000) (25,000) (25,000)
Profit/(loss) 20,250 (12,625) (25,000) (25,000)
At spot rates of 1.6612 and 1.7010, Viogen would not exercise the option and would simply lose the
premium.
Viogen would gain or lose on the futures contract (at a price of $1.6513/Tk) as follows:
($) 1.6250 1.6513 1.6612 1.7010
Inflow 2,064,125 2,064,125 2,064,125 2,064,125
Spot Value 2,031,250 2,064,125 2,076,500 2,126,250
Profit/(loss) 32,875 NIL (12,375) (62,125)
Alternatively:
Sell Tk for 1.6513 1.6513 1.6513 1.6513
Buy Tk for 1.6250 1.6513 1.6612 1.7010
Profit/(loss) 0.0263 0 (0.0099) (0.0497)
(per Tk)
Profit/(loss) 32,875 NIL (12,375) (62,125)
With the futures contract, Viogen will lock in a rate of $1.6513/Tk for total revenue of $1.6513 x
1.25m = $2,064,125.
(c) Viogen will receive Tk1.25m. If Viogen chose to proceed on an unhedged basis, the cash flows would
be as follows:
($) 1.6250 1.6513 1.6612 1.7010
2,031,250 2,064,125 2,076,500 2,126,250
If Viogen chose to use an option contract, the cash flows would be as follows:
Profit/(loss) 20,250 (12,625) (25,000) (25,000)
Royalty 2,031,250 2,064,125 2,076,500 2,126,250
2,051,500 2,051,500 2,051,500 2,101,250
If Viogen chose to use a futures contract, the cash flows would be as follows:
Profit/(loss) 32,875 NIL (12,375) (62,125)
Royalty 2,031,250 2,064,125 2,076,500 2,126,250
2,064,125 2,064,125 2,064,125 2,064,125
As the above figures illustrate, the use of futures contracts will lock in the royalty's net $ value at
$2,064,125, whilst the use of option contracts will set a floor of $2,051,500 for Viogen's net $ cash
flow from the royalty. The upside is that the option-hedged royalty cash flow will exceed $2,064,125 if
the future spot rate is greater than $1.6713/Tk. At this spot rate, the royalty payment will be worth
$2,089,125 gross and will be just equal to $2,064,125 net of the option premium.
(d) On the option contract, the spot rate would have to fall to the exercise price less the premium for
Viogen to break-even on the contract i.e. Tk1.6612 – $0.02 = $1.6412/Tk.
On the futures contract, the break-even point occurs when the spot rate equals the futures rate i.e.
$1.6513/Tk.
(e) There is a body of opinion that hedging may not add to shareholder wealth if the shareholders can
effectively manage the exposure themselves – they can often diversify their own portfolios in line with
their preferences and risk tolerance.
In addition, it is argued that hedging may not reduce the non-diversifiable (systematic/market) risk of
the firm, therefore shareholders who hold a diversified portfolio are not helped when managers hedge
and so they should be unwilling to pay a premium for such hedging activities.
Also, it is said that hedging is often undertaken by managers for their own benefit rather than that of
shareholders (the classic agency problem), particularly as they will not hold a portfolio of jobs or if
they are compensated on the basis of short-term results.
Also, if markets are in equilibrium the net present value of hedging will be zero.
However, these arguments may only be valid in a perfect capital market. In the presence of market
imperfections, there is another body of opinion that firms should hedge for the following reasons:
To reduce the volatility (and, hence, risk) of a firm's cash flows caused by changes in exchange rates
and hence to reduce the volatility of the firm's value and to help the planning and investment
capabilities of the firm.
To avoid financial distress that increases the cost of capital and which can adversely affect the ability of
the firm to raise finance. This will also help the firm in its dealings with suppliers, customers and
financiers and will provide assurance to all stakeholders.
Because managers may have access to better information regarding the firm's exposure than
shareholders – they have a comparative advantage in knowing the actual exposure of the firm.
Hedging instruments tend to be traded on wholesale markets and some techniques of currency
exposure management (operational) are only truly available at the firm level.
A firm may be able to hedge at better prices than shareholders.
Hedging smoothes cash flows which can potentially reduce the present value of taxes if rates are
progressive.
Marking guide
Marks
(a) Number of contracts 2

(b) Gain/loss on hedges 6
(c) Total cash flow 8
(d) Break even 2
(e) Arguments 12
8
26
70 York Ltd
(a) The cost of equity:
ke = D0 (1 + g) / P0 + g = 1(1.04) / 13.50 + 0.04 = 11.7%.
The cost of debt:
Df PV Df PV
10% 5%
t0 (101.50) 1 (101.50) 1 (101.50)
t1 – t3 9.00(1 – 0.3) 2.487 15.67 2.723 17.16
t3 100.00 0.751 75.10 0.864 86.40
(10.73) 2.06
Therefore, cost of debt = 5% + 2.06/12.79  5% = 5.81%.

Market value of equity = (100m  Tk13.50) = Tk1,350m (86.9%)
Market value of debt = (200m  Tk101.50) = Tk 203m (13.1%)
Therefore, WACC = (1,350  11.7%) + (203  5.81%) / (1,350 + 203) = 10.93%.
(b) The choice between debt and equity financing revolves initially around four key issues – risk,
ownership and control, duration and debt capacity.
(1) With regard to risk – how uncertain is the environment in which the firm operates? How
sensitive is the firm to fluctuations in the economy? How risky are the firm's investment
opportunities? A risky and fast-changing environment may tend to favour equity finance rather
than debt, which has a fixed commitment to pay interest.
(2) With regard to ownership and control – major injections of capital by new shareholders can
dilute the ownership and control exercised by the present owners and smaller family firms such
as this may prefer to take on debt in order to retain that control. Even a rights issue risks altering
the balance of voting control e.g. if shares are acquired by underwriters. Debt carries no voting
rights, so the only diminution in control is imposed by the incorporation of restrictive covenants
in the loan agreement.
(3) With regard to duration – finance raised should correspond with the use to which it is put. If the
investment is not expected to produce profits in the early years, then equity may be preferred,
but if profits are expected from the outset then debt may be suitable. Similarly, it would be
unwise to raise long-term debt if the life span of the investment was shorter-term.
(4) With regard to debt capacity – a firm's existing gearing levels will impact on the perceptions (and
pricing) of potential lenders, as will the type of industry in which it operates, the nature and
quality of any security the firm can offer, the variability of its expected cash flows.
In addition, debt is likely to be cheaper, particularly as the company is in a tax-paying situation and will
be able to take advantage of the tax shield on debt interest. In addition, the cost of debt finance will be
known in advance, as the capital element will be fixed and a fixed rate of interest can be negotiated.
Dividends on equity finance do not have to be paid each year, allowing the company more flexibility in
its operations.
Equity is likely to be more expensive as the risk of shareholders is greater than the risk of lenders.
This is likely to be exacerbated as the financial risk of the firm increases as gearing levels increase –
too high a level of borrowing imposes are long-term prior charge against profits which has to be met
year in, year out, regardless of firm performance.
Consideration might also be given to the impact of the financing decision on reported profits and
ratios such as earnings per share, gearing, interest cover and dividend cover.
Use of debt finance also imparts a 'gearing effect' to shareholder profits, under which an increase in
activity and thus sales revenue of a given proportion will have a more than proportional impact. Use of
debt is therefore excellent when companies expand, but the reverse applies in adverse trading
conditions. Use of debt, therefore, can have dire consequences in a recession.
The level of operating gearing might also influence the choice between debt and equity. Firms that
have high operational gearing (high proportions of fixed costs relative to variable costs) will have
higher break-even points and so may prefer equity to debt financing.
(c) (i) Cost of equity
Since the company is already highly geared (at book values) the most likely effect of the new
finance will be to increase the company's cost of equity. This is because shareholders will require
higher returns because a higher proportion of profits is now pre-empted by interest so that
residual equity earnings, from which dividends are paid, become riskier. Also, the risk of the
company defaulting on debt interest increases and so finance distress becomes more likely.
(ii) Cost of debt
Although gearing is modest at market values, lenders tend to focus more closely on book values
especially when imposing debt covenants. Lenders also look at the fixed asset backing for their
loans. Debt already exceeds net assets of the company, even ignoring short-term borrowings.
The proposed loan will add Tk20m to long-term debt and further increase the company's gearing
ratio whilst reducing interest cover, at least in the short-term. Consequently, the proposed new
debt will also increase the cost of debt.
(iii) WACC
The impact on the WACC is ambiguous. An increase in debt, even at high levels of gearing, can
still lower the WACC because debt is invariably cheaper than equity, especially when the tax
shield on interest is taken into account. Although the costs of both equity and debt are both
likely to rise, the net effect is uncertain, given the relative cheapness of debt. It really depends on
the nature of the reaction of shareholders to the increase in gearing and whether the company is
beyond its critical gearing ratio. If its gearing already exceeds the level at which the WACC is
minimised, or if the proposed increase propels it beyond this point, then WACC will certainly
increase. Any beneficial effect of cheap debt will be outweighed by the shareholders' expectations
of higher returns to compensate them for their higher risk.
(d) In law, a debenture is any written acknowledgement of a debt and consequent obligation to repay, but
the term is usually applied to secured loan stock. The loan may be secured on specific assets (fixed
charge) or on the company's assets in general (floating charge). Debentures normally specify a fixed
interest rate and repayment date or interval, when the principal will be repaid. Once issued,
debentures can be traded on the secondary market, i.e. the stock exchange for a listed company.
A bank loan is usually a contract to borrow money from either a single lender or a syndicate of
lenders. Bank loans are not generally traded, although securitisation has been used by lenders to sell
loan portfolios to investors. Loans can be secured or unsecured. Interest rates can be fixed or floating
(often linked to bank rate for larger companies). Bank loan documentation will include a range of
potential covenants and a fixed schedule of interest and capital repayments.
Why do their costs differ?
Because debentures are marketable, investors may accept a lower interest rate in return for greater
liquidity.
As a bank is better able than investors to monitor the borrower, these lower monitoring costs may be
reflected in lower interest rates for bank loans.
Different levels of security and different covenants may explain price differences.
Banks usually operate with a more widely diversified portfolio of loans than debenture holders and so
banks may pass on the benefits of lower risk from diversification in lower interest rates.
Marking guide
Marks
(a) Calculate WACC 4

(b) Factors to consider 13½
10
(c) Impact on cost of capital 7
(d) Explanation to Directors 6
5
26
ANSWER BANK
1 Objective test questions

1 C Wealth for shareholders can come in two forms: either from increasing the capital growth of the
shares they own or increasing the dividend that is paid out annually to shareholders.
2 C Stakeholders are all those parties interested in the continued prosperity of the company. Hence
all of the parties would be stakeholders.
3 C Achieving market share (a relative measure), or customer satisfaction (a qualitative measure), are
non-financial objectives.
4 D
Cash Discount Discount
Time flow factor cash flow
CU CU
0 (49,500) 1 (49,500)
1–8 (see Working) 9,429 5.146 48,522
(978)
WORKING
Cost structure CU
Sales 140 33,000
Cost of sales 100 23,571
Gross profit 40 9,429
5 C –CU100,000 + CU(30 – 8)  10,000 units  3.791

–CU10 x 10,000 units  (1 + 3.170) = CU317,000
6 C
CU
Q 200  22 4,400
R 500  36 18,000
200  34 6,800
T 400  14 5,600
34,800
7 A Skilled labour
(200  4)  (9 + [6  3]) = CU8,800
Semi-skilled labour has no relevant cost.
8 C
Time Flow DF @ 10% PV
0 (150,000) 1 (150,000)
0 (4,000) 1 (4,000)
2 4,000 0.826 3,304
150,696
 Contract price @ time 2  0.826 = 150,696

Price = 150,696  0.826 = CU182,441
Objective and investment appraisal: objective test questions
9 C The investment is made on 1 January 20X5, so tax depreciation can first be set off against profits
for the accounting period ended 31 December 20X5. The tax cash saving will therefore be at
31 December 20X5, i.e. time 1.
Time Date Tax saved Payment time
CU CU
0 1 January 20X5 2,000,000
1 31 December 20X5
TDA (500,000) at 30% = 150,000 1
1,500,000
2 31 December 20X6
Sale proceeds (300,000)
BA 1,200,000 at 30% = 360,000 2
Present value = (CU150,000  0.870) + (CU360,000  0.756) = CU402,660

10 A –150 + (25  0.572) + (300 – 210 – 15)  (1 – 0.30)  2.855 = CU14,188
11 C (1 + Money rate) = (1 + Real rate)  (1 + Inflation rate)
1.21 = (1 + Real rate)  1.09
Real rate = 11%
12 B As there are different rates of inflation the 'money approach' must be used, i.e. the cash flows
must be inflated at their specific rates and discounted at the money cost of capital.
(1 + Money rate) = (1 + Real rate)  (1 + Inflation rate) = 1.1  1.05 = 1.155
13 D
Time Cash flow DF @ 21% PV
CU CU
0 (50,000) 1 (50,000)
1 33,000 0.826 27,258
2 36,300 0.683 24,793
3 39,930 0.564 22,521
3 15,000 0.564 8,460
NPV 33,032
Present value using money cost of capital is CU33,000 (to the nearest CU000).
1 m
Using the formula 1 + r = , the money cost of capital is 21%.
1 i
1
The DF is obtained using
(1  r)n
The same answer could be obtained by applying the real cost of capital to flows expressed in
current terms.
14 B Money cost of capital = [(1.08  1.12) – 1]  100 = 20.96%
Time t0 t1 t2
CU CU CU
Outlay (13,500)
Labour 7,000 7,700
Salvage 5,000
12,700
20.96% discount factor 1 0.8267 0.6835
Present value – CU13,500 CU5,787 CU8,680
NPV = CU970 rounded
ANSWER BANK
1  Money rate 1  0.20

15 D r = –1= –1 = 13.2%
1  Inflation rate 1  0.06
so (1.132) (1.05) – 1 = 18.9%
16 B
PV (CU'000) = 150 + 20  0.909 + 30  0.826 + 40  0.751 + 20  0.683
= 236,660
CU236,660
Equivalent annual cost = = CU74,656
3.170
CU74,656
Payment in advance = = CU67,869  CU67,900 rounded
1.10
 CU150,000  CU25,000  0.233  CU5,000  2.106

 CU8,000  2.991 0.579
17 C NPV = = CU43,900
3.837
18 C The payback period will decrease and the IRR increase, because the outflow at time 0 is
unaffected by inflation.
Consider a simple project.
Time Cash flow Inflation at, say, 10% Revised cash flow
CU CU
0 (100) 1 (100)
1 (100) 1.1 (110)
2 100 1.12 121
3 100 1.13 133
4 100 1.14 146
Payback period 3 years to 2.7 years
IRR  17% to  30%
19 C (1,000  CU4 + 500  CU6) + (2,000  CU10) = CU27,000

20 B The deprival value is
Lower of
Replacement Higher of
cost CU10,000
Disposal value Economic value

CU5,000 CU7,500
Therefore deprival value = CU7,500
21 A The amount already spent is sunk; therefore ignore the CU8,000. The chemical would not be
replaced if used on Job M, as it has no other use; therefore ignore the CU8,500.
If not used on the job, the chemical would be disposed of at a cost of CU1,000. Thus this cost
would be saved if Job M were undertaken.
22 C
CU
Loss of the opportunity to gain revenue now 5,000
Pay for dismantle 1,500
6,500
23 B
t0 t1 t2 t3
CU'000 CU'000 CU'000 CU'000
Sales revenue 5,000 6,000 7,200 –
10% - working capital 500 600 720 –
Increase (500) (100) (120) 720
Discount factors 1 0.833 0.694 0.579
Present value (500) (83.3) (83.28) 416.88
(CU000)
NPV = CU(249,700)
24 C Money cost of capital = [(1.1 1.07) – 1] = 17.7%
25 C PV = 20,000  CU4  5.019 = CU402,000
26 C
t0 t1 t2 t3
CU CU CU CU
Equipment (400,000)
Labour (550,000) (605,000) (665,500)
Materials (350,000)
Sales ______ 900,000 945,000 992,250
(750,000) 350,000 340,000 326,750
PV factor 1 0.87 0.75 0.65

PV (750,000) 304,500 255,000 212,388
NPV = CU21,888
27 D Compare machines by calculating the equivalent annual cost (EAC) of each, where
Present value of one cycle
EAC =
Annuity discount factor for length of cycle
(All calculations in CU'000s)

I (5 years) PV = 70 + (5.6  3.791) = 91.230
91.230
EAC = = 24.1 pa
3.791
I (8 years) PV = 70 + (5.6  5.335) + (49  0.621) = 130.305
130.305
EAC = = 24.4 pa
5.335
II PV = 56 + (8.4  3.170) = 82.628
82.628
EAC = = 26.1 pa
3.170
III PV = 98 + (4.9  4.355) = 119.340
119.340
EAC = = 27.4 pa
4.355
Therefore choose model I, replacing every five years.
28 A The original purchase cost of Q is irrelevant as it is sunk. The choice is therefore to sell Q for
CU4,000 or to use it in project Y to yield contribution of CU(10,000 – 5,000) = CU5,000.
Hence choose project Y, the relevant cost being CU5,000.
ANSWER BANK
29 B
CU
Material X
1,000 kg in inventory could be sold for 4,000
500 kg must be purchased for 3,000
Material Y
Since it has alternative uses, 2,000 kg must be replaced for 20,000
27,000
30 D The deprival value is
Lower of
Replacement Higher of
cost
CU25,000
Disposal value Economic value

CU23,000 CU24,000
The firm's policy would therefore be to use the asset, since CU24,000 is higher than CU23,000.
It would not replace it at a cost of CU25,000.
31 B The maximum benefit forgone relates to the conversion to RP, i.e. CU(2,200 – 100) = CU2,100.
32 D Using the inventory implies that the 600 kg would need to be replaced in order that Q could be
produced. The extra 400 kg required in the quotation would need purchasing. Therefore the
relevant cost = 1,000 kg  CU6 = CU6,000.
33 B
Time Flow DF PV
CU @ 15% CU
0 (80,000) 1 (80,000)
1 (6,400) 0.870 (5,568)
2 (6,912) 0.756 (5,225)
3 93,312 0.658 61,399
NPV (29,394)
34 D Machine time is obviously a scarce resource since producing the beta would mean that alpha
could not be produced. The relevant costs are therefore the contribution forgone of CU46 per
unit and the machine running costs of CU28 per unit.
As the production of beta reduces the value of the machine to a greater extent than the
production of alpha, this additional cost of CU25,000 is also relevant.
Absorbed maintenance costs are not relevant.
35 D Amounts expressed in actual (money/nominal) terms must always be discounted at
money/nominal discount rates.
36 C Tax calculation
Year Reducing Tax Depreciation Tax saved
balance allowance (30%)
CU CU CU
1 120,000 (25%) 30,000 9,000
2 90,000 (25%) 22,500 6,750
3 67,500 (25%) 16,875
End of 3 50,625 625 5,250
Sale price 50,000
625
Project evaluation
Year Cash flow Discount factor PV

at 20%
CU CU
0 Machine cost (120,000) 1.000 (120,000)
1-3 Cash profits 50,000 2.106 105,300
1-3 Tax on profits (15,000) 2.106 (31,590)
1 Tax saving (tax 9,000 0.833 7,497
depreciation)
2 Tax saving (tax 6,750 0.694 4,685
depreciation)
3 Tax saving (tax 5,250 0.579 3,040
depreciation)
3 Sale of machine 50,000 0.579 28,950
NPV (2,118)
37 C
EMV (100 units) = CU400
EMV (200 units) = 0.25  Nil + 0.75  CU800 = CU600
EMV (300 units) = – 0.25  CU400 + 0.40  CU400 + 0.35  CU1,200 = CU480
Therefore, optimal policy is to order 200 units per day.
38 B The internal rate of return (C) and the cost of the initial investment (A) are independent of the
risk of the project. The higher the risk of the project, the greater (not less) is the required rate
of return (D).
39 A A has higher risk but lower return than D.
40 D Systematic risk cannot be diversified away.
41 C The expected value criterion is independent of risk.
42 B
43 C
44 C Return per CAPM = Rf + β(Rm – Rf)
Return = 5% + (0.90  4%) = 8.6%
Note: market risk premium = (Rm – Rf)
45 C The companies are identical except for their gearing and the beta factor of equity shares will
increase with the gearing level. The beta of B Ltd (gearing 80%) is therefore higher than the beta
for D Ltd (gearing 60%), i.e. over 1.22. The beta of C Ltd (gearing 35%) is higher than the beta
for A Ltd (gearing 30%) and below the beta for D Ltd. It must therefore be in the range 0.89 to
1.22.
ANSWER BANK

1 D The market will consider information about the company's future prospects, which do not
depend on how it has performed in the past.
A is not correct as the key to market efficiency is the availability and processing of information. If
all relevant information is easily available to all investors, and investors respond to information in
a rational way, then share prices will move quickly to reflect this information in a logical manner.
B is not correct as the transaction costs of buying and selling should not be so high as to
discourage trading significantly.
C is not correct as the market should be large enough so that no one individual can, by his
actions, affect the movement of the market.
2 C The correct answer is: CU6 per share after 3rd April and CU6.60 per share after 10th April.
When a market displays semi-strong form efficiency, share prices react both to announcements
about historical results and also to information such as company announcements. On 3rd April,
nothing is disclosed to the stock market, so there will be no change in the share price. When the
announcement is made on 10th April, the shares should increase by the NPV of the investment,
i.e. by CU120 million or CU0.60 per share.
3 C A loan agreement or bond issuance agreement might include a covenant on dividend restraint.
This would be an undertaking by the company to restrict dividends in a specified way as long as
the loan or debt remains outstanding.
4 C The preferred approach is a good spread of shares, as this minimises the risk in the portfolio and
should ensure that Mr Hollins does achieve something approaching the average return for the
market.
5 A New MV ex-div per share = (4  CU3.05 + CU2) ÷ 5 = CU2.84
6 D The coupon rate gives the annual interest based on the nominal value of the debenture stock.
7 D
CU CU
Now 3  1.52 = 4.56
Plus 1  1.00 = 1.00
Gives 4  1.39 = 5.56
Value of right per existing share = CU(1.39 – 1.00) ÷ 3 = CU0.13

0.2(1  0.02)
8 A P0  = CU1.96
0.08  ( 0.02)
9 B The dividend valuation model assumes that share values are determined by shareholders'
expectations of future dividends, given that they have no control themselves over dividend policy.
In theory, shareholders in Bangladesh can vote to reduce the proposed final dividend, but not
increase it. However, this power is rarely exercised.
Valid criticisms of the model are as follows.
The share valuation derived from the model is based on expectations of future dividends in
perpetuity, but these are not easily predictable and investors will have differing expectations.
The cost of equity is difficult to establish with accuracy.
The model assumes that all retained earnings will be reinvested to earn a return equal to the cost
of equity, which is not necessarily correct.
CU490,000
10 A The current MV of equity =
0.196
= CU2,500,000
= CU2.50 per share
If the project is financed by debt capital:
CU
Profit before interest (+ CU200,000) 1,200,000
Interest on (CU3,500,000  12%) 420,000
780,000
Tax at 30% 234,000
Earnings and dividends pa in perpetuity 546,000
New cost of equity 22%

New MV of equity CU2,481,818
= CU2.48 per share
There would be a 2p fall in the share price.
11 D The period 20X1 to 20X5 covers four years of growth, and the average growth rate g can be
calculated as follows
1
 4,236  4
1+g =  
 2,200 
1+g = 1.178
g = 17.8%
4,236 1.178
P0 = = CU69,306,000
0.25 - 0.178
Price per share (40 million shares) = CU1.73
12 D Since d0 (1 + g) is the dividend after one year, we have:
8
74 =
0.16  g
74(0.16 – g) = 8
74g = 3.84
g = 0.052 or 5.2%
13 D Let EPS =1
 Pps = 1  9.3 = 9.3
 d0 =½
d0 (1  g) 1
2 (1.10)
 ke = +g= + 0.10 = 15.9%
P0 9.3
 10.8   4.2 
14 B g = 4     1 = 0.0822
 90   48 
10.8 1.0822
ke = + 0.0822 = 16.88%
90 1.50
ANSWER BANK
125  0.3  (1  0.15  0.7)

15 B ke = + 0.15  0.7 = 13.3%
1,500
4
16 B kd (6 months) = = 4.878%
82
kd (pa) = 1.048782 – 1 = 9.99%
I (1  T) 10  (1  0.3)
17 C kd = = = 7.8%
D 90
18 B kd = coupon rate  (1 – T) for redeemable debt standing at par in the market and redeemable at
par.
kd = 13  (1 – 0.30) = 9.1%
ke = 12%
Ek e  Dk d 20m  CU2.80 12%  CU7m  9.1%
k = = = 11.7%
ED 20m  CU2.80  CU7m
0.15  (24 x 2.25)  (8  92)  6  0.92  0.125  (1 0.3)  8
19 C k = = 13.74%
24  2.25  6  0.92  8
20 A g = rb = 0.15  0.7 = 0.105
D 0 (1  g) 50,000,000 1.105
MV = = = CU442,000,000
ke  g 0.23  0.105
22.4 1.14
21 D + 0.14 = 23.9%
280  22.4
Current dividend
22 D Net dividend yield =
Market value
Cost of equity = [Dividend yield  (1 + g)] + g
where g is the expected future rate of dividend growth
= (0.052  1.156) + 0.156
= 0.216, i.e. 21.6%
EPS
23 B Dividend cover =
Dividend per share
EPS = 3.84  8p = 30.72p

Price per share
Also P/E =
EPS
Price per share = 12.8  30.72p = 393.2p
8 1.16
Hence ke = + 0.16 = 18.4%
393.2
5.60
24 A 6 month ke = = 0.08069
75  5.60
Annual ke = (1.08069)2 – 1 = 0.1679 or 16.79%
25 B Ke = [d0 (1 + g)] / [MVex div] + g = 35  [1.10 / 250] + 0.10 = 0.254, or 25.4%
2 .3
26 D b =1– = 0.55
5.1
5.10  200,000
r = = 20.4%
5,000,000
rb = 11.22%
2.3 1.1122
ke = + 0.1122 = 0.3254, i.e. 32.54%
12
27 D The market value of a bond equals the net present value of future flows discounted at the bond
holders' required rate of return (probably the market interest rate). If the coupon rate falls,
future interest receipts will fall, as will the market value.
28 B The cost will increase as a result of the increase in gearing and hence financial risk.
29 B The traditional view is that, as an organisation introduces debt into its capital structure, the
weighted average cost of capital will fall, because initially the benefit of cheap debt finance more
than outweighs any increases in the cost of equity required to compensate equity holders for
higher financial risk. As gearing continues to increase, equity holders will ask for progressively
higher returns and eventually this increase will start to outweigh the benefit of cheap debt
finance, and the weighted average cost of capital will rise.
30 A As more debt is taken on, the cost of equity capital will rise.
31 A If the company were to automate its production line, its level of fixed costs would increase and
its variable costs decrease.
Therefore operating leverage would increase.
32 C The return to shareholders becomes less variable when gearing is lower.
33 D Operating leverage = fixed costs  variable costs, so an increase in the gearing ratio implies a
higher proportion of fixed costs. Therefore C is wrong.
Consider the following example.
Higher gearing Lower gearing
CUm CUm
Sales 100 100
Variable costs (20) (30)
Fixed costs (30) (20)
Profit 50 50
Operating gearing ratio 3/2 2/3
Suppose sales volume, and hence variable costs, fall by 20%.
The profits will be affected as follows.
CUm CUm
Sales 80 80
Variable costs ((16) (24)
Fixed costs (30) (20)
Profit 34 36
With the higher gearing ratio, profits are more affected by the change in volume. D is correct.
A is wrong – profitability is unconnected to gearing. B is wrong – profits are more risky, as the
example above shows.
34 A If a perfect market exists, MM applies.
35 B Operating risk depends on the firm's operating gearing, which is measured by the ratio of fixed to
variable costs. Hence, if fixed operating costs rise, operating gearing rises, as does operating risk.
36 B Value of merged company = 40 + 8 + 5 + 1 = CU54m
R's shareholders have 80%  CU54m = CU43.2, a gain of CU3.2m
ANSWER BANK

1 B Generally it will be disadvantageous from the viewpoint of tax to receive an immediate capital
gain as opposed to continuing to receive dividend income on the shares.
2 A If a company announces that its long-term policy is to pay no dividends, the only investors in the
shares should be investors seeking capital growth through reinvestment. Companies such as
Microsoft have argued that shareholders needing cash can sell their shares in the market at any
time, and so do not need dividends. The argument is also made that capital gains are not taxed
until the shares are sold, which means that capital gains tax will be deferred, whereas tax on
dividends would be an annual event. The tax treatment of capital gains is therefore favourable for
investors seeking capital growth.
3 D A company should invest its post-tax profits in all projects that are available with a positive net
present value, and pay out as dividend only those profits that are left over.
4 C A bonus issue (or scrip issue) does not affect the market value or earnings of the company: it is
merely a free issue of shares which raises no new capital. Therefore the earnings per share will
decrease, due to the larger number of shares
68
5 C (1 + g)2 = = 1.26; g = 12.2%
54
68 1.122
ke = + 0.122 = 16.7%
4.5  375
6 B Venture capital organisations may provide loan finance as well as equity finance to a company.
They do not normally invest in established (stock market) companies.
7 B Debt (extra interest of CU70,000, extra prior charge capital of CU1,000,000, no extra equity):
Gearing = CU3,500,000 / CU7,200,000 = 48.6%
Interest cover = CU3,022,000 / CU293,000 = 10.3 times
Earnings per share = CU2,047,000 / 3,000,000 = 68.2p per share
Shares (no extra interest, no extra debt, CU1,000,000 extra equity, 400,000 extra shares):
Gearing = CU2,500,000 / CU8,200,000 = 30.5%
Interest cover = CU3,022,000 / CU223,000 = 13.6 times
Earnings per share = CU2,099,000 / 3,400,000 = 61.7p per share
Note: Earnings = (PBIT – Interest) – tax @ 25% = (PBIT – Interest)  75%
8 C Maximum is cost to set up equivalent venture.
9 B
CU'000
Value of Alpha and Beta combined (200 + 800 + 100)  20 22,000
Value of Beta on its own 800  21 (16,800)
Maximum value of Alpha 5,200
10 B The least they will accept is the break-up value.
11 B When a management team wants to buy a company that the parent company is selling off, they
will almost certainly be reluctant to co-operate with the sale to an outside buyer, particularly if
the MBO team offers the same price. This is likely to be an important influence on the parent
company's choice of buyer.
Although the MBO team will know more about the company than the external buyer, this is not
a matter of direct concern to the selling company. Since the parent company has two potential
buyers, avoiding redundancy costs is not an issue either. The external buyer would have to take
on the employees of Tucker, and any decisions about redundancies would be the responsibility of
and at the cost of the buyer. There is no obvious reason why a sale to an MBO team would be
quicker than a sale to an external buyer.
12 C If X Ltd buys another company and values the target company on a higher P/E ratio, and if there
is no increase in the combined profits after the acquisition (i.e. no synergy) there will be a
reduction in the earnings per share of X Ltd. Since the acquisition is paid for by using new shares,
the gearing ratio of X Ltd will fall, and existing shareholders will own a smaller proportionate
stake in the company. It is unlikely that the share price will increase: in view of the reduction in
earnings per share, it is more likely that the share price will fall after the takeover.
13 C A higher P/E ratio valuation may be justified when the target company has higher growth
prospects, or when it is in an industry where the normal P/E ratio is higher than in the industry of
the bidder. Better-quality assets might also be a reason for offering a price that values the target
on a higher P/E. Higher gearing ratios are more likely to reduce the P/E ratio than increase it.
14 A It increases the number of shares without affecting the value of the company, so market price per
share and earnings per share will fall.
ANSWER BANK
Risk management

1 C The correct answer is: to reduce or eliminate exposure to risk.
2 A The value of a swap is the difference between the present value of future interest and the future
value of future interest payments under the swap. When interest rates rise, the cost of capital
will also rise, and so the present value of a swap to the receiver of the fixed interest payments
will fall. A general rise in interest rates will not affect the slope of the yield curve. If interest rates
rise, the market price of bonds will fall, and so the price of bond futures will also fall. Call options
on bond futures will increase in value and put options on bond futures will fall in value.
3 A Multilateral netting is a method of reducing interest charges by setting off credit balances held in a
bank by some members of a group against debit balances held by other group members.
4 D Interest rate risk arises for investors and lenders, as well as for borrowers, and risk can arise
from a fall as well as a rise in interest rates, or from a change in the structure of interest rates
(the shape of the yield curve).
5 B An interest rate option guarantees against the worst-possible interest rate. It protects against
downside risk.
6 A To hedge an exposure to a rise in short-term interest rates with futures, it is necessary to sell
futures. December futures are more appropriate than September futures, since the December
futures relate to a three-month interest period from December, whereas the September futures
would relate to a three-month period starting next September.
7 A In the swap, the bank would pay the fixed rate and receive the floating (LIBOR). It will therefore
quote the lower of the two rates, the bid rate of 8.50%. The company would pay LIBOR in the
swap and receive 8.50% fixed. It would also pay 9.40% by issuing bonds. This gives a net effective
cost of LIBOR + (9.40 – 8.50)% = LIBOR + 0.90%. If it borrowed at a floating rate, it would pay
LIBOR plus 0.60%. It would therefore be cheaper to borrow at a floating rate.
8 C The option is in-the-money, because an investor could exercise the call to buy a future at 93.00
and sell the future at 93.50, a gain of 0.50. The intrinsic value of an option is the amount by which
it is in-the-money. The intrinsic value is therefore 0.50 and the rest of the premium must be its
time value.
9 D A forward rate agreement fixes the interest rate on future borrowing.
10 D The exposure to a fall in short-term interest rates can be obtained by selling a 4 – 7 FRA, buying
December futures or by buying a call option on December futures. Dealing in September futures
or options does not provide sufficient cover against the interest rate exposure.
11 C To hedge an exposure to an increase in the interest rate, a company will buy an FRA. The start
of the interest rate period is after 4 months, and the end is after 7 months, so the FRA is 4 – 7.
12 C The diagram best illustrates the position of the put option holder. The maximum potential profit
is equal to the exercise price, which is the position if the share price falls to zero. Then, the put
option holder has the option to sell worthless shares at the exercise price. You should be able to
appreciate that the put option can be used to protect a holder of shares against a fall in their
value. As the diagram shows, the loss on the option is limited to the size of the premium.
13 D The time value of an option decays through time, shrinking to zero on expiry of the option.
14 D The holder of a put option – which gives the right to sell the share at the exercise price – will
abandon the option if the share price is higher than the exercise price at expiry.
CU
Share price (3.50)
Sell at exercise price 3.00
Gain if option is exercised 0
Abandon
Less: premium (0.15)
Overall loss (0.15)
15 A The loan will need to be taken out in October/November for 6 months therefore December
futures would be most appropriate. Since the loan is for 6 months the number of three-month
futures required will be double the number based upon value.
Number of contracts required = CU6,000,000 / CU500,000  6 3
= 24 contracts
16 A To fix a rate for interest income, you should sell an FRA. An FRA for a four-month interest
period starting at the end of three months is a 3 – 7 FRA.
17 A The increase in Bangladesh interest rates would strengthen the Taka against the dollar at the spot
rate, because the Taka becomes a more attractive currency to buy and invest in.
The forward rate premium is measured approximately by
1  US dollar interest rate
1  sterling interest rate
So, for example, if US interest rates are 9%, and Bangladesh rates went up from 14% to 15%, the
forward rate would change from 1.09/1.14 = 0.956 to 1.09/1.15 = 0.948 of the spot rate. The
premium would increase from 0.044 (4.4% of the spot rate) to 0.052 (5.2% of the spot rate).
18 B Both revenues and costs will rise.
The decline in the value of the Taka will make the company's goods cheaper abroad, since
exports will probably be priced in Taka. (For example, if a product sells for Tk100 and the
exchange rate declines from $1.50 = Tk1 to $1.35 = Tk1, its cost to a US buyer would fall from
$150 to $135). Lower prices to foreign buyers will increase overseas demand and exports.
The fall in the Taka’s value will also make imported goods more expensive to buy, because the
company will need more Taka to pay for goods invoiced in a foreign currency. Unit variable costs
will therefore rise and contribution/profit margins will be squeezed.
19 D Tk1 invested now for three months will accumulate to Tk1.01 (+ (Tk1  0.04  1/4))
$1.44 invested now for three months will accumulate to $1.476(+($1.44  0.10 1/4))
1.476
Three-month forward rate will equate these two figures = = Tk1 = $1.4614
1.01
20 C According to purchasing power parity theory, the exchange rate will change according to the
relative rates of inflation in each country next year.
The Taka’s value against the yen will fall, as a percentage of its current level, to:
100%  (1.03/1.08) = 95.4%
This is a fall of 4.6% in value. To prevent such a fall, the Bangladesh authorities might need to
raise Taka interest rates, in order to attract more investors into buying Taka securities (investing
in Bangladesh).
21 D The Ruritanian $ buy rate is 3.4050
Taka cost of imports = $130,000 / 3.4050 = Tk38,179
Profit = Tk42,500 - Tk38,179 = Tk4,321
ANSWER BANK
22 C Economic exposures are strategic exposures to currency risk. An economic exposure gives rise
to transaction exposures. In this example, transaction exposures will arise whenever the
company buys supplies in the euro zone for payment in euros and whenever it sells to customers
in the US for payment in dollars.
23 C Leading and lagging means advancing or delaying payments to a time when the exchange rate is
favourable. Matching receipts and payments in the same currency reduces the need to convert
currencies. Forward contracts hedge against changes in exchange rate and provide certainty in
conversion. Invoicing in local currency means that profits are held in local currency. Remitting
these profits to Bangladesh will then be open to exchange risk.
24 B X's forward rates are lower than the spot rates: they are quoted forward at a premium against
the Taka. The currency of X is therefore 'stronger' forward than spot, due to the fact that
interest rates are lower in country X.
The premium of 190c – 191c translates to $X 1.90 – $X 1.91.
The approximate interest rate difference can be calculated as:
((197.05 – 1.90)/197.05)  (12/3)  100% = approximately 4%.
The 3-month differential has to be converted to an annual interest rate using the factor  (12/3)
25 B The idea of a single currency is to overcome the problems of operating in many different
currencies. Intergroup trade, pricing and accounts preparation in one currency are all examples
of the suggested benefits of a single currency. Bangladesh customers dealing with Beta in euros
are exposed to an exchange rate risk that they had not experienced when Beta invoiced in Taka.
26 B The coupling of two simple financial instruments to create a more complex one is a definition of
financial engineering. Matching refers to the balancing of receipts and payments in the same
currency.
27 C Leading with the payment eliminates the foreign currency exposure by removing the liability.
Borrowing short-term in euros to meet the payment obligation in three months' time matches
assets and liabilities and provides cover against the exposure. A forward exchange contract is a
popular method of hedging against exposure.
28 C 200,000 / (2.24 – 0.03) = Tk90,498
If you chose Tk91,013, you used the rate at which Gordonbear would buy Swiss francs.
If you chose Tk88,398, you used the rate at which Gordonbear would buy Swiss francs and added
the premium rather than subtracting it.
If you chose Tk88,106, you added the premium rather than subtracting it.
29 D The company wants the currency 2½ months from now, and the bank will quote a rate for the
krona under a forward exchange option agreement. This will give the company the choice of
when to obtain the currency at any time between 2 months and 3 months for the date of
agreeing the contract – here, at any time between 1 June and 1 July.
2-month rate 3-month rate
Spot 9.90 9.90
Premium 1 1/4 1 3/4
Forward rate 9.8875 9.8825
The forward rate will be either the 2-month forward rate or the 3-month forward rate,
whichever is more beneficial for the bank.
The bank is selling krona, and so the lower of these rates will be used.
Costs 200,000 / 9.8825 = Tk20,237.79.
30 B [(1.42 – 1.4) / 1.4]  (12 / 3)  100 = 5.71% discount

If you chose 'The $ is at a premium of 5.71 percent', then you quoted the answer at a premium.
If you chose 'The $ is at a premium of 1.43 percent', then you missed out the annualisation and
quoted the answer at a premium.
If you chose 'The $ is at a discount of 1.43 percent', then you missed out the annualisation.
31 B Even when a company does not export or import, it might be exposed to the threat of foreign
competition in its domestic markets. A strong domestic currency makes foreign imports
relatively cheap. Borrowing in a foreign currency at a lower rate of interest is not a cheap option,
because the foreign currency will be quoted forward at a premium, and its spot rate value could
also strengthen over time. Since the foreign currency loan has to be repaid at some time, and
since interest payments will be made in the currency, the effective cost could be about the same
as borrowing in domestic currency.
32 A The new contract offsets the original contract. Unless this is done, the original forward contract
creates a currency exposure, since the $650,000 will not be received in July but the company has
contracted to sell $650,000. The forward contract is a binding contract, not an option, and
cannot be cancelled unilaterally by one party.
33 C The option premium makes foreign currency options quite expensive, and could therefore be
unsuitable for any company trading on narrow profit margins. Options are often used by
companies faced with (1) a currency exposure that might not arise at all or (2) where the amount
of the total receipt or payment is uncertain.
Option premium = 240  1.2% = 2.88 yen
Worst case = 240 – 2.88 = 237.12 yen
If the spot rate in six months' time is 245, the company will allow the option to lapse, and buy
yen at the spot rate. Its all-in cost would be 245–2.88 option premium = 242.12 yen to Tk1.
34 C Dollars are quoted forward at a discount, so forward bid and ask rates are 1.7805 – 1.7896.
The bank is selling dollars, and will want the more favourable rate, which is 1.7805. (At this rate,
it will receive more in Taka for the dollars it sells than at a higher rate of 1.7896.)
35 C The company is selling euros, and so the bank is buying. Forward rates are at a premium to spot
rates, and premiums should be deducted.
Euros
Spot rate 2.74
2 months forward premium 0.03
2 months forward rate 2.71
Income to the company = 120,000 euros  2.71 = Tk44,280.44
36 B Delivery dates on futures contracts are specified by the futures exchange and not by the buyer
and the seller.
37 B Moving payment obligations from one currency to another can be achieved using a cross-
currency swap. The main purpose of interest rate swaps for non-financial companies is probably
to manage the balance between fixed and floating rate debt. Occasionally, a credit arbitrage
opportunity might exist to lower borrowing costs by arranging swaps.
38 C As the tender is not certain an option would be more appropriate as with a forward contract the
contract must be honoured. The amount that must be hedged is the difference between the
dollar costs and the dollar income $18.75 million ((100% – 25%) $25m).
39 C Matching receipts and payments is another method of hedging transaction exposure, not
translation exposure.
40 C The correct answer is: buy Thai Baht futures.
41 C 3-month forward buying rate = 63.25 + 0.06 = 63.31. (Remember to add on a discount.)
ANSWER BANK
42 D The 3-month forward rate is given by deducting the premium from spot rates.
Spot rate 1.7920 – 1.7930
Premium 0.0022 – 0.0024
3-month rate 1.7898 – 1.7906
Since the company is buying $ forward, the appropriate rate is the lower rate of 1.7898.
Appendix
255
Financial management
APPENDIX
The Institute of Chartered Accountants of Bangladesh
Professional Stage Application Examination
Financial Management
Formulae and Discount Tables

Formulae you may require:
a. Discounting an annuity
1 1 
The annuity factor: AF1 n = 1 
r  (1 r)n 
Where AF = annuity factor

n = number of payments
r = discount rate as a decimal
D 0 (1+ g)
b. Gordon growth model: k e = +g
P0
Where ke = cost of equity

D0 = current dividend per ordinary share
g = the annual dividend growth rate
P0 = the current ex-div price per ordinary share
c. Capital asset pricing model: rj = rf + ßj (rm – rf)

Where rj = the expected return from security j
rf = the risk free rate
ßj = the beta of security j
rm = the expected return on the market portfolio
d. e = a ( 1 + D(1 T) )
E
Where e = beta of equity in a geared firm
a = ungeared (asset) beta
D = market value of debt
E = market value of equity
T = corporation tax rate
Note: Candidates may use other versions of these formulae but should then define the symbols they use.
Financial management
Discount Tables
Interest Number of Present value of Present value of
rate years CU1 receivable at CU1 receivable at
p.a. n the end of n years the end of each of
n years
1% 1 0.990 0.990
2 0.980 1.970
3 0.971 2.941
4 0.961 3.902
5 0.951 4.853
6 0.942 5.795
7 0.933 6.728
8 0.923 7.652
9 0.914 8.566
10 0.905 9.471
5% 1 0.952 0.952
2 0.907 1.859
3 0.864 2.723
4 0.823 3.546
5 0.784 4.329
6 0.746 5.076
7 0.711 5.786
8 0.677 6.463
9 0.645 7.108
10 0.614 7.722
10% 1 0.909 0.909
2 0.826 1.736
3 0.751 2.487
4 0.683 3.170
5 0.621 3.791
6 0.564 4.355
7 0.513 4.868
8 0.467 5.335
9 0.424 5.759
10 0.386 6.145
15% 1 0.870 0.870
2 0.756 1.626
3 0.658 2.283
4 0.572 2.855
5 0.497 3.352
6 0.432 3.784
7 0.376 4.160
8 0.327 4.487
9 0.284 4.772
10 0.247 5.019
20% 1 0.833 0.833
2 0.694 1.528
3 0.579 2.106
4 0.482 2.589
5 0.402 2.991
6 0.335 3.326
7 0.279 3.605
8 0.233 3.837
9 0.194 4.031
10 0.162 4.192
REVIEW FORM – FINANCIAL MANAGEMENT
Your ratings, comments and suggestions would be appreciated on the following areas of
this Question Bank
Very useful Useful Not useful

Number of questions in each section
Standard of answers
Amount of guidance on exam technique
Quality of marking guides
Excellent Good Adequate Poor
Overall opinion of this
Question Bank
Please return to:

Deputy Director, Learning & Professional Development
Email: dd@icab.org.bd
ICAB
Chartered Accountant Bhaban
100 Kazi Nazrul Islam Ave.
Kawran Bazar
Dhaka-1215
www.icab.org.bd
For space to add further comments please see overleaf.
259
REVIEW FORM (continued)
TELL US WHAT YOU THINK
Please note any further comments and suggestions/errors below.
260

Financial Management QB

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Financial Management QB

Uploaded by

Copyright:

Available Formats

The Institute of Chartered Accountants of Bangladesh

All rights reserved. No part of this publication may be reproduced or

ii © The Institute of Chartered Accountants in England and Wales, March 2009

Objectives and investment

Finance and capital structure

Business plans, dividends and

iv © The Institute of Chartered Accountants in England and Wales, March 2009

Objective test questions

© The Institute of Chartered Accountants in England and Wales, March 2009 v

Your exam will consist of

Part one – 5 – 15 objective test questions 20 marks

© The Institute of Chartered Accountants in England and Wales, March 2009

Objectives and investment appraisal

© The Institute of Chartered Accountants in England and Wales, March 2009 3

4 © The Institute of Chartered Accountants in England and Wales, March 2009

4 Global Power Ltd

© The Institute of Chartered Accountants in England and Wales, March 2009 5

6 Quattro Air Ltd

6 © The Institute of Chartered Accountants in England and Wales, March 2009

7 Clearchannel Dredging Ltd

© The Institute of Chartered Accountants in England and Wales, March 2009 7

8 Broadham Hotels Ltd

8 © The Institute of Chartered Accountants in England and Wales, March 2009

10 Henwood Green Ltd

© The Institute of Chartered Accountants in England and Wales, March 2009 9

(If Year 1 net cash flows increase by CU220,000)

10 © The Institute of Chartered Accountants in England and Wales, March 2009

 Carried out a sensitivity analysis on the positive NPV

12 CAPM and project appraisal

© The Institute of Chartered Accountants in England and Wales, March 2009 11

13 Starr Chemicals Ltd

14 Holden Ltd (S04)

12 © The Institute of Chartered Accountants in England and Wales, March 2009

15 Maritime Specialists Ltd

© The Institute of Chartered Accountants in England and Wales, March 2009 13

16 Zola Holdings Ltd

14 © The Institute of Chartered Accountants in England and Wales, March 2009

© The Institute of Chartered Accountants in England and Wales, March 2009 15

20 Sunday newspaper article

16 © The Institute of Chartered Accountants in England and Wales, March 2009

© The Institute of Chartered Accountants in England and Wales, March 2009 17

18 © The Institute of Chartered Accountants in England and Wales, March 2009

© The Institute of Chartered Accountants in England and Wales, March 2009 19

20 © The Institute of Chartered Accountants in England and Wales, March 2009

© The Institute of Chartered Accountants in England and Wales, March 2009 21

22 © The Institute of Chartered Accountants in England and Wales, March 2009

Finance and capital structure

© The Institute of Chartered Accountants in England and Wales, March 2009 23

24 © The Institute of Chartered Accountants in England and Wales, March 2009

© The Institute of Chartered Accountants in England and Wales, March 2009 25

29 Ellis Ltd (M03)

30 Personal investment (J03)

26 © The Institute of Chartered Accountants in England and Wales, March 2009

© The Institute of Chartered Accountants in England and Wales, March 2009 27

28 © The Institute of Chartered Accountants in England and Wales, March 2009

© The Institute of Chartered Accountants in England and Wales, March 2009 29

30 © The Institute of Chartered Accountants in England and Wales, March 2009

Balance sheet as at 31 March 20X6

© The Institute of Chartered Accountants in England and Wales, March 2009 31

37 Quigley Industries Ltd

32 © The Institute of Chartered Accountants in England and Wales, March 2009

39 Efficient markets hypothesis

© The Institute of Chartered Accountants in England and Wales, March 2009 33