5 Tinep Co is planning to raise funds for an expansion of existing business activities and in preparation for this the

company has decided to calculate its weighted average cost of capital. Tinep Co has the following capital structure:
$m $m
Equity
Ordinary shares 200
Reserves 650
––––
850
Non-current liabilities
Loan notes 200
––––––
1,050
––––––
The ordinary shares of Tinep Co have a nominal value of 50 cents per share and are currently trading on the stock
market on an ex dividend basis at $5·85 per share. Tinep Co has an equity beta of 1·15.
The loan notes have a nominal value of $100 and are currently trading on the stock market on an ex interest basis
at $103·50 per loan note. The interest on the loan notes is 6% per year before tax and they will be redeemed in
six years’ time at a 6% premium to their nominal value.
The risk-free rate of return is 4% per year and the equity risk premium is 6% per year. Tinep Co pays corporation tax
at an annual rate of 25% per year.

Required:
(a) Calculate the market value weighted average cost of capital and the book value weighted average cost of
capital of Tinep Co, and comment briefly on any difference between the two values. (9 marks)

(b) Discuss the factors to be considered by Tinep Co in choosing to raise funds via a rights issue. (6 marks)

(15 marks)

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

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

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

(15 marks)

4
4 Dinla Co has the following capital structure.
$000 $000
Equity and reserves
Ordinary shares 23,000
Reserves 247,000 270,000
––––––––
Non-current liabilities
5% Preference shares 5,000
6% Loan notes 11,000
Bank loan 3,000
––––––––
19,000
––––––––
289,000
––––––––
The ordinary shares of Dinla Co are currently trading at $4·26 per share on an ex dividend basis and have a nominal
value of $0·25 per share. Ordinary dividends are expected to grow in the future by 4% per year and a dividend of
$0·25 per share has just been paid.
The 5% preference shares have an ex dividend market value of $0·56 per share and a nominal value of $1·00 per
share. These shares are irredeemable.
The 6% loan notes of Dinla Co are currently trading at $95·45 per loan note on an ex interest basis and will be
redeemed at their nominal value of $100 per loan note in five years’ time.
The bank loan has a fixed interest rate of 7% per year.
Dinla Co pays corporation tax at a rate of 25%.

Required:
(a) Calculate the after-tax weighted average cost of capital of Dinla Co on a market value basis. (8 marks)

(b) Discuss the connection between the relative costs of sources of finance and the creditor hierarchy.
(3 marks)

(c) Explain the differences between Islamic finance and other conventional finance. (4 marks)

(15 marks)

4
Section C – BOTH questions are compulsory and MUST be attempted

Please write your answers to all parts of these questions on the lined pages within the Candidate Answer Booklet.

31 Tin Co is planning an expansion of its business operations which will increase profit before interest and tax by 20%.
The company is considering whether to use equity or debt finance to raise the $2m needed by the business expansion.
If equity finance is used, a 1 for 5 rights issue will be offered to existing shareholders at a 20% discount to the current
ex dividend share price of $5·00 per share. The nominal value of the ordinary shares is $1·00 per share.
If debt finance is used, Tin Co will issue 20,000 8% loan notes with a nominal value of $100 per loan note.
Financial statement information prior to raising new finance:
$’000
Profit before interest and tax 1,597
Finance costs (interest) (315 )
Taxation (282 )
––––––
Profit after tax 1,000
––––––
$’000
Equity
Ordinary shares 2,500
Retained earnings 5,488
Long-term liabilities: 7% loan notes 4,500
–––––––
Total equity and long-term liabilities 12,488
–––––––
The current price/earnings ratio of Tin Co is 12·5 times. Corporation tax is payable at a rate of 22%.
Companies undertaking the same business as Tin Co have an average debt/equity ratio (book value of debt divided by
book value of equity) of 60·5% and an average interest cover of 9 times.

Required:
(a) (i) Calculate the theoretical ex rights price per share. (2 marks)
(ii) Assuming equity finance is used, calculate the revised earnings per share after the business expansion.
(4 marks)
(iii) Assuming debt finance is used, calculate the revised earnings per share after the business expansion.
(3 marks)
(iv) Calculate the revised share prices under both financing methods after the business expansion. (1 mark)
(v) Use calculations to evaluate whether equity finance or debt finance should be used for the planned
business expansion. (4 marks)

(b) Discuss TWO Islamic finance sources which Tin Co could consider as alternatives to a rights issue or a loan
note issue. (6 marks)

(20 marks)