QUESTION BANK

Finance and capital structure

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.

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 Finance and capital structure

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.

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

 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.

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

 Finance and capital structure

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.

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

 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.'

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

 Finance and capital structure

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%.

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

 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%.

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

 Finance and capital structure

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)

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

 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)

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

 Finance and capital structure

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

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

 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)

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

 Finance and capital structure

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)

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