Finance II
Autumn 2014 solutions
AUTUMN 2014 EXAMINATIONS – SUGGESTED
SOLUTIONS
Finance II
Module Description:
1
Finance II
Autumn 2014 solutions
Question 1 (a) (i) WACC before issue of new bonds
Marks
Cost of equity
Geometric average dividend growth rate = (16.02/13.45)0·25 – 1 = 0.0447 or 4.47%
Using the dividend growth model, ke = 0·0447 + ((16.02 x 1·0447)/310) = 0·0447 + 0·054 = 9.9% say 10%
2.00
2.00
The current after-tax cost of debt is 9%
0.50
Market values of equity and debt
Market value of equity = Ve = 200m x 3.10 = €620 million
Market value of bonds = Vd = 80m x (95/100) = €76 million
Total market value = Ve + Vd = 620 + 76 = €696 million
0.50
0.50
0.50
Current WACC calculation
WACC
=
(10 * 620/696) + (9 * 76/696)
=
9.9%
2.00
8.00
Question 1 (a) (ii) WACC after issue of new bonds
Marks
After-tax cost of debt of new bond issue
After-tax interest rate = 7 x (1 – 0·3) = 4.9% per year
Using linear interpolation:
Year
Cash flow
€
15% DF
0 Market value
(100.00)
1.000
1 to 8 Interest
4.90
4.487
8 Redemption
104.00
0.327
1.00
PV
5% DF
PV
(100.00)
1.000 (100.00)
21.99
6.463
31.67
34.01
0.677
70.41
(44.01)
2.08
Using linear interpolation, after-tax cost of debt =
5 + ((2.08/(2.08 +44.01))* (15-5))
=
5.45% say
5.50%
The market value of the new issue of bonds is €60 million
The total market value increases to €696m + €60m = €756 million
WACC = (10 * 620/756) + (9 * 76/756) + (5.5 * 20/756)
=
4.00
0.50
0.50
9.3%
2.00
8.00
After the new issue of bonds, the weighted average after-tax cost of capital has fallen from 9.9% to 9.3% because
the proportion of debt finance, which has a lower required rate of return than equity finance, has increased.
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Finance II
Autumn 2014 solutions
(b) Sample answer

There is certainly a relationship between the weighted average cost of capital (WACC)
and the market value of the company, since the market value can be expressed as the
present value of future corporate cash flows, discounted by the WACC.

Marginal and average cost of debt: If the marginal cost of capital, in this case the cost of
debt of the new bond issue, is less than the weighted average cost of capital (WACC), it
would seem logical to expect the WACC to decrease. However, increasing gearing will
increase financial risk and may lead to an increase in the cost of equity, offsetting the
effect of the cheaper debt.

Traditional view of capital structure: This view states that there is a non-linear
relationship between the cost of equity and financial risk, as measured by gearing. Equity
investors are indifferent to the addition of small amounts of debt, so as a company gears
up by replacing expensive equity with cheaper debt, the WACC initially decreases. Debt
is cheaper than equity because of the relative positions of the two sources of finance in
the creditor hierarchy. As equity investors start to respond to increasing financial risk,
however, the cost of equity begins to increase until a point is reached where WACC
ceases to fall. This corresponds to an optimal capital structure, since at this point WACC
is at a minimum and hence the market value of the company is at a maximum. After this
point, the WACC starts to increase as the company continues to gear up, rising more
quickly at very high levels of gearing due to the appearance of bankruptcy risk. Under the
traditional view the finance director might be correct in his belief that issuing debt will
decrease WACC, depending on the position of the company relative to its optimal capital
structure.

Modigliani and Miller: M&M showed that in a perfect capital market without corporate
taxation, the replacement of expensive equity with cheaper debt did not lead to a decrease
in the WACC, since the effect of adding in cheaper debt was exactly offset by the
increase in the cost of equity, which had a linear relationship with financial risk, as
represented by gearing. This meant that the market value of the company was
independent of its capital structure (financial risk) and depended only on its business
operations (business risk). In their second paper on capital structure M&M showed that,
if taxation were allowed (so that the after-tax cost of debt was considered, rather than the
before-tax cost of debt), replacing equity with debt led to a linear decrease in the WACC,
because of the tax shield on profits gained by interest payments being an allowable
deduction in calculating tax liability. Under this contribution to capital structure theory,
gearing up as much as possible would maximise the market value of the company and the
finance director would be correct in his belief that issuing traded bonds would decrease
the WACC of Charlton Ltd.

Market imperfections view: In reality, companies do not gear up as much as possible
because of the dangers of high gearing. Further market imperfections, relative to the idea
of a perfect capital market in Miller and Modigliani’s first paper on capital structure,
included bankruptcy risk and the costs of financial distress at high levels of gearing.
These reduced and finally reversed the tax shield effect noted by Miller and Modigliani,
resulting in an optimal capital structure at the point where the WACC was at its lowest
and the value of the company was at its highest.
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Finance II
Autumn 2014 solutions

Pecking order theory: In practice it has been noticed that companies do not appear to base
their financing decisions on the objective of achieving an optimal capital structure, but
rather have a preference for sources of finance in the order of retained earnings, bank
loans, ordinary debt, convertible debt and equity. A number of reasons have been
suggested for this ‘pecking order’.

Any four of these points = full marks
(9 marks)
(Total: 25 marks)
Question 2 (a) - Net present value
Marks
Year
Sales (W1)
Variable costs (W1)
Net trading inflows
Taxation (12.5%)
Initial investment
Scrap proceeds
CA tax benefits (W2)
Working capital (W3)
Net cash flow
Discount factors (W4)
Present values
0
€
1
€
1,856,400
(886,830)
969,570
2
€
1,930,656
(913,435)
1,017,221
(121,196)
3
€
2,007,882
(940,838)
1,067,044
(127,153)
75,000
(1,545)
969,480
0.769
745,530
200,000
56,250
40,158
1,236,299
0.675
834,502
4
€
(133,381)
(2,400,000)
(37,128)
(2,437,128)
1.000
(2,437,128)
(1,485)
968,085
0.877
849,010
NPV
143,750
3.00
3.00
0.50
0.50
0.50
0.50
3.00
2.00
10,369
0.592
6,138
2.00
(1,948)
0.50
NPV is negative, therefore reject.
Presentation
4
0.50
16.00
Finance II
Autumn 2014 solutions
Workings
Working 1 - Revenue and variable costs
Revenues
1
2
3
No. of units *
21,000
21,000
21,000
Sales price inflation
Selling price/unit * (1 + inflation)t =
85
1.04
85
1.0816
85
1.124864
1,856,400
1,930,656
2,007,882
4.00%
Variable costs
1
2
3
No. of units *
21,000
21,000
21,000
Variable costs inflation
VC/unit *
41
41
41
(1 + inflation)t =
1.03
1.0609
1.092727
CA Rate
25%
25%
CA (€)
600,000
450,000
1,050,000
886,830
913,435
940,838
3.00%
Working 2 - Capital allowances
Year
1
2
Opening balance
2,400,000
1,800,000
3
Balancing allowance = WDV - Scrap value
= 1,350,000 - 200,000
=
1,150,000
Tax benefit
75,000
56,250
143,750
Working 3 - Working capital requirements
€millions
Sales
WC requirements
Year 0
Year 2
1,930,656
40,158
Year 3
2,007,882
37,128
Year 1
1,856,400
38,613
37,128
(37,128)
38,613
(1,485)
40,158
(1,545)
0
40,158
2%
Incremental investment
WC requirement
Annual WC investment
Working 4 - Money rate of return
Real rate (r)
General inflation rate (h)
Money rate (i)
Rounded
9.00%
4.60%
14.01%
14.00%
(1+i) = (1+r)(1+h)
5
Closing balance
1,800,000
1,350,000
Finance II
Autumn 2014 solutions
Solution 2 (b) - Internal rate of return
Marks
Cost of capital
Trial rate
14
6
Year
0
€
(2,437,128)
1.000
(2,437,128)
After-tax cash flows
Discount at 6%
Present values
1
€
968,085
0.943
912,904
2
€
969,480
0.890
862,837
NPV
Internal rate of return
3
€
1,236,299
0.840
1,038,491
4
€
10,369
0.792
8,212
1.00
1.00
1.00
385,316
1.00
IRR = L + {(NL/(NL - NH)) x (H-L)}
L
H
NL
6
14
385,316
NH
-1,948
IRR =
6 + ((385,316/(385,316 + 1,948)) * (14-6)
4.00
13.96%
(Reject project as IRR < Cost of capital))
Based on the analysis, NPV is negative and IRR is less than cost of capital, therefore reject.
1.00
9.00
(Total: 25 marks)
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Finance II
Autumn 2014 solutions
Question 3 (a)
Marks
Years prior
to listing
Number of shares
Total dividend
Payout ratio
5
4
3
2
1
33,333,333
33,333,333
40,000,000
40,000,000
40,000,000
990,000
1,153,333
1,640,000
1,880,000
2,120,000
56.4%
56.6%
56.5%
56.5%
56.6%
50,000,000
125
*
No. of shares year 1:
=
No. of shares year 4:
100
40,000,000
40,000,000
120
=
1.00
1.00
1.00
1.00
1.00
33,333,333
0.50
*
100
0.50
Payout ratio = total dividends / earnings after tax
Discursive comment regarding the company's dividend policy
1.00
7.00
Prior to listing
Staunton adopted a policy of paying dividends that are a constant percentage of after tax
earnings. A dividend policy that maintains a constant payout ratio will lead to both rises and falls
in dividends per share if the company experiences fluctuations in earnings per share. Staunton’s
shareholders have not experienced a reduction in dividend per share during the last five years as
the company has experienced a continued growth in profits. (2.5 marks)
Post-listing
If dividend policy is believed to affect the valuation of the company any fall in dividend per
share might have an adverse effect on share price. In practice companies appear to be reluctant to
reduce the level of dividend per share even if profitability and/or liquidity are poor. A fall in
future profitability might occur and a constant payout ratio is not normally considered a suitable
dividend policy for quoted companies. Investors might seek a minimum cash flow from dividend
payments and a stable policy that maintains at least the existing dividend per share is more usual.
(2.5 marks)
(12 marks)
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Finance II
Autumn 2014 solutions
(b) Sample answer
(i) Irrelevance theory
 In 1961, Modigliani and Miller published a paper arguing that dividend policy is
irrelevant in a world without taxes and transaction costs. (1 mark)
 M&M argue as follows: imagine your firm has decided on its investment plans. They are
being financed by fixed borrowing and retained earnings. Now, think what happens if
you want to increase dividends, without changing your investment and financing policies.
The extra money must come from somewhere. If borrowing and retained earnings are
being used already, then the only option is to sell more shares. If the value of the firm has
not changed, then new shareholders will get shares that are worth less than before the
dividend change was announced. The old shareholders will suffer a capital loss on their
shares, which will be offset by the extra cash dividend they receive. The extra dividend is
not the only way that the old shareholders can get their hands on cash. As long as there
are efficient capital markets, investors can raise cash by selling shares. So the old
shareholders can ‘cash-in’, either by persuading management to pay a higher dividend, or
by selling some of their shares. Conclusion: Because investors do not need dividends to
convert their shares to cash, they will not pay higher prices for firms with higher dividend
payouts. Dividend Policy has no impact on the value of the firm. (Example = 1 mark)
 There are strong arguments against MM’s view:
 Different tax rates on dividends and capital gains can create a preference by shareholders
for a high dividend or one for high earnings retention.
 Earnings retention smay be preferred by companies in a period of capital rationing.
 Due to imperfect markets and the possible difficulties of selling shares easily at a fair
price, shareholders might need high dividends in order to have funds to invest in
opportunities outside the company.
 Because of transaction costs on selling shares, investors who want some cash from their
investments should prefer to receive dividends rather than sell some of their shares to get
the cash they want (home-made dividends).
 Information available to shareholders is imperfect and they are not aware of the future
investment plans and expected profits of their company (future capital gains). Even if
management were to provide them with profit forecasts, these forecasts would not
necessarily be accurate.
 Perhaps the strongest argument against M&M’s view is that shareholders will tend to
prefer a current dividend to future capital gains because the future in more uncertain.
 Any two arguments against = 1 mark each
(4 marks)
(ii) Traditional theory

The traditional finance literature before MM has favoured high dividends. This belief is
supported by many in the real business world, because they believe increased dividends
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Finance II
Autumn 2014 solutions
today make shareholders better off. Traditionalists would value shares differently
depending on whether or not a dividend was to be paid. Greater value would be placed on
a share that pays a dividend than one that does not. (1 mark)

















Arguments for traditional theory
The traditional theory deals with real world situations that MM do not take into account.
For example, there is a natural clientele for high-dividend shares. Some financial
institutions are legally restricted from holding shares lacking established dividend
records.
Certain shareholders may look to their shares as a ‘pension’. In principle, they could
create cash from shares that pay no dividends, simply by selling off shares every now and
then.
However, it is simpler and cheaper (no transaction costs) for the company to send a
quarterly cheque, than for its shareholders to sell shares.
Some experts have referred to behavioural psychology to explain why we may prefer
regular dividends rather than having the ‘temptation’ of dipping into capital whenever we
want cash. The dividend takes that decision away from us.
Dividend increases send a good signal about cash flows and earnings. Because a high
dividend will be expensive for firms that do not have the cash flow to support it, dividend
increases signal manager’s confidence in future cash flows.
Dividends are more stable than capital gains, and managers have more control over them,
so investors prefer companies that pay dividends.
Paying out a dividend prevents managers from misusing or wasting the form’s money.
Suppose a company has plenty of cash but no positive NPV investment opportunities.
Shareholders may not trust the managers to spend the retained earnings wisely. Therefore
they may demand a higher dividend.
Any two arguments for traditional theory = 1 mark each
Arguments against traditional theory
While it is true that dividends are more stable than capital gains, it is also true that the
risk of cash flows of the firm is determined by the firm’s investment and debt policy. The
dividend payout should not have any effect.
As for the clientele argument, it is true that there are groups of investors who like regular
and high dividends and therefore high payout firms but is does not follow that any
particular firm can benefit by increasing its dividends.
The high dividend clientele already have plenty of high dividend companies to choose
from. It is hard to imagine a company can gain value by changing its payout ratio.
Any two arguments against traditional theory = 1 mark each
(5 marks)
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Finance II
Autumn 2014 solutions
(iii)Radical left theory






The third position in the dividend controversy focuses primarily on taxation.
If dividends are taxed more heavily than capital gains, investors should pay more for
shares with low dividends. In other words, they prefer shares offering returns in the form
of capital gains rather than dividends.
When dividends are taxed more heavily than capital gains, paying higher dividends will
actually lead to a loss in value. The firm is better off paying any excess cash through
share repurchases (tax free) rather than dividends.
Thus, the radical view is that dividends are bad for the shareholders as they cause
avoidable taxes.
Empirical studies give some support to the leftist’s view in that investors in low marginal
tax brackets appear to prefer high payout shares and vice versa.
Any four of these points = 1 mark each
(4 marks)
(Total: 25 marks)
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Finance II
Autumn 2014 solutions
Question 4 (a)
(i) Market capitalisation
Value of ordinary shares in statement of financial position = €40 million
Par value of ordinary shares = €1
Ordinary share price = €2.50 per share
Market capitalisation = 40m x €2.50 = €100 million
Marks
0.50
0.50
0.50
1.50
3.00
(ii) Net asset value (liquidation basis)
Current net asset value (NAV) =102m + 9·3m – 6.8m – 10m = €94.5m
Decrease in value of non-current assets on liquidation = 95m – 102m = €7m
Increase in value of inventory on liquidation = 5.3m – 4.2m = €1.1m
Decrease in value of trade receivables = 5.1m x 10% = €0.51m
NAV (liquidation basis) = 94.5m – 7m + 1.1m – 0.51m = €88.09m
1.50
0.50
0.50
0.50
1.00
4.00
(iii) Price/earnings ratio value
Historic earnings = €11.1m
Average price/earnings ratio within business sector = 14 times
Price/earnings ratio value of Giles = 14 x 11·1m = €155.4m
0.50
0.50
2.00
3.00
(iv)
(1) Dividend growth model value (using historic dividend growth rate)
Historic dividend growth rate = [(6.8m/6.1m)1/3 – 1] x 100 = 3.65%
An assumption is made that future dividend growth is similar to historic dividend growth.
Value of Giles = (6.8m x 1·0365)/(0·07 – 0·0365) = €210.4m
(2) Dividend growth model value (using Gordon’s growth model)
1.00
Historic retention ratio (b) = 100 x (3.1 + 3.2 + 3.7 + 4·3)/(9.2 + 9.5 + 10.2 + 11·1) = 35.75%
1.00
1.00
1.00
1.50
7.00
Current return on shareholders’ funds (re) = 100 x 6.8/54.5 = 12.5%
Dividend growth rate = 35.75 x 0·125 = 4.47%
Value of Giles = (6.8m x 1·0447)/(0·07 – 0·0447) = €280.8m
(b) (i) Calculation of market value of bond
The market value of the bond is the present value of the future cash flows from the bond,
discounted at the before-tax cost of debt.
Market value of bond = (10 x 4.917 6 Yr AF ) + (100 x 0.705 year 6 DF) = €119.67
(ii) Debt/equity ratio (book value basis)
D/E = 100 x 10/94.5= 10.6%
(iii) Debt/equity ratio (market value basis)
Market value of debt = 10.0 x 119.67/100 = €11.967m
Market value of equity = 2.50 x 40m = €100m
D/E = 100 x 11.967/100 = 12%
1.50
3.00
2.00
1.00
1.00
1.00
3.00
(Total: 25 marks)
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Finance II
Autumn 2014 solutions
Question 5
a)
(i)




Modigliani & Miller view of capital structure (1 mark)
Modigliani and Miller’s 1958 paper directly disagrees with the traditional view of capital
structure. They argue that WACC will remain unchanged at all levels of gearing.
This implies that no optimal capital structure exists, and that how a company is financed
is irrelevant. i.e. WACC is unchanged as gearing levels rise. (3 marks)
As gearing increases, Cost of equity increases in such a way as to exactly offset the
greater proportion of cheaper debt capital. i.e. WACC will remain constant. This implies
that the method of financing projects is irrelevant. (2 marks)
(6 marks)
(ii)



Traditional view of capital structure (1 mark)
There is an optimal mix at which the cost of capital will be minimised. The firms cost of
capital does depend on the level of gearing. A company can increase its market value by
using the best mix of equity and debt. Therefore, selecting a particular method of
financing is important. (3 marks)
As debt increases, the cost of equity (Ke) rises. The cost of debt (Kd) remains unchanged
up to a certain level of debt, and then rises, due to default risk. WACC does not remain
constant, but rather falls initially as the level of debt increases, and then begins to
increase as the rising cost of equity, and then debt, becomes more significant. (2 marks)
(6 marks)
(iii)






Increased cost of borrowing as gearing increases
Negative impact on borrowing capacity
Tax exhaustion (when a company has increased its gearing to such a level that there is no
sufficient tax liability, or in other words, has negative taxable income, and, consequently,
it cannot benefit from ‘all’ the tax relief)
Bankruptcy costs (Lawyers, accountants, and the cost of having to sell off assets below
their market value)
Agency costs (extra covenants imposed on management which will restrict their freedom)
Any four of these = 1 mark each
(4 marks)
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Finance II
Autumn 2014 solutions
b)
(i)
Asset Beta (Atkinson) =
0.7 (85)
85 + 15(1-.125)
=
0.61
(4 marks)
(ii)
0.70 = Equity beta x
80
80+ 20(1-0.125)
Therefore, 0.70 = equity beta * 0.82, so Equity beta = 0.70/0.82 = 0.85.
(5 marks)
(Total: 25 marks)
Question 6
a)





Number of contracts = £500,000 / £62,500 =
8
Exporter needs to sell futures (sell £’s)
In July, the hedge is set up by selling (8 contracts x £62,500) = £500,000, for
December delivery at €1.15
In December, the futures position is closed by buying (8 contracts x £62,500) =
£500,000 for December delivery at €1.18
Summary of futures position:
€
1.15
(1.18)
(0.03)
Sell £ for
Buy £ for


Loss on futures position
=
€0.03/£ x (£62,500 x 8 contracts) = €15,000
Setting up hedge = 5 marks. Calculation of outcome = 4 marks
(9 marks)
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Finance II
Autumn 2014 solutions
b)
Interest rates
5.75%
4.60%
Interest payable:
€20m * .0575 * 6/12
(575,000)
€20m * .046 * 6/12
(460,000)
Compensation receivable (€575,000 - €542,000)
33,000
Compensation payable (€460,000 - €542,000)
(82,000)
Net payment
(542,000)
(542,000)
Note:
You are locked into a payment of €20m * .0542 * 6/12 = €542,000

5 marks for each scenario
(10 marks)
c)
Note: Using the option, we would get $20m / $1.60 = $12.5m. Ignore premium, it is a
sunk cost.
(i)
Future spot = $1.80: Exercise the option. $20m / $1.80 = $11.11m
(3 marks)
(ii)
Future spot = $1.40: Abandon the option. $20m / $1.40 = $14.29m
(3 marks)
(Total: 25 marks)
14