Q1) Discuss THREE problems a company might face as a result of its current high level of gearing. (IMP) • Debt Capacity: Co's high gearing level limits its ability to acquire new debt finance and affects its overall debt capacity. The company might struggle to raise additional debt finance due to its existing high gearing. • Bankruptcy Risk: High gearing also escalates the risk of bankruptcy. Inability to meet high interest obligations, especially during periods of reduced profits or cash flow, could lead to default on interest payments and possible forced liquidation by lenders. • Earnings Volatility: High operational gearing in Co leads to greater earnings volatility. Fixed interest payments remain constant regardless of activity levels. A fall in activity causes a larger decrease in earnings, highlighting the financial risk. • Cost of Equity Finance: This increased earnings volatility raises the cost of equity finance. Q2) Discuss the assumptions made by the capital asset pricing model. (IMP) • Diversified Portfolios: CAPM assumes investors hold diversified portfolios, focusing only on systematic risk and requiring compensation for this risk. • Single-Period Horizon: It considers returns over a standard single-period, typically one year, to compare different asset returns. • Perfect Capital Market: Assumes a market with no taxes, no transaction costs, and perfect information available to all. • Risk-Free Rate Borrowing and Lending: CAPM assumes all investors can borrow and lend at a risk-free rate, a key variable in the model's equation. Q3) Explain and discuss the relationship between systematic risk and unsystematic risk. (IMP) • Diversification in Portfolio Theory: Suggests that diversifying investments across various assets reduces total risk. For example, investing in multiple shares instead of focusing on just one or two companies. • Limit to Risk Reduction: Despite diversification, there remains a level of risk that cannot be eliminated. This undiversifiable risk, is known as systematic or market risk. • Systematic vs. Unsystematic Risk: • Systematic Risk: The inherent market risk that can't be diversified away. • Unsystematic Risk: Company-specific risk that can be minimized through diversification. • Focus of Portfolio Theory: Concerned with total risk, which is a combination of systematic and unsystematic risks. • Types of Systematic Risk: Includes business risk (inherent to business operations) and financial risk (associated with using debt finance). A company with no debt faces only business risk, while one with both equity and debt faces both types. Q4) Discuss and recommend whether company should raise the finance it requires by reducing its annual dividend. (IMP) • • • Signalling Effect: • Concept: In markets without perfect information, dividend announcements act as signals to investors. • Impact: A reduced dividend could be perceived negatively, potentially lowering the company's share price. Clientele Effect: • Investor Preferences: Different investors seek varying balances of income and capital growth. (Individual investors and/or institutional investors) • Implications: Historically consistent dividend payments mean a reduction could alienate shareholders, possibly leading to significant share price decline. Liquidity Preference: • Shareholder Desire: Even investors favoring reinvestment typically prefer some dividend payout for immediate, certain returns over uncertain future gains. Q5) Discuss the ways in which a company can issue new equity shares. • Rights Issue: Issues shares to existing shareholders based on their current holdings. It's cost-effective and simpler than a public issue but limited by shareholders' investment willingness. Mandatory if pre-emptive rights are not waived. • Private Placing: Involves finding new investors, usually financial institutions, for equity investment. Cheaper than public issues, suitable for smaller amounts, but dilutes control. • Public Offer: Applicable for listed companies to offer shares to the public. Involves high regulatory costs, dilutes control, but allows raising large equity amounts. • Initial Public Offering (IPO): For unlisted companies to list on the stock exchange and raise equity. Costlier than public offers due to extra regulations, suitable for large companies seeking significant finance. Q6) Discuss TWO Islamic finance sources which Tin Co could consider as alternatives to a rights issue or a loan note issue. (IMP) • • Mudaraba (Rights Issue): • A contract between a capital provider (rab al mal) and an expertise partner (mudarab) for business operations, compliant with Sharia law. • Mudarab manages daily operations; rab al mal does not participate. • Profits are shared as per the contract; losses borne by rab al mal up to the capital provided. Sukuk (Loan Notes): • Shari'a law prohibits conventional loan notes due to interest (riba) and lack of tangible asset linkage. • Sukuk are asset-backed, passing ownership of the asset to holders, without interest. • Sukuk holders bear risks and rewards of the asset, including losses and income rights. • Ijara (Alternative to Loan Notes: Similar to Lease): • Islamic lease finance where the lessee uses an asset in return for rental payments to the lessor. • Major maintenance and insurance are lessor's responsibilities; minor maintenance is the lessee's. • The lease may allow asset ownership transfer to the lessee at the end of the lease. Q7) Discuss the circumstances under which it is appropriate to use the current WACC of Co in appraising an investment project. (IMP) • Same Business Projects: Suitable as a discount rate for projects that don't change business risk, like business expansions. • Similar Financing Structure: Applicable when project financing mirrors Tufa Co's current capital structure, keeping financial risk stable. • Project Size Consideration: WACC's suitability as a discount rate depends on the project's relative size to Tufa Co; more fitting for smaller investments. Q8) Discuss THREE advantages to Co of using convertible loan notes as a source of long-term finance. • Conversion than redemption: If convertible loan note holders opt for shares, Co avoids cash redemption, a process known as 'self-liquidation'. • Lower Interest Rate: The conversion option into shares, typically offering higher returns, allows Co to issue convertible loan notes at a lower interest rate, reducing finance costs. • Debt Capacity: Issuing convertible notes initially raises Co’s gearing and financial risk, reducing debt capacity. Upon conversion, these effects reverse, increasing debt capacity due to loan note elimination and new share issuance. • Investor Attractiveness: Convertible loan notes might appeal to investors reluctant to invest in ordinary loan notes due to the future conversion option. • Planning Advantage: Fixed-interest nature of convertible loan notes aids in Co's financial planning, offering predictability in future payments Q9) Discuss the factors to be considered by Co in choosing to raise funds via a rights issue. (IMP) A rights issue raises equity finance by offering new shares to existing shareholders in proportion to the number of shares they currently hold. • Discounted Issue Price: Rights issue shares are typically offered at a discount to market value, but determining the discount size can be challenging. • Cost-Effectiveness: Rights issues are less expensive than other equity-raising methods like IPOs or placings, mainly due to lower transaction costs. • Ownership and Control Preservation: Offering new shares to current shareholders prevents dilution of ownership and control, as long as shareholders exercise their rights. • Impact on Gearing and Financial Risk: A rights issue increases equity in Tinep Co's capital structure, potentially decreasing its gearing and financial risk, which might be viewed favorably by shareholders depending on their risk preferences. Q10) Discuss the connection between the relative costs of sources of finance and the creditor hierarchy. • Creditor Hierarchy in Liquidation: The order of financial claim settlements during liquidation is secured creditors, unsecured creditors, preference shareholders, and ordinary shareholders, with risk increasing as priority decreases. • Risk and Return Relationship: The required rate of return for finance providers correlates with their risk level. Secured creditors have the lowest required return, followed by unsecured creditors, preference shareholders, and ordinary shareholders, making the cost of debt lower than preference shares, and preference shares cost lower than equity. Q11) Explain the differences between Islamic finance and other conventional finance. (IMP) • Risk and Reward Sharing: Islamic finance emphasizes sharing risk and reward between the finance provider and user, including broader economic benefits like employment and social welfare. • Contrast with Conventional Finance: Traditional finance doesn't mandate risk and reward sharing; it separates the roles of investors and finance users. • Prohibition of Interest (Riba): Islamic finance strictly forbids interest, viewing it as immoral, unlike conventional finance where interest is the primary return for lenders and cost for borrowers. • Sharia Law Compliance: Islamic finance only supports business activities that comply with Sharia law. • Murabaha and Sukuk vs. Conventional Debt: While similar to conventional debt finance, Islamic financial instruments like Murabaha and Sukuk require a direct link to tangible assets, unlike conventional debt Q12) Discuss whether changing the capital structure of a company can lead to a reduction in its cost of capital and hence to an increase in the value of the company. (IMP) • Company Valuation and WACC: A company's value is the present value of future cash flows, discounted by its WACC. Minimizing WACC can theoretically maximize company value. • Impact of Capital Structure: WACC depends on the balance between debt and equity. The lowest WACC, and thus the highest company value, occurs at an optimal capital structure. • Debate on Optimal Capital Structure: • • Traditional View: Initially, introducing debt lowers WACC until a minimum point, after which it increases as equity cost rises due to higher financial risk. • Miller and Modigliani's Perspective: Argued WACC is independent of capital structure, only influenced by business risk, under the assumption of a perfect capital market without corporate taxation. • M&M with tax: Argued that when considering tax the WACC reduces as gearing increases until all capital is debt. This theory prefers debt at all times over equity. Real-World Considerations: • Tax Efficiency of Debt: Interest on debt is tax-deductible, making debt a tax-efficient finance source. Substituting equity with debt can lower WACC in reality. • Gearing and WACC: Increasing gearing reduces WACC and potentially raises company value, but high gearing levels can increase WACC due to risks like bankruptcy. Optimal use of debt involves maintaining acceptable gearing levels. Q13) Discuss the factors to be considered in choosing between traded bonds, new equity issued via a placing and venture capital as sources of finance. • Traded Bonds Overview: Bonds are debt securities issued for cash, to be repaid at a specified redemption date, usually within 5-15 years. They are often secured against the issuer's non-current assets, offering lenders reduced risk. In case of default, bondholders can appoint a receiver to liquidate assets for recovering investments. Interest on bonds is tax-deductible, lowering the issuing company's debt cost. • Bond Finance vs. Equity Issue: • • Unlike bonds, equity finance via new share issuance doesn't require redemption, making it permanent. • Interest vs. Dividends: Bond interest is usually fixed, while dividends to shareholders vary based on the company's decision and are not tax-deductible, unlike bond interest. • Tax Efficiency: Debt finance is more tax-efficient than equity finance due to the tax-deductibility of interest. Venture Capital Characteristics: • Context: Typically used in high-risk finance situations like management buyouts. • Composition: Can include both equity and debt finance. • High Returns: Due to the higher risk, venture capital investors expect substantial returns. Q14) Discuss how the capital asset pricing model can be used to calculate a project-specific cost of equity for Co, referring in your discussion to the key concepts of systematic risk, business risk and financial risk. (IMP) • CAPM and Systematic Risk: CAPM assumes investors have diversified portfolios, focusing on systematic risk. Companies use CAPM to calculate a project-specific discount rate, assessing the minimum return needed to compensate for an investment project's systematic risk. • Use in Diverse Business Risk: CAPM is particularly useful when an investment project's business risk differs from the company's existing operations. Proxy companies with similar risks are used to assess systematic risk. • Degearing and Regearing Process: • • Degearing: Adjusts a proxy company's equity beta to an asset beta, isolating business risk from capital structure effects. • Regearing: Transforms the asset beta back into an equity beta, integrating the investing company's financial risk. • The process involves averaging asset betas of several proxies and using weighted average beta formulas. Calculating Project-Specific Cost of Equity: The regeared equity beta is used in CAPM to determine a projectspecific cost of equity. This rate can be employed in discounting cash flows for investment appraisal methods like NPV or IRR, or in calculating a project-specific WACC for DCF evaluations. Q15) Discuss the attractions of leasing as a source of both short-term and long-term finance. • Leasing as a Finance Source: Leasing serves as both short-term and long-term finance, offering flexibility and accessibility to assets without outright purchase. • Short-Term Leasing Benefits: • • • Addresses Obsolescence: Ideal for businesses needing current technology, allowing frequent updates. • Flexibility: Typically comes with short-term contracts and often cancellable without penalties. • Maintenance Access: Often includes skilled maintenance services, though at an additional cost. Long-Term Leasing Advantages: • Cost Spread: Spreads the cost of an asset over much of its useful life, easing financial burden. • No Need for Separate Finance: Eliminates the need to secure separate finance for asset purchases. Leasing Accessibility: • Suitable for Companies with Borrowing Challenges: Useful when borrowing is difficult due to lack of collateral or high perceived risk. • Risk Mitigation for Lessor: Ownership remains with the lessor, offering them security if lease payments are defaulted. Q16) Briefly explain the factors that will influence the rate of interest charged on a new issue of bonds. • • Company-Specific Factors Influencing Bond Interest Rates: • Risk Assessment: Interest rates depend on the perceived risk of the company, assessed by its ability to meet future interest payments and to redeem the bonds at maturity. • Security Backing: Secured bonds, backed by assets like land or buildings, typically have lower interest rates than unsecured bonds. Economic Environment Factors: • Typically, short-term debt is cheaper than long-term debt, leading to an upward-sloping yield curve as bond maturity lengthens. • Influence of General Interest Rates: Determined by the overall economic activity level and monetary policy decisions. Rates tend to fall in recession and rise during economic growth. Central bank policies may also adjust interest rates to control inflation. Q17) Compare and contrast the financial objectives of a stock exchange listed company such as Bar Co and the financial objectives of a not-for-profit organisation such as a large charity. (10 Mark) • • • Shareholder Wealth Maximization in Listed Companies: • Primary Goal: Maximizing shareholder wealth, often equated with maximizing share price. • Share Price as Value Indicator: Seen as the present value of future dividends. • Equity Market Value: Maximizing share price equals maximizing equity market value (market capitalization). Maximizing Net Corporate Cash Income: • Strategy: Achieved by increasing net cash income and its growth, while minimizing corporate cost of capital. • Common Goal: Both listed companies and not-for-profit (NFP) organizations aim to maximize net cash income. Budget Control: • • • • Necessity for Both: Both listed companies and NFPs use budgets to control cash usage and aim to keep spending within budget. Value for Money (VFM): • NFP Focus: Emphasizes economy (resource acquisition cost), efficiency (resource utilization), and effectiveness (achieving objectives). • Listed Companies: Also seek VFM but with a focus on performance measures related to output, like maximizing equity market value. Performance Measures: • Quantitative vs. Service-oriented: Listed companies focus on profit-oriented metrics, while NFPs emphasize minimizing input costs for given output levels. • Common Accounting Ratios: Both types may use similar financial ratios, such as return on capital employed or income per employee. Comparative Overview: • While there are distinct differences in emphasis, listed companies and NFPs share common financial objectives like maximizing cash income and budget control. Q18) Explain the difference between systematic and unsystematic risk in relation to portfolio theory and the capital asset pricing model. (IMP) • Diversification in Portfolio Theory: Suggests that diversifying investments across various assets reduces total risk. For example, investing in multiple shares instead of focusing on just one or two companies. • Limit to Risk Reduction: Despite diversification, there remains a level of risk that cannot be eliminated. This undiversifiable risk, is known as systematic or market risk. • Systematic vs. Unsystematic Risk: • Systematic Risk: The inherent market risk that can't be diversified away. • Unsystematic Risk: Company-specific risk that can be minimized through diversification. • Focus of Portfolio Theory: Concerned with total risk, which is a combination of systematic and unsystematic risks. • CAPM's Focus on Systematic Risk: Capital Asset Pricing Model (CAPM) operates under the assumption that investors hold diversified portfolios, hence it primarily addresses systematic risk. Q19) Discuss the significance of the efficient market hypothesis (EMH) for the financial manager. • Capital Market Efficiency: Concerns pricing efficiency in terms of weak form, semi-strong form, and strong form efficiency. • Efficient Markets Hypothesis (EMH): Suggests that share prices fully and fairly incorporate all relevant and available information, including past, public, and private information. • Significance of EMH for Financial Managers: 1. No Incentive for Deception: Financial managers shouldn't try to mislead the market because such attempts are likely to fail. 2. Timing of Share Issuance: There's no specific "best time" for issuing new shares since share prices are always considered fair. 3. No Bargains on the Market: In an efficient market, there are no undervalued companies, making acquisition strategies seeking undervalued stocks pointless. • Role of Insider Information: In semi-strong form efficient markets, insider information can impact stock valuation, potentially deviating from the market's fair valuation. • Maximizing Shareholder Wealth: Financial managers should not only invest in positive Net Present Value (NPV) projects but also communicate this information promptly to the market, as efficient markets quickly incorporate such news into share prices.
