Which of the following represents Modigliani and Miller’s(M&M) proposition 1 on the effect of capital gearing on WeightedAverage Cost of Capital (WACC)?A. There is a negative relationship between financial gearing and theWACC because of the tax shieldB. There is a positive relationship between financial gearing and theWACC because of financial distressC. There is no relationship between financial gearing and the WACCas there are no tax benefits from higher gearingD. There is a positive relationship between financial gearing and theWACC because of the increased volatility of the ROE
9 21 ACFI3310 2018/2019 Faculty of Business and Law Programme/ Course Level 3 Subject/Module (including module code) ACFI3310 Advanced Corporate Finance Date 08 May 2019 Time Allowed 2 hours Start 09.00 Finish 11.00 Answer ALL questions in SECTION A on the EDPAC form provided All questions carry equal marks. Answer TWO questions from SECTION B. All questions carry equal marks. Formulae and tables are provided on pages 13-21. Completing your EDPAC Sheet Please check that the EDPAC sheet that you have been issued is headed Faculty of Business and Law. Please complete the EDPAC answer sheet using an HB pencil. ‘Module Code’ Box – please write the code of your exam which is included in the top right hand corner of your exam paper. ‘Date’ Box – please write today’s date in this box. ‘EXAM NO’ Box – please leave blank. ‘CANDIDATE’S P NUMBER’ Box - Enter your DMU Student ID number in the boxes provided (ignoring the P). If you do not know your candidate number please ensure you write your full name on the back of the EDPAC sheet. ANSWERING THE QUESTIONS Mark your answers by putting a clear heavy horizontal line like this: [▬] within the [ ] space provided for each question. DO NOT use a faint line [—], a tick [√] , a cross [x] or a circle [o]. DO NOT mark outside the area defined by the brackets [ ]. Your responses need to be clear. If you make a mistake, erase your previous answer. For each of the 10 questions in Section A of this exam paper there are 4 choices available to you. These choices are marked by four letters A, B, C and D. You must choose only one. Questions which are answered using more than one choice will be marked as being incorrect. For Section A, only questions answered on the EDPAC form will be marked. Unclear responses will be awarded zero marks. No marks will be deducted for incorrect answers or omissions. Section A: This section is compulsory. Attempt ALL questions from this section. All questions in this section are worth three (3) marks each and the section is worth thirty (30) marks in total. Question 1 - Which of the following represents Modigliani and Miller’s (M&M) proposition 1 on the effect of capital gearing on Weighted Average Cost of Capital (WACC)? A. There is a negative relationship between financial gearing and the WACC because of the tax shield B. There is a positive relationship between financial gearing and the WACC because of financial distress C. There is no relationship between financial gearing and the WACC as there are no tax benefits from higher gearing D. There is a positive relationship between financial gearing and the WACC because of the increased volatility of the ROE Question 2 - A company with 70% gearing is currently worth £30 million. It plans to issue more equity to payback the debt. It has 12 million shares outstanding. The corporate taxation rate is currently 25%. Under M&M proposition 2, what should happen to the share price? Assume the only market imperfection is corporate taxes. A. It should fall B. It should increase C. It should remain unchanged D. It is impossible to state. Question 3 The following picture depicts: A. Modigliani & Miller proposition without taxes and without bankruptcy risk B. Modigliani & Miller proposition with taxes and without bankruptcy risk C. Modigliani & Miller proposition without taxes and with bankruptcy risk D. Modigliani & Miller proposition with taxes and with bankruptcy risk Question 4 - Elegant Cakes company has no debt and its weighted average cost of capital is of 8.40%. The average debt-to-equity ratio for the industry is 0.12. What would Elegant Cakes’ cost of equity be if it took on the average amount of debt for its industry at a cost of debt before tax of 4%? Taxes are charged at 25%. A. 8.93% B. 8.74% C. 8.80% D. 8.40% Question 5 - You have sold a call option with a strike price of 112 pence. The bid price was 2 pence. If the actual share price is 108 pence on the day of expiry, what profit (or loss) will you have made? A. 6 pence profit B. 2 pence loss C. 2 pence profit D. 6 pence loss Question 6 - What is displayed in the diagram below? A. Payoff diagram for the buyer of a call option. B. Profit diagram for the buyer of a call option. C. Payoff diagram for the buyer of a put option. D. Profit diagram for the buyer of a put option. Question 7 - Company X has a present value of £123 million and Company Y has a present value of £58 million. Merging the two would enable cost savings with a present value of £17 million. Company X acquires Company Y for £72 million. What do Company X’s shareholders gain from this acquisition? A. Nothing; the gain all goes to Company Y’s shareholders B. £3 million C. £14 million D. £17 million Question 8 - Which of the following IS NOT a method of valuing a company for acquisition? A. Book value B. P/E ratio valuation C. Smooth valuation D. Free cash flow valuation Question 9 - In general, investors interpret the announcement of an increase in dividends as: A. Bad news and the share price drops. B. Very good news and the share price soars. C. A non-event that does not affect the share price. D. Good news and the share price increases. Question 10 - Carnegie plc has 850,000 shares outstanding. Its earnings are £4 million this year and it expects to pay all of it as a dividend. The required rate of return is 6%. From next year onwards it expects to earn £5 million what would the share price be today? A. £98.04 B. £4.71 C. £176.47 D. £102.75 Section B: Attempt TWO (2) questions only from this section. All questions in this section are worth thirty five (35) marks each and the section is worth seventy (70) marks in total. Question 11 - Capital structure Hanns plc (Hanns) specializes in the development and assembly of high quality boats. The business is considering a new project which is the development of a car production plant. The new plant will specialise in car production and it is an entirely new line of business for Hanns. The Finance Director has been asked to evaluate the project. The investment is expected to cost £350 million immediately and to receive cash inflows, after tax, of £100 million per year for years 1 to 5. The investment will be financed 50% by equity and 50% by debt, which is in line with Hanns’ previous capital structure. Hanns’ current weighted average cost of capital is 12%, and their pre-tax cost of debt is 2%. The rate of corporate tax is 30%. The market return is 8% and the risk-free rate is 2%. The Finance Director has obtained the betas and debt ratio of a proxy company, Good plc. These are: Equity Debt Debt ratio Beta Beta (debt: equity) Good plc 1.13 0 3:2 REQUIRED: a) Calculate the risk-adjusted WACC for Hanns using Good plc as a proxy. (15 marks) b) Calculate the NPV for the project, using the risk-adjusted WACC as the cost of capital. Suggest whether the project should be accepted. (5 marks) c) Discuss the limitations of using risk-adjusted WACC and describe an alternative approach which could be used. Explain why this might be a better approach. (15 marks) TOTAL 35 MARKS Question 12 - Dividends Blades plc. (Blades) has usually followed a residual policy when it comes to paying dividends. The company directors have been considering changing policy and the following calculations are required to assist the analysis of this proposal. Blades has the following forecast cash flows for the next 5 years, as well as possible additional cash flows to consider:- NB: All forecast cash flows have been calculated before the deduction of additional investment in fixed capital and working capital. All additional investments have been forecast to have a positive NPV. Year Forecast cash flow £’000 Additional investments £’000 2019 8,800 6,800 2020 11,100 8,750 2021 14,300 11,300 2022 17,500 14,100 2023 19,100 15,600 Table 1 – cash flows and investments for Blades plc (2019-2023). There are currently 6,500,000 shares in issue. REQUIRED: a) Calculate the annual cash flows available for dividend payments and the dividend per share if the residual policy was strictly adhered to. (5 marks) b) If Blades chose to have a smooth dividend policy based on maintainable regular growth what would you suggest the dividend per share and the total dividend payment each year should be? (12 marks) c) Following your calculations in (b), calculate the cash flow available to Blades for a share repurchase or a special dividend for each year. (5 marks) d) Using your calculations from parts (a), (b) and (c) evaluate whether Blades should change from the residual policy to the smooth dividend policy. Your discussion should include how the special dividend or a share repurchase might be used. (5 marks) e) One board member said “the pattern of dividend payments is irrelevant and so the change of policy is not necessary”. Evaluate the board member’s statement. (8 marks) TOTAL 35 MARKS Question 13 - Mergers and Acquisitions Scrum plc (Scrum) is considering an offer to purchase Down plc. Scrum’s Finance Director has obtained the following information: Scrum plc Down plc P/E ratio 14.2 6.5 Shares outstanding 2 million 600,000 Earnings (£) 5 million 720,000 Total Dividends (£) 500,000 140,000 Scrum understands that a merger with Down plc could lead to synergistic benefits of 5% of the value of the combined present values of the individual companies. Though, with further efficiency measures, this could increase to 12%. Down plc is a relatively new organisation, and still quite small, comparatively. The companies are both in the leisure industry but offer different services and are not, therefore, direct competitors. However, they share some competitors who offer a wider range of services. The leisure industry has an average P/E ratio of 8.3, with a range of 3.2 to 21.7. REQUIRED: a) Establish, with supporting comments to explain your method, the market value of both Scrum plc and