Financial Management Assessment: End-of-Semester Exam

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Financial Management Assessment
1

Contents
Question 1........................................................................................................................................3
(a).................................................................................................................................................3
(b).................................................................................................................................................6
(c).................................................................................................................................................9
(d)...............................................................................................................................................10
Question 2......................................................................................................................................11
(a)...............................................................................................................................................11
(b)...............................................................................................................................................14
References......................................................................................................................................16
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Question 1
(a)
Data are given:
Particulars Book Value
Market
Value
Ordinary Shares 20,000,000 20,000,000
Ordinary Shares Price
£
1
£
2.65
Reserves 5,000,000 5,000,000
7% preference shares 10,000,000 10,000,000
Preference Shares Price
£
1
£
0.75
10% Irredeemable Bonds 150,000 150,000
Bond Price
£
100
£
107
Tax Rate 30% 30%
Calculation of
Growth:
Year Dividend Growth
1 0.21 -
2 0.23 9.52%
3 0.25 8.70%
4 0.27 8.00%
5 0.28 3.70%
Average Growth
Rate 7.48%
No fixed growth rate has been provided in the question has been provided and hence the average
of the growth rate over the last 4 years have been considered for arriving at the future growth rate
for the company (Hann, et. al., 2013). There is no definite trend provided, and hence average
growth rate is the most appropriate method that could be utilised in the given scenario. It has also
been assumed that the given growth rate will be maintained perpetually, and hence dividend
discount model has been used for the calculations.
3

Calculation of Weighted Average Cost of Capital (Book Value):
Particulars Book Value Weights Costs
Weighted Average
Costs
Cost of Equity Shares
£
25,000,000 0.50
37.57
% 18.79%
Cost of Preference Shares
£
10,000,000 0.20 7% 1.40%
Cost of Debt
£
15,000,000 0.30 7% 2.10%
Weighted Average Cost of
Capital
£
50,000,000 22.29%
For the purpose of the calculation of the cost of equity of the company, Ke = [(D1/Po) + g] has
been used in the workings. D1 (Next year’s dividend) has been calculated by multiplying the
growth rate with the current year’s dividend. Reserves will also form part of the book value of
the equity such that the cost of equity’s proportion will be calculated on the basis of such value
(Li, et. al., 2013).
Cost of Preference shares has been calculated by using the formula Kp= [Dp/P], where Dp is the
dividend for the preference share and P is the total value of the preference shares.
Cost of Debt has been calculated using the formula Kd= [(I/D) x (1-T)], where D is the total
value of the long term borrowings of the company. The same has been adjusted with the tax rate
as the company will receive a tax benefit on the interest costs, and hence, such costs will be
reduced owing to this benefit.
In the book value method, book values of the acquired funds are taken into consideration and on
the basis of that proportion of each type are calculated in comparison to the total value of the
funds. Individual costs are then adjusted with the respective ratios, and hence, the weighted
average cost of capital is calculated for the company (Hicks, 2017).
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Calculation of Weighted Average Cost of Capital (Market Value):
Particulars Market Value Weights Costs
Weighted Average
Costs
Cost of Equity Shares
£
58,000,000 0.71
18.84
% 13.40%
Cost of Preference Shares
£
7,500,000 0.09 9.33% 0.86%
Cost of Debt
£
16,050,000 0.20 6.54% 1.29%
Weighted Average Cost of
Capital
£
81,550,000 15.54%
In the market value method, the proportions are calculated using the market value of the funds of
the company. Owing to this, a difference can be seen in the cost of the individual funds have
changed, and the overall weighted average cost of capital has decreased from the above book
value method (Cheynel, 2013).
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(b)
Data are given:
Particulars Book Value Market Value
Ordinary Shares 20,000,000 15,578,702
Ordinary Shares Price £ 1 £ 2.85
Reserves 5,000,000 5,000,000
7% preference shares 10,000,000 10,000,000
Preference Shares Price £ 1 £ 0.68
10% Irredeemable Bonds 150,000 150,000
10% Irredeemable Bonds Price £ 100 £ 107
11% Bonds 150,000 150,000
11% Bonds Price £ 100 £ 84
Tax Rate 30% 30%
Calculation of New Growth and
New Dividend:
Particulars Rate
Original rate 7.48%
Current Year's Dividend
£
0.28
Growth
£
0.02
Increase in growth rate 20%
New growth in relative terms
£
0.03
Next Year's Dividend
£
0.31
The new growth rate has been calculated by increasing the average annual growth of 20%, such
that the dividend has increased in relative terms.
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Calculation of Theoretical Price of 10%
Bonds:
Year
Coupon @
11%
Redemption
price Total
DCF @
15.33%
Discounted
Total
1
£
1,650,000
£
-
£
1,650,000
£
0.87
£
1,430,677.19
2
£
1,650,000
£
-
£
1,650,000
£
0.75
£
1,240,507.40
3
£
1,650,000
£
-
£
1,650,000
£
0.65
£
1,075,615.54
4
£
1,650,000
£
-
£
1,650,000
£
0.57
£
932,641.59
5
£
1,650,000
£
-
£
1,650,000
£
0.49
£
808,672.15
6
£
1,650,000
£
-
£
1,650,000
£
0.42
£
701,181.08
7
£
1,650,000
£
15,750,000
£
17,400,00
0
£
0.37
£
6,411,404.89
Theoretical
Value
£
12,600,699.83
Number of
Bonds
150
,000
Theoretical
Price
£
84
Theoretical price of the bond has been calculated for the issue of the new bond, and hence the
price has come out to be £84 per bond. The same is also assumed to be the market price of the
bond as no information has been provided for the question.
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Purchase of Equity:
Particulars Amount
Value of bonds Issued
£
12,600,699.83
New Market Share price
£
2.85
No. of Shares Re-
purchased 4,421,298
Shares Remaining 15,578,702
The amount generated from the issue of the bonds have been utilised in the re-purchase of the
equity shares, and hence, the capital structure of the company has changed significantly.
4,421,298 shares have been re-purchased from the funds generated (Hicks, 2017).
Calculation of Weighted Average Cost of Capital (Market Value):
Particulars
Market
Value Weights Costs
Weighted Average
Costs
Cost of Equity Shares
£
49,399,300 0.58 18.19% 10.59%
Cost of Preference Shares
£
6,800,000 0.08 10.29% 0.82%
Cost of Debt (10% Irredeemable
Bonds)
£
16,050,000 0.19 6.54% 1.24%
Cost of Debt (11% Bonds)
£
12,600,700 0.15 9.17% 1.36%
Weighted Average Cost of
Capital
£
84,850,000 14.01%
Weighted Average Cost of Capital has come out to be 14.01%. Equity shares have been reduced
to 15,578,702 with the fund generated from the issue of the bonds. The capital structure of the
company has changed in the new scenario, and hence, the cost of the capital has changed. There
is no significant change in the individual costs, but the overall WACC has decreased owing to
the further distribution of funds from the equity part to the debt part (Da, et. al., 2012).
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(c)
Companies require funds to carry out their business activities so as to generate profit and
increase their shareholders' value in the market. For this purpose, the company may procure
funds in the form of issue of equity, issue of preference and the issue of the bonds in the market.
Each method has its own advantages and disadvantages depending on the requirement of the
company and the nature of the industry it operates in. Company may choose to rely on debts
more than the equity, such that the process is termed as the 'Gearing' and results in the reduction
of the weighted average cost of capital for the company. Following are the reasons for such
reduction:
 Tax benefit: As the interest is charged on the profit before deducting tax and hence, the
company gets a tax benefit on the interest cost charged on the debt. The interest costs
reduce the profits of the company and hence tax charged less than before. Such practice is
known as tax benefit on the expenses of the company. Such benefit allows the company
to generate more profit and hence reduce the cost of capital for the company. Hence, the
interest rate on the debt in substance is reduced owing to the charging of tax on the
company. This leads to a reduction in the overall reduction of the Weighted Average Cost
of Capital (Aggarwal and Thakur, 2013).
 Inherent Risk: The Equity component of the funds of the company, involves inherent
risk such that the equity component comprises of the risk premium attached to the issue
of equity, and also the investors' expectations play a great role in the ascertainment of the
risk premium component of the equity. Such premium risk is also the result of the
opportunity cost, such that the company is appraising their alternatives and hence
expecting more from the company to generate maximum returns.
 Inclusion of Reserves: Equity Component of the company includes the amount of the
reserve such that this aspect of the equity has no cost and thus adds to the weight of the
cost of the capital calculations. This leads to increased weight and hence increases in the
portion of the cost of equity in the Weighted Average Cost of Capital of the company
(Hann, et. al., 2013).
9

(d)
A company may face bankruptcy owing to the changing business environment and instability in
the business operations of the company. Bankruptcy may have several impacts on the business
process, which may be positive or negative:
 When a company declares bankruptcy, pressure from its creditors may lighten as now the
company had publicly announced its inability to pay off its debts. It may even lead to
forgoing of debts on the part of the creditors as a part of the settlement process in order to
recover some amount from the company.
 As the company declares bankruptcy, the business processes and operations of the
company come under the scrutiny of the government authorities and the trustees of the
company. Company assets and accounts are frozen such that the company is no longer
able to enter into transactions and contracts (Li, et. al., 2013).
As a company operates, it may have to face agency problems in the course of the business. There
may be situations where the managers may face a conflict of interests and tempted to work
through their own selfish motives. Managers may be tempted to procure funds through equity
option as it does not create a finance cost burden on the profits of the company and hence
managers will receive more remuneration from the earned profits although the equity route will
dissolve the shareholding of the company and hence create management issues in the later
period.
10

Question 2
(a)
Given Data:
Particulars Amount
Investment £ 320,000
Annual Inflow £ 105,000
Annual Outflow £ 15,500
Period 6
Salvage £ 32,000
Cost of Capital 12%
WDV Rate 20%
i. Payback Period:
Particulars Amount
Investment £ 320,000
Cash inflow for 5 years
(WN) £ 232,358
Remaining Amount £ 87,642
Time required 10.46
Total Payback Period
5 years 10
months
WN:
Year
Annual
Inflow
Annual
Outflow
Depreciatio
n
Net Cash
inflow
1 £ 105,000 £ 15,500 £ 64,000 £ 25,500
2 £ 105,000 £ 15,500 £ 51,200 £ 38,300
3 £ 105,000 £ 15,500 £ 40,960 £ 48,540
4 £ 105,000 £ 15,500 £ 32,768 £ 56,732
5 £ 105,000 £ 15,500 £ 26,214 £ 63,286
6 £ 105,000 £ 15,500 £ 20,972 £ 100,528
£ 332,886
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ii. Accounting Rate of Return:
Particulars Amount
Investment (WN) (£ 320,000)
Profit for 6 years
(WN) £ 332,886
Average Profit £ 55,481
Accounting Rate of
Return 17%
iii. NPV
Calculation:
Yea
r
Investmen
t
Annual
Inflow
Annua
l
Outflo
w
Depreciatio
n
Net cash
inflow
DCF
@
20%
Discounted
Cash Flows
0 £ 320,000 - - -
(£
320,000) 1.00 (£ 320,000)
1 - £ 105,000
£
15,500 £ 64,000 £ 25,500 0.89 £ 22,768
2 -
£
105,000
£
15,500 £ 51,200 £ 38,300 0.80 £ 30,533
3 - £ 105,000
£
15,500 £ 40,960 £ 48,540 0.71 £ 34,550
4 - £ 105,000
£
15,500 £ 32,768 £ 56,732 0.64 £ 36,054
5 - £ 105,000
£
15,500 £ 26,214 £ 63,286 0.57 £ 35,910
6 £ 32,000 £ 105,000
£
15,500 £ 20,972 £ 100,528 0.51 £ 50,931
NPV (£ 109,255)
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