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Cima F3 Exam Question No 14

Question No 14:

FF is a company that specialises in the manufacture, supply and installation of fixtures and fittings for offices. It uses F$ as its currency. FF is currently evaluating a project to build a new distribution and sales centre.

The company is currently wholly equity funded and has 30 million shares in issue. The share price is F$11 per share before announcing the proposed project and the ungeared cost of equity is 9%. FF pays corporate income tax at 25%.

The proposed project requires an initial capital investment of F$80 million. The present value of future cash flows following this initial investment is estimated to be of the order of F$110 million, based on a discount rate of 9%. The F$30 million forecast increase in entity value is expected to be fully reflected in the share price immediately the project is announced.

There has been some discussion amongst the directors of FF about how the F$80 million capital investment should be funded. Any new equity would be raised through a rights issue and any borrowings would be at a pre-tax cost of 7%. Both would be required indefinitely. Three alternative financing structures are being considered as follows:

• A: F$80 million equity funding.
• B: F$80 million borrowings.
• C: F$48 million equity plus F$32 million borrowings. 

Required:
(a) Calculate the following, based on Modigliani and Miller’s (MM’s) capital theory with tax and assuming the project goes ahead:
(i) The total value of FF (before deducting debt) on a discounted cash flow basis for each of the financing structures A, B and C.

(ii) FF’s WACC for each of the financing structures A, B and C.

Note that MM formulae are provided on pages 23 and 24.
.
(b) Explain your results in (a) above with reference to MM’s capital theory with tax, illustrating your answer by drawing graphs of your results in (a) above. Use the graph paper provided.

(c) Advise, with reasons, which financing structure FF should adopt.

Answer:

 Level of gearing
Under MM (with tax), increasing gearing increases the value of the company due to the tax relief available on debt and nothing else. Given that the value of the debt is determinable then the increase in value associated with the tax shield on the debt will flow to the equity providers and hence increase shareholder wealth.

Also, by introducing debt finance, the overall (weighted average) cost of capital falls. This is because the increasing cost of equity resulting from the additional debt being taken on is more than off-set by the impact of the tax shield on that debt.


Requirement (c)
I would advise that FF proceed with funding structure B as it gives the greatest value of shareholder wealth value without creating significant danger of financial distress due to the low gearing level created.

The value of FF and hence also shareholder wealth (since the value of debt remains constant) is increased largely due to the tax benefit in perpetuity that arises from the use of debt financing.
MM’s theory based on a number of assumptions which do not necessarily hold in practice. These assumptions include:

• MM ignores the impact of financial distress at very high levels of gearing which will push up the cost of equity (and usually the cost of debt) to such an extent that the WACC will increase.
• MM is also based on unrealistic assumptions about perfect capital markets and perfect information.
However, these considerations are not important here as the level of debt being considered is quite small, being just approximately 20% of the value of the company.

Cima F3 Exam Question No 13

Question No 13:

When valuing an unlisted company, a P/E ratio for a similar listed company may be used but adjustments to the P/E ratio may be necessary.
Which THREE of the following factors would justify a reduction in the proxy p/e ratio before use?

A. The relative lack of marketability of unlisted company shares.
B. A lower level of scrutiny and regulation for unlisted companies.
C. Unlisted companies being generally smaller and less established.
D. Control premium not being included within the proxy p/e ratio used.
E. The forecast earnings growth being relatively higher in the unlisted company.
F. A profit item within the unlisted company's latest earnings which will not reoccur.
 
Answer: A, B, C
 

Cima F3 Exam Question No 12

Question No 12:

A company's gearing (measured as debt/(debt + equity)) is currently 60% and it is investigating whether an optimal gearing structure exists within the industry.
It has analysed the capital structure of similar companies in the industry and it would appear that there is evidence supporting the traditional theory of capital structure.
Companies with the lowest WACC in the industry have gearing of around 45% to 50%.
Which of the following actions would result in the company achieving a more optimal capital structure?

A. Undertaking a rights issue of equity to repay some of its debt.
B. Refinancing to replace some of its short term debt with long term debt.
C. Increasing the level of dividend to return more cash to shareholders.
D. Using retained cash to undertake a buyback of some of its equity.

Answer: A 

Cima F3 Exam Question No 11

Question No 11:

A listed company is planning to raise $21.6 million to finance a new project with a positive net present value of $5 million. The finance is to be raised via a rights issue at a 10% discount to the current share price. There are currently 100 million shares in issue, trading at $2.00 each.
Taking the new project into account, what would the theoretical ex-rights price be?
Give your answer to two decimal places.
$ ?

Answer: 2.02, 2.03

Cima F3 Exam Question No 10

Question No 10:

A profit-seeking company intends to acquire another company for a variety of reasons, primarily to enhance shareholder wealth.
Which THREE of the following offer the greatest potential for enhancing shareholder wealth?

A. Achieving more press coverage for the company.
B. Creating new opportunities for employees.
C. Achieving greater cultural diversity.
D. Acquiring Intellectual Property assets.
E. Exploiting production synergies.
F. Elimination of existing competition.

Answer: D, E, F

Cima F3 Exam Question No 9

Question No 9:

When valuing an unlisted company, a P/E ratio for a similar listed company may be used but adjustments to the P/E ratio may be necessary.
Which THREE of the following factors would justify a reduction in the proxy p/e ratio before use?  

A. The relative lack of marketability of unlisted company shares.
B. A lower level of scrutiny and regulation for unlisted companies.
C. Unlisted companies being generally smaller and less established.
D. Control premium not being included within the proxy p/e ratio used.
E. The forecast earnings growth being relatively higher in the unlisted company.
F. A profit item within the unlisted company's latest earnings which will not reoccur.

Answer: A, B, C

Cima F3 Exam Question No 8

Question No 8:

A company wishes to raise additional debt finance and is assessing the impact this will have on key ratios.
The following data currently applies:

• Profit before interest and tax for the current year is $500,000
• Long term debt of $300,000 at a fixed interest rate of 5%
• 250,000 shares in issue with a share price of $8

The company plans to borrow an additional $200,000 on the first day of the year to invest in new project which will improve annual profit before interest and tax by $24,000.
The additional debt would carry an interest rate of 3%.
Assume the number of shares in issue remain constant but the share price will increase to $8.50 after the investment. The rate of corporate income tax is 30%.

A. Interest cover will fall; P/E ratio will fall.
B. Interest cover will fall; P/E ratio will rise.
C. Interest cover will rise; P/E ratio will rise.
D. Interest cover will rise; P/E ratio will fall.

Answer: B