SECTION A – Answer ONE Question
Question 1
LEO Ltd is a small, listed entity based in a country in the eurozone. Its principal
activity is haulage. Head office and key operations are located in the home
country. The company operates a large number of articulated vehicles and
revenues are generated in euros.
Due to a shortage of lorry drivers during the recent global pandemic and the
operating shock from the UK’s decision to leave the European Union, the group
believes there is significant scope to expand its operations through acquiring
new vehicles and hiring drivers.
To expand its operations, the company requires the use of 100 additional
vehicles, which would increase the size of the existing fleet by 50 per cent. LEO
is considering the following choice of payment methods to acquire the use of
the new articulated vehicles (information is given on a per-vehicle basis):
Purchase asset
Pay the whole capital cost of €200,000 on 1 December 2021, funded by bank
borrowings. If LEO follows this approach they will be required to pay on-going
consultation and maintenance costs annually at the end of each year. These
costs are forecast to be of the order of €10,000 in the first year and to increase
by 5 per cent each year due to inflation. Fuel costs are anticipated to be €20,000
per annum per vehicle and increase at 3 per cent per annum over the next five
years.
The vehicles are expected to have little or no resale value after five years
although they could still be usable within the entity or be sold in the secondhand market at this time. If the firm continues to operate the vehicles for more
than five years, it is expected that maintenance costs will increase significantly
in older vehicles. Given the uncertainty in resale / re-use after five years the
company has not provided any costings or financial data after this point.
Operating Lease
Enter into an operating lease with the manufacturer of the vehicles. Lease
payments are made in advance and the firm will be required to pay an amount
of €50,000 immediately on 1 December 2021. A further four annual payments
will be made at the start of each year of the five-year lease period and the lease
payment will increase at a rate of 8 per cent each year. This fee will include
annual maintenance. Under the terms of the operating lease the company
would remain response for fuel costs as described for Method 1.
At the end of five years there is an option to continue the lease agreement for
a further three years, paying for maintenance on a time and materials basis.
This has not been costed.
Patrick McColgan 3
Other information
Due to the reduction in central bank rates and the known shortage of supply in
the industry, banks are competing to lend to LEO and the company is able to
borrow at a secured interest rate of 5 per cent per year. The entity is liable to
pay tax at a marginal rate of 30 per cent, payable 12 months after the end of
the accounting year in which the liability arises. This rate is not expected to
change. The weighted average cost of capital for investment projects relating
to the use of these vehicles is 10 per cent. The company’s financial year end
is 30 November each year. Tax depreciation on the capital cost is available on
a reducing balance basis at a rate of 25 per cent over the five years of operation.
There is significant uncertainty in the haulage industry as of today. There is an
expected long-term shortage of lorry drivers and vehicles for the foreseeable
future. However, there is uncertainty over how long this shortage is expected
to last and the role of industry competition in resolving this shortage. Some
industry experts believe the shortage of lorry drivers reflects a long-term
requirement for more long-haul drivers and vehicles, while others believe this
is likely to a medium term event and the higher demand seen today will decline
over the next several years.
a) Calculate the net advantage to leasing and recommend which payment
method is expected to be cheaper for LEO in present value terms.
(20 marks)
b) Discuss the real options inherent in this project and how risks associated
with these are affected by the choice of leasing or purchasing the assets.
(10 marks)
(Total 30 marks)
Patrick McColgan 4
Question 2
Bracken Inc is a publicly traded entity listed on the NASDAQ exchange in the
United States. The company specialises in pet food manufacturing. The
company has traditionally relied on equity financing for its long-term funding
needs and has zero long-term debt on its balance sheet. However, following
the interest rate cuts seen during the recent global pandemic the company is
considering a financial restructuring in order to take advantage of the ‘cheaper’
cost of debt financing today.
Under the proposed restructuring, Bracken Inc would issue long-term perpetual
debt and use the proceeds to repurchase stock. The company would plan to
issue debt to raise $500million and buyback stock to the same value at the
current market price. Bracken Inc’s shares are trading at a price of $10.00 per
share and the company currently has 125million shares in issue. The interest
rate on debt will be 5 per cent. Bracken Inc is expected to generate earnings
before interest and taxes (EBIT) of $200million in perpetuity. The corporate tax
rate is 30 per cent.
Assuming that all cash flows are constant in perpetuity, you have been asked
to provide the following information to the company’s board of directors:
a) An estimate of the firm’s earnings per share under the current capital
structure and the proposed debt issue and stock buyback.
(4 marks)
b) Estimate the level of EBIT where the firm will be indifferent between the
proposed financing policies.
(4 marks)
c) Determine the cost of equity capital for Bracken Inc before the proposed
restructuring.
(3 marks)
d) What is the value of the firm and of the firm’s equity after the capital
restructuring?
(3 marks)
e) Calculate the geared cost of equity capital and the weighted average
cost of capital for Bracken Inc following the proposed restructuring.
(4 marks)
f) Comment on the view that Bracken Inc can maximise its value and
minimise its cost of capital by employing a very high level of debt
financing with specific reference to the financial environment facing the
firm during and after the global pandemic.
(12 marks)
(Total 30 marks)
[END OF SECTION A, SECTION B CONTINUES ON THE NEXT PAGE]
Patrick McColgan 5
SECTION B – Answer TWO Questions
Question 3
As the financial manager of Baird Plc you have been asked to evaluate the
company’s options with regards to a new equity offering. The company has
experienced a decline in revenue in 2020 and 2021 during the economic crisis
but the directors believe that the firm has a long-term sustainable business
model that will be successful once the economy rebounds.
Baird Plc currently has 250million shares in issue at a current market price of
75p per share. The company plans to raise £125million of new equity. The
company’s investment bank has put forward the following proposals to the
board:
i. A rights offering at a 1/3 discount to the current market price.
ii. A deep-discounted rights offering at a 60 per cent discount to the current
market price.
Baird Plc’s management is leaning towards using the deep discounted rights
offering due to the poor financial market conditions the company has
experienced over the past two years. However, the board of directors is
concerned about the potential dilutive effect of the offering on the firm’s
earnings per share (EPS). Once business conditions return to normal, the firm
expects to generate long-term net income after-tax of £50m per annum.
a) Set out the terms of the rights offering for i and ii.
(6 marks)
b) Use the earnings per share and earnings yield calculations to determine
whether the deep discounted offering is dilutive to EPS and
shareholder’s wealth.
(6 marks)
c) Explain why the company may prefer a deep discounted offering during
a period of financial market volatility and a downturn following the recent
global pandemic.
(3 marks)
(Total 15 marks)
Patrick McColgan 6
Question 4
Bolt Plc is expected to declare earnings of £25million for the next financial year.
Analysts believe that the company will reinvest 60 per cent of its earnings next
year, 50 per cent the following year, 50 per cent in year three, and from year
four onwards the firm will reinvest 40 per cent of its earnings.
The internal rate of return on new investment projects is expected to be 40 per
cent for investments made at the end of year one, falling to 30 per cent in year
two, 25 per cent in year three, and thereafter will remain steady at 18 percent
for investments made from year four onwards.
The company can be valued using a discount rate generated from the capital
asset pricing model (CAPM). The risk-free rate is currently 1 per cent, the
expected market risk premium is 8 per cent, and the firm has an equity beta of
1.5.
Required:
a) Calculate the required return on the firm’s shares using the CAPM
(2 marks)
b) Prepare a schedule of dividends, reinvested earnings, incremental
earnings, and the net present value of new investment projects for Bolt
Plc in years one to four.
(5 marks)
c) Value the company using the dividend discount model.
(4 marks)
d) Value the company using the earnings-based valuation method.
(4 marks)
(Total 15 marks)
Patrick McColgan 7
Question 5
Thunder Plc is a publicly traded company. You currently hold 5,000 shares in
the firm and are unsatisfied with the current dividend policy of the firm. The
company is expected to announce that it intends to pay a dividend of $3.00 per
share for the current financial year. You would prefer that the company adopted
a higher dividend policy and paid out $5.00 per share.
Required:
a) Explain the process you could take as an investor to create a homemade
dividend in line with your preferred payout policy for the firm, showing
any relevant numerical workings. The share price prior to the
announcement of the proposed $3.00 dividend is $60 per share.
(6 marks)
b) The intended dividend of $3 per share would be paid from earnings per
share of $10. The company has a long-term target payout ratio of 40
percent or earnings and a speed of adjustment factor of 0.6.
i. Assuming earnings per share of $12, $14, $15, and $16 in years two
to five respectively, and assuming the firm proceeds with the $3
dividend at time one, determine the expected value of the firm’s
dividends in years two to five under the Lintner dividend model.
(4 marks)
ii. If Thunder Plc continues to earn $16 per share for the long-term
future what will the dividend of the company tend towards?
(1 mark)
iii. Explain the determinants of the long-term payout ratio and the speed
of adjustment factor under the Lintner model.
(4 marks)
(Total 15 marks)
[END OF SECTION B, SECTION C CONTINUES ON THE NEXT PAGE]
Patrick McColgan 8
SECTION C – Answer TWO Questions
Question 6
Explain the main strategies that firms can employ for the management of their
net working capital, from very aggressive to very conservative policies. Your
answer should explain how UK firms may be expected to adjust their working
capital policy in 2021 as a result of Brexit, the Covd-19 pandemic, and supply
shortages facing UK retailers.
(20 marks)
(Maximum 800 words)
Question 7
Describe the main mechanisms that UK quoted companies can use to raise
equity through a seasoned equity offering (SEO).
(20 marks)
(Maximum 800 words)
Question 8
Explain and provide examples of the direct and indirect costs of bankruptcy.
Explain how such are such costs expected to change during a financial market
crisis, such as a global financial crisis or a pandemic.
(20 marks)
(Maximum 800 words)
Question 9
Critically evaluate the main methods that companies use to calculate their cost
of equity capital. Explain the strengths and weaknesses of each method.
(20 marks)
(Maximum 800 words)
AG215 Exam Paper
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