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Revision 4 Business Finance

Answer 1 (a) 1. Venture capital is long-term capital that is available for around five years. It is normally offered by specialist institutions, and is aimed at small and medium-size businesses that have a fairly high level of ris . 2. Venture capitalists are prepared to provide capital to such businesses if the e!pected returns are commensurate with the level of ris ta en . This means that venture capitalists will only be interested in a business with good profit and growth prospects. The amount of capital invested will vary according to need and may be provided in stages, sub ect to certain !ey ob ectives being met. "# mar s$ " venture capitalist may be interested in providing capital for the following types of business situations. Business start-ups This can cover a wide range of situations from businesses that are still at the concept stage through to businesses that are about to begin operations. In practice it seems that venture capitalists prefer to invest in start#ups that are fairly well advanced. %rowth capital This is designed for businesses that have passed the start#up phase and are see!ing capital for further e$pansion. It is, therefore, a form of second#stage funding. &anagement ac'uisitions Venture capitalists will often provide capital for managers that wish to ta!e over an e$isting business. The managers may be already employed by the business or they may be outside managers that are loo!ing for a vehicle for their ambitions. This type of financing has proved to be e$tremely popular among venture capitalists in recent years. (hare purchases %apital may be provided to help finance the buy out of a part#owner of a business. This may be provided to someone outside the business or to the other part#owners. Business recoveries %apital may be provided to help turn round the fortunes of a business that is currently e$periencing difficulties. )enture capitalists do not usually loo! for &uic! cash returns and are often content to wait for a cash return on realisation of the investment. "Any five types of business * mar s$

(b) 1.




The directors of a business must recognise that venture capitalists will be see ing high returns for the ris!s that they are prepared to underta!e. This is li!ely to mean that the directors will be under considerable pressure to perform and to meet agreed targets. The venture capitalists will usually e$pect to wor closely with the business in order to protect the investment made. It is &uite common for venture capitalists to have a representative on the board of directors and to be consulted over any proposed changes to agreed plans. It is also &uite common for the venture capitalist to receive forecasts and other financial information to help monitor the direction and performance of the business. The venture capitalist will e!pect to receive an e'uity sta e in the business and will often sell this sta!e after a period of five years or so. *ence, the directors should appreciate that the business may be sold to another business or come under the control of other investors at some stage. "4 mar s$

(c) The !ey factors that a venture capitalist may ta!e into account include the following+ Financial performance The financial trac! record of the business to date as well as forecast performance will be closely scrutinised. ,here forecasts are presented, the validity of the underlying assumptions as well as !ey estimates will be chec!ed. +he mar et for the products or services The nature of the mar!et is an important factor to consider. The degree of competition, the threat of substitutes, the bargaining power of suppliers and employees and the barriers to mar!et entry will be considered along with the si-e and future prospects for the mar!et as a whole. In addition, the standing of the business within the mar!et, as viewed by customers and suppliers, will be e$amined. ,wner investment The owners will usually be re&uired to invest a significant proportion of their personal wealth in the venture. The venture capitalist will e$pect the owners to demonstrate their belief in the venture in a tangible way. +he 'uality of management The &uality of management will often be the most important factor in the future success of the business. Thus, the management team will be e$amined to see whether it has the right blend of s!ills, and e$perience to manage the business. The

commitment of the managers and their ability to wor! together as an effective team will also be scrutinised. Ris The different types of ris! that will be encountered by the business and the ways in which these ris!s will be managed will be identified and evaluated. Business operations The nature and comple$ity of internal business operations will be e$amined to see whether these are dependent on !ey s!ills or !ey individuals. The effectiveness and efficiency of the operations will also be e$amined. -!it route The venture capitalist will see! to realise the investment in the business at some point. This may be done in various ways, such as floating the company and then selling the shares through the .toc! /$change or by a sale to another business. The venture capitalist will normally identify a possible e$it route and time frame before entering into the investment. 0# mar s per point. ma!/ 0 mar s$ &ar ing (cheme


Answer # (a) " stoc! e$change is, in essence, a mar!et place that is designed to bring together providers of capital and companies see!ing to raise capital. It acts as both a primary mar!et and a secondary mar!et for securities. The purpose of each of these mar!ets is as follows+ (i) 1rimary mar!et. In this role, a stoc! e$change facilitates the issue of new shares and debentures by public companies. These companies would find it more difficult to raise finance without an organised and regulated mar!et in which issues of securities can ta!e place. "# mar s$ .econdary mar!et. In this role, a stoc! e$change facilitates the purchase and sale of 2second#hand3 securities. Investors are more li!ely to purchase shares and debentures in companies if they are confident that these securities can be sold when re&uired. " stoc! e$change enables investors to transfer their investments easily and &uic!ly. "# mar s$


(b) The advantages of a company obtaining a stoc! e$change listing are as follows+ (hare transferability "s mentioned above, shares that are listed on a stoc! e$change can be transferred with ease and this, in turn should encourage investment. 1ost of capital .hares in listed companies are perceived by investors as being less ris!y than shares in e&uivalent unlisted companies because of their mar!etability. "s the ris!s associated with listed shares are lower, the returns re&uired by investors will also be lower. *ence, the cost of capital for listed companies will be lower. (hare price .hares that are traded on a stoc! e$change are closely scrutinised by investors, who will ta!e account of all available information when assessing their worth. This results in shares that are efficiently priced, which should give investors confidence when buying or selling shares. 1ompany profile %ompanies listed on a stoc! e$change have a higher profile among investors and the wider business community than unlisted companies. This higher profile may help in establishing new contacts or in developing business opportunities. 1redit rating " listed company may be viewed by the business community as being more substantial and, therefore, more creditworthy than an e&uivalent unlisted company. This may help in obtaining loans and credit facilities.

Business combinations " stoc! e$change listing can facilitate ta!eovers and mergers. " listed company can use its shares as a form of bid consideration when proposing a ta!eover of another company. .hareholders in a target company will usually be more prepared to accept a share#for#share e$change when the shares offered are mar!etable and have been efficiently priced. 4urthermore, when two companies propose to combine, the shareholders of each company can assess the attractiveness of the proposal more easily if the shares are listed. The disadvantages of obtaining a stoc! e$change listing are as follows+ Flotation costs The costs of floating a company on a stoc! e$change can be high. The fees paid to professional advisors, such as lawyers and accountants, as well as underwriting fees often account for a large part of the total cost incurred. Regulatory costs 5nce the company is floated, the cost of maintaining a stoc! e$change listing can be high. "n important reason for this is the cost of additional regulatory re&uirements surrounding listed companies. The regulations of modern stoc! e$changes re&uire greater transparency between management and owners and this causes some of the additional costs. 1ontrol " company see!ing a stoc! e$change listing must normally ensure that a substantial &uantity of its total issued share capital is available to new investors. This means that the e$isting shareholders may suffer loss of control. 2nvestors e!pectations There is a widely#held view that investor e$pectations often put the directors of companies under pressure to produce gains over the short term. To do this, the directors may ta!e decisions that have an adverse effect on the long#term profitability of the business. *owever, the evidence to support this view is flimsy. 3ublic scrutiny 6isted companies attract much attention from investors, the financial press and the broadcasting media. 7eing in the public spotlight ma!es it difficult for a company to engage in controversial activities or to conduct sensitive negotiations. It also ma!es it difficult for directors to hide poor decisions. +a eover target The e$istence of a ready mar!et for shares in a listed company means that a listed company is much more vulnerable to a ta!eover than an unlisted company. " listed company may be particularly vulnerable when there is a fall in its share price, perhaps caused by disillusionment with the level of returns that are being provided.

&ar ing (cheme

Answer 4 (a) %alculation of share price T*1 %o dividend per share 9 :( $ ;<8 9 )2c per share .hare price of T*1 %o 9 ()2 $ 1<;8)=(;<12 > ;<;8) 9 ?(<@; Aar!et capitalisation of T*1 %o 9 (<@; $ )m 9 ?1(<(m

"1 mar $ "# mar s$ "1 mar $

(b) 'ights issue price This is at a 2;B discount to the current share price 9 (<@; $ ;<@ 9 ?)<@( per share "1 mar $ Cew shares issued 9 )m=) 9 1m %ash raised 9 1m $ )<@( 9 ?),@(;,;;; "1 mar $ Theoretical e$ rights price 9 0() $ (<@;) D )<@(E=( 9 ?(<8: per share "1 mar $ Aar!et capitalisation after rights issue 9 1(<(m D )<@(m 9 ?1@<2( > ;<)2m 9 ?1F<G2m "# mar s$ This is e&uivalent to a share price of 1F<G2=( 9 ?(<(@ per share The issue costs result in a decrease in the mar!et value of the company and therefore a decrease in the wealth of shareholders e&uivalent to @c per share. (c) 1rice=earnings ratio valuation 1rice=earnings ratio of T*1 %o 9 (@;=:( 9 F<8 "1 mar $ /arnings per share of %'H %o 9 ((<@c per share Ising the price earnings ratio method, share price of %'H %o 9 (((<@ $ F<8)=1;; 9 ?)<): Aar!et capitalisation of %'H %o 9 )<): $ 1m 9 ?),):;,;;; "# mar s$ ("lternatively, earnings of %'H %o 9 1m $ ;<((@ 9 ?((@,;;; $ F<8 9 ?),):;,;;;) (d) 1.

In a semi-strong form efficient capital mar!et, share prices reflect past and public information.


-!pected annual after-ta! savings not announce 2. If the e$pected annual after#ta$ savings are not announced, this information will not therefore be reflected in the share price of T*1 %o. ). In this case, the post ac'uisition mar et capitalisation of T*1 %o will be the mar et capitalisation after the rights issue, plus the mar et capitalisation of the ac'uired company (%'H %o), less the price paid for the shares of %'H %o, since this cash has left the company in e$change for purchased shares. It is assumed that the mar!et capitalisations calculated in earlier parts of this &uestion are fair values, including the value of %'H %o calculated by the price=earnings ratio method. 1rice paid for %'H %o 9 )<@(m > ;<)2m 9 ?)<82m Aar!et capitalisation 9 1F<G2m D )<):m > )<82m 9 ?1F<F:m This is e&uivalent to a share price of 1F<F:=( 9 ?(<(( per share (. The mar et capitalisation has decreased from the value following the rights issue because T*1 %o has paid ?)<82m for a company apparently worth ?)<):m. This is a further decrease in the wealth of shareholders, following on from the issue costs of the rights issue.

-!pected after-ta! savings announed 8. If the annual after#ta$ savings are announced, this information will be reflected 'uic ly and accurately in the share price of T*1 %o since the capital mar!et is semi# strong form efficient. :. The savings can be valued using the price5earnings ratio method as having a present value of 67#8.888 (F<8 $ G:,;;;). The revised mar et capitalisation of T*1 %o is therefore 619:49m (1F<F:m D ;<F2m), e'uivalent to a share price of 64:;# per share (1@<(@=(). This ma!es the ac&uisition of %'H %o attractive to the shareholders of T*1 %o, since it offers a higher mar!et capitalisation than the one following the rights issue. /ach shareholder of T*1 %o would e!perience a capital gain of 14c per share ((<:2 > (<(@). F. In practice, the capital mar et is li!ely to anticipate the annual after-ta! savings before they are announced by T*1 %o.

(e) There are a number of factors that should be considered by T*1 %o, including the following. %earing and financial ris


-'uity finance will decrease gearing and financial ris , while debt finance will increase them. 2. %earing for T*1 %o is currently ;9:*< and this will decrease to 4*< if e'uity finance is used, or rise to 1#1< if debt finance is used. There may also be some ac&uired debt finance in the capital structure of %'H %o. T*1 %o needs to consider what level of financial ris is desirable , from both a corporate and a sta!eholder perspective. "1 # mar s$ +arget capital structure ). T*1 %o needs to compare its capital structure after the ac&uisition with its target capital structure. If its primary financial ob=ective is to ma!imise the wealth of shareholders, it should see to minimise its weighted average cost of capital (>A11). (. 2n practical terms this can be achieved by having some debt in its capital structure, since debt is relatively cheaper than e&uity, while avoiding the e!tremes of too little gearing (,"%% can be decreased further) or too much gearing (the company suffers from the costs of financial distress). "1 # mar s$ Availability of security 8. ?ebt will usually need to be secured on assets by either a fi!ed charge (on specific assets) or a floating charge (on a specified class of assets). :. The amount of finance needed to buy 1R@ 1, would need to be secured by a fi!ed charge to specific fi!ed assets of T*1 %o. 2nformation on these fi$ed assets and on the secured status of the e$isting @B loan notes has not been provided. "1 # mar s$ -conomic e!pectations F. If T*1 %o e!pects buoyant economic conditions and increasing profitability in the future, it will be more prepared to ta e on fi!ed interest debt commitments than if it believes difficult trading conditions lie ahead. 1ontrol issues @. " rights issue will not dilute e$isting patterns of ownership and control, unli!e an issue of shares to new investors. The choice between offering new shares to e!isting shareholders and to new shareholders will depend in part on the amount of finance that is needed, with rights issues being used for medium-sized issues and issues to new shareholders being used for large issues. G. 2ssuing traded debt also has control implications however, since restrictive or negative covenants are usually written into the bond issue documents. "1 # mar s$

,or!ings %urrent gearing (debt=e&uity, boo! value basis) 9 1;; $ 8,;;;=F,);; 9 :@<8B Jearing if e&uity finance is used 9 1;; $ 8,;;;=(F,);; D ),@(;) 9 (8B Jearing if debt finance is used 9 1;; $ (8,;;; D ),@(;)=F,);; 9 121B A11A &ar ing (cheme

Answer 4 (a) 'ights issue price 9 (<;; $ ;<@8 9 K)<(; Theoretical e$ rights price 9 ((8 $ (<;;) D )<(;)=: 9 K)<G; Value of rights per e$isting share 9 ()<G; > )<(;)=8 9 1;p (b) Value of 1,2;; shares after rights issue 9 1,2;; $ )<G; 9K(,:@; Value of 1,;;; shares before rights issue 9 1,;;; $ (<;; 9K(,;;; Value of 1,;;; shares after rights issue 9 1,;;; $ )<G; 9 K),G;; %ash subscribed for new shares 9 2;; $ )<(; 9 K:@; %ash raised from sale of rights 9 1,;;; $ ;<1 9 K1;;

"# mar s$ "1 mar $

The investor could do nothing, ta!e up the offered rights, sell the rights into the rights mar!et, or any combination of these actions. The effect of the rights issue on the wealth of the investor

depends on which action is ta!en. The rights issue has a neutral effect if the rights attached to the 1,;;; shares are e!ercised to purchase an additional #88 shares, since the value of 1,2;; shares after the rights issue (K(,:@;) is e&ual to the sum of the value of 1,;;; shares before the rights issue (K(,;;;) and the cash subscribed for new shares (K:@;). 1art of the investor3s wealth has changed from cash into shares, but no wealth has been gained or lost . The theoretical e$ rights per share therefore acts as a benchmar! following the rights issue against which other e$ rights share prices can be compared. "# mar s$ The rights issue also has a neutral effect on the wealth of the investor if the rights attached to e!isting shares are sold. The value of 1,;;; shares after the rights issue (K),G;;) plus the cash received from the sale of rights (K1;;) is e&ual to the value of 1,;;; shares before the rights issue (K(,;;;). In this case, part of the investor3s wealth has changed from shares into cash. "# mar s$ If the investor neither subscribes for the new shares offered nor sells the rights attached to the shares already held, a loss of wealth of A188 will occur, due to the difference between the value of 1,;;; shares before the rights issue (K(,;;;) and the value of 1,;;; shares after the rights issue (K),G;;). "# mar s$ The theoretical e$ rights price is simply a weighted average of the cum rights price and the rights issue price, ignoring any use made of the funds raised. The actual e$ rights price will depend on the use made of the funds raised by the rights issue, as well as the e$pectations of investors and the stoc! mar!et. (c) %urrent share price 9 K(<;; /arnings per share 9 1;; $ ((<;;=18<2() 9 2:<28p Cumber of ordinary shares 9 2m=;<8 9 (m shares /arnings of Tirwen 9 (m $ ;<2:28 9 K1<;8m 4unds raised from rights issue 9 @;;,;;; $ K(<;; $ ;<@8 9 K2,F2;,;;; 4unds raised less issue costs 9 2,F2;,;;; > 22;,;;; 9 K2,8;;,;;; Lebenture interest saved 9 2,8;;,;;; $ ;<12 9 K);;,;;; 1rofit before ta$ of Tirwen 9 1,;8;,;;;=(1 > ;<)) 9 K1,8;;,;;; %urrent debenture interest paid 9 (,8;;,;;; $ ;<12 9 K8(;,;;; %urrent overdraft interest 9 1,28;,;;; $ ;<;F 9 K@F,8;; Total interest 9 8(;,;;; D @F,8;; 9 K:2F,8;;

"1 mar $ "1 mar $ "1 mar $ "1 mar $

%urrent profit before interest and ta$ 9 1,8;;,;;; D :2F,8;; 9 K2,12F,8;; 'evised total interest 9 :2F,8;; > );;,;;; 9 K)2F,8;; 'evised profit after ta$ 9 (2,12F,8;; > )2F,8;;) $ ;<F 9 K1,2:;,;;; (5r revised profit after ta$ 9 1,;8;,;;; D ();;,;;; $ ;<F) 9 K1,2:;,;;;) Cew shares issued 9 (m=8 9 @;;,;;; .hares in issue 9 (,;;;,;;; D @;;,;;; 9 (,@;;,;;; 'evised earnings per share 9 1;; $ (1,2:;,;;;=(,@;;,;;;) 9 2:<28p (d) 1. 2.

"1 mar $

"1 mar $


"s the price5earnings ratio is constant, the share price e$pected after redeeming part of the debentures will remain unchanged at A4:88 per share (2:<28 $ 18<2(). .ince this is greater than the theoretical e! rights share price of A4:08 , using the funds raised by the rights issue to redeem part of the debentures results in a capital gain of 18p per share. The proposal to use the rights issue funds to redeem part of the debentures therefore results in an increase in shareholder wealth. "4 mar s$

(e) " rights issue will be an attractive source of finance to Tirwen plc as it will reduce the gearing of the company. The current debt5e'uity ratio using boo! values is+ Lebt=e&uity ratio 9 1;; $ (,8;;=),8;; 9 12GB Including the overdraft, debt=e&uity ratio 9 1;; $ 8,F8;=),8;; 9 1:(B 7oth values are above the sector average of 1;;B and issuing new debt will not be attractive in this situation. " substantial reduction in gearing will occur, however, if the rights issue is used to redeem K2<8m of debentures+ Lebt=e&uity ratio 9 1;; $ 2,;;;=:,;;; 9 ))B Including the overdraft, debt=e&uity ratio 9 1;; $ ),28;=:,;;; 9 8(B If the rights issue is not used to redeem the debenture issue , the decrease in gearing is less dramatic+ Lebt=e&uity ratio 9 1;; $ (,8;;=:,;;; 9 F8B Including the overdraft, debt=e&uity ratio 9 1;; $ 8,F8;=:,;;; 9 G:B "# mar s$ In both cases, the debt=e&uity ratio falls to less than the sector average, signalling a decrease in financial ris . The debt=e&uity ratio would fall further if increased retained profits were included in the calculation, but the absence of information on Tirwen3s dividend policy ma!es retained profits uncertain.

"# mar s$ If the rights issue is used to redeem K2<8m of debentures, there will be an improvement in interest cover from )<( times (2,12F,8;;=:2F,8;;), which is below the sector average of : times, to :<8 times (2,12F,8;;=)2F,8;;), which is marginally better than the sector average. Interest cover might also increase if the funds raised are invested in profitable pro ects. "# mar s$ " rights issue will also be attractive to Tirwen plc since it will ma!e it more li!ely that the company can raise further debt finance in the future , possibly at a lower interest rate due to its lower financial ris . "1 mar $ It should be noted that a decrease in gearing is li!ely to increase the average cost of the finance used by Tirwen plc, since a greater proportion of relatively more e!pensive e'uity finance will be used compared to relatively cheaper debt. This will increase the discount rate used by the company and decrease the net present value of any e$pected future cash flows. &ar ing (cheme


Answer * (a) The following are the main principles of Islamic finance+ "ll investments must be made according to the rules of .hariah (Islamic 6aw). Co transaction must be carried out for goods that are not halal, e.g. alcohol, gambling, drugs, etc. The ris! relating to a transaction must be shared. The entities investing funds and the entities managing the funds share the business ris! in return for a share in profit. The following are prohibited+ 'iba, i.e. payment or receipt of interest Aasir, i.e. speculation or gambling Jaharar, i.e. uncertainty regarding the sub ect of sale or the terms of the contract. " person must not trade in things that they do not own. (b) The following are the differences between Islamic finance and conventional finance+ 2slamic finance 'eligious principles Lebt capital 1onventional finance

"dheres to the principles of Loes not follow rules of any Islam religion 'eceipt and payment of Co prohibition interest is prohibited. *ence, securities. debt securities cannot be issued. on debt

*ybrid securities .peculation *alal goods

%annot be issued because Co prohibition. They are they are part debt. used to raise capital. Is not allowed Is allowed 5nly supports businesses in Trading in all types of goods halal goods. is allowed as long they do not violate any applicable law. "llowed Cot re&uired

Trading in none$istent Void goods 5wnership of the sub ect 'e&uired of the trade

1ossession of the sub ect 1hysical or constructive Cot re&uired of sale possession is re&uired


.ale at future date %onditional sale



"llowed only when the "llowed. 4re&uently used in condition according to the real estate transactions. usage of trade is recogni-ed as a part of the transaction

Answer ; (a) The word MribaN means e$cess, increase or addition. Inder Islamic laws it is prohibited because it refers to any e$cess compensation without due consideration. The ban on riba means that interest cannot be charged under Islamic finance. Lue to this, suppliers of funds under Islamic finance use profit sharing or fee based approach for obtaining returns on the funds provided by them. (b) I ara is a leasing contract that allows an entity to obtain an asset on lease for a specific time and cost. Inder i ara, the lessor ac&uires an asset and leases it out for a rental fee. The rental fee consists of the capital cost of the asset and the profit margin of the lessor. (c) The features of su!u! are+ They are asset#bac!ed securities. There is an active secondary mar!et where they can be traded. Their holders obtain a proportional beneficial ownership in the underlying assets. They are entitled for a share in the revenues earned from the su!u! assets. " share from the reali-ation proceeds of the su!u! assets is paid to the su!u! holder. (d) Aurahaba is a contract of sale between a financer and its client for financing the ac&uisition of assets by the client. The price consists of the cost the asset and premium (profit margin agreed between the financer and its client). There are two ways for the client to pay the ban! for the asset+ Leferred payment 'epayment in instalments

.teps involved in Aurahaba


.tep 1+ an agreement is signed between the financer and its client that from time to time the financer will sell assets, the client will re&uire and purchase them. The assets will be sold at a premium to the client. The margin of premium and repayment schedule will be mentioned in the agreement. .tep 2+ when the client re&uires an asset, the financer will appoint the client as its agent to purchase the asset. .tep )+ the client will buy the asset as the financer3s agent and will ta!e possession of the asset. .tep (+ the client will inform the financer that the asset has been purchased by it as the financer3s agent. The client will immediately give an offer to the financer to buy the asset. .tep 8+ the financer will accept the client3s offer and will sell the asset at a premium to the client. The client will pay for the asset as determined according to the agreement signed in step 1.


Answer 7 (a) ?ebt finance 6888 8:,;;; 2@,8:; (,8;; 22,G(; 1(,F;; @,2(; @;; F,((; 2,2)2 8,2;@ -'uity finance 6888 8:,;;; 2@,8:; (,8;; 22,G(; 1(,F;; @,2(; );; F,G(; 2,)@2 8,88@

.ales revenue (8;,;;; $ 1.12) Variable cost of sales (@8B $ sales) 4i$ed cost of sales (18B $ );,;;;) Jross profit "dministration costs (1(,;;; $ 1.;8) 1rofit before interest and ta$ Interest (,1) 1rofit before ta$ Ta$ation at );B 1rofit after ta$ BoteC Lividends paid (:;B) Cet change in e&uity (retained profit)

),128 2,;@)

),))8 2,22)

,1 Interest under debt financing 9 ?);;,;;; D (?8,;;;,;;; $ 1;B) 9 ?@;;,;;;. (b) Financial gearing If financial gearing is measured as the debt + e&uity ratio+ %urrent Lebt .hare capital and reserves Lebt=e&uity ratio (B) 2,8;; 22,8:; 11.1B Lebt finance F,8;; 2(,:() );.(B /&uity finance 2,8;; 2G,F@) @.(B

,or!ings+ .hare capital and reserves (debt finance) 9 22,8:; D 2,;@) 9 ?2(,:() .hare capital and reserves (e&uity finance) 9 22,8:; D 8,;;; D 2,22) 9 ?2G,F@)


If financial gearing is measured as the ratio of debt capital to total capital+ %urrent Lebt Total long#term capital %apital gearing (B) 2,8;; 28,;:; 1;.;B Lebt finance F,8;; )2,1() 2).)B /&uity finance 2,8;; )2,2@) F.FB

,perating gearingC If operational gearing is measured as the ratio of fi$ed costs to total costs+ %urrent 4i$ed costs Total costs 5perating gearing (B) 1@,8;; ((,;;; (2.;B Lebt finance 1G,2;; (F,F:; (;.2B /&uity finance 1G,2;; (F,F:; (;.2B

Total costs are assumed to consist of cost of sales plus administration costs. If operational gearing is measured as the ratio of fi$ed costs to variable costs+ %urrent 4i$ed costs Variable costs 5perating gearing (B) 1@,8;; 28,8;; F2.8B Lebt finance 1G,2;; 2@,8:; :F.2B /&uity finance 1G,2;; 2@,8:; :F.2B

If operational gearing is measured as the ratio of contribution to profit before interest and ta$ (17IT) %urrent %ontribution 17IT 5perating gearing 2nterest coverC %urrent 17IT Lebt interest Interest cover :,;;; );; 2; Lebt finance @,2(; @;; 1;.) /&uity finance @,2(; );; 2F.8 2(,8;; :,;;; (.1 Lebt finance 2F,((; @,2(; ).) /&uity finance 2F,((; @,2(; ).)


-3(C %urrent 1rofit after ta$ Co. of shares /1. (cents) ),GG; 1;,;;; )G.G Lebt finance 8,2;@ 1;,;;; 82.1 /&uity finance 8,88@ 11,28; (G.(

1ommentC The debt finance proposal leads to the largest increase in /1., but results in an increase in financial gearing and a decrease in interest cover. ,hether these changes in financial gearing and interest cover are acceptable depends on the attitude of both investors and managers to the new level of financial ris!O a comparison with sector averages would be helpful in this conte$t. The e&uity finance proposal leads to a decrease in financial gearing and an increase in interest cover. The e$pansion leads to a decrease in operational gearing, whichever measure of operational gearing is used, indicating that fi$ed costs have decreased as a proportion of total costs. DcEDiE 7usiness ris!, the inherent ris! of doing business for a company, refers to the ris! of ma!ing only low profits, or even losses, due to the nature of the business that the company is involved in. 5ne way of measuring business ris! is by calculating a companyPs operating gearing or Poperational gearingP. The significance of operating gearing is as follows. (1) If contribution is high but 17IT is low, fi$ed costs will be high, and only ust covered by contribution. 7usiness ris!, as measured by operating gearing, will be high. (2) If contribution is not much bigger than 17IT, fi$ed costs will be low, and fairly easily covered. 7usiness ris!, as measured by operating gearing, will be low. DcEDiiE " high level of debt creates financial ris!. This is the ris! of a company not being able to meet other obligations as a result of the need to ma!e interest payments. The proportion of debt finance carried by a company is therefore as significant as the level business ris!. . 4inancial ris! can be seen from different points of view. (1) The company as a whole. If a company builds up debts that it cannot pay when they fall due, it will be forced into li&uidation.


(2) ())

1ayables. If a company cannot pay its debts, the company will go into li&uidation owing payables money that they are unli!ely to recover in full. 5rdinary shareholders. " company will not ma!e any distributable profits unless it is able to earn enough profit before interest and ta$ to pay all its interest charges, and then ta$. The lower the profits or the higher the interest#bearing debts, the less there will be, if there is anything at all, for shareholders.

&ar ing (cheme

&ar s (a) .ales and administration cost %ost of sales Interest 1rofit after ta$ Lividends (b) 'evised share capital and reserves 4inancial gearing 5perational gearing Interest cover /1. %alculation of current values Liscussion (c) /$planation of business ris! /$planation of financial ris! Ip to 2 mar!s for each danger of high gearing 1 1 1 1 1 1 2 2 2 2 1 2 1 1 : @ 28 12 8

Answer 9 (a) .mall businesses face a number of well#documented problems when see!ing to raise additional finance. These problems have been e$tensively discussed and governments regularly ma!e initiatives see!ing to address these problems. Ris and security 2nvestors are less willing to offer finance to small companies as they are seen as inherently more ris y than large companies.


.mall companies obtaining debt finance usually use overdrafts or loans from ban!s, which re&uire security to reduce the level of ris! associated with the debt finance. .ince small companies are li ely to possess little by way of assets to offer as security , ban!s usually re&uire a personal guarantee instead, and this limits the amount of finance available. "# mar s$ &ar etability of ordinary shares The e'uity issued by small companies is difficult to buy and sell , and sales are usually on a matched bargain basis, which means that a shareholder wishing to sell has to wait until an investor wishes to buy. There is no financial intermediary willing to buy the shares and hold them until a buyer comes along , so selling shares in a small company can potentially ta!e a long time. This lac! of mar!etability reduces the price that a buyer is willing to pay for the shares. Investors in small company shares have traditionally loo ed to a flotation , for e$ample on the FG Alternative 2nvestment &ar et , as a way of realising their investment, but this has become increasingly e$pensive. .mall companies are li!ely to be very limited in their ability to offer new e&uity to anyone other than family and friends. "# mar s$ +a! considerations Individuals with cash to invest may be encouraged by the ta$ system to invest in large institutional investors rather than small companies, for e$ample by ta! incentives offered on contributions to pension funds . These institutional investors themselves usually invest in larger companies, such as stoc!#e$change listed companies, in order to maintain what they see as an acceptable ris! profile, and in order to ensure a steady stream of income to meet ongoing liabilities. This ta! effect reduces the potential flow of funds to small companies. "# mar s$ 1ost .ince small companies are seen as ris!ier than large companies, the cost of the finance they are offered is proportionately higher. 5verdrafts and ban! loans will be offered to them on less favourable terms and at more demanding interest rates than debt offered to larger companies. -'uity investors will e!pect higher returns, if not in the form of dividends then in the form of capital appreciation over the life of their investment. "# mar s$ A11A &ar ing (cheme


(b) 2ntroduction .A/s contribute in a significant way to many economies in the world. 7esides generating income, in often large proportions in relation to JC1 across the world, they are fre&uently ma or employers and the sector which is most identified with new ideas and entrepreneurial spirit. It is these latter factors that help sustain and support growth rates in many economies. Lespite this bac!ground of potential there is often associated with .A/s difficulties in accessing appropriate sources of finance. There are three main issues involved+ uncertainty concerning the business, lac! of assets available to offer as collateral or security, and the sources of finance for business start#ups or very new businesses. Fncertainty concerning the business " defining characteristic of .A/s is the uncertainty surrounding their activities. 4irst, the .A/s, in general, do not have a trac record on their business and also do not have the good and long-term relationship with their ban s. Fnli e larger businesses, they have grown from smaller businesses and have a trac record > especially in terms of a long#term relationship with their ban!ers. Ban ers can observe, over a period of time, that the business is well-run, that managers can manage its affairs and can therefore be trusted with handling ban! loans in a proper way. Harger businesses conduct more of their activities in public (e.g. sub ect to more e$ternal scrutiny) than do .A/s. Thus, if information is public, there is less uncertainty. 4or e$ample, a larger business might be &uoted on an e$change and therefore be sub ect to press scrutiny, e$change rules regarding the provision of certain of its activities, and has to publish accounts that have been audited. &any (&-s do not have to have audits, certainly don3t publish their accounts to a wide audience and the press are not really interested in them. Hac of assets available to offer as collateral or security If .A/s wish to access ban! finance, for e$ample, then ban s will wish to address the information problem referred to above. Ban s will screen loan applications to assess the underlying product or service,

the management team, the mar et addressed and, importantly, any collateral or security that can be offered. It is this last point which is of interest here. 7esides investigating business plans, ban!s will loo! to see what security is available for any loan provided. This phase is li!ely to involve an audit of the firm3s assets and detailed e$planation of any personal security offered by the directors and owner managers. 1ollateral is important because it can reduce the level of ris a ban! is e$posed to in granting a loan to a new business. In assessing a business plan and security, a ban! would ma!e an assessment of the ris! of the business and any loan interest rate will reflect that ris!. " !ey feature for accessing ban! finance is therefore in the assessment of ris! from the information gathered and the security offered.

3otential sources of finance for very new businesses 2nitial owner finance is nearly always the first source of finance for a business, whether from the owner or from family connections. "t this stage many of the assets may be intangible and thus e$ternal financing is an unrealistic prospect at this stage, or at least has been in the past. This is often referred to as the e&uity gap. +rade credit finance is important at this point too, although it is nearly always very e$pensive if viewed in terms of lost early payment discounts. "lso, it is inevitably very short term and very limited in duration (e$cept that always ta!ing :; days to pay a payables will obviously roll#over and become medium term financing). Business angel financing or venture capital may be important and is represented by high net worth individuals or groups of individuals who invest directly in small businesses. It is possible, when a new business, or its owner, can offer ade'uate security that a ban loan may be arranged. "nother form of security that may underpin a ban! loan is in the form of a guarantee from a reliable individual or other business with a ban!ing trac! record. 5ther sources of finance can be, for e$ample, overdraft, leasing and factoring.


Answer 0 (a) 'ights issue price 9 2<8 $ ;<@ 9 ?2<;; per share "1 mar $ Theoretical e$ rights price 9 ((2<8; $ () D (1 $ 2<;;)=89?2<(; per share "# mar s$ ("lternatively, number of rights shares issued 9 ?8m=?2<;; 9 2<8m shares /$isting number of shares 9 ( $ 2<8m 9 1;m shares Theoretical e$ rights price per share 9 ((1;m $ 2<8;) D (2<8m $ 2<;;))=12<8m 9 ?2<(;) (b) %urrent price=earnings ratio 9 28;=)2<( 9 F<F times "1 mar $ ;<28 "verage growth rate of earnings per share 9 1;; $ (()2<(=2F<F) > 1) 9 (<;B /arnings per share following e$pansion 9 )2<( $ 1<;( 9 ))<F cents per share "1 mar $ .hare price predicted by price=earnings ratio method 9 ))<F $ F<F 9 ?2<:; "1 mar $ .ince the price=earnings ratio of Lartig %o has remained constant in recent years and the e$pansion is of e$isting business, it seems reasonable to apply the e$isting price=earnings ratio to the revised earnings per share value. (c) ?iscussion of share price companies 1. The proposed business e$pansion will be an acceptable use of the rights issue funds if it increases the wealth of the shareholders. The share price predicted by the price5earnings ratio method is 6#:;8. This is greater than the current share price of 6#:*8, but this is not a valid comparison, since it ignores the effect of the rights issue on the share price. 2. The rights issue has a neutral effect on shareholder wealth , but the cum rights price is changed by the increase in the number of shares and by the transformation of cash wealth into security wealth from a shareholder point of view. The correct comparison is with the theoretical e! rights price, which was found earlier to be ?2<(;. Lartig %o shareholders will e!perience a capital gain due to the business e$pansion of ?2<:; > 2<(; 9 2; cents per share. Iowever, these share prices are one year apart and hence not directly comparable. "4 4 mar s$ 1alculation of effect on shareholder wealth If the dividend yield remains at ;< per year (1;; $ 18<;=28;), the dividend per share for #889 will be 1*:;p (other estimates of the 2;;@ dividend per share are possible). Adding this to the capital gain of #8p gives a total shareholder return of 4*:;p or 14:#4< (1;; $ )8<:=2(;). This is greater than the cost of e'uity of 1;B and so shareholder wealth has increased. "1 # mar s$

(d) In order to use the dividend growth model, the e$pected future dividend growth rate is needed. *ere, it may be assumed that the historical trend of dividend per share payments will continue into the future. The geometric average historical dividend growth rate 9 1;; $ ((18<;=12<@);<28 > 1) 9 (B per year. "# mar s$ ("lternatively, the arithmetical average of annual dividend growth rates could be used. This will be (8<8 D ;<; D F<( D )<8)=( 9 (<1B. "nother possibility is to use the Jordon growth model. The average payout ratio over the last ( years has been (FB, so the average retention ratio has been 8)B. "ssuming that the cost of e&uity represents an acceptable return on shareholders3 funds, the dividend growth rate is appro$imately 8)B $ 1;B 9 8<)B per year.) Ising the formula for the dividend growth model from the formula sheet, the e$ dividend share price 9 (18<; $ 1<;()=(;<1 ;<;() 9 ?2<:; "# mar s$ ?iscussion This is 18 cents per share more than the current share price of Lartig %o. There are several reasons why there may be a difference between the two share prices. The future dividend growth rate for e$ample, may differ from the average historical dividend growth rate, and the current share price may factor in a more reasonable estimate of the future dividend growth rate than the (B used here. The cost of e'uity of Lartig %o may not be e!actly e'ual to 18<. Aore generally, there may be a degree of inefficiency in the capital mar et on which the shares of Lartig %o are traded. "# mar s$ (e) The primary financial management ob ective of a company is usually ta!en to be the ma$imisation of shareholder wealth. In practice, the managers of a company acting as agents for the principals (the shareholders) may act in ways which do not lead to shareholder wealth ma$imisation. The failure of managers to ma$imise shareholder wealth is referred to as the agency problem. .hareholder wealth increases through payment of dividends and through appreciation of share prices. .ince share prices reflect the value placed by buyers on the right to receive future dividends, analysis of changes in shareholder wealth focuses on changes in share prices. The ob ective of ma$imising share prices is commonly used as a substitute ob ective for that of ma$imising shareholder wealth.


The agency problem arises because the ob ectives of managers differ from those of shareholders+ because there is a divorce or separation of ownership from control in modern companiesO and because there is an asymmetry of information between shareholders and managers which prevents shareholders being aware of most managerial decisions. 5ne way to encourage managers to act in ways that increase shareholder wealth is to offer them share options. These are rights to buy shares on a future date at a price which is fi$ed when the share options are issued. .hare options will encourage managers to ma!e decisions that are li!ely to lead to share price increases (such as investing in pro ects with positive net present values), since this will increase the rewards they receive from share options. The higher the share price in the mar!et when the share options are e$ercised, the greater will be the capital gain that could be made by managers owning the options. .hare options therefore go some way towards reducing the differences between the ob ectives of shareholders and managers. *owever, it is possible that managers may be rewarded for poor performance if share prices in general are increasing. It is also possible that managers may not be rewarded for good performance if share prices in general are falling. It is difficult to decide on a share option e$ercise price and a share option e$ercise date that will encourage managers to focus on increasing shareholder wealth while still remaining challenging, rather than being easily achievable. A11A &ar ing (cheme


Answer 18

"; 7 mar s$ Achievement of corporate ob=ectives 1. QQJ %o has shareholder wealth ma$imisation as an ob ective. The wealth of shareholders is increased by dividends received and capital gains on shares owned. Total shareholder return compares the sum of the dividend received and the capital gain with the opening share price. 2. The shareholders of QQJ %o had a return of *9< in #889, compared with a return predicted by the capital asset pricing model of 1(B. The lowest return shareholders have received was #1< and the highest return was 9#<. 5n this basis, the shareholders of the company have e$perienced a significant increase in wealth. ). It is debatable whether this has been as a result of the actions of the company, however. (hare prices may increase irrespective of the actions and decisions of managers , or even despite

them. In fact, loo!ing at the dividend per share history of the company, there was one year (2;;:) where dividends were constant, even though earnings per share increased. It is also difficult to now when wealth has been ma!imised. "# 4 mar s$ (. Another ob=ective of the company was to achieve a continuous increase in earnings per share. "nalysis shows that earnings per share increased every year , with an average increase of 1(<GB. This ob=ective appears to have been achieved. "# 4 mar s$ 1omment on financial performance 8. 'eturn on capital employed (R,1-) has been growing towards the sector average of #*< on a year-by-year basis from 22B in 2;;8. This steady growth in the primary accounting ratio can be contrasted with irregular growth in turnover, the reasons for which are un nown. :. Return on shareholdersJ funds has been consistently higher than the average for the sector . This may be due more to the capital structure of QQJ %o than to good performance by the company, however, in the sense that shareholders3 funds are smaller on a boo! value basis than the long#term debt capital. In every previous year but 2;;@ the gearing of the company was higher than the sector average. "1 # mar s$ (b) 1alculation of theoretical e! rights per share %urrent share price 9 ?@<:( per share %urrent number of shares 9 8<8 million shares 4inance to be raised 9 ?18m 'ights issue price 9 ?F<8; per share Cumber of shares issued 9 18m=F<8; 9 2 million shares Theoretical e$ rights price per share 9 ((8<8m $ @<:() D (2m $ F<8;))=F<8m 9 ?@<)( per share The share price would fall from ?@<:( to ?@<)( per share *owever, there would be no effect on shareholder wealth "# 4 mar s$ -ffect of rights issue on earnings per share %urrent /1. 9 1;; cents per share 'evised /1. 9 1;; $ 8<8m=F<8m 9 F) cents per share The /1. would fall from 1;; cents per share to F) cents per share *owever, as mentioned earlier, there would be no effect on shareholder wealth "# 4 mar s$ -ffect of rights issue on the debt5e'uity ratio %urrent debt=e&uity ratio 9 1;; $ 2;=(F<8 9 (2B

'evised mar!et value of e&uity 9 F<8m $ @<)( 9 ?:2<88 million 'evised debt=e&uity ratio 9 1;; $ 2;=:2<88 9 )2B The debt5e'uity ratio would fall from 4#< to 4#<, which is well below the sector average value and would signal a reduction in financial ris "1 # mar s$ (c) The current debt=e&uity ratio of QQJ %o is (2B (2;=(F<8). "lthough this is less than the sector average value of 8;B, it is more useful from a financial ris! perspective to loo! at the e$tent to which interest payments are covered by profits.


The interest on the bond issue is 61:; million (@B of ?2;m), giving an interest coverage ratio of ;:1 times. If QQJ %o has overdraft finance, the interest coverage ratio will be lower than this, but there is insufficient information to determine if an overdraft e$ists. The interest coverage ratio is not only below the sector average, it is also low enough to be a cause for concern . ,hile the ratio shows an upward trend over the period under consideration, it still indicates that an issue of further debt would be unwise. "1 # mar s$


" placing. or any issue of new shares such as a rights issue or a public offer, would decrease gearing. If the e$pansion of business results in an increase in profit before interest and ta$, the interest coverage ratio will increase and financial ris! will fall. %iven the current financial position of KK% 1o, a decrease in financial ris is certainly preferable to an increase .


" placing will dilute ownership and control , providing the new e&uity issue is ta!en up by new institutional shareholders, while a rights issue will not dilute ownership and control , providing e!isting shareholders ta e up their rights. "# 4 mar s$


" bond issue does not have ownership and control implications , although restrictive or negative covenants in bond issue documents can limit the actions of a company and its managers.

"ll three financing choices are long#term sources of finance and so are appropriate for a long#term investment such as the proposed e$pansion of e$isting business. 8. -'uity issues such as a placing and a rights issue do not re'uire security. Co information is

provided on the non#current assets of QQJ %o, but it is li ely that the e!isting bond issue is secured. If a new bond issue was being considered, QQJ %o would need to consider whether it had sufficient non-current assets to offer as security , although it is li!ely that new non# current assets would be bought as part of the business e$pansion. "# 4 mar s$ A11A &ar ing (cheme

Answer 11 (a) Cugfer %o is loo!ing to raise ?2;;m in cash in order to ac&uire a competitor. "ny recommendation as to the source of finance to be used by the company must ta!e account of the recent financial performance of the company, its current financial position and its e$pected financial performance in the future, presumably after the ac&uisition has occurred. Recent financial performance The recent financial performance of Cugfer %o will be ta!en into account by potential providers of finance because it will help them to form an opinion as to the &uality of the management running the company and the financial problems the company may be facing. "nalysis of the recent performance of Cugfer %o gives the following information+


"1 4 mar s$ Jeometric average growth in turnover 9 (1@G<)=122<:) > 1 9 18<:B Jeometric average operating profit growth 9 (8:<F=(1<F);<)) > 1 9 1;<@B 5ne positive feature indicated by this analysis is the growth in revenue, which grew by #4< in #880 and by #1< in #818. .lightly less positive is the growth in operating profit , which was 1:B in 2;;G and 1)B in 2;1;. 7oth years were significantly better in revenue growth and operating profit growth than 2;;@. ,ne 'uery here is why growth in operating profit is so much lower than growth in revenue. 7etter control of operating and other costs might improve operating profit substantially and decrease the financial ris! of Cugfer %o.

The growing financial ris of the company is a clear cause for concern. The interest coverage ratio has declined each year in the period under review and has reached a dangerous level in 2;1;. The increase in operating profit each year has clearly been less than the increase in finance charges, which have tripled over the period under review. The reason for the large increase in debt is not nown , but the high level of financial ris! must be considered in selecting an appropriate source of finance to provide the ?2;;m in cash that is needed. "1 4 mar s$ 1urrent financial position The current financial position of Cugfer %o will be considered by potential providers of finance in their assessment of the financial ris! of the company. "nalysis of the current financial position of Cugfer %o shows the following+ Lebt=e&uity ratio 9 long#term debt=total e&uity 9 1;; $ (1;;=221) 9 (8B Lebt e&uity=ratio including short#term borrowings 9 1;; $ ((1;; D 1:;)=221) 9 11@B The debt5e'uity ratio based on long-term debt is not particularly high . *owever, the interest coverage ratio indicated a high level of financial ris and it is clear from the financial position statement that the short#term borrowings of ?1:;m are greater than the long#term borrowings of ?1;;m. In fact, short-term borrowings account for ;#< of the debt burden of Cugfer %o. If we include the short-term borrowings, the debt5e'uity ratio increases to 119<, which is certainly high enough to be a cause for concern. The short-term borrowings are also at a higher interest rate (@B) than the long#term

borrowings (:B) and as a result, interest on short#term borrowings account for :@B of the finance charges in the income statement. It should also be noted that the long-term borrowings are bonds that are repayable in #81#. Cugfer %o needs therefore to plan for the redemption and refinancing of 6188m of debt in two yearsJ time, a factor that cannot be ignored when selecting a suitable source of finance to provide the ?2;;m of cash needed. "1 4 mar s analysis$ "1 4 mar s discussion$ Recommendation of suitable financing method There are strong indications that it would be unwise for Cugfer %o to raise the ?2;;m of cash re&uired by means of debt finance, for e$ample the low interest coverage ratio and the high level of gearing. 1. If no further debt is raised , the interest coverage ratio would improve after the ac&uisition due to the increased level of operating profit, i.e. (8:<Fm D 2@m)=1@<@ 9 (<8 times. "ssuming that ?2;;m of @B debt is raised, the interest coverage ratio would fall to ((@(<F=(1@<@ D 1:)) 9 2<( times and the debt=e&uity ratio would increase to 1;; $ (2:; D 2;;)=221 9 2;@B. If convertible debt were used, the increase in gearing and the decrease in interest coverage would continue only until conversion occurred, assuming that the company3s share price increased sufficiently for conversion to be attractive to bondholders. 5nce conversion occurred, the debt capacity of the company would increase due both to the li&uidation of the convertible debt and to the issuing of new ordinary shares to bond holders. In the period until conversion, however, the financial ris! of the company as measured by gearing and interest coverage would remain at a very high level. If Cugfer %o were able to use e'uity finance, the interest coverage ratio would increase to (<8 times and the debt=e&uity ratio would fall to 1;; $ (2:;=(221 D 2;;)) 9 :2B. "lthough the debt=e&uity ratio is still on the high side, this would fall if some of the short#term borrowings were able to be paid off, although the recent financial performance of Cugfer %o indicates that this may not be easy to do. The problem of redeeming the current long#term bonds in two years also remains to be solved. *owever, since the company has not paid any dividend for at least four years, it is unli ely that current shareholders would be receptive to a rights issue , unless they




were persuaded that dividends would be forthcoming in the near future. "c&uisition of the competitor may be the only way of generating the cash flows needed to support dividend payments. " similar negative view could be ta!en by new shareholders if Cugfer %o were to see! to raise e&uity finance via a placing or a public issue. 8. (ale and leasebac of non-current assets could be considered, although the nature and &uality of the non#current assets is not !nown. The financial position statement indicates that Cugfer %o has ?);;m of non#current assets, ?1;;m of long#term borrowings and ?1:;m of short#term borrowings. .ince its borrowings are li ely to be secured on some of the e!isting non-current assets , there appears to be limited scope for sale and leasebac!.


)enture capital could also be considered, but it is unli ely that such finance would be available for an ac'uisition and no business case has been provided for the proposed ac&uisition. "4 ; mar s$ ,hile combinations of finance could also be proposed, the overall impression is that Cugfer %o is in poor financial health and, despite its best efforts, it may not be able to raise the 6#88m in cash that it needs to ac'uire its competitor. "1 mar $ (b) ,hen a new issue of bonds is made by a company, the interest rate on the bonds will be influenced by factors that are specific to the company, and by factors that relate to the economic environment as a whole. 1ompany-specific factors The interest rate charged on a new issue of bonds will depend upon such factors as the ris associated with the company and any security offered. 1. The ris associated with the company will be assessed by considering the ability of the company to meet interest payments in the future, and hence its future cash flows and profitability, as well as its ability to redeem the bond issue on maturity. ,here an issue of new bonds is bac!ed by security, the interest rate charged on the issue will be lower than for an unsecured bond issue. " bond issue will be secured on specific non#current assets such as land or buildings, and as such is referred to as a


fi$ed#charge security. "# 4 mar s$ -conomic environment factors ). "s far as the duration of a new issue of bonds is concerned, the term structure of interest rates suggests that short-term debt is usually cheaper than long-term debt , so that the yield curve slopes upwards with increasing term to maturity. The longer the duration of an issue of new bonds, therefore, the higher will be the interest rate charged. (. The shape of the yield curve, which can be e!plained by reference to li'uidity preference theory. e!pectations theory and mar et segmentation theory, will be independent of any specific company. 8. The rate of interest charged on a new issue of bonds will also depend on the general level of interest rates in the financial system . This is influenced by the general level of economic activity in a given country, such as whether the economy is in recession (when interest rates tend to fall) or e$periencing rapid economic growth (when interest rates are rising as capital availability is decreasing). :. The general level of interest rates is also influenced by monetary policy decisions ta!en by the government or the central ban!. 4or e$ample, interest rates may be increased in order to e$ert downward pressure on demand and hence decrease inflationary pressures in an economy. "# 4 mar s$ (/$aminer3s note+ the above answer is longer than would be e$pected from a candidate under e$amination conditions.) (c) The three forms of capital mar!et efficiency are wea! form, semi#strong form and strong form efficiency. The three forms of efficiency can be distinguished by considering the different !inds of information that are reflected in security prices. >ea form efficiency This refers to a situation where securities trading on a capital mar!et (e.g. shares and bonds) are shown to reflect all relevant past information. If a capital mar!et is wea! form efficient, it is not possible to predict security prices by studying share price movements in the past. There is no correlation between share price movements in successive periods and, in fact, share prices appear to be following a random wal!. "# mar s$ (emi-strong form efficiency This refers to a situation where securities trading on a capital mar!et are shown to reflect all

past and public information. If a capital mar!et is semi#strong form efficient, it is not possible to ma!e above#average (abnormal) returns by studying information in the public domain (this includes past information), because the prices of securities move &uic!ly and accurately to reflect new information as it becomes available. "# mar s$ (trong form efficiency If a capital mar!et is described as strong form efficient, the prices of securities trading on the mar!et reflect all information, whether past, public or private. It is not possible for this form of capital mar!et efficiency to e$ist in the real world, since it is always possible for an individual with access to relevant information which is not public to benefit from it by buying and selling securities. "# mar s$ A11A &ar ing (cheme