ANSWER

1. The correct answers are A and B.

In a strong form efficient market, insider dealing regulations would not be necessary as all
private information is reflected in the share price anyway.

The market can still be outperformed by individual investors, but only by luck and not
consistently.

Share prices will not react to the public announcement as the private information will already be
known as the share price would react to the initial decision instead.

There would be no need for quick announcement as the information will already be known and
reflected in the share price.

2. This proxy beta needs to be ungeared. βa = 2 x (75/100) = 1.5

The asset beta does not need to be regeared.

Using CAPM, Ke = 5 + 1.5 x 4 = 8.96% = 11%.

3. A

Market value of equity = $8m x ($5.00/$0.5) = $80 million

Market value of bonds = $4m x ($105/$100) = $4.2 million
Market value of preference shares = $2m x ($0.80/$1.00) = $1.6 million

Prior charge capital = $4.2m + $6.2m + $1.6m = $12 million

Market value based gearing = 100 x ($12m/$80m) = 15.0%

4. B
Current shares: 5.00m x $8.00 $40m
New shares under 1 for 4: 1.25m x $6.00 $7.5m
Total shares after rights issue 6.25m $47.5m

Theoretical ex rights price $47.5m / 6.25m = $7.60

Current price = $6.00
Value of a right = $7.60 -$6.00 = $1.60
Value of right per share $1.60 / 4 = $0.40

5. A
As risk rises, the investor needs to receive an increased yield in order to compensate for the
higher level of risk. If the irredeemable security pays a fixed rate of interest, an increased yield is
achieved when the market value of the security falls, as the interest will then comprise a higher
percentage of the market value.
6. C
Share price = (0·826 x 0·5)/ (0·1 – 0·03) + (0·25 x 0·826) = $6·11 per share

The DVM states that the ex-dividend market value of an ordinary share is equal to the present
value of the future dividends paid to the owner of the share. No dividends are to be paid in the
current year and in year 1, so the value of the share does not depend on dividends from these
years. The first dividend to be paid is in year 2 and this dividend is different from the dividend
paid in year 3 and in subsequent years. The present value of the year 2 dividend, discounted at
10% per year, is (0.25 x 0.826) = $0.2065

The dividends paid in year 3 and subsequently can be valued using the DGM. By using the
formula P0 = D1/ (re - g) we can calculate the present value of the future dividend stream
beginning with $0.50 per share paid in year 3. This present value will be a year 2 value and will
need discounting for two years to make it a year 0 present value.

P0 = (0.826 x 0.5)/ (0.1 – 0.03) = 0.826 x 7.1429 = 5.90

An alternative approach is to discount the year 3 dividend by 0.826 to give a year 1 dividend, and
then apply the dividend growth model P0 = D1/ (re - g). Mathematically, this is the same, as
follows:

(0.826 x 0.5)/ (0.1 – 0.03) = 0.413/ (0.1 – 0.3) = 0.413/ 0.07 = 5.90

The current share price is then the sum of the two present values:

P0 = 5.90 + 0.2065 = $6.11 per share

7. A

Market value of equity = $8m x ($5.00/$0.5) = $80 million

Market value of bonds = $4m x ($105/$100) = $4.2 million
Market value of preference shares = $2m x ($0.80/$1.00) = $1.6 million

Prior charge capital = $4.2m + $6.2m + $1.6m = $12 million

Market value based gearing = 100 x ($12m/$80m) = 15.0%

8. D

9. FR-decrease
OR-decrease

10. A
11. 25 %

g = reinvestment level g=br

b = % earning retained
r = return rate of investment

b = (2.10-0.8)/(2.10) 62%
r = 2.10/6.70 31%
=62% x 31% 0.19

Ke = dividend growth model

= Do (1 + g) 0.8 ( 1+ 0.19) 0.95

= =
Po 4.60-0.80 3.8
= 25 %

12. D

Machine 1
Time 0 1-4 4
Intial cost (480,000) (72,000) 60,000
DF @ 10% 1.000 3.170 0.683 EAC= 667,260
PV (480,000) (228,240) 40,980 3.170
NPV (667,260) = 210,492.11
211,000.00
Machine 1
Time 0 1-3 3
Intial cost (540,000) (47,000) 120,000
DF @ 10% 1.000 2.487 0.751 EAC= 566,769
PV (540,000) (116,889) 90,120 2.487
NPV (566,769) = 227,892.64
228,000.00

Answer A relate to error in Annuity Factor

Answer B relate to machine 2 assume project is 4 years instead of 3 years
Answer C relate to NPV question and not divided by Annuity Factor
13. A and C

Statements Relate to

Our shareholders rely on the level of dividend we pay

and we cannot ignore that. We must pay out as expected
Dividend dependency theory
otherwise our shareholders will be forced to sell shares
or invest elsewhere

What matters is the underlying value of the projects that

we are doing now and we will do in future. We should Dividend irrelevancy theory
stop wasting time discussing this.

14. C - By eliminating a competitor, there is a synergy potential for Sigma meaning they would
prepare to pay more for Alpha Co

A If Lambda Co could achieve more synergy, the value placed on the company should be higher
B Negotiation skills will determine the final price paid for Alpha Co, not the initial valuation
D If Sigma Co used more prudent growth estimates, this would reduce value of Alpha Co

15. C – Return required by project

Section B

16. A
Minimum value to the seller is given by NRV(this would have already deducted the value of the
loan)

17. $50
To get an estimate of future earnings we need firstly the historic figure by 3% and then secondly
adjust for the post-tax salary

Sustainable earnings = (7,000,000 x 1.03) – (100,000 x o.70) = 7,140,000

MV = 7 x 7,140,000 = 49,980,000 or $50m

18. A

PV of future CFs discounted at the WACC = 6/(0.12 – 0.040) = $75m

However, this gives the value of equity = debt, so the value of the debt must be deducted

MV equity = 75 - 2.5 = $72.5m

19. A and B

A is true. The decision by owner/managers how to take funds out of a company is usually made
to reduce tax.

B is true. In a service business the goodwill may be tied up with the owner/manage rather than
the company.

20. B
Statement (i) is true. Minnow operates in a service industry that is not capital intensive
Statement (ii) is true – DCF approaches are generally seen as superior
Statement (iii) is false for two reasons – firstly historic dividend have been artificially high. A
trend unlikely to continue and, secondly, DVM is less useful for valuing a majority stake.

21. D - $103.18

Future share price = 4.60 x 1.045^5

= 5.73
Convert to = 18
103.18
22. 6 %

Time Cash flows $ DF@5% PV DF@10% PV

0 Market value 1.000 1.000
(106.20) (106.20) (106.20)
1-5 Interest* 5.6 4.329 3.791
24.24 21.23
5 Redemption 110 0.784 0.621
86.24 68.31
= 100 x 110%
4.28 (16.66)

Interest* i(1-t) = 8 (1-0.3)

IRR = 5 + (10-5)*(4.28/(4.28+16.66))
= 6.02 %
Nearest 6.00 %

23. 9 %
Ke = Rf + β(Rm-Rf)
= 5 + 1.5 (4)
= 11 %
Market
value $'m
Share 46
Bond 21.24 =106.2/100*20
67.24

(46 x 0.11) + ( 21.24 x 0.06)

WACC =
67.24
= 9.421% Nearest 9.0%
24. 11 %
Ungear
= (7/(7+1)) x 1.15 = 1.0 Regear = 1.0*((46+21.24)/46) = 1.5
Ke = 5 + 1.5 (4) = 11 %

25. 10 %
Since the company is an all equity financed, the asset beta does not need to be regear.
Ke = 5 + 1.3 (4)
= 10.2
Nearest= 10%

26. A, B, C, D
A- The profitability index is suitable for single period capital rationing
B- Bank restriction is related to external factor which is hard capital rationing factor
C- Projects being divisible is realistic for some projects. Let say the project is an expansion of business on expanding
5 branches. Due to tight in fund, they could open maybe 1-2 branches. Not all situation are unrealistic
D- Soft capital rationing is relate to internal factor while hard capital rationing is due to external factor

27. 15,775
Profitability
Project NPV Investment Investment NPV
index
$’000 $’000
A 4,900 3,200 1.53 3200 4900
B 7,400 9,300 0.80
C 5,900 7,300 0.81
(1400/5600 x 7500)
D 7,500 5,600 1.34 1400 1,875
E 9,000 5,400 1.67 5400 9000
10000 15775

28. A and E

29. 13,900
NPV for project A and E.
= 4,900 + 9,000 = 13,900

30. B
31.
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