Department of Accounting and Finance

M.Sc. Investment and Finance

M.Sc. International Banking and Finance
M.Sc. Economics and Finance
And
M.Sc. Finance and Management
AG917: Topics in Corporate Finance

Monday 27th April 2020 10.30am – 12.30pm (2 hours)

Instructions for Candidates – Please Read Carefully
Answer ALL Questions from Section A and
ONE Question from Section B
ONLINE EXAM INSTRUCTIONS
This is an open book exam
 You are allowed to use notes, lecture materials and books to help you answer the exam questions
 Financial calculators are not allowed.
 You will be required to confirm that by submitting this form and examination answers, you confirm that you are
uploading my own work for this examination.
 The only acceptable format for your answer file is Word or pdf file. Answers submitted in any other file type will
be ignored for marking purposes. If you are using a Mac then it is solely your responsibility to ensure you can
create and save your answer as a Word file or a pdf file. Any case of file corruption associated with saving Mac-
generated files in Word format or pdf format will be ignored for marking purposes and treated as an
unauthorised absence.
 Word/pdf answer files must comply with the following style guidelines:
Font: Calibri                Minimum font size: 12 point              Line spacing: 1.5 lines
 You need to complete the Online Exam Submission Cover Sheet for each examination you are
undertaking, you should have already downloaded this.  Complete this by creating a separate answer
file in Word for each exam. You must apply the following file naming convention:
<Module number>_<last name>_<first name>_<registration number>_<course>.docx
For example, AG914_Smith_Steven_201912345_Acc.docx the corresponding pdf file can then also be
uploaded, for example AG914_Smith_Steven_201912345.Acc.pdf

Abbreviations for each of the course for naming purposes are noted below
Acc – M.Sc. International Accounting and Finance    Fin – M.Sc. Finance
Inv – M.Sc. Investment and Finance                           Bank – M.Sc. International Banking and Finance
F&M – M.Sc. Finance and Management                    FT – M.Sc. Financial Technology
Econ – M.Sc. Economics and Finance                         QF – M.Sc. Quantitative Finance
AS – M.Sc. Actuarial Science
Failure to follow these requirements will lead to a deduction of marks.
To Be Issued: Discount Tables

1 of 8
 Section A
Answer All Questions
Q1. Stark plc has recorded losses over the last three years and has been forced to increase its
borrowing. The board of directors has decided that the company cannot increase its debt-equity
ratio further and it has been decided to raise equity financing. On this basis it has decided to
undertake a rights issue to raise £400 million. The company’s shares are trading at £4.00 and it is
proposed to make the rights issue at a discount of 20 per cent to this price. The company has 500
million shares outstanding before the rights issue.
a) Determine the terms of the issue, the expected ex-rights price of a share, and the value of a
right to purchase one new share.

PS = P0 (1 – d) = £4 (1 – 0.20) = £3.2
ΔN = F/PS = £400m/£3.2= 125m
Term: 125 for 500 → 3 for 12
PX = (500 x £4 + £400)/ (500+125)= £2400/625 = £3.84
V(R) = (PX – PS) = £3.84 - £3.2 = £0.64
(6 marks)
b) Demonstrate that in principle a shareholder, holding 100 shares, will be equally well off from
subscribing to the rights issue, selling rights, or tail swallowing.
Exercise Right
100 shares @ £4 = £400
Exercise Rights 25 shares @ £3.2 = £ 80
Total £480
125 shares @ 3.84 = £480
No change in wealth

Sells Right
100 shares @ £4 = £400
Proceeds from sale 25@ 0.64=16
Total = 416

Value of investment 125@3.84 =480

There is change =64

the value of invest is more than selling right

(7 marks)
c) Rather than issuing shares at a 20% discount, the firm decides to issue at a deep discount of
50% to the current market share price. Estimate the theoretical ex-rights price under the
revised offer terms.
PS = P0 (1 – d) = £4 (1 – 0.5) = £2
ΔN = F/PS = £400m/£2= 200m
Term: 200 for 500 → 4 for 10
PX = (500 x £4 + £400)/ (500+200)= £2400/700 = £3.43
V(R) = (PX – PS) = £3.43 - £2 = £1.43

2 of 8
 (3 marks)
d) Calculate the earnings per share and earnings yield under both a 20% discount and 50%
discount and comment on the view that deep discounted rights offers are unattractive because
they reduce earnings per share. Assume Stark plc generates after tax net income of
£150million per annum.

20% 50%
EAT 150 150
Shares 625 600
EPS 0.23077

(4 marks)
(20 MARKS)

[Please Turn Over]

3 of 8
Q2. The management of Rogers plc is considering borrowing on a long term basis for the first time to
finance a major investment programme. It has been established that it is possible to borrow £100
million at an interest rate of 8 per cent to cover its capital investment needs. Alternatively, it could
issue 200 million shares at the prevailing market price of £0.50 through a private placement. The
market has been kept informed of the company’s investment plans and it is anticipated that such
an issue will leave the share price unchanged. The company currently has 800 million shares
outstanding. The company's expected earnings before interest and taxes for next year, after taking
the expansion of the company's assets into account, has been estimated to be £80 million.
Assuming a corporate tax rate of 40 per cent determine:
a) The expected earnings per share of the company under both forms of financing.

Issue Borrow
EBIT 80 80
Interest - 8
EBT 80 72
Tax 32 28.8
EAT 48 43.2
Shares 1000 800
EPS £0.0.048 £0.054

(4 marks)
b) The level of earnings before interest and taxes at which both financing plans will produce the
same expected earnings per share.

EPS ( U )+ EPS ( G )
X ( 1−t C ) ( X −k i B )( 1−t C )
=
N (U ) N (G)
X∗0 .6 ( 0 .6 X −8∗0 .6 )
=
1000 800
480 X =600 X−4800 )
120 X=4800
X =40

Issue Borrow
EBIT 40 40
Interest - 8
EBT 40 32
Tax 16 12.8
EAT 24 19.2
Shares 1000 800
EPS £0.0.024 £0.024
(4 marks)

4 of 8
 c) Determine the company’s cost of equity capital, assuming that the company issues additional
shares and maintains its established policy of avoiding the use of debt.

VU=(800*0.5+200)=400m+200m=600m
KU = X(1 - tc)/VU = 80m (1 – 0.40)/600m = 0.0.08=8%
(2 marks)
d) Calculate the value of the company if the company employs the debt to finance the company,
and break down this value into its debt and equity components.
VU=(800*0.5+100)=400+100=500m
500/(600+500)=500/900=5/9=0.56
(4 marks)
e) Determine the company’s cost of equity capital and the weighted average cost of capital if the
company employs the debt financing.

KU = X(1 - tc)/VU = 80m (1 – 0.40)/500m = 0.096=9.6%.

(6 marks)
(20 MARKS)

Q3. Banner owns 1000 shares in a company and the company’s shares are trading at £50 per share.
The company has announced that it intends paying a dividend of £2 per share. Banner would
prefer the company to adopt a higher payout so as to receive a dividend of £4 per share. What
action can Banner take to obtain the additional net cash inflow? Demonstrate that Banner will be
just as well off if the company had paid a dividend of £2 per share.

1- When we assume perfect markets and a fall in the price of a share equivalent to the dividend paid.
The current wealth of the investor is 1000 shares @ £50 = £50,000.
2- For the company’s proposed dividend the price will fall by £2 to £48.
3- A dividend of £4 will push the price down to £46.

Evaluation of company’s current policy, augmented by sale of shares

Ex dividend value of share = £40

Dividend income £2 x 1000 = £2,000

Sell 100 shares at £48 = £4,800
Cash inflow = £6,800
Value of remaining shares (900 at £48) = £43,200
Total wealth = £50,000

Evaluation of position if company increases dividend

Ex dividend value of share = £46

Dividend income £4 x 1000 = £4,000

Cash inflow = £4,000
Value of remaining shares (1000 at £46) = £46,000
Total wealth = £50,000

5 of 8
 (6 marks)

Q4. Thor Inc intends to pay a dividend of £5 per share and this would be paid from expected earnings
per share of £10 in year 1. The company has a long-term target payout ratio of 70 percent of
earnings and a speed of adjustment factor of 0.4.
a) Assuming earnings per share of £12, £14, £16, and £20 in years two to five respectively, and
assuming the firm proceeds with the £5 dividend at time one, determine the expected value
of the firm’s dividends in years two to five under the Lintner dividend model.

Year EPS Target Discrepancy Adjustment Dividend

Dividend
0 5
1 10 7 2 0.8 5.8
2 12 8.4 3.4 1.36 7.16
3 14 9.8 4.5 1.8 8.96
4 16 11.2 6.2 2.48 11.44
5 20 14 9 3.6 15.04
(3 marks)
b) If the company continues to earn £20 per share for the long-term future what will the
dividend of the company tend towards?
The dividend will tend towards £14 per share or 70% of £20.

(1 mark)
(4 MARKS)
(TOTAL 50 MARKS)

[Please Turn Over]

6 of 8
 Section B
Answer ONE Question

Q1. A significant weakness of the trade-off model of capital structure is the empirical evidence that
stock prices decline, on average, when a company announces the intention to raise equity
capital through as seasoned equity offering (SEO). Critically evaluate the reasons put forward
for the declining share price surrounding SEO announcements and explain why the empirical
data is inconsistent with the trade-off model.
(Maximum Word Count 750)
(50 MARKS)

Q2. In their work on payout policy, Miller and Modigliani argue that firm value is unrelated to the
level and method of cash payouts to the firm’s investors. Critically evaluate their theory on the
relevance of payout policy and explain how this supports or contradicts traditional valuation
models that express the value of a firm’s shares as the present value of future dividend
payments.

Modigliani - Miller 's theory holds the main theory of the "irrelevant yield" concept. According to
this concept, investors are not interested in dividends, and therefore, when investors value the
company, they do not include dividends in their accounts. This theory is inconsistent with the
theory of "the importance of profits", which considers that profits are important in evaluating
the company.

Modigliani-Miller theory states that whether a company pays dividends or not, investors are
able to obtain their cash outlays from stocks by selling part of their investment to offset the
difference. At the same time, if the investor does not have current cash obligations, he will
always be able to reinvest the profits received in the stock. Thus, Modigliani Miller's theory
explicitly states that the company's dividend policy has no bearing on investment decisions of
investors.

This theory holds has many assumptions, "perfect capital markets" exist. The limitation of this
assumption is that there is tax in capital market paid on both dividend and capital gain. Other
assumptions in this theory are that all investors are rational, and all information can be accessed
for free, there are no floating costs or transactions and no investor controls the market.

All investors are confident that market prices and future profits are confirmed. This means that
the same discount rate applies to all types of shares in all time periods.

According to this theory, there is no difference between internal and external financing. But if
we take into account the costs of the new floating releases, this is not true. This theory holds
that shareholder wealth is not affected by profits. However, there are transaction costs when
shares are sold to obtain cash flows. This makes investors prefer dividends. The assumption of
uncertainty is incorrect, because share dividends are linked in certain circumstances.
 
It is assumed that the investor does not pay attention between the income of the dividends and
the income of the capital gains. This means that if he needs cash flows, his art may get a portion
of it through cash dividends and the second part as income for capital, and in either of the cases
he gets satisfaction.

7 of 8
 When studying M&M theory, we cannot come to the conclusion that their assumptions are
entirely related to the value of the company. Their assumptions are: no taxes, ideal markets, no
transactions or costs, cost bankruptcy, etc. These assumptions show that their ideas you
imagined in a controlled environment cannot be seen anywhere in the real world. Moreover,
these assumptions are still discussed by many economists and finance experts.

(Maximum Word Count 750)

(50 MARKS)

Q3. Firms benefit from a corporate tax shield as they borrow and this creates an incentive to finance
almost 100 per cent of a firm’s total capital through debt. Explain the role of bankruptcy
costs/costs of financial distress and personal taxes to limit the corporate tax benefits of debt.
(Maximum Word Count 750)
(50 MARKS)

Q4. Explain the impact of leverage on a firm’s earnings per share (EPS) and expected return on
equity capital? Does a higher EPS and return on equity imply that shareholder value has
increased? Your discussion should consider the role of both corporate taxes and risk on the
observed relationship.

Leverage is defined as the financial exchange between the return on the issuance of preferred
shares or debts and the cost of holding the stock or debt. In other words, can a company earn
more from its investment than the cost of holding preferred stocks or debts?

(Maximum Word Count 750)

(50 MARKS)

End of Paper

8 of 8