3 Rupab Co is a manufacturing company that wishes to evaluate an investment in new production machinery.

The
machinery would enable the company to satisfy increasing demand for existing products and the investment is not
expected to lead to any change in the existing level of business risk of Rupab Co.
The machinery will cost $2·5 million, payable at the start of the first year of operation, and is not expected to have
any scrap value. Annual before-tax net cash flows of $680,000 per year would be generated by the investment in
each of the five years of its expected operating life. These net cash inflows are before taking account of expected
inflation of 3% per year. Initial investment of $240,000 in working capital would also be required, followed by
incremental annual investment to maintain the purchasing power of working capital.
Rupab Co has in issue five million shares with a market value of $3·81 per share. The equity beta of the company
is 1·2. The yield on short-term government debt is 4·5% per year and the equity risk premium is approximately 5%
per year.
The debt finance of Rupab Co consists of bonds with a total book value of $2 million. These bonds pay annual interest
before tax of 7%. The par value and market value of each bond is $100.
Rupab Co pays taxation one year in arrears at an annual rate of 25%. Capital allowances (tax-allowable depreciation)
on machinery are on a straight-line basis over the life of the asset.

Required:
(a) Calculate the after-tax weighted average cost of capital of Rupab Co. (6 marks)

(b) Prepare a forecast of the annual after-tax cash flows of the investment in nominal terms, and calculate and
comment on its net present value. (8 marks)

(c) Explain how the capital asset pricing model can be used to calculate a project-specific discount rate and
discuss the limitations of using the capital asset pricing model in investment appraisal. (11 marks)

(25 marks)

4
2 Card Co has in issue 8 million shares with an ex dividend market value of $7·16 per share. A dividend of 62 cents
per share for 2013 has just been paid. The pattern of recent dividends is as follows:
Year 2010 2011 2012 2013
Dividends per share (cents) 55·1 57·9 59·1 62·0
Card Co also has in issue 8·5% bonds redeemable in five years’ time with a total nominal value of $5 million. The
market value of each $100 bond is $103·42. Redemption will be at nominal value.
Card Co is planning to invest a significant amount of money into a joint venture in a new business area. It has
identified a proxy company with a similar business risk to the joint venture. The proxy company has an equity beta
of 1·038 and is financed 75% by equity and 25% by debt, on a market value basis.
The current risk-free rate of return is 4% and the average equity risk premium is 5%. Card Co pays profit tax at a rate
of 30% per year and has an equity beta of 1·6.

Required:
(a) Calculate the cost of equity of Card Co using the dividend growth model. (3 marks)

(b) Discuss whether the dividend growth model or the capital asset pricing model should be used to calculate
the cost of equity. (5 marks)

(c) Calculate the weighted average after-tax cost of capital of Card Co using a cost of equity of 12%.
(5 marks)

(d) Calculate a project-specific cost of equity for Card Co for the planned joint venture. (4 marks)

(e) Discuss whether changing the capital structure of a company can lead to a reduction in its cost of capital
and hence to an increase in the value of the company. (8 marks)

(25 marks)

3 [P.T.O.
 The equity risk premium is 5% per year and the risk-free rate of return is 4% per year. BKB Co pays profit tax at an
annual rate of 30% per year.
Required
(a) Calculate the market value after-tax weighted average cost of capital of BKB Co, explaining clearly any
assumptions you make. (12 marks)
(b) Discuss why market value weighted average cost of capital is preferred to book value weighted average cost
of capital when making investment decisions. (4 marks)
(c) Discuss the attractions to a company of convertible debt compared to a bank loan of a similar maturity as a
source of finance. (4 marks)
(Total = 20 marks)

216 Fence Co (6/14, amended) 36 mins

The equity beta of Fence Co is 0.9 and the company has issued 10 million ordinary shares. The market value of each
ordinary share is $7.50. The company is also financed by 7% bonds with a nominal value of $100 per bond, which
will be redeemed in 7 years' time at nominal value. The bonds have a total nominal value of $14m. Interest on the
bonds has just been paid and the current market value of each bond is $107.14.
Fence Co plans to invest in a project which is different to its existing business operations and has identified a
company in the same business area as the project, Hex Co. The equity beta of Hex Co is 1.2 and the company has
an equity market value of $54m. The market value of the debt of Hex Co is $12m.
The risk-free rate of return is 4% per year and the average return on the stock market is 11% per year. Both
companies pay corporation tax at a rate of 20% per year.
Required
(a) Calculate the current weighted average cost of capital of Fence Co. (7 marks)
(b) Calculate a cost of equity which could be used in appraising the new project. (4 marks)
(c) Explain the difference between systematic and unsystematic risk in relation to portfolio theory and the capital
asset pricing model. (4 marks)
(d) Explain the limitations of the capital asset pricing model. (5 marks)
(Total = 20 marks)

74 Questions BPP Tutor Toolkit Copy

Required
(a) Evaluate the effect on the wealth of the shareholders of Grenarp Co of using the net rights issue funds to
redeem the loan notes. (8 marks)
(b) Discuss whether Grenarp Co might achieve its optimal capital structure following the rights issue. (7 marks)
(c) Discuss THREE sources and characteristics of long-term debt finance which may be available to Grenarp Co.
(5 marks)
(Total = 20 marks)

219 Dinla Co (Mar/Jun 16, amended) 36 mins

Dinla Co has the following capital structure.
$'000 $'000
Equity and reserves
Ordinary shares 23,000
Reserves 247,000
270,000
Non-current liabilities
5% preference shares 5,000
6% loan notes 11,000
Bank loan 3,000
19,000
289,000

The ordinary shares of Dinla Co are currently trading at $4.26 per share on an ex dividend basis and have a nominal
value of $0.25 per share. Ordinary dividends are expected to grow in the future by 4% per year and a dividend of
$0.25 per share has just been paid.
The 5% preference shares have an ex dividend market value of $0.56 per share and a nominal value of $1.00 per
share. These shares are irredeemable.
The 6% loan notes of Dinla Co are currently trading at $95.45 per loan note on an ex interest basis and will be
redeemed at their nominal value of $100 per loan note in 5 years' time.
The bank loan has a fixed interest rate of 7% per year.
Dinla Co pays corporation tax at a rate of 25%.
Required
(a) Calculate the after-tax weighted average cost of capital of Dinla Co on a market value basis. (8 marks)
(b) Discuss the connection between the relative costs of sources of finance and the creditor hierarchy.
(3 marks)
(c) Discuss the circumstances under which the current weighted average cost of capital of a company could be
used in investment appraisal and indicate briefly how its limitations as a discount rate could be overcome.
(5 marks)
(d) Explain the differences between Islamic finance and other conventional finance. (4 marks)
(Total = 20 marks)

Questions 75
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