3.business Plan Divident and Grought AB

ANSWER BANK
Business plans, dividends and growth
41 Newton Pearce Ltd

(a) Finance to be raised CU
New assets 950,000
Reduction in overdraft (2,240 – 2,000) 240,000
Reduction in payables (2,870,000 × 10/45) 637,777
1,827,777
(b) (i)
Rights issue Debenture issue
Earnings per share (CU420,700/3,434,014) CU0.123
CU0.136
(CU267,167/1,960,000)
CU CU
Sales 34,500,000 34,500,000
Net margin (CU28.5m × 3%) 855,000 855,000
(CU6m × 5%) 300,000 300,000
1,155,000 1,155,000
Interest Current debentures (8% × CU2,550) 204,000 204,000
New debentures (12% × CU1,827,777) 0 219,333
Bank overdraft (CU2m × 17.5%) 350,000 350,000
(554,000) (773,333)
Profit before taxation 601,000 381,667
Taxation (30%) (180,300) (114,500)
Profit after tax/Earnings 420,700 267,167
WORKING 1
Rights issue (CU1,827,777/[CU1.55 – 20%]) 1,474,014 shares
Plus existing shares (CU980,000/CU0.50) 1,960,000 shares
Total 3,434,014 shares
(b) (ii)
Gearing % (see Working 2) (CU2,550,000/CU7,560, 33.7% 58.5%
777)
(CU4,377,777/CU7,480,
944)
WORKING 2
Profit after tax/earnings (part (a)) 420,700 267,167
Dividends Existing shares (5p × (980/CU0.50)) (98,000) (98,000)
New shares (5p × 1,474,014) (73,700) 0
Retained profit 249,000 169,167

Total long term funds at 31/12/X6 CU5,484,000 CU5,484,000
Plus: New long term funds raised 20X7 1,827,777 1,827,777
Plus: Retained profit 20X7 249,000 169,167
Total long term funds at 31/12/X7 CU7,560,777 CU7,480,944
Total geared funds at 31/12/X7 CU2,550,000 CU4,377,777

(CU2,550,000 + CU1,827,777)
© The Institute of Chartered Accountants in England and Wales, March 2009 177
Note: an alternative calculation in this gearing calculation, i.e. using the nominal value of the new
debentures issued (CU2,193,332 – see below), would not have been penalised.
10% Debenture issue (CU1,827,777  12%/10%) = CU2,193,332 nominal value
(c) NP's current earnings per share figure is 9.25 pence. This is significantly lower than both of the
forecast earnings per share figures for the forthcoming year.
The debentures issue will lead to a higher earnings per share figure for shareholders than the rights
issue of shares.
Debenture issue: the risks associated with this issue are greater than those associated with the rights
issue. The level of gearing under the debenture issue option might be considered far too high in
relation to the expected returns. The interest cover ratio under this option of 1.49
(CU1,155,000/773,333) is also low. From the company viewpoint, the level of interest payments under
this option will prove a burden unless profits can be maintained at a high level.
Do the existing debenture holders have any collateral, e.g. on the company's non-current assets? Will
the new debenture holders expect something similar? Is there potential conflict here? Is there
sufficient security for these borrowings – the current book value of the assets is only CU3,518,000
(plus new assets of CU950,000). What is the market value of the non-current assets?
Rights issue: although the EPS is less than for the debenture issue, it will be higher than in 20X6. The
level of gearing is much lower than under the debenture issue option. Also it gives a lower level of
gearing than the current one. The interest cover ratio of 2.08 is higher than that for the debenture
issue. Shareholders may find it difficult to raise the required finance to subscribe to the issue because
the rights issue equates to 75% (1,474,014/1,960,000) of the existing shares in issue. This may limit the
potential success of the issue.
(d) Working capital typically comprises inventories, trade receivables, bank/cash and trade payables.
Contrary to management's view, NP's expansion into northern England and Scotland is likely to affect
its level of working capital required as follows:
It would be prudent to carry sufficient additional inventory to avoid the embarrassment of a 'stock out'
(which could cause a loss of customers in the future). With inventory, NP must strike a balance
between the costs of 'stock outs', ordering costs and holding costs.
To encourage potential new customers in northern England and Scotland to buy its products, NP
would be unwise not to offer credit terms on its 'new' sales – thus the level of trade receivables will
increase.
In contrast NP should continue with its policy of purchasing goods on credit and, once the ten day
adjustment has been made to the creditors' payment period, the expansion of trade means that the
level of trade payables will increase, which will reduce NP's working capital investment.
Marking guide
Marks
(a) Calculation 1
(b) (i) Calculation: 1 mark per line max 7
(ii) Calculation: 1 mark per line max 5
(c) 1 mark per paragraph max 5
(d) 1 mark per paragraph max 4
22
178 © The Institute of Chartered Accountants in England and Wales, March 2009
ANSWER BANK
42 Wentworth Ltd
(a) The potential reasons are as follows.
(1) The existence of limited investment opportunities due, for example, to the maturity of existing
product lines or a downturn in the market for the company's goods or services
(2) Traditionally strong cash flows generated by the business
(3) To signal confidence in the future of the company, thereby raising the company's stock market
rating (and facilitating future financing) as well as impacting positively on the share price
(4) The knowledge that an actual or potential shareholder clientele prefers a high dividend payout
policy
(5) As a discipline on their managers (thereby addressing the classic agency problem), who will more
often have to seek out funds from the market to fund investment and, therefore, be called upon
to justify proposals to potential investors, rather than simply being able to rely on the use of
internally generated funds
(6) The 'bird in the hand' theory – the company may be persuaded that the market will value more
highly a firm that pays dividends and issues shares to finance a new investment, than one that uses
retentions
(b) This refers to the theory of dividend policy irrelevance, first developed by Modigliani and Miller (M&M)
in 1961. They showed the irrelevance of dividends in a world without taxes, transaction costs or other
market imperfections. M&M showed that if a company has a set investment and borrowing policy, the
source of equity finance (retained earnings or new issues of equity) had no impact on shareholder
wealth – the gain or loss to existing shareholders is the same whether a reduction in dividend
(retained earnings) or a new issue of shares was used to finance an investment. Therefore, the
dividend decision was irrelevant. In other words, if a change in dividend policy leaves the present value
of future dividends unchanged, then that policy must be irrelevant. It does not matter when the
dividends occur, provided that their present value is maximised.
(c) In practice there are a number of reasons why those directors who feel that dividend policy is not an
irrelevance may have a point. The practical risks involved in changing an established dividend policy
comprise:
(1) It is argued that companies attract a clientele of investors who favour their current dividend
policy for tax, cash flow and other reasons. Any change in policy could cause this clientele to
dispose of their shares, in turn causing the share price to fall.
(2) Dividends resolve uncertainty, such that investors may prefer high payout policies, as they regard
future capital gains as uncertain. If investors are rational they will perceive future dividends and
gains to be equally risky, but evidence suggests they tend not to be fully rational, preferring a
current dividend to a cut and the promise of future increased dividends.
(3) Similarly, in the absence of perfect information, dividends will be used as information signals by
shareholders of future earnings and dividends. In the short term, a share price might fall as a
result of a dividend cut to finance an investment, since investors might have incomplete
information regarding the new investment and may consequently revise downwards their future
dividend expectations. This may also affect the firm's cost of capital.
(4) Any change in dividend policy may adversely affect either investors (e.g. tax) or the firm (e.g.
share price fall).
(d) Shareholders who are faced with a dividend cut which is not their preference can 'manufacture' a
dividend by selling shares or conversely, can purchase shares out of dividend income to cancel out, to
a certain extent, the effect of the dividend.
The company could use the option of a scrip dividend, where shares are issued as dividend rather than
cash. This would enable the company to maintain its current level of dividend whilst conserving
liquidity, although the extent to which this might be achieved would depend on the precise terms of
the scrip dividend on offer. A scrip dividend can either be in one of two 'normal' forms 1) for example,
a 1 for 10 scrip dividend in place of the usual cash dividend – this would maximise liquidity
preservation; or 2) a choice between cash or scrip dividend – which would conserve liquidity only to
the extent that shareholders opt for the scrip dividend; or it can be undertaken in its 'enhanced' form,
where a choice would be given between a cash dividend and an enhanced scrip dividend, to encourage
uptake of the scrip option and therefore encourage liquidity preservation.
This strategy, therefore, would, to some extent, address both the risks inherent in an absolute change
(cash reduction) in dividend policy, whilst maintaining the actual level of the dividend and preserving
liquidity.
Lesser credit was also given for suggestions to pass or reduce the dividend (or to adopt a residual
dividend policy that would lead to either of these options), accompanied by clear communication to
the market of the reasons behind the decision.
Marking guide
Marks
(a) 1 mark per reason max 5

(b) 1 mark per point max 6
(c) 1½ marks per paragraph max 6
(d) 1½ marks per paragraph max 5
22
43 Krenn Ltd
Notes for the directors regarding a decision on a cash surplus
Director A
This business seems not to be in a growth phase: there seems to be no growth in sales. It seems to be in a
maturity phase. There is a danger that it may slip into a decline phase if something is not done to innovate.
Past experience may have been unsuccessful, but a change in consumer tastes or the entry of a competitor
could be disastrous.
Putting the cash in the bank is not using it more effectively, in terms of wealth generation, than the
shareholders could do for themselves, given the level of risk. This puts the cash on the margin for returning
to the shareholders.
The shareholders do not wish, presumably, to have their funds invested in such a low risk asset as a bank
deposit account. If so, they would have kept their funds and invested for themselves.
This director's comments may arise from a desire to have a relatively risk-free investment that would
protect the directors' position. This could be an example of an agency cost to the shareholders, with the
best interests of the shareholders conflicting with those of the directors.
Director B
It is true that a cash mountain could be a reason for a takeover attempt. A predator could see this as a way
to pick up some liquid resources cheaply.
Cancelling shares would affect the gearing ratio by increasing it. Both the traditional view of gearing and the
post-tax Modigliani and Miller position (and taking 'bankruptcy' cost into account) conclude that there is an
optimum gearing ratio. Whether such a reduction in gearing would be beneficial or detrimental depends on
the company's position relative to this optimum.
The gearing change could be seen, however, as moving back towards the position before the cash started to
build up. Having cash on interest-yielding deposit can be seen as negating the equivalent amount of gearing.
ANSWER BANK
This is because the deposit provides a fairly steady stream of income that would roughly match the servicing
of the equivalent amount of debt finance.
Altering the gearing ratio may cause some existing shareholders to want to sell their shares and reinvest
elsewhere in investments that they feel more comfortable (the 'clientele' effect). This could lead to net
reductions in shareholders' wealth.
It is argued that cancelling shares increases the share price because it lessens supply. However, this seems a
dubious conclusion in the context of capital market efficiency. Even if this were true, the effect of a shift in
gearing may well have an effect on share price.
Again, there may be an agency problem. A takeover may possibly increase the shareholders' wealth. It may
very well have an adverse effect on the directors' welfare.
Director C
This is a possibility but it would have a significant effect on gearing. All of the points made on gearing with
reference to Director B's comments apply here.
Director D
A large dividend is not necessarily the answer. According to Modigliani and Miller, dividend policy does not
in theory affect shareholders' wealth. In practice issues like tax and dealing charges are likely to have an
effect.
There appears to be a 'clientele' effect with dividend policy. Shareholders moving from one company to
another will cause wealth losses.
Thus a sudden change in dividend policy may well not improve market sentiment towards the company.
Though in theory it is always open to shareholders to negate dividends through reinvesting the proceeds in
shares, this action normally has costs attached.
Again, there could be an agency issue here, with the objective of the director to avoid a takeover.
Marking guide
Marks
Director A: 1 mark per point max 5

Director B: 1 mark per point max 5
Director C: 1 mark per point max 1
Director D: 1 mark per point max 5
16
44 Duofold Ltd
(a) Mr Jones' options
Ex-rights price of the company's ordinary shares
(10m  CU1.80)  CU5m  CU2m
= CU1.6666
10m  5m
He could reasonably sell his rights for CU1.6666 – CU1.00 = 66.66p
Option 1: Take up his rights
CU
Wealth prior to the rights issue = 2,000  CU1.80 3,600.00
Wealth post the rights issue = 3,000  1.6666 4,999.80
Less Cost of rights issue = 1,000  1.00 (1,000.00)
3,999.80
He is therefore CU399.80 better off as a result of taking up his rights.
Option 2: Sell his rights for 66.66p
CU
Wealth prior to the rights issue = 2,000  CU1.80 3,600.00
Wealth post the rights issue = 2,000  CU1.6666 3,333.20
Plus Proceeds of sale of rights = 1,000  66.66p 666.60
3,999.80
He is therefore CU399.80 better off as a result of selling his rights.
Option 3: Do nothing
CU
Wealth prior to the rights issue = 2,000  CU1,80 3,600.00
Wealth post the rights issue = 2,000  CU1.6666 3,333.20
He is therefore CU266.80 worse off as a result of doing nothing.

(b) Maximum price
The maximum that should be paid for the competitor is as follows.
CU6.8m
Value of Duofold Ltd and target combined = 68m
0.10
CU4.2m
Value of Duofold Ltd on its own = 35m
0.12
So the maximum that Duofold Ltd should pay is CU33m.
The usual justifications for an acquisition are as follows.
(1) Synergy (from issues such as administrative savings, economies of scale, shared investment, leaner
management structures and access to under-utilised assets).
(2) Risk reduction (reflected in reduced WACC).
(3) Reduction in or elimination of competition (as well as market access).
(4) Vertical protection (via acquisition of a supplier, distributor or customer).
(5) Increased shareholder wealth arising from any of the above.
ANSWER BANK
(c) Dividend policy

Dividend policy irrelevance is as follows.
 Modigliani and Miller (M&M) (1961) showed that dividends are irrelevant in a world without
taxes, transaction costs or other market imperfections.
 M&M showed that the dividend decision is irrelevant, since financing a project by either paying a
dividend and issuing shares or not paying a dividend has the same impact on shareholder wealth.
 Although the dividend decision was shown to be irrelevant, dividends themselves were not
considered irrelevant – the view is simply that if a change in dividend policy leaves the present
value of future dividends unchanged, then the dividend policy must be irrelevant.
 If a shareholder prefers income to capital gains they can 'manufacture' dividends by selling shares
with no loss of wealth (M&M).
 However, M&M's argument depends on a perfect capital market, and once the assumptions are
relaxed it can be shown that in the real world dividend policy is relevant due to the following.
(1) Transaction costs (that will reduce shareholder wealth in 'manufacturing' dividends).
(2) Taxation (which may lead to a preference on the part of individual investors for income or
capital gains).
(3) Dividends acting as information signals (in the absence of perfect information, i.e.
shareholders may not be aware of a particular positive NPV project).
(4) Dividends being (irrationally) perceived as resolving uncertainty (future capital gains are
viewed as uncertain).
(5) Dividends having a clientele effect (attracting investors who favour a particular dividend
policy for tax, cash flow or other reasons).
Marking guide
Marks
(a) Ex-rights price 1
Price to sell rights 1
Option 1 1½
Option 2 1½
Option 3 1½
Mmaxx 6
(b) Value combined 1
Value alone 1
Conclusion 1
Justifications 2
5
(c) 1 mark per point 4
M&M assumptions 2
6
17
45 Portico Ltd
Notes on dividend policy for a company in Portico's position
In theory, companies should make all investments available to them that increase shareholder value (i.e. all
positive NPV investments, when discounted at the shareholders' opportunity cost of capital). Any funds
remaining after undertaking such investments should be distributed to shareholders as dividends so that the
shareholders can invest them as they see fit. The dividend decision is, therefore, a residual decision. As a
company's share price is the PV of its future dividends, shareholders should be indifferent about how the PV
is made up (i.e. the size of each year's dividend).
One point of view is that individual shareholders who dislike a particular dividend policy can adjust the cash
flows to suit their own needs. They can do this by 'creating' dividends through the sale of shares or
conversely they can buy more shares to cancel the effect of dividends. One drawback to this strategy,
however, is the question of transaction costs in the real world.
However, in practice, Portico's dividend policy will be affected by a number of other issues than purely its
own investment policy.
Dividend signalling. In reality, shareholders do not have perfect information concerning the future
prospects of the company, so the pattern of dividend payments actually functions as a key indicator of likely
future performance (increased dividends is taken as a signal of confidence which causes estimates of future
earnings to increase, so increasing the share price, and vice versa). This supports the argument for the
relevance of dividend policy and the need for a stable (and increasing) dividend pay-out.
Preference for current income (as displayed by certain of the private shareholders referred to by
Director B). This implies that many shareholders will prefer companies which pay regular dividends and will,
therefore, value their shares more highly.
Clientele effect. Investors may be attracted to firms by their dividend policy, for example, because it suits
their particular tax position. Major changes in dividend policy may well upset particular clienteles who may
then sell their shares, so pushing down the share price. While this may be off-set by other clienteles buying
the shares and boosting the share price, the climate of uncertainty concerning long-term dividend policy
often depresses the share price.
Cash. Shortage of cash can affect dividend policy, although money may be borrowed to fund a dividend
payment to avoid negative signalling effects. In summary, companies should establish a dividend policy which
is stable, which sets a stable, rising dividend per share, and which sets the dividend at a level below
anticipated earnings to provide for new investment (avoiding the need for new share issues) and to provide
a cushion if an unexpected fall in earnings is experienced. Excess earnings over investment needs and
normal dividends can be returned to shareholders via a special dividend or used to repurchase the firm's
shares.
Director A's comments reflect the dividend valuation model but overlook the issues of both the funds
available to a company and the investment calls on the company in any given year. Furthermore, Modigliani
and Miller showed that, in the absence of taxes and transaction costs, dividends are irrelevant to the value
of a company. In principle, it does not matter when dividends occur, provided that their PV is maximised.
Furthermore, transaction costs somewhat undermine the director's comments on raising new finance.
Director B's comments are illustrative of the clientele effect as discussed above.
Addressing the issue of differing shareholder preferences
The way in which a company will try to address the issue of differing preferences of different groups of
shareholders depends on the current mix of shareholders (which the company must remain aware of at all
times), what other similar companies do, and the effect that changes in dividend payout have had on the
share prices of similar companies in the past. It is vital that the company makes clear to shareholders what
its long-term dividend policy is, why any changes in dividend policy are being made and what the likely effect
will be on shareholder value of any future proposed investments.
In reality, the aspirations of the new management team may mitigate against the family shareholders' desire
for dividend payments as required and so the only way ahead is to communicate a planned, long-term
dividend policy even if this means driving away those family shareholders.
The relationship between a company's dividend policy and the 'agency problem'
This is apparent in the way that managers/directors do not necessarily act in the best interests of
shareholders. Shareholders may seek to keep some control over their money by insisting on high pay-out
ratios (in line with Director A's comments), thereby forcing managers/directors wanting new funds for
investment to justify why the investment is sound. However, there is an agency cost here in the form of the
cost of the new share issue.
Managers/directors may, therefore, be motivated to adopt a low dividend pay-out policy which circumvents
this need to justify projects by creating retained earnings which can be used to fund new projects. Even if
they do this, however, there may still be an agency cost for shareholders in that managers may invest in
ANSWER BANK
empire building projects rather than in those that maximise shareholder wealth. In addition, an over-
reliance on retentions can lead to dividend cuts which upset shareholders, depress the share price and
increase the cost of equity.
Marking guide
Marks
General points 4
Dividend policy factors 5
Director comments 3
Different preferences 3
Agency problem 3
Maximum 18
Total available 16
46 Biojack Ltd
(a) Estimation of the new dividend
CU0.13
Current share price = + CU0.13 = CU1.31
0.11
The new dividend (d) is given by
d ÷ 0.14
CU1.31 =
1+ 0.14
d = 1.31 × 1.14 × 0.14 = CU0.2091, say 21 pence

(b) Discussion of the practical effects on the share price
The analysis in (a) assumes that the assertions of Modigliani and Miller (M&M) hold true. M&M argued
that share valuation is entirely dependent on the amount, timing and perceived riskiness of future
dividends. Changing the pattern of dividends, as in the Biojack Ltd case, will not affect shareholders'
wealth. M&M made the following assumptions in reaching this conclusion.
 Frictionless capital markets
 Efficient capital markets
 Companies can issue shares without cost or restriction
 No taxes on income or capital gains for companies or individuals.
This could be a situation where shareholders might choose to create 'home-made' dividends to ease
possible cash flow problems.
The issues likely to cause the new share price not to equal CU1.31 include the following.
 Informational content of dividends. It is believed that the failure to pay a dividend could cause
shareholders' perceptions of the future to alter.
Clientele effect. This company is planning to change its pattern of dividends. This may well not
appeal to existing investors, who may react by selling their shares. The lack of appeal may stem
from the shareholders' tax position or from their need for cash. Efficient market evidence
suggests that the market will correctly value the new situation, but there will be losses of value as
a result of the change in ownership of some of the shares.
The change in the risk profile of the company's returns could also cause a clientele effect.
 A disbelief that there will be a constant level of dividend in the future. In real life such constancy
would be unusual.
Marking guide
Marks
(a) Current share price 2

New dividend 3
5
(b) M&M assumptions 4
Relevant factors 5
9
14
47 Safeway Ltd
(a) Organic growth v acquisition
Organic growth normally means relatively slow growth, financed by profits and limited amounts of
borrowing.
A business such as Morrisons remains firmly in control of the growth process as a result of such a
strategy and is not dependent on lenders.
The main risk of such a strategy is that slow growth may mean losing out to competitors in the market
place.
Growth by acquisition means buying businesses to expand group revenue.
Often this means raising or borrowing money to finance growth.
This carries the risk of dependence on borrowers or on shareholders' expectations of prompt
returns.
Wal-Mart is exceptional in generating funds to finance its own acquisition programme.
There is a risk that acquired businesses may take time and management time and effort to assimilate.
(b) Financial and operational gearing
Financial gearing is the relationship between borrowed money and shareholders' funds.
It may be represented as
Debt
Debt  Equity
Operational gearing is the relationship between fixed costs and variable costs.
Sainsbury's would need to borrow money to buy Safeway. This would represent an increase in its
financial gearing.
Sainsbury's would acquire fixed costs (for the Safeway supermarkets) and variable costs (to pay the
people to run the ex-Safeway supermarkets and to buy the products to be sold in them).
Sainsbury's sale of stores and closure of Safeway head office would reduce fixed costs and borrowings.
It would also reduce variable costs.
ANSWER BANK
(c) Stakeholders
Shareholders
Immediate 'cash' from Wal-Mart, Sainsbury's
but loss of flow of income
Shares from Morrisons offer continuing interest in business and/or sector
but there is a risk of poor performance, especially in the period of assimilation
Employees
A takeover risks redundancies for some
but it may provide secure long-term future
Customers
Safeway customers may lose their favoured brands
but they will have the convenience of their 'local supermarket' continuing
Suppliers
Some may not continue as suppliers.
Suppliers who continue may be expected to reduce prices
but continuing suppliers will have the prospects of bigger volumes and bigger overall profits
Lenders
With the Sainsbury's offer existing lenders might be concerned with the increase in debt
A larger and more diversified company is likely to meet interest payments more easily
Professional advisers and banks
Will expect increased income as a result of any takeover activity
Marking guide
Marks
(a) 1 mark per point 4

(b) 1 mark per point 4
(c) 1 mark per point 8
16
48 Sunnydaze Ltd
(a) Evaluation of the offer price
Year 20X1 20X2 20X3 20X4
CUm CUm CUm CUm
Tents etc (1.000)
Tax depreciation (W1) 0.075 0.056 0.169
Operating cash flows (W2) 0.633 0.652 0.672
Tax thereon (0.190) (0.196) (0.202)
Working capital (W3) (0.126) (0.003) (0.004) 0.133
(1.126) 0.515 0.508 0.772
Discount factors (W4) 1.0000 0.8669 0.7514 0.6514
Discounted values (1.126) 0.446 0.382 0.503
Net present value = CU0.205m
The price that Sunnydaze would ask is CU205,000.
WORKINGS
(1) Tax depreciation
Year CUm CUm
20X2 Cost 1.000
TDA (0.250) @ 30% 0.075
0.750
20X3 TDA (0.188) @ 30% 0.056
0.562
20X4 Disposal –
Balancing allowance 0.562 @ 30% 0.169
(2) Operating cash flows
Real terms sales =(CU1.000m ×0.2) +(CU1.200m ×0.5) +(CU1.400m ×0.3)
= CU1.220m
Money (or nominal) operating profits
CUm
20X2 [(CU1.220m  0.75) – CU0.300]  (1.03) 0.633
20X3 [(CU1.220m  0.75) – CU0.300]  (1.03)2 0.652
20X4 [(CU1.220m  0.75) – CU0.300]  (1.03)3 0.672
(3) Working capital
Increment Cumulative
At 31 December CUm CUm
20X1 (CU1.220  1.03)  10% (0.126) (0.126)
20X2 [(CU1.220  1.032)  10%] – 0.126 (0.003) (0.129)
20X3 [(CU1.220  1.033)  10%] – 0.129 (0.004) (0.133)
20X4 0.133 zero
(4) Discount factors
20X2 1[(1 + 0.12) (1 + 0.03)] = 0.8669
20X3 1[(1 + 0.12) (1 + 0.03)]2 = 0.7514
20X4 1[(1 + 0.12) (1 + 0.03)]3 = 0.6514
ANSWER BANK
(b) Justification of the PV approach to valuation

Using the NPV of the future projected cash flows to evaluate an investment is the only truly logical
approach. The financing cost is accounted for and risk can be incorporated in the discount rate.
Any economic asset only has a value because it is believed capable of producing net positive cash flows
in the future. Logically its value should depend on the magnitude of those cash flows, their riskiness
and the cost of financing them until they materialise.
Discounting appropriately takes account of the fact that chronologically more distant cash flows are
less valuable, CU for CU, than nearer flows.
(c) Further issues for the buy-out team
Generally the offer price looks generous to the buy-out team, because of the short timescale of the
projected cash flows. The team presumably believes that the Bienvenue business can continue much
further into the future, possibly with higher levels of operating profits than it has experienced in the
past ten years.
The directors' scepticism about Bienvenue could well have led to the division being overlooked and
left to stagnate. As a separate business with committed managers, this could very well breathe life into
it.
The tax rate of the new independent Bienvenue business may well be less than 30% (Sunnydaze's rate),
which means that the effective value of the cash flows will be greater.
Though correct under the valuation formula, Bienvenue's share of head office costs was ignored
(because it would not represent a saving to Sunnydaze); this would be a cost to Bienvenue. Presumably
head office provided Bienvenue with services (perhaps accounting, personnel etc) that Bienvenue
would now have to provide. The valuation method therefore overvalues the division, from the team's
perspective, in this regard.
Sunnydaze's cost of capital may well not be the same for Bienvenue. Though it is not possible to know
without further information, it seems reasonable to speculate that the latter's cost of capital would be
higher. Larger organisations tend to be able to raise cheaper finance than smaller. Moreover, if
Bienvenue's tax rate is lower than that of Sunnydaze, the interest on any loan finance would be
relieved at a lower rate.
The buy-out team needs to get a finance professional to look at the figures to assess the
reasonableness.
The team must logically look at the cost of setting up a similar operation from scratch, bearing in mind
any goodwill value of the Bienvenue name and that Bienvenue could well stay on as a competitor. If
this looks cheaper than the buy-out, the buy-out should probably not go ahead.
The team needs to realise that unless it intends to proceed after the buy-out, in a different manner to
that projected by Sunnydaze, it will need to raise not only the funds determined in (a), but enough for
new tents and working capital. This totals about CU1.33 million.
If the team wishes to proceed, it will have to raise the necessary cash. It may be able to find the funds
from its own resources. It may be able to get Sunnydaze to accept instalments, with interest at an
agreed rate on the outstanding balances.
A firm of chartered accountants or other professional accountants might be able to offer funding and
other advice or provide a link to someone who can do so. A high street bank might also be able to
help.
Venture capital might be a possibility, but venture capitalists tend to take equity interests and need an
exit route. This could come from selling the business off in a few years to another company or, if it is
very successful, through a flotation on a stock market.
A bank might be prepared to advance a term loan, but it would almost certainly want security. There
is no mention that any of Bienvenue's assets include items which banks tend to favour as security. The
only tangible asset of the new Bienvenue will probably be its tents. These are quickly depreciating and
located in France. This may not be seen as suitable security for a bank, whether in the BANGLADESH
or in France. The personal assets (e.g. houses) of the buy-out team might provide some or all of the
security.
Leasing or hire-purchasing the tents could be possibilities.
A business angel could be another possibility.
Marking guide
Marks
(a) Tax depreciation (W1) 3½

Operating cash flows (W2) 5½
Tax 1
Working capital (W3) 2½
Discount factors 2½
NPV 1
Price to ask 1
17
(b) 1 – 2 marks per paragraph 4
(c) 1 – 2 marks per paragraph 8
29
49 Tinkler's Stores Ltd

REPORT
To: The Tinkler Family
From: An Accountant
Date: Today
Subject: Financial strategies under consideration
I have outlined below the merits and risks involved with the financial strategies that you are considering.
Option 1: CU1 million borrowing to finance the development of key departments
This option could be said to represent (further) organic growth by the company, that is to say the funding
of internally-generated projects.
The merits of this strategy would be that
 The company and the family keep control of the business
 The costs of the project are spread over time
 The rate of change with the business is likely to be slower than under other options.
The main risks would be
 The risk that the project does not succeed (the 'strategy' seems to be a defensive one – what the
company can afford rather than a clear strategy to differentiate the business)
 The process may be too slow and tentative for the company to survive
 The lenders are likely to want a relatively high rate of interest, given the company's current gearing
level, bank overdraft and net current assets at zero – although the land and buildings would seem to
provide good security.
ANSWER BANK
Option 2: Sell to a rival

This option may be said to represent the disposal (or possibly acquisition) option.
The main merit of this option would be that the risks of investing in the business would be removed.
Similarly, the concentration of risk in one entity could be replaced by investment in a more balanced
portfolio.
The main risk would be that the price being offered could be deemed to be too low. (The land and buildings
are said to be worth CU20 million and the net assets are worth CU14m (CU20m – [CU5m + CU1m]). An offer of
more than CU10 million from the rival would be necessary.)
It could be deemed a risk of the offer that it is an offer of shares in the rival rather than 'cash'.
This offer has the advantage of a degree of certainty (despite the possible change in share value). The rival is
well established; this should reduce risk.
The shareholders might incur capital gains tax upon disposal of the shares.
The timing of payment (in six months' time) is likely to be at least as good as the other offers.
Option 3: Management buy-out
This is the management buy-out (MBO) option.
The main merit of this financial strategy is that it is a cheaper alternative to a close down.
Management should be familiar with the business, paying a reasonable price and having a good chance of
success.
The main risks are likely to be that
 There is no guarantee of success
 It is often difficult for MBO teams to immediately finance for a full buy-out
 Management may be concentrating on the buy-out rather than increasing current profits for the
business
 Successful MBOs can lead to big gains for management – on which the previous shareholders will have
lost out.
In this particular case, the Tinkler family would be at risk to the extent of CU5 million until the second
instalment of the consideration were paid and have no control over the operations of the business during
this period.
Again, the price of CU10 million may be deemed to be too low – the net assets are worth CU14m.
Option 4: Closing the business
Closing the business represents the liquidation option. The main merit of this approach is that it allows the
assets of the business to be converted into cash before there are (financial) losses and value is lost to
shareholders.
The main risks are that the assets fail to realise the expected values and/or costs are greater than expected.
It appears that liquidation might not be attractive an option for Tinkler.
CUm
Land and buildings at market value 20
Less Closure costs (5)
Net 15
Less Bank overdraft and long-term loans (6)
Realisable 9
This compares with CU10 million offered by the rival and by the MBO.
Marking guide
Marks
Report format 1
Option 1: I mark per point max 3
Maximum 14
Total available 12
50 Bill Jackson Haulage Ltd

(a) REPORT
To: Paul Jackson, Chief Executive of Bill Jackson Haulage Ltd (BJH)
From: J Gray, Black, White and Gray, Chartered Accountants
Date: 13 June 20X2
Subject: Financing the purchase of the company's site
Terms of reference
To advise on possible sources of finance for the purchase of the freehold of the company's site
General points
Before proceeding with plans to purchase the site the directors must be confident that purchasing the
current site represents the best prospect. Moving to an alternative site, whether leased or bought,
may provide an economically preferable option. If such a site exists, a net present value assessment
should be made of the options.
Irrespective of other sites the directors must be confident that purchase of the site at the price
expected represents an economically viable prospect. In simple terms, can BJH afford this site, given
the use to which it will be put?
Financing
General points
Broadly, financing sources fall into two categories; equity and debt. A question arises about the extent
to use debt, which tends to be (or appears to be) cheaper. For most businesses, debt is relatively
cheap because interest payments attract tax relief. It also seems cheaper because interest rates tend
to be lower than the level of returns expected by shareholders. This is because lenders' returns are
less risky than those of shareholders.
Ignoring tax for a moment, as soon as a business starts to borrow (has capital gearing) the returns of
shareholders become more risky because they have the additional burden of legally enforceable
interest payments. It has been shown that the net effect on the shareholders of borrowing is zero.
Debt is cheaper but this benefit is precisely countered by the higher returns expected by shareholders
because of the additional risk.
Thus tax is the only reason that debt is cheaper. This is significant because it represents a 30%
discount on the cost of debt. From this it might appear that businesses should raise all or almost all of
their finance from borrowing. This is not practical for one main reason: there is the danger that the
business would not be able to meet its interest or loan redemption obligations, leading to the loan
creditors forcing it into liquidation (bankruptcy). This can be very costly to the shareholders because it
ANSWER BANK
tends to lead to assets being sold off for much less than they are worth to the shareholders on a 'going
concern' basis.
Thus a balance needs to be struck between taking advantage of tax relief and avoiding the costs of
bankruptcy. Where this balance lies is very difficult to say and, in practice, a matter of managerial
judgement.
Factors that tend to be involved include the following.
 Whether the business has sufficient profits to take advantage of tax relief on interest payments –
not a problem with BJH
 Whether the business can provide security, normally in the form of suitable assets – probably not
a problem for BJH with the lorries and the land itself
 The type of assets that the business owns – if they tend to have relatively high realisable values,
bankruptcy cost would be less
 The extent to which revenues fluctuate – high gearing is not consistent with fluctuating profits;
much of your business comes from the building trade, which tends to have peaks and troughs of
demand
 The level of operating gearing (fixed costs to total costs) – high operating gearing leads to profit
fluctuations which capital gearing would add to; a business like BJH tends to have relatively high
fixed costs
 The attitude of the shareholders – if they are prepared to take more risk for higher rewards,
higher capital gearing may be appropriate.
For your size of business CU500,000 is a large loan. On the other hand, you are presently paying rent
which I presume is commensurate with prospective interest payments, with broadly the same
implications, i.e. failure to pay implies eviction from the site. Borrowing to buy the site would lower
your operating gearing, but increase your capital gearing.
Sources of finance
Equity
New issue
The most obvious source of equity is a rights issue to existing shareholders. This has the advantage of
being relatively cheap to issue and does not provide the company with much of a problem regarding
the issue price. A key issue here is the extent to which the shareholders have the funds necessary to
take up new shares. They may also lack willingness to make further investment in the company. On
the other hand, they will see the company's problem and may be prepared to help if they can.
Normally, equity is rather more expensive to the company than debt; investors expect higher returns
than for debt, but their returns are distinctly more risky. This tends to be less of an issue with a
private company.
It is possible that the directors would consider taking the company public. There are companies as
small as this listed on the Alternative Investment Market (AIM), but this is very much at the lower end.
For this size of company the fixed costs of an AIM listing are very high. Moreover, the potential loss of
control, together with the exposure to public scrutiny associated with an AIM listing, would probably
not be welcome to the company.
A more fruitful area for an equity issue might be a business angel or a venture capitalist. Such investors
tend to need the prospect of high returns and an exit route for their investment. This means that such
investors are interested only in expanding companies that can be foreseen to be likely to be taken
over or to go public within a reasonable time.
Retained earnings
This is an important source of new finance to Bangladesh companies, but it is slow. It would not be
suitable in this case, since all of the company's available funds are already committed. There is the
option of waiting, perhaps a few years, until retained earnings build up before making the investment
but, commercially, this may not be realistic.
Retaining profit normally has implications for dividend policy and, possibly, for shareholder wealth, but
this too may not be a big issue for this company.
Term loan from a bank or similar institution
Your bank may well be prepared to lend you the money, or to put you in touch with another lender.
My firm has corporate finance contacts, which may be able to advise, if necessary.
A term loan tends to be tailored to the needs of the borrower. It may involve partial repayment of the
principal (the amount borrowed) with interest payments over the period of the loan (like a repayment
mortgage) or interest only payments until the loan is due to be repaid. Term loans tend to be very
cheap to negotiate.
Interest rates tend to be low where there is good security, which there would be in this case where
the site value would provide a good basis. Lenders would tend to want a margin of safety, so would be
reluctant to lend CU500,000 on the security of an asset costing that much. It may be that other assets
could also be pledged as security, or that other sources (see below) could reduce the amount
required.
It is not unusual for lenders to impose covenants or restrictions on the borrower, e.g. insisting that it
maintains a particular current assets/current liabilities ratio.
This type of finance looks as if it may be the most appropriate for BJH and should be seriously
considered.
Loan stocks
In theory this is a possibility but, for a small family company, it is probably not very practical. Probably
the main benefit of loan stocks is their transferability, but without a listing this is probably not an issue.
Working capital
It may well be worth assessing whether there is any scope for generating some cash from the
company's working capital. For example, might it be possible for you to reduce trade receivables
and/or increase trade payables? There is clearly little scope with inventory since you hold very little.
Anything that you can obtain from working capital, provided that you are prudent, would have little or
no cost. The amounts involved here would certainly not make great inroads on CU500,000, but it
might be worth considering.
Unused non-current assets
Are there any assets that you do not use or are not used profitably? If there are, and they could be
sold, cash could be generated. As with working capital, any cash sourced from here would be relatively
little.
(b) (i) Critical comments on the spin-off statement
The statement is comprehensively wrong. A spin-off occurs where a company takes a definable
part of its activities and places it in another, subsidiary company. It then hands out the shares in
the subsidiary to the members of the original company pro rata their shareholding in the latter.
Usually a stock exchange listing is obtained for the new, spun-off company.
The reasons for doing this are typically twofold.
 A desire to give the spun-off company its own distinct identity, which might enhance overall
shareholder value.
 To avoid a takeover attempt for the whole company, by making the spun-off element more
expensive.
Thus no new finance is raised and there is no effective change in ownership of any of the assets
of the original company.
What is described in the quote is a 'sell-off'.
ANSWER BANK
(ii) Critical comments on the capital rationing statement

Capital rationing is a situation where a company does not have sufficient funds to make all of the
investments that have a positive NPV, when discounted at the investors' opportunity cost of
capital.
The capital restriction may arise from the company's inability to raise funds in the market, so-
called 'hard' capital rationing. (A company-imposed restriction on the amount of investment
finance available to managers, say, at divisional level is known as 'soft' capital rationing.)
In principle, selecting investments on the basis of the highest NPV per CU of investment finance
(not necessarily the highest NPV projects) will lead to the maximum generation of shareholder
wealth.
Marking guide
Marks
(a) Report format 1

1 – 2 marks per point 15
16
(b) (i) 1 mark per point 4
(ii) 1 mark per point 4
24
51 Megagreat Ltd
(a) Evaluation of a takeover offer
Value of an Angelic Ltd share (P0) = D1 / (ke – g)
= 0.37 / (0.12 – 0.05)
= CU5.29
 0.43 (1.07) 
 
0.43 0.43  0.11  0.07 
Value of an Megagreat Ltd share =  
1.11 1.112 1.112
= CU10.07
CU6  (3  CU10.07)
The holder of one A Ltd share will receive = CU9.05
4
Therefore, accept the bid.
(b) Discussion of the limitations of the calculations in (a) as the basis of a decision
Possible reasons include the following.
 Lack of confidence in the estimates on which the calculations are based.
 Unwillingness on the part of A Ltd shareholders to hold M Ltd shares – dividend policy, level of
capital gearing etc and the cost of share dealing charges to move out of M Ltd shares.
 It looks as if these two companies may have a different risk profile and A Ltd shareholders may
not be happy with this.
 The cash payment may not be appealing to A Ltd shareholders because of the potential capital
gains tax charge to which this may give rise.
(c) Suggestions on how a target company's share price would tend to move when a takeover
offer is announced
If the market were to accept the estimates and believe that the bid would be successful and disregard
the factors in (b), A Ltd's share price would tend immediately to move to CU9.05.
If the market were to believe that the bid would be successful, but M Ltd would have to increase its
bid to succeed, the price would tend to rise to more than CU9.05.
If the market were to believe that the bid would be unsuccessful the A Ltd share price would tend to
remain at its present level.
Changes in market perceptions during the bid period may cause the share price to move around to
reflect those changes.
(d) Suggestions for strategies for growth without making takeovers
Alternatively, growth could be achieved organically by undertaking internally-generated projects,
perhaps using retained earnings to finance them.
Another growth strategy might be to 'buy-in' parts of other businesses, perhaps large parts, without
going for a full takeover. Buy-ins tend to involve only the assets, whereas takeovers involve the whole
of the business including the liabilities.
Marking guide
Marks
(a) Value of Angelic Ltd share 1½

Value of Megagreat Ltd share 2
Amount holders receive 1½
Conclusion 1
6
(b) 1 – 2 marks per point 4
(c) 1 – 2 marks per point 4
(d) 1 – 2 marks per explanation 3
17
52 Thebean Ltd
(a) When choosing between an issue of debt and an issue of equity finance, a company needs to consider
the following factors.
(i) Risk – additional debt finance will increase the gearing of the company, and increases its financial
risk because of the commitment to meet interest payments. There is no such commitment to
make dividend payments to shareholders.
(ii) Cost – debt is cheaper than equity because of the requirement to pay interest. This interest is
deductible when calculating taxable profit. It is also less risky from an investor's perspective,
because lenders have priority over equity shareholders in the event of liquidation. Debt finance is
often secured on the assets of the company to provide security.
(iii) Maturity – debt finance will ultimately need to be repaid, whereas equity finance does not. If a
company has to pay back a large amount of debt this can severely stretch the available cash
resources if there is no method of refinancing in place.
ANSWER BANK
(iv) Availability – both equity and debt finance can be unavailable to companies for various reasons.
The terms of a share issue or loan may be unacceptable, or there may be little enthusiasm for a
rights issue.
(v) Control – both debt and equity finance have implications for the control of the company. A
large issue of new shares via an offer for sale could bring in new shareholders with a different set
of interests or objectives as well as legal rights to appoint directors and auditors. An issue of debt
may necessitate the meeting of certain covenants on the part of the company (such as a certain
level of interest cover that must be met at all times). The company will need to report on its
performance against such covenants to the lender on a regular basis.
(vi) Flexibility – debt financing is more flexible in that specific amounts can be borrowed for a range
of rates and maturities. Also, generally debt is easier to repay (depending on the terms).
(b)
Debt finance Equity finance
CU'000 CU'000
Sales 65,400 65,400 60,000  1.09
Variable cost of sales (36,788) (36,788) 45,000  75%  1.09
Fixed cost of sales (11,250) (11,250) 45,000  25%
Gross profit 17,362 17,362

Administration costs (8,480) (8,480) 8,000  1.06
PBIT 8,882 8,882
Interest (1,150) (350) Debt finance cost 8%  CU10m =
CU800k
in addition to existing CU350k
Profit before tax 7,732 8,532
Tax at 30% (2,320) (2,560)
Profit after tax 5,412 5,972

Dividends at 55% (2,977) (3,285)
Retained earnings 2,435 2,687

(c)
Financial gearing Current Debt finance Equity finance
Debt/equity ratio:
Debt 3,500 13,500 3,500
Share capital and reserves 31,010 33,445 43,697
Debt/equity ratio % 11.3% 40.4% 8.0%
Operational gearing Current Debt finance Equity finance
Contribution/PBIT
Contribution 26,250 28,612 28,612
PBIT 7,000 8,882 8,882
Operational gearing 3.8 3.2 3.2
Earnings per share Current Debt finance Equity finance
Profit after tax 4,655 5,412 5,972
Number of shares 8,000 8,000 10,000
EPS (pence) 58.2 67.7 59.7
Interest cover Current Debt finance Equity finance
PBIT 7,000 8,882 8,882
Debt interest 350 1,150 350
Interest cover 20 7.7 25.4
The debt finance proposal increases EPS, but will reduce interest cover and increase financial gearing.
Whether these changes are acceptable depends both upon sector averages and the response of
investors and managers. A decision to use equity finance would decrease financial gearing but would
increase interest cover. A decrease in operational gearing would result from both proposals.
Marking guide
Marks
(a) Up to 2 marks for each well discussed factor 8
(b) Sales and administration cost 1

Cost of sales 1
Interest 1
Profit after tax 1
Retained earnings 1
5
(c) Revised share capital and reserves 1
Financial gearing 2
Operational gearing 2
Earnings per share 2
Interest cover 2
Calculation of current values 2
Discussion 1
12
25
53 Fituup Ltd
(a) Forecast income statements
Year 20X5 20X6 20X7
CU'000 CU'000 CU'000
Revenue 53,200 61,180 70,357 Up 15%
Cash based costs and expenses (39,741) (42,125) (44,652) Up 6%
Depreciation – (1,050) (1,050) 0% straight line on CU10.5
million.
Operating profit 13,459 18,005 24,655
Finance costs (4,680) (4,680) (4,680) Unchanged
Profit before tax 8,779 13,325 19,975
Tax (2,634) (3,525) (5,717) W1
Profit after tax 6,145 9,800 14,258
Dividend (2,458) (2,556) (2,658) Up 4%; paid following year
Retained profit for the year 3,687 7,244 11,600
Retained earnings b/f 8,314 15,558
Retained earnings c/f 15,558 27,158
WORKING 1
Tax payable
20X6 20X7
CU'000 CU'000
Plant value at start of year 10,500 7,875
Tax depreciation (25% reducing balance) (2,625) (1,969)

Add back depreciation 1,050 1,050
Less tax depreciation (2,625) (1,969)
Taxable profit 11,750 19,056
Tax at 30% (3,525) (5,717)
ANSWER BANK
(b) Cash flow forecasts

Year ended 20X6 20X7
CU'000
CU'000
Cash from sales (61,180 + 6,475 – 7,446) (W2) 60,209 69,240 Up 15%
Cash on costs and expenses (42,125 + 4,988 – 5,287) (41,826) (44,336) Up 6%
Cash from operations 18,383 24,904
Finance costs (4,680) (4,680) Constant
Dividend paid (2,458) (2,556) Previous year's div.
Tax paid (3,525) (5,717)
Purchase of plant and machinery (10,500) –
Net cash flow (2,780) 11,951
Balance brought forward 347 (2,433)
Balance carried forward (2,433) 9,518
WORKING 2
Trade receivables and payables
20X5 20X6 20X7
CU'000 CU'000 CU'000
Trade receivables (grow by 15% pa) 6,475 7,446 8,563
Trade payables (grow by 6% pa) 4,988 5,287 5,604
Financing of cash deficit

The cash deficit in 20X6 could be financed by increasing the company's overdraft; by taking out
a medium-term loan; by reducing the dividend (would only finance part of the deficit); or by
using a source of short term finance based on its receivables (factoring or invoice discounting).
The deficit is not large enough and does not last long enough to consider a longer-term source of
funds such as a share issue or long-term loan. The situation may be complicated if there are
restrictive covenants in the company's borrowing based on liquidity and/or gearing levels, in
which case equity funds would be needed unless the company can renegotiate terms with its bankers.
Reducing the dividend would require careful explanation to shareholders and most quoted
companies would probably opt to increase borrowings rather than reduce the dividend when the
profitability trend is firmly upwards.
(c) Key aspects of the company's performance
Pre-tax return
The company's stated targets are concerned with profitability and growth. On the basis of above
forecasts, the pre-tax return on closing book value of equity is forecast to stay consistently above the
target of 35% pa and to show steady growth:
20X5: 8,779 / (14,612 + 8,314) = 38.3%
20X6: 13,325 / (14,612 + 15,558) = 44.2%
20X7: 19,975 / (14,612 + 27,158) = 47.8%
Growth in equity earnings
At the same time, the forecast annual growth in equity earnings (profit after tax) is much higher than
the company's target.
20X6: (9,800 / 6,145) – 1 = 59.5%
20X7: (14,258 / 9,800) – 1 = 45.5%
These results are excellent, especially as an increase in sales (or reduction in cost) specifically from
the investment in plant has not been factored into the forecasts.
Liquidity position
However, the results cannot be looked at in isolation of the company's liquidity position. The
investment and rapid growth will cause a significant drop in the cash resources during 20X6, though
this is predicted to turn round in 20X7.
The liquidity ratios will change as follows:
20X5 20X6 20X7
CU'000 CU'000 CU'000
Inventories 7,893 7,893 7,893
Trade receivables 6,475 7,446 8,563
Cash 347 9,518
14,715 15,339 25,974
Current liabilities
Trade payables 4,988 5,287 5,604
Other payables: Dividends 2,458 2,556 2,658
Overdraft 2,433
7,446 10,276 8,262
Current ratio (current assets / current liabilities) 1.98 1.49 3.14

Quick ratio ((current assets – inventory) / current
liabilities) 0.92 0.72 2.19
Although the liquidity position is only bad for one year, the company will need to make use of an
overdraft facility with its bankers, or use one of the other sources of funds mentioned in part (b) above.
The 7% bonds will need to be redeemed in 20X8 and there will probably be enough cash by then to
do this, although an alternative would be to refinance with more long-term debt at that stage.
Marking guide
Marks
(a) Calculations: ½ mark per line 6

(b) Calculations: ½ mark per line 5
Comments 3
8
(c) Pre-tax returns 3
Growth in earnings 3
Liquidity position 5
11
25
ANSWER BANK
54 Narmer Ltd
(a) (i) Forecast income statements for the year ended 31 December 20X5
Debenture issue Share issue
CU'000 CU'000
Sales revenue (17.5 + 6) 23,500 23,500
Cost of sales and expenses (bal. fig.) (20,292) (20,292)
Operating profit (W) 3,208 3,208
Interest payable (400 + 10%  4,000) (800) (400)
Tax at 30% (722) (842)
Profit after tax 1,686 1,966
430 (545) (636)
Dividends ( at = 32.33%)
1,330
Retained profit for the year 1,141 1,330
WORKING
2,300
Current operating profit margin =  100% = 13.14%
17,500
 New sales have an operating profit margin of 13.14 + 2 = 15.14%
 Operating profit in 20X5 = 2,300 + (15.14%  6,000) = 3,208
(ii)
Earnings per share 1,686 1,966
= 112.4p = 63.4p
1,500 1,500  1,600
(iii)
Debt 5,000  4,000 5,000
Gearing ratio
Debt  Equity 9,000  5,800 1,141 5,000  5,800  1,330  4,000
= 56.5% = 31.0%
5,000
(b) The company's current gearing level is = 46.3%.
5,000  5,800
The debenture proposal would increase this somewhat to 56.5%, but this is not very high. The interest
charge in the income statement is well covered, and the directors have already identified potential
buyers for the new debentures. Thus the debenture issue seems possible.
1,330
The company's current earnings per share is = 88.7p.
1,500
This falls substantially to 63.4p under the share issue proposal. The rights issue appears to be planned
to be made at a deep discount. We are not told the current share price, but the shares have a net
5,800
asset value of = CU3.87, so the share price is probably well in excess of this, and offering new
1,500
shares at CU2.50 seems unnecessarily low and dilutive. Can the new shares be offered at a higher
price, to reduce the amount by which earnings per share will be reduced?
In deciding between the two proposals in the question, the directors should consider the risk of each
proposal (additional debt will increase financial risk) and the cost of capital of each proposal (the cost
of debt is less than the cost of equity). Furthermore it will be cheaper to issue new debt than to issue
new shares, and the existing shareholders must be consulted to see if they are willing and able to take
up their rights in a rights issue.
Marking guide
Marks
(a) Calculations (i) 6
Calculations (ii) 3
Calculations (iii) 3
12
(b) Comment on results of (a) 3
Key points 2
5
17

3.business Plan Divident and Grought AB

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3.business Plan Divident and Grought AB

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ANSWER BANK

Business plans, dividends and growth

41 Newton Pearce Ltd

Rights issue Debenture issue

Total geared funds at 31/12/X7 CU2,550,000 CU4,377,777

(a) 1 mark per reason max 5

Director A: 1 mark per point max 5

He is therefore CU266.80 worse off as a result of doing nothing.

(c) Dividend policy

d = 1.31 × 1.14 × 0.14 = CU0.2091, say 21 pence

(a) Current share price 2

(a) 1 mark per point 4

(b) Justification of the PV approach to valuation

(a) Tax depreciation (W1) 3½

49 Tinkler's Stores Ltd

Option 2: Sell to a rival

50 Bill Jackson Haulage Ltd

(ii) Critical comments on the capital rationing statement

(a) Report format 1

(a) Value of Angelic Ltd share 1½

Gross profit 17,362 17,362

Profit after tax 5,412 5,972

Retained earnings 2,435 2,687

(a) Up to 2 marks for each well discussed factor 8

(b) Sales and administration cost 1

Profit before tax 13,325 19,975

(b) Cash flow forecasts

Financing of cash deficit

Current ratio (current assets / current liabilities) 1.98 1.49 3.14

(a) Calculations: ½ mark per line 6

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