1. Cherry Tree Company

The Cherry Tree Company has issued 300,000 $1 par equity shares,which are at present selling for $4.40 per share. The company needs toraise additional finance in order to undertake a new project which itplans to obtain via a 2 for 5 rights issue priced at $3.00.

Required:

(a) Calculate the theoretical ex-rights price of Cherry Tree's equity shares.

(2 marks)

(b) Calculate the theoretical value of a Cherry Tree right before the shares sell ex-rights.

(2 marks)

(c) The chairman of the companyreceives a telephone call from an angry shareholder who owns 1,000shares. The shareholder argues that he will suffer a loss in hispersonal wealth due to this rights issue, because the new shares arebeing offered at a price lower than the current market value.

The chairman assures him that this wealth will not be reducedbecause of the rights issue, as long as the shareholder takesappropriate action.

Is the chairman correct? What should the shareholder do?

Present a statement showing the effect of the rights issue on this particular shareholder's wealth, assuming

(i)he exercises his rights

(ii) he sells all the rights

(iii)he exercises half the rights and sells the other half

(iv)he does nothing at all.

(7 marks)

(d) Are there any real circumstances which might lend support to the shareholder's claim? Explain.

(5 marks)

(e) Explain and evaluate the appropriateness of the following alternative methods of issuing equity finance:

a placing,

an offer for sale,

a public offer for subscription.

(9 marks)

2. M Co

The directors of M Co are considering opening a new factory tomanufacture a new product at a cost of $3.0 million. During the last 5years, the company has had 3 million shares in issue. The current marketprice of these shares (at 31 December 20X8) is $1.45 ex-dividend.

The company pays only one dividend each year (on 31 December) and dividends for the last five years have been as follows:

M Co currently has in issue $1 million 7% debentures redeemable on31 December 20Y2 at par. The current market price of these debentures is$83.60 ex-interest, and the interest is payable in one amount each yearon 31 December. The company also has outstanding a $500,000 bank loanrepayable on 31 December 20Y7. The rate of interest on this loan isvariable, being fixed at 3% above the bank's base rate which iscurrently 5%.

Required:

(a)Calculate the weighted average cost of capital (WACC) for M Co as at 31 December 20X8

(15 marks)

(b)Explain the terms business riskand financial risk and the significance of each in using an existingWACC to appraise a future project.

(7 marks)

(c)Briefly advise the directors of MCo on the suitability of using the WACC calculated in (a) above todiscount the expected cash flows of the project

(3 marks)

(Total: 25 marks)

3. Bacchante

Bacchante Co has a capital structure as follows:

The company's current operations are carried out from two locations.

The Oxford factory shows a cash surplus of $1,750,000 on capitalemployed of $27.5 million, while the Cambridge factory produces a cashsurplus of $640,000 on its capital of $3.5 million.

It is proposed to invest a further $1.5 million in facilities atCambridge which will increase cash flow by $150,000 to perpetuity.

Required:

(a)Calculate Bacchante's weighted average cost of capital.

(4 marks)

(b)Comment on the proposed expansion.

(6 marks)

(Total: 10 marks)

Ignore taxation.

4. Kingswick

Kingswick Co is an all-equity financed company with a cost of capital of 18.5%.

The risk-free rate is 8% and the expected return on an average market portfolio is 15%.

It is considering the following capital investment projects:

Required:

(a)Calculate Kingswick's beta factor.

(2 marks)

(b)Calculate the CAPM required return for each project.

(7 marks)

(c)Calculate the expected rate of return of each project.

(7 marks)

(d)Show which projects would beaccepted and rejected if they were discounted at the firm's cost ofcapital, and highlight those projects where an incorrect decision wouldbe made.

(9 marks)

5. AB Co

AB Co has always been an all equity financed company with a cost ofcapital of 12%. The finance director has read an article extolling thebenefits of raising debt finance and has asked you to provide him withadvice as to how AB Co should finance itself for the future. He is alsointerested in what discount rate he should be using for projectappraisal. In order to assist you the finance director has helpfullycollected data on four companies which is summarised below.

Companies C and D operate in the same industrial sector, whilstcompanies E and F both operate in a different industrial sector which isperceived as more risky than that of C and D.

All four companies and AB Co itself operate in Zee, a country that is at present a tax-free society.

You also ascertain that debt, which may be assumed to be risk-free, is currently yielding 4% per annum to investors.

Required:

(a)Comment on the data supplied bythe finance director in relation to the optimal capital structure of ABCo and advise on an appropriate discount rate for project appraisal.

(15 marks)

(b)Indicate how your advice might change if corporate taxes were introduced into Zee.

(10 marks)

Note: Your answer should address both theories of gearing.

6. PDQ Inc

The directors of PDQ Inc have commissioned a firm of consultants toconduct a wide-ranging review of the company's public image and marketposition. Although this is not predominantly a financial review, theconsultants need to examine the company's financial performance.

The company has the following summary information for the last five years:

Notes

(1)Each P/E ratio is the average for the year.

(2)The increased equity in year 4was partly the result of a share issue which took place at the beginningof the year. Some of the $20m raised was used to reduce debt.

For the past five years, PDQ Inc has stated its objectives as: 'Tomaximise shareholder wealth whilst recognising the responsibility of thecompany to its other stakeholders'.

As one of the consultants working on this assignment, you have beenasked to assess whether the company has achieved its objectives in thefive-year period under review and to discuss the key factors which havedetermined your assessment.

Required:

(a)to discuss whether the company has met its objectives, based solely on the information available

(15 marks)

(b)to comment on what other financial information you would need in order to provide your client with a more accurate assessment.

(10 marks)

7. Deerwood

The board of directors of Deerwood Inc are arguing about the company's dividend policy.

Director A is in favour of financing all investment by retainedearnings and other internally generated funds. He argues that a highlevel of retentions will save issue costs, and that declaring dividendsalways results in a fall in share price when the shares are traded exdiv. Director B believes that the dividend policy depends upon the typeof shareholders that the company has, and that dividends should be paidaccording to shareholders' needs. She presents data to the boardrelating to studies of dividend policy in the USA, and a breakdown ofthe company's current shareholders.

She argues that the company's shareholder 'clientele' must beidentified, and dividends fixed according to their marginal taxbrackets.

Director C agrees that shareholders are important, but points outthat many institutional shareholders and private individuals rely ondividends to satisfy their current income requirements, and prefer aknown dividend now to an uncertain capital gain in the future.

Director D considers the discussion to be a waste of time. Hebelieves that one dividend policy is as good as any other, and thatdividend policy has no effect on the company's share price. In supportof his case he cites the dividend irrelevancy theory proposed byModigliani and Miller.

Required:

Critically discuss the arguments of each of the four directorsusing both the information provided and other evidence on the effect ofdividend policy on the share price that you consider to be relevant.

8. Predator Co

The board of directors of Predator Co, a listed company, isconsidering making an offer to purchase Target Co, a private limitedcompany in the same industry. If Target Co is purchased it is proposedto continue operating the company as a going concern in the same line ofbusiness.

Summarised details from the most recent set of financial statements for Predator and Target are shown below:

Predator Co 50 cents ordinary shares, Target Co, 25 cents ordinary shares.

T5 is five years ago and T1 is the most recent year.

Target's shares are owned by a small number of private individuals.Its managing director who receives an annual salary of $120,000dominates the company. This is $40,000 more than the average salaryreceived by managing directors of similar companies. The managingdirector would be replaced, if Predator purchases Target.

The freehold property has not been revalued for several years and is believed to have a market value of $800,000.

The balance sheet value of plant and equipment is thought toreflect its replacement cost fairly, but its value if sold is not likelyto exceed $800,000. Approximately $55,000 of inventory is obsolete andcould only be sold as scrap for $5,000.

The ordinary shares of Predator are currently trading at 430 centsex-div. A suitable cost of equity for Target has been estimated at 15%.

Both companies are subject to corporation tax at 33%.

Required:

(a)Estimate the value of Target Co using the net asset method of valuation

(4 marks)

(b)Estimate the value of Target Co using the dividend valuation model

(7 marks)

(c)Estimate the value of Target Co using the P/E ratio method

(8 marks)

(d)Advise the board of Predator as to how much it should offer for Target's shares.