QUESTION 1

(a) List and explain the major functions performed by the capital markets. (5 marks) (b) Discuss the reasons why rights issues are often used to increase the equity of both small and relatively large entities. (5 marks) (c) Explain the different forms of borrowing that are available and suggest which form would be most appropriate for use by an entity that wishes to expand. (5 marks)

(TOTAL MARKS 15)

QUESTION 2

Lavinia Products plc manufactures toys and other goods for children. It has been trading for 3 years. Five people own the shares in the company, all of them employed full time in the business. The entity is doing well and now needs additional capital to expand operations. Assume that you are a consultant working for Lavinia Products plc. You have been assigned to the entity to advise on its objectives and financial situation. As well as being provided with financial statements for the year to 31 December 2016, the entitys accountant gives you the following information:

1. Revenue and costs of sales are expected to increase by 10% in each of the financial years ending 31 December 2017, 2018 and 2019. Operating expenses are expected to increase by 5% each year.

2. The company expects to continue to be liable for tax at the marginal rate of 33%. Assume tax is paid or refunded 12 months after the year end.

3. The ratios of receivables to revenues and payables to cost of sales will remain the same for the next 3 years.

4. The non-current assets are land and buildings, which are not depreciated in the entitys books. Capital allowances on the buildings may be ignored. All other assets used by the entity (machinery, cars, etc.) are rented.

5. Dividends will grow at 25% in each of the financial years 2017, 2018 and 2019, as per the entitys objectives.

6. The entity intends to purchase new machinery to the value of 500,000 during 2017 although an investment appraisal exercise has not been carried out. It will be depreciated straight line over 10 years. The entity charges a full years depreciation in the fi rst year of purchase of its assets. Capital allowances are available at 25% reducing balance on this expenditure.

7. Additional inventory was purchased for 35,000 at the beginning of 2017. The value of inventory after this purchase is likely to remain at 361,000 for the foreseeable future.

8. No decision has been made on the type of finance to be used for the expansion programme. However, the entitys directors think they can raise new medium-term secured debt if necessary.

9. The average P/E ratio of listed entities in the same industry as Lavinia Products plc is 15. The entitys objectives include the following: to earn a pre-tax return on the closing book value of shareholders funds of 35% per year; to increase dividends per share by 25% per year; to obtain a quotation on a recognised stock exchange within the next 3 years.

A summary of the financial statements for the year to 31 December 2016 is shown below.

LAVINIA PRODUCTS PLC

Summarised income statement for the year to 31 December 2016 000 Revenue 1,560 Cost of sales (950) Gross profit 610 Operating expenses (325) Interest (30) Tax liability (84) Net profit 171 Dividends declared 68

Summarised balance sheet at 31 December 2016 000 Non-current assets (net book value) 750

Current assets Inventory 326 Receivables 192 Cash and bank 50 1,318

000 Capital and reserves Ordinary share capital (ordinary shares of 1) 500 Retained profits to 31 December 2015 128 Retentions for the year to 31 December 2016 103 Total financing 731

Non-current liabilities 10% debenture redeemable 2020 300 Current liabilities Accounts payable 135 Other payables (including tax and dividends) 152 1,318

Requirements Using the information in the case:

(a) Prepare forecast income statements for the years 2017, 2018 and 2019, and calculate whether the entity is likely to meet its stated financial objective (return on shareholders funds) for these 3 years. (20 marks)

Notes: 1. You should ignore interest or returns on surplus funds invested during the 3-year period of review. 2. This is not an investment appraisal exercise; you may ignore the timing of cash flows within each year and you should not discount the cash flows. 3. Ignore inflation.

(TOTAL MARKS 20)

QUESTION 3 The following is an extract from the balance sheet of Leisure International plc at 30 June 2019: 000 Ordinary shares of 50p each 5,200 Reserves 4,850 9% preference shares of 1 each 4,500 14% debentures 5,000 Total long-term funds 19,550

The ordinary shares are quoted at 80 p. Assume that the market estimate of the next ordinary dividend is 4 p, growing thereafter at 12% per annum indefinitely. The preference shares, which are irredeemable, are quoted at 72 p and the debentures are quoted at par. Corporation tax is 35%.

(A) You are required to use the relevant data above to estimate the companys weighted average cost of capital (WACC), that is the return required by the providers of the three types of capital, using the respective market values as weighting factors. (5 marks) (B) You are required to explain how the capital asset pricing model would be used as an alternative method of estimating the cost of equity, indicating what information would be required and how it would be obtained. (5 marks) (C) Assume that the debentures have recently been issued specifically to fund the companys expansion programme under which a number of projects are being considered. It has been suggested at a project appraisal meeting that, because these projects are to be financed by the debentures, the cut-off rate for project acceptance should be the after tax rate on the debentures rather than the WACC. You are required to comment on this suggestion. (5 marks)

(D) Assume that instead of raising 5 m of 14% debentures, the company had raised the equivalent amount in preference shares giving the same yield as the existing preference capital. You are required: (10 marks) To demonstrate that the returns offered to investors in the two financial instruments are consistent with investor risk aversion;

To calculate how Leisure International plcs equity earnings would have been affected if the preference shares had been issued instead of the debentures.

(TOTAL MARKS 25)

QUESTION 4 RZ is a privately owned textile manufacturer based in the UK with sales revenue in the last financial year of 68m and earnings of 4.5m. The directors of the entity have been evaluating a cost saving project, which will require purchasing new machinery from the USA at a capital cost of $1.5m. The directors expect the new machinery to have a life of at least 5 years and to provide cost savings (including capital allowances) of 240,000 after tax each year. Cash flows beyond 5 years are ignored by RZ in all its investment decisions. The discount rate that the entity applies to investment decisions of this nature is its post-tax real cost of capital of 9% per annum.

RZ at present has no debt in its capital structure. The directors, who are the major shareholders, would be prepared to finance the purchase of the new machinery via a rights issue but believe an all-equity capital structure fails to take advantage of the tax benefits of debt. They therefore propose to finance with one of the following methods: Undated debt raised in the United Kingdom and secured on the entitys assets. The current pre-tax rate of interest required by the market on corporate debt of this risk is 7% per annum. Interest payments would be made at the end of each year. A fi nance lease raised in the United States repayable over 5 years. The terms would be 5 annual payments of US$325,000 payable at the beginning of each year. The machinery could be bought by RZ from the fi nance company at the end of the fi ve year lease contract for a nominal amount of $1. Assume the whole amount of each annual payment is tax deductible. An operating lease. No cost details are available at present.

Other information the entitys marginal tax rate is 30%. Tax is payable in the year in which the liability arises. Tax depreciation allowances are available at 25% reducing balance. if bought outright, the machinery is estimated to have a residual value in real cash flow terms, at the end of five years, of 10% of the original purchase price. the spot rate US$ to the is 1.58. Interest rates in the United States and the United Kingdom are currently 2.5 and 3.5%, respectively

Requirements Discuss the advisability of the investment and the advantages and disadvantages of financing with either (i) Undated debt, (ii) A finance lease or (iii) An operating lease compared with new equity raised via a rights issue and comment on whether the choice of method of finance should affect the investment decision. Provide appropriate and relevant calculations and assumptions to support your discussion. (18 marks)

Discuss the benefits and potential problems of financing assets in the same currency as their purchase. (7 marks) (TOTAL MARKS 25)

QUESTION 5 When determining the financial objectives of an entity, it is necessary to take three types of policy decision into account investment policy, financing policy and dividend policy.

Requirements (a) Discuss the nature of these three types of policy decision, commenting on how they are interrelated and how they might affect the value of the entity (i.e. the present value of projected cash flows.) (10 marks) (b) Describe the different function of treasury and financial control departments of an entity and comment on the relative contributions of these two departments to policy determination and the achievement of financial objectives. (5 marks)