Question 1

A few years ago, Innovy Pty Ltd commenced business in the renewal energy
industry. The company is unlevered. Currently, the company possesses very few
capital
assets.
By
the
nature
of
its
business,
the
company
has
been
investing,
and
will
continue
to
so,
in
research
and development projects
every
year.

Hence, the company is operating at a loss. It is only expected to turn profitable in
four years. After that, profits are expected to increase at a rate of 30 percent for a
period of six years. Thereafter, growth will moderate at 4 percent per annum into
the foreseeable
future.
The
directors are
optimistic
about
the
forecasts.

Required:

a.


Advise
the
directors of
Innovy
Pty
Ltd
the capital
structure
policy
the
company
should
adopt
for
the
next
four,
ten
and
fifteen
years.
Your
answer
must
apply
and
explain
the
relevant
capital structure
theories.

Word
count
limit
:
250
words.
To
provide
the
word
count
at
the
beginning
of
your
answer.


(15
marks)

b.


Explain
clearly
Modigliani
and
Miller’s
Proposition
I
in
a
perfect
world.
What
adjustments
must
be
made
to
this
proposition
if
corporate
taxes
and
bankruptcy risk exist? Your answer must include the explanation of the
appropriate cost curves and
value
graphs.

Word
count
limit :
300
words.
To
provide
the
word
count
at
the
beginning
of
your
answer


(25
marks)

c.


According
to
Graham
(2011),
the
two
most
popular
debt
policy

factors
listed
were
financial
flexibility
and
credit
rating.
Critically
discuss
this
finding.

(10
marks)

Question 2

Delcron


plc


issued


debentures


two
years
ago.
Currently,
the
debentures
are
valued
at £2.5 million with a yield of 6 percent per annum. Its shares are listed on the
London
Stock
Exchange
with
a
market
capitalization
of
£6
million.
Analysts
estimate the
equity
beta
to
be
at
2.17. The tax
rate
is
25 percent.

The firm plans to invest in either project P or Q, which will not change the risk
profile
of
the
firm.
The
two
projects’
cashflows are
estimated
as
follows:

The
FTSE
350
Index
is
expected
to
earn
a
return
of
15
percent
per
annum.
The
UK
T-bill rate is at
5
percent
per annum.

Required

:

(a)


Calculate the cost of equity and the after-tax weighted average cost of
capital
of Delcron plc. (10
marks)

(b)


Which
project
should
Delcron
plc
accept
using
the
net
present
value
rule?

(12 marks)

(c)


Assume that Delcron plc has yet to issue the debentures, with the same
equity beta as above. Which project should be accepted using the net
present
value rule? (12
marks)

(d)


Assume that the general inflation rate has risen by 30 percentage points.
Discuss the impact on the cost of equity, the after-tax weighted average
cost
of
capital
and
on
project
selection.
No
calculations
are
required
here.

(16 marks)

Question 3

In the year 2015, weaker demand from a slower-growing Chinese economy was

putting


the


global


freight


industry

through
rough
water.
Apart
from
China,
the
freight
market is also plagued by a chronic overcapacity of ships ordered during the
heydays
of
the industry.

Assume today is January 2015. Mega Machines plc manufactures winches on
freight vessels. Currently it has credit sales at £456,000 and the average debtor
collection period is 47 days. It is considering the introduction of a new policy on
debtor management to shorten the collection period to 30 days. Customers are
expected
to
react
adversely,
resulting
in
a
reduction
in
sales
by
£20,000.

Incremental


enforcement


cost


of


the


new

policy
are
expected
to
be
£1,000.
Mega’s
bank
charges
an
overdraft
rate
of
15
percent.
Mega’s
sales
contribution
to
profit
is
10 percent.

You are the finance manager of Mega. The Board of Directors has tasked you to
appraise
the above
proposal.

Required:

a.


Calculate
the
net
benefit
for
the
company
if
it
introduces
the
new
policy.
Provide
your
recommendation.
What
would
be
the
necessary
cautions?

(30
marks)

b.


Conduct
sensitivity
analysis
on
sales
and
comment
on
the
result.
How
should
the
company safeguard its
position
on sales?

(20
marks)

Question
4

The Great Flying Pterosaur Company (GFP) currently produces drones for
commercial use. This product is expected to be in use for the foreseeable
future, GFP's annual net profit after tax are expected to be $400,000 per
annum. Capital allowances (straight-line) are $20,000 per annum for the
company's
existing
non-current
assets.

GFP issued preference shares (perpetual) with face value $1 million and a
dividend rate is 5 percent. GFP is expected to pay its investors. There are
2,000,000
ordinary
shares
outstanding.
GFP's
cost
of
capital
is
10
percent.

GFP is considering to put aside $270,000 to purchase a machine to produce
an additional line of drones. This machine will operate for three years. At the


end of its useful life, it be disposed for zero value. The risk level of the company
will remain unchanged.
The expected demand is 10,000 new drones per year.
Each new drone will be priced at $40 and thereafter rise at 8 percent per year.
Total variable costs are expected to be $20 per drone in the first year and
thereafter
rise
at
5
percent
per
year.
The
corporate
tax
is
at
33
percent.

Required:

1.


Compute
the
value
of
the
firm
before
taking
on
the
investment
opportunity.

(10
marks)

2.


Compute
the
value
added
to
the
firm
if
the
investment
opportunity
is
undertaken.

(35
marks)

3.


What
is
the
price
per
share
of
GFP
if
the
investment
opportunity
is
undertaken?

(5
marks)

Question
5

The
following
information
applies
to
ATO
Inc.:

Number
of
ordinary
shares : 30 million

Irredeemable


debentures

at
12%
(book
value)
:
£58
million
Bank
loan
at
8% :
£7
million

Market
price
of
ordinary
shares :
£6
per
share

Market
value
of
debentures :
£120
per
£100
debenture

Dividends


(recently
paid) :
15p
per
share

Dividend
growth
rate :
4%
in
the
foreseeable
future

Tax
rate :
30%

Required:

a.


Compute
the
company's
cost
of
equity.

(5
marks)

b.


Compute
the
company's
after-tax
cost
of
the
two
debt
components.

(10
marks)

c.


Compute
the
company's
weighted
average
cost
of
capital
(WACC).

(15
marks)

d.


Discuss
three
situations
when
the
WACC
may
be
used
to
assess
the

company's
project.

(10
marks)

e.


The
company
used
the
WACC
to
appraise
a
project
when
the
required
return
is
higher.
Discuss
the
impact
of
this
on
shareholder
value.

(10
marks)