ANSWER BANK

Finance and capital structure

25 Oxfield Ltd
(a) WACC
D1 18 (1.07)
Ke = +g= + 0.07 = 0.1617 = 16.17%
P0 210
Kd = IRR of relevant cash flows from the company's perspective.
Consider a CU100 nominal value block of loan stock.
t Narrative CF DF PV DF PV
@ 5% @ 5% @ 7% @ 7%
0 Market value 97 1 97.00 1 97.00
1-3 Interest, net of corporation tax (5.04) 2.723 (13.72) 2.624 (13.22)
3 Redemption (105.00) 0.864 (90.72) 0.816 (85.68)
(7.44) (1.90)
(  7.44)  (7  5)
Kd = IRR ~
– 5+ = 7.685%
(  7.44  1.9)

MVequity  K e  MVdebt  K d
WACC =
MVequity  MVdebt

(160m  2.10 16.17%)  (67m  97%  7.685%)

=
(160m  2.10)  (67  97%)

= 14.79%
Assumptions/explanations
(i) The formula for Ke assumes that future growth in dividends will be constant.
(ii) The use of 7% for the growth rate assumes that past growth will be continued in the future.
(iii) In the Kd calculation it has been assumed that the interest is an allowable deduction for tax and
that there is no delay on the tax. Thus the post tax interest figure used is
7.2% × 100 × (1 – 0.3) = CU5.04 pa.
(iv) Tax is assumed to remain at 30% for the next three years.
(v) That the current share price is fair and not distorted by short-term market factors.
(vi) That the dividend valuation model is valid.
Basis of weightings
(i) Both costs of capital (Ke and Kd) and the WACC have been calculated using current ex-dividend
(ex-interest) market values, rather than balance sheet/nominal values.
(ii) This is to ensure that a current market cost of finance is determined, rather than an historic cost.
Ideally a future WACC is wanted to discount future project cash flows, and the current WACC
based on current market rates is the best estimate for this.
(b) Criticisms
The existing company WACC reflects the company's current gearing level and its existing Ke and Kd.
The Ke in turn reflects the shareholders' risk perception of the company's existing activities.
Thus the existing WACC is only suitable for project appraisal if the following apply.

© The Institute of Chartered Accountants in England and Wales, March 2009 145
 Finance and capital structure

(i) The project has the same business risk as the company's existing activities, so that overall
business risk is unchanged
(ii) The project is financed by a mixture of debt and equity, so as to leave the company's gearing
unaltered
(iii) New debt can be issued at the same cost as the existing loan stock.
These conditions may be relaxed if the project is small, as business risk and gearing do not change
much and/or if finance is deemed to come out of the 'pool' so any change in gearing is seen to be
short-term. However, in this case Oxfield is to undertake a 'major' investment, so the above three
concerns must be addressed.
The size of the investment may be such that a public issue of shares would be required for equity
finance. These new shareholders may have a different risk perception of the company and project than
existing shareholders, so the company Ke would change, again invalidating the existing WACC.
(c) CAPM
CAPM could have been used to estimate a project–specific Ke if the project activities were different
from that of the company. This could then have been used to calculate a project specific WACC.
The method for this would have been as follows.
(i) Find a listed company with activities similar to those of the project.
(ii) Look up its beta factor.
(iii) Adjust for gearing if necessary.
(iv) Put into the CAPM equation.
Project Ke = rf + ß (rm – rf)
Note: rf could be calculated by looking at yields on Government gilts.
rm could be calculated by looking at movements on the FT all share index.
The model's strengths and weaknesses include the following.
Strengths Weaknesses
 Gives a risk-adjusted discount rate specific  Only appropriate for well-diversified
to the project's activities. shareholders.
 Books of betas are readily available.  Published betas are calculated by looking at
past share price movements. The discount
rate is thus of limited use for future project
appraisal.

(d) WACC and gearing

There are two theories linking a company's WACC and its gearing ratio.
(i) The traditional theory of gearing proposes a 'U' shaped WACC curve.

146 © The Institute of Chartered Accountants in England and Wales, March 2009
 ANSWER BANK

Cost of capital

K equity

WACC

K
debt

Debt
G1 Gearing =
Equity
Thus if Oxfield is already at its optimal gearing level, G1, then any change in gearing will cause the
WACC to increase. If Oxfield is not already at optimal gearing, then were the change in gearing
to move it closer to G1 the WACC would drop, but if further away from G1 the WACC would
rise.
(ii) Modigliani and Miller ('M&M')
M&M predicted that with corporation tax, but without personal tax, firms should gear up as
much as possible.
Cost of capital

K equity

WACC

K
debt

Debt
Gearing =
Equity

Thus if Oxfield were to increase its gearing its WACC would drop, and a fall in gearing would
increase the WACC.
In practice the impact of a change in gearing would depend on market reaction.

Debt
(1) Oxfield's current gearing level =
Equity

© The Institute of Chartered Accountants in England and Wales, March 2009 147
 Finance and capital structure

67m  97%
=
160m  2.10
64.99
=
336
= 0.19, or 19%
This appears low.
(2) If Oxfield were to move to a gearing level higher than the industry average, the WACC
could increase as the company is perceived as being more risky.

Marking guide
Marks

(a) Calculations 3½
Assumptions/explanations 2½
Basis of weightings 1
7
(b) 1 mark per valid point max 7
(c) Explanations 1
CAPM equation 1
Strengths/weaknesses 3
5
(d) (i) 2½
(ii) 2½
5
24

26 Yollo Ltd
(a) Calculation of the weighted average cost of capital
Cost of equity
d (1  g)
Ke = +g
P
where g = rb
r = 0.25 = return on new investment
b = 0.40 = proportion of earnings retained
Thus
g = 0.25 × 0.4
= 0.1
240,000 (1.1)
 Ke = + 0.1
1.5  4m
= 0.044 + 0.1
= 14.4%

148 © The Institute of Chartered Accountants in England and Wales, March 2009
 ANSWER BANK

Cost of preference shares

100,000
KP =
1,100,000 – 100,000

= 10%
Value of debt
160,000 (0.7) 160,000 (0.7) 2,100,000
Vd = + +
(1.09) 2
2
(1.09) (1.09)

112,000 2,212,000
= +
(1.09) (1.09) 2
= CU1,964,548
WACC
Market value Cost of capital Weight Weighted cost
CU % %
Equity 6,000,000 14.4 6,000,000 9.638
8,964,548
Preference shares 1,000,000 10.0 1,000,000 1.116
8,964,548
Debt 1,964,548 9.0 1,964,548 1.972
8,964,548
8,964,548 12.726
Thus WACC = 12.726%
(b) Arriving at an appropriate discount rate
(i) Accountant's comments
The cost of a particular form of finance used for a new project is not usually the appropriate rate
to use for discounting.
The providers of finance are subject to the risk of the company being unable to repay debt or
make an adequate return on equity rather than separately being repaid from the cash flows of the
project (non-recourse finance is an exception to this general rule).
As such the accountant's suggestion of merely attempting to cover interest payments is not
appropriate, as additional debt would increase the financial risk of existing equity holders both by
increasing the variability of their residual returns and by representing a prior charge over assets
in the case of liquidation. The required return of equity holders is therefore likely to increase as a
result of financing this project by debt.
In a perfect M&M world without taxes the marginal increase in equity will precisely balance the
lower cost of debt, leaving the weighted average cost of capital constant. Given this, the marginal
cost of capital would be the weighted average cost of capital, rather than merely the cost of debt
as suggested by the accountant.
Finance director's comments
The above argument would appear to suggest that the finance director is correct in proposing
that the WACC be used in NPV calculations for the new project. This needs to be qualified,
however, in a number of ways.
First, the risk of the new project appears to be substantially higher than the risk of the average of
existing projects. It is clear that the existing portfolio of projects and the profit arising from them
is stable and seems likely to continue to be so given that they are based on long-term contracts.
Conversely, however, the new project is a departure both into new markets and new production
techniques, presumably with associated capital investment up-front which may not be recoverable
if the project fails. The risk of the new project would thus demand a higher rate of return than

© The Institute of Chartered Accountants in England and Wales, March 2009 149
 Finance and capital structure

that of the existing projects. This is likely to raise the overall cost of capital beyond the current
level of 12.726%.
Nevertheless it would be inappropriate to use even the new cost of capital as this would be the
average overall change. What is really needed is the marginal return required as a result of the
new project.
Given that the company is listed, it may be appropriate to estimate the required return on the
new project using CAPM, as it is the stock market that sets share prices and thus prices risk.
In so doing it is not the risk of an individual project that is the main issue but the marginal impact
on the risk of a diversified portfolio of shares. Thus, project specific risk would not demand a
price as it can be diversified away. As such, it is necessary to consider the correlation of returns
of the new project with those of the stock market as a whole, i.e. the systematic risk. It is not
easy to forecast betas with respect to a prospective project but one possibility is to consider the
share prices of companies engaged solely, or largely, in a similar industry.
Another is to consider the extent to which the returns of the project vary in relation to the
macroeconomic factors that drive share prices generally (growth, interest rates, exchange rates,
inflation, fiscal policy). To the extent that these could be estimated, an approximate required
return figure could be calculated and used as a discount rate in NPV calculations.
(ii) Debt
The cost of debt may change from the current figure of 9% if the new debt is of a different risk
class to the existing debt. This may arise because of the following.
 The period to maturity and thus exposure to risk
 The seniority of the debt, e.g. does it rank equally with existing debt?
 The availability of restrictive covenants to protect lenders
 The quantity and quality of the available security on the debt
 The risk of the company's cash flows changing over time
Preference shares
New debt would rank in front of preference shares both in terms of right to income and to
terms of claims on assets on a winding up. If the amounts of a new debt were significant this
might mean the price of preference shares falling as a result of an increase in the required rate of
return. The operating risk of the project would also suggest that the cost of preference capital
would increase further.
Cost of equity
New debt would similarly rank in front of equity shares both in terms of right to income and in
terms of claims on assets on a winding up. Again, this would mean an increase in the required
cost of equity in response to the increase in financial risk. The operating risk of the project would
also suggest that the cost of equity would increase further.
WACC
In a perfect M&M world without taxes one would expect that the lower cost of debt would be
precisely offset by the increases in the cost of other forms of capital, leaving the WACC
constant. There are two major reasons why this might not be the case.
 The operating risk of the project appears to be higher than the weighted average operating
risk of existing projects which would have the effect of pushing WACC upwards.
 The tax benefit of more debt would push WACC downwards.
 The failure of any of the other M&M assumptions to apply would mean that the M&M
conclusion of constant WACC may fail to hold.

150 © The Institute of Chartered Accountants in England and Wales, March 2009
 ANSWER BANK

Marking guide
Marks

(a) Cost of equity

Equation 1
rb figures 2½
g 1
Ke 1
Cost of preference shares 1
Value of debt 2½
WACC 2
11
(b) (i) 1 mark per point max 6
(ii) 2 marks per point max 5
11
22

27 Navarac Ltd
(a) NPV
Differential costs of bailing out
31 December 20X3 20X4 20X5 20X6
CU CU CU CU
Disposal proceeds 150,000
Tax depreciation 12,656 (7,031)
Tax depreciation forgone (12,656) (9,492) (7,119) (21,357)
Contributions forgone (72,000) (72,000) (45,000)
Tax on contributions avoided 21,600 21,600 13,500
Working capital 7,200 (2,700) (4,500)
157,200 (66,923) (60,219) (57,357)
Discount factor (15%) 1.000 0.870 0.756 0.658
Present values 157,200 (58,223) (45,526) (37,741)
Net present value = CU15,710
Therefore, 'bail out' of the project at the end of 20X3, disposing of the machine on 1 January 20X4.
WORKINGS
(1) Tax depreciation
Year CU CU
20X0 Cost 400,000
TDA (25%) 100,000
20X1 300,000
TDA (25%) 75,000
225,000
20X2 TDA (25%) 56,250
168,750
Either
20X3 Disposal proceeds 150,000
Balancing allowance 18,750 @ 30% 5,625

© The Institute of Chartered Accountants in England and Wales, March 2009 151
 Finance and capital structure

or
20X3 TDA (25%) 42,188 @ 30% 12,656
126,562
20X4 Disposal proceeds 150,000
Balancing charge 23,438 @ 30% (7,031)
Therefore retain the machinery until 1 January 20X4 if the decision is made to bail out at the end
of 20X3. This is because, although the total cash flow relating to the tax depreciation is the same,
a 20X4 disposal gives a more beneficial timing.
CU CU
or
20X3 TDA (25%) 42,188 @ 30% 12,656
126,562
20X4 TDA (25%) 31,641 @ 30% 9,492
94,921
20X5 TDA (25%) 23,730 @ 30% 7,119
71,191
20X6 Disposal proceeds Zero
Balancing allowance 71,191 @ 30% 21,357
(2) Contributions
Labour cost per unit of WX14 = CU(200 – 80 – 90) = CU30. Thus for each WX14 produced,
one unit of AP25 as its labour cost is also CU30. Labour cost is common, so net contribution per
WX14 = CU(110 – 80) = CU30.
Year Units Contributions
CU
20X4 2,400 × CU30 72,000
20X5 2,400 × CU30 72,000
20X6 1,500 × CU30 45,000
(3) Working capital
Flows if production had continued
20X3 20X4 20X5 20X6
CU CU CU CU
Amount of working capital required 7,200 7,200 4,500 Nil
Flow (7,200) – 2,700 4,500
If production ceases, these flows are reversed.
(4) Cost of capital
5% + 1.25 (13% – 5%) = 15%.
(b) CAPM
CAPM is a device for determining the investors' required return from risky investments, both real and
financial. It is based on the assumption that investors hold 'efficient' portfolios, i.e. portfolios of
investments that have all specific risk eliminated from them through diversification.
Specific risk is that part of total business risk that relates to the particular investment concerned. This
means that CAPM assumes that investors bear systematic or market risk, i.e. the risk that all
investments bear, but not all investments bear the same amount of it.
CAPM says that investors should expect to receive the risk-free rate, plus a risk premium. The risk
premium should be based on the premium available for the average investment, scaled up or down
according to how risky the particular investment is relative to the average investment. This relative
(systematic) riskiness is measured by a factor known as beta. Thus CAPM adds (or, in theory, could
subtract) a market-derived cost of risk to the risk-free rate.
Is the use of CAPM entirely suitable in the case of Navarac Ltd's investment decision? This is an
unlisted company, so it may very well be that the shareholders are not well diversified at a portfolio

152 © The Institute of Chartered Accountants in England and Wales, March 2009
 ANSWER BANK

level. On the other hand, unlisted companies have a problem with estimating their cost of capital, so
CAPM has some appeal, but the results from using CAPM need to be adjusted. Unfortunately, the
adjustment will have to be subjective.
The company would probably have found listed companies, for which there would be information on
the beta, similar to Navarac Ltd, and based the risk premium on the betas of those companies. For the
risk-free rate, probably a long-term historic rate on government securities would have been used.
Similarly, the expected return from the market portfolio (the average investment return) would
probably have been based on long-term historic equity returns. The resulting figure should probably be
adjusted upwards to recognise that smaller companies need higher returns than larger companies.

Marking guide
Marks

(a) NPV 5
Tax depreciation 6
Contributions 4
Working capital 2
Cost of capital 17
(b) 2 marks per paragraph max 7
24

28 Terry Ltd
(a) Gains for (1)
CU225,000
Required return of ordinary shareholders =  100
(1m  CU1.725)  CU225,000

= 15%
New dividend = CU(225,000 + 56,000)
= CU281,000

CU
CU281,000
New total market value of ordinary shares (ex div) 1,873,333
0.15
Less Amount raised by rights issue (225,000)
1,648,333
Less Old market value (ex div) (1,500,000)
Gain 148,333

(No reduction in current t0 dividend of CU225,000)

Project NPV
56,000
(225,000) + = CU148,333
0.15

© The Institute of Chartered Accountants in England and Wales, March 2009 153
 Finance and capital structure

(b) Gain to current shareholders

If all the gain goes to the current shareholders, their 1 million shares will be worth CU(1,500,000 +
148,333) = CU1,648,333, a market value of CU1.6483 per share.
Since none of the gain goes to the new shareholders and their shares will also have a market value of
CU1.6483 each, this must be the issue price. (Note that as the shares are currently valued at CU1.50
ex div, it is unlikely that the issue will succeed!)
CU225,000
The number of shares to be issued is therefore = 136,502.
CU1.6483
(c) Split gain
CU225,000
= 180,000 new shares will be issued at CU1.25 each, a total of 1,180,000 shares.
CU1.25
New total market value of ordinary shares ex div (as for (a)) = CU1,873,333
CU1,873,333
Market value per share = CU1.58757
1,180,000
Gain/loss to current shareholders
CU
New market value 1m × 1,587,570
CU1,873,333
1,180,000
Less Old market value (1,500,000)
Gain 87,570
Gain to new shareholders
CU
Market value 180,000 × 285,763
CU1,873,333
1,180,000
Less Amount raised (225,000)
Gain 60,763
Note: The total net gain is CU(87,570 + 60,763) = CU148,333 as in (a).
(d) Price and timing of a rights issue
These two factors are inter-related, but it is probably easier to discuss the timing first.
The reason for the rights issue will affect its timing. For example, funds for the overseas expansion
may be required quickly if the company is attempting to beat its competitors into a new market. In
other cases it may be less urgent, for instance if it intends to take over existing companies.
Firms usually try to make a share issue when the market price of their shares is high, reflecting good
accounting results, and when the stock market is generally rising. There are various reasons for this.
It is important that the shareholders are confident in the future prospects of the company, so that
they would all wish to subscribe if they could raise the money. It is also possible to issue fewer shares
if the price is high, thus decreasing issue costs. Furthermore, a rising stock market means that there is
less chance that the market price of the shares falls below the issue price, which would undermine the
issue.
However, the reason which is often stated, that it is better to issue at a high price because this
minimises the cost of paying dividends on the shares (i.e. fewer total shares in issue and dividend needs
to be maintained), conflicts with the theory of rights issues which suggests that the price is irrelevant.
As to the issue price, in theory the price is unimportant; however, there are opposing factors working
towards issuing at a higher or lower price.

154 © The Institute of Chartered Accountants in England and Wales, March 2009
 ANSWER BANK

The main factor favouring a low issue price is that there would be very little chance of the current
market price falling below the issue price in the period between the announcement and the issue. The
factors causing a fall in market price might be a downturn in the whole market or a lack of certainty as
to the reasons for the issue if the market were surprised by the announcement.
If the issue price is low enough it may be possible to avoid underwriting, which amounts to more than
2% of the proceeds. Merchant bankers and brokers would obviously not advise this course because
they would lose their commission, but theoretically there is no need for underwriting a rights issue if
the issue price is below market price and if investors act rationally by taking up or selling their rights.
The factors favouring a higher issue price have already been mentioned in the context of the timing of
the issue. Some issue costs will be saved and, if the company wishes to maintain its dividend per share,
the cost will be less. However, there is no rational need to maintain dividend per share if the issue
price is cheap.

Marking guide
Marks

(a) Calculations 4
(b) Gain to current shareholders 3
(c) Split gain 2
Gain to current shareholders 1
Gain to new shareholders 1
4
(d) 1 mark per paragraph 6
17

29 Ellis Ltd
Notes for initial family briefing
General
 Assumes expansion is desirable for the company.
 The family's interests as shareholders may differ from those of the management.
 Needs clear understanding by family of what/how to invest in new funds; discounting; sensitivity, as this
strategy carries a risk that it may not succeed.
Director A
 Venture capital is 'the provision of risk-bearing capital, usually in the form of participation in equity, to
companies with high growth potential'. That is, the venture capitalist will often provide funds in return
for shares, a seat on the board and a clear route to sell its shares in the medium term.
 Venture capital may be difficult to raise in current market conditions; may be expensive to raise; not
easy for a medium-sized company to raise, but it is potentially cheap and flexible funding.
 It will give away control of the company (or at least provide much more information). Venture
capitalists are likely to want capital growth.
Director B
 Organic growth is the retention of profits and/or raising new finance to fund internally generated
projects, e.g. new product development. It normally implies a relatively slow rate of growth.

© The Institute of Chartered Accountants in England and Wales, March 2009 155
 Finance and capital structure

 Such organic growth is superficially less risky to the family but what about the company and its long-
term future? (May be risky not to innovate and/or grow.)
 Bank borrowings can be inflexible; must provide security; interest is a 'fixed' cost compared to
discretion over dividend payments.
 Strategy is one of seeking long-term dividends/income rather than capital growth (Modigliani and Miller
assumption that the shareholders can sell shares will not apply, as not easily sellable).
Director C
 Sale and leaseback is the raising of funds by selling assets of the business and then leasing them back.
Often this will involve the sale of premises to a financial institution.
 No guarantee that marketing will necessarily increase sales; needs clear plan for spend and evaluation
of proposal.
 Sale and leaseback can be a risky way to raise funds; cedes control of key assets; interaction with
other forms of borrowing restricts choices but a good way to raise significant cash, if required.
(Unlikely that this much cash would be needed merely for a marketing campaign.)
 Sale of company = capital growth strategy. Implies loss of control by family – do they want this?

Marking guide
Marks

General 2
Director A 2½
Director B 4
Director C 3½
12

30 Personal investment
Banks and building societies
When you put money into a bank (or building society), you are lending money to it. It uses this cash to
make loans to other people and businesses. The bank will pay you interest on your deposit to encourage
you to do so. It charges interest to those to whom it lends. On this aspect of its business the bank makes a
profit from this. You are a customer of the bank and the reward (interest) that you get is not linked to the
profit that the bank makes.
There are no guarantees, but the major Bangladesh banks and building societies provide a very safe deposit
for your money. At the same time the rates of interest are very low. This partly reflects the fact that
returns are safe. Risk and return tend to be linked.
Interest rates are low at present, by historical standards, but they reflect low expectations of price inflation.
In reality you are probably not worse off by having your funds in a bank deposit account now than you were
a few years ago.
Shares
When you buy shares in a company, you become a part owner of that business. The benefits that you get
from ownership depend entirely on how profitable the company is.
Shares are slices of the ownership of the company. When you buy shares through the Stock Exchange you
are buying them from some person or investing institution (like an insurance company) that has decided to
sell its stake, or part of it, in the ownership of the company. You merely replace the previous owner of the
shares as a part owner of the company.

156 © The Institute of Chartered Accountants in England and Wales, March 2009
 ANSWER BANK

Sometimes companies expand by inviting investors to buy new shares that it issues. Here investors would
be buying new shares rather than 'second hand' shares from an existing shareholder.
Company profits and dividends
As already said, shareholders share in the profits made by the company in proportion to how many of the
total shares they own individually. Most companies whose shares are available to buy through the Stock
Exchange reinvest much of their profits in an attempt to generate greater future profits for their
shareholders. Most of them also pay part of the profit as a cash dividend to their shareholders, according to
how many shares each owns.
Dividends are not guaranteed. If a company makes no profit there would usually be no dividend, though
companies are allowed to pay dividends using funds generated from previous years' profits. Even where
profits are good, the directors may feel that reinvesting all of those profits and not paying any dividend will
serve the shareholders' best interests.
In theory, the dividend should be dependent on the amount of funds available and the investment
opportunities available to the business. If there are lots of profitable opportunities, no dividend would be
payable. The larger, better known companies, like Sainsco, usually pay part of their profit as a dividend,
partly because they know that many, perhaps most, of their shareholders need a regular stream of cash.
Companies seem reluctant to fail to pay any dividend. They seem to pay fairly steady dividends from one
year to the next, with relatively small increases from time to time. Whether the company pays a dividend
or not, the profits generated belong to the shareholders; so, if they are not getting a dividend, the value of
their shares should be increasing.
When you buy your shares you will have to pay the current market price. That price will depend on general
expectations of the future economic prospects for the company concerned. This, in turn, will depend on
such things as the perceived quality of the management, the future market for the product or service that
the company sells etc. No one knows what will happen in the future, but the price of a share at any
moment should represent the consensus view on what the share is worth taking account of the prospects
for the company. There is strong evidence that the price of a share at any time is a fair representation of its
fair value according to the information available.
Share prices alter on a minute-to-minute basis, according to investors' perceptions of their fair value. This
means that when you come to sell your shares, they may not be worth as much as you hope, or even as
much as you paid for them.
Risk and return
The rewards of share ownership are a combination of the dividends received plus any increases (less any
decreases) in the price of the shares. There are no guarantees. History shows that on average investing in
shares yielded significantly higher returns than putting your money in the bank. Despite this, over particular
short periods and with the shares of particular companies, investment in shares has been less rewarding
than bank interest.
Sainsco
Evidence shows that newspaper tips and advice of any 'experts', on individual shares, are not worth
following and that they will only be correct by chance. If Sainsco is a well-run company with a profitable
future, neither the newspaper tipster, nor you will be the only people to notice this. This information will
already be reflected in the share price. This is not to say that Sainsco does not represent a good
investment, but if the shares of all companies are fairly priced, then this will be equally true of all of them.
Share prices reflect expected returns.
Eggs and baskets
You would be ill-advised to put all of your money into the shares of one company. Evidence shows that
spreading your funds between 15 or more different shares can eliminate some of the risk of owning shares.
If the amount of funds that you have to invest is small, it may be uneconomic, in terms of agents' fees, to
spread your investment funds so thinly.
In this case it is possible to achieve this risk diversification by pooling your funds with those of other small
investors. Funds (unit trusts etc) are available for this. The disadvantage of this is that the managers of the

© The Institute of Chartered Accountants in England and Wales, March 2009 157
 Finance and capital structure

funds take a fee out of your investment for running the funds. These fees vary from fund to fund, so it may
be valuable to shop around.

Marking guide
Marks

Banks and building societies 2

Shares 3
Company profits and dividends 3
Buying and selling shares 3
Risk and return 1
Sainsco 2
Diversification 2
Maximum 16
Total available 14

31 Sheridan Ltd
Briefing notes
A substantial investment such as that proposed may be seen as increasing the business risk of the company,
despite the fact that the company being acquired operates in the same sector. This could increase the
required return of both shareholders and lenders.
Issuing more debt could reduce the average cost of capital, although an expansion of this size, funded
entirely by debt, could push up the cost of capital rather than reduce it.
The company may well be below its optimal capital gearing level at the present time and while the precise
optimal level is a matter of judgment (based on likely market response to particular capital structures),
forming that judgment must take account of Sheridan's current level of gearing as well as the sector average.
With regard to the comments by Director C, in theory gearing makes no difference to the wealth of
shareholders in the absence of taxes (M&M) – cheaper loan finance has a positive impact that is precisely
cancelled out by the higher returns required by shareholders in the face of higher risk.
However, taking account of the tax deductibility of loan interest, gearing favours shareholders, although at
higher levels of gearing the risk of non-servicing of interest commitments could impact adversely on
shareholder wealth via liquidation. Gearing policy, therefore, appears to be about striking a balance between
the benefits of tax relief and the potential costs of bankruptcy.
Rights issue
This is relatively cheap to issue and not as difficult to price compared to a public issue.
If fully taken up it will not change the control of the company and existing shareholders will retain all the
benefits of the acquisition.
There would, however, be no benefit from cheaper debt finance.
Investors need not lose out if they do not wish to participate as they can sell their rights (market efficiency
will dictate a price at which they will not lose out). Existing investors will only lose if they neither take up
nor sell their rights.
Equity is rather more expensive than loan finance as investors expect higher returns than they do for loans,
given that the returns are more risky and paid after the payments to lenders.

158 © The Institute of Chartered Accountants in England and Wales, March 2009
 ANSWER BANK

The comment made by Director A is somewhat illogical – market efficiency theory (and evidence) suggests
that whatever the current share price, it represents the best unbiased estimate of a share's worth based on
available evidence.
Unlike interest, dividends are not, in theory, a fixed commitment.
Loan stock or bank loan
Either would be cheaper to raise and service relative to equity, as it offers a fixed income to providers,
which is paid ahead of equity shareholders and for which they are prepared to accept a lower level of
return. However, it is often seen as more risky than equity.
With regard to the comments of Director B, the driver of EPS or share price is not how a project is
financed but the nature of the project itself – as long as it has a positive net present value it will generate
returns for shareholders over and above their required minimum return and should therefore increase both
earnings and share price.
The use of debt finance instead of equity should result in a lower overall average required rate of return
and, correspondingly, a higher share price.
This is a large acquisition for the company, so serviceability of additional debt would be a key issue. There is
also, often, an obligation to redeem loan stocks.
High gearing may increase the perceived risk, thereby increasing the interest rate demanded by lenders and,
unlike dividends, interest is a fixed commitment.
Another issue to consider is whether the loan stock would be secured or unsecured, which could, in turn,
have an impact on the interest cost.
With regard to the comments of Director D, a bank loan may well require good security and come with a
series of restrictive covenants. This raises the question of whether the company has sufficient unused debt
capacity in its assets.
Lenders have contractual rights to interest and redemption payments, but loan interest is tax deductible,
which makes it cheaper than equity.
Recommendation
Probably a mixture of rights issue and debt – the precise balance being based on estimated calculations of
the likely impact on the overall cost of capital.

Marking guide
Marks

Introduction 3
Rights issue 4
Loan stock / bank loan 5
Recommendation 2
Maximum 14
Total available 12

© The Institute of Chartered Accountants in England and Wales, March 2009 159
 Finance and capital structure

32 Nash Telecom
(a) Rights issues
A rights issue is an issue of new shares for cash to existing shareholders in proportion to their existing
holdings.
The ex-rights price is the price at which the shares will settle after the rights issue has been made.
Underwriting is the process whereby, in exchange for a fee, an institution or group of institutions will
undertake to purchase at the issue price any securities not subscribed for by the public.
(b) Theoretical ex-rights price
Market value of shares pre - rights issue  rights proceeds
The theoretical ex-rights price =
Number of shares ex - rights

Calculation of the theoretical ex-rights price

€
Current holding 20 shares at €20 each 400
Rights issue 16 shares at €15.5 each 248
Total new holding 36 shares worth 648
So theoretical ex-rights price = €18 (€648 ÷ 36) as stated in the newspaper.
However, it is possible that the actual price may be higher or lower than the theoretical figure,
depending on market expectations about the prospects for the business.
(c) Effect on wealth
You should consider a number of factors in deciding whether to take up the rights issue.
 Whether you wish to continue in the company for the long term (as its recent performance has
been poor and it has run up a debt mountain).
 Whether you want to maintain your holding at the same proportionate level. (If you give up your
rights, you will effectively have half the proportionate holding).
 Whether you have the money to subscribe for the rights issue.
 The market price for selling the rights.
In theory, this is the financial effect on uncle of him subscribing or nor subscribing for the rights issue.
€ €
Uncle's current holding (say 200 shares) is worth (200  €20) 4,000
(i) If uncle takes up the rights
New holding is worth ((200 + 160)  €18) 6,480
Less Cost of new shares (160  €15.5) (2,480)
Net effect 4,000
(ii) If uncle sells the rights
Holding is now worth (200  €18) 3,600
Plus Sale of rights (160  (€18 – €15.5)) 400
Net effect 4,000
(iii) If uncle does nothing
Holding is now worth (200  €18) 3,600

Thus in situations (i) and (ii) above uncle 'breaks even', i.e. his wealth remains the same (€4,000). If he
chooses to do nothing (situation (iii)), however, he will lose €400 (€4,000 – €3,600).
However, in practice the company might well sell the rights on uncle's behalf and reimburse him with
the difference (€400).

160 © The Institute of Chartered Accountants in England and Wales, March 2009
 ANSWER BANK

(d) Reducing debts

Nash Telecom seems to have considered debt-based options. Other possibilities might include the
following.
 Make a public issue of shares – this would dilute the control of existing shareholders. This would
also be expensive. However, existing lenders would be encouraged, as gearing will be declining.
 Negotiate the conversion of (substantial) loans into equity – this dilutes existing shareholders'
interests and eliminates right of lenders to repayment.
 Seek to be taken over by a large company with limited debts, i.e. to produce a combined
company with a reasonable debt to equity relationship – this reduces risks for existing
shareholders and for employees.
 Seek a venture capitalist investment – this dilutes the existing shareholders' interests; and there is
continuing uncertainty about long-term ownership for both employees and shareholders.
 Divestment, i.e. sell off assets and raise cash to reduce debt. This subsequent lack of assets might
well affect the company's performance, and a sale and leaseback arrangement might be preferred.
 Seek Government finance to re-structure the company and/or to support specific operations –
this increases the Government's stake in the future of the business.
(e) WACC
The cost of equity is generally deemed to be greater than that for debt. This is not least because of the
tax advantages of debt (since the interest payments get tax relief). In addition debt holders normally
require a lower rate of return, as the level of return is fixed and the company is obliged to pay it.
So, it is probable that the weighted average cost of capital would increase with the shift from debt to
equity, but it would depend on whether the company is close to (or even above) its optimal level of
gearing.
Interest rates are currently relatively low, but Nash Telecom would need to pay higher than market
rates due to its high level of debt.
However, Modigliani and Miller originally concluded that a company's weighted average cost of capital
should not be affected by its capital structure. They argued that, as a company's level of debt increased
the cost of equity would increase in direct proportion, thus cancelling out the effect of the cheaper
debt. Subsequently they developed their theory to show that in the presence of corporation tax it is
advantageous to issue debt.

Marking guide
Marks

(a) 1 mark per point 3

(b) 1 mark per point 4
(c) 1 mark per point 4
(d) Up to 2 marks for each reasoned point 5
(e) 1 mark per point 3
19

© The Institute of Chartered Accountants in England and Wales, March 2009 161
 Finance and capital structure

33 Zimba Ltd
(a) Determination of whether an investment should be undertaken
(i) The new investment does not take place
(0.2)(1.02)
Share price = 0.2  (3 year annuity factor @ 15%) + ( )  1.153
0.15 – 0.02
= 0.2  2.283 + 1.0318
= 0.4566 + 1.0318
= 1.4884, i.e. CU1.49
Value of equity excluding project = CU1.4884  150 million = CU223,260,000
(ii) The new investment takes place

0.21
Share price = = 1.75, i.e. CU1.75
0.16 – 0.04
Value of equity including project = CU1.75  200 million = CU350,000,000
CU
Difference in values 126,740,000
Initial outlay (50,000,000)
Value generated by investment 76,740,000
Thus the new investment appears to be viable.
(b) REPORT
To The Directors, Zimba Ltd
From A Jones, External Consultant
Date Today
Subject Investment and financing of digital television investment
Introduction
The new investment is significant in relation to the existing size of the company and is a departure into
a related, but new, market. The implications for returns, risk, liquidity and form of finance thus need to
be carefully considered.
The new investment
Returns
The calculations provided in Appendix 1 (part (a)) show that, using the dividend model, there is an
increase in share price and hence the project appears to be worthwhile. One minor concern is that, in
effect, profits net of taxes are distributed and thus the increase in annual dividend is an increase in
profit rather than cash flows. The information relating to cash flows of the project has not been
provided. Nevertheless, in the longer term profits are equivalent to cash and the dividend stream is
maintained in perpetuity. Therefore the two can, in this instance, be seen as more or less equivalent.
Additionally, there appears to be a significant increase in the value of the company, so there is
considerable margin for error.
Risk (company accountant and managing director)
The existing business relating to digital cameras appears to be risky in the sense of sales volatility and
in terms of cost structure (operating gearing). Nevertheless, the question of introducing some financial
gearing should not be ruled out entirely on risk grounds without considering other issues. The
problem of gearing is examined below.

162 © The Institute of Chartered Accountants in England and Wales, March 2009
 ANSWER BANK

Debt financing (finance director)

The company currently has zero gearing. The introduction of debt to finance the project will produce
an advantage with respect to the value of the tax shield on interest.
The finance director is not, however, correct in stating that debt finance at 8% is necessarily cheaper
than equity at 15%. The risk of the project is greater than the average of existing projects, but if the
project were debt financed there would be further financial risk exposure for shareholders in addition
to this operating risk. In a perfect world the cost of equity would rise sufficiently to maintain the
weighted average cost of capital at 15%, but with the tax advantage of debt it would be a little lower
than this.
This point relates to the irrelevance of gearing. This concerns a perfect world (e.g. no tax, equal
borrowing and lending rates, risk averse investors, costless transactions, zero bankruptcy costs). The
tax shield generates an advantage to gearing but ultimately bankruptcy costs will create additional cost
to gearing as debt approaches high levels. Moreover, gearing will increase both company specific and
systematic risk and, in the latter case, will demand a price in the market.
A further cost of debt may be the existence of restrictive covenants, which may prevent the company
from taking certain actions, such as the issuing of further debt ranking above this issue. The
importance of financial flexibility would thus need to be considered.
A final point relates to the form of debt. The finance director argues for a publicly-issued debenture,
but consideration should also be given to privately-issued debt, e.g. from a bank. This type of debt
tends to have lower interest rates and issue costs than debentures, but more covenants and other
forms of control.
Rights issue (company accountant)
Where a company faces high operating and business risk it may be prudent to limit financial gearing.
The question of the optimal level of gearing is, however, a question of balancing costs and benefits and,
even where other types of risk are high, this does not entirely exclude the possibility of debt. The debt
financing of this new investment would give a gearing level which would not be high but would still
need to be considered after a more detailed examination and quantification of operating and business
risk.
Regarding the rights issue, its main function is to implement pre-emption rights in respect of existing
shareholders, such that they capture the value of the new project and have the opportunity to
maintain their share of equity and control in the company.
The issue costs, while smaller than a public issue of shares, and possibly debentures, are likely to be
greater with a rights issue than with privately-issued debt.
Conclusion
The project looks to be viable with a considerable margin of safety, notwithstanding the fact that it is
likely to result in an increased risk to all finance providers. The optimal form of financing is, however,
far from clear: it should be the subject of further detailed analysis and negotiation with the potential
finance providers.

Marking guide
Marks

(a) (i) Calculations 3½

(ii) Calculations 3½
Conclusion 1
8
(b) Report format 1
1 – 2 marks per paragraph 11
12
20

© The Institute of Chartered Accountants in England and Wales, March 2009 163
 Finance and capital structure

34 Genesis Ltd
(a) WACC
0.05 1.08
Cost of equity = + 0.08 = 0.036 + 0.08 = 11.6%
1.5

Cost of debt = 5 (1 – 0.3) / 50 = 7%

8.40
Cost of preference shares = = 10.5%
80
(300  0.116)  (20  0.07)  (16  0.105)
WACC =
300  20  16
34.8  1.4  1.68
= = 11.27%
336
(b) Use of WACC
The use of the WACC as a discount rate in investment appraisal depends upon a number of principal
assumptions.
(1) The objective of the company is to maximise the current market value of the ordinary shares.
(2) The market is perfect and the share price is the discounted present value of the dividend stream
(the dividend valuation model is correct).
(3) The project is of the same level of operating risk as the existing activities.
(4) The finance for the project comes from a pool of funds and is not project specific (and market
values are stable). There are no other forms of financing.
(5) The project is marginal, i.e. small in size relative to the size of the company.
(c) Gordon growth estimate
Gordon growth model: g = r  b
CU30m 100
r (ARR) = = 7.32%
CU410m
b (ERR) = 66.6%
g = 7.32%  66.6% = 4.9%
(d) Major limitations
The major limitations relate to the assumptions/premises on which the model is based.
(1) The assumption that r and b will be constant (inflation can substantially distort the accounting
rate of return if assets are valued on an historical cost basis).
(2) The assumption that all new finance comes from equity.
(3) Dividend growth is based on future earnings.
(4) The dubious reliance on accounting profits (the model is based on the premise that the higher
the company's level of retentions and the more effectively the funds are used, the greater is the
potential growth rate).

164 © The Institute of Chartered Accountants in England and Wales, March 2009
 ANSWER BANK

Marking guide
Marks

(a) Calculations 5
(b) 1 mark per point 6
(c) 2 marks max 2
(d) 1 mark per point max 3
16

35 Educare Ltd
(a) WACC
Cost of equity
D 0 (1+ g)
ke = +g
P0

0.052 (1  0.05)
= + 0.05
1.21- 0.052
= 9.7%
Cost of debt
This is given as 5.5% after tax.
Value of equity
120m  (1.21 – 0.052) = CU139m
Value of debt
(Normally given value of debt and find after tax cost. Here given after tax cost – so reverse
procedure.)
0.09 (1 - 0.30)  30 [0.09 (1 - 0.30)  30]  30
VD = +
(1  0.055) (1  0.055)2
= CU30m
WACC
(9.7% 139)  (5.5%  30)
WACC =
(139  30)

= 9.0%
(b) Discussion of colleagues' points
Dividends and WACC
The dividend valuation models do not suggest what dividends should be paid, simply that whatever
level of dividends are expected to be paid dictates the market value of the company. Assuming that
Educare were to pay a lower dividend than normal, this would mean that it would have more
investment funds available than normal and this would lead to a higher profit than normal. This must
mean either that the growth rate of dividends must increase relative to what it would otherwise be, or

© The Institute of Chartered Accountants in England and Wales, March 2009 165
 Finance and capital structure

funds would build up in the company and these would sooner or later be paid to the shareholders.
One way or another the shareholders would receive dividends or some other cash receipt from the
company.
Unlisted loan stock
Since the loan stock is unlisted there is no ready market for it. Any investor who wishes to liquidate
the loan may well have to wait until the redemption date before being able to do so, though a buyer
might be found. To induce investors to take up the loan stock, the company would normally have to
offer a premium rate of interest. When basing the cost of this debt on similar, but listed, loan stocks, it
would be necessary to allow for this factor. The extent of this 'allowance' would be a subjective
judgement.
Target dividend growth rate
In theory (Modigliani and Miller) dividends should only be paid where the company cannot find positive
NPV projects in which to invest. As these will not follow a regular pattern, and neither will the
available funds, a target dividend growth rate seems odd. It may be achievable, but only by risking the
possibility that wealth-enhancing investments may be overlooked. The only way in which these two
points can be reconciled is by the company raising additional finance from a share issue or borrowing
to meet the shortfall in funds.
In practice, companies seem eager to maintain steadily rising dividend levels over the years.
(c) Use of WACC
Possible reasons for the WACC determined in (a) being unsuitable for the investment in China include
the following.
 As discussed in (b), the target growth rate of dividends may well not be achievable, calling the
cost of equity into question.
 The loan stock is to be redeemed in two years. The company may not be able to negotiate a
similar loan at a similar rate. On the other hand the cost of debt is market-determined.
 The weightings may alter as a result of changes in the market values of debt and/or equity. The
investment in China may itself shift these weights, since the investment's NPV will all accrue to
the shareholders (not to the loan stock holders).
 An explicit change in the company's financial structure would cause the weights to alter.
 The tax rate may alter during the course of the project.
 The project may be in a risk class different from the generality of projects currently undertaken
by the company.
 There could be other sources of finance used by the company in future, e.g. a bank overdraft,
that has not been considered.

Marking guide
Marks

(a) Cost of equity calculation 2

Value of debt 2
WACC 2
6
(b) 2 marks per point max 5
(c) 1 – 1½ marks per point max 6
17

166 © The Institute of Chartered Accountants in England and Wales, March 2009
 ANSWER BANK

36 Saddlebrook Ltd
Use of WACC
The discount rate that should be used is the weighted average cost of capital (WACC), with
weightings based on market values. The cost of capital should take into account the systematic risk of the
new investment, and therefore it will not be appropriate to use Saddlebrook Ltd's existing equity beta.
Instead, the estimated equity beta of the main Czech competitor in the same industry as the new proposed
plant will be ungeared, and then the capital structure of Saddlebrook Ltd applied to find the WACC to be
used for the discount rate.
Ungearing of Czech company beta
Since the systematic risk of debt can be assumed to be zero, the Czech equity beta can be ungeared using
the following expression.

a =  e E
×
E  D (1 t)
where:
a = asset beta
e = equity beta
E = proportion of equity in capital structure
D = proportion of debt in capital structure
t = tax rate
For the Czech company:
a = 1.5 × 60 / (60 + 40(1 – 0.3))
= 1.023

The next step is to calculate the debt and equity of Saddlebrook Ltd based on market values.

CUm
Equity: 2 × 225m = 450m shares at 376p 1,692.00
Debt: Bank loans (210m – 75m) 135.00
Bonds (75m  1.195) 89.63
Total debt 224.63
We can now apply Saddlebrook's gearing level to the asset beta to calculate the relevant equity beta.

E  D (1 – t)
e = a 
E
1,692  224.63 (1 – 0.3)
= 1.023 
1,692
= 1.118
This can now be substituted into the capital asset pricing model (CAPM) to find the cost of equity.
k e = rf +  (rm – rf)
= 7.75% + 1.118 (14.5% – 7.75%)
= 15.3%

© The Institute of Chartered Accountants in England and Wales, March 2009 167
 Finance and capital structure

Bank loans CU135m have a cost of (8.25% + 1%) × (1 – 0.30) = 6.475%.

Bonds CU89.63m have a cost of [CU10.5m (1 – 0.30)]/CU89.63m = 8.2%.

Then, calculate the WACC:

WACC = [(1,692  15.3) + (135  6.475) + (89.63  8.2)]/[1,692 + 224.63]

= [25,888 + 874.125 + 734.966]/1,916.63 = 14.35%

Marking guide
Marks

Use of WACC 3
Ungearing of Czech beta 3
Cost of equity 3
Debt and equity 3
WACC 3
15

37 Quigley Industries Ltd

Financing and other issues relating to a major investment
Gearing
Quigley Industries Ltd (QI) is operating in a classic cyclical industry, with high capital intensity and, almost
certainly, high operating gearing. Operating profits are susceptible to great fluctuations in the face of
fluctuations in revenue. History shows this trade to be subject to such fluctuations.
Financial gearing must therefore be approached with caution. Identifying the optimal level of gearing seems
very difficult to achieve. It can only be a matter of judgement, but forming that judgement must take
account of QI's current level of gearing and of levels of gearing in the industry, particularly with market
leaders and with companies having high operating gearing, such as QI.
In theory (Modigliani and Miller) gearing makes no difference to the wealth of the shareholders: cheap loan
finance has a positive effect that is precisely cancelled out by the higher returns required by shareholders in
the face of higher risk. If we take account of the tax deductibility of loan interest, gearing in theory favours
shareholders since, in effect, there is a transfer of wealth from the tax authorities to shareholders.
At higher levels of gearing the risk of the company being unable to meet its debt commitments of interest
and capital repayment, particularly during a period of low revenue/operating profitability, could force the
company to liquidate, to the detriment of shareholders' wealth (Director B's comment). Gearing policy
tends, therefore, to be seen as striking a balance between the benefits of tax relief and the potential costs of
'bankruptcy'.
Other factors that could come into play
Agency
Directors may be unwilling to gear the company up to a level optimum to the shareholders. This is because
gearing imposes a set of disciplines on the directors, i.e. of having to meet interest payments and arranging
continuing finance when the loan is due for redemption.
Signalling
It is believed by some that a company making a loan issue implies confidence in the future, and this could
have a favourable effect on the share price.

168 © The Institute of Chartered Accountants in England and Wales, March 2009
 ANSWER BANK

Clientele effect
It is believed that particular shareholders are attracted to the shares of a particular company, because of the
level of gearing. Altering the level of gearing could have a detrimental effect on the share price as investors
move away from the company to a 'preferred habitat'. Uncertainty about the company's intentions could
also have a detrimental effect.
A large positive NPV project, such as the new plant, will affect gearing, since it will add value to the equity
of the company.
Equity
This is an obvious source of finance, subject to the gearing level. 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
face the company with much of a problem regarding the issue price. There is normally a right that existing
shareholders are offered new shares before a public issue can be made. Usually the shareholders would
need to vote away their 'pre-emption' rights, before the company could go for a public issue.
A public issue is much more expensive than a rights issue to achieve, because there are legally-required,
expensive procedures to be met. Public issues tend to be more likely to fail. Setting prices for public issues
tends to be difficult to judge.
Equity is rather more expensive to QI than loan finance: investors expect higher returns than they do for
loans, but their returns are distinctly more risky. (Director C's comment). Equities seem popular at present.
Loan finance
Whether a loan stock issue to the public or a term loan from a financial institution, loan finance is relatively
cheap to raise relative to equity. Lenders typically expect good security, and freehold land tends to offer the
best security. So the ability of QI is likely to be linked to the extent that it has unused 'debt capacity' in its
assets.
Lenders typically expect lower returns than equity holders, but they have contractual rights to interest and
redemption payments on the due dates. This exposes the company to risk and to discipline.
Provided that the company has sufficient taxable profits, loan interest is tax deductible and this makes it still
cheaper for the company.
Retained earnings
This is an important source of new finance to Bangladesh companies. 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 a
real option.
The revenue reserves are not cash, but part of the owners' claim. Therefore they are not available as
investment funds (Director D's comment).
Retaining profit has implications for dividend policy and, possibly, for shareholder wealth.
Market efficiency
The evidence is clear, that in sophisticated stock markets charted price patterns do not repeat themselves,
except by chance. Weak form efficiency is present in such markets.
It is illogical to feel that a time of low share prices is a bad time to issue new shares. Market efficiency
theory (and evidence) suggests that whatever the share price is at any point represents the best unbiased
estimate of its worth based on available evidence (Director A's comment).
Other sources
 Leasing the plant
 Sales and leaseback
 Working capital efficiencies
 Possibility of grants from public funds

© The Institute of Chartered Accountants in England and Wales, March 2009 169
 Finance and capital structure

Advice
It is possible that QI has sufficient 'in-house' expertise to enable it to avoid the need for professional advice.
Raising the level of finance that we are probably considering here is not an everyday event for a commercial
company, so it is probably better to seek advice from experts.
Investment banks can typically offer advice and may well be able to put the company in touch with potential
investors, assuming that the rights-issue route is not taken.
The larger firms of chartered accountants, almost certainly QI's auditors, have close links to corporate
finance advisors.
The advice will not typically be cheap (Director B's comment).

Marking guide
Marks

Gearing 3
Other factors: 1½ marks per point 4
Equity 3
Loan finance 3
Retained earnings 3
Market efficiency 3
Other sources 3
Advice 4
Maximum 26
Total available 22

38 Philpot Ltd
(a)
The rights issue price = CU5.00 × 0.90 = CU4.50
The theoretical ex-rights price = [(4 × CU5.00) + CU4.50]/5 = CU4.90
The value of the rights per existing share = (4.90 – 4.50)/4 = CU0.10
(b)
The value of 625 shares after the rights issue = 625 × CU4.90 = CU3,062.50
The value of 500 shares before the rights issue = 500 × CU5.00 = CU2,500.00
The value of 500 shares after the rights issue = 500 × CU4.90 = CU2,450.00
The amount of cash subscribed for the new shares = 125 × CU4.50 = CU562.50
The amount of cash raised from the sale of rights = 500 × CU0.10 = CU50.00
The shareholder could do nothing, take up the rights or sell the rights (or any combination of these).
The effect on the shareholder's wealth depends on the action taken:
(1) If the shareholder takes up the rights, the rights issue will have a neutral effect on his wealth. As
an owner of 500 shares, he will purchase an additional 125 shares and the value of the total 625
shares (CU3,062.50) will be the same as the value of 500 shares before the rights issue
(CU2,500.00) plus the cash subscribed for the new shares (CU562.50). The make-up of the
shareholder's wealth will have changed (less cash, more shares), but not his total wealth.
(2) If the shareholder sells his rights, the rights issue will also have a neutral effect on his wealth. The
value of 500 shares after the rights issue (CU2,450.00) plus the cash received from selling the
rights (CU50.00) equals the value of 500 shares before the rights issue (CU2,500.00). Again, the
make-up of the shareholder's wealth will have changed (more cash, less shares), but not his total
wealth.

170 © The Institute of Chartered Accountants in England and Wales, March 2009
 ANSWER BANK

(3) If the shareholder neither takes up the rights nor sells the rights, a loss of wealth of CU50 will
occur, representing the difference between the value of 500 shares before the rights issue
(CU2,500.00) and the value of 500 shares after the rights issue (CU2,450.00).
(c) Factors that may influence the actual share price following the rights issue
(1) The expectations of investors/the stock market regarding the company's future.
(2) The level of take-up of the rights issue – if the issue was not fully taken up, for example, the share
price might fall.
(3) Information regarding the use to which the proceeds will be put and the market's reaction to that
information – possibly being used to restructure finances in a way that affects the company's cost
of capital; or being used in a project with a positive net present value.
(4) General stock market conditions/sentiment at the time of the issue, or conditions/sentiment
within the company's particular sector of the stock market.
(5) The existence of specific information (positive or negative) regarding the company or its sector
at the time of the issue.
(6) It is assumed that the details of any new investment/strategy are communicated to, and believed
by, the stock market, but if this is not the case then the share price will differ from the
theoretical ex-rights price. In other words, the degree of efficiency of the market could impact
on the actual share price.
(d) The three forms of theoretical stock market efficiency are weak, semi-strong and strong.
If a stock market has weak form efficiency then only past information is currently reflected in share
prices. Weak form efficiency, therefore, implies that share prices fully and fairly reflect all past
information about the share and investors cannot, therefore, make abnormal gains by studying and
acting upon any past information.
If a stock market has semi-strong form efficiency then not only all past information but also all publicly
available current information (e.g. financial statements, press reports) is currently reflected in share
prices. Semi-strong form efficiency, therefore, implies that share prices fully and fairly reflect all past
and current publicly available information and investors cannot, therefore, make abnormal gains by
studying and acting upon any such information.
If a stock market has strong form efficiency then not only all past and current publicly available
information but also all relevant private information (e.g. board minutes) is currently reflected in share
prices. Strong form efficiency, therefore, implies that share prices fully and fairly reflect all past,
current publicly available and private information and investors cannot, therefore, make abnormal gains
by acting upon information of any sort.
The implication of all this is that if the stock market is efficient in all three forms, investors cannot beat
the market by having superior information as it does not, by definition, exist. However, if the stock
market is not strong form efficient then abnormal gains can be made from possession of private
(insider) information.
Discussion
Empirical evidence suggests that stock markets are certainly not strong form efficient, so the bank's
claim appears misguided. There is much empirical evidence, however, that stock markets are semi-
strong efficient and so it is unlikely that the company's shares are undervalued and certainly not to any
extent that might justify deferring a public issue.
Regarding the finance director's statement, its accuracy depends in part on which form of market
efficiency is evident. Strong form efficiency does suggest that share prices are 'correct' (they reflect
true values) at all times, but the other two forms of efficiency would not generate 'correct' share
prices as they do not fully consider all information. However, even with a strong form efficient market
there may be a time lag between the emergence of new, relevant information and the market reaction
to it, meaning that for a time prices will not be 'correct'.

© The Institute of Chartered Accountants in England and Wales, March 2009 171
 Finance and capital structure

Finally, as regards the ability of analysts to predict future share prices, if the stock market is strong
form efficient then analysts will be unable to achieve consistently superior rates of return. But that
does not mean they cannot predict share prices – by chance they may do so on occasions, but the
implication is that they will be unable to do so consistently. However, if the market is only semi-strong
form efficient, then if the analysts have access to any private information then they may be able to
predict the future share price and make superior rates of return.

Marking guide
Marks

(a) Calculation 2
(b) Calculations: 1½ ; explanations 2½ 4
(c) 1 mark per paragraph max 4
(d) 1 mark per paragraph max 8
18

39 Efficient markets hypothesis

(a) Three forms of EMH
The efficient market hypothesis considers how efficient the market is at impounding in prices
information available to investors. Three possible levels of efficiency have been postulated.
Weak form
A market is weak form efficient if all the information which has been gleaned from a security's past
price movement has been reflected in the current market value of that security.
Semi-strong form
A market is semi-strong form efficient if all publicly-known information about a company, including its
plans, together with information about the security's past price movements, is reflected in the current
market value of that security.
Strong form
A market is said to be strong form efficient if the current market value of a security reflects all
relevant information, including information which is supposedly secret to the company.
(b) Stock market efficiency
One of the principal assumptions underlying financial management is that the market value of a
security is based upon investors' expectations of future earnings derived from that security, and that
those earnings are discounted at the investors' required rate of return. Expectations of future earnings
are based upon information available in the market.
First statement
The first view given in the question is stating that having released information regarding a company's
earnings, this has resulted in a revision of investors' expectations. In this situation this has led to an
increase in the market value of the security because the information was favourable – actual earnings
being better than market expectations.
Because this high return was experienced over two or three days following the announcement, it
suggests that the market transmission mechanism is not perfect. Had it been perfect there would have
been no time delay: all investors would have received the information at the same time and acted upon it.
This scenario is characteristic of a semi-strong form efficient market, in that investors are revising
their expectations regarding future earnings as soon as the information is publicly known, although as

172 © The Institute of Chartered Accountants in England and Wales, March 2009
 ANSWER BANK

stated there is a time delay. Having acted upon this information, a new equilibrium is achieved over a
period of two to three days following the announcement.
Second statement
Implicit in the second view is that a professionally-managed portfolio may give a return which is no
better than that which can be achieved by a naive investor, because both have access to the same
information.
This may accord with the view that the market is strong form efficient, all investors having access to all
relevant information. Therefore no party is in a more favourable position relative to the other party,
and neither party can make a gain.
It is also consistent with semi-strong efficiency, i.e. fund managers do not have access to better (inside)
information.
Third statement
This suggests that it is possible to earn abnormal returns by adopting a strategy ('buy just before the
fiscal year end and sell a week or so later'), which is based on information contained in the past time
series. This implies inefficiency. The fact that there is an identifiable cause does not eliminate the
inefficiency. If the market were weakly efficient, arbitrageurs would eliminate the excess return at the
start of the fiscal year by creating buying pressures for the under-priced shares being sold at the end of
the previous fiscal year.

Marking guide
Marks

(a) Explanation of the hypothesis 1

Each form of hypothesis: 1 mark × 3 3
4
(b) Max 3 marks per statement max 8
12

40 Abydos Ltd
(a) Expected NPV
The NPV is found by discounting the relevant cash flows at the weighted average cost of capital,
calculated as follows.
Cost of equity
Using CAPM
Ke = rf +  (rm– rf)
= 5 + 1.4(12 – 5) = 14.8%
Cost of debt
After tax cost of debt = 8(1 – 0.3)
= 5.6%

© The Institute of Chartered Accountants in England and Wales, March 2009 173
 Finance and capital structure

Weighted average cost of capital

Gearing after the investment has been financed is expected to be E = 0.6, D = 0.4
E D
WACC = Keg +K d
E +D E +D
= 14.8(0.6) + 5.6(0.4)
= 11.12%, say 11%
Tax depreciation
These are on the CU10 million part of the investment that is non-current assets (not working capital
or issue costs).
Year Value at start of year Tax depreciation Tax saving
25% 30%
CU'000 CU'000 CU'000
1 10,000 2,500 750
2 7,500 1,875 563
3 5,625 1,406 422
4 4,219 1,055 316

Year 0 1 2 3 4
CU'000 CU'000 CU'000 CU'000 CU'000
Pre-tax operating cash flows 3,000 3,400 3,800 4,300
Tax @ 30% (900) (1,020) (1,140) (1,290)
Tax savings from tax depreciation 750 563 422 316
Investment cost (11,500)
Issue costs (1,000)
After tax realisable value 4,000
Net cash flows (12,500) 2,850 2,943 3,082 7,326
Discount factor 11% 1.000 0.901 0.812 0.731 0.659
Present values (12,500) 2,568 2,390 2,253 4,828
The expected net present value is
CU(461,000)
Expected APV
To calculate the base case NPV, the investment cash flows are discounted at the ungeared cost of
equity, assuming the corporate debt is risk free (and has a beta of zero).
E
ßa = e
E +D(1– t)

0 .6
= 1.4  = 0.955
0.6  0.4(1  0.3)

The ungeared cost of equity can now be estimated using the CAPM:
Keu = 5 + 0.955 (12 – 5)
= 11.69% (say, approximately 12%)
Year 0 1 2 3 4
CU'000 CU'000 CU'000 CU'000 CU'000
Net cash flows (excl issue costs) (11,500) 2,850 2,943 3,082 7,326
Discount factor 12% 1.000 0.893 0.797 0.712 0.636
Present values (11,500) 2,545 2,346 2,194 4,659
The expected base case net present value is CU244,000.

174 © The Institute of Chartered Accountants in England and Wales, March 2009
 ANSWER BANK

Financing side effects

Issue costs

CU1m, because they are treated as a side-effect they are not included in this NPV calculation.
Present value of tax shield

Debt issued by project = 40%  CU12.5m = CU5m

Annual tax savings on debt interest = CU5m × 8% × 30% = CU120,000
PV of tax savings for 4 years, discounted at the risk-free rate 5%, is CU120,000 × 3.546 = CU425,520
CU'000
Adjusted present value
Base case NPV 244
Tax relief on debt interest 426
Issue costs (1,000)
(330)
The adjusted present value is CU330,000
(b) Validity of the views of the two directors

Sales director

The sales director believes that the net present value method should be used, on the basis that the
NPV of a project will be reflected in an equivalent increase in the company's share price.
However, even if the market is efficient, this is only likely to be true if:

 The financing used does not create a significant change in gearing

 The project is small relative to the size of the company
 The project risk is the same as the company's average operating risk
Finance director

The finance director prefers the adjusted present value method, in which the cash flows are
discounted at the ungeared cost of equity for the project, and the resulting NPV is then adjusted for
financing side effects such as issue costs and the tax shield on debt interest. The main problem with
the APV method is the estimation of the various financing side effects and the discount rates
used to appraise them. For example in the calculation the risk-free rate has been used to discount the
tax effect when the cost of debt of 8% could have been used instead and produced a different result.
Problems with both viewpoints

Both methods rely on the restrictive assumptions about capital markets which are made in the capital
asset pricing model and in the theories of capital structure. The figures used in CAPM (risk-free rate,
market rate and betas) can be difficult to determine. Business risks are assumed to be constant.
Neither method attempts to value the possible real options for abandonment or further investment
which may be associated with the project.

© The Institute of Chartered Accountants in England and Wales, March 2009 175
 Finance and capital structure

Marking guide
Marks

(a) Tax depreciation/tax saving 2

NPV calculations 4–5
APV calculations
Base case NPV 3–4
Financing side effects 2–4
Give credit for technique max 14

(b) Reward sensible discussion. Bonus mark for mention of real options max 6
20

176 © The Institute of Chartered Accountants in England and Wales, March 2009