MAN3080 21-22 exam Jan22 ANSWERS Question 1 (a) Debt GBP million Equity GBP million D/D+E Book values 1000 780 56% Market values 1080 (= 200+800 x110/100) 1200 (= 300 x 4.00) 47% [Total 6] (b) A book gearing of 56% appears to be too high and the market based gearing figure of 47% is only slightly better so it does seem that the company is likely to experience problems in the future due to this position. Benefits of high gearing to raise in discussion: Higher EpS, therefore greater returns to shareholders Higher company and share value (refer to MM propositions with and without tax) Up to a limit – explain static theory, with theoretical optimal maximum gearing level Drawbacks of high gearing Risk of financial distress, insolvency, Greater risk in times of stressed business environment (e.g. Covid pandemic) Risk of fall in credit rating and/or re-financing problems Lack of confidence of suppliers, markets pr other stakeholders Lack of flexibility to pursue future business opportunities requiring new finance. Diverts management time to managing the liquidity and funding position rather than on the business itself and value-creation opportunities. Best practice and case studies [Total 14 max] (c) Amount to raise: 50% x ￡800m x 110/10 = ￡440 million Number of shares Total value Price per share Before rights issue 300m ￡1200m ￡4.00 New issue 150m =300m/2 ￡440m ￡2.93 (= ￡440/150) After rights issue 450m ￡1640m ￡3.64 (= ￡1640/450) [Total 7 max] 1 MAN3080 21-22 exam Jan22 ANSWERS (d) Workings: To calculate profit after tax (PAT) after the rights issue and debt buy-back: Interest is lower by 4% x 800 x 50% = ￡16m Impact after tax is a reduction in PAT of ￡16m (1 – 0.80) = ￡12.8m So PAT after the rights issue and debt buy-back is ￡119m + ￡12.8m = ￡131.8m Earnings Number of shares Earnings per share Before rights issue/debt buy back ￡119m 300m ￡0.397 After rights issue/debt buy-back ￡131.8m 450m ￡0.293 This is a fall of 26% (= (0.397 – 0.293) / 0.397), which is highly material. EpS is a key measure that is followed by analysts and shareholders and is used as a measure of value-added to shareholders. This significant fall is therefore likely to be unpopular and lead to a large fall in the share price , unless the impact on returns is welcomed in return for a large reduction in risk. [Total 11 max] (e) Need to arrive at EpS of ￡0.357 (= 0.397 x 0.90) Total earnings are ￡131.8, so need to end up with 367m shares ( = 131.8m / 0.359) That is, only issue 67m new shares At a price of ￡6.57 each (= ￡440m/67m) This is clearly not feasible given that the shares are only trading at ￡4.00 each at the moment. No-one will be willing to pay ￡6.57 for new shares if they can buy additional shares in the market at ￡4.00. [Total 7 max] (f) Ethical: Confidentiality – Unpublished information of a price sensitive nature should remain confidential, not be disclosed. Code of ethics: ‘respect the confidentiality of information acquired as a result of professional and business relationships’. Professional behaviour. Code of ethics: ‘to comply with relevant laws and regulations and avoid conduct that the professional accountant knows or should know might discredit the profession. Objectivity/conflict of interest is also relevant Legal: risk of being accused of insider dealing if either deal yourself or pass on information to others [Total 5 max] 2 MAN3080 21-22 exam Jan22 ANSWERS SECTION B Question 2 (a) Arguments in favour of hedging Guaranteed EUR price for goods sold/bought Reduces volatility of cash flows/earnings FX rates can be very volatile Lower risk of insolvency Reduced risk should lead to lower cost of capital and therefore reduces the risk of insolvency Use figures from the question to illustrate the extent of losses that could be incurred if orders left unhedged. Arguments against hedging Cost Risk may not be material Lose benefit of favourable rate movements Shareholders can hedge the position themselves and might have purchased shares in this company in order to obtain such currency exposure as part of a diversified portfolio Appropriate strategy Use forward contracts to fix
the price at the point at which a firm order is received. If a firm price is quoted some time before the order is received, consider using an option contract to hedge this exposure up to the point when a firm order is received. [Total 9 max] (b) The currency with the higher interest rate is expected to weaken against the currency with the lower interest rate according to the combination of interest rate parity theory and expectations theory. That is, the EUR is expected to weaken against GBP (good news for an exporter such as RED because they will receive more EUR for each GBP) and strengthen against the USD (bad news for RED). [Total 8 marks] (c) Order 1: EURGBP 1 September 2022 = 0.6720 x (1 + 0.01 x 7/12) / (1 + 0.02 x 7/12) = 0.668 EUR value locked in using a forward contract is 5 million / 0.6681 = EUR 7.48 million Order 2: EURUSD 1 September 2022 = 1.3010 x (1 + 0.05 x 5/12) / (1 + 0.02 x 5/12) = 1.3171 EUR value locked in using a forward contract is 10 million / 1.3171 = EUR 7.59 million [Total 8 marks] 3 MAN3080 21-22 exam Jan22 ANSWERS Question 3 a. There are 1,000m shares in issue (= $500m / 0.50). The projects are expected to have a positive NPV of $10m (= $110m – $100m), which is worth $0.01 per share. So the share price is expected to increase to $2.21 after the announcement of the project Shareholder with 100 shares: Value of shareholding Number of shares Share price Cash received Before dividend $221 = $2.21 x 100 100 $2.21 After dividend waived $221 (no change) 100 $2.21 $0 After scrip dividend $221 (no change) 125 $1.768 = $221/125 $0 [5] Dividend irrelevancy theory states that the dividend decision does not affect firm value and is therefore independent from the investment decision. It is the investment decision that has caused an increase in the share price, not the dividend decision. In this example, the scrip dividend does not change the value of the company and therefore there is no impact on shareholder wealth, even though the number of shares in issue has increased. [Total 13 max] b. In practice, dividends provide ‘signalling’ about the future prospects of the company. So cancelling the dividend altogether is likely to send a bad signal to shareholders and push the share price down. Psychologically, a scrip dividend feels like a reward and result in a smaller fall in share price than is indicated by the new theoretical price calculated above. [Total 5 max] c Green finance = green bonds or green loans, where the use of proceeds is for green projects . The government also provides green loans. Green projects include improvements to the natural environment, reducing carbon emissions etc. Advantages: Cheaper finance. Good publicity. Attract more investors, including more attractive to fund managers. [Total 7 max] 4 MAN3080 21-22 exam Jan22 ANSWERS Question 4 a. Calculations Where: and d1 = [ln(4/3.50) + (0.05+ 0.12^2 / 2) x 3/12] / (0.12^2 x 3/12)^0.5 = (0.13353 + 0.0143) / 0.06 = 2.4638 d2 = 2.4638 – (0.12^2 x 3/12)^0.5 = 2.4638 – 0.06 = 2.4038 So C = 4 x N(2.4638) – 3.50 x e^-0.0125 x N(2.4038) = 4 x 0.9931 – 3.50 x 0.987578 x 0.9919 = ￡0.544 Explanation: The investor could sell the option today for ￡0.544. The shares are currently trading at ￡4.00 and the exercise price of the option is ￡3.50 and so you might expect the option to only be worth around ￡0.50. However, given the high standard deviation of the share price, there is a probability that the share price rises well above the exercise price of ￡3.50 in 3 months’ time, making the option slightly more valuable for the holder of the option. [Total 16 max] b. Discussion of use of values for follow-on real options when evaluating project 1 in this scenario. Variables given: similar to a call option where: Premium is the cost of the first project Exercise price is the cost of the follow-on project at time 3 Asset value is the present value of the cash inflows from the follow-on project at time 0 Time period is 3 years Asset volatility needs to be estimated. If these are typical projects that the company undertakes, the share price volatility could be used as a proxy for the asset volatility. [Total 9 marks max] 5