Question 1The finance director of Otterplc wishes to establish its cost of capital for investment appraisal purposes.The information below has been provided:The following extract is from the statement of financial position(balance sheet)of Otterplc as at 31stDecember 2020:Non-current Liabilities:5% Irredeemable bonds£3,600,000Long term variable rate loan£2,400,000Equity:Ordinary shares (nominal value 50p)£5,000,000The current ex-interest market price of a bond is £105.The ex-dividend current market price of a share is 525p. The historic growth rate of dividends has been 8%. The total dividend per share for 2020was 85p.LIBOR (London Interbank Offer Rate) is currently 1%, and the interest rate on the loan is 1% above this.The rate of corporation tax is 30%.Required:a) Calculate the weighted average cost of capital (WACC) for Otterplc, using market weightings.(15 marks)
b)Explain why market weightings are preferable to book weightings when calculating a company’s WACC. (3marks)
c) Briefly evaluate the issues associated with the method used above in part a) to calculate the cost of equity.(4marks)
d)Using diagrams to illustrate your discussion, explain how Miller and Modigliani’s(1958)view of capital structure changes with the introduction of taxation. (8marks)(Total: 30marks)
Page 3of 6FN281: Financial Management 3rdJune 2021
SECTION B –You are required to answer ONE question from this section
Question 2
An investor has two investment opportunities in the shares of Company X and Company Y. The risk and return characteristics of the two securities are shown below:XYExpected Return12%22%Risk(Standard deviation)6%9%The investor plans to invest 70% of available funds in X and 30% in Y. The correlation coefficient between the returns of the two securities is -0.5.Required:
a)(i)Calculate the expected return from the proposed portfolio of securities X and Y.(2 marks)
(ii)Calculate the risk of the portfolio and comment upon your result in the context of the risk reduction effect of diversification.(6 marks)
(iii)In the context of portfolio theory,explain how the envelope curve is established and what is meant by the efficiency frontier.(4 marks)
b)Explain what beta means within the context of theCapital Asset Pricing Model (CAPM). (4marks)c) Calculate thereturnthat a well-diversified investor would expect fromsecurityA given the following informationand identify whether the security is defensive or aggressive:σA = 15%, σM=10% and ρA,M=+0.4Risk free rate = 2%, Return on the market =8%(4marks)(Total: 20marks)
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Question 3
a)Discuss and evaluate the motives for mergers and acquisitions that could potentially create value for shareholders.(6marks)
b)You are provided with the following information regarding Company A:Over the past four years,Company A’s management has increased their dividend per share every year and their dividendper sharehas grown from 27p to 44p.Company A’s shareholders require a return of 15%.The most recent EPS (earnings per share) of Company A is 250pand the average PER (price earnings ratio) for the sector is 12. The statement of financial position (the balance sheet) forCompany A shows anet asset value of £15m. The property and land however haverecently been revalued by independent valuers and have risen by £3m in value over the balance sheet value. In addition,managers are concerned that some of their customers who owe them money will be unable to pay. They estimate they will have to write off £1.5m fromaccounts receivable. The company has 10millionshares in issue.Required:
i)Using the information above and a different method for each valuation,calculate three valuations on a per share basis for Company A.(6 marks)
ii)Explain and discuss any differences in the three valuations calculatedin part i) above. (4marks)
iii)Discuss how information signalling may potentially explain why Company A has maintained growth in the dividendpaid out to shareholders.
