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Revision 4 Business Finance

Answer 1

(a)1. Venture capital is long-term capital that is available for around five years. It is

normally offered by specialist institutions, and is aimed at small and medium-size

businessesthat have a fairly high level of ris.

2. Venture capitalists are prepared to provide capital to such businesses if the e!pected

returns are commensurate with the level of ris taen . This means that venture

capitalists will only be interested in a business with good profit and growth

prospects. The amount of capital invested will vary according to need and may be

provided in stages, subect to certain !ey obectives being met.

"# mars$

" venture capitalist may be interested in providing capital for the following types of business

situations.

Business start-upsThis can cover a wide range of situations from businesses that are still at

the concept stage through to businesses that are about to begin operations. In practice it seems

that venture capitalists prefer to invest in start#ups that are fairly well advanced.

%rowth capitalThis is designed for businesses that have passed the start#up phase and are

see!ing capital for further e$pansion. It is, therefore, a form of second#stage funding.

&anagement ac'uisitionsVenture capitalists will often provide capital for managers that

wish to ta!e over an e$isting business. The managers may be already employed by the

business or they may be outside managers that are loo!ing for a vehicle for their ambitions.

This type of financing has proved to be e$tremely popular among venture capitalists in recent

years.

(hare purchases%apital may be provided to help finance the buy out of a part#owner of a

business. This may be provided to someone outside the business or to the other part#owners.

Business recoveries%apital may be provided to help turn round the fortunes of a business

that is currently e$periencing difficulties.

)enture capitalistsdo not usually loo! for &uic! cash returns and are often content to wait

for a cash return on realisation of the investment.

"Any five types of business * mars$

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(b)

1. The directors of a business must recognise that venture capitalistswill be seeing high

returnsfor the ris!s that they are prepared to underta!e. This is li!ely to mean that the

directors will be under considerable pressure to perform and to meet agreed

targets.

2. The venture capitalistswill usually e$pect to wor closely with the businessin order

to protect the investment made. It is &uite common for venture capitalists to have a

representative on the board of directors and to be consulted over any proposed

changes to agreed plans.

. It is also &uite common for the venture capitalist to receive forecasts and other

financial information to help monitor the direction and performance of the

business.

. The venture capitalistwill e!pect to receive an e'uity staein the business and will

often sell this sta!e after a period of five years or so. *ence, the directors should

appreciate that the business may be sold to another business or come under the

control of other investorsat some stage.

"4 mars$

(c)

The !ey factors that a venture capitalist may ta!e into account include the following+

Financial performanceThe financial trac! record of the business to date as well as forecast

performance will be closely scrutinised. here forecasts are presented, the validity of the

underlying assumptions as well as !ey estimates will be chec!ed.

+he maret for the products or servicesThe nature of the mar!et is an important factor to

consider. The degree of competition, the threat of substitutes, the bargaining power of

suppliers and employees and the barriers to mar!et entry will be considered along with the

si-e and future prospects for the mar!et as a whole. In addition, the standing of the businesswithin the mar!et, as viewed by customers and suppliers, will be e$amined.

,wner investmentThe owners will usually be re&uired to invest a significant proportion of

their personal wealth in the venture. The venture capitalist will e$pect the owners to

demonstrate their belief in the venture in a tangible way.

+he 'uality of managementThe &uality of management will often be the most important

factor in the future success of the business. Thus, the management team will be e$amined to

see whether it has the right blend of s!ills, and e$perience to manage the business. The

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commitment of the managers and their ability to wor! together as an effective team will also

be scrutinised.

RisThe different types of ris! that will be encountered by the business and the ways in

which these ris!s will be managed will be identified and evaluated.

Business operations The nature and comple$ity of internal business operations will be

e$amined to see whether these are dependent on !ey s!ills or !ey individuals. The

effectiveness and efficiency of the operations will also be e$amined.

!it routeThe venture capitalist will see! to realise the investment in the business at some

point. This may be done in various ways, such as floating the company and then selling the

shares through the toc! /$change or by a sale to another business. The venture capitalist will

normally identify a possible e$it route and time frame before entering into the investment.

0# mars per point. ma!/ 0 mars$

&aring (cheme

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Answer #

(a)

" stoc! e$change is, in essence, a mar!et place that is designed to bring together providers of

capital and companies see!ing to raise capital. It acts as both a primary mar!et and a

secondary mar!et for securities. The purpose of each of these mar!ets is as follows+

(i) rimary mar!et. In this role, a stoc! e$change facilitates the issue of new shares and

debentures by public companies. These companies would find it more difficult to raise

finance without an organised and regulated mar!et in which issues of securities can ta!e

place. "# mars$

(ii) econdary mar!et. In this role, a stoc! e$change facilitates the purchase and sale of

second#hand3 securities. Investors are more li!ely to purchase shares and debentures in

companies if they are confident that these securities can be sold when re&uired. " stoc!

e$change enables investors to transfer their investments easily and &uic!ly. "# mars$

(b)

The advantagesof a company obtaining a stoc! e$change listing are as follows+

(hare transferability"s mentioned above, shares that are listed on a stoc! e$change can be

transferred with ease and this, in turn should encourage investment.

ost of capitalhares in listed companies are perceived by investors as being less ris!y than

shares in e&uivalent unlisted companies because of their mar!etability. "s the ris!s associated

with listed shares are lower, the returns re&uired by investors will also be lower. *ence, the

cost of capital for listed companies will be lower.

(hare pricehares that are traded on a stoc! e$change are closely scrutinised by investors,

who will ta!e account of all available information when assessing their worth. This results in

shares that are efficiently priced, which should give investors confidence when buying orselling shares.

ompany profile %ompanies listed on a stoc! e$change have a higher profile among

investors and the wider business community than unlisted companies. This higher profile may

help in establishing new contacts or in developing business opportunities.

redit rating" listed company may be viewed by the business community as being more

substantial and, therefore, more creditworthy than an e&uivalent unlisted company. This may

help in obtaining loans and credit facilities.

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&aring (cheme

Answer

(a)

%alculation of share price

T* %o dividend per share 9 : $ ;


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!pected annual after-ta! savings not announce

2. If the e$pected annual after#ta$ savings are not announced, this informationwill not

therefore be reflected in the share priceof T* %o.

. In this case, the post ac'uisition maret capitalisationof T* %o will be the maret

capitalisation after the rights issue, plus the maret capitalisation of the ac'uired

company(%'H %o), less the price paid for the sharesof %'H %o, since this cash has

left the company in e$change for purchased shares. It is assumed that the mar!et

capitalisations calculated in earlier parts of this &uestion are fair values, including the

value of %'H %o calculated by the price=earnings ratio method.

rice paid for %'H %o 9 ;


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1. 'uity finance will decrease gearing and financial ris, while debt finance will

increasethem.

2. %earing for T* %o is currently ;9:*


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or!ings

%urrent gearing (debt=e&uity, boo! value basis) 9 1;; $ 8,;;;=F,;; 9 :@


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depends on which action is ta!en.

The rights issue has a neutral effectif the rights attached to the 1,;;; shares are e!ercised to

purchase an additional #88 shares, since the value of 1,2;; shares after the rights issue

(K,:@;) is e&ual to the sum of the value of 1,;;; shares before the rights issue (K,;;;) and

the cash subscribed for new shares (K:@;). art of the investor3s wealth has changed from

cash into shares, but no wealth has been gained or lost . The theoretical e$ rights per share

therefore acts as a benchmar! following the rights issue against which other e$ rights share

prices can be compared.

"# mars$

The rights issue also has a neutral effecton the wealth of the investor if the rights attached

to e!isting shares are sold. The value of 1,;;; shares after the rights issue (K,G;;) plus the

cash received from the sale of rights (K1;;) is e&ual to the value of 1,;;; shares before the

rights issue (K,;;;). In this case, part of the investor3s wealth has changed from shares into

cash.

"# mars$

If the investor neither subscribes for the new shares offered nor sellsthe rights attached to

the shares already held, a loss of wealth of 188will occur, due to the difference between the

value of 1,;;; shares before the rights issue (K,;;;) and the value of 1,;;; shares after the

rights issue (K,G;;).

"# mars$

The theoretical e$ rights price is simply a weighted average of the cum rights price and the

rights issue price, ignoring any use made of the funds raised. The actual e$ rights price will

depend on the use made of the funds raised by the rights issue, as well as the e$pectations of

investors and the stoc! mar!et.

(c)

%urrent share price 9 K ;


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%urrent profit before interest and ta$ 9 1,8;;,;;; D :2F,8;; 9 K2,12F,8;;

'evised total interest 9 :2F,8;; > ;;,;;; 9 K2F,8;;

'evised profit after ta$ 9 (2,12F,8;; > 2F,8;;) $ ;


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"# mars$

If the rights issue is used to redeem K2


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Answer *

(a)

The following are the main principles of Islamic finance+

"ll investments must be made according to the rules of hariah (Islamic 6aw).

Co transaction must be carried out for goods that are not halal, e.g. alcohol, gambling,

drugs, etc.

The ris! relating to a transaction must be shared. The entities investing funds and the

entities managing the funds share the business ris! in return for a share in profit.

The following are prohibited+

'iba, i.e. payment or receipt of interest

Aasir, i.e. speculation or gambling

Jaharar, i.e. uncertainty regarding the subect of sale or the terms of the contract. "

person must not trade in things that they do not own.

(b)

The following are the differences between Islamic finance and conventional finance+

2slamic finance onventional finance

'eligious principles "dheres to the principles of

Islam

Loes not follow rules of any

religion

Lebt capital 'eceipt and payment of

interest is prohibited. *ence,

debt securities cannot be

issued.

Co prohibition on debt

securities.

*ybrid securities %annot be issued because

they are part debt.

Co prohibition. They are

used to raise capital.

peculation Is not allowed Is allowed

*alal goods 5nly supports businesses in

halal goods.

Trading in all types of goods

is allowed as long they do

not violate any applicable

law.

Trading in none$istent

goods

Void "llowed

5wnership of the subect

of the trade

'e&uired Cot re&uired

ossession of the subect

of sale

hysical or constructive

possession is re&uired

Cot re&uired

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ale at future date rohibited "llowed

%onditional sale "llowed only when the

condition according to the

usage of trade is recogni-edas a part of the transaction

"llowed. 4re&uently used in

real estate transactions.

Answer ;

(a)

The word MribaN means e$cess, increase or addition. nder Islamic laws it is prohibited

because it refers to any e$cess compensation without due consideration. The ban on riba

means that interest cannot be charged under Islamic finance. Lue to this, suppliers of funds

under Islamic finance use profit sharing or fee based approach for obtaining returns on the

funds provided by them.

(b)

Iara is a leasing contract that allows an entity to obtain an asset on lease for a specific time

and cost. nder iara, the lessor ac&uires an asset and leases it out for a rental fee. The rental

fee consists of the capital cost of the asset and the profit margin of the lessor.

(c)

The features of su!u! are+

They are asset#bac!ed securities.

There is an active secondary mar!et where they can be traded.

Their holders obtain a proportional beneficial ownership in the underlying assets.

They are entitled for a share in the revenues earned from the su!u! assets.

" share from the reali-ation proceeds of the su!u! assets is paid to the su!u! holder.

(d)

Aurahaba is a contract of sale between a financer and its client for financing the ac&uisitionof assets by the client. The price consists of the cost the asset and premium (profit margin

agreed between the financer and its client). There are two ways for the client to pay the ban!

for the asset+

Leferred payment

'epayment in instalments

teps involved in Aurahaba

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tep 1+ an agreement is signed between the financer and its client that from time to time the

financer will sell assets, the client will re&uire and purchase them. The assets will be sold at a

premium to the client. The margin of premium and repayment schedule will be mentioned in

the agreement.

tep 2+ when the client re&uires an asset, the financer will appoint the client as its agent to

purchase the asset.

tep + the client will buy the asset as the financer3s agent and will ta!e possession of the

asset.

tep + the client will inform the financer that the asset has been purchased by it as the

financer3s agent. The client will immediately give an offer to the financer to buy the asset.

tep 8+ the financer will accept the client3s offer and will sell the asset at a premium to the

client. The client will pay for the asset as determined according to the agreement signed in

step 1.

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Answer 7

(a)

?ebt finance 'uity finance

6888 6888

ales revenue (8;,;;; $ 1.12) 8:,;;; 8:,;;;

Variable cost of sales (@8B $ sales) 2@,8:; 2@,8:;

4i$ed cost of sales (18B $ ;,;;;) ,8;; ,8;;

Jross profit 22,G; 22,G;

"dministration costs (1,;;; $ 1.;8) 1,F;; 1,F;;

rofit before interest and ta$ @,2; @,2;

Interest (1) @;; ;;

rofit before ta$ F,; F,G;

Ta$ation at ;B 2,22 2,@2

rofit after ta$ 8,2;@ 8,88@

oteC

Lividends paid (:;B) ,128 ,8

Cet change in e&uity (retained profit) 2,;@ 2,22

1

Interest under debt financing 9 ?;;,;;; D (?8,;;;,;;; $ 1;B) 9 ?@;;,;;;.

(b)

Financial gearing

If financial gearing is measured as the debt + e&uity ratio+

%urrent Lebt finance /&uity finance

Lebt 2,8;; F,8;; 2,8;;

hare capital and reserves 22,8:; 2,: 2G,F@

Lebt=e&uity ratio (B) 11.1B ;.B @.B

or!ings+

hare capital and reserves (debt finance) 9 22,8:; D 2,;@ 9 ?2,:

hare capital and reserves (e&uity finance) 9 22,8:; D 8,;;; D 2,22 9 ?2G,F@

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If financial gearing is measured as the ratio of debt capital to total capital+


Lebt 2,8;; F,8;; 2,8;;Total long#term capital 28,;:; 2,1 2,2@

%apital gearing (B) 1;.;B 2.B F.FB

,perating gearingC

If operational gearing is measured as the ratio of fi$ed costs to total costs+


4i$ed costs 1@,8;; 1G,2;; 1G,2;;

Total costs ,;;; F,F:; F,F:;

5perating gearing (B) 2.;B ;.2B ;.2B

Total costs are assumed to consist of cost of sales plus administration costs.

If operational gearing is measured as the ratio of fi$ed costs to variable costs+


4i$ed costs 1@,8;; 1G,2;; 1G,2;;

Variable costs 28,8;; 2@,8:; 2@,8:;

5perating gearing (B) F2.8B :F.2B :F.2B

If operational gearing is measured as the ratio of contribution to profit before interest and ta$

(7IT)


%ontribution 2,8;; 2F,; 2F,;

7IT :,;;; @,2; @,2;

5perating gearing .1 . .

2nterest coverC


7IT :,;;; @,2; @,2;

Lebt interest ;; @;; ;;

Interest cover 2; 1;. 2F.8

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3(C


rofit after ta$ ,GG; 8,2;@ 8,88@Co. of shares 1;,;;; 1;,;;; 11,28;

/ (cents) G.G 82.1 G.

ommentC

The debt finance proposal leads to the largest increase in /, but results in an increase in

financial gearing and a decrease in interest cover. hether these changes in financial gearing

and interest cover are acceptable depends on the attitude of both investors and managers to the

new level of financial ris!O a comparison with sector averages would be helpful in this

conte$t. The e&uity finance proposal leads to a decrease in financial gearing and an increase

in interest cover. The e$pansion leads to a decrease in operational gearing, whichever measure

of operational gearing is used, indicating that fi$ed costs have decreased as a proportion of

total costs.

DcEDiE

7usiness ris!, the inherent ris! of doing business for a company, refers to the ris! of ma!ing

only low profits, or even losses, due to the nature of the business that the company is involved

in. 5ne way of measuring business ris! is by calculating a companyPs operating gearing or

Poperational gearingP.

The significance of operating gearing is as follows.

(1) If contribution is high but 7IT is low, fi$ed costs will be high, and only ust covered

by contribution. 7usiness ris!, as measured by operating gearing, will be high.

(2) If contribution is not much bigger than 7IT, fi$ed costs will be low, and fairly easily

covered. 7usiness ris!, as measured by operating gearing, will be low.

DcEDiiE

" high level of debt creates financial ris!. This is the ris! of a company not being able to meet

other obligations as a result of the need to ma!e interest payments. The proportion of debt

finance carried by a company is therefore as significant as the level business ris!. . 4inancial

ris! can be seen from different points of view.

(1) The company as a whole. If a company builds up debts that it cannot pay when they fall

due, it will be forced into li&uidation.

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(2) ayables. If a company cannot pay its debts, the company will go into li&uidation owing

payables money that they are unli!ely to recover in full.

() 5rdinary shareholders. " company will not ma!e any distributable profits unless it is

able to earn enough profit before interest and ta$ to pay all its interest charges, and then

ta$. The lower the profits or the higher the interest#bearing debts, the less there will be,

if there is anything at all, for shareholders.

&aring (cheme

&ars

(a) ales and administration cost 1

%ost of sales 1

Interest 1

rofit after ta$ 1

Lividends 1 8

(b) 'evised share capital and reserves 1

4inancial gearing 2

5perational gearing 2

Interest cover 2

/ 2

%alculation of current values 1Liscussion 2 12

(c) /$planation of business ris! 1

/$planation of financial ris! 1

p to 2 mar!s for each danger of high gearing : @

28

Answer 9

(a)

mall businesses face a number of well#documented problems when see!ing to raise

additional finance. These problems have been e$tensively discussed and governments

regularly ma!e initiatives see!ing to address these problems.

Ris and security

2nvestors are less willing to offer finance to small companies as they are seen as

inherently more risythan large companies.

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mall companies obtaining debt finance usually use overdrafts or loans from ban!s,

which re&uire security to reduce the level of ris! associated with the debt finance. ince

small companies are liely to possess little by way of assets to offer as security ,

ban!s usually re&uire a personal guarantee instead, and this limits the amount of finance

available.

"# mars$

&aretability of ordinary shares

The e'uity issued by small companies is difficult to buy and sell, and sales are usually

on a matched bargain basis, which means that a shareholder wishing to sell has to wait

until an investor wishes to buy. There is no financial intermediary willing to buy the

shares and hold them until a buyer comes along, so selling shares in a small company

can potentially ta!e a long time. This lac! of mar!etability reduces the price that a buyer

is willing to pay for the shares.

Investors in small company shares have traditionally looed to a flotation, for

e$ample on the G Alternative 2nvestment &aret, as a way of realising their

investment, but this has become increasingly e$pensive. mall companies are li!ely to be

very limited in their ability to offer new e&uity to anyone other than family and friends.

"# mars$

+a! considerations

Individuals with cash to invest may be encouraged by the ta$ system to invest in large

institutional investors rather than small companies, for e$ample by ta! incentives

offered on contributions to pension funds. These institutional investors themselves

usually invest in larger companies, such as stoc!#e$change listed companies, in order to

maintain what they see as an acceptable ris! profile, and in order to ensure a steady

stream of income to meet ongoing liabilities. This ta! effect reduces the potential flow

of funds to small companies.

"# mars$

ost

ince small companies are seen as ris!ier than large companies, the cost of the financethey are offered is proportionately higher. 5verdrafts and ban! loans will be offered to

them on less favourable terms and at more demanding interest rates than debt offered to

larger companies.

'uity investorswill e!pect higher returns, if not in the form of dividends then in the

form of capital appreciation over the life of their investment.

"# mars$

AA &aring (cheme

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(b)

2ntroduction

A/s contribute in a significant way to many economies in the world. 7esides generating

income, in often large proportions in relation to JC across the world, they are fre&uently

maor employers and the sector which is most identified with new ideas and entrepreneurial

spirit. It is these latter factors that help sustain and support growth rates in many economies.

Lespite this bac!ground of potential there is often associated with A/s difficulties in

accessing appropriate sources of finance. There are three main issues involved+ uncertainty

concerning the business, lac! of assets available to offer as collateral or security, and the

sources of finance for business start#ups or very new businesses.

ncertainty concerning the business

" defining characteristic of A/s is the uncertainty surrounding their activities. 4irst,

the A/s, in general, do not have a trac recordon their business and also do not

have the good and long-term relationship with their bans.

nlie larger businesses, they have grown from smaller businesses and have a trac

record> especially in terms of a long#term relationship with their ban!ers. Baners can

observe, over a period of time, that the business is well-run, that managers can manage

its affairs and can therefore be trustedwith handling ban! loans in a proper way.

Harger businesses conduct more of their activities in public (e.g. subect to more

e$ternal scrutiny) than do A/s. Thus, if information is public, there is less

uncertainty. 4or e$ample, a larger business might be &uoted on an e$change and

therefore be subect to press scrutiny, e$change rules regarding the provision of certainof its activities, and has to publish accounts that have been audited. &any (&s do not

have to have audits, certainly don3t publish their accounts to a wide audience and the

press are not really interested in them.

Hac of assets available to offer as collateral or security

If A/s wish to access ban! finance, for e$ample, then banswill wish to address the

information problemreferred to above.

Bans will screen loan applicationsto assess

the underlying product or service,

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the management team, the maret addressedand,

importantly, any collateral or securitythat can be offered. It is this last point which

is of interest here. 7esides investigating business plans, ban!s will loo! to see what

security is available for any loan provided. This phase is li!ely to involve an audit

of the firm3s assets and detailed e$planation of any personal security offered by the

directors and owner managers. ollateral is importantbecause it can reduce the

level of risa ban! is e$posed to in granting a loan to a new business. In assessing

a business plan and security, a ban! would ma!e an assessment of the ris! of the

business and any loan interest rate will reflect that ris!. " !ey feature for accessing

ban! finance is therefore in the assessment of ris! from the information gathered

and the security offered.

3otential sources of finance for very new businesses

2nitial owner financeis nearly always the first source of finance for a business, whether

from the owner or from family connections. "t this stage many of the assets may be

intangible and thus e$ternal financing is an unrealistic prospect at this stage, or at least

has been in the past. This is often referred to as the e&uity gap.

+rade credit financeis important at this point too, although it is nearly always very

e$pensive if viewed in terms of lost early payment discounts. "lso, it is inevitably very

short term and very limited in duration (e$cept that always ta!ing :; days to pay a

payables will obviously roll#over and become medium term financing).

Business angel financing or venture capitalmay be important and is represented by

high net worth individuals or groups of individuals who invest directly in small

businesses.

It is possible, when a new business, or its owner, can offerade'uate security that a

ban loan may be arranged. "nother form of security that may underpin a ban! loan is

in the form of a guarantee from a reliable individual or other businesswith a ban!ing

trac! record.

5ther sources of finance can be, for e$ample, overdraft, leasing and factoring.

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Answer 0

(a)

'ights issue price 9 2


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(d)

In order to use the dividend growth model, the e$pected future dividend growth rate is

needed. *ere, it may be assumed that the historical trend of dividend per share payments will

continue into the future. The geometric average historical dividend growth rate 9 1;; $

((18


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The agency problem arises because the obectives of managers differ from those of

shareholders+ because there is a divorce or separation of ownership from control in modern

companiesO and because there is an asymmetry of information between shareholders and

managers which prevents shareholders being aware of most managerial decisions.

5ne way to encourage managers to act in ways that increase shareholder wealth is to offer

them share options. These are rights to buy shares on a future date at a price which is fi$ed

when the share options are issued. hare options will encourage managers to ma!e decisions

that are li!ely to lead to share price increases (such as investing in proects with positive net

present values), since this will increase the rewards they receive from share options. The

higher the share price in the mar!et when the share options are e$ercised, the greater will be

the capital gain that could be made by managers owning the options.

hare options therefore go some way towards reducing the differences between the obectives

of shareholders and managers. *owever, it is possible that managers may be rewarded for

poor performance if share prices in general are increasing. It is also possible that managers

may not be rewarded for good performance if share prices in general are falling. It is difficult

to decide on a share option e$ercise price and a share option e$ercise date that will encourage

managers to focus on increasing shareholder wealth while still remaining challenging, rather

than being easily achievable.

AA &aring (cheme

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Answer 18

(a)

"; 7 mars$

Achievement of corporate ob=ectives1. QQJ %o has shareholder wealth ma$imisation as an obective. The wealth of shareholders is

increased by dividends received and capital gains on shares owned. Total shareholder return

compares the sum of the dividend received and the capital gain with the opening share price.

2. The shareholders of QQJ %o had a return of *9< in #889, compared with a return predicted by

the capital asset pricing model of 1B. The lowest return shareholders have received was

#1< and the highest return was 9#


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them. In fact, loo!ing at the dividend per share history of the company, there was one year

(2;;:) where dividends were constant, even though earnings per share increased. It is also

difficult to now when wealth has been ma!imised.

"# mars$

. Another ob=ectiveof the company was to achieve acontinuous increase in earnings per

share. "nalysis shows that earnings per share increased every year, with an average increase

of 1


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'evised mar!et value of e&uity 9 F


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provided on the non#current assets of QQJ %o, but it is liely that the e!isting bond issue is

secured. If a new bond issue was being considered, QQJ %o would need to consider whether

it had sufficient non-current assets to offer as security , although it is li!ely that new non#

current assets would be bought as part of the business e$pansion.

"# mars$

AA &aring (cheme

Answer 11

(a)

Cugfer %o is loo!ing to raise ?2;;m in cash in order to ac&uire a competitor. "ny

recommendation as to the source of finance to be used by the company must ta!e account of

the recent financial performance of the company, its current financial position and its

e$pected financial performance in the future, presumably after the ac&uisition has occurred.

Recent financial performance

The recent financial performance of Cugfer %o will be ta!en into account by potential

providers of finance because it will help them to form an opinion as to the &uality of the

management running the company and the financial problems the company may be facing."nalysis of the recent performance of Cugfer %o gives the following information+

'"#2G


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"1 mars$

Jeometric average growth in turnover 9 (1@G


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borrowings (:B) and as a result, interest on short#term borrowings account for :@B of

the finance charges in the income statement.

It should also be noted that the long-term borrowings are bondsthat are repayable in

#81#. Cugfer %o needs therefore to plan for the redemptionand refinancing of 6188m

of debt in two yearsJ time, a factor that cannot be ignored when selecting a suitable

source of finance to provide the ?2;;m of cash needed.

"1 mars analysis$

"1 mars discussion$

Recommendation of suitable financing method

There are strong indications that it would be unwise for Cugfer %o to raise the ?2;;m of cash

re&uired by means of debt finance, for e$ample the low interest coverage ratio and the high

level of gearing.

1. If no further debt is raised, the interest coverage ratio would improve after the

ac&uisition due to the increased level of operating profit, i.e. (8:


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were persuaded that dividends would be forthcoming in the near future. "c&uisition of

the competitor may be the only way of generating the cash flows needed to support

dividend payments.

" similar negative view could be ta!en by new shareholders if Cugfer %o were to see!

to raise e&uity finance via a placing or a public issue.

8. (ale and leasebac of non-current assetscould be considered, although the nature and

&uality of the non#current assets is not !nown. The financial position statement indicates

that Cugfer %o has ?;;m of non#current assets, ?1;;m of long#term borrowings and

?1:;m of short#term borrowings. ince its borrowings are liely to be secured on

some of the e!isting non-current assets , there appears to be limited scopefor sale

and leasebac!.

:. )enture capitalcould also be considered, but it is unliely that such finance would

be available for an ac'uisition and no business case has been provided for the

proposed ac&uisition.

"4 ; mars$

hile combinations of finance could also be proposed, the overall impression is that Cugfer

%o is in poor financial health and, despite its best efforts, it may not be able to raise the

6#88m in cash that it needs to ac'uire its competitor.

"1 mar$

(b)

hen a new issue of bonds is made by a company, the interest rate on the bonds will be

influenced by factors that are specific to the company, and by factors that relate to the

economic environment as a whole.

ompany-specific factors

The interest rate charged on a new issue of bonds will depend upon such factors as the risassociated with the companyand any security offered.

1. The risassociated with the company will be assessed by considering the ability of

the company to meet interest paymentsin the future, and hence its future cash flows

and profitability, as well as its ability to redeem the bond issue on maturity.

2. here an issue of new bonds is bac!ed by security, the interest rate charged on the

issue will be lower than for an unsecured bond issue. " bond issue will be secured on

specific non#current assets such as land or buildings, and as such is referred to as a

'"#2


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fi$ed#charge security.

"# mars$

conomic environment factors

. "s far as the duration of a new issue of bonds is concerned, the term structure of

interest rates suggeststhat short-term debt is usually cheaper than long-term debt ,

so that the yield curve slopes upwards with increasing term to maturity. The longer the

duration of an issue of new bonds, therefore, the higher will be the interest rate charged.

. The shape of the yield curve, which can be e!plained by reference to li'uidity

preference theory. e!pectations theory and maret segmentation theory, will be

independent of any specific company.

8. The rate of interest charged on a new issue of bonds will also depend on the general

level of interest rates in the financial system. This is influenced by the general level

of economic activityin a given country, such as whether the economy is in recession

(when interest rates tend to fall) or e$periencing rapid economic growth (when interest

rates are rising as capital availability is decreasing).

:. The general level of interest rates is also influenced by monetary policy decisions

ta!en by the government or the central ban!. 4or e$ample, interest rates may be

increased in order to e$ert downward pressure on demand and hence decrease

inflationary pressures in an economy.

"# mars$

(/$aminer3s note+ the above answer is longer than would be e$pected from a candidate under

e$amination conditions.)

(c)

The three forms of capital mar!et efficiency are wea! form, semi#strong form and strong form

efficiency. The three forms of efficiency can be distinguished by considering the different

!inds of information that are reflected in security prices.

>ea form efficiency

This refers to a situation where securities trading on a capital mar!et (e.g. shares and bonds)

are shown to reflect all relevant past information. If a capital mar!et is wea! form efficient, it

is not possible to predict security prices by studying share price movements in the past. There

is no correlation between share price movements in successive periods and, in fact, share

prices appear to be following a random wal!. "# mars$

(emi-strong form efficiency

This refers to a situation where securities trading on a capital mar!et are shown to reflect all

'"#


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past and public information. If a capital mar!et is semi#strong form efficient, it is not possible

to ma!e above#average (abnormal) returns by studying information in the public domain (this

includes past information), because the prices of securities move &uic!ly and accurately to

reflect new information as it becomes available. "# mars$

(trong form efficiency

If a capital mar!et is described as strong form efficient, the prices of securities trading on the

mar!et reflect all information, whether past, public or private. It is not possible for this form

of capital mar!et efficiency to e$ist in the real world, since it is always possible for an

individual with access to relevant information which is not public to benefit from it by buying

and selling securities. "# mars$

AA &aring (cheme

revision4 ans

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