ACCA FM Syllabus E. Business Finance - Debt or Equity? - Past Papers ^{1 / 6}

The following statement of financial position information relates to Tufa Co, a company listed on a large stock market which pays corporation tax at a rate of 30%.

The share capital of Tufa Co consists of $12m of ordinary shares and $5m of irredeemable preference shares.

The ordinary shares of Tufa Co have a nominal value of $0·50 per share, an ex dividend market price of $7·07 per share and a cum dividend market price of $7·52 per share. The dividend for 20X7 will be paid in the near future.

Dividends paid in recent years have been as follows:

The 5% preference shares of Tufa Co have a nominal value of $0·50 per share and an ex dividend market price of $0·31 per share.

The long-term borrowings of Tufa Co consist of $10m of loan notes and a $3m bank loan. The bank loan has a variable interest rate.

The 7% loan notes have a nominal value of $100 per loan note and a market price of $102·34 per loan note. Annual interest has just been paid and the loan notes are redeemable in four years’ time at a 5% premium to nominal value.

Required:
(c) Discuss THREE advantages to Tufa Co of using convertible loan notes as a source of long-term finance. (6 marks)

AMH Co wishes to calculate its current cost of capital for use as a discount rate in investment appraisal. The following financial information relates to AMH Co:

The ordinary shares of AMH Co have an ex div market value of $4·70 per share and an ordinary dividend of  36·3 cents per share has just been paid. Historic dividend payments have been as follows:

The preference shares of AMH Co are not redeemable and have an ex div market value of 40 cents per share. The 7% bonds are redeemable at a 5% premium to their nominal value of $100 per bond and have an ex interest market value of $104·50 per bond. The bank loan has a variable interest rate that has averaged 4% per year in recent years.

AMH Co pays profit tax at an annual rate of 30% per year.

Required:

Discuss why the cost of equity is greater than the cost of debt.

(5 marks)

4 GXG Co is an e-business which designs and sells computer applications (apps) for mobile phones. The company needs to raise $3,200,000 for research and development and is considering three financing options.

Option 1
GXG Co could suspend dividends for two years, and then pay dividends of 25 cents per share from the end of the third year, increasing dividends annually by 4% per year in subsequent years. Dividends in recent years have grown by 3% per year.

Option 2
GXG Co could seek a stock market listing, raising $3·2 million after issue costs of $100,000 by issuing new shares to new shareholders at a price of $2·50 per share.

Option 3
GXG Co could issue $3,200,000 of bonds paying annual interest of 6%, redeemable after ten years at par.

Recent financial information relating to GXG Co is as follows:

Under options 2 and 3, the funds invested would earn a before-tax return of 18% per year.

The profit tax rate paid by the company is 20% per year.

GXG Co has a cost of equity of 9% per year, which is expected to remain constant.

Required:

Discuss the factors to be considered in choosing between traded bonds, new equity issued via a placing and venture capital as sources of finance.

(9 marks)

Zigto Co is a medium-sized company whose ordinary shares are all owned by the members of one family. It has recently begun exporting to a European country and expects to receive €500,000 in six months’ time. The prospect of increased exports to the European country means that Zigto Co needs to expand its existing business operations in order to be able to meet future orders.

All of the family members are in favour of the planned expansion, but none are in a position to provide additional finance. The company is therefore seeking to raise external finance of approximately $1 million. At the same time, the company plans to take action to hedge the exchange rate risk arising from its European exports.

Zigto Co could put cash on deposit in the European country at an annual interest rate of 3% per year, and borrow at 5% per year. The company could put cash on deposit in its home country at an annual interest rate of 4% per year, and borrow at 6% per year. Inflation in the European country is 3% per year, while inflation in the home country of Zigto Co is 4·5% per year.

The following exchange rates are currently available to Zigto Co:

Current spot exchange rate 2·000 euro per $
Six-month forward exchange rate 1·990 euro per $
One-year forward exchange rate 1·981 euro per $

Required:

Discuss the factors that Zigto Co should consider when choosing a source of debt finance and the factors that may be considered by providers of finance in deciding how much to lend to the company.