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Question 1 Each of the following parts to this question is worth five marks (total of 30 marks). a. A company has just paid an annual dividend of

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Question 1 Each of the following parts to this question is worth five marks (total of 30 marks). a. A company has just paid an annual dividend of $0.20. Dividends are expected to grow indefinitely at an annual rate of 5%. What is the intrinsic value of this share to an investor who’s required rate of return is 12%? (Answer to the nearest cent.) b. If the price of the foregoing share is $2.00, what is its cost (% pa to two decimals)? c. Briefly explain why the cost of a company’s retained earnings is likely to be less than the cost of a new equity issue. d. A company’s capital structure comprises $10m of long-term debt, $15m of preference shares and $30m of ordinary shares. The after-tax cost of each source of capital is respectively 7.5%, 9% and 13%. What is the company’s after-tax weighted average cost of capital (WACC)? e. A company reports a half-yearly net profit of $50m after paying a final dividend of 25 cents per share. The company has 100 million issued shares. The current share price (ex div.) is $5. What is the company’s cost of ordinary share capital? f. What are the limitations of the previous approach and how would you modify it to provide a more reliable estimate of the company’s cost of ordinary capital? Question 2 Each of the following parts to this question is worth five marks (total of 35 marks). (a) ABC Ltd is an unlevered firm in which shareholders require an after-tax return of 15 %. ABC is valued at $2,000,000 and the corporate tax rate is 40%. (i) What is the implied annual value of ABC's perpetual earnings before interest and taxes ? (ii) What will be the market value of ABC if it substitutes debt for equity by issuing $320,000 in perpetual debt at 10% interest? (iii) What return will shareholders require in ABC after it becomes levered? (iv) What is the weighted average cost of capital of ABC when unlevered? (v) What is the weighted average cost of capital of ABC after it becomes levered? (b) Modigliani and Miller (M & M) have postulated that when a corporation is in a taxpaying situation and interest is tax-deductible, it can add to its market value (and decrease its weighted average cost of capital) by substituting debt for equity. Briefly explain -
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(i) the rationale of the M & M proposition; (ii) the principal factors that limit the extent to which a corporation can add to its market value by substituting debt for equity. Question 3 (Module 9 & 10) Each of the following parts to this question is worth five marks . (a) Briefly explain the costs and benefits of investment in accounts receivable. (b) What effective annual return must a purchaser earn, without risk, to be indifferent between taking a prompt settlement discount of 1% or paying a supplier's account in full 23 days later? [Credit terms are 1/7, net 30.] (c) A firm that operates on a cash basis is considering offering credit terms of 2/30, net 60. Current monthly sales average $90,000 and associated variable costs $72,000. It is forecast that if credit is offered monthly sales will grow to $100,000 and 80% of credit customers will take advantage of the discount, but the firm is uncertain about the percentage of customers who will buy on credit. Credit administration and collection costs are forecast to be $2,000 per month (incurred at the time of sale) plus 1% of collections (incurred at the time of collection). The firm's required return is 1% per month. (i) Should the firm introduce credit terms if 50% of all customers buy on credit? (ii) If all customers buy on credit, what monthly sales volume would be required for the firm to be neither worse nor better off than at present (cash sales only)? Question 4) (a) Critically evaluate the claim that leasing (as opposed to owning) an asset increases the lessee's borrowing capacity. (b) A corporation is evaluating leasing the following asset: (i) Purchase price: $500,000. (ii) Tax deductible depreciation allowance: 10% pa straight line (no adjustment for salvage value). (iii) Estimated salvage value after six years: $150,000. (iv) Corporate income tax rate: 40%. (v) Required after tax rate of return on investment: 15% pa. (vi) After tax cost of borrowing: 9% pa. (vii) Annual lease payments, payable at the beginning of each year for six years: $105,300.
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