SL 02 – Mock Exam 01 – Infinity Learning Space

Welcome to your SL 02 Mock Exam 01

Question 1

An investor is evaluating the following financial information related to Leema PLC in order to buy shares of the company.

Year	Earnings per share (Rs.)	Dividend payout ratio

2016	1.80	60.00%
2017	2.10	55.00%
2018	2.45	50.00%
2019	2.50	52.00%

For the year 2020, the company has recorded a net profit after tax of Rs. 138 million and has proposed a dividend payout of 50%. The number of ordinary shares issued by the company is 50 million.

Due to the adverse effects of the COVID-19 pandemic on the country, the expected dividend growth rate of the company for the next two years would decline by 1% when compared to the current dividend growth rate of the company. Thereafter, the expected dividend growth rate would be 4%.

Investors also expect an additional risk premium of 2% compared to the 13% return given by other companies in the same industry due to recent changes in the board of directors of Leema PLC.

The market price of a share of the company is Rs. 18.75.

Required:

Advise whether an investor should invest in the shares of Leema PLC. (10 Marks)

Please do in excel and upload . Shortcuts are not allowed.

Question 2

KFP Co, a company listed on a major stock market, is looking at its cost of capital as it prepares to make a bid to buy a rival unlisted company, NGN. Both companies are in the same business sector.

Financial information on KFP Co and NGN is as follows:

	KFP		NGN
	Rs.m	Rs.m	Rs.m	Rs.m
Non-current assets		36		25
Current assets	7		7
Current liabilities	3		4
Net current assets		4		3
Total assets less current liabilities		40		28
Ordinary shares, par value 50c	15		5
Retained earnings	10		3
Total equity		25		8
7% bonds redeemable in seven years' time		15		–
9% bonds, redeemable in two years' time		–		20
Total equity and non-current liabilities			40	28

Other relevant financial information:
Risk-free rate of return 4.0%
Average return on the market 10.5%
Taxation rate 30%
The bonds are redeemable at par

NGN has a cost of equity of 12% per year and has maintained a dividend payout ratio of 45% for several years. The current earnings per share of the company is 80c per share and its earnings have grown at an average rate of 4.5% per year in recent years.

The ex div share price of KFP Co is Rs. 4.20 per share and it has an equity beta of 1.2. The 7% bonds of the company are trading on an ex interest basis at Rs. 94.74 per Rs. 100 bond. The price/earnings ratio of KFP Co is eight times.
The directors of KFP Co believe a cash offer for the shares of NGN would have the best chance of success. It has been suggested that a cash offer could be financed by debt.

Required:

a ). Calculate the weighted average cost of capital of KFP Co on a market value weighted (10 marks)

b ).Calculate the total value of the target company, NGN, using the following valuation methods: (6 marks)

i. Price/earnings ratio method, using the price/earnings ratio of KFP Co;
and
ii. Dividend growth

Please do in excel and upload. for each question open a new sheet. shortcuts are not allowed

c ). Discuss the relationship between capital structure and weighted average cost of capital, and comment on the suggestion that debt could be used to finance a cash offer for NGN. (9 marks)

Question 3

The statement of financial position of BKB Co provides the following information:

	Rs.m	Rs.m
Equity finance
Ordinary shares (Rs.1 nominal value)	25
Reserves	15	40
Non-current liabilities
7% bonds (Rs.100 nominal value)	20
5% preference shares (Rs.1 nominal value)	10	30
Current liabilities
Trade payables	10
Overdraft	15	25
Total liabilities		95

BKB Co has an equity beta of 1.2 and the ex-dividend market value of the company's equity is Rs.125m. The ex-interest market value of the 7% bonds is Rs. 21m. They are redeemable in five years' time at Rs. 115 per Rs. 100 of nominal value. The ex-dividend market value of the preference shares is Rs. 6.25m and these are irredeemable.

The overdraft has a variable interest rate which is currently 6% per year and BKB Co expects this to increase in the near future. The overdraft has not changed in size over the last financial year, although one year ago the overdraft interest rate was 4% per year. The company's bank will not allow the overdraft to increase from its current level.

The equity risk premium is 5% per year and the risk-free rate of return is 4% per year. BKB Co pays profit tax at an annual rate of 30% per year.

Required

a ). Calculate the market value after-tax weighted average cost of capital of BKB Co, explaining clearly any assumptions you (12 marks)
b ). Discuss why market value weighted average cost of capital is preferred to book value weighted average cost of capital when making investment decisions. (4 marks)

Please do in excel and upload. for each question open a new sheet. shortcuts are not allowed

c ). Explain the difference between systematic and unsystematic risk in relation to the capital asset pricing model. (4 marks)

d ). Explain the limitations of the capital asset pricing model. (5 marks)

Question 4

Alpex Company is public company listed in the Colombo Stock Exchange. You are provided the following summarized balance sheet as at 31^st March 2018.

The summarized balance sheet of the company as at 31/03/2018 is as follows:

	(Rs. ‘000)
Equity capital (Rs.10/- each)	5,200	property, Plant and equipment	6,000
Reserves	2,000	Motor vehicle	5,000
Retained profit	1,200	Inventory	300
14.6% - Bonds	4,600	Trade debtors	2,500
Trade creditors	1,800	Cash and bank balance	1,000
	14,800		14,800

The company is planning to invest in a personnel training programme in the next year. Investment outlay, Rs. 1,000,000/- will be charged off as an expense by the firm in next year. The returns from the programme in the form of greater productivity and a reduction in employee turnover are estimated as follows (on an after-tax basis):

Years 1-10 Rs.150,000 per annum

Years 11-15 Rs.100,000 per annum

The Company’s new financing policy is to finance its assets with 60% equity (book value) and the balance with long-term debt. Any adjustment at the end of accounting year is to be done by the use of additional bond at 12%. Company’s cost of equity was at 15% in the past and also expects to maintain its new capital structure policy for the explicit future period.

The company plans to issue bond and uses the proceeds to increase its inventory by 200%, to increase Plant and Equipment by Rs. 1.4 million and to decrease trade debtors by Rs. 1 million. The company expects that next year’s net profit after taxes would be Rs. 3.2 million.

Income tax rate is 35%.

You are required to:

a ). Estimate weighted average cost of capital of the company after implementing new financing policy.

b ). Assess the investment project based on net present value criteria and decide whether the company should undertake the training programme? Why?

c ). Assess the requirement of new issue of bond capital in order to consistent with new capital structure policy.

d ). Prepare new balance sheet immediately after implementing new proposals (ignore other changes).

e ). Discuss the immediate impact of the changes in balance sheet item on the following ratios? Current ratio, Quick ratio, Debt to total assets ratio, and ROE

State any assumptions that you made.
(40 marks)

Please do in excel and upload. for each question open a new sheet. shortcuts are not allowed

SL 02 – Mock Exam 01

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