QUESTION 1

Part A

Every time a listed company does a share buyback, investors and media alike would debate fiercely on the merits of such a scheme. There are investors who prefer buybacks to high dividends payments and vice versa. Proponents of both schemes point to share price increases as their proof that such schemes increase shareholder value

Required

Explain whether shareholders' value is enhanced not by a change in financial structure or dividend policies but by a more fundamental factor based on information asymmetry. Support your argument with empirical evidences

Part B

I.Hose plc presently has a capital structure which is 30 per cent debt and 70 percent equity. The cost of debt (i.e. borrowings) before taxes is 9 percent and that of equity is 15 percent. The firm's future cash flows, after tax but before interest, are expected to be perpetuity of Rs. 750,000. The tax rate is 30 per cent

Required

Calculate the weighted average cost of capital and the value of the firm

II.The Directors are considering the partial replacement of equity finance with borrowings so that the borrowings make up 60 per cent of the total capital. Director A believes that the cost of equity capital will remain constant at 15 per cent; Director B believes that shareholders will demand a rate of return of 23.7 per cent; Director C believes that shareholders will demand a rate of return of 17 per cent. Following the assumption that the cost of borrowings before income taxes remains at 9 per cent

Required

Calculate the weighted average cost of capital and the value of the firm under each of the director's estimates

QUESTION 2

Professor Steward Hamilton (2003) wrote a case on the Enron collapse. He stated that when Enron failed and filed for bankruptcy protection on December 2001, the whole world came to a shock. Everyone was wondering that how such a high profile and world leader company could have failed? Many employees of Enron found themselves devastated since they had invested their retirement and savings into the Enron shares. Not only did they run into financial ruin, they did lose their jobs as well. Enron which employed 25000 people worldwide was the seventh largest company in the United States revenue wise and was also one of the most admired company in the United States. Its high performance was often cited in several business school cases. However, as more and more facts emerged, it soon become evident that the company had many elements of a ‘ponzi' scheme. In view of maintaining the share price of the company it was evident to show sustained growth and this was achieved through the use of ‘aggressive' accounting policies which enhanced profits. Some other accounting practice was to move assets and liabilities off the Balance Sheet

Required

One of the prevalent concerns in the present times, for both management, academics and practitioners, relates to the principles which determine corporate successes and failures. Explain the various determinants of corporate failures.

QUESTION 3

Part A

Paris Co. Ltd has Equity Share Capital of Rs 500,000 (face value Rs 100 per share). To meet the expenditure of an expansion programme, the company wishes to raise Rs 300,000 and is having the following four alternatives to raise the funds

Plan A: To have full money from equity shares

Plan B: To have Rs 100,000 from equity and Rs 200,000 from borrowing from the Financial Institution @ 10% p.a

Plan C: Full money from borrowing @ 10% p.a

Plan D: Rs 100,000 in equity and Rs 200,000 from preference shares at 8% p.a

The company's earnings before interest and tax is Rs 150,000 and the corporate tax is 50%

Required

As a financial controller, suggest which plan you would recommend the company to adopt?

Part B

In a world of no-tax, a firm's cost of capital is independent of its capital structure. Discuss the above statement and provide appropriate illustrations

QUESTION 4

A factoring company has offered a one-year agreement with Glub Ltd to both manage its debtors and advanced 80 per cent of the value of all its invoices immediately a sale is invoiced. Existing invoices will be eligible for an immediate 80 per cent cash payment

The annual sales on credit of Glub are Rs6M spread evenly through the year and the average delay in payment from the invoice date is at present 80 days. The factoring company is confident of reducing this delay to only 60 days and will pay the remaining 20 per cent of invoice value to Glub immediately on receipt from the customer. The charge for debtor management will be 1.7 per cent of annual credit turnover payable at the year-end. For advance payment on he invoices a commission of 1 per cent will be charged plus interest applied at 10 per cent per annum on the gross funds advanced

Glub will be able to save Rs80, 000 during this year in administration costs if the factoring company takes on the debtor management. At the moment it finances its trade credit through an overdraft facility with an interest rate of 11 per cent

Required

Advise Glub on whether to enter into the agreement. Discuss the relative advantages and disadvantages of overdraft, factoring and term loan financing