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REVISION QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

The UK government currently only taxes income from multinational companies’ overseas subsidiaries when such income is remitted to the UK. UK tax liability is based upon the grossed up dividend distributions to the UK (grossed up at the local tax rate and before deduction of any withholding tax).

The UK government is now considering taxing the gross income earned by overseas subsidiaries. If such gross income were to be taxed, credit against UK tax liability would be available for all corporate tax paid overseas.

Required:

(i)Estimate the impact on the cash flows of Boxless if the UK government alters the tax rules as detailed above.

Assume that the taxable income in each of the subsidiaries is the equivalent of £100,000. (7 marks)

(ii)For each of the current and possible new tax rules, evaluate what benefit, if any, Boxless would experience if it were to transfer income from its overseas subsidiaries to the parent company via a tax haven holding company. Assume that the UK tax authorities would then treat all income from overseas

subsidiaries as coming from a single source, the tax haven holding company.

(a)Discuss whether or not an increase in dividends is likely to benefit the shareholders of a

(b)The board of directors of Serty Plc is discussing the level and nature of the company’s next dividend payment.

Three options are under consideration:

(i)A cash dividend of 15 pence per share, or

(ii)A 5% scrip dividend, or

(iii)The company repurchases 10% of the ordinary share capital at the current market price and then pays a cash dividend as in (i) above.

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ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

Calculate the expected effect of each suggestion on a shareholder in Serty owning 1,000 shares. Explain briefly how accurate your estimates are likely to be.

(15 marks)

Question 49 AVT PLC

(a)Discuss how a decrease in the value of each of the determinants of the option price in the

Black-Scholes option-pricing model for European options is likely to change the price of a call option. (6 marks)

(b)AVT plc is considering the introduction of an executive share option scheme.

The scheme would be offered to all middle managers of the company. It would replace the existing scheme of performance bonuses linked to the post-tax earnings per share of the company. Such bonuses in the last year ranged between £5,000 and £7,000. If the option scheme is introduced new options are expected to be offered to the managers each year.

It is proposed for the first year that all middle managers are offered options to purchase 5,000 shares at a price of 500 pence per share after the options have been held for one year. Assume that the tax authorities allow the exercise of such options after they have been held for one year. If the options are not exercised at that time they will lapse.

The company’s shares have just become ex-div and have a current market price of 610 pence. The dividend paid was 25 pence per share, a level that has remained constant for the last three years. Assume that dividends are only paid annually.

The company’s share price has experienced a standard deviation of 38% during the last year. The short-term risk free interest rate is 6% per annum.

Required:

(i)Discuss the relative merits for the company of the existing bonus scheme and

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ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

Assume that it is now 1 June and that option contracts mature at the month end.

LIFFE Traded options (1,000 shares)

Required:

(a)Illustrate how Folter plc might use traded options to protect against a fall in the share

price of Magterdoor plc. Assuming that Folter has to sell the shares at the end of October at a price of 485 pence, evaluate the outcome of the hedge(s). (4 marks)

(b)Assume that the call option delta of Magterdoor is 0·47. Illustrate how a delta neutral hedge might be used to protect against price movements of the shares of Magterdoor. Comment upon any practical problems of using a delta hedge for this purpose. (4 marks)

(c)Discuss the reasons why the January 550 call option premium is not the same as the

(d)The managing director of Folter suggests increasing its holding in Magterdoor from 2%

to 6% of that company’s issued shares. Discuss briefly the advantages and

The finance director of Netra plc, a company listed on the AIM (Alternative Investment Market) wishes to estimate what impact the introduction of debt finance is likely to have on the company’s overall cost of capital. The company is currently financed only by equity.

The company’s current share price is 420 pence, and up to £4 million of fixed rate five-year debt could be raised at an interest rate of 10% per annum. The corporate tax rate is 33%.

Netra’s current earnings before interest and tax are £2.5 million. These earnings are not expected to change significantly for the foreseeable future.

The company is considering raising either:

In either case the debt finance will be used to repurchase ordinary shares.

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REVISION QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Required:

(a)Using Miller and Modigliani’s model in a world with corporate tax, estimate the impact on Netra’s cost of capital of raising:

(i)£2 million and

(ii)£4 million in debt finance.

(b)Briefly discuss whether or not the estimates produced in part (a) are likely to be

(10 marks)

Question 53 MERCHANT BANK

You have purchased the following data from a merchant bank.

The market return and market standard deviation are 14.5% and 5% respectively, and the risk free rate is 6%. Returns and all other data relate to a one-year period.

Required:

(a)Estimate the “alpha” values for each of these companies’ shares and explain what use

(b)Briefly discuss reasons for the existence of alpha values, and whether or not the same

(10 marks)

Question 54 PHANTOM

Phantom plc wishes to buy £1 million of shares in each of two companies from a choice of three companies that it might wish to acquire at some future date. The companies are in different industries. Historic five-year data on the risk and returns of the three companies are shown below.

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ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

An adviser to Phantom plc has suggested that the decision about which shares to buy should be based upon selecting the most efficient portfolio of two shares.

Required:

(b)Discuss whether or not Phantom plc’s strategy should be to purchase the most efficient

(10 marks)

Question 55 KULPAR

The finance director of Kulpar plc is concerned about the impact of capital structure on the company’s value, and wishes to investigate the effect of different capital structures.

He is aware that as gearing increases the required return on equity will also increase, and the company’s interest cover is likely to decrease. A decrease in interest cover could lead to a change in the company’s credit rating by the leading rating agencies.

He has been informed that the following changes are likely:

The company’s growth rate of cash flow may be assumed to be constant, and to be unaffected by any change in capital structure.

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