MBA: Man Fin. Nov main exam (2013) Marking Memo. Question 1 [25] Ordinary Shares

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1 MBA: Man Fin Nov main exam (2013) Marking Memo Question 1 [25] Ordinary Shares Equity is the capital provided to a firm by its owners, thus equity s most important characteristic is that it represents an ownership claim. Equity is often defined as the residual value of the company i.e. the difference between the value of a firm s total assets and total liabilities. Equity holders are entitled to the residual assets of a firm on dissolution, but otherwise equity finance is not repayable. In the process of ordinary business, shareholders have a claim on the residual earnings of a firm, after all expenses, including interest, have been paid. Shareholders may receive these residual earnings in the form of dividends, but a firm is not obliged to automatically pay dividends. Dividends are only payable after the firm has declared a dividend payment. The amount of the dividend is neither fixed nor tax deductible and it is determined by the firm s management. Shareholders cannot force a firm into liquidation if it has not paid dividends. Equity holders, being the owners of the company, have the right to control the firm and do so through voting for and choosing directors/managers who run the company on their behalf. In addition, shareholders have the right to vote on major decisions affecting the firm, such as merger and take-over offers, or the sale of subsidiaries. The ownership of a significant proportion of the total equity in a company allows a considerable control over the company. For example, ownership above a specified percentage allows the blocking of special resolutions, gives effective control over the Board of Directors and allows the passing of special resolutions without restraint. Preference Shares In addition to ordinary shares, companies may also issue preference shares, which have some of the characteristic of ordinary equity and some of the characteristics of debt. Preference shares typically have stated fixed dividend and can be redeemable, thus resembling debt as far as the firm has a fixed commitment and the original capital can be repaid. Alternatively, preference shares may be participating, which means that preference 1

2 shareholders are entitled to a share of the residual earnings of a firm. Some preference shares may have a convertibility provision, which allows them to be converted into ordinary shares under certain circumstances. For tax purposes, preference shares are treated, as equity and preference dividends are not tax-deductible. Preference shares present an ownership claim, but have a reduced risk in comparison to ordinary shares. The trade-off is often a limitation on the amount of control preference shareholders have on the company. As a general rule, preference shareholders have no voting rights. (10) Debt Financing Debt is generally referred to as the capital that a firm borrows for a limited period of time. The most important characteristic of debt is that it does not constitute an ownership claim on a firm. A debt obligation is a contractual agreement, which usually states the amount borrowed, the interest payable and the dates at which interest payments and capital repayments are due. An important feature of debt financing is that interest payments are tax-deductible i.e. the firm s tax liability is calculated only after interest payments have been deducted from the firm s earnings. Debentures A debenture is a document issued by a company containing an acknowledgement of debt. It need not give, although it usually does, a charge on the assets of the company. The Companies Acts define debenture as including debenture stock and bonds, it is quite common for the expressions debenture and bond to be used interchangeably. Company debentures can also be referred to as loan share. Usually a debenture is a bond given in exchange for money lent to the company. Debentures can be offered to the public only if the application form is accompanied by a prospectus. The company agrees to repay the principal to the lender by some future date, and in each year up to repayment it will pay a stated rate of interest in return for the use of the funds. A debenture holder is a creditor of the company and the interest has to be paid each year before a dividend is paid to any class of shareholder. Secured or unsecured Debentures and debenture share can be secured or unsecured. It is usual, however, to use the expression debenture when referring to the more secure form of issue, and loan share for less secure issues. When secured this is by means of a trust deed. The deed is usually in favour of the trustees and may be the whole or part of the property of the 2

3 company. The advantage of a trust deed are that a prior charge cannot be obtained on the property without the consent of the debenture holders, the events on which the principal is to be repaid are specified, and power given for the trustees to appoint a receiver and in certain events to carry on the business and enforce contracts. The debentures can be secured by a charge upon the whole or a specified part of a company s assets, or they can be secured by a floating charge upon the assets of the company. In this latter case, the company is not precluded from selling its assets. The latter case is known as a general lieu, whereas the debenture issued on the security of a specific asset is a mortgage debenture or mortgage bond. With a floating charge, when the company makes a default in observing the terms of the debentures, a receiver may be appointed and the charge becomes fixed, with the power to deal in the assets passing into the hands of the receiver. Such restrictions are referred to as covenants. (8) Convertibles Convertible loan share is a loan share, which, at the option of the holder, may be converted into ordinary shares in the company under specific conditions. One advantage, which is often quoted for convertible debt, is that it is cheaper than ordinary debt finance since the conversion option allows the security to be issued with a lower coupon rate than would otherwise be the case. Although it is true that the coupon on convertibles is lower, this does not mean that the overall cost is lower since one must also consider the expected cost of the conversion option. The lower coupon rate of a convertible may, however, be advantageous from a liquidity point of view. This form of finance may suit a project where the cash inflows are expected to be low in the early years. Prior to conversion, the security will represent debt finance and will therefore increase the level of gearing of a company. However, the increase in gearing will not be as great as for ordinary debt because of the lower coupon rate. It is for this reason that convertible securities are often issued in cases of companies already being highly geared and not wanting to raise straight equity finance. Convertibles are seen as a way of issuing deferred equity. This may be particularly advantageous if existing shareholders want to minimise any loss of control since the number of shares issued via a convertible (assuming conversion takes place) will be smaller than if straight equity were issued. 3

4 A useful aspect of convertibles is that, assuming the company s share price rises sufficiently to force conversion, the debt is self-liquidating. Since it is replaced by equity, conversion will reduce the level of gearing and thereby enable the company to issue further debt finance. While convertibles remain as debt, the interest is tax deductible. This gives rise to the tax advantage, which also accompanies other forms of debt finance. However, since the coupon rate on this security is lower than that associated with normal debt, the tax advantage is consequently reduced also. Unlike most debentures, convertibles are often not secured upon the assets of the company. When they exist in this form they are known as convertible unsecured loan shares. This may be particularly advantageous if a company does not have assets appropriate for use as security, or if the assets have already been used up with other debt finance. (7) Question 2 [25] 2.1 Exchange ratio based on MV TC/AC 8.00/ (2) 2.2 Exchange ratio based on EPS 0.90/ (2) 2.3 Post-acquisition EPS: No. of shares to be issued 2m x m shares Total no. of shares 6m m 7.44m 4

5 Combined value: B 6m x R1.25 P 2m x 0.90 Synergy R7.5m R1.8m R10m R19.3m/7.44m =R 2.59 (6) 2.4 Benefits: B R R1.25 R 1.34 P R2.59 (0.72) - R0.90 R R0.90 =R 0.96 (5) 2.5 Post acquisition EPS: No. of shares to be issued 2m x 1 2m shares Total no. of shares 6m + 2m 8m shares R19.3m/8m =R 2.41 (4) P/E Ratio x EPS 5

6 2.6 Expected post-acquisition MP Therefore MP 13 x 2.59 Expected growth 6% R MP = R20 x 1.06 =R Yes, MP with the acquisition is R33.67, compared with next year price of R21.20 without the acquisition. (6) Question 3 [25] 3.1 Set up New division at home: Y1 to 10 Y0 Rm Rm Cost of setting up premises (30.0) Cost of machinery (18.0) Annual sales 23 Less: annual variable costs (6.0) additional head office expenses (1.0) Annual cash flow 16 (48.0) Annuity 12% for 10 years Net present value

7 Acquisition: m m Acquiring shares (11.0) Redundancy costs (3.5) Annual sales 19 Less: annual variable costs (9.5) annual fixed costs (3.5) Annual cash flow 6 (14.5) Annuity 11% for 10 years Net present value Exchange rate 20.83m x 13 = R270.80m (22) 3.2 Reject the set up at home, NPV of +42m Accept the Acquisition (German) higher of the 2 NPV s, positive NPV of R270.8m vs R42.40m. (3) 7

8 Question 4 [25] 4.1 Calculation of market value of debenture: 1m x x Market value Amount Proportion O/s 1.5m x R P/s 1m x R Debentures Bank loan Cost D1 = 0.9(1.13) = R1.02 Ke = (1.02/3.00) % Kp = 0.12/2.00 6% 8

9 Kd = 10 (0.7) 7% Kbl = 14 (0.7) 9.80% WACC O/s 0.54 x 47% 25.38% P/s 0.24 x 6% 1.44% Debenture 0.11 x 7% 0.77% Bank loan 0.11 x % 28.67% (22) 4.2 CAPM: Rf + B(Rm - Rf) (15 7) = 20.60% (3) 9

10 Question 5 [25] 5.1 LEASE Y0 Y1 Y2 Y3 Y4 Lease payment ( ) ( ) ( ) ( ) ( ) Tax shield Net cash flow ( ) ( ) ( ) ( ) ( ) PV % = 12% PV cash outflows ( ) ( ) ( ) ( ) ( ) NPV (R ) PURCHASE Y1 Y2 Y3 Y4 Loan payments ( ) ( ) ( ) ( ) Dep. Tax shield Int. tax shield Net cash flows ( ) ( ) ( ) ( ) PV 12% PV cash outflows ( ) ( ) ( ) ( ) 10

11 5.2 Lease, because the cash outflows are lower by R (2) NPV (R ) (23) 11