QUESTION: 73

An unlisted company is attempting to value its equity using the dividend valuation model.

Relevant information is as follows:

· A dividend of $500,000 has just been paid.

· Dividend growth of 8% is expected for the foreseeable future.

· Earnings growth of 6% is expected for the foreseeable future.

· The cost of equity of a proxy listed company is 15%.

· The risk premium required due to the company being unlisted is 3%.

The calculation that has been performed is as follows:

Equity value = $540,000 / (0.18 - 0.08) = $5,400,000

What is the fault with the calculation that has been performed?

The cost of equity used in the calculation should have been 12% (15% subtract 3%).
The dividend cashflow used should have been $500,000 rather than $540,000.
The dividend growth rate is unsuitable given that earning growth is lower than dividend growth.
The cost of equity used in the calculation should have been 15%; no adjustment was necessary.

Answer(s): C

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QUESTION: 74

A company is considering the issue of a convertible bond compared to a straight bond issue (non-convertible bond).

Director A is concerned that issuing a convertible bond will upset the shareholders for the following reasons:

· it will dilute their control

· the interest payments will be higher therefore reducing liquidity

· it will increase the gearing ratio therefore increasing financial risk

Director B disagrees, and is preparing a board paper to promote the issue of the convertible bond rather than a non-convertible.

Advise the Director B which THREE of the following statements should be included in his board paper to promote the issue of the convertible bond?

The convertible bond may not dilute control as the bond holder has an option to choose conversion.
The coupon rate on the convertible bond will be lower than that on a non-convertible bond.
When converted into shares, the company will receive a cash inflow which can be used for future investments.
Issuing a convertible bond will have a more favourable impact on the gearing ratio than a non-convertible bond.
Over the life of the bond, a convertible will be more expensive than a non-convertible.

Answer(s): A,B,D

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QUESTION: 75

A project requires an initial outlay of $2 million which can be financed with either a bank loan or finance lease.

The company will be responsible for annual maintenance under either option.

The tax regime is:

· Tax depreciation allowances can be claimed on purchased assets.

· If leased using a finance lease, tax relief can be claimed on the interest element of the lease payments and also on the accounting depreciation charge.

The trainee management accountant has begun evaluating the lease versus buy decision and has produced the following data. He is not confident that all this information is relevant to this decision.

Using only the relevant data, which of the following is correct?

The bank loan is $30,000 MORE expensive than the finance lease.
The bank loan is $20,000 LESS expensive than the finance lease.
The bank loan is $70,000 LESS expensive than the finance lease.
The bank loan is $120,000 LESS expensive than the finance lease.

Answer(s): C

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QUESTION: 76

Company A plans to acquire Company B, an unlisted company which has been in business for 3 years.

It has incurred losses in its first 3 years but is expected to become highly profitable in the near future.

No listed companies in the country operate the same business field as Company B, a unique new high-risk business process.

The future success of the process and hence the future growth rate in earnings and dividends is difficult to determine.

Company A is assessing the validity of using the dividend growth method to value Company B.

Which THREE of the following are weaknesses of using the dividend growth model to value an unlisted company such as Company B?

The company has been unprofitable to date and hence, there is no established dividend payment pattern.
The future projected dividend stream is used as the basis for the valuation.
The future growth rate in earnings and dividends will be difficult to accurately determine.
The dividend growth model does not take the time value of money into consideration.
The cost of capital will be difficult to estimate.

Answer(s): A,C,E

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