QUESTION: 17

A company has in a 5% corporate bond in issue on which there are two loan covenants.

· Interest cover must not fall below 3 times

· Retained earnings for the year must not fall below $3.5 million

The Company has 200 million shares in issue.

The most recent dividend per share was $0.04.

The Company intends increasing dividends by 10% next year.

Financial projections for next year are as follows:

Advise the Board of Directors which of the following will be the status of compliance with the loan covenants next year?

The company will be in compliance with both covenants.
The company will be in breach of both covenants.
The company will breach the covenant in respect of retained earnings only.
The company will be in breach of the covenant in respect of interest cover only.

Answer(s): C

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QUESTION: 18

A company wishes to raise additional debt finance and is assessing the impact this will have on key ratios.

The following data currently applies:

· Profit before interest and tax for the current year is $500,000

· Long term debt of $300,000 at a fixed interest rate of 5%

· 250,000 shares in issue with a share price of $8

The company plans to borrow an additional $200,000 on the first day of the year to invest in new project which will improve annual profit before interest and tax by $24,000.

The additional debt would carry an interest rate of 3%.

Assume the number of shares in issue remain constant but the share price will increase to $8.50 after the investment.

The rate of corporate income tax is 30%.

After the investment, which of the following statements is correct?

Interest cover will fall; P/E ratio will fall.
Interest cover will fall; P/E ratio will rise.
Interest cover will rise; P/E ratio will rise.
Interest cover will rise; P/E ratio will fall.

Answer(s): B

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QUESTION: 19

A new company was set up two years ago using the personal financial resources of the founders.

These funds were used to acquire suitable premises.

The company has entered into a long-term lease on the premises which are not yet fully fitted out.

The founders are considering requesting loan finance from the company's bank to fund the purchase of custom-made advanced technology equipment.

No other companies are using this type of equipment.

The company expects to continue to be profitable for the forseeable future.

It re-invests some of its surplus cash in on-going essential research and development.

Which THREE of the following features are likely to be considered negatives by the bank when assessing the company's credit-worthiness?

The equipment is advanced technology custom-made equipment.
The company will continue to remain profitable and to generate net cash.
The company premises are on a long-term lease but are not yet fully fitted out.
The founders invested their personal financial resources in the company.
Essential on-going research and development expenditure is required.

Answer(s): A,C,E

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QUESTION: 20

Company Y plans to diversify into an activity where Company X has an equity beta of 1.6, a debt beta of zero and gearing of 50% (debt/debt plus equity).

The risk-free rate of return is 5% and the market portfolio is expected to return 10%.

The rate of corporate income tax is 30%.

What would be the risk-adjusted cost of equity if Company Y has 60% equity and 40% debt?

11.6%
11.9%
9.1%
13%

Answer(s): B

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