Topic: Capital structure

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SCS – Nov 2019 – L3 – Q2b – Capital structure

Discuss the potential benefits and problems of converting short-term borrowing into long-term loans.

i) Discuss the potential benefits and problems with proposals to convert the company’s short-term borrowings into a longer-term loan.

ii) Pay bigger cash salaries, or add a share option element to the remuneration packages.

iii) Maintain the dividend for 2019 at the 2018 level, or even reduce it further.

iv) Convert any surplus dollar cash into cedis.

(10 marks)

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FM – May 2021 – L2 – Q3a – Capital Structure

Discuss the main difficulties associated with highly geared companies.

a) Shareholders and Management of companies generally agree that it is good to introduce gearing into a company’s financing structure to enhance returns to shareholders. Excessive debt and gearing above a level that a company can comfortably afford is risky.

Required:

State and explain THREE (3) main difficulties associated with highly geared companies. (6 marks)

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FM – May 2020 – L2 – Q1b – Capital structure | Portfolio theory and the capital asset pricing model (CAPM)

Analyze the degree of operating and financial leverage for two subsidiary companies to determine the implications for their capital structure.

Firm A and Firm B are both subsidiary companies of Groupe Trojan Electronics. The directors of Groupe Trojan Electronics are reviewing the capital structure of the two subsidiary companies. You have been engaged to advise the directors on the appropriate capital structure for the subsidiaries.

You have obtained extracts from the financial results of the two companies for the past financial year and projection of the annual results for the current year, which is in its first quarter.

Required:

i) Compute the degree of operating leverage for each of the two companies. Based on the degree of operating leverage you obtain, advise the directors on the relative level of business risk associated with the two subsidiaries and the implication of that for capital structure design. (5 marks)

ii) Compute the degree of financial leverage for each of the two companies. Based on the degree of financial leverage you obtain, advise the directors on the relative level of financial risk associated with the two subsidiaries and the implication of that for capital structure design. (5 marks)

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FM – MAY 2016 – L2 – Q4 – Capital structure | Cost of capital

Discuss the reasons for pecking order in financing, factors influencing capital structure, and calculate the appropriate cost of capital for Pusher Mining Ltd’s new project.

a) The Directors of Moore Plastics Ltd have been deliberating on the company’s capital structure with a view to identifying an optimal financing mix. Opening the deliberation, the Board Chair remarked, “For the past 10 years, we have deployed a financing strategy of reinvesting as much profit as available. When profit is inadequate, we go for borrowing. New equity offers have been a last resort.”

Required:
i) Explain with THREE reasons why most managers tend to use financing strategies that follow the pecking order. (6 marks)
ii) Identify and explain TWO factors the directors of Moore Plastics Ltd should consider in redesigning the company’s capital structure. (4 marks)

b) Pusher Mining Ltd, a large listed company, operates five mineral concessions in Ghana and Ivory Coast. The company’s financial performance for the past five years has been impressive. The company’s recently published financial results indicate that it earned after-tax profit of GH¢250 million and paid dividends of GH¢50 million out of that profit.

Reserves at two of the five mineral concessions will be exhausted in two years’ time, and stakeholders fear this will adversely affect the company’s profitability. Nevertheless, the directors are aiming at maintaining the company’s dividend payment record. To achieve this, they want to pursue a new project in the oil industry to provide additional cash flows. Though the new project will be financed with existing equity and long-term debts, the directors are not sure what cost of capital to use in appraising the new project.

A summary of the company’s financial position before the new oil project follows:

Item GH¢m
Noncurrent assets 620
Current assets 425
Total assets 1,045
Equity
Stated capital 180
Income surplus 685
Shareholders’ fund 865
Liabilities
Current liabilities 20
Bank loans 40
Bonds 120
Total liabilities 180
Total equity and liabilities 1,045

Notes:

  1. Stated capital: Pusher has in issue 40 million ordinary shares of no par value, all of which are listed on the stock exchange. The current market value of the ordinary stock is GH¢5.5 per share. It is estimated that the market value of the ordinary stock will increase by 8% per annum. The equity beta is 1.25.
  2. Bank loans: These are fixed-rate loans from banks in Ghana. The after-tax cost of the loans is 14.5%.
  3. Bonds: These are 16% coupon bonds with a face value of GH¢100 each. The bonds are currently trading at GH¢98.1 each. In 10 years’ time, the bonds may be either converted into 10 ordinary shares or redeemed at face value at the choice of bondholders. Bondholders are assumed to be rational investors.

If the new oil project is implemented, Pusher Mining Ltd’s main competitor in the oil industry would be Cargo Oil Ltd. The estimated equity beta of the competitor is 1.80 and the market value of its equity stock is GH¢150 million. The long-term debt stock of the competitor is valued at GH¢100 million. The systematic risk of debt stocks is assumed to be zero. The risk-free return is 14% and the market return is 20%. The corporate tax rate is 25%.

Required:
Estimate the appropriate cost of capital Pusher Mining Ltd should use in appraising the new project in the oil industry. Show all relevant computations. (10 marks)

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FM – Nov 2023 – L2 – Q4 – Capital structure | DCF: Risk and uncertainty

Explain systematic, business, and financial risk; compute expected NPV for projects; and discuss traditional and Modigliani-Miller views on gearing and WACC.

a) Understanding risk is key for a robust risk and control environment in modern business organisations.
Required:
In the light of the above, explain the following:
i) Systematic risk (2 marks)
ii) Business risk (2 marks)
iii) Financial risk (2 marks)

b) Quantum Investment Ltd in the past has been concentrating all its investments in one project that performed badly consistently over the past few years. They have therefore decided to adopt a diversification strategy by investing in projects A, B, and C. The table below presents the Net Present Value (NPV) of the projects under different states of the economy.

State of Economy Probability Project A Project B Project C
Bad 0.2 GH¢10 million GH¢12 million GH¢15 million
Average/Normal 0.5 GH¢20 million GH¢22 million GH¢30 million
Good 0.3 GH¢35 million GH¢40 million GH¢45 million

The company has GH¢200 million for investments in these three projects:
Project A = GH¢40 million
Project B = GH¢60 million
Project C = GH¢100 million

Required:
Compute the expected NPV for each of the three projects. (9 marks)

c) In capital structure decisions, there are two views of gearing and weighted average cost of capital (WACC): the traditional view and the Modigliani-Miller view.
Required:
Explain the two views with respect to gearing and WACC. (5 marks)

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FM – AUG 2022 – L2 – Q4 – Capital structure

Evaluates the decision between leasing and buying, calculates NPV, and explains the benefits of listing on the stock market.

a) Lease or Buy decision could be a tough call to make, especially considering that different industries benefit more than others from leasing or buying outright depending on the specific needs of that sector.

Freda Automobile (Freda), an emerging automobile company has taken a decision to provide a new Toyota Land Cruiser for its Chief Executive Officer (CEO). The company is considering whether to buy or lease. The Toyota Land Cruiser has a useful life of six years and will cost GH¢1,000,000 to buy and will be funded with a bank loan. The Finance Director provided the borrowing interest rate for the loan at 22% per annum. The annual repairs and maintenance cost when the V8 is bought is GH¢18,000. The corporate tax rate is currently 25% paid in the same year the profit is made. The capital allowance on the V8 is 25% per annum on reducing balance basis.

Alternatively, the Toyota Land Cruiser could be leased at a rental cost of GH¢250,000 per annum for six years payable at the beginning of each year.

Required:
i) Explain TWO (2) reasons why Freda will prefer leasing option to outright buy. (4 marks)
ii) Calculate the Net Present Value (NPV) for the buy option. (5 marks)
iii) Calculate the Net Present Value (NPV) for the lease option. (4 marks)
iv) Based on your computations in ii) and iii) above, advise management which option should be considered. (2 marks)

b) The Ghana Stock Exchange (GSE) market has recently been intensifying its public education for Ghanaian companies to list on the stock market to raise the needed capital for expansion and growth. You have been approached by owners of Asafo Ghana Ltd who have expressed interest in getting listed on the stock market but have limited knowledge on what they stand to benefit by listing their company on the market.

Required:
Explain FOUR (4) advantages Asafo Ghana Ltd could derive from listing on GSE. (5 marks)

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FM – April 2022 – L2 – Q1b – Capital structure

Calculate the capital structure of Boom Ltd and determine the earnings required to achieve a 25% return for equity holders.

Boom Ltd is into the provision of online conference call facilities which has become popular due to the rising trend in Covid-19 cases in Ghana. The company has 10 million issued shares currently at GH¢50 each, 3 million preference shares trading at GH¢25 each, and 5,000 bonds also trading at GH¢600 each.

Required:
i) Calculate the Capital Structure of the Company. (4 marks)
ii) How much should the company earn annually to achieve a return of 25% per annum on capital employed for equity holders if the dividend rate on preference shares per annum is 20% and the coupon on the bonds is 18%? In Ghana, interest paid on debt is tax deductible and corporate tax is at 25%. (6 marks)

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FM – MAY 2019 – L2 – Q2b – Capital structure

Explain share repurchase and identify situations where it is useful for Mempeasem Ltd.

At a recent Board meeting, the Board Chair of Mempeasem Ltd suggested the need to restructure the capital of their company. The Chair proposed shares repurchase as the option to consider, but the majority of the Board members were hearing this term for the first time. As the Finance Manager, you have been directed to help the Board members to understand this option for decision making.

Required:

  1. Explain the term share repurchase to a non-finance person. (1 mark)
  2. Identify FOUR (4) situations under which share repurchase will be useful for Mempeasem Ltd. (5 marks)

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FM – MAY 2019 – L2 – Q2a – Capital structure

Calculate the current market capitalization of M&E Ltd and the Weighted Average Cost of Capital (WACC) prior to financing a new project.

Question:
M&E Ltd, recognized as the leader in steel manufacturing, has received an invitation to supply steel for the construction of rail lines to connect the ECOWAS countries, starting from Nigeria. The contract will be for 10 years, and management is considering appraising the investment to enable them to present their proposals for the contract. The following information was extracted from the recently published accounts of M&E Ltd:

GH¢ ‘000
Equity Shares (1,000,000 shares) 70,000
15% Preference shares 50,000
10% (Bonds irredeemable) 30,000
Total 150,000

The Treasury unit of M&E Ltd has estimated that it will require GH¢ 10 million to finance the new project. The total amount would be raised through 10% Irredeemable bonds at the current market price. The cost of Preference shares and Bonds will not change, but equity shareholders will demand an increase of 20% on the current cost of equity.

M&E Ltd has a beta of 0.8, the market risk premium for the steel industry is 6.25%, and the Government of Ghana Bond rate is 20%. The current market price for Irredeemable Bonds of GH¢1,000 nominal value is GH¢850.

M&E Ltd’s dividend policy is to pay constant dividends, and this policy will not change in the foreseeable future. The recent dividend paid was GH¢20 per share. M&E Ltd is a Free Zones Company and therefore pays tax at a rate of 8%.

Required:

i) Calculate the current market capitalization of M&E Ltd. (5 marks)

ii) Calculate the Weighted Average Cost of Capital (WACC) prior to the consideration of the finance for the proposed project. (9 marks)

(Total: 14 marks)

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SCS – Nov 2019 – L3 – Q2b – Capital structure

Discuss the potential benefits and problems of converting short-term borrowing into long-term loans.

i) Discuss the potential benefits and problems with proposals to convert the company’s short-term borrowings into a longer-term loan.

ii) Pay bigger cash salaries, or add a share option element to the remuneration packages.

iii) Maintain the dividend for 2019 at the 2018 level, or even reduce it further.

iv) Convert any surplus dollar cash into cedis.

(10 marks)

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FM – May 2021 – L2 – Q3a – Capital Structure

Discuss the main difficulties associated with highly geared companies.

a) Shareholders and Management of companies generally agree that it is good to introduce gearing into a company’s financing structure to enhance returns to shareholders. Excessive debt and gearing above a level that a company can comfortably afford is risky.

Required:

State and explain THREE (3) main difficulties associated with highly geared companies. (6 marks)

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FM – May 2020 – L2 – Q1b – Capital structure | Portfolio theory and the capital asset pricing model (CAPM)

Analyze the degree of operating and financial leverage for two subsidiary companies to determine the implications for their capital structure.

Firm A and Firm B are both subsidiary companies of Groupe Trojan Electronics. The directors of Groupe Trojan Electronics are reviewing the capital structure of the two subsidiary companies. You have been engaged to advise the directors on the appropriate capital structure for the subsidiaries.

You have obtained extracts from the financial results of the two companies for the past financial year and projection of the annual results for the current year, which is in its first quarter.

Required:

i) Compute the degree of operating leverage for each of the two companies. Based on the degree of operating leverage you obtain, advise the directors on the relative level of business risk associated with the two subsidiaries and the implication of that for capital structure design. (5 marks)

ii) Compute the degree of financial leverage for each of the two companies. Based on the degree of financial leverage you obtain, advise the directors on the relative level of financial risk associated with the two subsidiaries and the implication of that for capital structure design. (5 marks)

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FM – MAY 2016 – L2 – Q4 – Capital structure | Cost of capital

Discuss the reasons for pecking order in financing, factors influencing capital structure, and calculate the appropriate cost of capital for Pusher Mining Ltd’s new project.

a) The Directors of Moore Plastics Ltd have been deliberating on the company’s capital structure with a view to identifying an optimal financing mix. Opening the deliberation, the Board Chair remarked, “For the past 10 years, we have deployed a financing strategy of reinvesting as much profit as available. When profit is inadequate, we go for borrowing. New equity offers have been a last resort.”

Required:
i) Explain with THREE reasons why most managers tend to use financing strategies that follow the pecking order. (6 marks)
ii) Identify and explain TWO factors the directors of Moore Plastics Ltd should consider in redesigning the company’s capital structure. (4 marks)

b) Pusher Mining Ltd, a large listed company, operates five mineral concessions in Ghana and Ivory Coast. The company’s financial performance for the past five years has been impressive. The company’s recently published financial results indicate that it earned after-tax profit of GH¢250 million and paid dividends of GH¢50 million out of that profit.

Reserves at two of the five mineral concessions will be exhausted in two years’ time, and stakeholders fear this will adversely affect the company’s profitability. Nevertheless, the directors are aiming at maintaining the company’s dividend payment record. To achieve this, they want to pursue a new project in the oil industry to provide additional cash flows. Though the new project will be financed with existing equity and long-term debts, the directors are not sure what cost of capital to use in appraising the new project.

A summary of the company’s financial position before the new oil project follows:

Item GH¢m
Noncurrent assets 620
Current assets 425
Total assets 1,045
Equity
Stated capital 180
Income surplus 685
Shareholders’ fund 865
Liabilities
Current liabilities 20
Bank loans 40
Bonds 120
Total liabilities 180
Total equity and liabilities 1,045

Notes:

  1. Stated capital: Pusher has in issue 40 million ordinary shares of no par value, all of which are listed on the stock exchange. The current market value of the ordinary stock is GH¢5.5 per share. It is estimated that the market value of the ordinary stock will increase by 8% per annum. The equity beta is 1.25.
  2. Bank loans: These are fixed-rate loans from banks in Ghana. The after-tax cost of the loans is 14.5%.
  3. Bonds: These are 16% coupon bonds with a face value of GH¢100 each. The bonds are currently trading at GH¢98.1 each. In 10 years’ time, the bonds may be either converted into 10 ordinary shares or redeemed at face value at the choice of bondholders. Bondholders are assumed to be rational investors.

If the new oil project is implemented, Pusher Mining Ltd’s main competitor in the oil industry would be Cargo Oil Ltd. The estimated equity beta of the competitor is 1.80 and the market value of its equity stock is GH¢150 million. The long-term debt stock of the competitor is valued at GH¢100 million. The systematic risk of debt stocks is assumed to be zero. The risk-free return is 14% and the market return is 20%. The corporate tax rate is 25%.

Required:
Estimate the appropriate cost of capital Pusher Mining Ltd should use in appraising the new project in the oil industry. Show all relevant computations. (10 marks)

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FM – Nov 2023 – L2 – Q4 – Capital structure | DCF: Risk and uncertainty

Explain systematic, business, and financial risk; compute expected NPV for projects; and discuss traditional and Modigliani-Miller views on gearing and WACC.

a) Understanding risk is key for a robust risk and control environment in modern business organisations.
Required:
In the light of the above, explain the following:
i) Systematic risk (2 marks)
ii) Business risk (2 marks)
iii) Financial risk (2 marks)

b) Quantum Investment Ltd in the past has been concentrating all its investments in one project that performed badly consistently over the past few years. They have therefore decided to adopt a diversification strategy by investing in projects A, B, and C. The table below presents the Net Present Value (NPV) of the projects under different states of the economy.

State of Economy Probability Project A Project B Project C
Bad 0.2 GH¢10 million GH¢12 million GH¢15 million
Average/Normal 0.5 GH¢20 million GH¢22 million GH¢30 million
Good 0.3 GH¢35 million GH¢40 million GH¢45 million

The company has GH¢200 million for investments in these three projects:
Project A = GH¢40 million
Project B = GH¢60 million
Project C = GH¢100 million

Required:
Compute the expected NPV for each of the three projects. (9 marks)

c) In capital structure decisions, there are two views of gearing and weighted average cost of capital (WACC): the traditional view and the Modigliani-Miller view.
Required:
Explain the two views with respect to gearing and WACC. (5 marks)

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FM – AUG 2022 – L2 – Q4 – Capital structure

Evaluates the decision between leasing and buying, calculates NPV, and explains the benefits of listing on the stock market.

a) Lease or Buy decision could be a tough call to make, especially considering that different industries benefit more than others from leasing or buying outright depending on the specific needs of that sector.

Freda Automobile (Freda), an emerging automobile company has taken a decision to provide a new Toyota Land Cruiser for its Chief Executive Officer (CEO). The company is considering whether to buy or lease. The Toyota Land Cruiser has a useful life of six years and will cost GH¢1,000,000 to buy and will be funded with a bank loan. The Finance Director provided the borrowing interest rate for the loan at 22% per annum. The annual repairs and maintenance cost when the V8 is bought is GH¢18,000. The corporate tax rate is currently 25% paid in the same year the profit is made. The capital allowance on the V8 is 25% per annum on reducing balance basis.

Alternatively, the Toyota Land Cruiser could be leased at a rental cost of GH¢250,000 per annum for six years payable at the beginning of each year.

Required:
i) Explain TWO (2) reasons why Freda will prefer leasing option to outright buy. (4 marks)
ii) Calculate the Net Present Value (NPV) for the buy option. (5 marks)
iii) Calculate the Net Present Value (NPV) for the lease option. (4 marks)
iv) Based on your computations in ii) and iii) above, advise management which option should be considered. (2 marks)

b) The Ghana Stock Exchange (GSE) market has recently been intensifying its public education for Ghanaian companies to list on the stock market to raise the needed capital for expansion and growth. You have been approached by owners of Asafo Ghana Ltd who have expressed interest in getting listed on the stock market but have limited knowledge on what they stand to benefit by listing their company on the market.

Required:
Explain FOUR (4) advantages Asafo Ghana Ltd could derive from listing on GSE. (5 marks)

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FM – April 2022 – L2 – Q1b – Capital structure

Calculate the capital structure of Boom Ltd and determine the earnings required to achieve a 25% return for equity holders.

Boom Ltd is into the provision of online conference call facilities which has become popular due to the rising trend in Covid-19 cases in Ghana. The company has 10 million issued shares currently at GH¢50 each, 3 million preference shares trading at GH¢25 each, and 5,000 bonds also trading at GH¢600 each.

Required:
i) Calculate the Capital Structure of the Company. (4 marks)
ii) How much should the company earn annually to achieve a return of 25% per annum on capital employed for equity holders if the dividend rate on preference shares per annum is 20% and the coupon on the bonds is 18%? In Ghana, interest paid on debt is tax deductible and corporate tax is at 25%. (6 marks)

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FM – MAY 2019 – L2 – Q2b – Capital structure

Explain share repurchase and identify situations where it is useful for Mempeasem Ltd.

At a recent Board meeting, the Board Chair of Mempeasem Ltd suggested the need to restructure the capital of their company. The Chair proposed shares repurchase as the option to consider, but the majority of the Board members were hearing this term for the first time. As the Finance Manager, you have been directed to help the Board members to understand this option for decision making.

Required:

  1. Explain the term share repurchase to a non-finance person. (1 mark)
  2. Identify FOUR (4) situations under which share repurchase will be useful for Mempeasem Ltd. (5 marks)

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FM – MAY 2019 – L2 – Q2a – Capital structure

Calculate the current market capitalization of M&E Ltd and the Weighted Average Cost of Capital (WACC) prior to financing a new project.

Question:
M&E Ltd, recognized as the leader in steel manufacturing, has received an invitation to supply steel for the construction of rail lines to connect the ECOWAS countries, starting from Nigeria. The contract will be for 10 years, and management is considering appraising the investment to enable them to present their proposals for the contract. The following information was extracted from the recently published accounts of M&E Ltd:

GH¢ ‘000
Equity Shares (1,000,000 shares) 70,000
15% Preference shares 50,000
10% (Bonds irredeemable) 30,000
Total 150,000

The Treasury unit of M&E Ltd has estimated that it will require GH¢ 10 million to finance the new project. The total amount would be raised through 10% Irredeemable bonds at the current market price. The cost of Preference shares and Bonds will not change, but equity shareholders will demand an increase of 20% on the current cost of equity.

M&E Ltd has a beta of 0.8, the market risk premium for the steel industry is 6.25%, and the Government of Ghana Bond rate is 20%. The current market price for Irredeemable Bonds of GH¢1,000 nominal value is GH¢850.

M&E Ltd’s dividend policy is to pay constant dividends, and this policy will not change in the foreseeable future. The recent dividend paid was GH¢20 per share. M&E Ltd is a Free Zones Company and therefore pays tax at a rate of 8%.

Required:

i) Calculate the current market capitalization of M&E Ltd. (5 marks)

ii) Calculate the Weighted Average Cost of Capital (WACC) prior to the consideration of the finance for the proposed project. (9 marks)

(Total: 14 marks)

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