Question 1:

Raymond borrows a principal and interest loan amounted at $100,000. The loan will
be repayable in weekly instalments over 10 years. The nominal interest rate is 12%
p.a. What is the weekly repayment?

Answer:
The weekly interest rate is 0.12/52 = 0.0023.
Using Equation 3.19:
$100 000 =
52*10
1
1
0.0023 (1.0023)
C
(

(


= C*303.1231
C = $329.899



Question 2:

Describe the characteristics of a cumulative, non-redeemable, non-participating
preference share.

Answer:

Cumulative non-redeemable non participating preference shares are preference
shares issued by a firm where:
- any unpaid preference dividends from past years must be paid before any
current distribution can be made to ordinary shareholders (the cumulative
part).
- the preference shares have a life equal to the life of the firm (the non-
redeemable part).
- preference shareholders are not entitled to a return in excess of the stated
dividend rate (the non-participating part).


Question 3:

Discuss the most important difference between:
1) Secured debt and unsecured debt
2) Subordinated debt and unsubordinated debt
3) Commercial paper and commercial bill

Answer:

(a) If debt is secured, the borrowers promise to repay is supported by a fixed or
floating charge over assets. Unsecured debt does not involve any charge over
assets.
(b) Subordinated debt ranks below other debt in the event that the borrower is
wound up. Unsubordinated debt is debt that has not been subordinated.
(c) in commercial paper only the borrower has the responsibility to pay on the
maturity date, whereas in a bill of exchange there is an acceptor who also
carries responsibility for repayment

Question 4

There is evidence to suggest that dividends have a more stable pattern than earnings.
What reasons can you suggest for management adopting a policy of paying a stable
dividend in the face of fluctuating earnings?

Answer:

The existence of dividend clienteles and the information content of dividends provide
possible reasons for pursuing a stable dividend policy

Clientele effect: If a companys dividends fluctuate wildly, its shares may not appeal
to any clientele of investors.

In addition, students can discuss the outcome of a decrease in dividend payment, i.e.
managers are reluctant to increase a dividend that is going to be reversed in the future.


Question 5

Kin, an Australian resident, has this situation for the tax year 2010-2011:
- Salary of $100,000;
- Dividend income of $15,000 to which full imputation credit applies;
- Interest on bonds of $5,000.

The personal income tax rates are shown below:

Taxable Income Tax on this income
$1 - $6,000 Nil
$6,001-$35,000 15 cents for each $1 over $6,000
$35,001 and over $4,350 plus 30 cents for each $1 over $35,000

What is Kins net tax liability for the tax year 2010-2011? Assume the
corporate tax rate is 25%.


Answer:

Gross dividend = 15,000/(1-0.25)=$20,000

Imputation credit = 20000-15000=$5000

Taxable income = 100,000+5,000+20,000 = $125,000

Gross tax = 4350+(125000-35000)*0.3 = $31,350

Net tax = 31,350-5000=$26,350


Question 6:

Briefly discuss why asymmetric information pushes companies to raise external funds
by borrowing rather than issuing common stock.

Answer:

Need to argue that in general, companies have an incentive to issue securities when
companies believe the shares are overpriced

When a company issues securities, outside investors worry that management may
have unfavourable information. If so, the security can be overpriced. This worry is
much less with debt than equity. Debt security is safer than equity and their price is
less affected if unfavourable news comes out later.


Question 7:

The following information relates to two companies with the same business risk. The
two companies are identical in every respect except their capital structures.

Item Company A Company B
Earnings before interest $10,000 $10,000
Market value of debt $50,000 -
Cost of debt 4% -
Cost of equity 12% 10%
Market value of equity $66,666 $100,000
Total market value $116,666 $100,000

According to MM theory, the total market value of the two companies should be the
same, irrespective of the methods used to finance their investments.

Suppose you hold 1% of the shares in company A. Show the process and the amount
by which you could increase your income by arbitrage.


Answer:

Sell 1% of A, get $666.66

Since debt/equity of A is 50000/66666=75%

Borrow: 666.66*0.75=$500 at 4%

Invest in B: 500+666.66=1166.66

Payoff:

Income from B: 116.666 (1166.66*0.1)
- income from A: 666.66*0.12=(80)
=increase in income $36.67
less interest (500*0.04) 20
arbitrage profit $16.67






END