# Explain the meaning of the capital rationing, the reason why it may occur and how an organisation can determine the best way to invest available capital under capital rationing.

Success Ltd is considering to invest in a project with expected life of four years. The following forecast o future sales revenue and costs was prepared

Sales Revenue Variable costs

$000 $000

Year 1 1150 700

Year 2 2300 1000

Year 3 6500 2300

Year 4 4500 1630

The forecast for sale revenue is expressed in current prices and the forecast for variable costs is stated in future prices. The annual general inflation is expected to be 3%.

The company has undertaken market research at the cost of $300.000 in order to forecast the future cash flows.

During the life of the project incremental fixed cost of $375.000 per year expressing current price terms will be incurred.

The capital cost of the investment project payable at the start of the first year, will be $3.000.000. Scrap value of $300.000 is expected to arise at the end of four years

The level of working capital investment at the start of each year is expected to be 15% of the sales revenue in that year.

Tax allowance depreciation would be available in the capital cost of the investment project on a 25% reducing balance basis. Success limited pays taxes on profits at the rate of 10% per year with tax being paid on one year in early years

Success limited has a real after-tax cost of capital of nine point 9.7% per year.

You are required to

a)Calculate the NPV of the investment project in nominal terms and comment whether the company should accept or reject it.(15 marks)

b)Explain the meaning of the capital rationing, the reason why it may occur and how an organisation can determine the best way to invest available capital under capital rationing.(You should refer to divisible and non-divisible projects).(8marks)

The investment funds of success limited are limited to $8.000.000 in the current year in the addition to project 1 which is considered in part (a) there are two more projects available for investment of funds. The details are as followsꓽ

Initial investment NPV

$000 $000

Project 2 2000 1.125,65

Project 3 4000 1.876,45

c)Determine the best way for Success limited to invest their available funds and calculate the resultant NPV on the assumptions that

– each of the three projects are divisible (4 marks)

– each of the three projects are non-divisible. (3 marks)

Total 30 marks

Question 2

You are provided with the following extract from the financial statements of Giant PLC which is the large listed companyꓽ

$m $m

Equity Finance

Ordinary shares($0.50 nominal value) 200

Reserves 540 740

Non-current liabilities

8% bond($100nominal value) 300

6% Preferences shares($1 nominal Value) 100 400

1140

The shares of the company are currently traded on the Stock Exchange market on ex interest basis at $4.95. Giant plc has an equity beta of 1.10.

The bonds are currently traded on the Stock Exchange market on an ex interest basis at $104.50. They will be redeemed in six years time added 10% premium on their nominal value.

The ex dividend market value of preference share is $85.75m.

The risk free rate of return is 6% and the market risk premium is 7%. Giant plc pays corporation tax at the rate of 20% per year.

Giant PLC is planning to raise finance through a rights issue and to use these funds to pay off some of its debt. The rights issue will be at 25% discount to its current ex dividend share price on a 1 for 5 basis. Giant plc believes that paying off some of its debt will not affect its current P/E ratio. The EPS of giant plc is currently $0.32.

You are required

Calculate the market value after tax WACC and book value after tax WACC of Giant PLC. Explain the differences between two values and advise what values should be used and why. (20 marks)

Calculate the theoretical ex rights price following the rights issue and evaluate whether using the cash raised by the rights issue to pay off some of the debt is financially acceptable for the shareholders. (Consider the effect on the wealth of shareholders) (15 marks)

Total 35 marks

Question 3

Knick-Knack limited is a listed company. The financial results of the company make it attractive as a potential target for acquisition.

You are provided with her initial statement of knick-knack limited for the year 20 Y 7.

$m $m

Non-current assets 85.0

Current assets

Inventory 2.6

Trade receivables 4.5

Cash and Cash eqiuvalents 0.7 7.8

Total assets 92.8

Equity Finance

Ordinary shares($1nominal value) 18.0

Reserves 54.0 72.0

Non-current liabilities

9% bond ($100 nominal value) 20.0 20.0

Current liabilities 0.8 0.8

92.8

The expected net realisable value of the inventories is $2.4. The non-current assets are recorded at the net book values. A recent valuation revealed that the non current assets are undervalued by $5m. Only 80% of trade receivables are expected to be collectible.

Knick-Knack limited pay the dividend of $8.4m this year.

It has a cost of equity of 12% and has forecast its future dividends as follow

dividends is expected to grow at a 3% rate for three years and 2% afterwards.

The earning of Knick-Knack limited over the last five years have been as follows

20Y3 $8.5m

20Y4 $9.2m

20Y5 $9.9m

20Y6 $10.2m

20Y7 $10.4m

Knick-Knack has P/E ratio of12.The average P/E ratio of listed companies similar to Knick-knack ltd is 11 times.

You are required to

Calculate the value of Knick knack limited using the net asset value method. (3 marks)

Calculate the value of Knick knack limited using the dividend growth model method.( 7 marks)

Calculate the suitable range of valuations of Knick-Knack limited using P/E ratio method. Justify the results.

Total 20 marks

Question 4

Spread limited is UK based company. It is due to receive $4m in 3 months time. The company can arrange a 3 month forward exchange contract with the bank or use money market hedge against the foreign exchange risk.

The spot exchange rate is $/£1.4362-1.4404 and the three month forward rate is $/£1.4244-1.4306. The following information about interest rates is availableꓽ

US prime 5.3%-6.0% per annum

UK LIBOR 3.8%-4.5% per annum

The inflation in the US is expected to be 5% while the inflation in the UK is expected to be 7%.

You are required to

Calculate the expected Sterling receipts in three month’s time using the forward exchange contract method. (2 marks)

Show how spread limited can use the money markets to hedge their risk and calculate if the expected sterling receipts in three months time. (7 marks)

Calculate using the purchasing power parity Theory what the exchange rate will be

– in one year time

– in two years time

For your calculation use the current spot rate $/£ 1.4362 (6 marks)

The post Explain the meaning of the capital rationing, the reason why it may occur and how an organisation can determine the best way to invest available capital under capital rationing. appeared first on Essay Quoll.