M.Sc.

Finance 2003

in Glasgow Finance III: Tutorial One

Options
Q1. The following data is taken from the Financial Times on Thursday February 1st and gives Abbey
National’s share price and the prices of options written on the share with exercise prices of 1150
and 1200, maturing in April, July and October.

Abbey National Calls Puts

(1167) April July Oct April July Oct
X = 1150 71 109½ 126½ 65 91½ 106
X = 1200 48½ 86½ 104 94 119 133½

a) Determine the intrinsic and time values of the various puts and calls with an exercise price of
1150.

b) Contrast the breakdown of the prices into an intrinsic value component and a time value
component for the calls with April and October maturity dates.

c) Assume that the annual interest rate is 6 per cent provide and estimate of the minimum value
of an October call given that the current share price is 1167. What would this value be if the
interest rate had been 12 per cent rather than 6 per cent? Draw an illustrative diagram to
represent the set of minimum prices for different share prices if the rate of interest is 6 per
cent (assume 0.5 per cent per month).

d) Estimate the value of an April put with an exercise price of 1150 using the put-call parity
proposition if the interest rate is 6 per cent per annum or 1 per cent for the two month period.

e) Using the data provided draw illustrative diagrams for a straddle strangle, a covered call, and
a bull spread. Identify the key features in each diagram.

Q2. The price of a share is 80p and over the next period it is anticipated that the price of the share
may increase or decrease by 10p. Estimate a price of a call with an exercise price of 85p if the
interest rate for the period is 2 per cent. Assume next that the returns on the share are more
volatile and the price can increase or decrease by 20p.

Q3. It is usually assumed that only non-diversifiable risk is relevant for the pricing of assets in highly
competitive capital markets? Is this true of options?

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 M.Sc. Finance 2002

in Glasgow Finance III: Tutorial Two

Rights Issues

Q1. Radiant plc is considering raising additional equity capital of £60 million through a rights issue.
The company has 90 million shares outstanding and its current share price is £2.50. One
possibility would be to set the subscription price at £2.00, giving a conventional discount of 20
per cent. To ensure that the company obtains the funds it requires the issue could be
underwritten. Alternatively, the company could make a deep discount issue, setting the
subscription price at £1.20.

a) Determine the theoretical ex-rights price and the value of the rights for the conventional and
the deep discount issue.

b) What will happen to the value of the right if the subscription price is set with a conventional
discount, and the cum-rights share price falls to £2.20 during the subscription period?

c) Demonstrate, using the two possible sets of terms, that in principle shareholders will be
indifferent to the level of subscription price set in a rights issue.

Q2. a) Explain what is meant by the price-pressure hypothesis.

b) The evidence suggests that the share prices falls on the announcement of a new issue. (This
is a real fall in price rather than the mechanical adjustment to the terms of a rights issue.)
Should this evidence deter companies from making rights issues?

c) Consider the value of underwriting a rights issue.

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 M.Sc. Finance 2002

in Glasgow Finance III: Tutorial Three

Gearing and Capital Structure

Q1. Tartan plc has always followed a policy of avoiding any debt financing. But the company needs
to raise an additional £20m to finance a major project and is considering the issue of a debentures
at 10 per cent. Alternatively it could sell 10 million additional shares at the prevailing market
price of £2. This would increase the number of shares outstanding by 50 per cent. Earnings
following the investment in the new project are expected to reach £20m before tax. One of the
advantages of employing debt would be the tax savings associated with the interest expense. The
tax rate is 40 per cent. But it is also recognised that earnings could fall below the expected level.

a) Calculate the expected earnings per share for both financing possibilities.

b) Calculate the level of earnings at which earnings per share would be the same for both
financing possibilities.

c) As the expected earnings per share is greater if debt financing is employed doe this imply
that the new project should be financed by debt?

Q2. A company’s expected earnings before corporate tax for the coming year is £10m and it is
anticipated that it will be able to maintain this level of earnings indefinitely into the future. The
company is financed entirely by equity but is considering the possibility of issuing debt of £20m
at an interest rate of 8 per cent to replace some of its equity.

a) In a world without taxes the all equity financed company is valued at £50m. Determine the
cost of equity capital and the weighted average cost of capital for the company if its capital
structure is reorganised to include debt of £20m. use both the traditional and Modigliani-
Miller approaches.

b) Determine the value of the company for both the non-geared and geared capital structures if
the corporate tax rate is 40 per cent, and the required rate of return after corporate tax on the
all equity financed company is 15 per cent. There are no personal taxes. (Assume that the
Modiglianai-Miller model with corporate tax is valid.)

c) Determine the equity cost of capital and the weighted average cost of capital using the
Modigliani-Miller model with taxes.

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 M.Sc. Finance 2002

in Glasgow Finance III: Tutorial Four

Capital Structure and Cost of Capital

Q1. SAD plc is expected to record profits of £135 million before tax next year. The company has no
growth prospects and all its profits are paid out in the form of dividends. The company is finance
entirely by equity and the Finance Director is considering restructuring the company’s capital to
increase its expected earnings per share, and boost the company’s share price. It is proposed to
replace 30 million shares of the 90 million outstanding with the proceeds of an issue of debt at 6
per cent. The shares are currently trading at £5.00 and the issue of debt would be for £150
million. One perceived advantage of the debt issue is the tax saving to be made on the interest
payments, and the tax rate is 40 per cent.

a) Determine the company’s cost of capital assuming it continues to be financed entirely by

equity and comment briefly on the assumptions underlying your analysis.

b) Determine the value of the company following the restructuring, assuming that the proposed
debt issue is free of bankruptcy risk.

c) Determine the equity cost of capital and the weighted average cost of capital following the
restructuring.

d) Assume that the Miller (Debt and Taxes) model holds, there is no risk of bankruptcy, and the
capital gains tax is 20 per cent, profits tax is 40 per cent, the personal tax rate on interest
income is 30 per cent. Determine the value of SAD plc using this model.

e) Demonstrate, using the following diagram

i. the impact of the introduction of a more progressive schedule for the taxation of
interest income
ii. a reduction in the rate of corporate tax
iii. the elimination of the tax exempt status of all institutions

Adjusted Interest Rate

D
S

Aggregate debt
B*

Q2. a) If the corporate tax rate is 40 per cent, the personal tax rate on interest income is 20 per cent,
4
 and the effective capital gains tax is 10 per cent, determine the tax advantage of employing
debt.

b) Given t c  .40 and t g  .10 determine the value of t p that it necessary to eliminate the tax
advantage of debt.

Q3. If the cost of debt and equity in equilibrium is 15 per cent on a risk adjusted basis, interest is a tax
deductible expense and the corporate tax rate is 25 per cent determine the interest rate level at
which the company will be indifferent between issuing debt and equity.

Q4. Determine the cost of capital (ie. the rate of return required after allowing for corporate tax) for
an investment if the required rate of return on an ungeared company is 20 per cent and the
corporate tax rate is 40 per cent, personal tax rate is 25 per cent, capital gain rate is 5 per cent and
the firm employs 30 per cent debt in its financing.

Q5. What factors might be important in the debt-equity decision that appear to be ignored in the
theoretical literature?

Q6. a) “If bankruptcy is costless the risk of bankruptcy produced by gearing should not deter a
company from issuing debt.” Explain

b) Differentiate between the nature of bankruptcy costs on an ex ante and ex post basis. (Who
bears the costs on an ex ante and ex post basis?).

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 M.Sc. Finance 2002

in Glasgow Finance III: Tutorial Five

Debt Policy

Q1. Assume that there are no personal taxes but interest is a tax deductible expense for purposes of
calculating corporation tax. The required rate of return on ungeared equity is 14 per cent, the
interest rate is 8 per cent, and the tax rate is 40 per cent.

a) Calculate the weighted average cost of capital for a project expected to produce net cash
flows in perpetuity if the debt-equity ratio is 1 to 2.

b) A project has the following net cash flows

0 1 2 3
-10,000 2,400 2,400 12,400

Calculate the cost of capital assuming that the debt-equity ratio is 1 to 2, and calculate the
NPV of the project. What is the present value of the tax savings?

Q2. Assume there are no personal taxes and the value of a geared company can be determined using
the Modigliani-Miller model with corporate tax. An ungeared company has expected earnings of
£25m and is valued at £120. The tax rate is 40 per cent and the interest rate is 6 per cent on risk
free debt.. It is estimated that if the company employed £30m of debt following restructuring it
will be worth £132 million. If the company were to employ £60m of debt it is estimated that its
value would be £140m. Determine its cost of capital for the different levels of gearing and
comment on your results.

Q3. a) Consider the Miller model with bankruptcy costs. Explain the nature of the equilibrium for a
firm and the economy in these circumstances.

b) “Unless a firm has sufficient profits after depreciation to take full advantage of the tax
deductibility of interest it should not employ gearing”. Is this true, if the

i. M-M model holds?

ii. Miller model holds?

Explain your answer.

Q4. Provide a description of the type of firm that you would expected to employ

a) relatively large amounts of debt

b) relatively small amounts of debt.