Residual dividend policy → dividends are not a good reflection of underlying performance → rules out A.

Highly cyclical earnings and capital structure not matched by listed peers make simple P/E comparison (D) unreliable.

Net asset value (C) rarely captures earnings potential for a going concern.

A discounted cash flow approach using free cash flows and a cost of equity derived from a proxy company (adjusted for gearing) is most appropriate.

Answer: B: Discounted cash flow analysis at WACC based on free cash flow to equity.

(Conceptually: FCFE discounted at cost of equity.)

Step 1 – Work out current gearing

Current values:

Equity = $80m

Debt = $20m

Total value VVV = 80 + 20 = $100m

So:

DE=2080=0.25\frac{D}{E} = \frac{20}{80} = 0.25ED​=8020​=0.25

Tax rate T=20%T = 20\%T=20% → after-tax cost of debt:

Kd(1−T)=6%(1−0.2)=4.8%K_d(1-T) = 6\%(1-0.2) = 4.8\%Kd​(1−T)=6%(1−0.2)=4.8%

Given cost of equity Ke=14%K_e = 14\%Ke​=14%.

Step 2 – Find the ungeared (asset) cost of capital KuK_uKu​

Use Modigliani–Miller with tax for equity:

Ke=Ku+(Ku−Kd)(1−T)DEK_e = K_u + (K_u - K_d)(1-T)\frac{D}{E}Ke​=Ku​+(Ku​−Kd​)(1−T)ED​

Substitute:

14=Ku+(Ku−6)×0.8×0.2514 = K_u + (K_u - 6)\times 0.8 \times 0.2514=Ku​+(Ku​−6)×0.8×0.25 14=Ku+0.2(Ku−6)14 = K_u + 0.2(K_u - 6)14=Ku​+0.2(Ku​−6) 14=1.2Ku−1.214 = 1.2K_u - 1.214=1.2Ku​−1.2 1.2Ku=15.2⇒Ku≈12.67%1.2K_u = 15.2 \Rightarrow K_u \approx 12.67\%1.2Ku​=15.2⇒Ku​≈12.67%

Step 3 – Re-gear the cost of equity for the new structure

New target mix: Debt : Equity = 40 : 60 ⇒

DE=4060=0.6667\frac{D}{E} = \frac{40}{60} = 0.6667ED​=6040​=0.6667

Reapply MM with tax:

Ke′=Ku+(Ku−Kd)(1−T)DEK_e' = K_u + (K_u - K_d)(1-T)\frac{D}{E}Ke′​=Ku​+(Ku​−Kd​)(1−T)ED​ Ke′=12.67+(12.67−6)×0.8×0.6667K_e' = 12.67 + (12.67 - 6)\times 0.8 \times 0.6667Ke′​=12.67+(12.67−6)×0.8×0.6667 Ke′≈12.67+3.56=16.23%K_e' \approx 12.67 + 3.56 = 16.23\%Ke′​≈12.67+3.56=16.23%

Step 4 – Calculate new WACC

New proportions:

E/V=60100=0.6,D/V=40100=0.4E/V = \frac{60}{100} = 0.6,\quad D/V = \frac{40}{100} = 0.4E/V=10060​=0.6,D/V=10040​=0.4 WACC′=0.6×16.23%+0.4×4.8%\text{WACC}' = 0.6 \times 16.23\% + 0.4 \times 4.8\%WACC′=0.6×16.23%+0.4×4.8% WACC′≈9.74%+1.92%=11.66%\text{WACC}' \approx 9.74\% + 1.92\% = 11.66\%WACC′≈9.74%+1.92%=11.66%

B. Low deposit interest rates – cash received will likely earn poor returns compared with equity.

D. Taxation on realised capital gains – cash offer crystallises a disposal now, potentially triggering CGT.

E. No opportunity to participate in Company U’s future success – once they take cash, they no longer share in upside from post-acquisition performance.

Option A is actually an advantage of cash (certainty), and C relates to the dividend policy if they take shares, not a disadvantage of cash itself.

The company needs to raise $40 million via a rights issue.

Current share price = $10

Rights issue at a 20% discount, so issue price =

10×(1−0.20)=10×0.8=$810 \times (1 - 0.20) = 10 \times 0.8 = \$810×(1−0.20)=10×0.8=$8

Number of new shares needed:

New shares=40m8=5 million shares\text{New shares} = \frac{40\text{m}}{8} = 5\text{ million shares}New shares=840m​=5 million shares

There are currently 20 million shares in issue, so the rights issue ratio is:

New sharesExisting shares=520=14\frac{\text{New shares}}{\text{Existing shares}} = \frac{5}{20} = \frac{1}{4}Existing sharesNew shares​=205​=41​

So, shareholders will receive 1 new share for every 4 existing shares.

In CIMA F3, the Calculated Intangible Value (CIV) method is used to estimate intangible value by comparing a business’s profits to what would be expected from its tangible asset base, typically relying on normalised, sustainable earnings and an assumption of continuing returns. This scenario has three features that reduce CIV validity. First, the business owns freehold property whereas the industry norm is to lease (A). CIV depends on a “normal” tangible asset base and the return on those tangibles; a non-standard capital structure in tangibles can distort the benchmark return and the computed “excess earnings,” so adjustments would be required. Second, significant profits are forecast only for three years with negligible profits thereafter (B). CIV implicitly assumes excess earnings are sustainable (often capitalised as a continuing benefit), so a short-lived profit window undermines the idea of capitalising excess returns into a continuing intangible value. Third, the business has not yet made a profit (C), which weakens CIV because it typically uses observed/established earnings to compute excess returns; early-stage forecasts add significant estimation risk. CIV can be applied to unlisted companies (so D is not a limitation), and the fact that software IP is not in the accounts is exactly why an intangible valuation approach is considered (so E is not a limitation).

In CIMA F3, capital structure choice affects tax, risk and shareholder expectations. Debt interest is tax-deductible whereas dividends are not, so using more debt reduces taxable profit. Therefore statement A (“no impact on tax”) is false. Retained earnings are not “free”: shareholders could have taken that cash and invested elsewhere, so the cost of retained earnings equals the cost of equity – B is false.

As gearing rises, equity becomes riskier because fixed interest must be paid before any earnings go to shareholders. Under Modigliani–Miller with or without tax, this raises the cost of equity, so D is true. Replacing debt with equity reduces the probability of default and so reduces overall financial risk, making E true.

Issuing more equity increases the number of shares; investors will expect dividends on those shares in future, so total dividend outflows are likely to rise even if DPS stays the same. This added distribution pressure makes F true. C (“debt is always preferable”) is rejected in F3 because of higher financial risk and potential increase in WACC beyond an optimal gearing level.

Advantages of issuing 20-year bonds vs a 20-year bank loan:

A. Larger capital market – bond markets tap many investors.

B. Greater availability of long-term funds – banks often prefer shorter maturities.

E. Lower interest rate – disintermediation can give cheaper funding for a strong credit.

C and D are usually disadvantages of bonds (higher arrangement cost and more admin).