business

Question 1 (10 marks)

Mac and Bhaird (2010), Holmes et al (2003), and Brav (2009) all consider “Pecking

Order Theory‟ is relevant to the study of small business finance.

Required:

(1)   Explain what is meant by the term “Pecking Order Theory.” 

 (2) Explain its relevance to small business finance.

Question 2 (10 marks)

“Capital structure theory originates in the irrelevance propositions of Modigliani

and Miller (1958).... There is ... a trade-off between the tax benefits of debt and

potential costs of financial distress” (mac an Bhaird, 2010:10)

“The effect of agency costs is more pronounced if businesses are small because

information asymmetries are greater”(mac an Bhaird, 2010:14)

Holmes, Hutchison et al (2003) have integrated the above two concepts into their

discussion on small business finance.

Required:

Explain how the two concepts assist in understanding how finance is managed in

small business.

Question 3 (4 marks)

It is stated that “… the principal role of financial reporting is essentially

retrospective and confirmatory” (Holmes, Hutchison, et al p. 107).

Explain the above statement in the context of the “typical” behaviour of small

business owners.

Question 4 (10 marks)

One of the ten principles of finance put forward by Petty, Keown, et al is that taxes

bias business decisions.

Required:

Using WACC show and explain how taxes may bias a business decision if a

business has a debt/equity ratio of 1.5, is able to borrow at 8.5%, has a cost of

equity of 12.1% and a corporate tax rate of 30%.

Question 5 (6 marks)

Analysis of performance of large organisations has identified that “Investors react

to poor company decisions (such as investment or dividend decisions) by causing

the total value of the firm’s shares to fall, and they react to good decisions by

pushing up the price of the shares.”

Required:

Explain whether the above statement does or does not apply to small businesses?

Question 6 (25 marks)

1)      Assuming an equitable return of 8% and an expected growth rate of 4%, calculate the present value of future cash flows (incorporating cash flows and horizon value) if you use a horizon period of 3 years.

2)      Explain why the value calculated may or may not be an appropriate representation of the value of the business.

3)      Calculate the break-even point for 2015.  Is it likely to change during the periods in question?  If so, explain what factors could be affecting the values?

Question 7 (20 marks)

Sam Carapella is the food and grocery retail sector analyst for a major Australian business broker and is currently working on his recommendation to an entrepreneurial client interested in acquiring Australian Foods Pty Limited, an operator of a retail food outlet in regional Australia.

From his research Sam has also ascertained the following:

• The current cash rate of 2.75% p.a. set by the Reserve Bank of Australia is an appropriate risk free proxy.
• On the basis of investment return data for the past 90 years, Sam considers 10.5% is a reasonable estimate of the long-term average annual return for an Australian investor with a well-diversified portfolio.
• Although in the recent past the company has paid Australian income tax at less than the full marginal rate (resulting from claiming GFC tax incentives that are ceasing) the company’s policy to use the current Australian company income tax rate of 30 percent to evaluate its capital investment projects.
• As Australian Foods P/L had received a number of expressions of interest from other potential purchasers, the owners of the company had all of the company’s long-term assets valued in February 2014.  The resulting valuation of $1.5M surprised the owners.
• Appropriate multiple-to-net operating profit after tax being used for last year is 18.
• Earnings growth for Australian Foods P/L is estimated as 3% for 2015, 3% for 2016, 2% for 2017, 4% for 2018 and 5% for 2019.
• It is estimated that some of the Australian Foods P/L facilities need upgrading, therefore investment is estimated for the next five years to be:  $20K for 2015, $25K for 2016, $20K for 2017, $30K for 2018, and $35K for 2019.
• An unlevered publicly listed firm in the same industry as Australian Foods P/L has a beta of 1.38.
• Sam’s client wishes to limit Australian Foods P/L exposure to debt to 60% of the value of the firm.  This is because the client believes they are able to achieve their optimum borrowing rate of 9% at this amount of leverage.

Required:

Determine the current after tax WACC of Australian Foods P/L.