Page 30 - CIMA MCS Workbook November 2018 - Day 1 Suggested Solutions

CIMA NOVEMBER 2018 – MANAGEMENT CASE STUDY

need to be convinced of Grapple’s ability to generate an acceptable rate of return, whether by
payment of dividends and/or capital growth in the share value over a period of time.

Alternatively Grapple could consider a rights issue to its’ existing shareholders. A rights issue
would have the advantage of maintaining the current ownership and would avoid any dilution of
ownership. It would also be cheaper compared to a full market issue. However such an issue is
unlikely to raise any significant funds, given that there are only five shareholders, with just one
with a significant holding and a commitment to the business.

Grapple could consider creating and issuing alternative classes of shares such as preference
shares. However, it would need to be careful as to whether the preference shares would meet the
definition of a financial liability (debt) or not. If the preference shares were redeemable or carried
an obligation to pay a dividend, they would have to be classed as debt finance. The related
dividends would be recognised as finance costs and charged against profit as an expense. This, in
turn, would have the impact of increasing the gearing ratio and reducing interest cover.

Creating an additional class of shares would be beneficial to Grapple if it wanted to be able to be
pay different levels of dividend to new shareholders compared to current equity shareholders, or
attached different voting rights to the different classes of shares.

Compound instruments
A further option would be to issue a compound financial instrument, such as a convertible loan or
bond. This would enable Grapple to raise finance at a lower cost compared to simple debt
finance. Since convertible bonds will be recorded partly as debt and partly as equity they would
also have a less adverse effect on the gearing ratio compared to other forms of debt finance.

Investors may consider a convertible loan or bond to be a less risky way of investing in Grapple
and may be attracted by the potential of becoming an equity shareholder in the future with the
ability to receive future dividends. This form of raising finance tends to be less common than
raising finance by the issue or equity shares or a loan.

Calculation of WACC

Cost of debt

Effective interest rate (per exercise 1) is 8.5% in 2018 and 11.9% in 2016.

Effective tax rate is 22% (to nearest %) in 2018 and 23% 2017.

Based upon 2018, the post‐tax cost of debt is therefore in the region of 8.5% x (1‐0.22) = 6.6%,
and higher in 2017 at 11.9% x (1‐0.23) = 9.2% for 2017 assuming that debt is long‐dated or
irredeemable.

Cost of equity
It is not possible to calculate the cost of equity as Grapple is unlisted and there is no information
in relating to a share price (e.g. for a recent transaction).

80 KAPLAN PUBLISHING