Page 30 - CIMA MCS Workbook February 2019 - Day 1 Suggested Solutions

CIMA FEBRUARY 2019 – MANAGEMENT CASE STUDY

discount to the market price it may not raise as much finance in comparison to an issue of shares
at market value.

Currently there are forty equity holders in Crowncare (from the original eight at incorporation). It
is possible to increase this number, but this is dependent upon Crowncare identifying suitable
candidates in terms of professional qualification and currently involved in the company.
Therefore, access to additional equity finance via a rights issue is likely to be restricted due to the
relatively small number of shareholders in the company. Any issue of shares to a third party may
potentially reduce the control exercised by the current equity holders.

Crowncare 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 Crowncare if it wanted to be able to
be pay different levels of dividend to new shareholders compared to current equity shareholders.

Compound instruments
A further option would be to issue a compound financial instrument, such as a convertible bond.
This would enable Crowncare 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 regular bonds.

Investors may consider convertible bonds to be a less risky way of investing in Crowncare and may
be attracted by the potential of becoming an equity shareholder in the future with the ability to
receive future dividends.
Calculation of WACC ‐ Crowncare

Cost of debt

Effective interest rate (per exercise 1) is nil for both 2018 and 2017.
Effective tax rate is 28% (to nearest %) in 2018 and 2017.

Based upon 2017, the post‐tax cost of debt is therefore in the region of 8.0% x (1‐0.22) = 6.2%,
and slightly higher in 2016 at 8.4% x (1‐0.24) = 6.4% for 2016 assuming that debt is long‐dated or
irredeemable. Even though there was a part‐repayment of the debt finance in 2017, it had been
classified as a non‐current liability, indicating that it was an early or voluntary repayment by
Crowncare.

Cost of equity
It is not possible to calculate the cost of equity as the share price of Crowncare is not provided – it
is an unlisted company. Also, the breakdown between issued share capital and share premium has

80 KAPLAN PUBLISHING