Topic: Financial Distress and Bankruptcy

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SFM – May 2024 – PL – SC – Q5 – Financial Distress and Bankruptcy

Explain problems/costs of financial distress; describe impacts of high gearing on stakeholders and protective measures.

a. Explain the main problems and costs which might arise for a company experiencing a period of severe financial difficulties. (7 Marks)

b. Describe how interested parties, other than bondholders, will be affected by high financial gearing levels, and describe what protective measures they can take. (8 Marks)

(Total 15 Marks)

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SFM – May 2025 – PL – SB – Q3 – Cost of Capital

Calculate current and project-specific cost of equity for Zeco Plc, discuss gearing issues, and explain risk-return relationship in financing costs.

Zeco Plc (ZP) is a listed company in the residential building construction industry. Over the past five years results have been disappointing and consequently the share price has fallen from a high of N3.50 per share five years ago to only N1.05 per share today. This deterioration in performance and share price have been accompanied by an increase in financial gearing to a high level.

Zeco Plc capital structure is as follows:

N’m
Equity:
Share capital (N0.50 per share nominal value) 40
Retained earnings 35
Long – term liabilities:
6.5% irredeemable loan notes (N100 per loan note nominal value) 250
7% bank loan 20

Zeco Plc. loan notes are quoted at N65 per loan note and both the loan notes and the bank loan are secured. Zeco Plc equity beta is 2.3.

New venture To improve performance, Zeco Plc. is considering the construction of commercial properties such as office blocks and industrial complexes. This is a new activity for Zeco Plc and it is expected that the risks involved will be different from its current activity. The Finance Director has proposed that a project-specific discount rate should be used to appraise the new venture, but the Commercial Director does not believe this is necessary.

Delac Commercial Properties Plc. (DCP) undertakes commercial construction projects similar to those being considered by Zeco Plc. DCP has an equity beta of 1.25. DCP has N100m of ordinary shares in issue, currently quoted at N2.60 per N1 nominal value ordinary share. The company also has N110m of loan notes in issue, currently quoted at N96 per N100 nominal value.

Both companies pay tax at 20%, the risk-free rate is 4% and the expected return on the market portfolio is 10%.

Required:

a. i. Using the Capital Asset Pricing Model, calculate Zeco Plc current cost of equity and a project-specific cost of equity suitable for the new venture. (6 Marks)

ii. Referring to your calculations above, comment briefly on the view of the Commercial Director. (2 Marks)

b. Discuss three problems Zeco Plc may be facing as a result of its current high level of gearing. (6 Marks)

c. In respect of both equity and debt, discuss the risk-return relationship and how it affects Zeco Plc. financing costs. (6 Marks)

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FM – May 2024 – L3 – SC – Q6 – Financial Distress and Bankruptcy

Discuss economic exposure in currency risk management and calculate impact of USD strengthening on Linko Plc’s market value.

(a) With respect to foreign currency risk management, explain economic exposure and discuss generally how a company can manage economic exposure. (8 Marks)

(b) Linko Plc is a UK-based company supplying medical equipment to the USA and Europe, while importing raw materials from the USA. It has net imports of 8 million dollars from the USA, which is expected to continue for the next six years. The company’s cost of capital is 10% per year. Assume cash flows occur at year-end and ignore taxation.

Required:
Assuming no change in the physical volume or dollar price of imports, estimate the impact on the expected market value of Linko Plc, if the market expects the dollar to strengthen by 4% per year against the pound. The current spot exchange rate (US$ per £1) is 1.9156 – 1.9210. (7 Marks)

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FM – May 2024 – L3 – SC – Q5 – Financial Distress and Bankruptcy

Discuss problems of severe financial difficulties and the impact of high financial gearing on stakeholders, excluding bondholders.

(a) Explain the main problems and costs which might arise for a company experiencing a period of severe financial difficulties. (7 Marks)

(b) Describe how interested parties, other than bondholders, will be affected by high financial gearing levels, and describe what protective measures they can take. (8 Marks)

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SFM – May 2024 – PL – SC – Q5 – Financial Distress and Bankruptcy

Explain problems/costs of financial distress; describe impacts of high gearing on stakeholders and protective measures.

a. Explain the main problems and costs which might arise for a company experiencing a period of severe financial difficulties. (7 Marks)

b. Describe how interested parties, other than bondholders, will be affected by high financial gearing levels, and describe what protective measures they can take. (8 Marks)

(Total 15 Marks)

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SFM – May 2025 – PL – SB – Q3 – Cost of Capital

Calculate current and project-specific cost of equity for Zeco Plc, discuss gearing issues, and explain risk-return relationship in financing costs.

Zeco Plc (ZP) is a listed company in the residential building construction industry. Over the past five years results have been disappointing and consequently the share price has fallen from a high of N3.50 per share five years ago to only N1.05 per share today. This deterioration in performance and share price have been accompanied by an increase in financial gearing to a high level.

Zeco Plc capital structure is as follows:

N’m
Equity:
Share capital (N0.50 per share nominal value) 40
Retained earnings 35
Long – term liabilities:
6.5% irredeemable loan notes (N100 per loan note nominal value) 250
7% bank loan 20

Zeco Plc. loan notes are quoted at N65 per loan note and both the loan notes and the bank loan are secured. Zeco Plc equity beta is 2.3.

New venture To improve performance, Zeco Plc. is considering the construction of commercial properties such as office blocks and industrial complexes. This is a new activity for Zeco Plc and it is expected that the risks involved will be different from its current activity. The Finance Director has proposed that a project-specific discount rate should be used to appraise the new venture, but the Commercial Director does not believe this is necessary.

Delac Commercial Properties Plc. (DCP) undertakes commercial construction projects similar to those being considered by Zeco Plc. DCP has an equity beta of 1.25. DCP has N100m of ordinary shares in issue, currently quoted at N2.60 per N1 nominal value ordinary share. The company also has N110m of loan notes in issue, currently quoted at N96 per N100 nominal value.

Both companies pay tax at 20%, the risk-free rate is 4% and the expected return on the market portfolio is 10%.

Required:

a. i. Using the Capital Asset Pricing Model, calculate Zeco Plc current cost of equity and a project-specific cost of equity suitable for the new venture. (6 Marks)

ii. Referring to your calculations above, comment briefly on the view of the Commercial Director. (2 Marks)

b. Discuss three problems Zeco Plc may be facing as a result of its current high level of gearing. (6 Marks)

c. In respect of both equity and debt, discuss the risk-return relationship and how it affects Zeco Plc. financing costs. (6 Marks)

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FM – May 2024 – L3 – SC – Q6 – Financial Distress and Bankruptcy

Discuss economic exposure in currency risk management and calculate impact of USD strengthening on Linko Plc’s market value.

(a) With respect to foreign currency risk management, explain economic exposure and discuss generally how a company can manage economic exposure. (8 Marks)

(b) Linko Plc is a UK-based company supplying medical equipment to the USA and Europe, while importing raw materials from the USA. It has net imports of 8 million dollars from the USA, which is expected to continue for the next six years. The company’s cost of capital is 10% per year. Assume cash flows occur at year-end and ignore taxation.

Required:
Assuming no change in the physical volume or dollar price of imports, estimate the impact on the expected market value of Linko Plc, if the market expects the dollar to strengthen by 4% per year against the pound. The current spot exchange rate (US$ per £1) is 1.9156 – 1.9210. (7 Marks)

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FM – May 2024 – L3 – SC – Q5 – Financial Distress and Bankruptcy

Discuss problems of severe financial difficulties and the impact of high financial gearing on stakeholders, excluding bondholders.

(a) Explain the main problems and costs which might arise for a company experiencing a period of severe financial difficulties. (7 Marks)

(b) Describe how interested parties, other than bondholders, will be affected by high financial gearing levels, and describe what protective measures they can take. (8 Marks)

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You're reporting an error for "FM – May 2024 – L3 – SC – Q5 – Financial Distress and Bankruptcy"

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