Corporate Finance – BBA2103

Tutorial 2 (Questions)
Corporate Finance – BBA2103

1. When a company seeks a listing for its shares on a stock exchange, it usually recruits the
assistance of a merchant bank. Explain the role of a merchant bank in a listing operation
with respect to the various matters on which its advice will be sought by a company.

MERCHANT BANKS NOWADAYS CONCENTRATE ON DEALING WITH

INSTITUTIONAL INVESTORS, LARGE CORPORATIONS AND GOVERNMENTS.
THEY HAVE THREE MAJOR ACTIVITIES, FREQUENTLY ORGANISED INTO
SEPARATE DIVISIONS: CORPORATE FINANCE, MERGERS AND
ACQUISITIONS, AND FUND MANAGEMENT.

MERCHANT BANKS' ACTIVITIES INCLUDE GIVING FINANCIAL ADVICE TO

COMPANIES AND ARRANGING FINANCE THROUGH SYNDICATED LOANS
AND NEW SECURITY ISSUES. THIS INVOLVES ADVISING A COMPANY ON
THE CORRECT MIX OF FINANCIAL INSTRUMENTS TO BE ISSUED AND ON
DRAWING UP A PROSPECTUS AND UNDERWRITING THE ISSUE. THEY ALSO

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PLAY A LEADING ROLE IN THE DEVELOPMENT OF NEW FINANCIAL

PRODUCTS, SUCH AS SWAPS, OPTIONS AND OTHER DERIVATIVE
PRODUCTS THAT HAVE BECOME VERY WIDELY TRADED IN RECENT
YEARS.

ANOTHER AREA OF ACTIVITY FOR WHOLESALE BANKS IS ADVISING

COMPANIES ON CORPORATE MERGERS, ACQUISITIONS AND
RESTRUCTURING. THIS INVOLVES BOTH ASSISTING IN THE NEGOTIATION
OF A FRIENDLY' MERGER OF TWO INDEPENDENT COMPANIES AND ALSO
DEVELOPING STRATEGIES FOR 'UNFRIENDLY' TAKEOVERS, OR ACTING AS
AN ADVISER FOR A COMPANY DEFENDING AGAINST AN UNWANTED
BIDDER.

FINALLY, MERCHANT BANKS FULFIL A MAJOR ROLE AS MANAGERS OF

THE INVESTMENT PORTFOLIOS OF SOME PENSION FUNDS, INSURANCE
COMPANIES, INVESTMENT AND UNIT TRUSTS, AND VARIOUS CHARITIES.
WHETHER IN ARRANGING FINANCE, ADVISING ON TAKEOVER BIDS OR
MANAGING THE FUNDS OF INSTITUTIONAL INVESTORS, MERCHANT
BANKS EXERT CONSIDERABLE INFLUENCE ON BOTH CORPORATE FINANCE
AND THE CAPITAL MARKET.

2. Briefly outline the major functions performed by the capital market and explain the
importance of each function for corporate financial management. How does the existence
of a well-functioning capital market assist the financial management function?

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THE FINANCIAL MARKETS PROVIDE MECHANISMS THROUGH WHICH THE

CORPORATE FINANCIAL MANAGER HAS ACCESS TO A WIDE RANGE OF SOURCES
OF FINANCE AND INSTRUMENTS. CAPITAL MARKETS FUNCTION IN TWO
IMPORTANT WAYS: (2 significant function: primary and secondary markets)

PRIMARY MARKET - PROVIDING NEW CAPITAL FOR BUSINESS AND OTHER

ACTIVITIES, USUALLY IN THE FORM OF SHARE ISSUES TO NEW OR EXISTING
SHAREHOLDERS (EQUITY), OR LOANS.

SECONDARY MARKET TRADING EXISTING SECURITIES, THUS ENABLING SHARE

OR BOND HOLDERS TO DISPOSE OF THEIR HOLDINGS WHEN THEY WISH. AN
ACTIVE SECONDARY MARKET IS A NECESSARY CONDITION FOR AN EFFECTIVE
PRIMARY MARKET, AS NO INVESTOR WANTS TO FEEL 'LOCKED IN' TO AN
INVESTMENT THAT CANNOT BE REALIZED WHEN DESIRED.

IMAGINE WHAT BUSINESS LIFE WOULD BE LIKE IF THESE CAPITAL MARKETS

WERE NOT AVAILABLE TO COMPANIES. NEW BUSINESSES COULD START UP
ONLY IF THE OWNERS HAD SUFFICIENT PERSONAL WEALTH TO FUND THE

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INITIAL CAPITAL INVESTMENT; EXISTING BUSINESSES COULD DEVELOP ONLY

THROUGH RE-INVESTING PROFITS GENERATED; AND INVESTORS COULD NOT
EASILY DISPOSE OF THEIR SHAREHOLDINGS. IN MANY PARTS OF THE WORLD
WHERE FINANCIAL MARKETS ARE EMBRYONIC OR EVEN NON-EXISTENT, THIS IS
EXACTLY WHAT DOES HAPPEN. THE DEVELOPMENT OF A STRONG AND
HEALTHY ECONOMY RESTS VERY LARGELY ON EFFICIENT, WELL-DEVELOPED
FINANCIAL MARKETS. FINANCIAL MARKETS PROMOTE SAVINGS AND
INVESTMENT BY PROVIDING MECHANISMS WHEREBY THE FINANCIAL
REQUIREMENTS OF LENDERS (SUPPLIERS OF FUNDS) AND BORROWERS (USERS
OF FUNDS) CAN BE MET.
In the nutshell financial system need to perform well.

3. What is meant by Efficient Market Hypothesis? Explain the three forms of EMH.
If the markets are informationally efficient the prices of the assets in the market reflect all
available relevant information.重要这个是 definition.

IN AN EFFICIENT STOCK MARKET, CURRENT MARKET PRICES FULLY

REFLECT AVAILABLE INFORMATION AND IT IS IMPOSSIBLE TO
OUTPERFORM THE MARKET CONSISTENTLY, EXCEPT BY LUCK.
ACADEMICS DEFINE THREE 'STRENGTHS' OF MARKET EFFICIENCY AND
TEST THE MARKET USING EMPIRICAL DATA.

Weak form of EMH

-The current share prices fully reflect all information contained in past price movements.
-If this level of efficiency holds, there is no value in trying to predict future price
movements by analyzing trends in past price movements.
-No abnormal returns can be made.
-Efficient stock market prices will fluctuate more or less randomly, any departure from
randomness being too expensive to determine.

Semi Strong Form of EMH （useless to analysis past information）

-The current share prices fully reflect all information contained in past price movements.
-If this level of efficiency holds, there is no value in trying to predict future price
movements by analyzing trends in past price movements.
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-No abnormal returns can be made.

-Efficient stock market prices will fluctuate more or less randomly, any departure from
randomness being too expensive to determine.

Strong Form of EMH (whatever what outside information is not going to help you
to make any investment)
-The market prices reflect all relevant information – even if privately held.
-The market price reflects the ‘true’ or intrinsic value of the share based on the
underlying future cash flows.
-The implications of such a level of market efficiency are clear: no one can consistently
beat the market and earn abnormal returns.
-Few would go so far as to argue that stock markets are efficient at this level.

4. What does the financial service sector comprise of? Explain the services offered by this
sector.
Re-packaging, or pooling, finance: gathering small amounts of savings from a large
number of individuals and re-packaging them into larger bundles for lending to
businesses.

Risk reduction: placing small sums from numerous individuals in large, well-diversified
investment portfolios, such as unit trusts.

Liquidity transformation: bringing together short-term savers and long-term borrowers

(e.g. building societies and banks). Borrowing ‘short’ and lending ‘long’(more than 1
year) is acceptable only where relatively few savers will want to withdraw funds at any
given time. (we can withdraw the money through ATM) long term loan has higher risk,
these money come from short term depositer.

Cost reduction: minimising transaction costs by providing convenient and relatively

inexpensive services for linking small savers to larger borrowers. (banking sectors can
minimize transaction cost)

Financial advice: providing advisory and other services for both lender and borrower.
(investment bank, advisory about issue to financial securities)

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FINANCIAL SERVICE SECTOR PROVIDE THE FOLLOWING SERVICES:

RE-PACKAGING, OR POOLING, FINANCE: GATHERING SMALL AMOUNTS OF

SAVINGS FROM A LARGE NUMBER OF INDIVIDUALS AND RE-PACKAGING THEM
INTO LARGER BUNDLES FOR LENDING TO BUSINESSES.

RISK REDUCTION: PLACING SMALL SUMS FROM NUMEROUS INDIVIDUALS IN

LARGE, WELL-DIVERSIFIED INVESTMENT PORTFOLIOS, SUCH AS UNIT TRUSTS.

LIQUIDITY TRANSFORMATION: BRINGING TOGETHER SHORT-TERM SAVERS AND

LONG-TERM BORROWERS (E.G. BUILDING SOCIETIES AND BANKS). BORROWING
'SHORT' AND LENDING 'LONG' IS ACCEPTABLE ONLY WHERE RELATIVELY FEW
SAVERS WILL WANT TO WITHDRAW FUNDS AT ANY GIVEN TIME.

COST REDUCTION: MINIMISING TRANSACTION COSTS BY PROVIDING

CONVENIENT AND RELATIVELY INEXPENSIVE SERVICES FOR LINKING SMALL
SAVERS TO LARGER BORROWERS.

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FINANCIAL ADVICE: PROVIDING ADVISORY AND OTHER SERVICES FOR BOTH

LENDER AND BORROWER.

EXAMPLES OF FINANCIAL SERVICES SECTOR AND THEIR SERVICES ARE AS THE

FOLLOWING:

CLEARING BANKS

THEY MANAGE NATIONWIDE NETWORKS OF BRANCHES AND ON-LINE

FACILITIES,

THEY OPERATE A NATIONAL PAYMENTS SYSTEM BY CLEARING CHEQUES AND

BY RECEIVING AND PAYING OUT NOTES AND COINS, AND

THEY ACCEPT DEPOSITS IN VARYING AMOUNTS FROM A WIDE RANGE OF

CUSTOMERS.

HENCE, THESE OPERATIONS ARE OFTEN CALLED RETAIL BANKING.

WHOLESALE BANKS (MERCHANT BANKING)

A BANK THAT DEALS MOSTLY IN (BUT IS NOT LIMITED TO) INTERNATIONAL

FINANCE, LONG-TERM LOANS FOR COMPANIES AND UNDERWRITING.

MERCHANT BANKS DO NOT PROVIDE REGULAR BANKING SERVICES TO THE

GENERAL PUBLIC.

THEY HAVE THREE MAJOR ACTIVITIES, FREQUENTLY ORGANIZED INTO

SEPARATE DIVISIONS: CORPORATE FINANCE, MERGERS AND ACQUISITIONS, AND
FUND MANAGEMENT. EXAMPLES ARE DISCOUNT HOUSES AND BUILDING
SOCIETIES.

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5. The following are the financial statements of Prospect plc for last year and this year:

Calculate all financial ratios for Prospect plc for last year and this year. (Use year-end figures
where balance sheet items are involved). Comment on the performance of the company based on
liquidity, activity, debt, profitability and market ratios of the company.

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6. Glad Tidings plc produces electronic measuring instruments for medical research. It has
recorded strong and consistent growth during the past 10 years since its present team of
managers bought it out from a large multinational corporation. They are now
contemplating obtaining a stock market listing.

Glad Tidings’ accounting statements for the last financial year are summarised below.
Fixed assets (i.e. non-current assets), including freehold land and premises, are shown at
historic cost net of depreciation. The debenture is redeemable in 2 years, although early
redemption without penalty is permissible.

Profit and Loss Account (Income Statement) for the year ended 31 December
2018 (£ million)
Turnover 80.0
Cost of sales (70.0)
Operating profit 10.0
Interest charges (3.0)
Pre-tax profit 7.0
Corporation Tax (after capital (1.0)
allowances)
Profits attributable to ordinary 6.0
shareholders
Dividends (0.5)
Retained earnings 5.5

Statement of Financial Position at at 31 December 2018 (£ million)

Assets employed
Fixed: Land and premises 10.0
Machinery 20.0 30.0
Current: Stocks 10.0
Debtors 10.0
Cash 3.0 23.0
Current liabilities: Trade creditors (15.0)
Bank overdraft (5.0) (20.0)
Net current assets 3.0
Total assets less current liabilities 33.0
14% debentures (5.0)
Net assets 28.0
Financed by:
Issued share capital (par value £0.50):
Voting shares 2.0
Non-voting ‘A’ shares 2.0
Profit and Loss Account 24.0
Shareholders’ funds 28.0

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The following information is also available regarding key financial indicators

for Glad Tidings’ industry.
Return on (long-term) capital employed 22% (pre-tax)
Return on equity 14% (post-tax)
Operating profit margin 10%
Current ratio 1.8
Acid test ratio 1.1
Gearing 18%
Interest cover 5.2
Dividend cover 2.6
Price-to-Earnings (P/E) ratio 13

Discuss the performance and financial health of Glad Tidings plc in relation to that of the
industry as a whole.

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