CIMA Updated F3 Exam Questions and Answers by damien

A spin-off/demerger normally involves separating a division or subsidiary and giving its shares to the existing shareholders. It doesn’t in itself raise finance (A), it doesn’t introduce new shareholders to the core entity (B), and it does not inherently increase takeover risk (D). Its main advantage is that it allows the market to value the demerged business separately, revealing its “true” value – C is correct.

Given currently:

Cost of equity ke=10%k_e = 10\%ke​=10%

Post-tax cost of debt = 4%

WACC = 7.6%

Gearing D/(D+E)=40%D/(D+E) = 40\%D/(D+E)=40%

Tax 20%

New gearing after raising more debt: 50%.

Under Modigliani & Miller with tax (no distress costs):

Cost of debt remains constant as gearing changes (until very high levels of debt). So

➜ F is TRUE, A is FALSE.

As gearing increases, the tax shield on debt becomes larger, so WACC falls.

➜ B (WACC will decrease below 7.6%) is TRUE, E is FALSE.

Higher gearing increases financial risk borne by shareholders, so cost of equity rises with more debt.

➜ C (cost of equity will increase above 10%) is TRUE, D is FALSE.

So the correct set is B, C and F.

According to Modigliani and Miller with tax, the value of a levered firm is:

VL=VU+Tc×DV_L = V_U + T_c \times DVL​=VU​+Tc​×D

where TcT_cTc​ is the corporate tax rate and DDD is the market value of debt. With corporate income tax, interest is tax-deductible, so increasing debt creates a tax shield and increases total firm value.

Initially:

Debt = 40

Equity = 60

Total value = 100

Tax rate = 20%.

If the company increases debt and uses the proceeds to buy back shares until debt equals equity, then:

New structure: D=ED = ED=E

Total firm value rises because Tc×DT_c \times DTc​×D increases.

The extra value (PV of the additional tax shield) accrues to shareholders, even though the accounting market value of equity after the buyback may fall in absolute terms; shareholders have also received cash from the buyback, so their total wealth increases.

Business risk (and therefore asset beta) is unchanged; however equity beta would rise, not fall, because of higher financial leverage. Therefore the only correct statement is that the plan would increase shareholder wealth – answer C.

 TERP = $4.80 (given).

 Issue price = $4.00 → value of one right per new share = 4.80 − 4.00 = $0.80.

 The company offers $1.00 per right, which is more than the theoretical value.

So shareholders who don’t want to invest more cash are better off selling the rights back to the company for $1 rather than exercising them or selling on the market.

That means fewer shareholders will take up the rights, so the company is likely to raise less cash → option D.