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BS224 Managerial Finance

BS/BF 224: MANAGERIAL/CORPORATE FINANCE

ASSIGNMENT

INSTRUCTIONS:

  1. Answer all SIX (6) questions
  2. Be brief and cogent in your answers to theoretical questions
  3. Show all calculations where applicable
  4. You are allowed to use your calculator and Interest Factor tables
  5. Be neat and legible

MARKS:

Each question carries 25 marks

QUESTION 1

A worldwide cosmetics company can upgrade the quality of one of its products by purchasing new equipment at a cost of K155,000. The new equipment would replace old equipment that has a current market value of K23,000. The old equipment originally cost K180,000 and was three quarters depreciated. If the old equipment was used for an additional 12 years, its salvage value at that time would be K5,000. The new equipment has an expected life of 12 years. Its salvage value is estimated at K30,000.

By upgrading the quality of this product, the company would be able to increase the sale price. As a result, the operating income before tax will increase by K20,000 per year for the first 3 years, and by K25,000 per year during the last 9 years.

The company’s tax rate is 40% and its cost of capital after tax is 15%. Depreciation is on straight line basis.

Required

Compute the net present value (NPV) and the internal rate of return (IRR) for the investment and state whether the company should proceed with the investment. (25 marks)

QUESTION 2

ABC Company is planning an expansion of its business operations which will increase profit before interest and tax by 20%. The company is considering whether to use equity or debt finance to raise the K2m needed by the business expansion.

If equity finance is used, a 1 for 5 rights issue will be offered to existing shareholders at a 20% discount to the current  share price of K5·00 per share. The nominal value of the ordinary shares is K1·00 per share.

If debt finance is used, ABC will issue 20,000 8% loan notes with a nominal value of K100 per loan note.

Financial statement information prior to raising new finance:

K’000

Profit before interest and tax                                     1,597

Finance costs (interest)                                               (315 )

Taxation                                                                      (282 )

––––––

Profit after tax                                                             1,000

–––––– 

K’000

Equity

Ordinary shares                                                          2,500

Retained earnings                                                       5,488

Long-term liabilities: 7% loan notes               4,500

–––––––

Total equity and long-term liabilities             12,488

–––––––

The current price/earnings ratio of ABC is 12·5 times. Corporation tax is payable at a rate of 22%.

Companies undertaking the same business as ABC have an average debt/equity ratio (book value of debt divided by book value of equity) of 60·5% and an average interest cover of 9 times.

Required:

  1. Calculate the theoretical ex rights price per share. (3 marks)
  2. Assuming equity finance is used, calculate the revised earnings per share after the business expansion. (5 marks)
  3. Assuming debt finance is used, calculate the revised earnings per share after the business expansion. (5 marks)
  4. Calculate the revised share prices under both financing methods after the business expansion. (6 mark)
  5. Use calculations to evaluate whether equity finance or debt finance should be used for the planned business expansion. (6 marks)

(Total: 25 marks)

QUESTION 3

1. Company A is funded as follows:

Balance Sheet Extract

Ordinary Shares (50n)                    K 2000

12% Loan Notes                              1500

8% Preference Shares (K1)           500

Details on these are as follows:

The company has an equity beta of 1.2. Government bonds are currently trading at 6% and the average market risk premium is 7%.

The Loan notes are currently trading at K106 per K100 note (and assume that the before tax cost of debt is now 10%).

The preference shares are trading at K0.92.

The current share price is K1.25.

The tax rate is 30%.

Calculate the Weighted Average Cost of Capital. (10 marks)

2. Company B currently has 5 million preferred shares outstanding. The shares have a par value of K22.50 per share and their current price is K25 per share. B’s tax rate is 40% and flotation costs on a new issue of preferred shares are 5%.

What per-share dividend are the preferred shares paying if the component cost of the preferred shares in a weighted average cost of capital calculation is 8.25%? (5 marks)

3. Company C is a large firm listed on the LuSE. It has the following capital structure:

                                                                                    K mil

Debt – 5 yrs; 8%                                                       25

Preferred Stock – 5% coupon, K100 par             15

Common Equity – K100 par                                   10

Retained Earnings                                                  23

The current dividend for the company is K 50/share and is expected to grow at 3% per year in the foreseeable future. The equity shares trade at K 450/share. The preferred shares trade at K104/share. The debt currently trades at K 900 per K1,000 nominal value bond.

Required:

Calculate the firm’s WACC. (10 marks)

(Total: 25 marks)

QUESTION 4

  1. Why is the dividend decision one of the major areas that a finance manager should pay particular attention to? What considerations must be taken into account when setting a dividend policy of a company? (12 marks)
  2. A company’s sources of long-term funds include bonds, preferred stock and common stock. Identify some financing risks associated with these sources and explain how these risks affect the return expected from investments financed by these sources. (13 marks) 

(Total: 25 marks)

QUESTION 5

XYZ Company is a listed company that plans to spend K10m on expanding its existing business. It has been suggested that the money could be raised by issuing 9% loan notes redeemable in ten years’ time. Current financial information on XYZ is as follows.

Income statement information for the last year:

k000

Profit before interest and tax                                                 7,000

Interest                                                                                    (500)

Profit before tax                                                                      6,500

Tax                                                                                           (1,950)

Profit for the period                                                                4,550

Balance sheet for the last year:                                 

K000                K000

Non-current assets                                                                             20,000

Current assets                                                                                     20,000

Total assets                                                                                         40,000

Equity and liabilities

Ordinary shares, par value K1                                     5,000

Retained earnings                                                       22,500

Total equity                                                                                         27,500

10% loan notes                                                           5,000

9% preference shares, par value $                 2,500

Total non-current liabilities                                                                7,500

Current liabilities                                                                                5,000

Total equity and liabilities                                                                  40,000

The current ordinary share price is K4.50 per share. An ordinary dividend of K0.35 per share has just been paid and dividends are expected to increase by 4% per year for the foreseeable future. The current preference share price is K0.76. The loan notes are secured on the existing non-current assets of XYZ and are redeemable at par in eight years’ time. They have a current market price of K105 per K100 loan note (assume before tax cost is now 10%). XYZ pays tax on profits at an annual rate of 30%.

The expansion of business is expected to increase profit before interest and tax by 12% in the first year.

Average sector ratios:

Financial gearing: 45% (prior charge capital divided by equity capital on a book value basis)

Interest coverage ratio (EBIT/I): 12 times

Required:

  • Calculate the current weighted average cost of capital of XYZ. (10 marks)
  • Evaluate and comment on the effects, after one year, of the loan note issue and the expansion of business on the following ratios:
  • interest coverage ratio;
  • financial gearing;
  • earnings per share. (5 marks each)

(Total: 25 marks)

QUESTION 6

1. A business is evaluating a project for which the following information is relevant:

  1. Sales will be K100,000 in the first year and are expected to increase by 5% per year.
  2. Costs will be K50,000 and are expected to increase by 7% per year.
  3. Capital investment will be K200,000 and attracts tax allowable depreciation of the full value of the investment over the 5 year length of the project.
  4. The tax rate is 30%.
  5. The business uses a real discount rate of 9%.

Calculate the NPV for the project. (15 marks)

2. It is generally argued that the corporate objective of shareholder wealth maximization should override that of profit maximization. Distinguish these objectives and explain why wealth maximization should take precedence over profit maximization. (10 marks)

(Total: 25 marks)

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