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1 FEEDBACK TUTORIAL LETTER 2 ND SEMESTER 2016 ASSIGNMENT 2 MANAGERIAL FINANCE 320 MAF411S 1

2 MANAGERIAL FINANCE 320 SECOND SEMESTER 2016 FEEDBACK TO ASSIGNMENT 2 Dear student Below are the suggested solutions for the second assignment. Interestingly, you did exceptionally well in question 1 and 2 which I thought were challenging. However, performance on question 3 was dismal. The performance confirmed what I also say: that students do read their study guide prior to attempting the assignments questions. Remember the study guide is your major resource and you should use it. In this tutorial I have attached also attached test 3 written by the full time students together with the memorandum for your preparation to examination. Question 1: To begin, the dividend in each time period must be calculated [D = D 0 (1+g)] D 1 = (0.25)(1.06) = D 2 = (0.265)(1.06) = D 3 = (0.281)(1.03) = Since we expect the dividend to grow indefinitely in year 3 and on, the present value of the stock price in year 3 is calculated as follows: P 3 = = ( ) The value of Newco's common stock is as follows: Newco's cs = $ $ $4.133 = $3.80 (1.10) 1 (1.10) 2 (1.10) 3 (1.10) 3 (b) 2

3 The price of any bond (or financial instrument) is the PV of the future cash flows. Even though Bond R makes different coupons payments, to find the price of the bond, we just find the PV of the cash flows. The PV of the cash flows for Bond R is: P R = N$12 000(PVIFA 4%,16 ) + N$15 000(PVIFA 4%,12 )(PVIF 5%,28 ) + N$20 000(PVIF 4%,40 ) P R = N$ Notice that for the coupon payments of N$1 500, we found the PVA for the coupon payments, and then discounted the lump sum back to today. Bond V is a zero coupon bond with a N$ par value, therefore, the price of the bond is the PV of the par, or: P N = R20 000(PVIF 4%,40 ) = R4 165,78 (c) We will begin by finding the market value of each type of financing. We find: MV D = 4 000(R1 000)(1,03) = R4,12M MVE = (R57) = R5,13M MV P = (R104) = R1,352M And the total market value of the firm is: V = R4,12M + 5,13M + 1,352M = R10,602M Now, we can find the cost of equity using the CAPM. The cost of equity is: R E = 0,06 + 1,10(0,08) = 0,1480 or 14,80% The cost of debt is the YTM of the bonds, so: P 0 = R1 030 = R35(PVIFA R%,40 ) + R1 000(PVIF R%,40 ) 3

4 R = 3,36% YTM = 3,36% 2 = 6,72% And the after-tax cost of debt is: R D = (1 0,35)(0,0672) = 0,0437 or 4,37% The cost of a preference share is: R P = R6/R104 = 0,0577 or 5,77% Now we have all of the components to calculate the WACC. The WACC is: WACC = 0,0437(4,12/10,602) + 0,1480(5,13/10,602) + 0,0577(1,352/10,602) = 9,60% Notice that we didn t include the (1 t C ) term in the WACC equation. We simply used the after-tax cost of debt in the equation, so the term is not needed here. Question 2 a. The earnings per share are: EPS = R16 000/2 000 shares EPS = R8,00 So, the cash flow for the company is: Cash flow = R8,00(100 shares) Cash flow = R800 b. To determine the cash flow to the shareholder, we need to determine the EPS of the firm under the proposed capital structure. The market value of the firm is: V = R70(2 000) V = R

5 Under the proposed capital structure, the firm will raise new debt in the amount of: D = 0,40(R ) D = R in debt. This means the number of shares repurchased will be: Shares repurchased = R56 000/R70 Shares repurchased = 800 Under the new capital structure, the company will have to make an interest payment on the new debt. The net profit after tax with the interest payment will be: NPAT = R ,11(R56 000) NPAT = R9 840 This means the EPS under the new capital structure will be: EPS = R9 840/1 200 shares EPS = R8,20 Since all earnings are paid as dividends, the shareholder will receive: Shareholder cash flow = R8,20(100 shares) Shareholder cash flow = R820 5

6 Question 3 (a) A factor normally manages the debts owed to a client on the client s behalf. Services provided by factoring organisations: Administration of the client s invoicing, sales accounting and debt collection services. Credit protection of the client s debts, whereby the factor takes over the risk of loss from bad debts and so insures the client against such losses. The factor may purchase these debts without recourse to the client, which means that if the client s customers do not pay, the factor will not ask for the money from the client. Factor finance may be provided, the factor advancing cash to the client against outstanding debts. (b) It will be assumed that the factor finance will not be replacing any existing credit lines, and therefore the full interest cost of the agreement will be relevant when determining the cost of factoring: Annual sales are N$ x 12 =N$4.8m Daily sales are N$4.8m/365=N$ The annual cost of factoring is: Interest (N$ x 40days x 75% x 10%) Service fee (4.8 x 2%) Total annual charge Less internal cost savings (N$5 000 x 12) Net annual cost (C) Annual cost = [100/(100-d)] 365/t 1 t = 40days- 10days =30 days d =2% Annual cost = [100/(100-2)] 365/30 1 Cost = 27.9% 6

7 (d) Key issues in the discount option: The proposal is expensive. The company should be able to get cheaper overdraft finance than this, and longer term debt may cost even less. The company may need to offer a discount in order to make terms competitive with other firms in the industry. Key issues in the factoring option The factor may be able exercise better credit control than is possible in a small company. The amount of finance that will be received is much more certain than for the discounting option as 75% of the value of the invoices will be provided immediately. The relationship with customers may deteriorate due partly to the reduction in the level of contact with the company, and partly to the historical view of the factor as the lender of last resort 7

8 FACULTY OF MANAGEMENT SCIENCES DEPARTMENT OF ACCOUNTING, ECONOMICS AND FINANCE BACHELOR OF ACCOUNTING (07BAC) MANAGERIAL FINANCE 320 (MAF411S) DATE: September 2016 DURATION: 2 Hours MARKS: 50 TEST 3 INSTRUCTIONS 1. This test paper is made up of two (2) questions 2. Answer BOTH the questions and in blue or black ink 3. Show your formula and all workings 4. Round off only final answers to two decimal places. REQUIREMENTS None EXAMINER(S): MODERATOR: E. Mushonga and L. Odada A. Makosa This paper consists of 3 pages excluding this cover page Question 1 [25 Marks] 8

9 Consider the following information on two assets and three states of the economy: State of the economy Probability of state of economy Share A rate of return if state occurs Share B rate of return if state occurs Recession 20% % Normal 50% % Boom 30% % Suppose Mr Dlamini has twenty thousand Namibian dollars to invest and decides to invest fifteen thousand Namibian dollars in share A and the remainder in share B. Required: a) Determine the expected returns of the two shares [4] b) Determine the variance and standard deviations of the two shares [10] c) Determine the coefficient of variation of the two shares [2] d) Determine the expected return of the portfolio [4] e) Determine the variance and standard deviation of the portfolio [5] Question 2 [9 Marks] Suppose shares in Trustco Corporation have a beta of The market risk premium is eight percent and the risk free rate is ten percent. Trustco s last dividend was two Namibian dollars per share, and the dividend is expected to grow at eight percent indefinitely. The share currently sells for twenty four Namibian dollars. Assume that Trustco s capital structure is made up of 67% equity and 33% debt. Its cost of debt is fourteen percent, before taxes. If the tax rate is thirty percent, determine: a) Trustco s cost of equity using the Capital Asset Pricing Model (CAPM) approach [3] b) Trustco s Weighted Average Cost of Capital (WACC) using the dividend discount model (DDM) for cost of equity. [6] Question 3 [16 Marks] X Ltd is expected to experience a sustained growth of 8% per year in after tax earnings for the next 4 years, after which earnings are expected to grow at a constant growth rate of 4% per annum, indefinitely. As X Ltd is a mining company, it is seen as high risk 9

10 and as such its beta is The expected return on the market is 12.8% while the risk free rate is 7%. Next year, the company will declare an ordinary dividend of 34 cents per share for the 2017 financial year and the company is expected to maintain a constant dividend payout ratio of 70% of after tax earnings in the future. X Ltd has also issued zero coupon bonds of N$100 each which will be redeemed on 25 September 2026, ten years from today. Similar bonds with an A rating are currently indicating a market yield of 8.5%. The company has also issued bonds of N$100 each with a coupon rate of 10% per year, interest payable semi-annually which also mature on the same date in Similar bonds are offering an annual market yield of 12% (6% per half year). In addition, X Ltd issued a perpetual preference shares paying an annual dividend of N$10. For the preference shares, investors demand a yield of 3% over the 30-year riskless rate (considering that preference shares commonly have a perpetual term, and the 30-year bond rate is commonly the longest maturing bond available), which is 6%. The following is an extract from the financial statements of the company showing the equity and liabilities of the entity. Oceana Ltd Notes to the financial statements for the year ended 30 September Equity and liabilities Units Units Equity: Ordinary shares N$1 each Preference shares N$1 each Liabilities: Zero coupon bonds % coupon bonds of N$100 each Required: a) Calculate the total market value of the ordinary shares of X Ltd [7] b) Calculate the total market value of the preference shares of X Ltd [2] c) Calculate the total market value of the zero coupon bonds and the 10% coupon bonds of X Ltd d) Indicate the cost of each instrument of X Ltd and calculate its weighted average cost of capital. END OF TEST QUESTION [4] [3] 10

11 SUGGESTED SOLUTIONS Question 1 a) Expected Returns [25 Marks] Share A Share B State of economy Probability (P) Return (Ra) (P x Ra) Return (Rb) (P x Rb) Recession Normal Boom Expected Return ( = ½ mark) b) Variance and Standard Deviation Share A Share B State of Probability economy (P) [Ra - E(Ra)] 2 [Ra - E(Ra)] 2 x P [Rb - E(Rb)] 2 [Rb - E(Rb)]2 x P Recession Normal Boom Variance Standard Deviation 26.36% 7.00% ( = 1 mark) c) Coefficient of Variance Share A Share B Expected Return Standard Deviation Coefficient of Variation ( = 1 mark) d) Expected Return of Portfolio Portfolio Weights = / = 0.75 = 5 000/ = 0.25 E(R p ) = 0.75 x E(R A ) x E(R B ) = (0.75 x 0.25) + (0.25 x 0.31) = or 26.50% ( = 1 mark) 11

12 Alternative Way of Calculating Expected Return of Portfolio State economy of Share A Share B = (2 x 3) = (5 x 6) 8 =(4 + 7) 9 Probability Return Weight Return Weight Portfolio (P) (Ra) (Wa) Ra x Wa (Rb) (Wb) Rb x Wb) Return Recession Normal Boom Expected 26.50% Return ( = 1 mark) e) Variance of Portfolio Probability State of economy (P) Recession Normal Boom Variance Standard Deviation ( = 1 mark) Portfolio Return P(R) [P(R)-E(R)] [P(R)-E(R)] 2 [P(R)-E(R)] 2 x P 21.59% Question 2 a) Cost of Equity R E = R f + β x (R m - R f ) = (0.08) = or 16.4% [9 Marks] b) Weighted Average Cost of Capital (WACC) Projected dividend = D 0 x (1 + g) = N$2.00 x ( ) = N$2.16 R E = [D 1 /P 0 ] + g = [2.16/24] = = 0.17 or 17% WACC = (E/V) x R E + (D/V) x R D x (1 t) = 67% x 17% + 33% x 14% x (1-0.30) ( = 1 mark) = or 14.62% 12

13 Question 3 (a) Value of equity [16 Marks] YEAR Earnings after tax Dividends (70%) ( = 1/2 mark) Cost of equity: k e = R f + β(e (rm) R f ) k e = 7% (12.8 7%) =14.83% ( = 1/2 mark) P 4 = D 5 /(ke g) P 4 = /(14.83% 4%) 411 Discounting the future dividend and P 4 34/( ) + (36.82/ ) + (39.66/ ) + (42.83/ ) + [( )/ ] = P o = cents Total market value = N$3.36 x = N$ ( = 1/2 mark) (b) Preference shares P p = N$10 /0.09 V= N$ Total value = N$ x =N$ ( = 1/2 mark) (c) Zero coupon Bonds Bo = N$100 /(1.085) 10 = N$ x N$44.23 = N$ ( = 1/2 mark) 10% Bonds : Bo = ( x 5) + (100/ ) Bo = Bo =N$88.53 Total value N$88.53 x = N$ ( = 1/2 mark) 13

14 (d) Calculating the weights Market Value Weight Cost Weighted cost Equity % Preference shares % Zero coupon bonds % % Bonds % Total value % WACC 10.74% ( = 1/2 mark) 14