Question 1 [25] Lease payment ( ) ( ) ( ) ( ) ( ) Tax shield

Transcription

1 MBA: Man Fin Jan 2014 Supp/Aegro exam Marking Memo Question 1 [25] 1.1 LEASE Y1 Y2 Y3 Y4 Y5 Lease payment ( ) ( ) ( ) ( ) ( ) Tax shield Purchase option (59 990) Net cash flow (97 650) (97 650) (97 650) (97 650) ( ) PV 7% PV cash outflows (91 264) (85 288) (79 712) (74 497) ( ) NPV (R ) 1

2 PURCHASE Loan payments ( ) ( ) ( ) ( ) ( ) Maintenance 0.7 (10 500) (10 500) (10 500) (10 500) (10 500) Dep. Tax shield Int. tax shield Net cash flows ( ) ( ) ( ) ( ) ( ) PV 7% PV cash outflows ( ) ( ) ( ) ( ) ( ) 1.2 Lease, because the cash outflows are lower by R (2) NPV (R ) (23) 2

3 QUESTION 2 [25] 2.1 Calculation of market value of debentures: x m x = Market values Proportion O/s 2m x R P/s 1.5m x R Debenture Bank loan (not traded) Cost Ke (Cost of equity using Capm) = Rf + B(Rm - Rf) (17-9) % Kp Do/Po 0.26/ % Kd 8 (0.7) 5.60% Kbl 16 (0.7) 11.20% 3

4 WACC O/s 0.51 x 21% 10.71% P/s 0.26 x 10.4% 2.70% Debenture 0.21 x 5.6% 1.18% Bl 0.04 x 11.2% 0.45% 15.04% (22) 2.2 (Cost of equity using Gordon Growth) D1 = Do (1 + g) 0.60 (1.10) 0.66c Ke (D1/Po) + g (0.66/4.00) = 26.5% (3) 4

5 QUESTION 3 [25] 3.1 Project 1 Y1 to 10 Y0 $m $m Cost of plant (60) Profit 1.8 Add back depreciation 6 existing overheads 0.17 Net Cash flow 7.97 (60) Annuity 8% for 10 years Net present value (6.52) Project 2 Rm Rm Cost of facility (17.2) Annual sales 9.5 Annual fixed costs (1.6) 5

6 Annual variable cost (4.4) Annual depreciation (1.72) Add back depreciation 1.72 Net cash flow 3.5 (17.2) Annuity 9% for 10 years Net present value 5.26 Exchange rate R10.25/$ R5.26/10.25 = $ mill Accept Project 2, it has a positive NPV of $ million and reject Project 1, it has a negative NPV of $6.52 million. (23) 3.2 No! If cost is reduced to R16m, the NPV will be greater than $ million (2) QUESTION 4 [25] Net operating losses the combined firm will have a lower tax bill than the two firms considered separately. - Unused debt capacity - Asset write-ups- increased valuations, more depreciation, bigger tax deduction - Reduction in capital needs (5) 6

7 4.2 Value of combined acquisition R20 x 4 = R80m + (R16 x 1m + R20m) = R80m + R36m = R116m (2) 4.3 Net present value of proposal R36m R24m = R12m (2) 4.4 Acquisition premium R24m R16m =R8m (2) 4.5 Post acquisition price per share (R116m R24m) / 4 million shares =R92m /4m =R23 (3) 4.6 Increase in share price R23 R20 =R3 (2) 4.7 Exchange ratio based on EPS R4.80/ R6.00 = 0.8 (2) 4.7 Total no. of shares (1m x 0.8) + 4m shares 0.8m +4m shares =4.8m shares (3) 4.8 Post acquisition EPS: Combined value: S Ltd 4m x R6.00 R 24.00m C Ltd 1m x R4.80 R 4.80m Synergy R20.00m R48.80m R48.80m/4.8m =R (4) 7

8 Question 5 [25] 5.1 Legal Constraints We ll start by looking at actual restrictions on payment of dividends While dividends can be paid from past and present earnings, they cannot be paid from any capital reserve. So, if any funds have been transferred from income statements, or another revenue reserve, into a capital reserve, such as a capital redemption reserve, then this reserve is not available for payment of cash dividends. This rule also covers funds, which have been entered directly into a capital reserve, and have never come from the income statement, such as share premium and revaluation reserves. As we have already seen, such reserves may be used for the issue of bonus shares, which may be considered to take the place of cash dividends in a particular year. Companies that are insolvent cannot legally pay dividends; that is, if their external liabilities exceed their assets. Companies with various kinds of debt capital may in fact have agreed to restrictions on dividend payments to protect long-term creditors. A company with a loan requiring redemption may need to retain funds for this purpose. Contractual Constraints Often, the firm s ability to pay cash dividends is constrained by restrictive provisions in a loan agreement. Constraints on dividends help to protect creditors from losses due to the firm s insolvency. Internal Constraints The firm s ability to pay cash dividends is generally constrained by the amount of excess cash available rather than the level of retained earnings against which to 8

9 charge them. Although a firm may have high earnings, its ability to pay dividends may be constrained by a low level of liquid assets (cash and marketable securities). 5.2 Growth Prospects The firm s financial requirements are directly related to the anticipated degree of asset expansion. If the firm is in a growth stage, it may need all its funds to finance capital expenditures. Firms exhibiting little or no growth may nevertheless periodically need funds to replace or renew assets. A firm must evaluate its financial position from the standpoint of profitability and risk to develop insight into its ability to raise capital externally. It must determine not only its ability to raise funds, but also the cost and speed with which financing can be obtained. Generally, a large, mature firm has adequate access to new capital, whereas a rapidly growing firm may not have sufficient funds available to support its numerous acceptable projects. A growth firm is likely to pay out only a very small percentage of its earnings as dividends. A more stable firm that needs long-term funds only for planned outlays is in a better position to pay out a large proportion of its earnings, particular if it has ready sources of financing. 5.3 Owner Considerations In establishing a dividend policy, the firm s primary concern should be to maximize owner wealth. Although it is impossible to establish a policy that maximizes each owner s wealth, the firm must establish a policy that has a favourable effect on the wealth of the majority of owners. One consideration is the tax status of a firm s owners. If a firm has a large percentage of wealthy shareholders who are in a high tax bracket, it may decide to pay out a lower percentage of its earnings to allow the owners to delay the payment of taxes until they sell the share. Of course, when the share is sold, if the proceeds are in excess of the original purchase price, the capital gain will be taxed, possibly at a more favourable rate than the one applied to ordinary income. Lower-income shareholders, however, who need dividend income, will prefer a higher payout of earnings. 9

10 A second consideration is the owners investment opportunities. A firm should not retain funds for investment in projects yielding lower returns than the owners could obtain from external investments of equal risk. The firm should evaluate the returns that are expected on its own investment opportunities and, using present value techniques, determine whether greater returns are obtainable from external investments such as government securities or other corporate stocks. If it appears that the owners have better opportunities externally, the firm should pay out a higher percentage of its earnings and vice versa. A final consideration is the potential dilution of ownership. If a firm pays out a higher percentage of earnings, new equity capital will have to be raised with ordinary shares, which may result in the dilution of both control and earnings for the existing owners. By paying out a low percentage of its earnings, the firm can minimize such possibility of dilution. (Gitman, 2003:568) 5.4 Market Considerations An awareness of the market s probable response to certain types of policies is helpful in formulating a suitable dividend policy. Shareholders are believed to value a fixed or increasing level of dividends as opposed to a fluctuating pattern of dividends. This belief is supported by the research of John Lintner, who found that corporate managers are averse to changing the rand amount of dividends in response to changes in earnings, particularly when earnings decline. In addition, shareholders are believed to value a policy of continuous dividend payment. Because regularly paying a fixed or increasing dividend eliminates uncertainty about the frequency and magnitude of dividends, the earnings of the firm are likely to be discounted at a lower rate. This should result in an increase in the market value of the share and therefore increased owner s wealth. A final market consideration is the informational content of dividends. As indicated earlier, shareholders often view the firm s dividend payment as a signal relative to its future success. A stable and continuous dividend is a positive signal that conveys to the owners that the firm is in good health. If the firm skips a dividend payment in a given period due to a loss or to very low earnings, shareholders are likely to interpret 10

11 this as a negative signal. The non-payment of the dividend creates uncertainty about the future, and this uncertainty is likely to result in lower share value. Owners and investors generally construe a dividend payment during a period of losses as an indication that the loss is merely temporary. (Gitman, 2003: 569) 5.5 The Clientele Effect Do companies resort to particular dividend policy because of the type of shareholder they have? Some shareholders might, for example, prefer low dividends because of their tax position. Remembering that many shares are today held by pension funds and insurance companies, who would like a steady stream of ready cash inflows to balance their outflows, there may be a requirement from other shareholders for a high level of dividend, preferably a steady one. So if different shareholders have different requirements, and prefer not to create their own dividends as already described, because of the costs or effort involved, maybe they have bought shares in particular companies because of the observed dividend policies of those companies? In this case, firms should maintain their dividend policies or risk antagonising their existing shareholders also, the lack of an observable policy might put off new shareholders. This could have a bad effect on share price and therefore cost equity. Research tends to show that firms are loath to change dividend patterns, particularly downwards! Gentle growth seems to be the target too rapid growth might not be sustainable. One evidence of a clientele effect has been found by various research studies. (5 x 5) 11