UNIVERSITY OF MAURITIUS

FACULTY OF LAW AND MANAGEMENT

FIRST SEMESTER EXAMINATIONS MSC FINANCE YEAR I DATE THURSDAY 4 DECEMBER 2003 TIME !30 " 12!30 P!M!

SERIES NOVEMBER 2003

MODULE CORPORATE FINANCIAL MANAGEMENT [ACF 5102]

INSTRUCTIONS TO CANDIDATES
TIME ALLOWED# 3 HOURS NO! OF $UESTIONS SET# FOUR %4& NO! OF $UESTIONS TO BE ATTEMPTED# FOUR %4& PRESENT VALUE TABLE, ANNUITY TABLE AND LIST OF FORMULAE ARE ATTACHED

CORPORATE FINANCIAL MANAGEMENT [ACF 5102]

ANSWER ALL QUESTIONS $'()*+,- 1 Alpha Ltd has details of two machines which could fulfill the companys future production plans. nly one of these machines will !e purchased. "he #standard model costs Rs 500,000, and the #de$lu%e &s ''0(000( paya!le immediately. )oth machines would re*uire the input of &s100(000 wor+in, capital throu,hout their wor+in, li-es( and !oth machines ha-e no e%pected scrap -alue at the end of their e%pected wor+in, li-es of four years for the standard machine and si% years for the .e$Lu%e machine. "he forecast pre$ta% operatin, net cash flows in &s000 associated with the two machines are/ 0ear 4tandar d .e$ Lu%e 1 205 2 225 1 222 2 212 5 3

200

210

220

250

150

100

"he two machines are identical in terms of capacity and *uality of wor+. "he rele-ant discount rate is 126. "he company is proposin, to finance the purchase of either machine with a term loan at a fi%ed interest rate of 106 per year. "a%ation at 206 is paya!le on operatin, cash flows one year in

arrears( and capital allowances are a-aila!le at 25 % per year on a reducin, !alance !asis.

"he pay!ac+ and the net present -alue 789:; for the .e$lu%e model ha-e !een calculated !y the accountant as !ein, 2 years and &s 10'(000 respecti-ely. R(.'+/(0# 7a; Calculate for the standard machine/ 7i; 7ii; pay!ac+ period< net present -alue.

&ecommend( with reasons( which of the two machines Alpha Ltd should purchase. [10 mar+s] 7!; =f Alpha Ltd were offered the opportunity to lease the standard model machine o-er a four year period at a rental of &s150(000 per year( not includin, maintenance costs( e-aluate whether the company should lease or purchase the machine. [5 mar+s] 7i; >hat is meant !y a profita!ility inde%? mar+s] 7ii; [2

(c)

@%plain why it is not a helpful approach in multi$ period capital rationin, situations? [2mar+s]

7d;

)eta 9lc has a limit of &s10m of in-estment finance this year( and it has the followin, possi!le in-estment opportunities/ P/,1(2* A : > B 0 C I-3()*4(-* /(.'+/(0 *5+) 6(7/ &sm '.0 1.2 5.1 2.0 2.5 0.5 N(* P/()(-* V78'( 1.1 0.5 1.2 0.5 2.0 0.2

Assume that the capital shorta,es relate only to the current year and that each proDect can !e underta+en in part. R(.'+/(0# Calculate the profita!ility inde% of each proDect and outline the optimal in-estment strate,y. [3mar+s] [T,*78# 25 47/9)]

$'()*+,- 2 7a; "he finance director of Eamma plc wishes to find the companys optimal structure. "he cost of de!t -aries accordin, to the companys credit ratin,( which depends( amon,st other factors( upon the le-el of ,earin, of the company. : D(;* %D(;*<D(;* = E.'+*6& 20 10 20 50 30 L+9(86 2/(0+* /7*+-> AA A ))) )) ) P/( T7? 2,)* ,@ 0(;* F.16 F.'6 '.56 106 126

"he companys un,eared e*uity !eta 7asset !eta; is 0.'5. "he ris+ free rate is 36 per annum and the mar+et return 126 per annum. Corporate ta%ation is at the rate of 106 per year. R(.'+/(0# i. Calculate the e*uity !eta for the different le-els of ,earin,. ii. @stimate the companys optimal wei,hted a-era,e cost of capital. [' Gar+s]
5

7!;

.elta plc is an all e*uity company with an e*uili!rium mar+et -alue of &s125 million and a cost of capital of 1'6 per year. "he company proposes to purchase and cancel &s50 million of e*uity and to replace it with 106 irredeema!le loan stoc+. .eltas earnin,s !efore interest and ta% are e%pected to !e constant for the foreseea!le future. Corporate ta% is at the rate of 106. All profits are paid out as di-idends.

R(.'+/(0# Assumin, that the assumptions of Godi,liani and Giller 7in a world with ta%es;( how will the capital restructurin, affect/ (i) (ii) (iii) the mar+et -alue the cost of e*uity the firms wei,hted cost of capital of .elta plc.

[F mar+s]

7c;

>hat are the factors that are li+ely to influence a firms decision on capital ,earin,? [5 Gar+s] @%plain how the pec+in, order theory ar,ues a,ainst an optimal de!tHe*uity ratio. [5 mar+s] [T,*78# 25 47/9)]

7d;

$'()*+,- 3 7a; "he financial controller of "heta plc is re-iewin, the companys stoc+ mana,ement procedures. 4toc+ has ,radually increased to 256 of the companys total assets and( with finance costs at 126 per annum( currently costs the company &s25 million per year( includin, all orderin, and holdin, costs. .emand for the companys maDor product is not su!Dect to seasonal fluctuations. "he product re*uires &s 30 million of standard semi$finished ,oods annually which are
6

purchased in e*ual *uantities from three separate suppliers at a cost of &s200 per unit. "hree suppliers are currently used to pre-ent pro!lems that could result from industrial disputes in a sin,le supplier. 4toc+ costs &s20 per unit per year to hold( includin, insurance costs and financin, costs( and each order made costs &s1(000 fi%ed cost and &s1.00 per unit -aria!le cost. "here is a lead time of one month !etween the placin, of an order and deli-ery of the ,oods. R(.'+/(0# 7i; Calculate the e%istin, economic order *uantity for the semi$finished ,oods. [1 mar+s] 7ii; Calculate the chan,e in annual stoc+ mana,ement costs that would result if the ,oods were !ou,ht from ,-86 ,-( supplier. Assume that no *uantity discounts are a-aila!le. [3 mar+s] 7iii; "he financial controller feels that the I=" 7Dust in time; stoc+ mana,ement mi,ht !e useful for the company. )riefly discuss three possi!le ad-anta,es of I=". [1mar+s] 7!; me,a Company has recently offered their customers an incenti-e to pay promptly. 4ales durin, the ne%t year are forecast to !e &s11.2 million and '06 of sales are on credit terms. n a-era,e customers ta+e 5F days to ma+e payment. All companies settlin, their in-oices within F days of the in-oice date are offered 1.56 cash discount on the in-oice price. "he discount would cost an additional &s 25(000 per year to administer( and reduce !ad de!ts from 0.F56 to 0.506 of credit sales.

=t is e%pected that 206 of credit customers would use the cash discount. "he current short$term deposit interest rate is 15 6 p.a. R(.'+/(0# Ad-ise me,a company as to the economic -ia!ility of the cash discount offer. [5 Gar+s] 7c;7i; @%plain the si,nificance of the cash operatin, cycle in relation to wor+in, capital mana,ement. [1 mar+s]

7ii; "he followin, information relates to :e,a 9lc for the last year/ R)4 9urchases of raw materials Asa,e of raw materials 4ales of finished ,oods 7all on credit; Costs of sales of finished ,oods A-era,e creditors A-era,e raw material stoc+ A-era,e wor+$in$pro,ress A-era,e finished ,oods stoc+ A-era,e de!tors R(.'+/(0# Calculate the len,th of the cash operatin, cycle? [5 mar+s] 3F 35 1'0 12 12 10 21 2F 250

$'()*+,- 4
8

7a;

@%plain the term a,ency relationships and discuss the conflicts that mi,ht e%ist in the relationships !etween shareholders and mana,ers. >hat steps mi,ht !e ta+en to o-ercome these conflicts? [3mar+s]

7!;7i;>hat do you understand !y the term #homemade di-idends in the conte%t of GG? >hy mi,ht a shareholder want such di-idends? [1 mar+s] 7ii;>hy firms attract a #clientele of shareholders as a result of their di-idend policy? [1 mar+s] 7c; @psilon plc is e%pected to enDoy an a!o-e a-era,e performance for three years( with di-idends ,rowin, at 106 per annum. After that time( !ecause of competition and the company losin, its present technolo,ical leadership( the ,rowth in di-idends will re-ert to 56. "he current di-idend is &s 1 per share. @psilons asset !eta is 0.F23( the !eta of de!t is 0.20 and its financial ,earin, is 306 e*uity and 206 de!t !y mar+et -alue. "he ris+ free rate is 3.06 per annum and the mar+et return is 126 per annum. "he corporation ta% rate is 106. R(.'+/(0# i. Calculate the current share price of @psilon 9LC. [F mar+s] ii. Comment on the limitations of the di-idend ,rowth model. [2 mar+s]

iii. Calculate an appropriate !ase case discount rate in order to e-aluate future cash flows for a potential in-estment of &s 25 million. "he in-estment would !e an e%pansion of @psilons acti-ities and it is e%pected that the financial ,earin, would chan,e as a result of the e%pansion. [2 mar+s] [T,*78# 25 47/9)]

A END OF $UESTION PAPER A

10

FORMULA SHEET

1. 2.

F: J 9: 71 K r;n 9resent :alue of an annuity 9:o J CF1 % A.F

1.

9resent :alue of a perpetuity 9:o J

CF1 r

2.

9resent :alue of a perpetuity with ,rowth 9:o J

CF1 r-g

5.

A&& J

Average ann&a' ( %#st e$) $r#"its !e"#re interest an tax Average Investment

3.

I,, = *+, +

(%)*+, ( HDR LDR ) (%)*+, NPV HDR

F.

%.I =

(%) Initia' #&t'a-

'.

@*ui-alent annual annuity 7@AA; approach

.AA = (%) A.Fact#r

5.

CA9G
K e = , f + ( , m - , f ) /e

10. .i-idend :aluation model 8o ,rowth Po = 0 e Constant ,rowth Po =

#

(1 + g )

1e - g

11. >ACC J K e

. +1 . ++

(1 - t )

+ . ++

12. Capital ,earin, J

D D+E

11. =ncome ,earin, J

Interest PBIT

12.

peratin, ,earin, J

3 c2ange in ./I4 3 c2ange in sa'es

15. Cost of e*uity in a ,eared company

Ke g = 1e & + ( 1e & K d ) + (1 - t ) .

13. Gar+et :alue of a ,eared company :, J :u K .t

1F. Cost of capital in a ,eared company

Dt 5acc = 1e & 1 D +E

1'. @conomic

rder *uantity

Q=

2 DC o CH

15. D =

I (1 t ) Kd

20. D =

Rn I (1 t ) I (1 t ) I (1 t ) + + ................ + 2 n 1 + k d (1 + k d ) (1 + k d ) ( 1 + k d ) n

21.

B a = Be

E D(1 t ) + Bd E + D (1 t ) ) E + D (1 t )