CORPORATE FINANCE I EXAM FOR MAY 2015 DR G MUPONDA

SECTION A
QUESTION 1[Compulsory question 40 marks]
1(a) A firm has just reported net earnings, after-tax, of $28 million and paid a 2% dividend. The
shareholders equity was reported at $100 000. The firm has 10 million shares in issue. It is expected to
pass through three growth phases which are explained below.

High-growth phase
Length of phase, 3 years,
The current growth rate in earnings will be maintained during this period,
The following market parameters will apply: Beta coefficient, 1.50; T-bill rate, 11% pa; return on
the market, 26% pa.
Transitional phase
Length of phase, 3 years,
The growth rate in earnings and dividends will be 18% per year.
The following market parameters will apply: Beta coefficient, 1.10; T-bill rate, 11% pa; return on
the market, 24% pa.
Stable growth
Growth rate in earnings, 8% per year,
Beta coefficient, 0.80; T-bill rate, 9% per year, return on the market, 19% pa.

Required:

i.
ii.

Calculate the intrinsic value of the companys share and the total value of its equity
[15 marks].
Briefly explain some of the factors that the analyst had to consider in order to arrive at
the above estimations [10 marks]

1(b) A company has just paid dividend of 120 cents per share. The following dividends and
earnings have been reported over the past five years:
YEAR
2007
2008
2009
2010
2011
2012
2013

DPS (cents)
63
71
79
83
88
81
89

The required rate of return on the companys equity is 17%.

1

EPS (cents)
112
157
169
168
162
159
163

CORPORATE FINANCE I EXAM FOR MAY 2015 DR G MUPONDA

Required:
i.
ii.
iii.
iv.

Calculate the average growth rate in dividends during the period using both the geometric
and arithmetic mean [5 marks].
In your opinion, which of these two growth rates would you accept and why? [2 marks]
Calculate the intrinsic market value of the share [5 marks].
What assumption did you have to make about growth rates in order to calculate the above
price? [3 marks]

SECTION B [Answer any THREE questions from this section]

QUESTION 2 [20 Marks]
A large retail company is considering the introduction of a debit card system which will be
directly linked to the customers bank current account when making purchases. It is envisaged
that the new debit card will bring in extra revenues through increased transactions. It is estimated
that 100 000 new transactions will be made using this card each year at an average transaction
size of $50.00. Each transaction will attract a charge of $2.50, payable by the company to the
customers bank. The use of the card will also reduce overall stores administration costs for the
company by $50 000 per year. All service point staff will however, have to undergo a staff
development program which will cost $20 000 and David, who was being paid an annual salary
of $60 000 as the IT Manager will be replaced by Mary, a specialist in this kind of Software.
Mary will earn a salary of $80 000 per year.
Software developers within the IT department will develop the debit card at a cost $15 000. The
card system will also be pilot-tested and installed at a cost of $2 000. The card system will
require the replacement of all the 500 sales points with new ones at a cost of $4 000 each. The
card system is expected to operate for five years. The salvage value of the new sales points is
expected to be $200 000. There will be an increase of $500 000 in the overall working capital
requirements of the company (inventory and cash) resulting from the increased sales. The
existing sales points were installed two years ago at a cost of $200 000 and a certain retail
organisation has offered to buy them for $100 000. Wear and Tear Allowance was being claimed
on these machines the rate of 50:25:25. The company elects to claim SIA on the new sales points
using the current rates of 50% per year.
The tax rate applicable to the companys earnings is 30% per year and the cost of capital is 20%
per year.
Required:
Use the NPV method to determine whether the shareholders of the company would accept this
proposal.

CORPORATE FINANCE I EXAM FOR MAY 2015 DR G MUPONDA

QUESTION 3 [20 marks]

3(a).The following are extracts from the balance sheet of Timber Mills as at 31 June, 2014
$
Share capital (par value $0.50)

10 000

Non-distributable reserves

40 000

Retained profit

175 000

7% loan (repayable in 3 years)

50 000

9%, $2.00 irredeemable preference shares

80 000

11%, $1 000 redeemable debentures (11 years to maturity)

100 000

Other information
The company also reported a net profit after tax of $70 000 and paid a dividend of 150 cents per
share. The companys equity beta is 1.10 whereas the T-bill rate is 11% per year and the return
on the market index is 23% per year. The preference shares are currently trading at 420 cents per
share, cum.div. The debentures carry a semi-annual coupon which is due shortly and are trading
at a market value of $957.60. The tax rate applicable to the companys earnings is 33%.
Required
Calculate the cost of capital for the company using
(i)
(ii)

Book values [6 marks]

Market values [8 marks].

3(b) An investor has approached you for advice regarding the equity of Betta Breweries Ltd.
You find that the share is trading at a beta coefficient of 0.75 and a negative alpha coefficient of
0.34. What advice would you give to the investor and why? [6 marks]

QUESTION 4 [20 marks]

4(a) Consider the following bond:

Par value, $1 000;

Coupon rate, 7.65% per year (payable once per year);
Yield to maturity, 9.34% pa;
Maturity, 5 years.
3

CORPORATE FINANCE I EXAM FOR MAY 2015 DR G MUPONDA

Required:
i.
ii.

Calculate the duration and convexity of the bond [8 marks]

Explain what is likely to happen to the price of the bond if interest rates increase
by 3% per year [2 marks]

4(b) An investor is considering the purchase of a bond issued by Dandaro Ltd and the following
quotation has been provided by the dealer:

Maturity, 12 October, 2023

Coupon rate, 7.65% per year.

The settlement date for the bond is 5 January, 2015.

Required: Calculate the clean price of the bond [10 marks]

QUESTION 5 [20 marks]

5 (a).A company is considering the purchase of an asset at a cost of $180,000. Alternatively, the
asset could be leased at an annual lease payment of $45,000 per year payable in advance for five
years. If the asset is purchased the company would have to pay maintenance costs of $24,000 per
year payable at the end of each year and insurance of $9,000 per year at the beginning of each
year.
If the company borrows money in order to finance the purchase of the asset, the interest rate
would be 18% per year, compounded once per year. The tax rate applicable to the companys
earnings is 33%. The company will claim Wear and Tear Allowance at 50%, 25% and 25% on
the asset if it is purchased. The asset will have a residual value of $30,000 at the end of its fiveyear economic life.
Determine whether the company should buy or lease the asset [12 marks]
5(b) Power Milling Company is considering a lease proposal from Precision Grinding Mills in
which Power Milling Company will be required to make annual lease payments of $56 000 for a
flour milling machine. The cost of the machine is $280,000 with an estimated economic life of 7
years. The asset will be depreciated using the straight-line method, with no estimated salvage
value. The interest rate on borrowed funds is 9% per year and the tax rate is 33%.
Required:
With the use of appropriate calculations, comment on whether the proposed lease payment is fair
to Power Milling Company [8 marks]
4

CORPORATE FINANCE I EXAM FOR MAY 2015 DR G MUPONDA

QUESTION 6 [20 marks]

6(a) Explain the services that a factoring company might provide to its client [8 marks]
6(b) A company has annual sales of $100 000 of which 60 percent are on credit. The official
credit terms are 30 days, however, due to collection problems, the average collection period is 50
days and the bad debt percentage is 1.5%. The company has been experiencing severe cash flow
problems and UDC limited, a factoring company has offered the following terms:
80% on each invoice will be paid immediately and interest will be charged at 0.85%
above the current prime rate of 13%. Service fees will be charged at 2% of the total credit
sales. The factoring company will take 30 days to collect on each invoice.
The company is currently able to obtain a 3% discounts from its suppliers on 45% of its sales.
Currently, the total annual cost of managing credit sales is $5 000.
Required
With the aid of relevant calculations, advise the company whether the offer from the factoring
company should be accepted [12 marks]

END OF EXAMINATION