Assignment 3/0/2019

Financial Strategy

MAC4865

Year module

Department of Management
Accounting
ADDITIONAL INFORMATION:

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Dear Student

This document contains compulsory assignment 3 due 1 July 2019.

This assignment will assess Part 1: Formulation of financial strategy.

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QUESTION 1 (50 marks; 90 minutes)

TecRock Ltd, a company listed on the Technology Hardware and Equipment sector of the JSE. TecRock
Ltd. is principally engaged in the manufacture and distribution of computer peripheral products. The
Company’s products mainly include personal computers (PCs) motherboards, industrial computers
motherboards, servers, workstation computers motherboards, mini home theaters, commercial systems
and barebones and high-end routers. The Company distributes its products within domestic market and
overseas markets, including Americas, Europe and Asia.

Presented the following abridged statement of financial position at 31 May 2019 during its road show to
analysts:

TecRock Ltd.'s statement of financial position

for the year ending 31 May 2019
2019
R'million
Non-current assets
Tangible and intellectual assets 3 211 000
Net working capital and investments 4 043 900
Total Assets 7 254 900

Equity
Unitholders' capital 2 000 000
Preference share capital 1 000 000
Reserves 1 254 900
Total equity 4 254 900
Non-current liabilities 3 000 000
Total equity and liabilities 7 254 900

The following additional information was also given:

· Assets and equity and liabilities are shown on a net basis.

· The unitholders’ capital comprises linked units consisting of 1 ordinary share of R2 and 1 debenture
of R2 500 million units were issued at R4. These units now trade at R7.25 each. Interest is paid on
the debentures at a rate with a fixed relationship to the prime overdraft rate.

· Preference shares were issued at 9% per annum. The current market yield on similar risk-profile
preference shares are 10%. The preference shares are convertible into linked units at a ratio of 1
preference share of R100 to 25 linked units, within the foreseeable future.

· The non-current liabilities consist of medium term loans that pay a fixed interest rate of 12% per
annum and cannot be traded in the market.

· TecRock has a market rating of 7% above the current R186's yield rate of 9.1% pa, maturing in 2029.

· The industry beta is 1,25.

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The product development manager of the company has made a suggestion to produce and sell a range
of hand-held tablets. The plant required to produce these computers would be purchased at a cost of
R44 million. His projection of the project’s profitability is as follows:

Year 1 Year 2 Year 3 Year 4

Rm Rm Rm Rm

Sales 80 120 150 125

Costs
Cost of raw materials used 32 48 60 50

Opening inventory 8 16 16 12
Purchases 40 48 56 38
48 64 72 50
Closing inventory 16 16 12 0

Labour 16 24 24 18
Other production expenses 16.5 17.5 18.5 18.5
Depreciation 8 8 8 8
Administration charge 12 15 15 15
Interest paid 4.5 4.5 4.5 4.5
Net profit/(loss) before taxation -9 3 20 11
Taxation @ 30% -2.7 0.9 6 3.3
Profit / (loss) for the year -6.3 2,1 14,0 7,7

On this basis he recommends that the project be accepted.

The following points are made in the product development manager’s report to the Board:

· The plant and equipment is highly specialised and is unlikely to have any residual value. There will
be costs of dismantling the plant of R3.3m, at the end of the project as much of the content is not
recyclable (ie at the end of 4 years - not allowable for taxation).

· Opening inventory in year 1 will be purchased at the same time as the plant and equipment. All
other changes in inventory levels will occur at year ends.

· Other production expenses include an apportionment of existing fixed production overheads on the
basis of 25% of labour costs.

· All new staff will have to be employed for this project.

· Depreciation has been based on official company policy of writing off plant and equipment over six
years.

· The administration charge is an apportionment of existing central fixed overheads.

· If the proposal goes ahead, it will enable the existing plant to be sold as its function will be performed
more efficiently by the new plant in curbing idle time with a saving of operating costs of R2m for the
first year and escalating at 10% per annum thereafter. This plant and equipment has a book and tax
value of R6m and could currently be sold for R4m. It could otherwise be sold in four years’ time for
R1.6m when the book and tax value would be nil. These details have not been included in the profit
projection above.
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On receipt of the proposal, the marketing director makes the following points:

· Sale of the computers will require an advertising and incentivising campaign which will cost R4m at
the beginning of the project and R3m per annum in each of the years 1 to 3.

· There will be an effect on the selling price of the company’s sophisticated calculators. This is
reflected in the revised forecasts of sales and unit prices as follows:

Old selling New selling

Units price per unit price per unit
R R

Year 1 500 000 320 300

Year 2 400 000 340 310
Year 3 300 000 360 320
Year 4 - - -

The production costs, per unit, of the calculators are expected to remain unchanged.

The financial director suggests that the calculation can be improved and points out the following:

· The average tax rate to be used for the project is 28%. A wear and tear allowance of 25%, straight
line, will be allowed in line with previous SARS allowances for this business. The company evaluates
each project as a stand-alone project from a tax perspective.

· The after tax hurdle rate (WACC) has been set as 18% and should be used to evaluate the project.

REQUIRED

(a) Calculate the weighted average cost of capital, based on the abridged balance sheet of
TecRock Ltd presented to analysts; (7)
(b) Critically comment on the managing director’s recent remark that: “the prime rate should
be used as the cost of capital rate, as all finances are linked to it”; (8)
(c) Evaluate the project presented by the product development manager, using the WACC
rate (18%) set by the financial manager and then determine the internal rate of return
(IRR) of the project. (15)
(d) Use the rates given and obtained under (c) above to explain the differences between
the Net Present Value and Internal Rate of Return methods and the risks inherent to the
methods to the Board of Directors of TecRock Ltd. (6)
(e) Recommend alternative methods of financing that might be suitable for TecRock (Pty)
Ltd. in the circumstances of the scenario. Where necessary, explain any assumptions
you have made. (14)

[50]

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QUESTION 2 (25 marks; 45 minutes)

Select only the number (1, 2, 3 or 4) of the correct answer for the question or statement. There is only one
correct answer.

Each question counts 1 mark.

1. The following are examples of stakeholders that need to be consulted/ considered when
converting a private company into a public company:

1. Existing shareholders/ managers, potential new shareholders

2. Employees, including managers who are not shareholders
3. Regulatory bodies and related entities
4. All of the above

2. The following information relates to a shoe manufacturing company:

Trade receivables collection period 27 days

Trade payables payment period 33 days
If the working capital cycle is 48 days, the inventory turnover period is:

1. 13 days
2. 19 days
3. 54 days
4. 108 days

3. An unspecified South African bond has a coupon rate of 6% per annum and will repay its face
value of R100 on its maturity in four years’ time. The yield to maturity on similar bonds is 4% per
annum. The annual interest has just been paid for the current year.

The expected market value of the bond at today’s date is:

1. R101.30
2. R106.00
3. R107.28
4. R112.64

4. MAC4865 is considering an investment in new equipment. If the equipment is purchased, income

will increase by R15 000 per year, and operating costs will decline by R6 000 per year. The
equipment will cost R60 000 and will be depreciated on a straight line basis over 10 years to a zero
estimated salvage value. The marginal tax rate is 30%. Determine the annual net cash flows
generated by the equipment.

1. R2 400
2. R5 400
3. R14 700
4. R16 500

5. Which of the following is incorrect:

1. A small script dividend will not significantly dilute the share price
2. Scrip dividends may provide investors with tax advantages as dividends are in the form of
shares
3. Investors hoping to expand their shareholding will support a decision to declare script dividends
as they can obtain more shares without incurring the transaction cost of buying more shares
4. A share issue will increase the company’s gearing and reduce its borrowing capacity
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6. A company based in Mozambique is considering investing in a project with an expected life of

four years. The project has a positive net present value of MZN280,000 when cash flows are
discounted at 12% per annum. The project’s estimated cash flows include net cash inflows of
MZN320,000 for each of the four years. No tax is payable on projects of this type.

The percentage decrease in the estimated annual net cash inflows that would cause the company’s
management to reject the project from a financial perspective is, to the nearest 0.1%:

1. 12.0%
2. 21.9%
3. 28.8%
4. 87.5%

7. Mac-Mac Ltd has a capital structure of R300 000 in equity, and R300 000 in perpetual debt. The
firm’s cost of equity is 14% and the cost of debt is 9%. If the firm has an expected, perpetual net
operating income of R120 000, and a marginal tax rate of 40%, what is the market value of the
firm? Assume all income is paid out as dividends.

1. R558 000
2. R698 571
3. R814 286
4. R818 571

8. A project requires an initial investment of R200,000. It has a life of five years and generates net
cash inflows in each of the five years of R55,000. The net present value of the project when
discounted at the company’s cost of capital of 8% is R19,615.
The sensitivity of the investment decision to a change in the annual net cash inflow is:

1. 8.9%
2. 9.8%
3. 17.0%
4. 35.7%

9. An investment pays end of the year annuities to the value of R48 000 per year for the next 20
years. The return on the investment is 9%. What is the present value of the investment today?

1. R398 144
2. R408 672
3. R429 600
4. R438 144

10. According to the shareholder wealth maximization goal, management should seek to maximize
the _______ of the _______ to the owners.

1. Present value; expected pre-tax cash flows

2. Present value; expected future returns
3. Future value; expected pre-tax cash flows
4. Future value; expected future returns

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11. Mr Mac’s first child was born on 1 January 2019. He calculated that he needs to have R20 000
for his child’s studies, assuming that he will go to university at 18 years of age. How much does
Mr Mac have to deposit on 1 January 2019 in order to have R20 000 in 18 years’ time, assuming
that the interest he receives will be constant at a nominal interest rate of 10%?

1. R 1 111,11
2. R 3 597,20
3. R 7 710,80
4. R20 054,00

12. One method of decreasing the cash outflows of a firm is to:

1. Decrease depreciation
2. Decrease dividends
3. Increase capital expenditures
4. Increase debt repayment

13. A company has a money cost of capital of 9%. The rate of inflation is 3%.

The company’s real cost of capital is nearest to:

1. 5.83%
2. 6.10%
3. 12.0%
4. 12.3%

14. Which of the following is NOT a feature of an agreed overdraft facility?

1. The borrower may draw funds, up to the agreed overdraft limit, as and when required.
2. Interest is payable on the total amount of the agreed overdraft limit rather than on the amount
borrowed.
3. There is no fixed repayment date for the amount borrowed.
4. The borrowing is repayable on demand.

15. The following is an advantage of a rights issue

1. The amount of finance that can be raised by a rights issue is limited

2. It is difficult to choose the best issue price
3. A rights issue can be used to widen the base of shareholders
4. Rights issues are more expensive than a new share offering to the general public

16. The following has to be considered when evaluating a lease or buy back

1. Effect on cash flow and who will be responsible for the running costs of the asset
2. The cost of capital
3. The trade in value of the asset
4. The effect on reporting profits and alternative uses for the funds

17. An increase in the debtor average collection period may suggest all of the following except

1. The company applies inadequate credit control before approving debtor accounts and does not
charge interest on long outstanding accounts
2. Customers are not paying their bills on time
3. The company could have a liquidity problem in the future
4. Sales have decreased

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18. What are the main factors that lenders will consider when deciding whether to offer debt finance?

1. The purpose of the loan, amount and repayment (when will the capital on the loan be re-paid)
2. The time period of the loan and security (whether the loan will be secured by assets)
3. All of the above (purpose, amount, repayment, time period and security)
4. Whether the debt will be convertible into shares in the future

19. A company has annual sales revenues of R30 million and the following working capital periods:

Inventory conversion period 2.5 months

Accounts receivable collection period 2.0 months
Accounts payable payment period 1.5 months

Production costs represent 70% of sales revenue.

The total amount held in working capital excluding cash and cash equivalents is:

1. R 5.00m
2. R 6.75m
3. R 9.00m
4. R21.00m

20. The net investment calculation for an asset replacement decision normally includes any:

1. new project cost plus shipping and installation charges

2. after-tax salvage value of the old asset (net proceeds from sale of old assets)
3. increase in net working capital at project inception
4. all of the above

21. Asset management ratios indicate

1. How efficiently a firm is allocating its liabilities

2. The return of shareholders and equity
3. How well a firm is using its assets to support sales/revenue
4. The profitability of the firm

22. The definition of “signalling” in the context of dividend policy is best described by

1. The use of dividend policy to indicate the future prospects of the entity
2. An indication that the entity has reached maturity
3. An indication to shareholders that a share buy-back is imminent
4. A change in financial strategy

23. The earnings and dividends of a company are expected to grow at an annual rate of 15% over
the next 4 years and then slow to a constant growth of 8% per year. The firm pays a dividend of
R0,50 per share. What the value of a share to an investor who requires a 14% rate of return?

1. R2.04
2. R9.31
3. R11.35
4. R15.73

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24. Shareholder wealth is measured by the _______ of the shareholders’ common stock holdings.

1. Book value
2. Compound value
3. Historic value
4. Market value

25. The _____ is largely outside of the direct control of managers.

1. Economic environment
2. Investment strategy
3. Capital structure
4. Dividend policy

[25]

TOTAL: 75 MARKS

© UNISA
2019

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