QUESTION ONE (40 MARKS) - COMPULSORY

You are the financial manager at Kumboedza Investments, a grocery retailing company
operating several branches in Harare and surrounding cities. The company wants to open a new
retail branch in Murehwa Centre. The new branch is expected to operate for six years before
competition intensifies and makes the branch less profitable.

The following cash flows will be generated by the branch.

Year 0 1 2 3 4 5 6
Cash (USD45,000 USD12,500 USD10,500 USD10,100 USD9,900 USD7,500 USD2,500
)
flow

Before financial resources are sought and committed to the project, you have been asked to
evaluate whether the project is feasible. In addition to the above cash flows, the following
information is also made available to you at the company’s head office in Harare.

The capital to finance the opening of the branch will be raised through a combination of debt,
preference shares and ordinary equity using current market values as the weights.

The company has 100 debentures outstanding. The debentures have 10 years remaining to
maturity, carry 10% annual coupon paid semi-annually. The current market value of each
debenture is $1 250. The coupon is due shortly. The debentures will be redeemed at 110 percent
of par value. If new debentures are to be issued, the company will incur a flotation cost of $10
per debenture issued.

The grocery company has 200, 8% $100 par outstanding preference shares that pay semi-annual
dividends. The preference shares will be redeemed at 110 percent par in exactly 8 years’ time.
Each preference share is currently trading at $108; also the dividend on preference shares is due
shortly. If new preference shares are issued, flotation costs will be $3 per share.

The grocery company also have 2 000, $30 par value ordinary shares outstanding. The current
treasury bill rate is 6%, the company has a stock beta of 1.50 and the average return on the
market is 20%. The directors of the company meet a week ago to declare an ordinary dividend of
$1.50 which is payable to shareholders whose names will be in the record of ordinary
shareholders by end of business on Friday next week. If new ordinary dividends are issued
flotation costs will be 9% per share.

The following table shows the dividend per share data for the company since 2013. You may
assume, that on average the company’s future dividends will continue to grow at the same rate
into the unforeseeable future.

Year Dividend Per Share

2018 $1.50
2017 $1.30
2016 $1.15
2015 $0.99
2014 $0.90
2013 $0.75

The company’s dividend policy is to retain 50% of net income for future business development.

The company is expecting to retain $3 000 this year after writing off $1 000 as depreciation in
the income statement.

The tax rate is 30%.

Required:

a. Calculate the discount rate that the grocery company should use to evaluate the feasibility of
the Murehwa centre branch. (25 marks)
b. Calculate the Net Present Value (NPV) of the Murehwa branch and advise management
accordingly (7 marks)
c. Estimate the number of debentures, preference and ordinary shares that must be issued to
raise enough capital for the project assuming the branch is viable (8 marks)