UNIVERSITY OF FORT HARE

ADVANCED FINANCIAL
MANAGEMENT
BEC524/BEC524E

OCTOBER 2022 SEMSETER TEST 2

…………………………………………………………………………….......

Time: 3 Hours

Subject: BEC524/BEC524E

Marks: 100

This paper consists of 5 pages including the cover page

Internal Examiners External Examiner

Prof O.A. Oni Dr O Dzomonda

Dr E.C. Rungani

INSTRUCTIONS

Answer all questions

This question paper consists of 5 pages including the cover page

QUESTION 1 [25 MARKS]
a. Your managing director has just returned from a business school seminar on
market efficiency. He is puzzled as he was told in the seminar that if markets
are efficient all investments have an expected NPV of zero, yet his finance
director has told him that it is essential for the company to maximise its
expected NPV. He also wonders how recent stock market volatility can be
explained if the market is efficient.[10]
Required:
You have been asked to produce a brief report for the managing director discussing
his concerns, and the importance of market efficiency to capital investment
decisions.

b. A company is able to invest in either Project X or Project Y. The company’s

required rate of return is 12%. Assuming no depreciation or taxation, you are
required to select either Project X or Project Y. The cost of either project is
R20 million.
Rm 0 1 2 3 4
Project X(R million) -20 4 4 12 12
Project Y(R million) -20 10 10 5 5

What is the NPV, IRR and payback period of each project? Which project would
you select and why? [15]

QUESTION 2 [25 marks]

Sterkink Ltd, a profitable company has the following summarized Balance Sheet at
the beginning of the year. You know that the required cost of equity is 20%, the tax
rate is 40% and the dividend payout ratio is 25%

Sterkink Ltd
Balance Sheet on 1 July 2.21
R R
Fixed assets 630,000 Ordinary shareholders 600,000
Net current assets 570,000 12% Debentures 420,000
18% Long Term Loan 180,000
1,200,00
1,200,000
0

You have the following information relating to the operations for the year.

Sales 1,350,000
Cost of sales 678,000
 Operating Expenses 487,900
Required:
(a) Calculate the weighted average cost of capital. [16]
(b) Draft a summarized Income Statement for the year and determine the retained
income for the year. [9]

QUESTION 3 [15 MARKS]

The following are abbreviated income statements of two companies, both of
which are active in the retail industry.
INCOME STATEMENT
Avon Electra
Sales [300 units] 3,000 3,000
Less Variable Costs 1,200 2,200
Contribution 1,800 800
Less Fixed Overhead Costs 1,000 200
Net Income before interest [EBIT] 800 600
Interest 300 100
Net Income 500 500

Required:
(a) Calculate the degree of operating leverage [5]
(b) Calculate the degree of financial leverage [5]
(c) Calculate the degree of combined leverage [2]
(d) Discuss the relative riskiness of the two companies based on the leverage
factors calculated.[3]

QUESTION 4 (18 MARKS)

Munxay Ltd is comprised of only four major investment projects, details of which are
as follows:

% of Annual % Risk as measured Correlation

company return during by standard with the
Project
market value the last 5 years deviation market
1 28 10 15 0·55
2 17 18 20 0·75
3 31 15 14 0·84
4 24 13 18 0·62
The risk free rate is expected to be 5% per year, the market return 14% per year,
and the standard deviation of market returns 13%.

Required:
a. Assume that Munxay Ltd’s shares are currently priced based upon the
assumption that the last five year’s experience of returns will continue for the
foreseeable future. Evaluate whether or not the share price of Munxay Ltd is
undervalued or overvalued. [10]
b. Discuss why your results in (a) above might not correctly identify whether or
not the share price of Munxay Ltd is undervalued or overvalued.[8]

QUESTION 5 [17 MARKS]

The finance director of Kulpar Ltd is concerned about the impact of capital structure
on the company’s value, and wishes to investigate the effect of different capital
structures.
He is aware that as gearing increases the required return on equity will also
increase, and the company’s interest cover is likely to decrease. A decrease in
interest cover could lead to a change in the company’s credit rating by the leading
rating agencies.
He has been informed that the following changes are likely:
Interest cover Credit rating Cost of long term debt
More than 6·5 AA 8·0%
4·0 – 6·5 A 9·0%
1·5 – 4·0 BB 11·0%
The company is currently rated A.
Summarised financial data:
Rmillion
Net operating income 110
Depreciation (20)
Earnings before interest and tax 90
Interest (22)
Taxable income 68
Tax (30%) (20·4)
Net income 47·6
Additional Information:
 Capital spending is R20 million, Market value of equity is R458 million, and of
debt R305 million.
 Kulpar’s equity beta is 1·4. The beta of debt may be assumed to be zero.
 The risk free rate is 5·5% and the market return 14%.
 The company’s growth rate of cash flow may be assumed to be constant, and
to be unaffected by any change in capital structure.
Required:
Determine the likely effect on the company’s cost of capital and corporate value if the
company’s capital structure was:
(i) 80% equity, 20% debt by market values;
(ii) 40% equity, 60% debt by market values.
Which capital structure should be selected based on your evaluation? [17]
Note: Any change in capital structure would be achieved by borrowing to repurchase
existing equity, or by issuing additional equity to redeem existing debt, as
appropriate. The current total firm value (market value of equity plus market value of
debt) is consistent with the growth model (CF1/(k – g)) applied on a corporate basis.
CF1 is next year’s free cash flow, k is the weighted average cost of capital (WACC),
and g the expected growth rate. Company free cash flow may be estimated using
EBIT(1 – t) + depreciation – capital spending.
Also note that A change in gearing will result in a change in the equity beta.
Assuming the beta of debt is zero, the equity beta with no gearing may be estimated
by the relationship: Beta ungeared = beta geared x E /[E + D (1-t)].
State clearly any other assumptions that you make.

GOOD LUCK AND BEST WISHES!!!