[Date]

FIN3701 Assignment 2
Semester 1 2024
(505104) - DUE 24 April
2024
Questions and Answers

[COMPANY NAME]
FIN3701 Assignment 2 Semester 1 2024 (505104) - DUE 24
April 2024

QUESTION 1 [10 marks]

Bonga currently has a portfolio of ordinary shares representing several different
companies. Bonga considers it to be a well-balanced investment portfolio, but he
wants to reduce the overall risk of the portfolio a bit more by including ordinary
shares from Titan Mining Corporation. The following information on Titan Mining
Corporation is available: For the period 2017 to 2020, the company paid the following
dividends per year respectively: R3,14; R3,55; R3,89; and R3,95. The 2021 dividend
is expected to increase by the average growth rate of the dividends between 2017 and
2020, and the dividend will increase by 10% per year indefinitely from 2022 onwards.
Bonga requires a return of 15% on his investment portfolio and is not prepared to pay
more than R52,00 per ordinary share of Titan Mining Corporation.
REQUIRED:
1.1 Calculate the current price of Titan Mining Corporation’s ordinary share. (8
marks)
1.2 Should Bonga purchase Titan Mining Corporation shares to include in his
investment portfolio? Provide reasons for your answer. (2 marks)
1.1 Calculating the Current Price of Titan Mining Corporation's Share (8 marks)
Step 1: Find the Average Dividend Growth Rate (2017-2020)
Average Growth Rate = [(Latest Dividend - First Dividend) / (Number of Years - 1)]
x 100%
Average Growth Rate = [(R3.95 - R3.14) / (4 - 1)] x 100% = 26.1%
Step 2: Estimate the 2021 Dividend
2021 Dividend = 2020 Dividend + (Average Growth Rate * 2020 Dividend)
2021 Dividend = R3.95 + (26.1% * R3.95) = R4.98

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Step 3: Identify the Constant Growth Rate (from 2022 onwards)
Constant Growth Rate = 10%
Step 4: Use the Dividend Discount Model (DDM) to find the Current Price
Current Price = D1 / (Required Return - Constant Growth Rate)
Where:
• D1 = Expected Dividend for next year (2022) = 2021 Dividend * (1 + Constant
Growth Rate)
• Required Return = 15%
Calculate D1:
D1 = R4.98 * (1 + 10%) = R5.48
Calculate Current Price:
Current Price = R5.48 / (0.15 - 0.10) = R54.80 (rounded to two decimal places)
Since Bonga is not willing to pay more than R52.00 per share, the calculated
price (R54.80) is higher.
1.2 Should Bonga Buy Titan Shares? (2 marks)
Based on the calculations, Bonga should not purchase Titan Mining Corporation
shares at the moment.
Here's why:
• The DDM calculation suggests the share price should be R54.80, which is
higher than Bonga's maximum price of R52.00.
• Buying above the calculated intrinsic value might not be a good investment
decision.
However, there are other factors to consider:
• Bonga's overall portfolio risk profile might justify a slight premium for a more
stable dividend-paying stock like Titan.

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 • Future growth prospects of Titan beyond the assumed 10% could increase the
share price.
It's recommended that Bonga considers these factors and conducts further
research before making a final decision.
share
more_vert

KINDLY NOTE THAT THERE ARE TWO COMPULSORY ASSIGNMENTS FOR

THE FIRST SEMESTER.
QUESTION 2 [15 marks]
The power systems company Raging Volts is currently 70% equity financed and aims
to raise R2 million to fund a set of attractive investment opportunities. Debt financing
may be obtained at an after-tax cost of 16%. The company’s management wants to
introduce 40% debt in the capital structure while keeping the cost of each financing
source together with its market value the same. Ordinary shares are currently selling
for R30 per share. The company paid a dividend (Do) of R1,50 per share in the
previous financial year and had a growth rate of 7% over the past few years. It is
expected that this growth rate will be maintained in future. The company’s tax rate is
29%. The market value of power systems company Volts is R2 000 000.
REQUIRED:
1.1 Calculate the component costs associated with capital investment financing. (3
marks)
2.2 Calculate the weighted average cost of capital (WACC), the break-point of equity
and the break-point of debt under the current structure. (4 marks)
2.3 Calculate the WACC, the break-point of equity and the break-point of debt under
the proposed structure. (4 marks)
2.4 Calculate the number of shares under the current structure. (2 marks)
2.5 Calculate the number of shares under the proposed structure. (2 mark)
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2.1 Component Costs (3 marks)
Cost of Debt (Kd)
We are given the after-tax cost of debt (Kd) as 16%.
Cost of Equity (Ke)
We can use the Gordon Growth Model (GGM) to estimate the cost of equity.
Calculate Ke using GGM:
Ke = (Do + Growth Rate) / Price per Share Ke = (R1.50 + 7%) / R30 = 22%
Component Costs Summary:
• Kd (Cost of Debt) = 16%
• Ke (Cost of Equity) = 22%
2.2 Current Capital Structure (4 marks)
Weighted Average Cost of Capital (WACC)
Calculate Equity Weight (We)
We are given the current equity financing is 70%. Therefore, Debt Weight (Wd) is 1 -
We = 1 - 0.7 = 0.3
Calculate WACC:
WACC = (We * Ke) + (Wd * Kd * (1 - Tax Rate))
WACC = (0.7 * 22%) + (0.3 * 16% * (1 - 0.29)) WACC = 15.4% + 3.52% = 18.92%
(rounded to two decimals)
Break-point of Equity (Be)
Formula:
Be = Kd / (Ke - Kd)
Calculate Be:
Be = 0.16 / (0.22 - 0.16) = 1.78 (rounded to two decimals)
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Break-point of Debt (Bd)
Formula:
Bd = Ke / (Kd - Ke * (1 - Tax Rate))
Calculate Bd:
Bd = 0.22 / (0.16 - 0.22 * (1 - 0.29)) = -2.33 (negative value indicates no break-point
for debt)
2.3 Proposed Capital Structure (4 marks)
Since the proposed structure aims for 40% debt, the equity weight (We) will be 1
- 0.4 = 0.6
Recalculate WACC under Proposed Structure:
WACC = (0.6 * 22%) + (0.4 * 16% * (1 - 0.29)) WACC = 13.2% + 4.48% = 17.68%
(rounded to two decimals)
Calculate Break-point of Equity (Be) under Proposed Structure:
Be = 0.16 / (0.22 - 0.16) = 1.78 (remains the same as the current structure)
Calculate Break-point of Debt (Bd) under Proposed Structure:
Bd = 0.22 / (0.16 - 0.22 * (1 - 0.29)) = -2.33 (remains the same as the current
structure)
2.4 Number of Shares under Current Structure (2 marks)
Market Value (MV) = Number of Shares (NS) * Price per Share (PS)
We are given MV = R2,000,000 and PS = R30.
Calculate NS:
NS = MV / PS = R2,000,000 / R30 = 66,667 shares (rounded to nearest whole
number)
2.5 Number of Shares under Proposed Structure (2 marks)

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Since the total market value remains the same (R2 million) and the price per
share is still R30, the number of shares will also be the same.
Number of Shares = 66,667 shares

QUESTION 3 [25 marks]

Hammerson Ltd is an all-equity financed company with 10 000 outstanding ordinary
shares, each valued at the market price of R25,00. The company has decided to
modify its capital structure to capture the tax benefits of debt. The plan is to have a
target debt ratio of 30%. The company pays all its earnings as dividends and is subject
to a 28% tax rate. The expected sales are R530 000, fixed costs are estimated at R250
000 and variable cost are estimated at 30% of sales. Details of the pursued capital
structures are as follow: • Capital structure A at 30% debt ratio Hammerson Ltd will
acquire debt at a before-tax cost of debt of 11.75%.
REQUIRED:
3.1 Which capital structure would you advise the company to choose if its objective is
to maximise earnings per share (EPS)? (8 marks)
3.2 Calculate the weighted average cost of capital (WACC) for both the current and
proposed debt structures. (13 marks) 12
3.3 Which capital structure would you advise the company to choose if the aim is to
maximise shareholder wealth?
3.1 Maximizing EPS (8 marks)
Since Hammerson Ltd. currently has no debt, EPS will be the same under both capital structures
assuming all earnings are paid out as dividends.
There won't be any tax shield benefit (interest expense deduction) under the current structure (no debt).
However, introducing debt under either Capital Structure A or any proposed structure will create a tax
shield, potentially increasing EPS.
Therefore, to maximize EPS, we recommend choosing a capital structure with debt (either Capital
Structure A or another proposed structure).
3.2 Weighted Average Cost of Capital (WACC) (13 marks)

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We need to calculate WACC for both the current and proposed debt structure (Capital Structure
A).
Current Structure (All Equity):
We are given there's no debt, so WACC (Ke) will be the cost of equity.
Cost of Equity (Ke) using Capital Asset Pricing Model (CAPM):
We don't have information on the risk-free rate (Rf), market return (Rm), or beta (β) for Hammerson Ltd.
Since the question doesn't provide this information, we cannot calculate Ke definitively using CAPM.
However, for illustration purposes, let's assume a hypothetical Ke of 15%.
WACC (Current Structure):
WACC = Ke (as there's no debt) WACC = 15% (hypothetical value)
Proposed Debt Structure (Capital Structure A):
Calculate Equity Weight (We)
Target Debt Ratio = 30% Equity Weight (We) = 1 - Debt Ratio = 1 - 0.3 = 0.7
We don't have information on the cost of debt (Kd) for Capital Structure A.
Therefore, we cannot definitively calculate the WACC for Capital Structure A.
However, for illustration purposes, let's assume a hypothetical Kd of 11.75% (given as before-tax
cost of debt).
Calculate WACC (Capital Structure A):
WACC = (We * Ke) + (Wd * Kd * (1 - Tax Rate))
We already have We (0.7) and a hypothetical Ke (15%).
Calculate Debt Weight (Wd):
Wd = 1 - We = 1 - 0.7 = 0.3
Calculate WACC:
WACC = (0.7 * 15%) + (0.3 * 11.75% * (1 - 0.28)) WACC = 10.5% + 3.36% = 13.86% (rounded to two
decimals)
Summary of Hypothetical WACCs:
• Current Structure: 15%
• Proposed Structure (Capital Structure A): 13.86% (assuming a Kd of 11.75%)

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Important Note: Since we used hypothetical values for Ke and Kd, these WACC calculations are for
illustration purposes only.
3.3 Maximizing Shareholder Wealth (4 marks)
Generally, a company should choose the capital structure that minimizes the WACC.
A lower WACC translates to a lower cost of capital, which can lead to higher profitability and ultimately,
greater shareholder wealth.
Based on our hypothetical calculations, Capital Structure A (assuming a Kd of 11.75%) has a lower
WACC (13.86%) compared to the current all-equity structure (15%).
Therefore, if the goal is to maximize shareholder wealth, Capital Structure A (or another proposed
structure with a lower WACC) would be the recommended choice.
However, this is based on limited information and assumptions. A more comprehensive analysis
would require calculating the actual Ke and Kd for each structure.

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