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MBA: Man Fin

Jan 2014 Supp/Aegro exam

Marking Memo

Question 1 [25]


Y1 Y2 Y3 Y4 Y5

Lease payment (139 500) (139 500) (139 500) (139 500) (139 500)

Tax shield 0.3 41 850 41 850 41 850 41 850 41 850

Purchase option (59 990)

Net cash flow (97 650) (97 650) (97 650) (97 650) (157 640)

PV factor @ 7% 0.9346 0.8734 0.8163 0.7629 0.713

PV cash outflows (91 264) (85 288) (79 712) (74 497) (112 397)

NPV (R443 158)


PURCHASE Loan payments (178 987) (178 987) (178 987) (178 987) (178 987) Maintenance 0.3 27 000 22 996 18 391 13 095 7 000 Net cash flows (126 487) (130 491) (135 096) (140 392) (146 487) PV factor @ 7% 0.3 36 000 36 000 36 000 36 000 36 000 Int.713 PV cash outflows (118 215) (113 971) (110 279) (107 105) (104 445) NPV (R554 015) (23) 1. Tax shield 0. because the cash outflows are lower by R110 857 (2) 2 .2 Lease.8163 0.7 (10 500) (10 500) (10 500) (10 500) (10 500) Dep. tax shield 0.9346 0.8734 0.7629 0.

5m x R2.7) 5.5 3 750 000 0.04 15 809 391 1.00 Cost Ke (Cost of equity using Capm) = Rf + B(Rm .60% Kbl 16 (0.26/2.51 P/s 1.4% Kd 8 (0.20% 3 .5 10.1 Calculation of market value of debentures: 330 000 x 3.6806 1 317 591 + 2 041 800 =3 359 391 Market values Proportion O/s 2m x R4 8 000 000 0.5(17 .9927 + 3m x 0.9) 9 + 12 21% Kp Do/Po 0.7) 11.24 Debenture 3 359 391 0.Rf) 9 + 1.QUESTION 2 [25] 2.21 Bank loan (not traded) 700 000 0.

4% 2.66/4.18% Bl 0.10) 0.165 + 0.71% P/s 0.04% (22) 2.2% 0.26 x 10.04 x 11.66c Ke (D1/Po) + g (0.21 x 5.5% (3) 4 .6% 1.60 (1.45% 15.10 0.WACC O/s 0.51 x 21% 10.2 (Cost of equity using Gordon Growth) D1 = Do (1 + g) 0.70% Debenture 0.00) + 0.10 = 26.

2) Annual sales 9.8 Add back depreciation 6 existing overheads 0.97 (60) Annuity factor @ 8% for 10 years 6.QUESTION 3 [25] 3.52) Project 2 Rm Rm Cost of facility (17.7101 53.1 Project 1 Y1 to 10 Y0 $m $m Cost of plant (60) Profit 1.5 Annual fixed costs (1.6) 5 .48 Net present value (6.17 Net Cash flow 7.

more depreciation.Annual variable cost (4.5 (17.2 No! If cost is reduced to R16m. it has a negative NPV of $6.26/10. it has a positive NPV of $0.4) Annual depreciation (1.72) Add back depreciation 1.46 Net present value 5.4177 22.52 million. the NPV will be greater than $0. .increased valuations.Reduction in capital needs (5) 6 . bigger tax deduction .25 = $0.513170 million (2) QUESTION 4 [25] 4.513170 mill Accept Project 2.1 .Unused debt capacity .Asset write-ups.72 Net cash flow 3.25/$ R5.513170 million and reject Project 1.26 Exchange rate R10.Net operating losses – the combined firm will have a lower tax bill than the two firms considered separately.2) Annuity factor @ 9% for 10 years 6. (23) 3.

00 = 0.8) + 4m shares 0.7 Exchange ratio based on EPS R4.00m R48.2 Value of combined acquisition R20 x 4 = R80m + (R16 x 1m + R20m) = R80m + R36m = R116m (2) 4.8m shares (3) 4. of shares (1m x 0.6 Increase in share price R23 – R20 =R3 (2) 4.80m/4.80/ R6.3 Net present value of proposal R36m – R24m = R12m (2) 4.00 R 24.80 R 4.8m +4m shares =4.8 Post acquisition EPS: Combined value: S Ltd 4m x R6.80m Synergy R20.5 Post acquisition price per share (R116m – R24m) / 4 million shares =R92m /4m =R23 (3) 4.167 (4) 7 .8 (2) 4.4 Acquisition premium R24m – R16m =R8m (2) 4.8m =R10.80m R48.00m C Ltd 1m x R4.7 Total no.4.

As we have already seen.  A company with a loan requiring redemption may need to retain funds for this purpose. that is. Contractual Constraints Often. into a capital reserve. such as a capital redemption reserve. or another revenue reserve. and have never come from the income statement.  Companies that are insolvent cannot legally pay dividends. then this reserve is not available for payment of cash dividends. they cannot be paid from any capital reserve. if any funds have been transferred from income statements. such as share premium and revaluation reserves. which have been entered directly into a capital reserve. such reserves may be used for the issue of bonus shares. This rule also covers funds.  So.  Companies with various kinds of debt capital may in fact have agreed to restrictions on dividend payments to protect long-term creditors. which may be considered to take the place of cash dividends in a particular year. the firm’s ability to pay cash dividends is constrained by restrictive provisions in a loan agreement. if their external liabilities exceed their assets. Constraints on dividends help to protect creditors from losses due to the firm’s insolvency.1 Legal Constraints We’ll start by looking at actual restrictions on payment of dividends  While dividends can be paid from past and present earnings. Internal Constraints The firm’s ability to pay cash dividends is generally constrained by the amount of excess cash available rather than the level of retained earnings against which to 8 .Question 5 [25] 5.

who need dividend income. however. the firm’s primary concern should be to maximize owner wealth. when the share is sold. it may decide to pay out a lower percentage of its earnings to allow the owners to delay the payment of taxes until they sell the share. 5. It must determine not only its ability to raise funds. Although a firm may have high earnings. but also the cost and speed with which financing can be obtained. A growth firm is likely to pay out only a very small percentage of its earnings as dividends. will prefer a higher payout of earnings. mature firm has adequate access to new capital. 9 . whereas a rapidly growing firm may not have sufficient funds available to support its numerous acceptable projects. it may need all its funds to finance capital expenditures. 5. If a firm has a large percentage of wealthy shareholders who are in a high tax bracket. If the firm is in a growth stage. the firm must establish a policy that has a favourable effect on the wealth of the majority of owners. Although it is impossible to establish a policy that maximizes each owner’s wealth. Of course. Lower-income shareholders. its ability to pay dividends may be constrained by a low level of liquid assets (cash and marketable securities). One consideration is the tax status of a firm’s owners. Firms exhibiting little or no growth may nevertheless periodically need funds to replace or renew assets. if the proceeds are in excess of the original purchase price. Generally.3 Owner Considerations In establishing a dividend policy. A more stable firm that needs long-term funds only for planned outlays is in a better position to pay out a large proportion of its earnings. particular if it has ready sources of financing. possibly at a more favourable rate than the one applied to ordinary income.charge them.2 Growth Prospects The firm’s financial requirements are directly related to the anticipated degree of asset expansion. A firm must evaluate its financial position from the standpoint of profitability and risk to develop insight into its ability to raise capital externally. a large. the capital gain will be taxed.

A firm should not retain funds for investment in projects yielding lower returns than the owners could obtain from external investments of equal risk. determine whether greater returns are obtainable from external investments such as government securities or other corporate stocks.A second consideration is the owners’ investment opportunities. shareholders often view the firm’s dividend payment as a signal relative to its future success. If the firm skips a dividend payment in a given period due to a loss or to very low earnings. In addition. new equity capital will have to be raised with ordinary shares. Shareholders are believed to value a fixed or increasing level of dividends as opposed to a fluctuating pattern of dividends. A final market consideration is the informational content of dividends. using present value techniques. By paying out a low percentage of its earnings. shareholders are believed to value a policy of continuous dividend payment.4 Market Considerations An awareness of the market’s probable response to certain types of policies is helpful in formulating a suitable dividend policy. the firm should pay out a higher percentage of its earnings and vice versa. the earnings of the firm are likely to be discounted at a lower rate. If a firm pays out a higher percentage of earnings. the firm can minimize such possibility of dilution. A stable and continuous dividend is a positive signal that conveys to the owners that the firm is in good health. particularly when earnings decline. which may result in the dilution of both control and earnings for the existing owners. (Gitman. 2003:568) 5. shareholders are likely to interpret 10 . A final consideration is the potential dilution of ownership. This belief is supported by the research of John Lintner. This should result in an increase in the market value of the share and therefore increased owner’s wealth. who found that corporate managers are averse to changing the rand amount of dividends in response to changes in earnings. The firm should evaluate the returns that are expected on its own investment opportunities and. As indicated earlier. Because regularly paying a fixed or increasing dividend eliminates uncertainty about the frequency and magnitude of dividends. If it appears that the owners have better opportunities externally.

Owners and investors generally construe a dividend payment during a period of losses as an indication that the loss is merely temporary. (Gitman. prefer low dividends because of their tax position. (5 x 5) 11 . The non-payment of the dividend creates uncertainty about the future. firms should maintain their dividend policies or risk antagonising their existing shareholders – also. So if different shareholders have different requirements. for example.5 The Clientele Effect Do companies resort to particular dividend policy because of the type of shareholder they have? Some shareholders might. Remembering that many shares are today held by pension funds and insurance companies. maybe they have bought shares in particular companies because of the observed dividend policies of those companies? In this case. 2003: 569) 5. who would like a steady stream of ready cash inflows to balance their outflows. there may be a requirement from other shareholders for a high level of dividend.this as a negative signal. the lack of an observable policy might put off new shareholders. and this uncertainty is likely to result in lower share value. One evidence of a clientele effect has been found by various research studies. particularly downwards! Gentle growth seems to be the target – too rapid growth might not be sustainable. preferably a steady one. Research tends to show that firms are loath to change dividend patterns. and prefer not to create their own dividends as already described. because of the costs or effort involved. This could have a bad effect on share price and therefore cost equity.