Graduate School of Business Examinations

THE UNIVERSITY OF ZAMBIA

GRADUATE SCHOOL OF BUSINESS

MBA Finance/MSc Accounting & Finance Test questions and

solutions

09:00 to 12:00 Hours

MAFF 5120: CORPORATE FINANCE

Instructions
1. Reading Time: 5 minutes
2. Duration : 3 hours
3. Show all your workings and present neat work
4. Unless stated use 5.5% as the equity risk premium.
5. Answer all questions in Section A, and any two questions from Section B

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 SECTION A

QUESTION 1

Tongabezi Plc one of the leading companies in Zambia. Tongabezi is planning to open a Theme Park
in Livingstone, Zambia. The company will spend K2.1 million in 2019 on equipment, fixtures and
fittings. These investments are expected to be depreciated using the straight-line method a life of
four years, at which point they will have a salvage value of zero. The Park will be built on land that
is currently owned by the firm. The land was bought three years ago at a cost of K50,000 has a
current market value of K300,000 before taxes. The revenues in the first year (2020) are expected to
be K2.4 million, growing 20% in year two, and 10% in the two years following. The operating costs
will be 50% of the revenues in each of the four years.

Three employees of the firm, each with a salary of K20,000 a year, who are currently employed by
the Movies Division, will be transferred to this Park. The Movies Division has no alternative use for
them, but they are covered by a union contract that will prevent them from being fired for two years
(during which they would be paid their current salary). The current general manager of the Zimba Theme
Park will run the Park. As a consequence, the salary of the general manager will be increased from
K100,000 to K110,000 in 2020; it is expected to grow 5 percent a year after that for the remaining
three years of the Park. After the Park is ended in the fourth year, the manager’s salary will revert
back to its old levels.

The working capital, which includes the inventory of books needed for the service will be 10% of the
revenues; the investments in working capital have to be made at the beginning of each year. At the
end of year 4, the entire working capital is assumed to be salvaged.

Tongabezi is also considering offering baby-sitting services to the Theme Park customers. It is
estimated that the licensing and set up costs will amount to K150, 000 initially and operating costs
will be about K60,000 annually to provide the service. The offering of baby-sitting services will lead
to increase in revenues at the Park by K900, 000 in year 1, growing at 10% a year for the following 4
years. In addition, assume that the pre‐tax operating margin on these sales is 10%.

Tongabezi’ s cost of capital for both the theme parks and movie theatres is 10%. The company’s is
taxed at 40%.

Required:

a. Estimate the NPV of the Theme Park. (20 ½ marks)

b. Estimate the NPV of the Baby-Sitting Service. (4 ½ Marks)
c. Would you recommend the opening of the Theme Park and or/ the Movie Theatre (2 marks)
d. What reinvestment rate assumptions are made by the IRR and NPV methods of investment
appraisal? (3 marks)

[Total Marks 30]

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 A Tongabezi Plc
(All amounts in K)
Description/Year 0 1 2 3 4
Revenues 2,400,000.0 2,880,000 3,168,000 3,484,800.0

Operating Expenses
Operating costs 1,200,000 1,440,000 1,584,000 1,742,400
General Manager Salary (w3) 10,000 10,500 11,025 11,576
Depreciation 525,000 525,000 525,000 525,000
Total Operating Expenses - 1,735,000.00 1,975,500.00 2,120,025.00 2,278,976.25
Operating Income 665,000.00 904,500.00 1,047,975.00 1,205,823.75
Less:Taxes(40%) 266,000.00 361,800.00 419,190.00 482,329.50
After-tax Operating Income 399,000.00 542,700.00 628,785.00 723,494.25
Add: Depreciation 525,000 525,000 525,000 525,000
Less: Change in Working
- 348,480.0
Capital(w1) 240,000 48,000 28,800 31,680
Less: Opportunity cost-Land 300,000
Less: Initial Investment 2,100,000
Cash flow after taxes (2,640,000) 876,000 1,038,900 1,122,105 1,596,974
salvage value -
Discount Factors 1.00 0.91 0.83 0.75 0.68
Present Value (2,640,000) 796,363.64 858,595.04 843,054.09 1,090,754.90
Net Present Value 948,768

Opportunity costs
Salaries for two employees

Employees will be paid for the two years when they under protection

PV of expenditures = 60,000*(1-0.4)/(1+0.16)^3 + K60,000*(1-0.4)^4= 23,076 +19872= K42,948

Combined NPV K
NPV for Bookstore 948,768
Salaries two employees (42,948)
NPV Book store 905,820

B NPV of Baby Sitting Service

I Additional sales after opening Baby Sitting Service

1 2 3 4
Increased Revenues 900,000.00 990,000 1,089,000 1,197,900
Operating Margin 10.00% 10.00% 10.00% 10.00%
Operating Income 90,000.00 99,000.00 108,900.00 119,790.00
Operating Income after Taxes 54,000.00 59,400.00 65,340.00 71,874.00
Discount factors 0.91 0.83 0.75 0.68
PV of Additional Cash Flows 49,090.91 49,090.91 49,090.91 49,090.91
PV of Synergy Benefits 196,363.64

II NPV of Baby Sitting Service

NPV Stand Alone =-150,000 + 60,000(PVA,10%, 4 Yrs)= (340,200)

III NPV WITH SYNERGIES K

NPV Additional sales 196,363.64

NPV of Baby Sitting Service (340,200)
Baby Sitting Service NPV (143,836)

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 iv recommendation WORKINGS
COMBINED NPV OF BOOKSTORE + NPV OF BABY SITTING SERVICE

NPV WITH SYNERGIES K

NPV Book store standalone 905,819.67

NPV of Baby Sitting Service (143,836)
Baby Sitting Service NPV 761,983

c. The theme park standalone is expected to produce a NPV of K905,819.67. Therefore, firm value and
consequently shareholder value is expected to increase by K905,819.67. However, when combined with the
baby sitting service, the Theme park NPV reduces by K143,836. Therefore Tongabezi should only open the
Theme Park only, as opening the Baby Park will reduce firm value.

d.

SECTION B

(ANSWER ANY TWO QUESTIONS)

QUESTION 2

a.) You are analysing the dividend policy of TazamaRail, a major railroad company, and you have
collected the following information from the past five years.
Year Net Income Capital Expenditure Depreciation Noncash Working Capital Dividends
(Million) (Million) (Million) (Million) (Million)
2011 K240 K314 K307 K35 K70
2012 K282 K466 K295 K(110) K80
2013 K320 K566 K284 K215 K95
2014 K375 K490 K278 K175 K110
2015 K441 K494 K293 K250 K124

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 The average debt ratio during this period was 30 percent, and the total non-cash working capital
at the end of 2010 was K20 million.
Required:

i. Estimate how much TazamaRail could have paid in dividends during this period.
(5 marks)
ii. If the average return on equity during the period was 13.5 percent, and Tazama
had a beta of 1.25, what conclusions would you draw about their dividend policy?
(The average Government bond rate during the period was 7 percent, and the
average return on the market was 12.5 percent during the period.) (5 marks)
Solution
Change
Net Cap. Noncash in Dividend
Year Depr. FCFE
Income Exp. WC Noncash s
WC
1991 240 314 307 35 25 70 217.6
1992 282 466 295 -110 -145 80 281.3
1993 320 566 284 215 325 95 -206.4
1994 375 490 278 175 -40 110 482.1
1995 441 494 293 250 75 124 219.8

FCFE = Net Income – (Cap Ex – Depr) (1-0.3) – Change in Working capital (1-0.3)

a. Mulobezi could have paid dividends each year equal to its FCFE, at least on average.

b. The average accounting return on equity that Mulobezi is earning = 13.5%, compared
to a required rate of return = 0.07 + 1.25(0.125‐0.07) = 13.875. Hence, Mulobezi’ s
projects have done badly on average. Its average dividends have been much lower than
the average FCFE. Hence, it would seem that Mulobezi will come under pressure to pay
more in dividends.

b. You have run a series of regressions of firm value changes at Itel, the semiconductor company,
against changes in a number of macroeconomic variables. The results are summarized here:
Change in Firm Value = 0.08 – 6.81 (Change in Long-Term Interest Rate)
Change in Firm Value = 0.03 - 4.68 (Change in Real GNP)
Change in Firm Value = 0.10 – 6.84 (Inflation Rate)
Change in Firm Value = 0.05 – 3.40 (Kwacha/Dollar exchange rate)
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 Required:

Design Intel’s’ financing. (5 marks)

[Total 15 marks]

Solution

 ¨Looking at the four macroeconomic regressions, we would conclude

that Mulobezi Plc’s assets collectively have a duration of about 6.51
years
 Mulobezi Plc is counter cyclical when the economy is doing badly it
performs well and vice-versa
 Mulobezi Plc is not affected by changes in exchange rates
 Mulobezi Plc’s operating income tends to move with inflation
The Financing
The debt issued should be long term and should have duration of about 6.5
years. A significant portion of the debt should be floating rate debt, reflecting
Mulobezi Plc’s capacity to pass inflation through to its customers and the fact
that operating income tends to increase as interest rates go up. Given
Mulobezi Plc’is not sensitive to a stronger kwacha, most of its debt should be
in kwacha.

QUESTION 3
JD Fashions Plc, a company headquartered in Lusaka, Zambia. It is a major retailer of mens clothing
in Lusaka. It has a debt to equity ratio of 20% and a debt to capital ratio of 10%. The company pre-
tax cost of debt is 15%. The Government of the Republic of Zambia has issued a Ten- year
Government bonds which has a yield of 12% . and the equity risk premium is 10%. Moody’s sovereign
rating for Zambia is Caa2 with a default spread of 2%. The company’s tax rate is 40%.
Table 1 contains information about some of the companies in the fashion industry in Zambia.
Table 1: Fashion Industry Information

Company Levered Beta Tax rate Debt to equity Ratio Cash/firm Value (%)
Monde Fashions Ltd 0.98 40% 30% 10%
CGC Brands Ltd 0.57 40% 25% 2%
Mija Clothing World Ltd 0.26 40% 23% 15%
Arcades Plc 0.78 40% 37% 5%
Dambwa Fashions Ltd 1.68 40% 30% 10%

Required (Rounding off your answers to 2 decimal places):

a. Estimate JD Fashions’ cost of capital. (10 marks)
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 b. Describe the determinants of Betas (5 marks)

[Total 15 Marks)

PART A
Debt to Cash/
Pureplay
Company Levered Beta Tax rate equity firm Ulevered Beta
beta
ratio value
Mushe milling 0.98 40% 30% 10% 0.83 0.92
Choma Milling 0.57 40% 25% 2% 0.50 0.51
Kasama Milling 0.26 40% 23% 15% 0.21 0.25
Geraldo Milling 0.78 40% 37% 5% 0.64 0.67 median number
Kachana Millers 1.68 40% 30% 10% 1.42 1.58

(i) Mulobezi Milling Levered Beta calculation = BU*(1+(1-t)(D/E)=0.67/(1+(1-0.40)(0.2)=

0.7504
(ii) Risk free rate= Bond yield less default spread= 12%-2%=10%
(iii) Cost of Equity = Risk-free rate + Beta(equity Risk premium) = 10% + 0.7504(10%) =
17.50%
(iv) Cost of Debt = Kd*(1-t)=15%*(1-0.4) = 9.00%
(v) Cost of Capital = WACC=We X ke + wd X Kd X (1-t)
= 9%* 0.1 + 17.50% * (1-0.1)= 14.90%
WORKINGS
1. Unlevered beta= BL/(1 + (1-t)(D/E)
Mushe milling = 0.98/(1 + (1-0.4)(0.3)=0.83
Choma milling = 0.57/(1 + (1-0.4)(0.25)=0.50
Kasama milling = 0.26/(1 + (1-0.4)(0.23)=0.21
Geraldo milling = 0.78/(1 + (1-0.4)(0.37)=0.64
Kachana millers = 1.68/(1 + (1-0.4)(0.30)=1.42

2. Pure play beta= Unlevered Beta/(1 -(cash/firm value)

Mushe milling = 0.83/(1- 0.1)=0.92
Choma milling = 0.50/(1 -0.02)=0.51
Kasama milling = 0.21/(1 -0.15)=0.25
Geraldo milling = 0.64/(1 -0.05)=0.67
Kachana millers = 1.42/(1-0.1)=1.58

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 QUESTION 4
Tonkatweende Plc is examining its capital structure with the intent of arriving at an optimal
debt ratio. It currently has no debt and has a beta of 1.6. Recently the company has been a
subject of a takeover bid. The riskless interest rate is 7% and the equity risk premium is 5 %.
Your research indicates that the debt rating will be as follows at different debt levels:
D/(D + E) Rating Interest Rate
0% AAA 10%
10% AA 10.5%
20% A 11%
30% BBB 12%
40% BB 13%

The firm currently has 2 million shares outstanding at K10 per share. Company tax rate = 40%.
Required:
a. What is the firm’s optimal debt ratio?( (9 ½ marks)
b. Advise the timing and options available to firm to move to its optimal debt ratio. (5 ½
marks)
[Total marks 15]

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Table: Tonkatweende Optimal Debt Ratio
D/E ratio 0% 11% 25% 43% 67%
D/(D+E )Ratio 0% 10% 20% 30% 40%
Debt(ZMK) - 2,000,000 4,000,000 6,000,000 8,000,000
Beta 1.6 1.7 1.8 2.0 2.2
Cost of Equity 17.00% 17.53% 18.20% 19.06% 20.20%
pretax cost of debt 10.00% 10.50% 11.00% 12.00% 13.00%
Tax rate 40% 40% 40% 40% 40%
cost of debt 6.00% 6.30% 6.60% 7.20% 7.80%
cost of capital 17.0% 16.4% 15.9% 15.5% 15.2%

Optimal Debt ratio is at 40%, where the cost of capital is minimal 15.2%. At this point the firm value
is maximised using the standard cost of capital approach and assuming the firm will do a
recapitalisation instead of using the debt issues to invest in projects.

PART B
Since the firm is a subject of a takeover bid , the firm has to move to its optimal debt ratio quickly.
The firm can do this by doing debt/equity swaps or borrow money and buyback shares

-END OF EXAMINATION-