Name Ndlovu .

S
Student Number 201924638
Course code BEC 313
Lecturer Dr E. Rungani
Task Assignment 1
Question 1
(a). Briefly discuss the meaning of agency problem and give examples in your
explanation. Do these interfere with shareholder’ wealth maximisation. [10
marks]
In the corporate finance world, principals are the shareholders who own the firm and
managers act as their agents who are in day-to-day control of the firm. This
separation of ownership and control give rise to a potential conflict between the
objectives of the shareholders on whose behalf the managers operate the firm, this
is what termed agency problem (McMenamin, 1999). It should be mentioned that
the agency problem only really arises in the context of large enterprises, not in small
and medium sized enterprises (SMEs) tend to be managed and controlled by the
owners who are frequently the founding members.

For the shareholders of a firm where ownership is separate from managerial control,
the agency problem is that managers, who are in day-to-day control of the firm, may
tend to act in their own personal best interests, rather than those of the shareholders,
the firm’s owners. For example, a manager act as an agent and not owning 100 % of
the share capital is likely concerned with maximization of personal wealth through
typically voting themselves generous and unjustified salaries and bonuses at the
expense of owner’s welfare ( shareholder’s wealth maximization ).

Do these interfere with shareholder’ wealth maximisation

Definitely, the agency problem do interfere with shareholder’s wealth maximisation.

By the time the managers start to act in the best of their interest, this results in agency
costs which have the effect of reducing owners’ wealth (Kuang & Yang, 2021). For
example the manager’s shortemism would sacrifice economic value for the firm in
order to meet that quarter’s earnings expectations could not be in the best interests
of shareholders’ who are seeking to improve the firm’s longer-term value.
(b). In what sense could one argue that if managers make decisions using break-
even analysis, they are not maximising shareholder wealth? How can break-
even analysis be modified to solve this problem? [10 marks]

The break-even analysis is narrowly concerned about probable level of profits at

different levels of output (McMenamin, 1999). While break-even analysis is
frequently used for profit maximization is not adequate for shareholder’s wealth
maximization decision because it goes on ignoring financial principles such as
timing of returns, cashflows and risk that are very important concepts on
maximization of shareholder’s wealth.

The managers who make decisions based on the break-even analysis they tend to
focus on the absolute value of returns and ignores their timing by simply seeking to
select those investments which yield the greatest total amount of profits (Moyer,
McGuigan, & Rao, 2014). For example, if Project A yields earnings of R100,000 a
year for the next three years, and Project B yields R330,000 of earnings in three
years’ time. The break-even analysis would dictate the choice of Project B, as it has
the greater amount of total profits, R330,000. However, this may not be the value
maximizing decision. With Project A, the firm has the opportunity to reinvest the
funds earned in years 1 and 2, and possibly accumulate even greater total returns in
the future. Therefore, in order to make wealth maximizing decisions, the managers
need to consider not only the absolute amounts but also the respective timings of
investment returns.

The objective of break-even analysis also ignores the concept of risk, which is
defined as the chance that the actual outcome of a decision may differ from the
expected outcome. By focusing solely on returns, the goal of break-even analysis is
only looking at ‘one side of the coin’ (Chandra, 2011). We cannot make a valid
comparison between investments unless we consider both the respective risk and
return of each investment. Investors can only earn higher returns by accepting higher
levels of risk.

From the financial management perspective, the valid goal of the firm is the
maximization of shareholder wealth and in a commercial firm, all management
decisions and actions should be directed towards this goal. It is an integral part of
the financial manager’s role to ensure that the financial decisions taken lead to an
increase in the firm’s long-term share price and consequently the long-term wealth
of its owners.

(c).
Extension cost needed R80 000
Deposit 10% R 8000
Therefore, Cecilia takes out a loan for R 72 000
[ ( ) ]
 P=

 P= R72000, I = 0.135, n = 3, m = 12
.
( ) ( ∗ )
 72000 = .

.
∗
 ∴x= .
^

 X = R 2443.34
 Cecilia must pay R 2443.34 monthly
Question 2

(a). Explain the concept of capital structure. [5 marks]

Capital structure is defined as the mix of debt and equity securities employed by a firm to fund its
operations and finance its assets (Leary & Roberts, 2005). Debt capital therefore is the firm’s long-
term borrowings the likes of bonds and debentures and equity capital is the long-term funds
provided by the shareholders the likes of ordinary shares and retained earnings. Capital structure
reflects the firm’s financing strategy, for example, its overall target debt-equity ratio, and also
financing tactics, for example, the design and timing of a particular debt issue.

When financial analysts refer to capital structure, they are most likely referring to a firm's debt-to-
equity (D/E) ratio, which provides insight into how risky a company's borrowing practices are.
Usually, a company that is heavily financed by debt has a more aggressive capital structure and
therefore poses a greater risk to investors.

( b).

 𝐹𝑣 = 𝑝(1 + 𝑖)
 P= R10 000 ,I = 0.06 , n = 8 ,m= 2
. ∗
 𝐹𝑣 = 10000 (1 + )

 𝐹𝑣 = 𝑹 𝟏𝟔𝟎𝟒𝟕 , 𝟎𝟔

Therefore, at the end of 8 years the balance will be R 16047.06

(c). Net Present Value (NPV).

ELECTRIC POWERED FORK LIFT GAS POWERED FORK LIFT

PRESENT VALUE PRESENT VALUE CASH PRESENT VALUE

YEAR OF R1 @12% CASH FLOWS OF CASH FLOWS FLOWS OF CASH FLOWS
0 1 -110000 -110000 -87500 -87500
1 0.893 31450 28084.85 25000 22325
2 0.797 31450 25065.65 25000 19925
3 0.712 31450 22392.4 25000 17800
4 0.636 31450 20002.2 25000 15900
5 0.567 31450 17832.15 25000 14175
6 0.507 31450 15945.15 25000 12675
NPV 19322.4 15300

Workings

18% 18%
ELECTRIC POWERED FORK LIFT GAS POWERED FORK LIFT
PRESENT VALUE PRESENT VALUE PRESENT VALUE PRESENT VALUE
YEAR OF R1 @12% CASH FLOWS OF CASH FLOWS YEAR OF R1 @12% CASH FLOWS OF CASH FLOWS
0 1 -110000 -110000 0 1 -87500 -87500
1 0.847 31450 26638.15 1 0.848 25000 21200
2 0.718 31450 22581.1 2 0.718 25000 17950
3 0.609 31450 19153.05 3 0.609 25000 15225
4 0.516 31450 16228.2 4 0.516 25000 12900
5 0.437 31450 13743.65 5 0.437 25000 10925
6 0.37 31450 11636.5 6 0.371 25000 9275
NPV -19.35 NPV -25
 𝑙𝑜𝑤𝑒𝑟 𝑟𝑎𝑡𝑒 𝑁𝑃𝑉
𝐼𝑅𝑅 = 𝐿𝑜𝑤𝑒𝑟 𝑟𝑎𝑡𝑒 + ∗ (ℎ𝑖𝑔ℎ𝑒𝑟 𝑟𝑎𝑡𝑒 − 𝑙𝑜𝑤𝑒𝑟 𝑟𝑎𝑡𝑒)
𝑙𝑜𝑤𝑒𝑟 𝑟𝑎𝑡𝑒 𝑁𝑃𝑉 − ℎ𝑖𝑔ℎ𝑒𝑟 𝑟𝑎𝑡𝑒 𝑁𝑃𝑉

IRR FOR ELECTRIC POWERED FORKLIFT

.
 𝐼𝑅𝑅 = 12 + . .
∗ (18 − 12) = 17.99 ≈ 𝟏𝟖 %

IRR FOR GAS POWERED FORKLIFT

 𝐼𝑅𝑅 = 12 + ∗ (18 − 12) = 17.973 ≈ 𝟏𝟖 %

Decision

The East London Industries should consider electric powered forklift than gas powered
forklift because the electric powered forklift has a higher NPV as compared to gas powered
forklift despite having the similar IRR as shown above.

Question 3

(a).

semiannual payment

C = 8%/2 = 4% , n = 5 * 2 = 10 , YTM = 10%/2 = 5% , nominal value = R1000

(i). The coupon payment = (8% * 1000)/2 = 40

(ii) The bond prices

[ /( ) ]
 𝐵𝑜𝑛𝑑 𝑣𝑎𝑙𝑢𝑒 = 𝐶 ∗ +
( )

/( . )
 𝐵𝑜𝑛𝑑 𝑣𝑎𝑙𝑢𝑒 = 40 ∗ +
. ( . )

 𝐵𝑜𝑛𝑑 𝑣𝑎𝑙𝑢𝑒 = 308.87 + 613.91

 = 𝑅 𝟗𝟐𝟐. 𝟕𝟖

Question 3 (b)

Current price per share R2.00

Current year’s dividends per share R0.10
Expected average annual growth rate of dividends 7%
Beta coefficient for Joel ltd 0.80

In addition the following information has been established

Expected rate of return on risk free securities 8%
Expected return on the market portfolio 12%
The before tax cost of debt 10%
Marginal Tax rate 35%
Total value of the firm 1000 000
Value of equity 650 000
Value of debt 450 000

1. Dividend growth model

( )
𝑃 = rearrange to 𝑅 = 𝑔 +

. ∗( . )
 𝑅 = 0.07 + = 0.1235 = 𝟏𝟐. 𝟑𝟓%
2. Capital Pricing Model

 𝐸(𝑟 ) = 𝑅 + 𝛽(𝐸(𝑟 − 𝑅 )
 𝐸(𝑟 ) = 8 + 0.8(12 − 8) = 𝟏𝟏. 𝟐 %

3. After tax cost of debt

After tax Cost of Debt = the before tax Cost of debt *(1 – Tax Rate)
10% * (1- 0.35) = 0.10*(0.65) = 0.065 = 6.5%

4. weighted average cost of capital of Joel ltd

 𝑊𝐴𝐶𝐶 = 𝑘 × + 𝐾 ×

 𝑊𝐴𝐶𝐶 = 0.1235 × + 0.065 ×

 𝑊𝐴𝐶𝐶 = (0.1235 × 0.591) + (0.065 × 0.409)

 𝑊𝐴𝐶𝐶 = 0.09957 = 𝟗. 𝟗𝟔%

References

Chandra, P. (2011). Financial management. Tata McGraw-Hill Education.

Kuang, J. Z., & Yang, Z. (2021). The Effects of Transparency and Voice on Managerial Decisions

and Employee Effort in Hierarchical Organizations. European Accounting Review, 0:0, 1-

25.

Leary, M. T., & Roberts, M. R. (2005). Do firms rebalance their capital structures? . The journal

of finance, 60(6), 2575-2619.

McMenamin, J. (1999). Financial Management: An Introduction (2nd ed.). Routledge.

Moyer, R. C., McGuigan, J. R., & Rao, R. P. (2014). Contemporary financial management.

Cengage Learning.