PROBLEM-SOLVING SESSION

FINANCIAL MANAGEMENT

FOR MAY 2019 EXAMS

[SET 2]

Prepared By: Godson Mkaro (Jr): MSc Finance & Investment, BSc. Computer Science, ATEC II, CPBE, CPA (T) &
Emmanuel Christopher: MBA (Finance), B.Com Accounting (Hons), CPA (T) |Phone1: +255 717 / 769 348 616 |
Phone2: +255 714 965 564 | Email us to: info@covenantfinco.com |Visit our Website at: www.covenantfinco.com
 COVENANT FINANCIAL CONSULTANTS SPECIAL PROBLEM SOLVING SESSION [SET 2]

QUESTION ONE [COST OF CAPITAL]

One of your clients has seen many references to the “Cost of Capital” in the Business and Financial
Times and has asked you to give him some guidance on what would be an appropriate figure for
his organization-Bushka Ltd. The following information are available for Bushka Ltd.

Existing capital structure

TAS ‘000’
Issue of ordinary shares- - 12,000,000 12,000
Retained earnings 4,000
6% Preference shares 2,000
9% Debenture 6,000
24,000
i) 9% Debenture
Issued at par (TAS 100)
Current price TAS 92
A similar issue if made now would require to be at TAS 90

ii) Preference Shares

Preference shares have a par value of TAS 1 and were originally issued at 92p per share
Current price 43p
A similar issue if made now would require to be 40p per share

iii) Ordinary Share

The market price of an ordinary share is TAS 7.00
TAS 6 million in dividends were paid this year which represented 75% of earnings and it is
expected to be that way in years to come.
Earnings are expected to grow at an annual rate of 5%
If new ordinary shares were issued now, costs incurred would represent 25p per share and
a reduction below market value of 50p per share would also be made.

iv) Corporate tax rate is 25%

Required:
Calculate Bushka Ltd Weighted Average cost of capital.

Prepared By: Godson Mkaro (Jr): MSc Finance & Investment, BSc. Computer Science, ATEC II, CPBE, CPA (T),
Emmanuel Christopher: MBA (Finance), B.Com Accounting (Hons), CPA (T) |Phone1: +255 717 / 769 348 616 |
Phone1: +255 714 965 564 | Email: info@covenantfinco.com |Website: www.covenantfinco.com Page | 1
 COVENANT FINANCIAL CONSULTANTS SPECIAL PROBLEM SOLVING SESSION [SET 2]

QUESTION TWO [TIME VALUE OF MONEY-EQUIVALENT ANNUAL COST]

Note Co plans to replace an existing machine and must choose between two machines. Machine
1 has an initial cost of TAS200, 000 and will have a scrap value of TAS25, 000 after four years.
Machine 2 has an initial cost of TAS225, 000 and will have a scrap value of TAS50, 000 after three
years. Annual maintenance costs of the two machines are as follows:

Year 1 2 3 4
Machine 1 TAS per year 25000 29000 32000 35000
Machine 2 (TAS per year) 15000 20000 25000

Where relevant, all information relating to this project has already been adjusted to include
expected future inflation. Taxation and tax allowable depreciation must be ignored in relation to
Machine 1 and Machine 2.

Note Co has a nominal before-tax weighted average cost of capital of 12% and a nominal after-
tax weighted average cost of capital of 7%.

Required: Calculate the equivalent annual costs of Machine 1 and Machine 2, and discuss which
machine should be purchased.

QUESTION THREE [ ]
a) The following information is available for 3 different stock:

state of Probability of Rate of return if state occurs

economy state of economy Stock A (%) Stock B (%) Stock C (%)
Boom 0.35 20 35 60
Normal 0.4 15 12 5
Bust 0.25 1 -25 -50

(i) If your portfolio invested 40 percent each in A and B, and 20% in C, what is the portfolio
expected return and standard deviation?
(ii) If the expected Treasury bill rate is 3.8%, what is the expected risk premium on the portfolio?

b) XYZ Ltd is financed by a mixture of equity and debt capital whose market values are in the
ratio of 3:2 respectively. The debt which is considered risk free yields 8% pre-tax. The average
return on the market portfolio is 14% and the beta value of the company’s equity is 0.85.
Corporate Tax rate is 25%.

Required: Calculate the appropriate cost of capital to be used for appraising new projects
with the same operating risk characteristics.

Prepared By: Godson Mkaro (Jr): MSc Finance & Investment, BSc. Computer Science, ATEC II, CPBE, CPA (T),
Emmanuel Christopher: MBA (Finance), B.Com Accounting (Hons), CPA (T) |Phone1: +255 717 / 769 348 616 |
Phone1: +255 714 965 564 | Email: info@covenantfinco.com |Website: www.covenantfinco.com Page | 2