FEEDBACK TUTORIAL LETTER

2nd SEMESTER 2017

ASSIGNMENT 1

MANAGERIAL FINANCE 4B
MAF412S

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Assignment 1

QUESTION 1

COMPANY A & B
a)
Co. A Co. B
Net Operating Income 5,000,000 5,000,000
Less: interest -1,500,000
Available to shareholders 3,500,000 5,000,000
Taxation 28% -980,000 -1,400,000
2,520,000 3,600,000

Value of Equity [NI/capitalisation rate] 25,200,000 36,000,000

Value of Debt 30,000,000
Value of company [Debs + shares] 55,200,000 36,000,000

or
S = (EBIT - KdD) (l-t)
Ks

A = (R5m - R1.5m) (.72) + D = R25.2m + R30m = R55.2m

0.10

B = (R5m - 0) (.72) + D = R36m + R0 m = R36m

.10

b) VB = R5m(1 - t) = R3.6m = R36 million

.10 .10

VA = R5m(1 - t) + Dt
.10

= R3.6m + (R30m x 0.28) = R44.4m

.10

Or
Co. A Co. B
Net Operating Income 5,000,000 5,000,000

Available to shareholders 5,000,000 5,000,000

Taxation 28% -1,400,000 -1,400,000
3,600,000 3,600,000

Value of Firm = Value of Unlevered Firm + Debt tax shield

Value of Equity [capitalisation rate 10%] 36,000,000 36,000,000
Value of Debt shield [Debt x tax rate] 8,400,000 -
Value of company [Debs + shares] 44,400,000 36,000,000

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or
VA = VB + Dt

= R36m + (R30m x 0.28)

= R36m + R8.4m
= R44.4m

c) For co A

kd = 5% (1 - t) = 5%(.72) = 3.6%

ks = Income available for shareholders

Market value of equity

Co. A
Net Operating Income 5,000,000

Available to shareholders 5,000,000

Taxation 28% -1,400,000
3,600,000

Value of Equity [capitalisation rate 10%] 36,000,000

Value of Debt shield [Debt x tax rate] 8,400,000
Value of company [Debs + shares] 44,400,000

Value of the Assets (VA) 44,400,000 100%

Value of Debt -30,000,000 68%
Value of Equity 14,400,000 32%

ks = 2.520m = 17.5%
14.4m

ka = 17.5% (14.4m) + 3.6% (30.0m) = 17.5% (0.32) + 3.6% (0.68)

(44.4m) (44.2m)

= 8.05% for co A

For co B, ka = 10%.

Neither company has an optimal capital structure; under the MM assumptions, the optimal
capital structure would call for 100 percent debt, or as close to it as the company could get.

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d)
The addition of debt increases the covariance of equity returns with the market. The
increased covariance implies higher risk and therefore the cost of equity increases. The
increase in the cost of equity is more than offset by the tax subsidy effect of debt so that
the WACC declines.

e)

What is 1% of the Equity? 1% 25,200,000 252,000

Income 1% 2,520,000 25,200

You sell your holdings in A for its market value 252,000

Lever yourself with debt equal to 1% 30,000,000 300,000
Total Funds 552,000

Purchase 1% of B's shares 1% 36,000,000 360,000

Income from new investment 1% 3,600,000 36,000

Less: After-tax Interest 4% 300,000 -10,800
25,200

The new investment offers the same income, R25200 but we have saved R192 000 in
capital (552000-360000).

Note: The cost of equity did not change as we increased the financial leverage. In practice,
we would expect the cost of equity to increase as the firm’s level of debt is increased.

Question 2
(a)
2017 2016 2015 2014 2013
EPS (c) 140 136 131 127 122
DPS (c) 82 81 79 78 77
Payout ratio (%) 58.6 59.6 60.3 61.4 63.1
Retention rate % 41.4 40.4 39.7 38.6 36.9
100% 100% 100% 100% 100%
Growth in EPS (%) 2.9 3.8 3.1 4.1

We use the dividend discount model (DDM) also called Gordon’s Growth Model which
you learnt last semester to find the value of the share:
DDM: Po=D1/(ke – g)

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We determine the compound growth rate from the FV formula: FV = PV (1+r)n

Which is substituted as: 140 = 122(1+r)4

Therefore annual compound growth rate, r= (140/122)(1/4)-1 = 3.5%
I accepted the use of the average annual growth: (2.9+3.8+3.1+4.1)/4 = 3.5%
Coincidentally the rate is the same as the compound growth rate.
Now, we determine the cost of equity, ke using the CAPM which you did last semester.
ke=rf + (rm –rf)β
= 6% + 1.5 x 4
= 12%
The expected dividend is 0.82, the required return is 12% and constant growth rate is
3.5%. therefore applying the DDM, the value of equity is:
Po= 0.82/(0.12-0.035)
Po=N$9.65

Alternative solution:
If the company is able to achieve an investment return of 15%, then the growth rate will
be higher. The company should achieve a growth in dividend equal to the growth in
EPS. Applying the sustainable growth formula we can determine the future growth in
earnings and dividends:
Growth rate in earnings and dividends= Return x Investment rate
= 15% x 41.4% = 6.214%p.a
Therefore, Po = 0.82/(0.12-0.06214) = N$14.17

(b) If future retentions are expected to be 50%, then our growth rate is higher than
the 6.214% at 41% retention:
Growth rate = 50% x 15% = 7.5% p.a.

The next dividend will therefore be:

50% x 140 =70c

Therefore Po= 70/(12%-7.5%) = N$15.56

D1 / (Ke-g)

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 i.e. (82c x 1.035) / (0.12 - .035) = R9.99

1.2:
In practice, share prices are determined by the interplay of supply and demand for the
shares, liquidity and market sentiment. In turn, these are fuelled by individual
judgements (based on facts, and sentiment) as to the likely future dividends and prices
– and may not always be driven by the directors’ calculations of earnings and net
present value. However, we would expect the share price in the long-term to reflect its
intrinsic value which will be driven by the investment rate, the growth rate and the cost
of equity.

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Question 3

a) Degree of operating leverage

DOL at N$1 mil sales level = Q(p –vc)

Q(p –vc) – FC

= 50 000(20 – 8)
50 000(20 – 8) – 200 000

= 1.5

Degree of financial leverage

DFL at N$400 000 level of EBIT = EBIT

EBIT – I

= N$400 000
N$400 000 – 125 000

= N$400 000
N$275 000

= 1.45

Combine leverage effect

DTL = DOL x DFL

= 1.5 x 1.45
= 2.18

b) Earnings per share

Stock financing Debt financing

Sales 1 000 000 1 000 000
Variable costs (200 000) (200 000)
Fixed operating costs(400 000) (400 000)
EBIT 400 000 400 000
Less interest (125 000) (195 000)
Profit before tax 275 000 205 000
Income tax at 40% (110 000) (82 000)
Net income 165 000) 123 000
No. of shares 120 000 100 000
EPS N$1.38 N$1.23

Combined leverage effect

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Stock financing
DTL = Q(p –vc)
Q(p –vc) – FC – I

= 50 000 (20 – 4)
50 000(20 – 4) – 400 000 – 125 000

= N$800 000
N$275 000

= 2.9

Debt financing

DTL = 50 000 (20 – 4)

50 000(20 – 4) – 400 000 – 195 000

= N$800 000
N$205 000

= 3.90

c) The debt financing will have the greatest impact because it has a higher degree of
total leverage than equity financing. Any example may be given, but the point is to
show the percentage changes in EPS, not absolute EPS only.