Assignment 5 feedback

Dear student,
Before continuing reading through the feedback to assignment 5, let me first congratulate you
on making it this far through the academic year. The past two years have been challenging for
many, for various reasons and while you were busy adapting to the new state of things you
have progressed with your studies. This deserves a commendation, well done.
Assignment 5 contained a capital structure decision making case. We broke it up into smaller
pieces for you so that you can learn how to structure your answers in larger cases, which
would carry over to how you structure your reports at work (now or in the future). It is important
to be able to structure your thoughts and process clearly when doing this type of analysis. In
practice, your work will be read or used by many others, so it must be relatively easy to
understand and follow. It should also be concise. Take this into account for your evaluations
as you will get a case in the examination.
Question two of assignment 5 dealt with a NAL analysis. It is recommended that you use the
incremental approach as shown in the textbook and the learning units as it is the more clear
and followable approach. It is also a bit shorter and saves some typing time in an exam setting.
In some cases, the marking of your assignments may differ slightly from one another as the
markers could apply some discretion in each case. Your technique could attract some marks
because your logic and arguments commonly generally differ between submissions. As an
example, in some cases two submissions may have the similar calculations and workings, but
in one the technique employed is evident through labelled calculations whereas in the other
the calculations are mostly bare; the one where the calculations are clearly labelled and the
marker could see the logic employed may attract a method (or technique) mark for a partially
correct method employed (at the discretion of the marker).

Before we get to the feedback, please note the following administrative issues:

• Assignment 6 is due on the 30th of November, please ensure that you do it when you
get time. No late submissions will be allowed without a valid doctor’s letter or a death
certificate for a close relative. It is only six questions and is quite short, so no other
excuses will be accepted as there is plenty of time to submit the assignment.
• Assignment 7 will be opened in December but does not count towards your year mark.
• Revision materials will be made available in December also.
• We do not know the exam date for the January/ February examination yet.
• When you e-mail me, please, use only your myLife e-mail account and place your
student number in the subject line to make it easier to track and follow up on your
queries (to make it easier to copy and paste them into other systems, or for in case
your query is forwarded on, it is easier to search for them on my side).
Question 1 (30 Marks)

a.) The company requires R10 000 000 + R20 000 000 = R30 000 000

If transaction costs are 10%, that means that the company will raise 20c * 0.9 = 18c
per right issued.

The company would have to issue : R30 000 000 ÷ 0.18 = 166 666 667, shares in
order to raise the amount of funds it requires.

b.) To calculate the WACC, the weights in the new structure is required and so also the
costs. The get the weights, we need to find the theoretical market capitalisation and
the value of debt after the issue.
Remember, from learning unit 7 that for the WACC calculation, market values are used
rather than book values. Therefore, the estimated market value is used for the WACC
calculation, but book values are used for the D/E ratio, Hamada’s equation and the
ROE.

The theoretical value per share would be :

[(0.20 x 166 666 667) + (1 x 10 000 000)] ÷ (10 000 000 + 166 666 667) = 43 333 333
÷ 176 666 667 = 24.53c

Note: This is simply the market price per new share offered in the rights issue,
multiplied by the amount of rights issued plus the old market value of the shares
multiplied by the old amount of shares in issue; and all then divided by the total amount
of shares in issue.

Equity value market value: [(0.20 x 166 666 667) + (1 x 10 000 000)] = 43 333 333

Value of debt: R40 000 000 – R20 000 000 = R20 000 000

Assets = Equity + Liabilities = R63 333 333

Therefore the weight of equity is: R43 333 333 ÷ R63 333 333 = 68.42%
Weight of debt = 100% – 68.42% = 31.58%

To find the costs, we would require an estimated beta and use that in CAPM to get the
cost of equity, while the cost of debt will have to equal the book cost of debt as that is
the only available data to work with.

Old D/E = 40 000 000 ÷ 10 000 000 = 4

New D/E = R20 000 000 ÷ R40 000 000* = 0.5

*Here the book value is used and not the market value.

Un-lever beta: BU = BL ÷ (1 + D/E(1-T)) = 1.9 ÷ 3.88 = 0.49

Re-lever at the new D/E ratio: BL = BU x (1 + D/E(1-T)) = 0.49 x 1.36 = 0.67
 Plug the values into CAPM: Re = Rf + B(MRP) = 4% + 0.67(6%) = 8.02%
Calculate the book cost of debt: Kd = R4 000 000 ÷ R40 000 000 = 10%

Then, the WACC is = (8.02% x .6842) + (10% x 0.72 x 0.3158) = 5.49 + 2.27 = 7.76%

c.)
Current ROE:
Profit before tax: R5 000 000 – R4 000 000 = R1000 000
Profit after tax = R1 000 000 x 0.72 = R720 000
ROE = R720 000 ÷ R10 000 000 = 7.2%

New:
Profit before tax: R5 000 000 – R2 000 000* = R3 000 000
*Due to the lower interest payment that needs to be made
Profit after tax: R3 000 000 * 0.72 = R2 160 000
ROE = R2 160 000 ÷ R40 000 000 = 5.4%

d.) Old EPS = R720 000 ÷ 10 000 000 = 7.2c

New EPS: R2 160 000 ÷176 666 667* = 1.2c
*This is the new amount of shares outstanding: 10 000 000 + 166 666 667

e.)
The question was:
“Considering the broader case and not just the EPS, briefly argue for or against the rights
issue and restructuring plan and provide at least one real-world example of a company that
used a rights issue to raise funds and the subsequent performance of the company to staff
your argument. “

Here, the need was to discuss the rights issue and restructuring. There were many angles to
discuss this from, but primarily risk changed (evident in the change in beta), performance
changed (evident in the change in ROE and EPS), the cost of capital would change; any or all
of these could have been discussed in varying degrees. It was important though that the
discussion was argued with a logical, theoretical plausible argument at the hand of the above
calculations. A real world example (of any sort and from any source, was accepted.
Question 2 (15 Marks)
The financing option has the same cost as the company’s cost of debt, therefore the net
present cost of this option is simply equal to its cost of R500 000 and no amortisation was
needed.

NAL table Year 0 Year 1 Year 2 Year 3 Year 4

Lease
R-90 000 R -90 000 R-90 000 R-90 000
payment

Tax shield
R 25 200 R 25 200 R 25 200 R 25 200
from lease payment

NPC of
R500 000
borrowing alternative

Depreciation
R-35 000 R-35 000 R -35 000 R -35 000
tax shield foregone

Residual value foregone

-R -40 000

Recoupment tax avoided

R 11 200

Net maintenance avoided R 28 800 R 28 800 R 28 800 R28 800

Net flows R500 000 R-71 000 R-71 000 R-71 000 R-99 800

NAL @7.2% R 238 781.98

Therefore, it would be better to lease the machine than to borrow and buy it.