DEPARTMENT OF ACCOUNTANCY

FINANCIAL MANAGEMENT 3B

ASSESSMENT OPPORTUNITY 1: 28 AUGUST 2017

TIME: 130 Minutes MARKS: 100

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ASSESSORS: Mr S Modiba
Ms M Dolamo

MODERATOR: Ms W Mabuto

INSTRUCTIONS TO CANDIDATES

1. This paper consists of 10 pages.

2. You are reminded that answers may NOT be written in pencil. NO tippex may be used.
3. The marks shown against the requirement(s) for every question should be regarded as an
indication of the expected length and depth of your answer.
4. Answer the questions by the use of:
- effective structure and presentation;
- clear explanations;
- logical arguments; and
- clear and concise language.
5. Show all calculations clearly.
6. Round all amounts to the nearest Rand.
7. All open spaces must be crossed out with a pen. Failure to cross out the open spaces will
disqualify you from handing in your script for a remark.

Question Marks Time allocated (minutes)

Reading -- 10
1 25 30
2 10 12
3 15 18
4 25 30
5 25 30

Total 100 130

MODULE: Financial Management (BSR3B01) (AO1 – 28 AUGUST 2017) Page 2 of 10

SECTION A [25 marks]

QUESTION 1 (25 marks)
[Where applicable, round all answers to the nearest rand]

Select the correct option by WRITING the corresponding letter of the answer on the answer sheet.

Question 1.1

The unlevered cost of capital is:

A the cost of capital for a firm with no equity in its capital structure.
B the cost of capital for a firm with no debt in its capital structure.
C the cost of preference shares for a firm with equal parts debt and ordinary shares in
its capital structure.
D the interest tax shield times pre-tax net income. (1)

Question 1.2

The equity risk derived from a firm’s capital structure policy is called:

A market risk.
B systematic risk.
C business risk.
D financial risk. (1)

Question 1.3

A firm should select the capital structure which:

A produces the highest cost of capital.

B minimizes taxes.
C maximizes the value of the firm.
D has no debt. (1)

Question 1.4

When a firm is operating with the optimal capital structure:

I. the debt-equity ratio will also be optimal.

II. the weighted average cost of capital will be at its minimal point.
III. the required return on assets will be at its maximum point.
IV. the weighted average cost of capital will be equal to the after tax cost of debt.

A I and II only.
B II and III only.
C II, III, and IV only.
D I, III, and IV only. (1)
MODULE: Financial Management (BSR3B01) (AO1 – 28 AUGUST 2017) Page 3 of 10

Question 1.5

Your firm uses both preference and ordinary shares as well as long-term debt to finance its
operations. Which one of the following will increase the capital structure weight of the debt, all
else equal?

A A decrease in the market price of the ordinary shares.

B An increase in the number of shares of preference shares outstanding.
C A decrease in the quoted price of the firm’s bonds as a percentage of face value.
D The redemption of debentures at par value. (1)

Question 1.6

The ordinary shares of Bingo Limited have a required return of 20% and a growth rate of 4%. The
recent annual dividend was R60 a share. What is the current price of this share?

A R390
B R375
C R300
D R250 (2)

Question 1.7

Togota Limited has a beta of 1.2 and an expected annual dividend growth rate of 4%. Togota has
12% bonds that currently yield a return of 11 percent. The market currently has an average return
of 18% and a risk premium of 8%. What is the expected cost of equity for Togota Limited?

A 20.00%
B 21.60%
C 19.60%
D 20.60% (2)

Question 1.8

Fairview Travels has a target debt ratio of 55 per cent. The ordinary shareholders of Fairview
currently require a return of 19% and the after tax cost of debt is 9%. What is the expected
weighted average cost of capital of Fairview Travels?

A 13.5%
B 14.5%
C 15.45%
D 12.55% (2)

Question 1.9

The market risk premium:

A varies over time as both the risk-free rate of return and the market rate of return vary.
B plus the risk-free rate of return equals the cost of capital for any firm with a beta of
zero.
C is equal to the risk-free rate of return multiplied by the beta of a firm.
D is equal to one per cent for a risk-free asset. (1)
MODULE: Financial Management (BSR3B01) (AO1 – 28 AUGUST 2017) Page 4 of 10

Question 1.10

The dividend growth model:

A generally produces the same estimated cost of equity for a firm regardless of the
source of information used to predict the rate of growth.
B can only be used if historical dividend information is available.
C is applicable only to firms that pay a constant dividend.
D ignores the risk that future dividends may vary from their estimated values. (1)

Question 1.11

The outstanding debentures of Power Limited are priced at R898 each. These debentures have
a 10% coupon and pay interest annually. The debentures are non-redeemable and have a par
value of R1 000 each. The company’s tax rate is 28%. What is Power Limited’s after-tax cost of
debt?

A 7.2%
B 10%
C 11.14%
D 8.02% (2)

Question 1.12

The most valuable investment given up if an alternative investment is chosen is a(n):

A salvage value expense.

B sunk cost.
C opportunity cost.
D erosion cost. (1)

Question 1.13

Incurred expenses that relate to a feasibility study of an investment in a project is called:

A salvage value expenses.

B sunk costs.
C opportunity costs.
D erosion costs. (1)

Question 1.14

Which one of the following statements concerning net present value (NPV) is correct?

A An investment should be accepted if, and only if, the NPV is exactly equal to zero.
B An investment should be accepted only if the NPV is equal to the initial cash flow.
C An investment should be accepted if the NPV is positive and rejected if it is negative.
D An investment with greater cash inflows than cash outflows, regardless of when the cash
flows occur, will always have a positive NPV and therefore should always be accepted.
(1)
MODULE: Financial Management (BSR3B01) (AO1 – 28 AUGUST 2017) Page 5 of 10

Question 1.15

Dee-dee Ltd is considering investing in two competing projects: Gee-gee and Bee-bee. Gee-gee
has a net present value (NPV) of R16 500 and an internal rate of return (IRR) of 17%. Details of
the estimated cash flows of Bee-bee are as follows:

Cash flows R000

Year 0 (200)
Year 1 120
Year 2 60
Year 3 80

The business has a cost of capital of 10%.

Which one of the following combinations is correct concerning the NPV and IRR of the two
projects?

Project
Gee-gee Bee-bee
A Higher NPV Higher IRR
B Higher NPV Lower IRR
C Lower NPV Higher IRR
D Lower NPV Lower IRR (2)

Question 1.16

An increase in which one of the following will increase the operating cash flow?

A Employee salaries
B Office rent
C Building maintenance
D Taxation wear and tear allowance of machinery. (1)

Question 1.17

A project will increase sales by R140 000 and cash expenses by R95 000. The project will require
an initial investment in assets of R100 000 which will be written off for taxation purposes at 25%
per annum. The South African company tax rate is applicable. The project has a useful life of four
years. What is the annual wear and tear tax shield?

A R6 650
B R7 000
C R9 800
D R12 600 (2)
MODULE: Financial Management (BSR3B01) (AO1 – 28 AUGUST 2017) Page 6 of 10

Question 1.18

Jozi Life (Pty) Ltd is considering accepting a project with a NPV index of 1.10. The project life is
5 years with a NPV of R5 750. The initial cost of the project can be calculated as:

A R63 250
B R57 500
C R5 750
D Impossible to calculate (2)

“End of Section A”
MODULE: Financial Management (BSR3B01) (AO1 – 28 AUGUST 2017) Page 7 of 10

SECTION B [25 marks]

QUESTION 2 (10 marks)

RE: Cost of Equity of entity with debt

RU: Cost of Equity of entity without debt
WACC: Weighted Average Cost of Capital
RD: Cost of debt before taxation
TC: Corporate tax rate

REQUIRED:

2.1 With reference to the capital structure proposition depicted in the diagram
above, explain why the cost of equity will be different for an entity with debt as
compared to an entity without debt. (3)

2.2 Briefly explain what is meant by “the traditional capital structure theory”. (7)
MODULE: Financial Management (BSR3B01) (AO1 – 28 AUGUST 2017) Page 8 of 10

QUESTION 3 (15 marks)

Fat-koek Palace Pty (Ltd) is considering investing in one of the following mutually exclusive
machinery. The company’s board of directors has set cost of capital at 9%.The cash flows
associated with the two machinery are as follows:

Year Machine X Machine Y

0 (R80 000) (R75 000)
1 R22 500 R37 500
2 R22 500 R30 000
3 R22 500 R15 000
4 R22 500 R15 000
5 R30 000 R15 000
6 R30 000 R15 000

REQUIRED:

3.1 Advise management of Fat-Koek which machinery they should invest in.
Note: Calculate the Net Present Value Index (NPVI) of each machinery. (7)

3.2 Describe two advantages of the Net present Value (NPV) method. (2)

3.3 Describe six qualitative factors that management of Fat-koek should consider
before investing in either one of the two machinery. (6)

“End of Section B”
MODULE: Financial Management (BSR3B01) (AO1 – 28 AUGUST 2017) Page 9 of 10

SECTION C [50 marks]

QUESTION 4 (25 marks)

Flymax Ltd (Flymax) is a South African technology company based in Johannesburg. Flymax
manufactures unmanned aerial vehicles (UAV), also known as drones, for aerial photography
and videography. The current capital structure of Flymax is presented below at book value:

R
Share Capital 2 000 000
Retained earnings 525 065
16% Preference shares 10 000 000
10% Loan term loan 30 000 000
42 525 065

The board of Flymax has requested you to assist in the calculation of the appropriate discount
rate to be used to evaluate future capital projects.

Flymax has 1 000 000 shares in issue. The company recently paid a dividend of 80 cents per
share. It is anticipated that the dividend will grow by 10% in the first year, 20% in the second year
and thereafter maintain a constant growth rate of 7% per annum. Flaymax shareholders currently
require a return of 20%.

Preference share currently trade at a discount of 5%. Preference shares are considered to form
part of the permanent capital structure of the company.

The loan will be redeemed in five years’ time at par. Flymax can currently obtain a similar loan at
a market related rate of 14%.

REQUIRED

4.1 Calculate the appropriate discount rate that Flymax should use in evaluating
future capital projects. (20)

4.2 Explain why the discount rate calculated in 4.1 above is appropriate for
evaluating future capital projects of Flymax Ltd. (5)
MODULE: Financial Management (BSR3B01) (AO1 – 28 AUGUST 2017) Page 10 of 10

QUESTION 5 (25 marks)

Mbombie (Pty) Ltd is a craft beer manufacturing company .The Management of Mbombie is
currently evaluating an investment in a new machine. The financial manager of Mbombie supplied
you with the following information relating to the new machinery:

Initial feasibility study costs (Incurred but still

outstanding) R7 200
Current cost of machine (to be incurred at the
beginning of the project - 2017) R60 000
Residual value at the end of the useful life of the
project R3 000
Useful life 5 years
Weighted Average Cost of Capital 10%

Cost per beer can :

Materials R10.00
Labour R5.00
Variable overheads R2.00
Selling price per unit R25

Fixed costs per annum: R108 000

Production of craft beer cans per annum: 45 000 cans

It is expected that the revenue and production costs will increase by 6% p.a.

Because the new machine is equipped with a computer system, the company will also have to
employ a new operator trained to work with such technology. The new operator’s salary is
R3 200 per month and is also subjected to 6% annual increase.

The machine will qualify for the S12 C tax allowance of 20% per annum. The higher production
capacity will result in a higher investment in working capital being required. Assume the working
capital closing balances at the end of each year are as follows:

Year Amount ( R)
2017 24 000
2018 36 000
2019 42 000
2020 42 000
2021 48 000

Assume the corporate South African tax rate is applicable.

REQUIRED:

5.1 Advise the management of Mbombie (Pty) Ltd whether they should invest in the
craft manufacturing machine (Use Net present Value calculation to support your
answer). (25)

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