Financial Management 3B

BSR3B01/FNM03B3

ASSESSMENT OPPORTUNITY 1

27 August 2018

TIME: 100 Minutes MARKS: 75

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ASSESSORS: Mr S Modiba
Ms M Hlobo

MODERATOR: Ms W Mabuto

INSTRUCTIONS TO CANDIDATES

1. This paper consists of 8 pages.

2. The total of 100 Minutes comprises of 10 minutes reading time and 90 minutes writing
time.
3. The reading time will be before the writing time begins during which you should read the
question paper and, if you wish, highlight and/or make notes on the question paper.
However, you will not be allowed, under any circumstances, to open the answer book
and start writing or use your calculator during this reading time.
4. You are reminded that answers may NOT be written in pencil. NO tippex may be used.
5. Show all calculations clearly.
6. Silent, non-programmable calculators may be used, unless otherwise instructed.
7. Where applicable, round all amounts to the nearest Rand.
8. 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 15 18
2 10 12
3 10 12
4 15 18
5 25 30
Total 75 100
MODULE: Financial Management (BSR3B01/FNM03B3) (AO1 – 27 AUGUST 2018) Page 2 of 8

SECTION A [15 marks]

QUESTION 1 (15 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 existence of _______ on the statement of financial position generates tax advantage that
directly influences the capital structure of the firm.

A a large proportion of fixed assets.

B long-term debt.
C retained earnings.
D preference shares (1)

Question 1.2

Assume that the economy has unexpectedly and immediately gone into a recession. Which of
the following firms that are in the same industry and exposed to the same business risks would
most likely experience the largest increase in the present value of bankruptcy costs?

A A firm with the highest proportion of equity financing.

B All firms will see an identical rise in the present value of bankruptcy costs since the
business risk is the same.
C A firm with the highest proportion of debt financing.
D A firm with the lowest proportion of debt financing. (1)

Question 1.3

An increase in leverage is likely to result in a(n):

A increase in business risk and returns.

B increase in financial risk and returns.
C decrease in financial risk and returns.
D decrease in business risk and returns. (1)

Question 1.4

The flotation costs for a firm is computed as:

A the mathematical average of the flotation costs of both debt and equity.
B the weighted average of the flotation costs associated with each form of financing.
C 50% of the flotation cost of debt plus 50% of the flotation cost of equity.
D a weighted average based on the book values of the firm’s debt and equity. (1)
MODULE: Financial Management (BSR3B01/FNM03B3) (AO1 – 27 AUGUST 2018) Page 3 of 8

Question 1.5

The cost of capital assigned to an individual project should be the rate which:

A corresponds to the risk level of the firm’s division which has responsibility for the
project.
B corresponds to the latest pre-tax cost of debt and equity for the overall company.
C is the industry’s current weighted average cost of capital.
D considers both the nature and the characteristics of the actual project. (1)

Question 1.6

Power Limited is evaluating a 5 year project with a positive NPV of R250 000. The project requires
an initial investment of R500 000.The company has an estimated WACC of 16%.

Identify which of the following statements are correct regarding the project.

I. The project has a profitability index of 0.5

II. The project has a payback period of 7 years
III. The project’s internal rate of return (IRR) is 12%.
IV. The project has a profitability index of 1.5
V. The project’s discounted payback period is not more than 5 years

A I, II and V.
B I, III and V.
C I, III and IV.
D IV and V. (2)

Question 1.7

The ordinary shares of Blue Bird Limited have a required return of 8% and a growth rate of 4%.
The recent annual dividend was R0.60 a share.

Calculate the current price of this share.

A R7.50
B R7.80
C R15.00
D R15.60 (2)

Question 1.8

Ben’s Ice Cream just paid an annual dividend of R0.75 a share. The share has a market price of
R32 and a beta of 0.90. The return on Government bonds is 4% and the market has a 12%
average return per annum.

Calculate Ben’s cost of equity capital.

A 7.24 %
B 8.67 %
C 11.20 %
D 12.92 % (2)
MODULE: Financial Management (BSR3B01/FNM03B3) (AO1 – 27 AUGUST 2018) Page 4 of 8

Question 1.9

Teri’s Tyres has 7% preference shares outstanding that trade at R68 per share. Similar
preference shares currently yield a return of 10.29%.

Calculate the book value of Teri’s preference shares.

A R46.26
B R68.00
C R60.00
D R99.96 (2)

Question 1.10

Auto Group has 1 200 bonds outstanding that are selling for R980 each. The company also
has 7 500 preference shares trading at a market price of R40 each. The ordinary shares
are priced at R32 per share and there are 32 000 shares outstanding.

Calculate the weight of the preference shares as it relates to the company’s weighted
average cost of capital.

A 10 %
B 12 %
C 14 %
D 16 % (2)

“End of Section A”
MODULE: Financial Management (BSR3B01/FNM03B3) (AO1 – 27 AUGUST 2018) Page 5 of 8

SECTION B [35 marks]

QUESTION 2 (10 marks)

VU = Value of an unlevered Firm

VL = Value of a levered Firm
TC x D = Present value of interest tax shield

REQUIRED:

2.1 Identify and explain the Modigliani and Miller proposition depicted in the diagram
above. (3)

2.2 Explain the concept of optimal capital structure in relation to the diagram
depicted above. (3)

2.3 Briefly explain the implications of Modigliani and Miller proposition II on the cost
of equity capital. (4)
MODULE: Financial Management (BSR3B01/FNM03B3) (AO1 – 27 AUGUST 2018) Page 6 of 8

QUESTION 3 (10 marks)

Dimension Ltd has a target capital structure of 60% debt and 40% equity. The company is
currently assessing the viability of a capital project that has an initial investment of R5 million and
a positive net present value (NPV) of R457 800. The NPV was calculated without taking into
account flotation costs. The project will be financed using external funding.

The directors of Dimension are of the opinion that the weighted average cost of capital (WACC)
should be adjusted to reflect the impact of flotation costs. They have requested you to assist in
finalizing the NPV calculation which will be used to either accept or reject the capital project.
Dimension has a WACC of 16%. The flotation costs of equity are 12% of the amount raised and
flotation costs of debt are 7% of the amount raised.

REQUIRED:

3.1 State whether it is correct to adjust the WACC to reflect the impact of flotation
costs. Provide a reason for your answer. (2)

3.2 Assuming that the WACC should not be adjusted to reflect the impact of flotation
costs, explain how flotation costs should be accounted for when calculating
NPV. (2)

3.3 Calculate the weighted average flotation costs of Dimension Ltd. (3)

3.4 Assuming that the weighted average flotation costs of Dimension is 10%,
calculate the correct NPV of the project (after taking into account flotation costs). (3)
MODULE: Financial Management (BSR3B01/FNM03B3) (AO1 – 27 AUGUST 2018) Page 7 of 8

QUESTION 4 (15 marks)

Zarah is a clothing retail company listed on the JSE. Zarah specialises in designing and
manufacturing African traditional clothing. The following information is extracted from Zarah’s
Annual Financial Statements:

R’000
Issued equity
3 000 000 ordinary shares 1 500

Issued long term debt:

12% Long term loan 1 500

Additional information:
• Ordinary shares trade at R10.44 per share.
• During the last 4 years the JSE had an average return of 16% per annum.
• Government bonds yield the following returns:
Bond R157 13% (Matures in a year’s time)
Bond R186 9.3% (Matures in 10 years’ time)
• The long term loan forms part of the permanent capital structure of Zarah. Similar long term
loan can be replaced at a rate of 14%.
• Zarah has a beta of 1.3. The retail sector on the JSE has a beta of 1.4 and the JSE (market)
has a beta of 1.002.
• Assume the South African company tax rate is applicable.

REQUIRED:

4.1 Calculate the weighted average cost of capital (WACC) for Zarah Limited. (10)

4.2 Briefly comment on how Zarah may use the WACC calculated in 4.1 above. (2)

4.3 Briefly discuss some of the disadvantages of increasing debt as a permanent

source of finance in the current capital structure. (3)

“End of Section B”
MODULE: Financial Management (BSR3B01/FNM03B3) (AO1 – 27 AUGUST 2018) Page 8 of 8

SECTION C [25 marks]

QUESTION 5 (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 company currently sells 15 000 units of product UAV001 at a contribution
of R35 per unit. This product was first introduced in the market 3 years ago and it is anticipated
that it will be available for sale for the next 3 years.

Flymax is considering replacing UAV001 with a much more technologically advanced product
UAV001S. It is anticipated that UAV001S will sell 5 200 more units than UAV001 annually.
Product UAV001S will require and initial investment in machinery of R650 000. It is expected that
the production of UAV001 will be discontinued once the production of UAV001S resumes. The
existing machinery (purchased 3 years ago for R400 000 and can only be used to produce
UAV001) can be sold for R140 000 currently. If not sold, the existing machinery can still be used
for a further 3 years and will have a salvage value of nil in 3 years’ time.

It is expected that UAV001S will be sold at a contribution of R45 per unit over the next 4 years
and thereafter the product will be discontinued. Machinery used to produce this product will have
a salvage value of R70 000 in 4 years’ time. The company estimates the useful life of machinery
to be 6 years. SARS allows wear and tear on machinery at 25% per annum. Company tax rate is
28%

The production of UAV001S will require an initial investment in working capital of R100 000 at
the end of the first year of production. Working capital investment will increase by 10% in the
following year and there after it is expected that only 90% of the total investment will be recouped
at the end.

Flymax will have to appoint a production manager to manage the production of UAV001S. The
manager will be transferred from another department (and not replaced as he was to have been
retrenched). The manager was due to be retrenched now and in terms of his employment contract
he is to receive a lump sum of R100 000 upon retrenchment. The manager will be retained and
paid his current annual salary of R200 000. The manager will then be retrenched in four years’
time under the same retrenchment terms. Assume normal company tax is applicable on
retrenchment lump sums.

Flymax will incur additional manufacturing overheads of R30 000 per annum (excluding
production manager’s salary) in order to produce UAV001S. Head office costs allocated to the
production department will increase by R10 000 per annum as a result of UAV001S production.

REQUIRED:

5.1 Briefly discuss the relevance of wear and tear when evaluating future capital
projects. (2)

5.2 Assuming the appropriate discount rate is 15%, advice whether management of
Flymax should replace product UAV001 with UAV001S.
Hint: Calculate the net present value (NPV). (20)

5.3 Calculate the internal rate of return (IRR) of the cash flows in 5.2 above and
also explain why NPV is superior to IRR. (3)