The University of the South Pacific

Serving the Cook Islands, Fiji, Kiribati, Marshall Islands, Nauru, Niue,
Samoa, Solomon Islands, Tokelau, Tonga, Tuvalu, and Vanuatu.

GRADUATE SCHOOL OF BUSINESS

___________________________________________________________

MBA 436: FINANCE

Trimester 2, 2018

Time Allowed 3 hours plus 10 minutes reading

100 marks (40% of final grade)

INSTRUCTIONS

1. This exam has four questions:

a. Question 1: 15 marks (approximately 25 minutes)

b. Question 2: 35 marks (approximately 60 minutes)

c. Question 3: 50 marks (approximately 95 minutes)

2. Answer ALL questions. There are no choices.

3. Write your answers in the answer booklet provided.

4. Begin answering each question on a fresh page.

5. You can use calculators.

6. This exam is worth 40% of your overall mark. The minimum exam
mark is 16/40.

7. Note that you must attain at least 16/40 in order to pass the course

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QUESTION ONE: Cost of Capital (15 Marks) Time: 25 minutes
Greigs Construction Limited is attempting to evaluate three alternative
capital structures – A, B, and C. The following table shows the three
structures along with relevant cost data. The firm is subject to a 40
percent marginal tax rate. The risk-free rate is 5.3 percent and the market
return is currently 10.7 percent.

Item A B C
Debt ($ million) 35 45 55
Preferred Shares($ million) 0 10 10
Ordinary Shares ($ million) 65 45 35
Total capital ($ million) 100 100 100

Debt (yield to maturity) 7.00% 7.50% 8.50%

Preference shares dividend --- $2.80 $2.20
Preference Share (price) --- $30.00 $21.00
Beta 0.95 1.1 1.25

REQUIRED

a. Calculate the after-tax cost of debt for each capital structure.

b. Calculate the cost of preferred shares for each capital structure.
c. Calculate the cost of ordinary shares for each capital structure.
d. Calculate the weighted average cost of capital (WACC) for each
capital structure.
e. Compare the WACCs calculated in part (d) and discuss the impact of
the firm’s financial leverage on its WACC and its related risk.

QUESTION TWO: Recapitalisation (35 Marks) Time: 60 minutes

VISHAL BHARTIYA LIMITED RECAPITALISATION

Vishal Bhartya Limited (VBL) was founded 28 years ago by the Niranjan’s
family and currently led by Bob Niranjan. The company is listed on the
South Pacific Stock Exchange. The company owns commercial real estate
and rents its property to Eurocars and other tenants. The company has
shown a profit every year since it was listed. The shareholders are satisfied
with the company’s management. Like a typical family founded businesses
in Fiji, the Niranjan’s are not keen in using long term debt to finance VBL.
As a result, the company is entirely equity financed, with 4 million shares
outstanding. The shares currently trade at $2.50 per share.

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VBL is evaluating a plan to purchase a commercial property just outside
Nadi town for $5 million. The property will be leased to Eurocars. This
investment is expected to increase VBL’s annual pre-tax earnings by $1
million in perpetuity. Aruna Kaitewera, the company’s CFO, has been put in
charge of this project. Aruna has determined that the company’s current
cost of capital to be 10.5%. Aruna is evaluating whether the company
should issue debt to finance the project entirely. Based on some
conversations with VBL’s bank, she determines that the company can
borrow the required funds at 6%. From her analysis, she also believes that
a capital structure in the range of 50% equity/ 50% debt would be optimal.
If the company goes beyond 50% debt, interest rates will increase
significantly. VBL has a 10% corporate tax rate.

QUESTIONS

1. If VBL wishes to maximise its total market value, would you recommend
that it use debt or equity to finance the purchase? Explain.

2. Construct VBL’s market value balance sheet before it announces the

purchase.

3. Suppose VBL decides to issue equity to finance the purchase.

a. What is the net present value of the project?

b. Construct VBL’s market value balance sheet after it announces that

the firm will finance the purchase using equity.

c. What would be the new price per share of the VBL’s shares?

d. How many shares will VBL need to issue to finance the purchase?

e. Construct VBL’s Market Value Balance Sheet after the equity issue
but before the purchase.

f. What is the share price after the equity issue but before the
purchase is made?

g. Construct VBL’s Market Value Balance Sheet after the purchase has
been made.

4. Suppose VBL decides to use debt to finance the entire purchase.

a. What will be the market value of VBL if the purchase is financed

with debt?

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 b. Construct VBL’s Market Value Balance Sheet after both the debt
borrowing and the purchase.

c. What is VBL’s share price after both debt borrowing and the
purchase?

5. Which method of financing maximises VBL’s share price and why?

QUESTION THREE: Capital Budgeting (50 Marks) Time: 95

minutes
MAGNETICS CORPORATION

Magnetics Corporation (MC) is an electronics manufacturer in India. The

company’s managing director is Gregranis Singh, a recent MBA graduate,
who inherited the company from her father. The company originally
repaired radio telephones when it was founded more than 60 years ago.
Over the years, the company has expanded, and it is now a reputable
manufacturer of wireless and mobile telephones.

One of the major revenue-producing items manufactured by MC is a smart

phone. MC currently has one smart phone model on the market and sales
have been excellent. The smart phone is a unique item in that it comes in a
variety of colours and is pre-programmed to play Justine Bibber’s music.
However, as with any electronic item, technology changes rapidly, and the
current smart phone has limited features in comparison with newer models.
MC has spent $750 000 developing a prototype for a new smart phone that
has all the features of the existing one, but adds new features, such as Wifi
Tethering. The company has spent a further $200 000 for a marketing study
to determine the expected sales figures for the new smart phone.

MC’s production manager has produced estimates of the costs associated

with manufacture of the new smart phone. Variable costs are estimated at
$205 per unit and fixed costs for the operation are expected to run at $5.1
million per year. The estimated sales volume is 64 000 units in Year 1;
106 000 units in Year 2; 87 000 units in Year 3; 78 000 units in Year 4; and
54 000 units in the final year. The unit price of the new smart phone will be
$485. The necessary manufacturing equipment can be purchased for $34.5
million and will be depreciated for tax purposes over a seven-year life
(straight-line to zero). It is believed the value of the manufacturing
equipment in five years’ time will be $5.5 million. The company has enough
cash to invest in the project.

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Net working capital for the smart phones will be 20% of sales and will have
to be purchased at the end of the year. The cost of the raw materials is
reflected in the variable unit cost. Changes in NWC will first occur at the
end of Year 1 based on the first year’s sales.

MC has 30% corporate tax rate, a target capital structure of 50% debt
and 50% equity, cost of borrowing of 8% and a 12% return on equity.

The Board has asked Gregranis to assess the financial viability of the new
smart phone.

QUESTIONS

1. What is the payback period of the project?

2. What is the profitability index of the project?

3. What is the IRR of the project?

4. What is the NPV of the project?

5. How sensitive is the NPV to a $10 increase in the price of the new
smart phone?

6. Should MC proceed with the production of the new smart phone?

7. Suppose MC loses sales on other models because of the introduction of

the new model. How would this affect Gregranis analysis?

FORMULAS
WACC = E/V (Re) + Ps/V (Rps) + D/V (Rd) (1-Tc)

Re= R + (R-Rd) D/E

PV Interest Tax Shields = Tc x Debt

VL = VU + PV Interest Tax Shields

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NPV = - CFO + CF [1-(1+r)-n ]
r
NPV = - CFO + CF (1+r)-1

NPV = - CFO + CF [1-(1+r)-n ] (1+r)

r
NPV =X/(1+r)1+X/(1+r)2 +X/(1+r)3+…+X/(1+r)n =
EAC

CFFA = EBIT – TAX + Dep - ∆FA - (∆CA - ∆AP - ∆

Accrual)

P0 = D0 (1+g)1/ (1+r)1 + D0 (1+g)2/ (1+r)2 +....+ D0

(1+g)N/ (1+r)N + [ 1/(1+r)N X D0 (1+g)N+1/ r-g2 ]

g = rr x ROE

Vs = VF – V D - VP
E(RA) = Rf + βA [E(Rm) – Rf]

R = D1/P0 + (P1-P0)/P0
R = D1/P0 + g
P = C [1-(1+r)-t]/r + F(1+r)-t

PVA = C [1-(1+r)-t]/r