FIN4801 Practice cases

These narratives are provided to guide your answers in the Practice case studies. See the
guidelines, but keep in mind, other answers may be acceptable also. Keep in mind that there
are other possible correct ways to answer the same question. Guidance is given in italics.
You need not number your calculations quite as extensively, if you work clearly and number
the calculations that are used in the evaluation, it should suffice.

Case 1

This case basically encompasses dividend payouts, capital structure decision making, other
issues in capital structure decision making and financial ratio analysis.

The first thing to take into account is that there are specific requirements that you must meet.
You can see that, specifically, financial performance, expected dividend pay-outs, the cost of
financing and risk needs to be considered.

Then there are also many other aspects one can look at that are not specifically asked for,
but we will start with the specifics as that is obviously required.

The very first thing we need to consider is whether scenario 2 is necessary at all. If the
amount of funds raised paired with retained earnings are not enough, it would be necessary
to borrow further and we need to also address scenario 2.

So let’s see:

Is Scenario 2 necessary?

The offering would have raised R122 per share – 8% = (122x.92) 112.24 per share.

The company sells 5 million of them, so in total: (5mil x 112.24 ) R 561 200 000 will be
raised.

If we add to this the current retained earnings of R300 000 000, we get R861 200 000 [A]
which is less than the required funds and therefore it will indeed be necessary to raise debt
financing for option 2.

From here, you can construct a table with the values of first, the WACC of each scenario, the
net profit, the equity and ROE then the expected dividend payout (the ratio is given and only
the Rand amount is necessary).

Scenario 1 calcuations: All equity financed.

The offering would have raised R122 per share – 8% = (122x.92) 112.24 per share. [1]

The company sells 5 million of them, so in total: (5mil x 112.24 [1] ) R 561 200 000 will be
raised.

The firm will have to raise R900 million – R861,2 million [A] = R38,8 million [3].

It can raise funds at an issuance price of R135 per share – 8% issuance cost.

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It means the firm has to issue R38,8 million / (R135 – 8%) = 312 399 shares [4]

Therefore, it will have 25 million + 312 399 [4] = 25 312 399 shares outstanding. [5]

So, its market price of equity will be: R135 x 25 312 399 [5] = R3 417,17 billion [6]

The cost of equity is given by CAPM:

Re = Rf + β(RM) = 7% + 0,9(6%) = 7% + 5,4% = 12,4% [7]

The amount of debt outstanding is given as R3 billion.

The cost thereof is 11% before tax, so the after tax cost is: 11% x (1 – T) = 8,58% [8]

No target capital structure is mentioned, so market weights should be used.

The total market value of capital is then R3 billion + R3 417 billion [6] = R6 417 billion. [9]

Weight of equity: R3,417 billion [6] ÷ R6 417 billion [9] = 53,25% [10]

Weight of debt: R3 billion ÷ R6 417 [9] = 46,75% [11]

So, the WACC will be: (12,4% [7] x 0,5325 [10]) + (8,58% [8] x 0,4675 [11]) = 10,61% [12]

The net profit for the company is then still R600 million as no interest payments are
introduced and no information regarding possible sales growth was provided.

What we need to determine next, is ROE, EPS, P/E even is possible as measures of
performance. Then, the expected dividend per share and the risk profile of the firm.

For the calculation of ROE, we need to remember that ROE makes use of the book value of
equity, which will be R4 billion from the original listing, R300 million in retained earnings,
R561,2 million and another R38,8 million raised giving a total of R4.9 billion. [13]

ROE is therefore R600 million ÷ R4900 million [13] = 12,24%.[14]

The EPS would be determinant on the amount of issued shares, which is 25 312 399
[calculation 4 + 20 000 000 in issue + 5000 000 from the book build], giving EPS of R600
million ÷ 25 312 399 = R23,07. [15a]

The P/E ratio is R135 ÷ R23,07 = 5,85 [15b]

The expected dividend is then R600 million x 20% = R120 million in total. [16]

So, R120 million ÷ 25 312 399 = R4,74 per share. (R4,61 is also OK, it’s just rounding) [17]

Discussion:

Due to the fact that the beta in the related sub-sectors where the firm is investing is similar to
that of the firm, it would mean that, given the information available, the effect of financial risk
is the only source of risk we can really comment on is that related to leverage. Technically,
the firm lowered its leverage, even though it only slightly by choosing equity only financing.
This would likely lower its financial risk slightly.

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One could use Hamada’s equation to estimate the unlevered beta and re-lever it, we will
however just comment on it as that is what was required.

The company will pay a dividend of R4,74 [17].

The total amount spent on dividend would under the current policy only be influenced by
changes in net profit, but the dividend per share would be diluted because of the new shares
issued. This would be compared to the dividend paid if debt is used.

Using equity financing only will lead to the company having a WACC of 10,61% [12].

The cost of financing needs to be compared to the other two scenarios and the performance
ratios calculated above can easily be compared to each other in a table.

ROE will be 12,24% [14] and the P/E ratio is expected to be 5,85 [15b].

Again, this will be compared to the ROE and P/E of the debt options.

We leave scenarios 2 and 3 for you to do independently.

In scenario 2, you will just finance the R38,8m shortfall with debt.

In scenario 3, you will finance the total requirement with debt.

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 Case 2

As the firm will only have to repay the loan amount at the end of the term, servicing interest
at the cost of borrowing will lead to the cost of borrowing equalling the loan amount.

Year 0 1 2 3 4

Interest payment 0 2400000 2400000 2400000 2400000

Principle 0 0 0 0 20000000

Tax shield 0 672000 672000 672000 672000

Total 1728000 1728000 1728000 21728000
NPV @ 8,64% R 20 000 000

Year 0 1 2 3 4
Lease payment 0 -7 400 -7 400 -7 400 -7 400 000
000 000 000
Tax Shield 2072000 2072000 2072000 2072000
Proceeds 0 0 0 0 0
Depreciation tax 0 -1 400 -1 400 -1 400 -1 400 000
shield forgone 000 000 000
Cost of borrowing 20 000 000
avoided
Net maintenance 1440000 1440000 1440000 1440000
avoided
Net residual value -7 200 000
Net 20000000 -5 288 -5288000 -5288000 -5288000
000
NAL -2 436 496

The net advantage of leasing is negative, therefore it would be better for the firm to borrow
and buy the machine than to lease it.

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 Case 3

(b = billion; m=million; all numbers in ZAR)

Guidance:

Long term debt is not spontaneous and would not increase.

The case made it clear that none of the variables in the acquired firm would change and that
the only real effect of the acquisition is that it remits its profits to the acquiring firm and of
course the R3 billion require to buy the firm.

What was required, was for you to determine the increase in assets of the acquiring (lets call
it the “original” firm) and then the sources of financing that goes towards it, such as
spontaneous liabilities and the profits retained. There were some assumption you could have
made which would have influenced your answer, see the last part of the solution for
guidance on this.

Solution:

Current assets become 14437.5 and fixed assets (after 2,5% growth) become 2562.5. This
totals then 17000 for assets. It used to be 16250, so growth in spontaneous assets is
R750m.

Now, this has to be financed somehow. We can apply spontaneous liabilities first as we can
increase our accounts payable and line of credit maybe to fund some of the increase in
current assets.

Here we have to note that there is an interpretation choice that you could make. One is to
consider short term debt as spontaneous; the other is to not do so. In the first case, short
term debt will also grow, in the other, it will stay constant. We will show the case where short
term debt is also assumed spontaneous, but offer an explanation of how to see if you got it
right if you assumed otherwise at the end.

Assumption: short term debt is spontaneous (as the case did not go into detail on it)

So, current liabilities would grow from a total of 6600 to 6930. That means it grew by R330m
and it will be used to finance the growth in spontaneous assets.

Then, we need to consider the profit of the firm. The R1b from the acquired firm is added to
net profit

The sales of the original firm grows to R21b with a profit margin of 12,5% leading to a net
profit of R2625m.

The acquired firm also contributes R1b of profit, leading to a total net profit of R3625m.

Only 45% of this is retained after dividends, leaving: R1631,25

This is then applied to the increase in assets together with the increase in current liabilities:

R750m – R330m – R1631,25 = -R1211,25

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This means we had R1211,25 more than our financing requirement before taking the
acquisition costs into account.

However, the amount of R3b of financing also needs to be taken into account:

R3b – R1211,25 = R1788,75 of external financing that is required.

If you assumed that short term debt was not spontaneous, subtract R170m from the answer
supplied to see if you got it right.

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Case 4

The calculations of the cash flows are as follows:

NPV
Year: 0 1 2 3 4
Cost -7000000
Sales 2500000 3500000 4000000 2000000
Var cost -500000 -700000 -800000 -400000
Fixed costs -200000 -200000 -200000 -200000
Gross CF 1800000 2600000 3000000 1400000
Tax -15000 -255000 -375000 -45000
Residual value 500000
NOWC -1000000 1000000
Net CF -8000000 1785000 2345000 2625000 2855000

Tax effects
Gross CF 1800000 2600000 3000000 1400000
Depreciation -1750000 -1750000 -1750000 -1750000
Recoupment 500000
Net taxable 50000 850000 1250000 150000
Tax payable 15000 255000 375000 45000

The remainder of the case relies mostly on the discount rate to be used.

The company has R2m in retained earnings and the company needs to finance an amount
of R8m (including NOWC). So, the firm needs to raise R6m of financing.

Scenario 1:

Then, the issue was to test a multitude of different discount rates.

The component costs were:

No market values are available, so book values are used:

Cost of equity = 12% and cost of debt = 5,6% after tax.

The different weights in the scenarios was:

No market or target information was provided, so we had to use book values.

Scenario 1:

R2m equity (25%) and R6m debt (75%);

Scenario 2:

R0 (0%) equity and R8m debt (100%).

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Scenario 3:

R1,6m equity (20%) and R6,4m debt (80%).

Leading to WACC’s, adjusted WACC’s (real rate: RR); unadjusted NPV’s; and inflation
adjusted NPV’s (IANPV) of:

WACC RR NPV Rm IANPV Rm

Scenario 1 7,2% 2,1% -1642 1091

Scenario 2 5,6% 0,57% 318 1465

Scenario 3 6,88% 1,79% 61 1165

If inflation is taken into account the project would be acceptable in all cases, though the use
of debt financing only yields the highest NPV regardless. The only scenario where the
project is not acceptable is if equity is used, to finance the expansion and debt only used to
top up the amount required (scenario 1).