ASSIGNMENT 6: FINANCIAL MANAGEMENT

QUESTION 1 (25)

Tony Limited is an American based manufacturer of heavy-duty equipment. The

company is currently investigating two projects for expansion. It can only undertake

one of them and has asked your advice in deciding which one to proceed with.

Project A:

Production at the existing factory could be expanded. The cost of the new plant for

this option would be an initial outlay of $50 million. This would result in an additional

$1 200 000 profit being earned in each of the 10 years that the project would last.

The new plant to be fully depreciated over the 10 years, on a straight-line basis, in

accordance with the company's accounting policy. The financial team has also

determined that the new plant must bear its share of the existing overheads and that

amounted to 8% of total sales per annum. Furthermore, additional expenses

attributed to the expansion of the existing factory is R44 750. All of these expenses

were included in the profit calculation.

Project B:

Production could be increased by purchasing a new manufacturing facility in South

Africa. The cost of the facility would be an initial outlay of R40 000 000. In addition,

equipment must be purchased and installed for the safety of workers according to

the laws and regulations set by the South African government. The cost of this

equipment is R3 000 000 and cost of installation is R250 000. Annual sales for the

10-year period is expected to be R210 million annually, and fixed and variable cost of

R60 million and R50 million respectively. The fixed cost includes depreciation of R22

million per annum. Consultants fees is expected to be R1.2 million.

Additional information:

* The South African inflation is expected to exceed the American inflation by 2%

throughout the life of the project.

* Tony's cost of capital is currently 12%.

* The current spot exchange rate is R15.27/$.

Required:

1.1 Make all the necessary calculations for the two options. (22)

1.2 Advise Tony Limited on which of these two projects would be more profitable (3)

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QUESTION 2 (25)

TimTam Limited uses a combination of shares and debt in their capital structure.

The details are given below:

There are 5 million ordinary shares in issue with a par value of R1.20 each and the

current market price is R5 per share. The latest dividend paid was R0.64 and a 9.3%

average growth for the past six years was maintained.

The company has 3 200 000 R4, 8% preference shares with a market price of

R2.20 per share.

TimTam Limited has a public traded debt with a face value of R3 million. The

coupon rate of the debenture is 7% and the current yield to maturity of 10%. The

debenture has 6 years to maturity.

They also have a bank overdraft of R0.8 million due in 5 years' time and interest is

charged at 15% per annum.

Additional Information:

Tim Tam Limited has a beta of 1.9, a risk-free rate of 8% and a return on the market

of 15%.

Company tax rate is 28%.

Required:

2.1 Calculate the weighted average cost of capital, using the Gordon Growth Model

to calculate the cost of equity. (22)

2.2 Calculate the cost of equity, using the Capital Asset Pricing Model. (3)

QUESTION 3 (25)

Monster Limited is considering upgrading its plant to expand it client base. The

financial details of the investment proposal are as follows:

Cost of plant R5 300 000

Import duty R700

000

Installation cost R300

000

Service charge R30

000

Net cash flows Year 1-10 R1 500 000 per annum (excluding residual value)

Residual value R 800 000

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The company uses straight-line depreciation. The cost of capital for projects of

similar risk is 18%. Ignore taxation.

Required:

3.1 Calculate the investment's Accounting Rate of Return (ARR). (4)

3.2 Briefly explain if the ARR is acceptable or not based on a target rate of return of

30%. (3)

3.3 Assume a required payback period of 3 years. Determine the payback period and

state if the investment is acceptable or not. (5)

3.4 Calculate and comment on the viability of the proposed investment based on the

net present value (NPV) method. (8)

3.5 Discuss whether the advantages of using the NPV method outweigh the

disadvantages. (5)

QUESTION 4 (25)

Bolton Limited needs to acquire equipment costing R500 000 to expand their

facilities in order to be more competitive. The machine can be purchased or leased.

The after-tax cost of the debt is 7 % and the company is in the 28% tax bracket.

The terms of the lease and purchase plans are as follows:

Lease The leasing agreement would require annual end-of-year payments of R96

400 over the five years. Service and maintenance costs are R20 000 per annum.

According to the lease agreement, these costs are shared equally amongst the

lessee and the lessor and is not included in the annual lease payment of R96 400. In

addition, the lessee will exercise its option to purchase the equipment for R32000 at

the termination of the lease.

Purchase The cost could be financed with a five-year, 15 % loan, requiring equal

annual payments of R130 000. The company will pay R10 000 per year for a service

contract that covers All costs. The straight-line method of depreciation is used. They

plan to sell the machine for spares after the five years for R50 000. The interest

payments for the respective five years are R70 000; R61 100; R50 868; R39 090 and

R25 500.

Required:

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