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Question 1: 10 marks 1. The Miller-Modigliani theorem proposes that debt is irrelevant. Under what conditions is this true? When these conditions are relaxed, how

Question 1: 10 marks

1. The Miller-Modigliani theorem proposes that debt is irrelevant. Under what conditions is this true? When these conditions are relaxed, how does changing the debt ratio affect firm value, if at all? [6 marks]

2. Managers of some firms often contend that they do not borrow money because they want to maintain financial flexibility.

a. How does not borrowing money increase financial flexibility? [2 marks]

b. What is the trade-off you would be making, if you have excess debt capacity, and you choose not to use it, because you want financial flexibility? [2 marks]

Questions 2A to 2D should be answered in chronological order. If you skip a preceding question whose answer is required in the next question, assume a value and state it clearly before using it for the rest of the questions.

Question 2 A 15 marks

Kwaito Sounds Ltd is a small Cape Town-based company that records and sells CDs and DVDs featuring African musicians/artists and promotes their concerts all around the world. Kwaito Sounds has 12 million shares outstanding, which are currently trading at twice their book value, and its debt is composed of 12% coupon-bearing BBB-rated bonds, which were issued 5 years ago and will mature on 30 June 2021. Typical BBB-rated bonds are currently yielding 10% in the market and the long-term government bond rate is 7.4%. Kwaito Sounds derives 75% of its total market value from its CD/DVD production business and 25% from its concert promotion business. The company's most recent income statements and balance sheets are presented in Exhibits 1 and 2, respectively. Because of the tight ownership of the company and insufficient price data, estimating the cost of equity for the company is quite problematic. As a result, management makes use of comparable firms in the same lines of business. Relevant information on these comparables has been provided in Exhibit 3. The typical marginal tax rate for firms in these businesses is 28%. Assume a market risk premium of 5.5%. a. Estimate the market value of the debt. [3 marks]

b. Estimate the current cost of equity. [5 marks]

c. Estimate the current weighted average cost of capital. [2 marks]

3 d. Explain how the cost of capital would change if the government bond rate were to increase from its current level to say 9%. [Hint: No need to recalculate the WACC. Only explain which variables in the WACC calculation will be affected and how.] [5 marks]

Exhibit 1: Kwaito Sounds Ltd: Historical Income Statements, June 30 (R' million) 2019 2020 Revenues 100 158 - Cost of Goods Sold 40 60 - Depreciation & Amortization 10 13 Profit before interest and taxes 50 85 Interest Expenses 5 5 Profit before tax 45 80 Taxation @ 28% 12.6 22.4 Net Profit after tax 32.4 57.6 Exhibit 2: Kwaito Sounds Ltd: Historical Balance Sheet, June 30, 2020 (R' million) 2020 Assets Property, Plant & Equipment 100 Land and Buildings 50 Current Assets 50 Total 200 Liabilities Current Liabilities 20 Debt 60 Equity 120 Total 200 Exhibit 3: Comparable Firms Business Average Beta(levered) Average D/E Ratio CD/DVD Business 1.15 50.00% Concert Business 1.20 10.00%

4 Question 2 B 15 marks

Kwaito Sounds had a dividend payout ratio of 25% in the financial year ending June 30, 2020. The company is seeking your advice on whether it should maintain this payout ratio. It is also considering a number of major investment opportunities for the coming year. These are listed in Exhibit 4 below.

The company intends to maintain its working capital at the same percentage of revenues next year as it has this year. The beta calculated in Question 2A (b) is considered to be a good estimate of the beta for the next five years. Exhibit 4: Kwaito Investment opportunities in the next year Project Total Investment (R' million) IRR on project (using CF to Equity) Beta (Levered) A 15 16.0% 1.60 B 30 15.0% 1.25 C 25 12.5% 1.00 D 20 11.5% 0.50 a. If revenues, net income and depreciation are all expected to grow at 20% next year, and the firm maintains its existing capital structure (in market value terms), how much can the firm afford to pay out as dividends after meeting working capital and capital budgeting needs? [12 marks] b. The company's current cash balance is R10 million. What will happen to this cash balance if Kwaito Sounds maintains its payout ratio at 25% next year? [3 marks]

Question 2 C 15 marks

The managers at Kwaito Sounds also believe that they are significantly undervalued, and have asked you to estimate the current value of the Kwaito share. To enable you to do the valuation, they have provided you with additional information. They believe that they can maintain the 'high growth' for the next five years. The current June 30, 2020 return on capital, debt to equity ratio, dividend payout ratio and interest rate will be maintained for the high growth period. After the high-growth period, the earnings growth rate is expected to drop to 6% and the firm's return on capital will also drop to 15%. The debt to equity ratio and interest rate are expected to remain unchanged. The book value of equity as at 30 June, 2019 was R 100 million (this is the opening book value of equity for the year ending 30 June, 2020) and that of debt is unchanged. Beta (levered) is expected to be 1.00 in the stable growth period. [Hint: ROE = ROIC + (ROIC-i(1-t))*D/E , where D/E is the capital structure in market value terms as in Questions 2A and 2B.]

5 a. Estimate the expected growth rate in the high growth period. [4 marks]

b. Estimate the expected dividends in the high growth period. [3 marks]

c. Estimate the expected payout ratio in the stable growth phase. [3 marks]

d. Estimate the terminal price (at the end of the high-growth period) [3 marks]

e. Estimate the equity value today using the dividend discount model. [2 marks]

Question 2 D 10 marks

Assume Kwaito Sounds is at present planning a major restructuring involving the following actions. It plans to sell part of the CD/DVD production division for R 50 million. This part of the division is currently earning R 5 million before interest and taxes. The cash from the sale of the division will be used to buy back shares. The dividend payout ratio will be reduced to 15%.

a. Estimate the D/E in market value terms, the new ROIC and the new ROE [3 marks]

b. Estimate the new growth rate in earnings, after the restructuring. [2 marks]

c. Estimate the new cost of equity for Kwaito Sounds after the restructuring. [5 marks]

Question 3:

Investment Appraisal 35 marks

Up until now, Mzansi Systems has been using the payback period in its capital budgeting decisions. A recent article in the GIBS Business Review on the use of discounted cash flow methods versus the payback method in capital budgeting decisions caught the attention of Edison Brown, the president of Mzansi Systems. The article indicated that use of the payback period frequently resulted in the decision not to make investments that may otherwise be profitable under a discounted cash flow technique. Brown decided that his firm should begin to use one of the more sophisticated techniques. Mzansi Systems manufactures fluid control devices that have a wide variety of applications. Most of its standard items sell in the range of R30,000 - R60,000. Since the control device is a specialised precision instrument, many of Mzansi Systems' salesmen are engineers or have at least some engineering background. Marketing of the control devices has emphasised only the engineering aspects of the products. Recently, however, the company has been giving increasing thought to stressing the economic aspects of the product line in its advertising campaigns. Management is considering giving the sales force a short course on the economics of replacement decisions to help them convince potential customers of the advantages of replacing old control systems with the new types Mzansi Systems has to offer. Edison learnt that Cohen, a UWC post graduate, who has recently joined Mzansi Systems as a Systems Analyst, has taken the Profit Determination and Financial 6 Analysis course on his management program and was well versed in capital budgeting techniques. He thus asked Cohen to help the marketing department develop the promotional literature and to train the salesmen in the use of discounted cash flow capital budgeting techniques. Cohen agreed to the assignment, and he and the sale manager, Charles Kane, decided to start by analysing one of the standard control devices - a unit that sells for R50,000 delivered. The following facts, which Kane indicated were fairly typical, were to be used in the illustrative material: 1. The equipment has a delivered cost of R50,000. An additional R3,750 is required to install the new machine. This amount is added to the cost of the machine for purposes of computing depreciation. 2. The new control device has a 20-year estimated service life. At the end of 20 years, the estimated salvage value is R1,250. 3. The existing control device has been in use for approximately 30 years, and it has been fully depreciated (that is, its book value is zero). However, its value for scrap purposes is estimated to be R1,250. 4. The new equipment is to be depreciated on a straight-line basis. The applicable tax rate for the illustrative firm is 40 percent. 5. The new control device requires lower maintenance costs and frees personnel who would otherwise have to monitor the system. In addition, it reduces product wastage. In total, it is estimated that the yearly savings will amount to R11,250 if the new control device is used. 6. The illustrative firm's cost of capital is 10 percent.

Questions a. Develop a capital budgeting schedule that evaluates the relative merits of replacing the old machine with the new one. Use the net present value method. [14 marks]

b. Calculate the payback period (using after-tax cash flows) for the investment in a new control device [3 marks]

c. Explain why the payback period puts long-term investments such as hydraulic control devices at a relative disadvantage vis-a-vis short-term investment projects. [3 marks]

d. Suppose one of the salesmen was making a presentation to a potential customer who used the internal rate of return method in evaluating capital projects. What is the internal rate of return of this project? [4 marks]

e. What would be the effect on net present value if accelerated depreciation, rather than straight line depreciation was used? Give the direction of change, not precise figures. [3 marks]

f. What would be the effect of an investment tax credit on the analysis? An investment tax credit is a credit against income taxes [3 marks] 7 equal to a specified percentage of the cost of an investment.

g. Suppose one of Mzansi Systems' potential customers had a 50% marginal tax rate.

Determine (a) what items would be changed and (b) whether the IRR and NPV would be raised or lowered by the shift in tax rates.

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