QUESTION 1

Busiki Ltd wishes to calculate its weighted average cost of capital, and the following related to the company at the current.

Number of ordinary shares-20 million

Book value of 7% convertible debt-K29 million

Book value 8% bank loan-K2 million

Market price of ordinary shares -K5.50 per share

Market value convertible debt-K107/11 per K100 bond

Equity beta of Busiku Ltd-1.2

Risk - free rate return-4.7%

Equity risk premium-6.5

Rate of taxation-30%

Busiku Ltd expects share prices to rise in the future at an average rate of 6% per year.

The convertible debt can be redeemed at par in eight years time or converted in six years time into 15 shares of Busiku Ltd per K100 bond.

Required

a)Calculate the market average cost of capital of Busiku Ltd. State clearly any assumptions that you make.

b)Discuss whether the dividend growth model offers the better estimate of equity.

QUESTION 2

IML Plc is an all equity financed listed company. It develops customized software for clients which are mainly large civil engineering companies. Nearly all its shares are held by financial institutions.

IML Plc chairman has been dissatisfied with the company's performance for some time. Some directors were also concerned about the way in which the company is perceived by financial markets. In response, the company recently appointed a new finance director who advocated using the capital asset pricing model as a means of evaluating risk and interpreting the stock markets reaction to the company.

The following initial information was put forward by the finance director for two rival companies operating in the same industry.

BETA

AZT PLC0.7

BOR PLC1.4

The finance director notes that the risk-free rate is 5% each year and the expected rate of return on the market portfolio is 15% each year.

The Chairman set out his concerns at a meeting of the board of director. "I fail to understand these calculations. AZT Plc operates largely oversees markets with all the risk which that involves, yet seem to be arguing that it is a lower risk company than BOR Plc whose income is mainly derived from long-term contracts in our domestic building industry. I am very concerned that we can take too much notice of the stock market. Take last year for instance, we had to announce a loss and the share price went up."

Required:

a)Calculate, using the capital asset pricing model, the required rate of return on equity of:

(i)AZT PLC(6 marks)

(ii)BOR PLC

b)Calculate the beta of IML Plc, assuming its required annual rate of return on equity is 7% and the stock market uses the capital asset pricing model to calculate the beta, and explain the significance of the beta factor.(6 marks)

c)As the new finance director, write memorandum to the Chairman which explains, in language understandable to a non-financial manager, the following:

(i)The assumptions and limitations of the capital asset pricing model; and

(ii)An explanation of why IMP PLC's share price could rise following the announcements of a loss.

In doing so, discuss the observations and concerns expressed by the chairman. You may refer where appropriate to you in (a) and (b) above.

QUESTION TEN

a)Kasama Ltd has available the following information related to its working capital:

Average interest rates on investments8%

Minimum cash balanceK12, 800

Transaction cost of selling investmentsK20

Standard deviation of cash flows per annumK2, 500

Required:

(i)Determine the upper limit, the return point and the spread using the miller Orr Model.

(4 marks)

(ii)Explain the significance of each of these values to the management of cash.(3marks)

(b)Mbala Ltd is a Zambian company in the manufacturing sector. The company is currently reviewing its credit policy. Mbala Ltd currently offers its customers a 30 days credit period. 80% of its customers pay within 30 days. The other 20% take 50 days to pay.

Mbala Ltd would like to change its credit policy to allow its customers to pay within 70 days and offer a discount of 5% for payment within 80 days.

Approximately 30% of its customers are expected to take up the discount. 40% of its customers are expected to pay within 70 days and the remaining 30% are expected to pay within 80 days.

The change in credit policy is likely to increase Mbala Ltd current turnover of K2million per annum by 30%. Mbala cost of short term finance is currently 5%.

Required:

(i)Explain the procedures that Mbala Ltd would take in investigating the credit worthiness of its potential customers.(7 marks)

(ii)Evaluate whether the proposed changes in credit policy will reduce the carrying cost of Mbala Ltd receivables. Ignore the effect on net profit.(8 marks)