Question 1

With the discovery of oil in commercial quantities in Ghana, more and more oil exploration companies are trooping into Ghana. You have been appointed as a Financial Analyst by one such company, Tulara Ltd, based in Volta Basin. At a meeting to brief you on your duties, management indicated Tulara has just started operation, and is operating on its target debt-to-equity ratio of 0.9. It was also clear that Tularas discount rate is 45%, which management justified on grounds of riskiness of the business and country risk. You were not satisfied with the rate as it will make your work very difficult to even breaking-even in the five years. Well, if you think the rate is high, provide us with alternate rate with justification the CEO said. Although Tulara Ltd borrows at 8.5% above government of Ghana 2-year fixed rate note, its share prices are not readily available because it is not listed for quick computation of the discount rate. A comparable company, Tokon Ltd, listed on the Ghana stock exchange operates on debt-to-equity ratio of 1.55 and levered beta of 1.45. The nominal risk-free rate is represented by the yield on the long-term 2-year fixed rate note of Ghana Government, which at the valuation date was 18.5% and the average long-term historical equity risk free premium in Ghana is assumed at 10.7%. The corporate tax rate in Ghana is 35%. To make your argument robust, you have decided to draw comparable company in other West African countries with similar sovereign risk into your computation as shown in Table 1.

Table 1

Comparable company's	Country	Corporate Tax rate (%)	D/E	Beta (estimates from CAPM)
Tunde Oils Morrison Ltd Nigara Ltd	Nigeria Liberia Niger	32.5 38.5 37.5	1.33 1.94 1.13	1.45 1.75 1.08
Average			1.13	1.08

Required:

Present a memo to management justifying:

1. Your stance with necessary computations and attachments. (14 marks)
2. The choice of cost of equity computation technique. (6 marks)

Question 2

Pizza Nubuke Limited has experienced a recent surge in demand from UCC students. The company is contemplating building an addition to the restaurant that will cost GHS50,000. The company believes that they can project cash flows from the addition for only 5 years. The company estimates that the addition will enable it to sell 15,000 more pizzas per year. The average price of a pizza is GHS8 and the average cost of labour and ingredients is GHS4. Ignore depreciation. Pizza Nubuke Limiteds required rate of return on the addition is 10% and corporate tax rate is 25%.

Required:

1. Calculate the NPV of the addition.
2. The company thinks they may be able to raise prices, and therefore revenues, by 3% per year. Labour and ingredients cost will probably rise at the same rate. How does this inflation rate affect the NPV of the addition?
3. Pizza Nubuke Limited is worried about rising interest rates and thinks that they may have to make 15% return on the addition. What effect would this have on the NPV of the addition? Assume the 3% inflation remains.

Question 3

A junior executive is fed up with the operating policies of his boss. Before leaving the office of his angered superior, the young man suggests that a well-trained baboon could handle the trivia assigned to him. Pausing a moment to consider the import of his closing statement, the boss seized by the thought that this must have been in the back of her own mind ever since she hired the junior executive. She decides to consider replacing the executive with a bright young baboon. She figures that she could argue strongly to the board that such capital deepening is necessary for the cost-conscious firm. Two days later, a feasibility study is completed and the following data are presented to the president:

• It would cost GHC20,000 to purchase and train a reasonably alert baboon with a life expectancy of 20 years.
• Annual expenses of feeding and housing the baboon would be GHC6,000.
• The junior executives annual salary is GHC12,000.
• The baboon will be depreciated on a straight-line basis over 20 years to a zero balance.
• The firms marginal tax rate is 25 percent.
• The firms cost of capital is estimated to be 16 percent.

Required:

On the basis of the net present value criterion, should the baboon be hired? (10 marks)

Question 4

You are considering buying shares in two companies that operate in the same industry; they have very similar characteristics except for their dividend payout policies. Both companies are expected to earn GHS6 per share this year. However, Company D (for dividend) is expected to pay out all of its earnings as dividends, while Company G (for growth) is expected to pay out only one third of its earnings, or GHS2 per share. Ds share price is GHS40. G and D are equally risky. Which of the following is most likely to be true? Explain your answer.

i. Company G will have a faster growth rate than Company D. Therefore, Gs share price should be greater than GHS40. (2 marks)

ii. Although Gs growth rate should exceed Ds, Ds current dividend exceeds that of G, and this should cause Ds price to exceed Gs. (2 marks)

iii. An investor in stock D will get his money back faster because D pays out more of its earnings as dividends. Thus in a sense, D is like a short-term bond, and G is like a long-term bond. Therefore if economic shifts cause bonds market interest rate and the required rate of return on shares to increase and if the expected streams of dividend from D and G remain constant, both Shares D and G will decline, but Ds price should decline further. (2 marks)

iv. Ds expected and required rate of return is 15%. Gs expected rate of return will be higher because of its higher expected growth rate. (2 marks)

v. If we observe that Gs price is also GHS40, the best estimate of Gs growth rate is 10%. (2 marks)