QUESTION 3 (17 Marks) You are a junior engineer at Electric Ltd ("Electric") a company that specializes in electronic equipment. Electric was established in 2002 and listed on the Johannesburg Stock Exchange (JSE) in 2012. Part of your responsibilities is to evaluate any new investment opportunities. You have identified Dynamic Ltd ("Dynamic") as a possible new acquisition opportunity. Dynamic is an electronic company that specializes in remote control electronics and you believe that this acquisition will benefit Electric in the long run as Dynamic's business model and strategies are similar to those of Electric. The following information of Electric has been provided to you for the 2019 financial year. Electric Limited Statement of financial position as at 31 August 2019 2019 R'000 ASSETS Non-current assets Property, plant and equipment Land and buildings Current assets Inventory Accounts receivable Cash and cash equivalents TOTAL ASSETS EQUITY AND LIABILITIES Ordinary share capital Retained earnings Non-current liabilities Long-term loan 8% redeemable debentures 12% non-redeemable preference shares Current liabilities Trade and other payables Current tax payable TOTAL EQUITY AND LIABILITIES The question continues on the next page. 27 121 12 000 15 121 3 300 1100 2 100 100 30 421 20 000 510 4000 5000 600 260 51 30 421 Additional information . Electric has 500 000 authorised ordinary share of which 100 000 have been issued. You extracted the following JSE share price report regarding the share price of Electric: Entity/Company Date Closing price (cents) 31 80 Electric Limited 31 Aug 2017 Electric Limited 31 Aug 2018 32 50 Electric Limited 31 Aug 2019 38 00 The average market return on the JSE is 10% and you have determined that the beta for similar companies on the JSE is 1.8, while that of Electric is 1.2. The current return for government bonds is 5% per year. The long-term bank loan is repayable over 10 years from 31 August 2019 in equal monthly instalments of R52 500, payable at the beginning of every month. The loan accumulates interest at a pre-tax rate 9.28% per annum compounded monthly. The 12% preference shares are made up of 400 000 non-redeemable shares that were issued at R1.50 per share. The current market rate for similar shares in the same class is 13% per year. 500 000 debentures were issued on the 31 August 2019 at R10 per debenture. Similar debentures in the market yield a return of 10% p.a. The debentures will be redeemed on the 31st August 2023 (exactly 4 years) at a discount of 8%. The after-tax market rate for similar debentures has been correctly calculated as 7.2%. It has been correctly calculated that creditors charge an average rate of 16.4% per year on accounts overdue. The current company tax rate is 28%. The chief financial officer (CFO) of Electric, Mr Venter, has contacted you and has asked you to assist him with a few financial calculations regarding the Weighted Average Cost of Capital. He is especially interested in the principle of gearing and the impact that gearing has on risk, if more debt than equity is used for financing. QUESTION 3: Subtotal Total (a) Calculate the weighted average cost of capital (WACC) of Electric as of 31 August 2019 using market values. 15 (b) Explain to the CFO what the principle of gearing is, as well as what the effect will be on risk if more debt than equity is used as a source of finance. 2 TOTAL MARKS FOR QUESTION 3 17 QUESTION 3 (17 Marks) You are a junior engineer at Electric Ltd ("Electric") a company that specializes in electronic equipment. Electric was established in 2002 and listed on the Johannesburg Stock Exchange (JSE) in 2012. Part of your responsibilities is to evaluate any new investment opportunities. You have identified Dynamic Ltd ("Dynamic") as a possible new acquisition opportunity. Dynamic is an electronic company that specializes in remote control electronics and you believe that this acquisition will benefit Electric in the long run as Dynamic's business model and strategies are similar to those of Electric. The following information of Electric has been provided to you for the 2019 financial year. Electric Limited Statement of financial position as at 31 August 2019 2019 R'000 ASSETS Non-current assets Property, plant and equipment Land and buildings Current assets Inventory Accounts receivable Cash and cash equivalents TOTAL ASSETS EQUITY AND LIABILITIES Ordinary share capital Retained earnings Non-current liabilities Long-term loan 8% redeemable debentures 12% non-redeemable preference shares Current liabilities Trade and other payables Current tax payable TOTAL EQUITY AND LIABILITIES The question continues on the next page. 27 121 12 000 15 121 3 300 1100 2 100 100 30 421 20 000 510 4000 5000 600 260 51 30 421 Additional information . Electric has 500 000 authorised ordinary share of which 100 000 have been issued. You extracted the following JSE share price report regarding the share price of Electric: Entity/Company Date Closing price (cents) 31 80 Electric Limited 31 Aug 2017 Electric Limited 31 Aug 2018 32 50 Electric Limited 31 Aug 2019 38 00 The average market return on the JSE is 10% and you have determined that the beta for similar companies on the JSE is 1.8, while that of Electric is 1.2. The current return for government bonds is 5% per year. The long-term bank loan is repayable over 10 years from 31 August 2019 in equal monthly instalments of R52 500, payable at the beginning of every month. The loan accumulates interest at a pre-tax rate 9.28% per annum compounded monthly. The 12% preference shares are made up of 400 000 non-redeemable shares that were issued at R1.50 per share. The current market rate for similar shares in the same class is 13% per year. 500 000 debentures were issued on the 31 August 2019 at R10 per debenture. Similar debentures in the market yield a return of 10% p.a. The debentures will be redeemed on the 31st August 2023 (exactly 4 years) at a discount of 8%. The after-tax market rate for similar debentures has been correctly calculated as 7.2%. It has been correctly calculated that creditors charge an average rate of 16.4% per year on accounts overdue. The current company tax rate is 28%. The chief financial officer (CFO) of Electric, Mr Venter, has contacted you and has asked you to assist him with a few financial calculations regarding the Weighted Average Cost of Capital. He is especially interested in the principle of gearing and the impact that gearing has on risk, if more debt than equity is used for financing. QUESTION 3: Subtotal Total (a) Calculate the weighted average cost of capital (WACC) of Electric as of 31 August 2019 using market values. 15 (b) Explain to the CFO what the principle of gearing is, as well as what the effect will be on risk if more debt than equity is used as a source of finance. 2 TOTAL MARKS FOR QUESTION 3 17