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.]

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

Average Average

Business Beta(levered) D/E Ratio

CD/DVD Business 1.15 50.00%

Concert Business 1.20 10.00%

Exhibit 4: Kwaito Investment opportunities in the next year

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.

Total Investment IRR on project

Project (R' million) (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?

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.]

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]