Reference no: EM132354048 , Length: word count:6000

QUESTION 1

The Randolph Limited has decided to acquire a new truck. One alternative is to lease the truck on a 4-year guideline contract for a lease payment of R10,000 per year, with payments to be made at the beginning of each year. The lease would include maintenance. Alternatively, Randolph Limited could purchase the truck outright for R40,000, financing the purchase by a bank loan for the net purchase price and amortizing the loan over a 4-year period at an interest rate of 10% per year. Under the borrow-to-purchase arrangement, RTC would have to maintain the truck at a cost of R1,000 per year, payable at year end. The truck falls into the MACRS 3-year class. It has a residual value of R10,000, which is the expected market value after 4 years, when Randolph Ltd plans to replace the truck irrespective of whether it leases or buys. Randolph Limited has a marginal tax rate of 40%.

1.1 What is Randolph's Present Value cost of leasing?

1.2 What is Randolph's Present Value cost of owning? Should the truck be leased or purchased?

1.3 The appropriate discount rate for use in the analysis is the firm's after-tax cost of debt. Why?

QUESTION 2

Curechem SA Limited is a large publicly traded firm on the Johannesburg Stock Exchange. Based on a R100,000 market feasibility study it is considering the manufacture and sale of a new line of products developed by its R&D research group at a cost of R 250,000. The finance department has gathered the following information on the investment proposal:

Initial investment (straight line depreciation)	R 9 million
Scrap value (year 4; tax paid yr. 5)	R 600 000
Selling price (current price)	R80/yr
Expected selling price inflation	4%/yr
Variable operating costs (current price)	R35/unit
Fixed operating costs	R450 000
Expected operating cost inflation	3%/yr

Market research estimates that demand for the product will be as follows:

Year	1	2	3	4
Demand (Units):	50, 000	85, 000	100, 000	75, 000

The company has a real return hurdle rate of 12%. Expected inflation over the project's lifespan is 2.5%. CureChem Limited pays income tax at 30% payable 1 year in arrears. The project would qualify for the tax offices "accelerated" capital cost allowance of 33.3% per year on a straight line basis.

Required:

2.1 Calculate the flowing values for the investment proposal:
i. Net present value (10)
ii. Internal rate of return (5)

2.2 Briefly discuss your findings and advise whether the proposal is financially attractive. (4)

2.3 Assuming that the stock market is semi-strong efficient, what will be the implication for the firm's stock price
if CureChem goes ahead with the project? (6)

QUESTION 3

AdvTech Limited is a large firm listed on the Johannesburg Stock Exchange. It has the following capital structure:

Long Term Capital	R million
Convertible Debt - 5 yrs; 8%	25
Preferred Shares - 5% coupon + nominal value	15
of 100
Common Equity (nominal value R 10/share)	10
Retained Earnings	23

The current dividend for the company is R 50/share and is expected to grow at 3% per year in the foreseeable future. The equity shares trade at R 450/share. The preferred shares trade at R 104/share. The convertible debt has a conversion privilege of 2 shares per R1,000 face value at maturity. The debt currently trades at R 950.

The firm's income tax rate is 30%

Required:

3.1 Calculate the firm's weighted average cost of capital (WACC).
3.2 Discuss the firm's dividend payout policy and whether it has an impact on share price.
3.3 Explain why the different sources of capital have different levels of risk and return.

QUESTION 4
Navidale, a listed engineering company, manufactures large scale plant and machinery for industrial companies. Until ten years ago, Navidale Limited pursued a strategy of organic growth. Since then, it has followed an aggressive policy of acquiring smaller engineering companies, which it feels have developed new technologies and methods, which could be used in its manufacturing processes. However, it is estimated that only between 30% and 40% of the acquisitions made in the last ten years have successfully increased the company's shareholder value.

Navidale Limited is currently considering acquiring Lochinvar, an unlisted company, which has three departments. Department A manufactures machinery for industrial companies, Department B produces electrical goods for the retail market, and the smaller Department C operates in the construction industry. Upon acquisition, Department A will become part of Navidale, as it contains the new technologies which Navidale is seeking, but Departments B and C will be unbundled, with the assets attached to Department C sold and Department B being spun off into a new company called Ndege Co.

Given below are extracts of financial information for the two companies for the year ended 30 April 2014.

Navidale Co		Lochinvar Co
R million		R million
Sales revenue	790·2	124·6
	------	------
Profit before depreciation, interest and tax (PBDIT)	244·4	37·4
Interest	13·8	4·3
Depreciation	72·4	10·1
	------	------
Pre-tax profit	158·2	23·0

Navidale Co Lonchivar Co
	R million	R million
Non-current assets	723·9	98·2
Current assets	142·6	46·5
7% unsecured bond	-	40·0
Other non-current and current liabilities	212·4	20·2
Share capital (50c/share)	190·0	20·0
Reserves	464·1	64·5

Share of current and non-current assets and profit of Navidale Co's three departments:

	Department A	Department B	Department C
Share of current and non-current assets	40%	40%	20%
Share of PBDIT and pre-tax profit	50%	40%	10%

Other information

(i) It is estimated that for Department C, the realisable value of its non-current assets is 100% of their book value, but its current assets' realisable value is only 90% of their book value. The costs related to closing Department C are estimated to be R3 million.

(ii) The funds raised from the disposal of Department C will be used to pay off Lonchivar Co's other non- current and current liabilities.

(iii) The 7% unsecured bond will be taken over by Ndege Co. It can be assumed that the current market value of the bond is equal to its book value.

(iv) At present, around 10% of Department B's PBDIT come from sales made to Department C.

(v) Ndege Co's cost of capital is estimated to be 10%. It is estimated that in the first year of operation Ndege Co's free cash flows to firm will grow by 20%, and then by 52% annually thereafter.

(vi) The tax rate applicable to all the companies is 20%, and Ndege Co can claim 10% tax allowable depreciation on its non-current assets. It can be assumed that the amount of tax allowable depreciation is the same as the investment needed to maintain Ndege Co's operations.

(vii) Navidale Co's current share price is R3 per share and it is estimated that Lochinvar Co's price-to-earnings (PE) ratio is 25% higher than Navidale Co's PE ratio. After the acquisition, when Department A becomes part of Navidale Co, it is estimated that Navidale Co's PE ratio will increase by 15%.

(viii) It is estimated that the combined company's annual after-tax earnings will increase by R7 million due to the synergy benefits resulting from combining Navidale Co and Department A.

Required:

4.1 Discuss the possible reasons why Navidale Co may have switched its strategy of organic growth to one of growing by acquiring companies

4.2 Discuss the possible actions Navidale Co could take to reduce the risk that the acquisition of Lochinvar Co fails to increase shareholder value

4.3 Estimate, showing all relevant calculations, the maximum premium Navidale Co could pay to acquire Lonchivar Co, explaining the approach taken and any assumptions made.

Attachment:- Financial Management.rar