UNIVERSITY OF ZIMBABWE

2018 May/June Examinations

BS207/BSFB202: CORPORATE FINANCE 2

Faculty: ..........COMMERCE...................................................

D ep artm en t: BUSINESS

D uration: 3 HOURS

Exam iner: MR P BASERA

A u th orized M aterials: N on- P ro g ra m m a b le C alculators

INSTRUCTIONS
1. This p a p e r co n tain s six (6) q u estio n s.
2. A nsw er b o th q u e s tio n s in sectio n A a n d any th re e (3) q u e stio n s fro m se ctio n B.
3. Each q u e stio n c a rrie s 20 m arks.
4. S ta rt each q u e stio n on a n e w page.
5. This q u e stio n p a p e r co m p rise s five (5) p rin te d pages
NB: DO NOT TURN OVER THE QUESTION PAPER OR COMMENCE WRITING UNTIL
INSTRUCTED TO DO SO

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SECTION A [40 MARKS]

BOTH QUESTIONS IN THIS SECTION ARE COMPULSORY

QUESTION ONE [20 MARKS]

The following is a balance sheet extract o f Capstone Holdings as at 31 Dec 2017 ($ million).

Long term debt 50

Preferred equity 30

Common stock 20

General reserves 50

The company considers the current capital structure optimal and wishes to maintain it into the
unforeseeable future.

The long-term debt consists o f 8%, 1 0 -year, semi-annual coupon bonds with 8 years remaining to
maturity. Currently, these bonds provide a yield to investors o f K d = 12%. If new bonds were sold,
they would yield investors 12%, but a flotation o f 5% per year would be required to sell the new
bonds.

The company’s perpetual preferred stock has a $50 par value, pays a semi-annual dividend o f $3,
and has a yield to investors o f 13.5%. N ew perpetual stock would have to provide the same yield
to investors, and the company would incur a 4% flotation cost to sell it.

The company has 4 million shares o f common stock outstanding, D 0 = $2 and EPS0 = $5. The
company has a constant dividend payout ratio and its return on ordinary equity (ROE) in 2017 was
17.14%, and management expects this ratio to remain the same in the unforeseeable future.

Beta for the company stock is 0.8, the T-bond rate is 10%, and the return on the market is 14%.
The company is in the 25% tax bracket.

N ew common stock would have a 15% flotation cost. The company has provided for depreciation
o f $3 million in the year ending 31 Dec 2017.

Required:

a) Calculate the prices at which new bonds, preference shares and common stocks would be
issued before deducting flotation costs. (6 marks)

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b) What was the company’s weighted average cost o f capital, around 01 January 2018:
i. Assuming the company raises the required capital using current retained earnings and
depreciation generated Hinds as the equity component o f the financing mix (10 marks)
ii. Assuming the company would have to issue new ordinary shares to raise the required
capital. (4 marks)
QUESTION TWO [20 MARKS]

a. Explain the following terms or phrases, giving practical examples where applicable.

i. Record date (2 mark)

ii. Ex-dividend date (2 mark)
iii. Cum dividend (2 mark)
iv. Yield to Maturity (2 mark)
V. Tax shield (2 mark)

b. The Tallman Tractor Company’s EPS at 31 December 2017 was $3.25 and on the same date
in 2010, it was $2.00. The company’s dividend policy is to payout 40 percent o f its earnings
as dividends. Following the company’s announcement on 20 December 2017 to pay the 2017
ordinary dividend, the share price surged to $25.20.
The company’s expected net income after tax for 2017 was $500 000.

Required:

i. What was the amount o f retained earnings in 2017? (3 marks)

*

ii. What was the company’s cost o f retained earnings (ks) around 01 January 2018?
(7 marks)

SECTION B [60 MARKS]

ANSWER ANY THREE QUESTIONS FROM THIS SECTION

QUESTION THREE [20 MARKS]

Bizzmark Investments is considering an investment in new technology that will reduce operating
costs. The new technology will cost $800 000 to buy and will have a four year life, at the end o f
which it will have nil scrap value. The technofogy requires paying license fees at the end o f each
year as follows: $104 000 first year; and thereafter the fee will increase by 5% annually.

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If Bizzmark Investments is to buy the new technofogy, it would finance the purchase through a
four year loan paying interest at an annual rate o f 10% compounded annually. The loan will be
repaid through four equal instalments payable at the end o f each year. Under the buying option,
the company would depreciate the asset on a straight line basis. Furthermore, the company would
incur maintenance costs o f $50 000 per year payable in advance.

The company pays taxation at the rate o f 30% per annum.

Instead o f buying the technology, Bizzmark Investments also has the option o f leasing the new
technology under an operating lease agreement. Under operating lease, the company would have
to pay four annual lease rental o f $380 000 per year in advance at the start o f each year. The annual
lease rentals include the cost o f the license fees.

Required:

a. Calculate net advantage o f leasing and advise whether the company should buy or lease the
new technology (10 marks)
b. Distinguish a financial lease from an operating lease (7 marks)
c. State why an operating lease is an example o f an off-balance sheet finance (3 marks)
QUESTION FOUR [20 MARKS]
XYZ limited issued a series o f bonds on 01 December 2008. Each bond was issued at $100 000
par, carries a 12% annual coupon and matures on 01 December 2028. The coupon payments are
paid semi-annually. You purchased one outstanding XYZ Ltd bond on the 5 th o f M arch 2018 when
the going interest rate was 14%.

Required:

a. Calculate the amount you would pay to complete the transaction (12 marks)
b. Calculate the accrued interest (4 marks)
c. Calculate the clean price o f the bond (4 marks)
QUESTION FIVE [20 MARKS]

A firm has just reported net earnings o f $10 million after tax and preference dividends and has
paid an ordinary dividend per share o f $2. The ordinary shareholder’s equity was reported at $32
million. The firm has 1 000 000 ordinary shares in issue. The firm is a recent start up and expects
to pass through 3 growth phases as explained below:

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High growth phase

> Length o f phase, 3 years.

> The current growth rate in earnings will be maintained during this period.
> The following market parameters will apply: beta coefficient 1.5; treasury - bill rate, 12% per
annum; and return on market 26%.
Transitional phase

> Length o f phase, 2 years

> The high growth rate in earnings and dividends will be 18% per year
> The following market parameters will apply: beta coefficient 1.2; treasury bill rate 11%; return
on market 24% per annum.
Stable growth

> Growth rate in earnings will be 8% per year

> Beta coefficient 0.8; treasury bill rate 9% per year, return on market 19% per year.
Required:

a. Calculate the intrinsic value o f the company’s share (17 marks)

b. Calculate the total market value o f the company’s equity (3 marks)

QUESTION SIX [20 MARKS]

McDowell Industries sells on 3/10, net 30. Total sales for the year are $800 000. Forty percent o f
the customers pay on the 10th day and take discounts; the other 60 percent pay, on average, 40 days
after their purchases.

Required:

a. What is the day’s sales outstanding? (5 marks)

b. What is the average amount o f receivables? (5 marks)
c. What would happen to average receivables if McDowell toughened up on its collection policy
with the result that all no-discount customers paid on the 30th day? (4 marks)
d. Outline the importance o f effective working capital management. (6 marks)

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