AC3059 Financial Management

Question 1

Zaha Ltd has an equity beta of 1.10. The market risk premium in South Africa is expected to be 5% and the yield on government bonds is currently 7.5%. Zaha has issued bonds and its R100 par-value bond is currently trading at R94.50. The coupon rate is 8%. The maturity date is in 5 years’ time and the corporate tax rate is 29%. Interest is payable annually in arrears. The company has just paid the coupon interest for the current year.

Required

• What is Zaha’s cost of equity, based on CAPM?
• What is the after-tax cost of debt?
• Zaha paid a dividend of R0.12 per share and the dividend per share is expected to grow at 7% indefinitely. The company’s share price is R2.30. What is the company’s cost of equity if we use the dividend growth model?
• What is the weighted-average cost of capital (WACC) if the target debt-equity ratio is 50%? (Use cost of equity as per CAPM)

Question 2

Afroflights wishes to make a takeover bid for Mayfly. Mayfly makes after-tax profits of R40 000 per year. Afroflights believes that if further money is spent on additional investments, the after-tax cash flows (ignoring the purchase consideration) could be as follows.

Year	Cash flow (net of tax) R
0	(100 000)
1	(80 000)
2	60 000
3	100 000
4	150 000
5	150 000

 

If Amandla bought the new technology, it would finance the purchase through a four-year loan paying interest at an annual before-tax rate of 8.6% per year. The loan repayment schedule is as shown in the table below:

Answers:

Post tax cost of debt = 9.43(1-0.29) = 6.7% pa

• Let the cost of equity be denoted by k_e

In accordance with dividend growth model,

Price = Next Year Dividend /(Cost of equity – Growth rate of dividends)

Next year dividend = 0.12*1.07 = R 0.1284

Growth rate of dividends = 7% or 0.07

Price = R2.30

Hence, 2.30 = 0.1284/(k_e – 0.07)

Solving the above, k_e = 12.58% pa

Let equity be 2X

Then debt would be X

Weight of debt = (Debt/Debt +Equity) = (X/3X) = 33.33%

Weight of equity = (Equity/Debt +Equity) = (2X/3X) = 66.67%

WACC = weight of debt *cost tax cost of debt + weight of equity *cost of equity

WACC = 0.3333*6.7 + 0.6667*13 = 10.9% pa

Question 2

2.1 The maximum price that the company should be willing to pay would be equal to the NPV of the expected cashflows of Mayfly. This is computed in the table shown below.

Year	Cash flows	PV Factor	PV ( R)
0	-100000	1.00	-100000.0
1	-80000	0.87	-69565.2
2	60000	0.76	45368.6
3	100000	0.66	65751.6
4	150000	0.57	85763.0
5	150000	0.50	74576.5
Total			101894.5

Hence, the maximum price that the company could pay for Mayfly is R101,894.5

2.2 Now, the terminal value of the firm would also be added to determine the value of the Mayfly.

Terminal value at the end of year 6 = 120000*1.06/(0.15-0.06) = R 1,413,333

The NPV of the firm in the given case can be computed as follows.

Year	Cash flows	PV Factor	PV ( R)
0	-100000	1.00	-100000.0
1	-80000	0.87	-69565.2
2	60000	0.76	45368.6
3	100000	0.66	65751.6
4	150000	0.57	85763.0
5	150000	0.50	74576.5
6	120000	0.43	51879.3
6	1413333	0.43	611023.0
Total			764796.8

Hence, the maximum price that the company could pay for Mayfly is R764,796.8

Question 3

3.1 Upfront cost of buying = R1 million or R1,000,000

Scrap value at the end of 4 years = R 100,000

In case the company goes ahead and buy, the applicable depreciation in the four years can

Depreciation (Year 1) = (1000000-100000)*0.25 = R 225,000

Depreciation (Year 2) = (775000-100000)*0.25 = R 168,750

Depreciation (Year 3) = (606250 – 100000)*0.25 = R 126,563

Depreciation (Year 4) = (1000000-100000) –( 225000+168750+126563) = R 379,687

Applicable discount rate = 8.6(1-0.3) = 6% pa

Further, based on the given information, the NPV of buying the new technology is indicated below.

Year	0	1	2	3	4
Production (units)		60000	75000	95000	80000
Cost savings		348000	435000	551000	464000
(-) licence fee		104000	108160	112486	116986
(-) Depreciation		225000	168750	126563	379687
(-) Iniital investment	1000000
(+) Salvage value					100000
Incremental profit before tax	-1000000	19000	158090	311951	67327
Tax expense (@ 30%)		5700	47427	93585	20198
Earnings after tax ( R)	-1000000	13300	110663	218365	47129
(+) Depreciation		225000	168750	126563	379687
Net cash flows	-1000000	238300	279413	344928	426816
PV factor	1.00	0.94	0.89	0.84	0.79
PV cash flows ( R)	-1000000	224811	248677	289609	338078
NPV	101,175

The PV of cost for leasing the new technology is indicated below.

Year	Fee Paid	PV factor	PV ( R)
1	380000	1	380000
2	380000	0.90	342342
3	380000	0.81	308417
4	380000	0.73	277853
Total			1,308,612

The PV of benefits arising from leasing are indicated below.

Year	Savings	PV factor	PV ( R)
1	348000	0.90	313514
2	435000	0.81	353056
3	551000	0.73	402886
4	464000	0.66	305651
Total			1,375,107

NPV of leasing = 1375107-1308612 = $ 66,495

As the NPV associated with buying is more than that associated with leasing, hence the company would prefer to buy the concerned technology.

3.2 The NPV computation under the nominal terms method would deploy the discount rate as 11% and is indicated below.

Year	0	1	2	3	4
Production (units)		60000	75000	95000	80000
Cost savings		348000	435000	551000	464000
(-) licence fee		104000	108160	112486	116986
(-) Depreciation		225000	168750	126563	379687
(-) Initial investment	1000000
(+) Salvage value					100000
Incremental profit before tax	-1000000	19000	158090	311951	67327
Tax expense (@ 30%)		5700	47427	93585	20198
Earnings after tax ( R)	-1000000	13300	110663	218365	47129
(+) Depreciation		225000	168750	126563	379687
Net cash flows	-1000000	238300	279413	344928	426816
PV factor	1.00	0.90	0.81	0.73	0.66
PV cash flows ( R)	-1000000	214685	226778	252209	281157
NPV ( R)	-25,172

As the NPV of the project is negative, hence it should not be pursued.