QUESTION ONE (25 Marks)

As a business owner discuss why you would prefer to acquire debt finance that you have been offered by a bank institution. (6 Marks)

The pooling of funds principle states that the various sources of finance available to any entity are grouped together and used in total various projects. Discuss the two ways or methods that are used to calculate the cost of ordinary shares. (6 Marks)

Distinguish between a capital lease and an operating lease. (4 Marks)

Return/ cost, risk and control are important considerations in deciding on a form of finance. You are required to complete the table below by indicating how these considerations apply to long term debt and owner’s equity: (9 Marks)

QUESTION TWO (25 Marks)

Gringo Limited is a South African based manufacturer of an award-winning generator. The company is currently investigating two investment projects. The information is given below:

Project S.A
Involves extending the company’s production facility in Cape Town. The plant will cost R42 million and is expected to create an additional annual profit of R3.8 million for the 8 years life of the project.
The following expenses were included in the annual profit:
• Depreciation was calculated on the straight-line method, over the life of project.
• Share of existing overheads, borne by head office amounting to R745 000p.a.
• Additional fixed cost of R800 500.
Project T.T
Involves setting up an independent manufacturing facility in Taiwan. The cost of the facility would be an initial outlay 180 000 000 Taiwan dollars. This would result in:
• annual profit of 75 000 000 Taiwan dollars, for the 8 years of the project.
• The annual fixed costs and variable costs are 8 000 000 and 6 200 000 Taiwan dollars respectively. These costs were not included in the profit calculation.
• Consultant fees of 525 000 Taiwan dollars were included in the calculation of profit for Project T.T.

Note:
• Gringo Limited current cost of capital is 15%.
• The Taiwanese inflation is expected to exceed the South African inflation by 4% p.a. throughout the life of the project.
• The current spot rate exchange is 4.2 Taiwan dollars to the Rand.

Required:
Compute the necessary calculations and advise Gringo Limited if it is worth investing in neither, in one or both of these two opportunities. (25 Marks)

QUESTION THREE (25 Marks)

MiWay Transport has determined that a new specialised delivery truck needs to be purchased. The truck can be leased from the manufacturer. The lease agreement requires:
• 5 annual payments of R800 000, with the first payment due on the delivery of the vehicle.
• Service costs amount to R17 000 p.a
• The lessee will exercise its option to purchase the truck at the end of the leasing period for R120 000.

The truck can also be purchased at:
• a cost of R2.8 million, inclusive of a 4-year maintenance contract with the manufacturer.
• The R2.8 million will be borrowed at an after-tax rate of 13% per annum.
• The loan would be secured against the truck and would be amortised over the useful economic life of the vehicle.
• The loan payments for each of the first four years are R791 000 payable at the end of each year.
• The vehicle can be depreciated straight-line over the same period and will have a zero-market value at the end of 4 years.
• Interest payments n included in the year end loan payments for the respective four years are R364 000; R273 000; R197 920 and R143 229.
Assume a current corporate tax rate of 30%. Required:
Determine the after-tax cash flows and the net present value of the cash outflows under each alternative. (23 Marks)
Briefly indicate which alternative should be recommended. (2 Marks)

QUESTION FOUR (25 Marks)

Pretoria Traders uses a combination of shares and debt in their capital structure. The details are given below:

There are 5 million R4 ordinary shares in issue and the current market price is R5.80 per share. The latest dividend paid was 70 cents and a 9% average growth for the past six years was maintained.

The company has 3 500 000 R5, 8% preference shares with a market price of R4.80 per share.

Pretoria Traders has a public traded debt with a face value of R13 million. The coupon rate of the debenture is 7% and the current yield to maturity of 16%. The debenture has 8 years to maturity.

They also have a bank overdraft of R8million due in 3 years’ time and interest is charged at 15% per annum.

Additional Information:
• Pretoria Traders has a beta of 1.7, a risk-free rate of 7.2% and a return on the market of 15.8%. • Company tax rate is 30%.

Required:
Calculate the weighted average cost of capital, using the Capital Asset Pricing Model to calculate the cost of equity. (22 Marks)

Calculate the cost of equity, using the Gordon Growth Model. (3 Marks)

Answers to Above Questions on Financial Management

Answer 1: Adequate funding is crucial to every type of business, and it is therefore essential for the financial managers to source adequate funds from different sources to accomplish their business goals. As the business owner, I would prefer to acquire debt finance for a number of reasons such as it provides easy accessibility to capital, and there is no need for any kind of dilution of ownership in case of debt finance. Debt finance also provides opportunity in terms of tax deduction on the interest paid on business loans in some countries.

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