FM303 CHAPTERS COVERED : CHAPTERS 1, 5, DUE DATE : 3:00 p.m. 19 AUGUST 2014

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1 Page 1 of 8 ASSIGNMENT 2 nd SEMESTER : FINANCIAL MANAGEMENT 3 () CHAPTERS COVERED : CHAPTERS 1, 5, 8-10 STUDY UNITS COVERED : STUDY UNITS 1-3 DUE DATE : 3:00 p.m. 19 AUGUST 2014 TOTAL MARKS : 100 INSTRUCTIONS TO CANDIDATES FOR COMPLETING AND SUBMITTING ASSIGNMENTS The complete Instructions to Students for Completing and Submitting Assignments must be collected from any IMM GSM office, the relevant IMM GSM recognised additional tuition centre or can be downloaded from the IMM GSM website. It is essential that the complete instructions be studied prior to commencing your assignment. The following points highlight only a few important notes. 1. You are required to submit ONE assignment per module. 2. The assignment will contribute 20% towards the final examination mark, and the other 80% will be contributed by the examination, however the examination papers will count out of 100%. 3. Although your assignment will contribute towards your final examination mark, you do not have to earn credits for admission to the examinations; you are automatically accepted on registering for the exam. 4. Number all the pages of your assignment (e.g. page 1 of 4) and write your name and surname, student number and module at the top of each page. 5. The IMM GSM requires assignments to be presented on plain A4 paper. You must show all working calculations, including and where appropriate multiple-choice working calculations. 6. A separate assignment cover, which is provided by the IMM GSM, must be attached to the front cover of each assignment. 7. Retain a copy of each assignment before submitting, in case the original does not reach the IMM GSM. 8. The assignment due date refers to the day up to which assignments will be accepted for marking purposes. The deadline is 3:00 p.m. on 19 August Late assignments will be accepted, but 25 marks will be deducted from the maximum mark, if received after 3:00 p.m. on 19 August 2014 and up to 5:00 p.m. the following day after which no assignments will be accepted. 9. If you fail to follow these instructions carefully, the IMM Graduate School of Marketing cannot accept responsibility for the return of the assignment. It may even result in your assignment not being marked. Results will be available on the IMM GSM website: on Friday, 3 October 2014.

2 Page 2 of 8 SPECIFIC INSTRUCTIONS: Answer ALL the questions The use of calculators is permitted. Show ALL calculations. Read all questions carefully to determine exactly what is required before attempting to answer. Number your answers clearly and set them out under appropriate headings and sub-headings. QUESTION 1 Short questions [30] PART A This question consists of THREE independent parts 1.1 Briefly state why the free cash flow valuation method may be difficult to do for the following types of organisations: a) A privately owned organisation, where the owner is the sole and key employee of the organisation. b) A biotechnology organisation, with no current products or sales, but with several promising product patents in the pipeline. c) An organisation that is very sensitive to the macroeconomic business cycle. I.e. during a recession, the company will suffer from more losses in sales than other organisations. d) A troubled organisation, which has made significant losses and is not expected to get out of loss making for the next few years. e) An organisation, which is in the process of restructuring, where it is selling some of its assets and changing its financial structuring of debt and equity. f) An organisation, which owns a lot of valuable land that, is currently unutilized. 1.2 You are provided with the following incorrect statements. For each of the following statements, provide a brief explanation as to why the statement would be considered incorrect: a) A negative free cash flow is always bad. b) An organisation s free cash flows will always be higher than the dividends paid out to shareholders. c) A historically high free cash flows figure for an organisation means that the organisation has been placing the interests of its shareholders as top priority. d) The entire free cash flows of an organisation cannot be paid out as a dividend because some of it has to be invested in new projects.

3 Page 3 of 8 PART B The primary goal of management of an organisation is to maximise shareholder wealth. 1.3 Discuss how MVA and EVA are used to measure wealth creation in an organisation. (4) PART C The board of directors of Tech-Phone were extremely happy with their strategic management over a new electronic division that was opened at the beginning of the financial year. The board of directors indicated that because of the new electronic division they have been able to create a market value added (MVA) of R254 million for the current year, a great success for Tech-Phone. One of Tech-Phone s shareholders, Mr Smith, was upset and stated that market value added (MVA) is an inaccurate measurement of their management contribution to Tech- Phone and it is not a reflection of the value added by the new electronic division. The following information is disclosed to you: Tech-Phone s new electronic division has reported an operational profit of R21 million and has a weighted average cost of capital (WACC) of 15%. Total investor-supplied operating capital equalled R89 million. The South African companies tax rate is 28%. 1.4 Calculate the economic value added (EVA ) for Tech-Phone s new electronic division. (3) 1.5 Discuss why Mr Smith is upset. Your discussion should refer to your answer calculated in 1.4. (3)

4 Page 4 of 8 QUESTION 2 - Risk and Return [25] PART A This question consists of TWO independent parts Ross wants to invest in one of the following three investment options that are provided below. Share A Government Bond B Share C Standard deviation 4.63% 0.15%??? The possible returns and related probabilities of Share C are as follows: Probability Possible return 10% 5% 30% 20% 60% 30% 2.1 Calculate the expected return of Share C using the following table: Probability Possible return ( ) Weighted value 2.2 Calculate the standard deviation for Share C using the following table: (3) 2.3 Based on the given standard deviations of Share A, Government Bond B and your calculated standard deviation for Share C in Question 2.2., indicate, with reasons, which one of the three investment opportunities could be classified as: a) a high return investment; and b) a low return investment. (No calculations are required for Question 2.3 a and b.)

5 Page 5 of Explain why the standard deviation of Bond B is so low. 2.5 You are provided with the following additional information: Share A Government Bond B Expected return 11.79% 10.12% If Ross is a risk adverse investor, indicate, with calculation and reasoning, which of the three investment opportunities (Share A, Government Bond B and Share C) you would recommend to him. Show all your workings. (4) PART B 2.6 Describe business risk and how it may be measured. (3) 2.7 Describe financial risk and how it may be measured. (3) 2.8 Explain the use of standard deviation and coefficient of variance in the measurement of risk. (4) QUESTION 3 The long-term investment decision [45] PART A This question consists of FIVE independent parts 3.1 Discuss what capital budgeting is and why it is important to an organisation. 3.2 What is the difference between independent and mutually exclusive projects? 3.3 Would the net present value (NPV) of a project change if the cost of capital changed? Motivate your answer. 3.4 What is the reinvestment rate assumption, and how does it affect the net present value (NPV) versus the IRR conflict? (4) 3.5 What is the benefit of scenario analysis if it does not produce an accept or reject decision for a proposed project? (3)

6 Page 6 of 8 PART B Print-Big, a company which produces printed T-shirts is considering buying a new machine which will produce printed pants. The financial director was asked to analyses the cash flows in assessing the feasibility of this investment. The following cash flows are provided: Year Cash flow description Amount Notes 0 Market research Initial cash outlay (cost of machine) Cash inflows generated Finance cost paid Cash inflows generated Finance cost paid Cash inflows generated Finance cost paid Cash inflows generated Finance cost paid Proceeds from sale of machine Notes: 1. The market research was paid for one year ago to determine if there is a market for printed pants. It was found that a market will exist for 5 years from the start of the project. 2. The amount of R reflects the cost of machinery to be paid at beginning of the project. 3. The cash inflows represent funds generated from sales of printed pants. 4. A big portion of debt finance will be obtained when Print-Big buys this machine. These cash flows represent the debt finance costs after tax. 5. Print-Big believes that it will be able to sell the machine at the end of 5 years for the amount of R It believes based on market research, that the project will come to an end after 5 years (refer to note 1).

7 Page 7 of Complete the table below by referring to the notes provided. Indicate with a Yes or No if the cash flows taken into consideration are relevant. Motivate your answer in each case. (10) PART C Note Relevant Motivation E.g. Yes Opportunity cost, going to be lost Tool (Ltd) plans to invest in a project to produce a new lightweight hammer. To start this project Tool (Ltd) must invest R in this new lightweight hammer patent. This new range of lightweight hammers will generate net cash inflows of R for three years and then R for an additional five years. Tool (Ltd) s cost of capital is 15%. 3.7 Calculate the payback period for the lightweight hammer project and give two reasons why the payback method is useful in making capital investment decisions. (5) PART D Two partners, Jack and Eddy, are electricians at an electrical company. The company has the opportunity to take on the following two mutually exclusive projects: Project 1: Private House Project 2: Restaurant Market research cost (10 000) Initial investment (60 000) (55 000) Cash inflows generated: Year Year Year Year Year

8 Page 8 of 8 Jack feels they should take on Project Restaurant while Eddy is much keener on Project Private House. They have approached you to aid them in their decision-making process. The directors of the company have calculated their WACC (weighted average cost of capital) to be 14%. 3.8 Calculate the net present value (NPV) of each project and indicate which one should be selected. Motivate your answer. (Show all workings.) (8) 3.9 If the IRR for Project Private House is 19.82% and 34.51% for Project Restaurant and the projects are mutually exclusive, which project would you select? Motivate your answer. PART E DRT Company has designed a new production system. Mr DRT, your boss, must choose among three alternative mutually exclusive courses of action. a) The organisation can sell the design outright to another corporation with payment over two years. b) It can license the design to another manufacturer for a period of five years, its likely life. c) It can manufacture and market the system itself; this alternative will result in six years of cash inflows. The net present values for each alternative option have been provided below Alternative Sell License Manufacture Net present value Mr DRT tells you that you should pick the project with the highest net present value. The required cost of capital is 12% State whether you agree or disagree with Mr DRT. Motivate your answer (3) 3.11 Rank the three alternatives to their profitability for DRT and state which one you would select. Justify your answer. (4) ASSIGNMENT TOTAL: 100