THE CATHOLIC UNIVERSITY OF EASTERN AFRICA A. M. E. C. E. A

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THE CATHOLIC UNIVERSITY OF EASTERN AFRICA A. M. E. C. E. A MAIN EXAMINATION P.O. Box 62157 00200 Nairobi - KENYA Telephone: 891601-6 Fax: 254-20-891084 E-mail:academics@cuea.

1 THE CATHOLIC UNIVERSITY OF EASTERN AFRICA A. M. E. C. E. A MAIN EXAMINATION P.O. Box Nairobi - KENYA Telephone: Fax: academics@cuea.edu JANUARY APRIL 2014 TRIMESTER FACULTY OF COMMERCE MBA- PROGRAMME CFI 619: CASES IN FINANCIAL MANAGEMENT Date: APRIL 2014 INSTRUCTIONS: Attempt ALL the FOUR Questions Duration: 3 Hours Q1. Read the attached case of Town and Country Mortgage Company on Business Risk Versus Financial Risk and answer the following questions: a) What is the subsidiary s breakeven sales volume after interest expense if the subsidiary is financed with 40 percent debt? b) i) If the firm is financed with 40 percent debt, what would expected ROE, and the coefficient of variation of ROE be i iv) ROE (8 marks) Assuming that the coefficient of variation of ROE for the average industrial firm is in the range of 0.5 to 0.7, how risky is the project? The sales estimates given in the case are based on discrete point estimates, not on a continuous distribution. The lowest sales level is units per year, which results in EBIT of $0. Is it realistic to assign a zero probability to an EBIT less than $0? How would (i above affect the expected riskiness project. Cuea/ACD/EXM/JANUARY - APRIL 2014/MBA Page 1

2 c) i) Using the formula given in the case, calculate the cost of equity, Ks, and then calculate the weighted average cost of capital, WACC, assuming the subsidiary is financed with 40 percent debt. On the basis of information developed thus far, should Town and Country set up the new subsidiary to produce the computer system and if so, how should it be financed? (Hint: Think about this question in terms of the effects on Town and Country s Stakeholders). d) Using the following formulas, calculate the subsidiary s total value and total market value if it were financed with $24 million of debt S EBIT K D1T V D S K d s Have Vis the total market value firm, D is total debt, and S is the total stock value (when D =$0, S = V = $60 million. When D = $12 million, S = $ million and V = $ million). Q2. Read the attached case of Weaver Foods Inc. of financing with convertibles and warrants and answer the following questions: a) i) Calculate Weaver s current market value capital structure. In your calculations, ignore the relatively minor amounts of spontaneously generated but do include notes payable, because Weaver uses them as permanent source of capital. Determine Weaver s current weighted average cost of capital based on the cost date and WACC equation given in the case. In your calculations, use the cost of new common stock given in Table 2 for the cost of equity. Cuea/ACD/EXM/JANUARY - APRIL 2014/MBA Page 2

3 b) i) Once a convertible becomes callable, what factors would influence a company s decision to call the issue as opposed to letting it remain outstanding? (1½ marks) What factors would induce the holders of a convertible to convert voluntarily? c) Assume that Weaver would call the 9 percent convertible issue after the first interest payment date on which the conversion value of the bond is 40 percent greater than the bond s par value. Using the assumptions embodied in figure 1, in what year should the bond be called for conversion? (Hint: Set C 1 = par value x 1.4, and find the value of t which forces equality) Note that the 7 percent convertible issue would be called in 9 years under the same set of assumptions. d) i) For this and the next question, assume that your answer to Question (c) above was N = 13, the number of years to conversion, regardless of your actual answer. What is the after tax cost to Weaver of the 9 percent convertible issue? For the 7 percent issue, K c is 7.86 percent if conversion occurs in years 9, this value is calculated as follows: Given the equation M I1T PN CR t 1K 1K t1 c c Cuea/ACD/EXM/JANUARY - APRIL 2014/MBA Page 3 n Where M = Market value of bond = $1000 N = Number of years to conversion = 9 I = Interest in dollars = $70 T = Tax rate = 0.4 P N = expected market price of stock at the end of period N = $ (1.05) = $ CR = Conversion ratio = 50 Then N

4 $ t 9 1K 1K PVIFA PVIF $ $ t1 c c $100 $42.00 $1454 K c 7,86% KC9 KC9 What is the expected before-tax rate of return to investor on the 9 percent convertible issue, assuming a call in year 13? i What accounts for the difference between the investors return and the company s cost on the same issue. (Note: For d(i assume a call in year 9, the expected before tax rate of return on the 7 percent convertible issue is 10.30) Q3. Read the attached case of Bayside Marine Corporation on inventory Management and answer the following questions: a) What is the economic ordering quantity for standard 5-inch winches if they are ordered from: i) Supplier A Supplier B b) i) What or assumptions are implied in the EOQ model. (4 marks) Do these assumptions appear reasonable when applied to Bayside Marine? c) i) How many orders should be place each year if Bayside buys from: I) Supplier A II) Supplier B What is the reorder point (in units) for each supplier? Assume for now that no safety stock are held and use a 360 day year. Cuea/ACD/EXM/JANUARY - APRIL 2014/MBA Page 4

5 d) i) Calculate the total inventory cost (the cost of ordering plus the cost of carrying inventories) that Bayside would incur from each supplier (2½ marks) On the basis of the information developed thus far which supplier should Bayside use? Q4. Read the attached case of Sure-Start Auto Parts Company on establishing the optimal Capital Budget and answer the questions that follow: a) Hartman concluded that Sure-starts present capital structure minimizes the firms weighted average cost of capital and maximizes the stock price. Ignoring the spontaneously generated accounts payable, calculate Sure Starts Capital structure. (4 marks) (Be sure to include notes payable in your answer, because Sure Start uses notes as a source of permanent financing) b) Assuming that the current capital structure is held constant, the dividend payout ratio is set at 60 percent, depreciation charges are $60 million, and earnings of $80 million are available to common shareholders in 1990, calculate the break point(s) in the marginal cost of capital curve and show where it occurs. (4 marks) c) Find the weighted average cost of capital (WACC = K a ) on each side of the break point and graph the marginal cost of capital structure. (7 marks) (Recall that Sure-Start s marginal tax rate is 40 percent, and use 60 percent of the estimate 1990 EPS for D 1 and the current price of the stock as P 1 ) *END* Cuea/ACD/EXM/JANUARY - APRIL 2014/MBA Page 5

.201 ( 1/2558) OUTLINE: (5) (Capital Structure) (Cost of Capital) (Financial Structure) (Financial Structure)

.201 ( 1/2558) OUTLINE: (5) (Capital Structure) (Cost of Capital) (Financial Structure) (Financial Structure) OUTLINE:.201 ( 1/2558) (5) (Capital Structure) (Cost of Capital) ( ) : (Component Cost) : (Weight Average Cost of Capital WACC) : (Marginal Cost of Capital) 1 2 (Financial Structure) Debt to Total Assets