SCHOOL OF ECONOMICS AND FINANCE NOVEMBER EXAMINATION: 2007 SUBJECT, COURSE AND CODE: THE CORPORATE INVESTMENT DECISION (FINA321)

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1 1 SCHOOL OF ECONOMICS AND FINANCE NOVEMBER EXAMINATION: 2007 SUBJECT, COURSE AND CODE: THE CORPORATE INVESTMENT DECISION (FINA321) EXAMINERS (INTERNAL): EXAMINER (EXTERNAL): MRS S DONNELLY MR J MASEKO, VAAL TECH DURATION: 2 HOURS TOTAL: 100 marks INSTRUCTIONS TO CANDIDATES: 1. This question paper consists of FIVE pages, including this page and Appendix A 2. There are THREE questions YOU ARE REQUIRED TO ANSWER ALL THREE QUESTIONS. 3. Answer each question in a separate book. Ensure that you complete the required information on the cover sheet of each answer book. 4. The use of a NON-PROGRAMMABLE calculator is permitted. 5. You are strongly advised to pay due attention to the use of language and to the proper presentation of information. 6. Show all workings. 7. Appendix A contains useful formulae. 8. PV tables are attached for your use.

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3 Question 1 (34 marks: 40 minutes) 3 Spongebob (Pty) Ltd is a bakery company, also involved in ice cream manufacture and specialized catering. For investment appraisal purposes, they use a 15% required rate of return. Management are considering the company s capital investment plans for the forthcoming year. One project under consideration is the purchase of a fleet of delivery vans. Two alternative proposals have been put forward: one is to purchase a fleet of petrol-powered vans; the other is to purchase electrically-powered vans. In addition to the purchase of a fleet of vans, the company has identified four other independent projects. All project outlays and NPV s are shown below: Project Outlay (t o ) (R000 s) NPV (R000 s) A B C D Petrol fleet (E) Electric fleet (F) The company has only R available for capital investment at t o. All projects are divisible, and have the same level of risk. (a) Calculate which projects the company should undertake in order to maximize shareholder wealth. (17 marks: 20 minutes) (b) Assuming that the projects are now indivisible, calculate those that should be undertaken in order to maximize shareholder wealth. Any unutilized capital can be invested at 15%. (9 marks: 11 minutes) (c) Assuming that the projects had different levels of risk, and you were establishing their NPV s, describe two ways in which you could account for their risk differences in the capital budgeting process. (8 marks: 9 minutes) Instructions: Work in R000 s and any rounding off must be to the nearest rand. Round off all ratios to two decimal places.

4 Question 2 (33 marks: 40 minutes) 4 ANSWER BOTH UNRELATED PARTS TO THIS QUESTION Part A (21 marks: 25 minutes) A German company manufactures a specialized piece of agricultural machinery and leases it to a UK enterprise. The lease calls for five end-of-year non-taxable payments of 1 million from the UK enterprise to the German manufacturer. The up-front cost to the German firm in producing the machine is 3.5 million, and the machine is expected to have no salvage value after 5 years. The current direct spot rate is 1.5/. The risk-free interest rate in Germany is 3%, and that of the UK is 5%. The German firm reasons that the appropriate (German) discount rate for this investment is 7%. Calculate the NPV of this investment using the Home Currency Approach. (21 marks: 25 minutes) Rounding instructions: All exchange rates and currency values to two decimal places. Part B As a multinational company, the German company should benefit from international diversification. Graphically illustrate and then describe the concept of international diversification. (12 marks: 15 minutes)

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6 Question 3 (33 marks: 40 minutes) 6 ANSWER BOTH UNRELATED PARTS OF THIS QUESTION Part A (21 marks: 25 minutes) Potter (Pty) Ltd, a natural remedy manufacturer is considering the possible acquisition of Dobby Industries, a producer of herbs. Neither firm has any debt. The financial manager of Potter has produced forecasts to show that this form of vertical integration would bring about annual after-tax cash flow savings of R in perpetuity for his company. The current market value of Dobby is R15 million. The current market value of Potter is R29 million. The appropriate discount rate for the incremental cash flows is 9 percent. (a) Calculate the synergy from the proposed acquisition. (4 marks: 5 minutes) (b) Calculate the value of Dobby to Potter. (4 marks: 5 minutes) Potter is trying to decide whether it should offer 20 percent of its stock, or R10 million in cash for Dobby. (c) Calculate the cost to Potter of each alternative. (d) (6 marks: 7 minutes) Use the NPV criterion to identify which alternative Potter should favour. (7 marks: 8 minutes) Part B (12 marks: 15 minutes) Some of the most colorful language of finance stems from defensive tactics in hostile takeover battles. Describe the following three such tactics: Poison Pill White Knight Golden Parachute (12 marks: 15 minutes)

7 APPENDIX A 7 Benefit-cost ratio = NPV / Initial outlay Profitability Index = Gross Present Value / Initial outlay Ft = S o x (1 + (r* - r) ) t E(S t ) = S o x (1 + (r* - r) ) t