BSc (Hons) Management with Finance Cohort: BMANF/15B/FT Examinations for Academic Year 2016 2017 Semester II / Academic Year 2017 Semester I MODULE: CORPORATE FINANCE MODULE CODE: ACCF 2204(A) DURATION: 2 HOURS READING TIME: 20 MINUTES Instructions to Candidates: 1. This paper consists of Sections A and B. 2. Section A is Compulsory. 3. Answer any two questions from Section B. 4. Non programmable calculators are allowed but relevant workings must be clearly shown. 5. Always start a new question on a fresh page. 6. Total Marks: 100. This Question Paper contains 4 questions and 5 pages EXCLUDING PRESENT AND FUTURE VALUE TABLES. This Question Paper is printed on BOTH SIDES. Page 1 of 5
SECTION A: COMPULSORY QUESTION 1: (40 MARKS) The capital structure of LE RENART Company Ltd consists of an ordinary share capital of Rs1, 000,000 (Rs100 per share) and Rs1, 000,000 of 10% debentures. The company is in the business of computer manufacturing and software development. Recently the company has observed an increase of 20% in sales from 100,000 units to 120,000 units. The prevailing Income tax rate stands at 50%, the selling price per unit was Rs 10, the variable cost per unit was Rs 6 and the noncurrent assets were Rs 200,000.Mr. Marylyn, the CFOprefers debt financing since this increases the firm s profit per share, and, thus, the value of the shares.within the board of directors there is a discussion about the optimal financing choice.the CFO is thinking aloud about an appropriate debt financing level for the company. He took up the matter with the consultants of the company. They explained to Mr Marylyn that if the objective of the firm is the maximization of shareholder wealth, then the debt to equity ratio does not matter. However, their comment holds in a world of no taxes and they argued that in a world with tax, it is best to gear-up the company as high as possible. Now the CFO may not know much about theories of financing decisions but he knows that there are limits to which the debt level is desirable. (a) Calculate the following: i. The percentage increase in earnings per share. ii. The degree of financial leverage at 100,000 units and 120,000 units. iii. The degree of operating leverage at 100,000 units and 120,000 units. (12 marks) (b) From the case above, the CFO prefers gearing since this increases the firm s profit per share, and, thus, the value of the shares. Do you agree with the CFO (ignore taxes)? (4 marks) (c) Write a report for the CFO both outlining the theoretical arguments and explaining the real-world influences on the gearing levels of firms. (24 marks) Page 2 of 5
SECTION B: ANSWER ANY TWO QUESTIONS QUESTION 2: (30 MARKS) Nice company Ltd is considering two mutually exclusive proposals to install new milling controls. The cost of proposal A is Rs 2,700,000 and proposal B is Rs.3, 000,000. The projects have a life expectancy of 6 years each and no salvage value. The tax rate is 50 per cent. Assume the firm uses straight line method of depreciation and the same is allowed for tax purposes. The estimated cash flows before depreciation and tax (CFBT) from the investment proposal are as follows: Tax Year Proposal A Rs. Proposal B Rs. 1 2 3 4 5 6 650,000 725,000 875,000 950,000 900,000 800,000 975,000 1,000,000 1,100,000 1,025,000 950,000 850,000 Present value of an annuity of One rupee Year 11% 12% 13% 14% 15% 16% 1 0.901 0.893 0.885 0.877 0.870 0.862 2 0.812 0.797 0.783 0.769 0.756 0.743 3 0.731 0.712 0.693 0.675 0.658 0.641 4 0.659 0.636 0.613 0.592 0.572 0.552 5 0.593 0.567 0.543 0.519 0.497 0.476 6 0.535 0.507 0.480 0.456 0.432 0.410 Compute the following: (a) Payback period, (2 marks) (b) Average Rate of Return, (3 marks) (c) Net present value @ 15%, (10 marks) (d) Profitability Index. (4 marks) (e) Recommend which project should be adopted by the company. (1 marks) (f) Explain the types and sources of Risk in Capital Budgeting. (10 marks) Page 3 of 5
QUESTION 3: (30 MARKS) PART A: (20 MARKS) Le Malin. Ltd id considering the possibility of purchasing a multipurpose machine which cost Rs 1,000,000. The machine has an expected life of 5 years. The machine generates Rs 600,000 per year before depreciation and tax, and the management wishes to dispose the machine at the end of 5 years which will fetch Rs 150,000. The depreciation allowable for the machine is 25% on written down value and the Company s Tax Rate is 50%. The company approached Mauritius Leasing Company for a five-year lease for financing the asset which quoted a rate of Rs 28 per thousand per month. The company wants you to evaluate the proposal with purchase option. The cost of capital of the company is 12% and for lease option, it wants you to consider a discount rate of 16%. Advise whether Le Malin. Ltd should opt for a five-year lease or purchase the multipurpose machine. PART B: (10 MARKS) Anonious Fertilizers Limited is considering a capital project requiring an outlay of Rs 15 million. It is expected to generate a net cash inflow of Rs 3.75 million for 6 years. The opportunity of cost of capital is 18%. Anonious Fertilizers can raise a term loan of Rs 10 million for the project. The term loan will carry an interest rate of 16% and would be repayable in 5 equal annual installments, the first installment falling due at the end of the second year. The balance amount required for the project can be raised by issuing equity. The issue cost is expected to be 8%. The tax rate for the company is 50%. a) What is the base case NPV? (1.5 marks) b) What is the adjusted net present value? (8.5 marks) Page 4 of 5
QUESTION 4: (30 MARKS) Theoretically Modigliani and Miller (1958)took a fairly straightforward view of the purpose of a company in an economy. They pointed out that companies take cash from providers of long-term funds, invest it in new projects with positive Net Present Value (NPV) and repay the future net inflows to these fund providers in the form of dividend plus interest. They showed that there is no relationship between debt and the value of the firm and it seems to be good enough in the light of the assumptions underlying their model. However, most of these assumptions are unrealistic and untenable. Explain the validity of the Modigliani and Miller (1958) model in the real world along with their assumptions. ***END OF QUESTION PAPER*** Page 5 of 5