FACULTY ECONOMIC AND MANAGEMENT SCIENCES DEPARTMENT FINANCIAL MANAGEMENT

FACULTY ECONOMIC AND MANAGEMENT SCIENCES DEPARTMENT FINANCIAL MANAGEMENT FINANCIAL MANAGEMENT 300 YEAR TEST 3 Suggested solution 25 September 2012 INTERNAL J E Klopper F Blom L Klopper EXTERNAL G J Plant 120 marks 180 minutes QUESTION 1 QUESTION 2 QUESTION 3 QUESTION 4 QUESTION 5 Inventory management Financing Dividend policy Analysis & interpretation MULTIPLE CHOICE: Introduction to Financial Management Working capital management Cost of capital Capital structure

QUESTION 1 25 Marks EGOLI GLASS COMPANY (a) The ordering cost per order is composed of the following costs: Customs inspection fee R375.00 Contract labour: receiving clerk 8 x R45.00 360.00 Variable overhead: receiving department 8 x R12.50 100.00 Relevant processing cost* 29.00 (2½) Total ordering cost per order R864.00 * Relevant processing cost per order Variable cost per order: change in orderingcost changein number of orders = (R63 500 R61 500) / (100-20) = R2 000/80 = R25.00 Recognition of 16% cost increase R25.00 1.16 R29.00 The storage cost per windscreen is composed of the following costs: Variable warehouse rent per windscreen (fixed fee not relevant) R26.75 Breakage cost per windscreen 15.00 Insurance per windscreen 5.75 Other carrying costs 52.50 Total carrying cost per windscreen R100.00 The economic order quantity (EOQ) is calculated as follows: EOQ = (2)(10 800)(R864.00) R100.00 EOQ = 432 windscreens per order (2)

(b) The minimum annual relevant cost at the economic order quantity is calculated as follows: = ordering cost + storage cost = 10 800 R864 432 R100.00 432 2 = R21 600 + R21 600 = R43 200 (2) (c) The reorder point in units is calculated as follows: Usage per day lead time in days = 36* units 6 days = 216 windscreens (2) * 10 800 50 weeks 6 days 12

QUESTION 1 (continued) (d) Re-order point in units taking into account optimal safety stock Expected number of windscreen sales per 6-day period (lead time) = 10 800 x [6/ (50x6)] = 216 (as calculated in (e)) Safety stock windscreens Carrying cost per screen p.a. (R) Total carrying cost p.a. (R) Number of screens out of stock (=A) Probability of out of stock (=B) Per event cost of one screen not in stock (R) (=C) Number of orders p.a. (= number of lead times)(=d) Total out of stock cost p.a. (R) (=E) Total cost p.a. (R) 0 150 0 14 0.213 0.01x3400= 34 10800/432=25 2 535 24 0.0875 34 25 1 785 0 4 320 4 320 14 150 2 100 10 0.0875 34 25 744 2 844 (2) 24 150 3 600 0 0 34 25 0 3 600 (1r/w) (1r/w) (1r/w) (1r/w) Thus, the optimal level of safety stock is 14 windscreens (lowest total relevant cost) Thus, the new re-order point is 216 + 14 = 230 windscreens 11 Note to markers: Total out of stock cost (E) = A x B x C x D For each component omitted / incorrect in the multiplication: -½ (a) to (d) Communication skills presentation and lay-out 2 See Note TOTAL NUMBER OF MARKS FOR QUESTION 1: [25]

QUESTION 2 23 Marks TNM LIMITED (a) Debt vs. equity Return: 1. Interest is payable on debt financing regardless of company performance and dividends are not compulsory. (Can only earn the mark here or at point 11) 2. Effect of gearing: positive or negative. 3. Debt is cheaper than equity because suppliers of debt carry less risk, they also expect a lower return (relative to equity) Or Because of the increased risk that equity holders carry (their claims against the company are subordinate to the claims of the debt suppliers), they expect a higher return and thus equity is more expensive than debt from a company view point. 4. Interest is tax deductible if the funds are used in the production of revenue. Dividends are not deductible for tax purposes. 5. TNM is already highly geared, with a debt / equity ratio of 1.69 OR it is unusually high and in comparison with TEL Limited (0.33) that is in the same industry, it is very high. 6. Although debt is a cheaper way of financing, additional debt will increase the financial risk further which can lead to a higher expected return from shareholders. 7. The effect of the larger source of cheap financing (debt) can possibly be cancelled-out by an increase in the cost of equity. In such a case this can lead to an increase in the weighted average cost of capital (WACC) which will decrease the value of the enterprise. 8. The high issue cost results in equity being more expensive than debt. 9. Refer to mark A under Control in respect of a possible loss of income due to the potential decrease in TNM s BEE rating (mark should only be awarded once for this) 10. All TNM s Property, plant and equipment are being used as security for their long term debt. The fact that there are no remaining unencumbered assets to serve as security for additional loans will most probably increase the cost of new debt. Risk: 11. Liability: interest is payable on debt financing, regardless of the company s performance (and consequently its liquidity position), while dividends are only declared if sufficient funds are available and the performance of the company justifies it. 12. Repayment of capital (debt) is compulsory, regardless of the liquidity position. No repayment claims in respect of equity capital. 13. Capital structure: a higher debt ratio increases the company s financial risk but WACC until shareholders / the market reconsiders the risk profile of the company and WACC (due to the increased return on equity now expected and less flexibility to obtain debt financing at favourable rates in the future). 14. Signalling effect: Issuing of new shares can be seen as negative (market can interpret that management believes that shares are overvalued). 15. Rights issue: often causes a decline in the share price of 2-5%. Control: 16. Effect on control (equity) > 75% for special decision > 50% for ordinary decision 35% deemed to give control through the Company s act in respect of a change in control (affected transaction) 20% - 30% of a listed company deemed as effective control

17. Debt can also influence the control of management (as the agents of the shareholders) if there are strict loan covenants. 18. An issue of shares (other than by way of a rights issue), will dilute the control of existing shareholders. 19. Umalume currently has effective control with 30% of the shares. Umalume however does not have the funds available to buy more shares in TNM. Umalume will lose effective control if they don t take up new shares and that can decrease TNM s BEE rating. (1 B ) which can lead to a loss in income from government contracts. (1 A ) 20. Number of shares to issue if this is fully financed with new equity: R120 000 000 / (R20.17 R0.15) = 5 994 006, thus approximately six million shares. Note: in order to calculate the WACC of a company, the pooling of funds principle will be followed and the assumption be made that financing will be done out of equity in the ratio of the target capital structure and that shares will only be issued when there is no retained income available. When control is however considered, the actual number of shares that needs to be issued, have to be considered. 21. Calculation of diluted control. (For a meaningful illustration) (2) Conclusion: 22. Because of the high debt / equity ratio TNM it is possible that TNM won t be able to obtain more debt financing (or if they obtain debt it will be at a very high rate). TNM will thus issue shares, and thus TNM s BEE rating will decrease(1 B ), but it doesn t look like the board has any other option. 23. The board should consider if the investment in the DRC and possible other investments in Africa will deliver higher returns than the returns that will be lost from government contracts if TNM s BEE rating will decrease with a shares issue. Presentation Layout Point 21: Calculation of diluted control: Illustrative: if TNM would undertake a rights issue of six million shares, a minimum of 1 800 000 shares will remain (= 30% of 6m and = 5.45% of the total issued shares of 33m) because Umalume will have to decline their rights. If TEL takes up 1 500 001 or more of these, Umalume will lose effective control over TNM to TEL. Currently Uptake Uptake After rights issue Shares Contro Rights issue Surplus Shares Control l Umalume 8 100 000 30% - - 8 100 000 24.54% TEL 5 400 000 20% 1 200 000 1 500 001 8 100 001 24.54% + 1share Other 13 500 000 50% 3 000 000 299 999 16 799 999 50.91% Total 27 000 000 100% 4 200 000 1 800 000 33 000 000 100% There are a large number of possible scenarios that can occur according to which Umalume can lose control to TEL or another shareholder (which is less likely) when new shares are issued. Possible marks for discussion 24 Maximum marks for discussion 16 Presentation and layout 2 Total number of marks for question 2(a): [18]

(b) Factoring (c) Credit sales 480 000 000 x 45% = 216 000 000 (0.5) Current debtors 216 000 000 x 30/360 = 18 000 000 (0.5) Net debtors (advance) 18 000 000 x 84% = 15 120 000 (0.5) Cost of factoring : Service charge 216 000 000 x 2% = 4 320 000 r/w Financing cost 15 120 000 x 8% = 1 209 600 (0.5) Total cost 5 529 600 Administration cost (2 600 000) (0.5) Net cost 2 929 600 (0.5) Effective factoring cost 2 929 600/ 15 120 000 = 19.38% (5) Total number of marks for question 2(b): [5] TOTAL NUMBER OF MARKS FOR QUESTION 2: [23]

QUESTION 3 17 Marks WOOLLIES LIMITED (a) Year Pay-out ratio 2004 0.28/0.7 = 0.4 2005 0.37/0.91 = 0.407 2006 0.38/0.95 = 0.4 2007 0.48/1.20 = 0.4 2008 0.46/1.12 = 0.411 Conclusion: A constant dividend cover of 2,5 (or pay-out ratio of 40%) is followed in general. (b) Dividend pay-out ratio 2009: 0.31/1.54 = 20% 1. The world recession started in 2008 where the global economy was under immense pressure. (Although Woollies growth in earnings per share was very high in 2009 (38%), the growth in 2008 was negative (-7%). (2) Following the uncertainty regarding the economy, management would probably have decided on declaring a lower dividend in order to recover its cash position after a difficult year so that the working capital demands for daily operations can be met. Of Woollies had good reason to believe that the growth prospects for 2010 were not good (actual growth in earnings: 0.7%) and hence they attempted tried to build up cash reserves in advance in order to satisfy daily working capital demands.. 2. Management withheld dividends so that it can be used as financing for potential investments. 3. Any other valid point. MAX (2) (c) Financing needed = R450m (A) + R155 680 000 (B) + R264 320 000 (C) (Projects with IRR>WACC) = R870m Financing through equity = R870m x 60% = R522m (0.5) Earnings per share 2012 = 1.92 x (1,09375) = R2,10 (0.5) Total earnings = R2,10 x 745 709 140 = R1 565 989 194 (0.5) Remainder earnings after financing needs were taken into account = R1 565 989 194 R(522 000 000) R1 043 989 194 Dividend per share = R1 043 989 194 / 745 709 140 = R1,40 per share (0.5) (4) (d) The implication of the residual dividend policy: all earnings that are not used for financing of projects are paid out as dividends. This can thus have a material impact on cash and/or the dividend cover. 1. LEGAL REQUIREMENTS (Company law nr. 71 of 2008) Dividends to be authorised by directors; May proceed with a dividend distribution if solvency & liquidity tests are satisfied: Assets fairly valued > liabilities fairly valued Appears likely that the company can pay debts (as they become due) for a period of 12 months after distribution; 2. CONTRACTUAL OBLIGATIONS The company may have entered into contracts which may limit the percentage of earnings that are to be declared as dividends. 3. INFORMATION CONTENT OF DIVIDENDS Analysts look at dividends for information regarding growth etc. Dividends are an indicator or

signal of management s confidence in the company. Example 1: Thee residual policy can lead to dividends that are very volatile and this situation can result in a signal-effect: Shareholders may react negatively and this can influence the share price negatively. Example 2: Div 2011: R1.44; Div 2012: R1.40 The decrease in the dividend can send a negative signal to the market which can lead to a decrease in the market price of the Woollies shares especially if the market is not aware of the suggested investments. (If the market is efficient however, the market will discount the expected return of the new investments into the market price of the Woollies shares and the market price will then not necessarily decrease because of the lower dividends.) 4. TAXATION Tax implications for shareholder: Dividend withholding tax of 10% on dividends or capital gains tax (25% inclusion rate for individuals and a 50% inclusion rate for companies). 5. NATURE OF THE SHAREHOLDERS Clientele effect: Cash dividend vs. capital growth: if Woollies has shareholders with a preference for cash dividends, they will not necessarily be happy with the change in the dividend policy. Shareholders that have a preference for capital growth however will be pleased with a change in the dividend policy of Woollies. MAKS (4) Marker s note: Maximum two marks can be awarded for headings. (e) 1. Dividend in specie (i.e. inventory) 2. Script dividends (shares) (2) (f) 1. Die active variable approach based on the view that the value of a company is influenced by the dividend that is declared. 2. The value of the company in terms of this approach is determined by the present value of future dividends. By using Gordon s Dividend-growth model, we can determine the value of a company. 3. We will not be able to determine Woolworths value with this model since the growth in dividends is not constant. (3) Original information of Woolworths Holdings Limited: (adjusted and used for this question) Price 35.00 Dividend P/E EPS Symbol SUR071 Date % Amount Amount Country South Africa Actual 4.10 1.44 18.2 1.92 Index 2010 2.49 0.67 17.40 1.55 Sector Consumer Services 2009 1.76 0.31 11.6 1.54 Subsector General Retailers 2008 6.22 0.79 11.3 1.12 Yield 1m % -4.0 2007 4.75 0.76 13.3 1.20 Yield YTD % 29.9 2006 3.50 0.63 19.0 0.95 Yield 12m % 29.4 2005 1.09 0.15 15.6 0.91 Analysts 2004 0.92 0.10 16.2 0.7 TOTAL NUMBER OF MARKS FOR QUESTION 3: [17]

QUESTION 4 30 Marks PARKER INVESTMENTS a. Liquidity ratios Food and Fashion House and Home 2012 2011 2012 2011 Current ratio 1.17 1.41 0.99 0.95 (2) Current Assets 5 034 4 950 12 297 10 416 Current Liabilities 4 296 3 512 12 450 10 985 Quick ratio 0.66 0.87 0.26 0.30 (2) (Current Assets - Inventory) 2 818 3 058 3 242 3 302 Current Liabilities 4 296 3 512 12 450 10 985 (½ Mark for each correct ratio) Ratio calculation (4) House and Home has increased their current asset ratio slightly in the current year due to increased inventory levels but its quick ratio has decreased slightly due to the higher portion of long term debt that is payable in the short term (increase of 50,7%) while making less use of trade credit (reduced by 8,7%). By carrying more inventory, House and Home Ltd is exposing itself to an increased risk of obsolescence, stock write offs etc. Food and Fashion s current asset and quick ratio declined during the year. The main reason for this is the relatively large portion of long term debt that has become payable in the short term. Food and Fashion does seem to be more liquid than House and Home. House and Home has significant short term debt commitments of R6,147m, especially when compared to cash of only R2,361m. This will further reduce the liquidity of House and Home The short-term debt commitments of Food and Fashion are less than its cash position indicating lower liquidity risk. It is also important to note that retail businesses require significant cash for day to day retail operations and hence, the cash balances reflected may not be available to meet the short term debt commitments. b. Debt management ratios Food and Fashion House and Home Discussion max (2) Total (6) 2012 2011 2012 2011 A: Debt ratio 52.36% 54.85% 69.69% 76.79% (2) Total Debt 5 260 4 972 16 758 19 538 Total Assets 10 045 9 065 24 046 25 443 B: Debt to equity 109.93% 121.48% 229.94% 330.87% (2) Total Debt 5 260 4 972 16 758 19 538 Total Equity 4 785 4 093 7 288 5 905 C: Gearing ratio 16.77% 26.29% 37.15% 59.16% (2) Permanent interest bearing debt 964 1 460 4 308 8 553 PIBD + Equity 5 749 5 553 11 596 14 458 As per the required part of the question only 1 of these ratios was to be calculated. Subtotal max (2)

D: Times interest earned 20.80 12.53 12.28 10.87 (2) EBIT 2 870 2 306 4 002 3 197 Interest 138 184 326 294 E: Debt payback period 3.31 3.38 10.86 12.95 (2) Total Debt 5 260 4 972 16 758 19 538 Cash flow from operations 1 590 1 471 1 543 1 509 F: Short term debt: Long term debt 4.46 2.41 2.89 1.28 Short term debt 4296 3512 12450 10985 Long term debt 964 1460 4308 8553 (2) As per the required part of the question 1 additional debt management ratio had to be calculated. Subtotal max (2) Ratio calculation (4) A, B, C: Debt ratio, debt to equity and gearing ratio Both House and Home and Food and Fashion decreased ratios A, B and C debt during 2012. House and Home decreased their total debt levels whilst both companies increased equity levels through an increase in retained earnings. Both companies seem to be taking the approach to lower their financial risk by lowering (repaying) their total debt. This could lead to a higher WACC if debt is replaced by equity in the company s capital structure and thus a lower return for shareholders in exchange for lower financial risk. Depending on the shareholders view of the quantum in the reduction in financial risk, the cost of equity could possibly reduce which would then not have a negative impact on the WACC Both companies however increased their risk by having significantly higher proportion of short term debt than long term debt. Their short term debt to long term ratios increased by 185% and 226% respectively. Any 2 relevant points, max (2) D: Times interest earned Despite an increase in finance costs, House and Home s time s interest earned ratio has increased by 13% during the year as a result of improved profits generated. Food and Fashion time s interest earned ratio increased significantly (66%) during the year and is a direct result of the increase in EBIT and a decrease in interest paid. E: Debt payback period House and Home decreased their debt payback period by approximately two years based on cash flow from operations. This is due to the decrease in the company s debt levels. Food and Fashion debt payback period remained relatively constant (3,3 and 3,4 years) although this can be expected as the payback period is already very low when compared to that of House and Home F: Short term to long term debt House and Home s short term debt increased by 13% whilst their long term decreased by 50%. Food and Fashion s short term debt increased by 22% in 2012 whilst their long term decreased by 34%. As short term carries much higher financial risk than long term debt it appears as though Food and Fashion short term debt is of higher risk than House and Home s. However when one compares the companies cash to their short term debt, Food and Fashion (R2 187 / R4 296 =51%) and House and Home (R2 361/ R12 450 = 19%) it is clear that Food and Fashion is in a much better position to cover its short term debt.

Discussion of time s interest earned, debt payback period or short term to long term debt max Conclusion In conclusion and to answer Miss Jean s question it would seem that Food and Fashion has much lower debt levels, has a higher Times interest earned ratio and is significantly lower geared than House and Home. All these factors contribute to lower financial risk when compared to House and Home. The company would certainly be able to take on much more debt than House and Home should the need arise Both companies seem adequately covered but given the high levels of debt of House and Home, it is questionable as to whether the company will be able to absorb much more debt c. Working capital cycle Conclusion max Total max (8) Both Food and Fashion and House and Home have very low debtor s days based on total turnover. This is to be expected as House and Home sells all their food items for cash. Food and Fashion offers all their products on credit (first 55 days interest free) but despite this they are able to keep their debtor days very low The quality of debtor management can only be assessed if the mix of credit vs. cash sales is known and debtor days are calculated using credit sales only Food and Fashion has lower inventory days than House and Home which could indicate better inventory management. It could also be because House and Home sells furniture that tends to have a slower turnover rate than food and clothing. House and Home also increased their inventory levels when compared to 2011 due to customer complaints which increased their inventory days substantially Food and Fashion has much higher creditor days when compared to that of House and Home indicating that they are able to pay their creditors later and thus reduce their net working capital cycle It is worth noting that Food and Fashion actually pays for its inventory purchases after cash has been collected from customers for sales which assists in shortening the cash cycle Food and Fashion has a much shorter cash cycle than House and Home. In fact Food and Fashion has a negative cash cycle indicating that the company should have excess cash on a continuous basis and that their inventory and debtors are financed interest free via creditors the strong cash position of Food and Fashion can be partly attributed to this fact. House and Home had to make additional investments in inventory in the current year and that has caused a significant increase in the company s net working capital cycle whereas Food and Fashion was able to keep their net working capital cycle more consistent. Food and Fashion certainly appear to be better at managing its cash cycle Discussion max (3) Additional information: A sales analysis for both companies showing the amount of sales per product group (food, clothes, furniture etc.) A sales analysis showing credit and cash sales (preferably per product group) An age analysis of inventory items (furniture, food, clothing etc.) Both company s credit policies A debtors age analysis Supplier terms for both companies A creditors age analysis 1 Mark each max (2) Total max (5)

d. Du Pont analysis Food and Fashion House and Home 2012 2012 Net profit margin 6.96% 3.33% Net profit 2 005 2 572 Sales 28 813 77 297 Total asset turnover 2.87 3.21 Sales 28 813 77 297 Total assets 10 045 24 046 Total assets/equity 2.10 3.30 Total assets 10 045 24 046 Equity 4 785 7 288 Return on equity 41.90% 35.29% Net profit 2 005 2 572 Equity 4 785 7 288 (½ Mark for each correct ratio) Ratio calculation max (4) Food and Fashion has a higher net profit margin than House and Home (6.96% vs. 3.33%) mainly due to a higher gross margin (2012: 36% vs. 25%) which offsets Food and Fashion s higher operating costs (operating costs as a % of revenue - 2012: 26% vs. 20%) sufficiently to generate an EBIT margin almost double that of House and Home (2012: 10% vs. 5.2%) (2).This is probably because Food and Fashion serves the middle to higher income group and can thus charge higher prices House and Home has a higher asset turnover of 3.21 times compared to that of Food and Fashion of 2.87 times. This appears to indicate that House and Home is able to utilise its assets more efficiently to produce sales It is however, more likely because House and Home had to write off a significant amount of assets during the year and thus has a lower asset base In terms of the financial leverage multiplier House and Home has significantly more debt in their capital structure when compared to that of Food and Fashion. Food and fashion has a debt ratio of 52.36% whereas House and Home has debt ratio of 69.69%. House and Home thus relies more heavily on debt to finance assets which creates higher returns for shareholders The effect of the higher financial leverage multiplier, as well as the higher assets turnover ratio was however still insufficient to offset the much lower net profit margin of House and Home and as such the company s return on equity is still lower (35.29% vs. 41.90%) when compared to that of Food and Fashion Discussion max (5) Total max (9) TOTAL NUMBER OF MARKS FOR QUESTION 4: [30]

QUESTION 5 26 Marks MULTIPLE CHOICE QUESTIONS 1. The main objective of financial management is: c) To maximise shareholder wealth 2. The cost of equity is higher than the cost of debt because: c) Shareholders take more risk than the providers of credit and demand a higher return for this 3. Based on the additional sales only, the expected increase in the gross profit is: b) R750 000 Additional sales x GP% R3 000 000 x 25% 4. The expected decrease in the bad debt amount before tax is: c) R960 000 Old credit policy R 1 080 000.00 R12 000 000 x 90% x 10% New credit policy R 120 000.00 R15 000 000 x 20% x 4% R 960 000.00 5. The expected increase in the discount amount before tax is: e) R1 164 000 Old credit policy R 36 000.00 3% x 10% x R12 000 000 New credit policy R 1 200 000.00 10% x 80% x R15 000 000 -R 1 164 000.00 6. The opportunity cost (in this case, the advantage) of the change in net working capital is: a) R270 833.33 Old credit policy Debtors with discount R 100 000 Debtors after discount R 2 700 000 New credit Calculation policy R12 000 000 x 30/360 x 10% R 166 666.67 R12 000 000 x 90/360 x 90% R 250 000.00 Additional inventory R 600 000.00 Additional creditors -R 300 000.00 Total investment in working capital R 2 800 000 R 716 666.67 Calculation R15 000 000 x 5/360 x 80% R15 000 000 x 30/360 x 20% Net change R 2 083 333.33 Cost of capital of 13% R 270 833.33

7. For purposes of calculating the weights of the components in the capital structure of ABC, the Randvalue (rounded off to the nearest Rand) of preference shares is: d) R1 777 778 40 000 x (0.08 x R50) / 0.09 = R1 777 778 8. For purposes of calculating the weights of the components in the capital structure of ABC, the Randvalue (rounded off to the nearest Rand) of debentures is: c) R6 143 741 Cf0 Cf1 Cf2 Cf3 0 11 11 116 i = 11.5%? NPV = R102.39568 60 000 x NPV as calculated = R6 143 741 9. In the calculation of ABC s WACC, the cost of preference shares (rounded off to two decimals) will be: c) 9.38% 0.09 / 0.96 = 9.38% 10. In the calculation of ABC s WACC, the cost of debt (rounded off to two decimals) will be: e) 8.89% Cf0 Cf1 Cf2 Cf3 Cf4 Cf5 (R 98.00) 11 11 11 11 116? i = 12.3412% After tax: 0.72 x i as calculated = 8.89% 11. The following table includes three different possibilities for the capital structure of Optimal Limited: Scenario 1 Scenario 2 Scenario 3 Target capital WACC Target capital WACC Target capital WACC structure structure structure Equity 50% 14% 60% 14,4% 80% 15,2% Debt 50% 40% 20% The following statements are true: d) B, D and E A The value of the company will be maximised in Scenario 3. X B The value of the company will be maximised in Scenario 1. C The financial risk of the company will be higher in scenario 2 than in scenario 1. X D The financial risk of the company will be higher in scenario 2 than in scenario 3. E Optimal Limited can increase its return on equity by using more debt, as long as the aftertax return on assets is higher than the after-tax cost of debt. F Optimal Limited can increase its return on equity by using more debt, as long as the asset turnover rate is higher than the financial leverage multiplier X 12. The following statement(s) is/(are) true: d) a en c

13. The following graphs in respect of capital structure theory are provided for consideration: A. B. Ke WACC Ke Cost% Kd Cost% WACC Kd Debt ratio Debt ratio C. Ke Cost% WACC Kd Debt ratio The following statement is not true: a) Graph A and C make the assumption that there is no taxation. a) Graph A and C make the assumption that there is no taxation. X b) Graph A takes financial distress into account. c) Graph C makes the assumption that there is no financial distress. d) Graph C concludes that the capital structure of a company is irrelevant. e) Graph B takes taxation into account. TOTAL NUMBER OF MARKS FOR QUESTION 5: [26] TOTAL NUMBER OF MARKS FOR THE PAPER: [120]