MAC4865/TL204/0/2017

Tutorial letter 4/0/2017

Financial Strategy

MAC4865

Year module

Department of Management
Accounting
ADDITIONAL INFORMATION:

 Please refer to the Tutorial Letter 101 for instructions regarding assignment
submissions.
 Please activate your myLife email address and ensure you have regular access to the
myUnisa module site for MAC4865 since this is a fully online module.
 Please familiarise yourself with the fully online study environment since you will not
receive printed tutorial letters for this module.

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Dear Student

This tutorial letter serves as a suggested solution for assignment 4.

The following questions

ASSIGNMENT 04: SELF-ASSESSMENT ASSIGNMENT

QUESTION 1 (30 MARKS)

1.1 C

1.2 D

1.3 B

1.4 B

1.5 A

1.6 C

1.7 D

1.8 A

1.9 A

1.10 B

Calculations

1.1

2012 2013 2014 2015 2017 2017

Cash flow 750 950 1400 2100 2100 2100

DR 0.909 0.826 0.751 0.683 0.621 0.564

1.868 Alternative
PV 681.75 784.7 1 051.4 1 434.3 1 304.1 1 184.4

NPV of cash inflows 6 440.65

Cost -6 500.00

NPV -59.35

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1.2

De-gear beta

Geared Beta: 1.95 Given

Value of equity: 1
Value of debt: 4
Tax rate 0.28

Therefore:

Ungeared beta: 1.95 x (4/4 + 1 (1 x 0,72))

= 1.652542

Rounded 1.65

1.3

Re-gear Beta

Ungeared beta 1.65 (from 4.2)

Beta of debt 0
Value of debt
minus tax 0.72
Value of equity 3 (CIP's debt equity ratio)

Therefore

the geared beta for 1.65 + 1.65 x (0,72) / 3 =

CIP is: 2,046

Rounded 2.05

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1.4

Calculate the new cost of equity

Risk free rate of return: 4% given

Market risk rate: 9% given

Beta 2,05 From 4.3

0.04 + (0.09 - 0.04) x

Therefore 2,05

Cost of equity 14.25%

1.5

WACC

Cost of equity: 14,25% From 1.4

Value of equity: 3 Given

Value of equity+ value of debt 4 (3+1) - debt equity ratio

Cost of debt (1minus tax) 0.0432 6% x (1-0.28)

Value of debt 1

0,1425 x (3/4) + 0,432 x

Therefore the new WACC (1/4)

=11.77%

ROUNDED 12%

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1.6

New NPV

2012 2013 2014 2015 2017 2017

750 950 1400 2100 2100 2100

0.893 0.797 0.712 0.636 0.567 0.507

1.709 Alternative

669.75 757.15 996.8 1335.6 1190.7 1064.7

NPV of cash
inflows 6 014.70

Cost -6 500.00

NPV -485.30

1.7 A

1.8 A

1.9 A

1.10 B

0.04 + (0.08 – 0.04) x 0.8

= 7,20%

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QUESTION 2 (30 MARKS)

1. (a) Grorem’ existing cost of equity

ke = Rf + [Rm – Rf]β

= 0,05 + (0,06) x 1.5

= 0,14

= 14%

(b) Grorem‘ existing WACC

 VE   VD 
WACC = ke    k d [1  t ] 
 VE  VD   VE  VD 

ke = 14% (from above)

VE = (100 – 40) = 60 (Gearing ratio given as 40%, therefore the other 60 will apply to
equity)

VD = 40 (given)

k d = 6% (given)

WACC = 0,14 (0,60) + 0,06 (70%) (40%)

WACC = 10,08%

(c) Suitable WACC based on You-SA

 V   V [1  t] 
βu = β g  E
  βd 
D

 E
V  VD [1  t]   E VD [1  t] 
V -

Debt betas are zero, therefore the second part of the formula will equal ZERO

βu = 0,80 x (75 / (75 + (25 x 0,70))

βu = 0,65

Re-gear for Grorem

VD [1  t ]
βg = βu + [βu - βg]
VE

βg = 0,65 + (0,65 x 40 (1 – 0,30) / 60)

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= 0,95

ke = Rt + [Rm – Rf]β

= 0,05 + 0,06 x 0.95

= 0,107 = 10,7%

Calculate WACC for the Specialist Division

 VE   VD 
WACC = ke    k d [1  t ] 
 VE  VD   VE  VD 

= 10,7% x 60% + 6% (1 – 30) x 40%

= 8,1%

2. (a) Range of value

Asset based

- Replacement value R20 million

- Book value R15 million

Earnings based

Cash flow using Grorem’ WACC

WACC = 10,08% with a growth rate of 1%

CF0[1  g]
PV =
ke - g

CF = R2,5 million

 2.5m x 1,01 / (0,1008 – 0,01)

 R27,8 million

Cash flow using Proxy “You-SA” WACC

WACC = 8,1% with a growth rate of 1%

CF0[1  g]
PV =
ke - g

CF = R2,5 million

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 2.5m x 1,01 / (0,081 – 0,01)

 R35,6 million

(b) Validity of each

Net Assets

- Not appropriate as it is only done in break up situations or liquidation.

- Does not take goodwill and intangible assets into account, thereby undervaluing the
division

Cash flows adjusted to NPV at Grorem’ existing WACC

- Method values the whole company before taking into account the way it is funded.
- This method will be appropriate as it does not have its own debt, as long as the correct
WACC is used.
- Although Grorem’ WACC reflects its capital structure, it does not necessarily reflect its
business risk.
- Business risk can be obtained by using an ungeared beta of the proxy company.

Cash flows adjusted to NPV at proxy company, You-SA’s WACC

- Business risk can be taken into account by ungearing and re-gearing the beta of the proxy
company to take into account the risk profile and capital structure of Grorem to calculate
both a cost of capital and WACC.
- This gives a significantly higher value, reflecting You-SA’s low risk compared to Grorem.
- The validity of this result is likely backed up by comparing the likely risk of both companies.
- You-SA has more experience and repeat business from this sector of publishing.
- This explains the higher beta value of Grorem.

Price – earnings valuation

- Information on Grorem or similar companies are not given in the question, however
estimates can be made.
- Note, the earnings valuation method only provides a value for equity, therefore the value of
debt should be deducted to obtain an estimate of the value of the assets acquired.

(c) Advise on price

It could be argued that all the above valuations have some degree of validity to them.
Scandal! should start the bargaining process near the bottom of the range as an initial offer.

Most likely, the third method of valuation (proxy WACC) is the most valid, as there is no debt
attached to the purchase. This gives a value of R35,6 million.

The estimated growth of 1% may be adjusted higher if the purchaser believes it may grow at
a higher rate, this would increase the offer price.

However, Scandal! should not start bargaining in the top bracket of the valuation.

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Conclusion, the parties should negotiate around the second figure, R27,8 million (discounted
at Grorem’ WACC), to a maximum of R35 million.

3.

Investment in positive NPV projects will increase the present value of cash for the company
which will lead to an increase in the present value of cash paid to shareholders. This in turn,
assuming an efficient market, will increase the share price and thereby shareholders wealth.

In order to finance these investments, cash will be needed which can be raised from raising
new finance or from cash reserves. New finance is more expensive as it will incur issue cost
and using cash reserves reduce available cash payable to shareholders as dividends. Reduced
dividend payments can lead to a decline in the share price unless the investor values the future
benefits that cash preservation hold. Therefore, there is a compromise between the dividend
policy and the financing decision.

In Grorem, there appears to have been investment and funding as follows:

ANALYSE THE INVESTMENTS AND HOW IT WAS FUNDED BY USING THE

INFORMATION IN THE SCENARIO.

It would appear that the dividends are kept in place and steady growth allowed, while issuing
debt when needed to make up for cash required for investment. This allows for access to
outside finance for in the cheapest way.

However, Grorem reduces the gearing level periodically by raising new equity. This has issue
cost and cost of equity is generally more expensive than cost of debt, which will eventually
increase the WACC, which will in turn decrease the NPV of future investment projects.

This discussion is very in depth, you should let the mark-allocation in a question lead you in
terms of how much you should write.

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QUESTION 3

3.1

Purchase price

Bonds 1 000 000.00 100 000.00

Bank loan 3 000 000.00 (@12,5%) 375 000.00
Total interest 475 000.00
Less tax -133 000.00
Net interest 342 000.00

Total Long term liabilities 4 000 000.00

Cost of debt (342/4000) 8.55%

Cost of equity

Ke = ß (Rm - Rf)
Ke = 1.5(0.15 – 0.06) 13.50%

Current Debt Equity ratio

WACC
Debt 4 000 8.55% 3.42%
Equity 6 000 13.50% 8.10%
10 000 11.52%

Therefore, WACC is 11,52%

3.2 Lease vs buy

Method: Calculate the NPV of both, the least expensive option will be the most beneficial to
the company.

Refer to the next page for calculations.

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LEASE

Year 0 1 2 3 4 5

Lease PMTS -1 000 0

Tax saving 280

-720 -720 -720 -720 -720 Nil

Discounted 1.000 0.897 0.804 0.721 0.647

11.52%

DCF -720.00 -645.62 -578.93 -519.13 -465.5 -

NPV -2 929.185

Note: Lease payments are paid in advance

BUY

Year 0 1 2 3 4 5

Purchase -5 000.00
-
Maintenance 60.00 -60.00 -60.00 -100.00 -100.00
Scrap value 1 000.00

Tax savings @28% 156.80 156.80 156.80 168.00 588.00

Capital allowance (10yrs) 500.00 500.00 500.00 500.00 500.00

Maintenance 60.00 60.00 60.00 100.00 100.00

Capital recoupment / write off 1 500.00

-5 000.00 96.80 96.80 96.80 68.00 1 488.00

Discounted 11.52% 1.000 0.897 0.804 0.721 0.647 0.580

DCF -5 000.000 86.801 77.834 69.794 43.964 862.659

NPV -3 858.948

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Conclusion

According to the calculations, the lease option would be the most beneficial to the company.

3.3 Report

Report to the Board of MAN Ltd

To: Board of MAN

From: Accountant

Date: 30 May 2017

RE: Considerations in a buy vs lease decision

Introduction

This report serves to discuss financial and non-financial information that should be
considered before entering into this agreement.

Report content

Discuss any of the following points:

 Cost (lease is cheaper)

 Certainty of information
 Flexibility
 Maintenance
 Disposal – 5 year vs 10 year
 Market conditions
 Cash flow (purchase with R5m cash)
 Tax
 Any other valid point

Conclusion

Conclude on the points you discussed above. Marks will be awarded as long it relates to the
discussion.

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