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MIDLANDS STATE UNIVERSITY

FACULTY OF BUSINESS SCIENCES

ACCOUNTING SCIENCES DEPARTMENT

CORPORATE FINANCE I
CODE: FDB 203/BF233/BF208

SESSIONAL EXAMINATIONS

APRIL - MAY 2023

DURATION: 3 HOURS

TOTAL MARKS 100

INSTRUCTIONS

1. There are five (5) questions.

2. Answer any four (4) questions
3. Each question carries 25 marks each.
4. The paper consists of six (6) pages.
5. Round off all answers to 4 decimal places.
6. Non- programmable silent electronic and financial
calculators maybe used.

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 QUESTION ONE

a) State and explain 3 uses of a statement of financial position to an investor seeking to

take over a company. [6 marks]
b) Distinguish direct agency costs from indirect agency costs. [3 marks]

c) State and explain four causes of agency problem in an organization. [8 marks]

d) Describe 4 importance of corporate governance to financial institutions. [8 marks]

TOTAL [25 marks]

QUESTION TWO
a) Alexander Corporation is considering investing into a new project. It will cost
$100 000 to invest into the new project. The investment has a 5 year life span and
after these 5 years it will have a residual value of $2 000. The Corporation has a target
Average Accounting Return (AAR) of 20% and a tax rate on profits of 4%. The
estimated profits per year are given below:

Year 1 $10 000

Year 2 $25 000

Year 3 $15 000

Year 4 $35 000

Year 5 $20 000

Use the AAR to assess the feasibility of the project and make your recommendations.

[8 marks]

b) Davis Industries must choose between a gas-powered and an electric-powered forklift

truck for moving materials in its factory. Since both forklifts perform the same
function, the firm will choose only one, (they are mutually exclusive investments).
The electric-powered truck will cost more, but it will be less expensive to operate; it
will cost $22 000 whereas the gas-powered truck will cost $17 500. The cost of

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 capital that applies to both investments is 12%. The life for both trucks is estimated to
be 6 years, during which time the net cash flows for the electric-powered truck will be
$6 290 per year and those for the gas-powered truck will be $5 000 per year.
Calculate the profitability index for both trucks and make your recommendations to
Davies industries. [7 marks]

c) The board of directors of ABC investments is divided over a product that must be
introduced to the market. Three members of the board feel that product X will
improve the corporate image of the company. Three other members of the board feel
that product Y must be introduced because it does not require huge capital investment.
For product X to be introduced a building worth US$1 000 must be demolished. If
product Y is introduced, an additional US$1 000 is required for working capital
purposes. Other relevant information relating to the 2 products is as follows:

Product X (US$) Product Y (US$)

Initial investment 7 000 4 000

Cash Flows: Year 1 2 000 1 500

Year 2 3 000 2 500

Year 3 4 000 500

Product X will have a residual value of US$500 in year 3 while product Y will have

• no salvage value. The cost of capital for both projects is 10%. Calculate the net
present value (NPV) for each of the two products and recommend to the board which
product must be introduced. [10 marks]

TOTAL [25 marks]

QUESTION THREE

a) ABC Investments is considering scrapping the existing product and replace it with a
new one. The firm hopes to improve its gearing levels and the profit margins as well.
For the new project to be implemented the company has to borrow $250 million
which will attract interest rate of 30% per annum.

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 Other information relating to the projects is provided below:

Item Existing Project New Project

Selling Price per unit $10 000 $15 000

Variable Costs per unit $2 000 $5 000

Fixed costs $1.5 million $2 million

Projected Sales $300 million $750 million

Profit before Interest & Tax $100 million $250 million

Interest Payments $40 million

Profit after interest and tax $60 million

Calculate the following for the two projects:

i. The degree of operating leverage. [6 marks]

ii. The degree of financial leverage. [6 marks]
iii. The degree of combined leverage. [4 marks]

b) Hackney carriage company has fixed costs of$100 000. Its product currently sells for

• $5 per unit and has variable costs per unit of $3. Mr Jones the head of manufacturing
proposes to buy new equipment that will cost $250 000 and drive up fixed costs to
$150 000. Although the price will remain at $5 per unit, the increased automation will
reduce variable costs per unit to $2.50. As a result of Mr Jones suggestion explain
whether the breakeven value increase or decrease. [5 marks]

c) Identify any two situations where a banker may require using breakeven analysis to
assist in decision making. [4 marks]

TOTAL [25marks]

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 QUESTION FOUR

a) Micro Spinoffs has preferred stock outstanding. The stock pays a dividend of $4 per
share, and the stock sells for $40. Ascertain the cost of preferred stock. [2 marks]

b) Reliable Electric is a regulated public utility, and it is expected to provide steady

growth of dividends of 5% per year for the indefinite future. Its last dividend was $5
per share; the stock sold for $60 per share just after the dividend was paid. Calculate
the company's cost of equity. [5 marks]

c) A firm has $4 million in outstanding bonds that mature in four years, with a fixed rate
of 7.5% (assume annual payments). The bonds trade at a price of $98 in the open
market. The firm's marginal tax rate is 35%. Using the bond-yield plus method,
calculate the firm's cost of equity assuming an add-on of 4%. [3 marks]

d) Pennsylvania Clean Coal Company ("PCCC") generates electricity for both industrial
customers as well as consumer households. An investment analyst with a private
equity fund which owns some of PCCC's stock needs to estimate the company's
weighted average cost of capital. PCCC's chief financial officer told the investment
analyst that PCCC will not invest in any project which cannot earn at least a 15%
Return on Assets. The company has 3.5 million shares of stock outstanding and these
shares are valued at $24.55 per share. The company has a stock beta of 1.84. Assume
the current average expected stock market return is 16% and the current U.S. Treasury
Bond interest rate in the market is 4.80%. The company also has some bonds
outstanding which are trading at $975 per bond, and the company has 195 000 of
these bonds outstanding. The bonds have an effective yield to maturity of 8.50%. The
company has a marginal income tax rate of 30%. Given this information, determine
PCCC's weighted average cost of capital. [10 marks]

e) Savemore Pvt Ltd is considering a project in the food distribution business. It has a
debt to equity ratio of 2, a marginal tax rate of 40%, and its debt currently has a yield
of 14%. Delta a publicly traded firm that operates only in the food distribution
business has a debt to equity ratio of 1.5, a marginal tax rate of 30% and an equity

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 beta of 0.9. The risk free rate is 5% and the expected return on the market portfolio is
12%. Calculate the project's equity beta. [5 marks]
TOTAL [25 marks]

QUESTION FIVE

a) Describe the semi-strong form of the efficient market hypothesis. [7 marks]

b) Briefly explain three responsibilities of a portfolio manager in an efficient market

environment. [6 marks]

c) Explain the following terms as they are used in the efficient market hypothesis:

i. Informational efficiency. [4 marks]

ii. Allocative efficiency. [4 marks]
iii. Operational efficiency. [4 marks]
TOTAL [25 marks]

**END OF PAPER**

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