FINANCIAL MANAGEMENT 2: TUTORIAL QUESTIONS
CAPITAL STRUCTURE
Que 1.The information below relates to two companies, company A and company B.
Company A Company B
($000) ($000)
Net operating income 90 000 90 000
Interest - (30 000)
Available to shareholders 90 000 60 000
Value of Equity 450 000 300 000
Value of debt - 200 000
Value of company 450 000 500 000
Company A is financed entirely by equity and company B is financed 40% by debt and 60%
by equity. The cost of equity is 20% and the cost of debt is 15%.
Required
Explain how an investor holding 10% shares in B can increase his return without increasing
risk by investing in 10% of shares in Company A. (Your explanation should be supported by relevant
calculations) (10 marks)
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TOPICS: WORKING CAPITAL MANAGEMENT
Que 1
PQ (Pvt) limited is a company that currently has no debt in its capital structure. A financial
advisor has indicated that the company will be able to create value for its shareholders by
paying back funds to its shareholders and borrowing an equivalent amount. The company has
an issued share capital of 100 million shares and the share price is currently trading at $6 per
share. The financial advisor has indicated that the debt to equity (market value) should be at
100%. This means that the company will borrow $300 million at 10% and use the funds to
engage in a share buy-back of 50 million shares at (hopefully) $6 per share. The market value
of the equity is equal to the book value of the company’s net assets. Assume that there is no
taxation.
The information below shows the company’s existing capital structure and proposed capital
structure at different levels of operating earnings.
Existing capital structure Proposed capital structure
and level of income and level of income
Level of operating income A B C A B C
Equity 600 600 600 300 300 300
Debt 0 0 0 300 300 300
EBIT 20 60 100 20 60 100
Interest 0 0 0 30 30 30
Net income 20 60 100 -10 30 70
Required
i. Advise on whether the company should accept the financial advisor’s proposal. Your
advice should be supported by relevant qualifications. (6 marks)
ii. Besides the above financial information, what other factors do you need to consider in
order to accept or reject the above proposal? (3 marks)
Que 3
The following information is extracted from K, L and M’s statements of financial position:
K L M
$ million $ million $ million
Non-current assets 400 500 600
Current assets 500 400 300
Total assets 900 900 900
Financed by :
Current liabilities 600 200 300
Long term debt and equity 300 700 600
Total equity and liabilities 900 900 600
Required:
i. Using the above information, identify the company with a moderate financing policy,
conservative financing policy and aggressive financing policy (3 marks)
ii. Give justifications for your answer in (i) above (6 marks)
iii. Explain how working capital management in small firms may differ from that of large
firms. (4 marks)
Que 4. Assume that you are the finance manager of Bhungaz (Pvt) Ltd. The finance director
of the company is considering investing in one of the following companies and has
approached you for advice. Below are extracts of statement of financial position for the three
companies
X Ltd Y Ltd Z Ltd
Non- current assets 1 000 000 1 000 000 1 000 000
Current assets 2 000 000 3 000 000 4 000 000
Total Assets 3 000 000 4 000 000 5 000 000
Equity 1 500 000 2 000 000 2 500 000
Long- term loan @ 10% per annum 500 000 1 000 000 1 500 000
Current liabilities 1 500 000 1 250 000 1 000 000
Total Equity and Liabilities 3 500 000 4 250 000 5 000 000
The companies are in the same industry. In each case, the finance director expects earnings
before interest and tax (EBIT) to be 10% of sales and annual sales to be twice the present
level of current assets. Corporate tax is 25%.
Required
i. Advise the finance manager on the best company to invest in. (Your advice should be
supported by relevant calculations). (10 marks)
ii. Besides the financial information provided, explain the other information on the
companies which may be needed in order to come up with an investment decision.(5
marks)
Que 5. The information below is extracted from the annual accounts of three companies
namely A Ltd, B Ltd and C Ltd.
A Ltd B Ltd C Ltd
Inventory : Raw material 108 000 145 000 200 000
Work in progress 76 000 97 000 93 000
Finished goods 86 000 130 000 140 000
Purchases 520 000 700 000 750 000
Cost of goods sold 500 000 600 000 700 000
Sales revenue 860 000 1 100 000 1 200 000
Trade receivables 170 000 259 000 297 000
Trade creditors 86 000 105 000 126 000
Required
Calculate the cash operating cycle (COC) for each company and advise on the best company
to invest in terms of the COC. (Assume that a year has 365 days) (10 marks)
Que 5
a) Explain the concept of overtrading (2 marks)
b) M (Pvt) Limited and N (Pvt) Limited are two companies in the retail sector which
specializes in fast moving consumer goods. The current working capital of the two
companies is shown in the table below:
M Ltd N Ltd
$ million $ million
Sales 100 100
Operating cash 5 1
Accounts receivable 20 10
Inventory 15 10
Accounts payable (12) (7)
Accruals (3) (8)
Net working capital 25 6
The finance managers of the two companies have forecasted that the sales for the two
companies in the following year will be $150 million. The after- tax profit margin on sales is
expected to be 5% in both companies. No dividends are to be declared in N Ltd while the
dividend payout ratio is 50% in M Ltd.
Required:
i. Identify with justifications the company that is likely to experience overtrading.
(3 marks)
ii. Forecast the increase in working capital financing requirements for each company in
the coming year. (5 marks)
iii. State the assumption(s) you made in the above forecast. (1 mark)
iv. For each company, calculate the amount needed to finance the additional working
capital from retained earnings and from external sources. (4 marks)
Que 6. The finance director of IM Ltd is considering changing the company’s credit policy.
Under current policy, the company expects to have sales of $20m. Its present credit terms are
2/10 net 50. All sales are on credit and at present 50% of the customers use the early
settlement discount of 2%. The average collection period is 30 days and bad debts losses are
currently 3% of sales for which discounts are not taken.
The proposal is to amend the credit terms to 3/10 net 30. Under this proposed credit policy,
60% of the customers are expected to use the early settlement discount. The average
collection period is expected to decrease to 18 days and bad debts losses are expected to
decline to 2% of sales for which discounts are not taken. Sales are expected to decrease by
$2m to $18m. The gross profit margin will remain unchanged at 25%. The company’s
opportunity cost of investments in working capital is 12%. The company is also considering
delaying payment to their major creditor, from whom they purchase under terms of 5/10 net
40 for an additional 20 days. Currently the company is paying on 40 days.
Required
i. Advise the finance director whether or not, the company should change its credit
policy.(10 marks)
ii. Calculate the effective cost of trade creditor finance. (3 marks)
(b) Discuss the major issues which must be addressed when formulating a policy on the
investment and financing of working capital. (9 marks)
(c) Explain the concept of overtrading (3 marks)
Que 7 .A company is considering changing its credit terms from 3/15 net 30 to 5/10 net 60. All
sales are on credit and at present 70% of the customers take advantage of the 3% early
settlement discount. However, under the new credit policy, only 60% of the customers are
expected to take advantage of the early settlement discount and the average collection period
is expected to increase from the current 20 days to 30 days. Sales are also expected to
increase from $240 000 000 to $270 000 000 if the new terms are used. It is estimated that the
gross profit margin will remain unchanged at 20%. Bad debt losses amount to 2% of sales for
which early settlement discounts are not taken. The opportunity cost associated with an
investment in working capital is 10% per annum.
Required
i. Advise whether the firm should change its credit terms or not. (10 marks)
ii. Discuss the factors to be considered in formulating a trade receivables management
policy.(4 marks)
iii. Identify and discuss the factors to be considered in determining the optimum level of
cash to be held by a company.(5 marks)
(b) A company currently orders 15,000 units per month of Product Z, demand for which is
constant. There is only one supplier of Product Z and the cost of Product Z purchases over the
last year was $540,000. The supplier has offered a 2% discount for orders of Product Z of
30,000 units or more. Each order costs the company $150 to place and the holding cost is 24
cents per unit per year. (6 marks)
DIVIDENDS
Que 8 The information below relates to five companies listed on a stock exchange.
Firms Surplus cash for the year ($m) Dividends paid in the year($m) ROE Beta
V 85 45 10% 1.60
W 70 12 20% 0.90
X -15 5 10% 1.80
Y 30 22 6% 1.90
Z -5 8 13% 1.5
The average return on equity (ROE) in the table above is for the last 10 years and this is
sustainable for the foreseeable future. Surplus cash for the year refers to amount remaining
after investment and payment of dividends. The risk-free rate of return is 10% and the
average return on the market was 15%.
Required
Comment on the appropriateness of the amount of dividends paid by each of the five
companies. (15 marks)
Que 9 The following information pertains to PQ (Pvt) limited:
Earnings - $80 million
Target debt-equity ratio - 1:1
Cost of capital - 10%
Funds need for projects - $82 million
Required
i. Calculate the dividends to be paid to shareholders assuming that the company uses the
residual approach to dividends policy. (3 marks)
Explain how payment of dividends will change if the annual earnings will be $35 million
instead of $80 million. (2 marks
TOPIC: LEASING
Que 1. A company is required to invest in used tooling equipment at a cost of $50million. A
finance company that specialises in the leasing of equipment has offered either a 5 year lease
requiring annual payments of $10 million per year payable in advance or a loan which is
payable in a single repayment at the end of 5 years. The leasing option includes servicing and
maintenance with a value of $2 million per year payable in arrears. Corporate tax is 25%. The
lease amounts are tax deductible one year after the year of payment because the payment is
done at the beginning of the year.
If the company takes the loan, it will be required to pay for the servicing and
maintenance costs. The residual value is expected to be $15 million in five years’
time. The cost of capital is 10% and the before tax cost of debt is 8%. The company is
able to depreciate the cost of the tooling equipment on a straight - line basis over 5
years.
To acquire the equipment at the end of the lease, the lessee is required to make a
residual payment of $9m.
Required
Advise the company whether it should lease the asset or borrow and purchase the
asset. (15 marks)
Que 2 .A Company is considering the purchase of a plant for $5 million. A loan could be
obtained at an effective rate of 15% repayable annually in areas over five years, to cover the
purchase price of the machine. Alternatively, the machine could be leased on a five-year
contract for $1.5 million per year, payable in advance. If the machine is owned, service and
maintenance charges will be $2 million per annum, whereas the lease charge includes
maintenance and servicing. The salvage value of the machine in five years’ time is expected
to be $800 000.The company claims special initial allowance (SIA) at 25% over four years.
The corporate tax rate is 25%. The company’s before tax cost of debt is 12% and the
weighted cost of capital is 25%.
Required
a) Advise whether the company should lease or buy the asset. (20 marks)
Besides the financial information above, what other factors need to be considered in
order to decide whether to buy or lease the asset. (5 marks)
Que 3. XYZ has decided to invest in a computer-controlled measuring device costing $1.2m.
The device has economic life of seven years, after which no salvage value is expected. The
company must determine whether it is better to finance the acquisition through debt or
leasing. XYZ expects profits before taxes of $1m next year, $2m the following year, $3m the
third year and $4m each year thereafter (before depreciation or leasing charges on the
device). The finance director of the company has a high degree of confidence in these
estimates. The company had break-even operations during the previous three years. The
company will qualify for special initial allowance (SIA) at the rate of 25% per annum.
If the machine is financed with debt, the company’s bank is willing to extend a loan for the
full purchase price at an interest of 10%, payable in equal annual amounts over seven years.
The bank also has a leasing division and has indicated that it is willing to provide lease
finance for the acquisition of the device over the seven year period at $300 000 per annum
payable in advance. The company’s cost of capital is 11% and corporate tax is 25%.
Required
i. Advise whether the company should finance the acquisition of the device by means of
the lease or loan. (12 marks)
ii. Outline the advantages of finance lease over operating lease (3 marks)
iii. Outline the advantage of operating lease over finance lease
TOPIC: MERGERS AND ACQUISITIONS
Que 2 Big Ltd, a company which specialises in the manufacture of fruit juice drinks intends
to acquire Small Ltd, a company which produces citrus fruits. The earnings per share of
Small Ltd have been declining for the past 2 years. The management of Big Ltd are of the
view that the poor performance of Small Ltd is as a result of poor management. The finance
director of Big Ltd has managed to convince the company’s shareholders that it is possible to
turn around the performance of Small Ltd. He also explained how the acquisition of Small
Ltd will result in post- merger synergistic benefits. As a result, the shareholders of Big Ltd
have authorised the directors to acquire Small Ltd. The acquisition of Small Ltd will be
financed by shares of Big Ltd.
The information below relates to Big Ltd and Small Ltd:
Big Ltd Small Ltd
Earnings per share (EPS) 100c 50c
Number of shares 2 million 0.5 million
The Finance director expects the synergistic benefits from the merger to be $3
million.
Required
i. Calculate the post-merger EPS (6 marks)
ii. Calculate the maximum exchange ratio that Big Ltd can offer before it
experiences a decline in EPS. ( 3 marks )
iii. Calculate the minimum exchange ratio that Small Ltd’s shareholders can
accept before suffering a dilution in EPS. (3 marks)
iv. Explain measures which can be taken by Small Ltd to avoid being taken over
by Big Ltd. (6 marks )
Que 3 Leisure Ltd is a company which owns and runs garden centres. Its directors are
considering whether to put in a bid for the entire share capital of Bridal Ltd, a company that
specialises in arranging events such as weddings.
The summarised statement of financial positions and statement of comprehensive incomes for
the two companies for the year just ended are as follows:
Statement of financial position as at 31 July 2011
Leisure Ltd Bridal Ltd
$000 $000
Fixed assets, less: depreciation 8 500 4 000
Net current assets 3 500 1 000
12 000 5 000
Represented by:
Shares of $1 each, issued and fully paid 5 000 3 000
Reserves 7 000 2 000
12 000 5 000
Statement of comprehensive income for the year ended 31 July 2011
Leisure Ltd Bridal Ltd
000 000
Turnover 20 000 8 000
Less: Expenses 17 200 6 900
Net profit 2 800 1 100
Dividends 2 100 1 100
Retained profit 700 ---
It has been estimated by the directors of Leisure Ltd that if the bid is successful, the
combined net profit for the year will be $732 000 higher than would be the case if the
companies were still separate.
Leisure has consistently retained and reinvested one quarter of its net profits and has
consistently returned 24% p.a on capital employed, while Bridal has always paid out all net
profits as dividends, the level of profit being constant.
At 1 August 2011 the market values of the two companies are:
Leisure Ltd $2.87 per share
Bridal Ltd $1.93 per share
The directors of Leisure intend to continue to invest one quarter of net profits and believe
that, as a result, the dividend growth rate for the enlarged company will be the same as the
rate formally achieved by Leisure Ltd.
It is, however, believed that the take- over will increase the perceived level of risk of the
company and that, accordingly, the rate of return required by shareholders will rise by 1.5%.
Required:
i. Calculate the maximum price that Leisure should offer for Bridal Ltd
ii. Assuming that the take-over price is fixed at $6 million, and that the price is to be
paid by a new issue of ordinary shares in Leisure Ltd having identical rights to those
already issued, calculate the total number of new shares which must be issued in
return for the entire ordinary share capital of Bridal Ltd
iii. Calculate the benefits from the take-over which will accrue to the shareholders of the
merged firm
