FIN 4801 ASSIGNMENT

Question 1 [60 Marks]
(This question is based mostly on study units 13 and 14) Constructo Ltd is a JSE listed building supplies manufacturer and distributor. Over the past
ten years, the company has been struggling with its profitability. Its operating profit margins
are only slightly lower than that of its competitors, however, its net profit margin is much lower.
The company is also not spending as much on new plant as its competition and it is expected
that this will eventually worsen its current situation. It is estimated that the company needs to
spend R5 million on new plant in order to remain competitive.
Over the past few years, the company has issued a large amount of bonds when it had an AA
rating. This rating however has dropped steadily to B. Together with this, an increase in the
cost of debt has been apparent as each new bond issued had a higher cost than the previous
one. The board and main shareholders of the company had been adamant that debt should
be used as far as possible. Recently however due to the increasing cost of financing, you have
been given free rein to explore any financing avenue for the new plant and also to lower the
debt ratio to the industry standard of 0,4. The financial statements of the firm was compiled recently and below is an extract from them:
Statement of financial position (All values in R 000’s)
Total assets
15 000
Long term liabilities
8 000
Short term liabilities
3 000
Statement of comprehensive income (All values in R 000’s)
Gross profit
20 000
Operating expenses
10 000
Financing costs
1 500
Net profit
6 120
*A tax rate of 28% applies.
Long-term debt consists of different bonds, all which can be retired at par value but with a 1%
penalty cost added to the par value. Short-term debt is financed solely by a R25 million, 12%
annual interest line of credit.
The following financing options are available:
A. A rights issue: The company’s shares are currently trading for R4.00 and it has
1 000 000 shares outstanding. It is expected that for a full- subscription, the
subscription price would have to be set at R3.00. It is envisaged that 90% of the rights
will be taken up by current shareholders and the remaining 10% by new shareholders.
B. Utilise the line of credit for all of the financing. Assume the funds will be borrowed
immediately.
C. Issue 1000, R10 000 par value, 14%, convertible bonds at a discount of 2% below par.
D. A negotiated R15 million long-term loan with a bank with a fixed interest rate of 13%
per annum and capital repayment at the end of the loan, with an option to renew the
loan indefinitely. This loan comes with a covenant that the company’s debt ratio is not
allowed to exceed 0,6 without the approval of the bank. 2 Required: 1. Evaluate the different financing options and create a brief report on the costs
associated with each, as well as a table clearly showing the expected net profit under
each financing option.
2. Evaluate the implied cost of equity by way of the re-levered beta (after refinancing)
using Hamada’s equation for each of the four financing options. Assume the current
beta for the company is 2.5.
Structure your final answer into a table (that is, place the unlevered beta and re-levered
beta in a table next to the cost of equity for each option).
3. Evaluate the current capital structure as well as all three financing options by
calculating the WACC of each option based on the cost of equity obtained in 2).
4. Calculate the debt ratio, times interest earned ratio and degree of financial leverage
under each option. Drawing from your earlier calculations also, draw a conclusion
(taking risk, flexibility, profitability and control into account) regarding which financing
source you would recommend. Keep your report to a maximum of one page and clearly
number your calculations. 3 Question 2 [30 Marks]
(This question is based on study unit 15) Juicy Ltd is a manufacturer of vegetable juice. The management of the company has indicated
that it wishes to obtain a new carrot-juicing machine to expand its product line. Juicy Ltd has
the options to either borrow the money needed for the juicer to buy it, or to lease the machine
from the manufacturer.
The juicer will cost R20 000 000 and will be depreciated over four years by way of the straightline method. The juicer has a useful life of four years and will have no residual value.
Maintenance of the machine will amount to R2 000 000 per year which will be paid at the end
of each year.
Financing for the machine can be obtained in two possible ways: Loan 1: An interest rate of 12% before tax with the principle sum being paid back at
the end of the four-year loan period.
Loan 2: An interest rate of 11% before tax. Alternatively, the manufacturer of the machine has offered Juicy Ltd a lease on the machine.
The option to lease will cost R7 400 000 per year (payable at the end of each year) for four
years, after which the lessor will take ownership of the machine. Maintenance is included in
the cost of the lease.
Juicy Ltd is subject to a 28% tax rate and evaluates such decisions at its 12% (before tax) cost
of debt. REQUIRED
Determine the net advantage to leasing (NAL) for each respective financing option and
comment on whether the company should borrow and buy the machine or take up the lease
offer from the manufacturer. 4 Question 3 [10 Marks]
(This question is mostly based on study unit 16) Logging Ltd has paid a dividend every year over the past ten years. The company maintained
a very healthy profit margin in the past and is expecting substantial growth in the future. This
is due to the weakening local currency and the fact that it; exports much of its products, has a
European subsidiary from which it can remit profits and is experiencing robust local growth.
All of the company’s new projects are financed through equity. The company has a beta of
2.00 and a credit rating of B from Moodey’s due to a default on a bond before 2007.
Below is a graph, from an online provider, showing the earnings per share (EPS) and dividend
per share (DPS) over the past ten years: Logging LTD
EPS and DPS 2007 - 2017
40
35
30 25 25
20
15
10 35 34 31 11 10
5 5 7.5
2 18 15 13 21 5 5 6 2009 2010 2011 6 7 8 2012 2013 2014 10 10 11 2015 2016 2017 0
2007 2008 EPS DPS A group of investors have banded together to ask that the company adopt a dividend policy
with a stable payout ratio of 50%. They indicated that the reason is that the dividend paid out
annually did not grow at the same rate as the business (assume that the growth rate of EPS
and the company’s market value is the same).
Assume a risk free rate of 6% and a market risk premium of 6%. Required:
The board has tasked you with drafting a brief report evaluating the situation and advising the
shareholders as to why the firm does not maintain such a high payout ratio; and how it is in
their interest that they do not do so in the future.
One of the directors tells you, on record, that in 2008, they used equity to purchase their
European subsidiary, which has shown massive growth, as an example of why they do not
want to pay out more dividends.
Note: Your report should be based on calculations and an application of dividend theory and
should not exceed 1.5 pages.
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