Question 1
A company requires R150 million to invest in a new project. Funds will be obtained
as follows:
• 60% through the issue of new shares
• 40% through the issue of 15% debentures
Earnings before tax and interest are expected to amount to R30 million. The tax rate
is 28%.
Calculate the following:
• Return on equity
• Return on assets
Question 2
Thelma Durandt is about to start an earth-levelling operation for which she requires
capital of about R100m to buy the equipment and operate the company. Earnings
before tax and interest are expected to amount to R20m (tax rate is 28%). The funds
can be raised by issuing shares for the full amount or, alternatively, half the
requirements may be raised through the issue of 12% debentures.
Solution is on chapter 14.10 of capital structure.
Question 3
Cadberry Ltd
Cadberry Ltd. is a growth-oriented company, over the past two years the company
sought growth by diversifying into other areas.
Investment opportunities for the coming year are:
Project Cost (R) IRR
1 14 000 000 14%
2 9 000 000 10%
3 8 000 000 13%
4 7 000 000 12%
5 6 000 000 16%
The profit (after tax) for the past year amounted to R30 million.
The company’s target debt ratio is 40% and its cost of capital is 11%.
Cadberry Ltd. follows the residual approach to dividends.
1. Name five factors that generally influence a firm’s dividend policy.
2. Determine the optimal capital budget for Cadberry Ltd.
3. Calculate the amount that Cadberry Ltd should distribute as a dividend.
Possible answers:
Shareholder - oriented factors
• Current income needs
• Alternative use of distributable profits
• Control
• Taxation – dividend withholding tax and capital gains tax
• Transaction costs
Firm oriented variables
• Contractual + legal constraints
• Solvency and liquidity
• Acquisition based factors
• Working capital requirements + business cycle
• Expansion and investment opportunities
• Future financing requirements
• Past dividend policy
• Capital structure
• Inflation
2. Answer
The optimal capital budget consists of projects 1, 3, 4, and 5 (i.e., all projects with an
IRR exceeding 11%). ✔️ Therefore, the optimal capital budget = R35 million. ✔️✔️
3. Answer
Financing: Debt = R14 million; Equity = R21 million ✔️✔️
Earnings available for distribution as dividend = R30 million ✔️ – R21 million ✔️P =
R9 million ✔️
Question 4
A Ltd’s debt-to-equity ratio is 25%. The interest on debt is 12% and the current cost
of equity is 15%. Tax is 30%.
What is the weighted average cost of capital?
Answer = 13.68
Question 5
OLSE Ltd applies a residual dividend policy. The earnings per share for the year
ending 2022 is 32.5 cents. The number of ordinary shares in issue in 2022 was 6
million. The firm’s debt-equity ratio is 60%. For 2023 the firm has profitable
investment opportunities amounting to R1 920 000.
Calculate the following:
1. The equity financing required. = 1 200 000
2. The total earnings for 2022. = 1 950 000
3. The earnings available for distribution as dividends.(1 950 000 – 1 200 000 =
750 000)
Question 6
Read the scenario below and answer the questions that follow:
Omega Ltd
Omega Ltd is a company operating in the retail sector. Omega Ltd manufactures
leather couches. The company is considering changing credit terms. The current
credit terms are 3/15 net 40, all sales are on credit. Currently, 30% of customers
take advantage of the discount, and bad debt losses amount to 15% of sales, for
which discounts are not taken.
Management wants to change the credit terms in order to encourage earlier
payment from customers. The new credit terms will be 5/10 net 30. As a result of
this policy, it is expected that bad debts will decrease to 10% of sales for which
discounts are not taken. With the new policy it is expected that 40% of customers
will take advantage of the discount.
Additional information:
• Management expects sales to increase with 25% from the current sales of R20
million.
• Gross profit margin is expected to stay constant at 35% of sales.
• Opportunity cost of the investment in working capital is 12%.
Source: Hunde, T. (2022)
Required:
Determine whether the new credit policy should be implemented. (25 Marks)
Note:
• Show all your calculations and draw a conclusion.
• Round all your values to the nearest Rand and/or nearest percentage.
• Make use of 365 days per year.
Answer
Note to Marker
Allocate marks as indicated.
∆P = ∆G – ∆I – ∆B – ∆D
Impact on Profit
Change in gross profit
Sales = R20 000 000 × 1.25 = R25 000 000 ✓
Increase = R25 000 000 – R20 000 000 = R5 000 000 ✓
Gross Profit = R5 000 000 × 0.35 = R1 750 000 ✓
Increase = Positive impact
Change in cost of carrying receivables
Accounts Receivable Period under Current Policy
Discount Sales 15 days × 30% = 5 days ✓
Non-discount sales 40 days × (100% - 30% - 10.5%) = 24 days ✓
less bad debts
= 29 days ✓
Bad debts: (100% – 30%) × 15% ✓✓ = 10.5%
Accounts Receivable Period under New Policy
Discount Sales 10 days × 40% = 4 days ✓
Non-discount sales 30 days × (100% - 40% - 6%) = 16 days ✓
less bad debts
= 20 days ✓
Bad debts: (100% – 40%) × 10% ✓✓ = 6%
Reduction in debtors:
(20 days – 29 days) × R20 000 000 = (R493 151)
365 days ✓
+
(20 days) × (1-0.35)(R5 000 000) = R178 082
365 days ✓
= (R315 069)
Saving (opportunity cost) = 12% × R315 069 = R37 808
Saving = Positive impact
Change in bad debts
Current Policy = 15% × [R20 000 000 × (100% – 30%)] = R2 100 000 ✓
New Policy = 10% × [R25 000 000 × (100% – 40%)] = R1 500 000 ✓
Change = R2 100 000 – R1 500 000 = R600 000
Decrease = Positive impact
Change in cash discount
Current Policy = 3% × (R20 000 000 × 30%) = R180 000 ✓
New Policy = 5% × (R25 000 000 × 40%) = R500 000 ✓
Change = R500 000 – R180 000 = R320 000
Increase = Negative impact
Change in profit
R’000
Increase in gross profit 1 750 ✓
Decrease in cost of carrying receivables 38 ✓
Decrease in bad debts 600 ✓
Increase in cash discounts (320) ✓
Change in profit (accept new policy) 2 068 ✓
On this basis Omega Ltd company should implement the new credit policy, since it
will increase the net income by R2 068 000.
Question 7
Study the scenario and complete the questions that follow:
Level Down Ltd is a company that is expected to trade at a price-to-earnings (P/E)
ratio of 6. The market price per share is expected to be R18 per share after the
dividend payment and the price-to-earnings ratio is based on this price. The
company has 1.8 million shares in issue. The company is expected to maintain its
current level of earnings in the future. The company has the option to either pay a
dividend or the company could engage in a share buy-back. The price-to-earnings
ratio is not expected to change after either decision. The retention rate is 20%.
Ignore tax.
Required:
If a shareholder owns 5 000 shares, proof (with calculations) that a shareholder’s
position will stay the same if the company decides to either make a dividend
payment or engage in a share buy-back.
(20 Marks)
Note:
• Round the number of shares to nearest total.
• Round amounts to one decimal.
Answer
Note to Marker
Allocate marks as indicated.
EPS = Share Price/ Price-earnings
EPS = R18 / 6 = R3
Dividend pay-out ratio = 100% - 20% = 80%
Dividend = R3 x 80% = R2.40
Net income = EPS x No. of shares
Net income = R3 x 1 800 000 = R5 400 000
Amount available to pay-out = 80% x R5 400 000 = R4 320 000
Share price before dividend = Share Price after dividend +
dividend
Share price = R18 + R2.40 = R20.40
No. of shares repurchased = net income/Price
Share repurchased = R4 320 000 / R20.40 = 211 765
No. of shares prior to buy-back = 1 800 000
Less No. of shares repurchased = (211 765)
Shares in issue = 1 588 235
EPS be after the buy-back
EPS = Net income / Number of shares in issue after buy-
back
EPS = R5 400 000 / 1 588 235 = R3.40
Share price after the share buy-back
Share price = EPS x P/E
Share price = R3.40 x 6 = R20.40
The shareholder with 5 000 shares will have the same value.
Value of shares and Dividend
5 000 x R18 = R90 000
5 000 x R2.40 = R12 000
Total value = R102 000
Share Buy-back
5 000 x R20.4 = R102 000
Value of shareholding:
Value of dividend = Value of share buy-back
