FINA202 TOPIC 3 REVISION PACK 2024

TEST 2 2018

Question 2 (40 marks: 36 minutes)

Given below are extracts from the annual accounts of two listed South African companies, together
with information about their stock market performance. Assume that the return on short-term
government issued securities is 11%, while the return on long-term loans is 12%. The return on the
JSE All Share Index is 20%, and a tax rate of 45% applies.
Annual Report Extracts: Company A Company C
Ordinary Shareholder Funds (Rm) 90.4 5.9
Long Term Loans (Rm) 1.1 -
Current Dividend Per Share (cents) 9.43 2.4
Annual Dividend Growth 12% 19%
Stock Market Details as at 5 Oct 18: Company A Company C
Equity Market Value (Rm) 68.0 68.8
Long-term Loan Market Value (Rm) 0.6 -
Beta Value 0.75 1.24
Share Price (R) 1.64 3.03

Required:
(a) Calculate the Weighted Average Cost of Capital for Firm A.
(16 marks: 14 minutes)
(b) Re-calculate the cost of equity using an alternative method to the one you used in estimating the
cost of equity for WACC in (a) above.
(5 marks: 4.5 minutes)
(c) Highlight two important differences between Firms A and B which are relevant to the amount of
risk these two firms face. Explain briefly why you have chosen these two differences.
(6 marks: 5.5 minutes)
(d) Firm C is able to use R100 000 of retained earnings before they will need to consider raising
additional capital through either new equity or new debt.
1. Calculate the break point associated with Firm C’s use of retained earnings. Explain why
your calculation is set up like this, given Firm C’s current situation.
(4 marks: 3.5 minutes)
2. Should Firm C decide to issue new common stock, those shares would be under-priced by
72c to sell, and flotation costs would be 50c per share. Calculate Firm C’s Cost of Equity
on such a new share issue.
(6 marks: 5.5 minutes)
3. Explain (no calculation required) which method your answers to (d) (1) and (d) (2)
belong to, and how that approach is used.
(3 marks: 3 minutes)
Question 3 (40 marks: 36 minutes)

PART A (20 marks: 18 minutes)

You are the Chief Risk Officer of KZN-Agri, an agricultural produce firm. The firm’s management
have asked you to assess the operating and financial risk of the firm for the firm’s current level of
operations.
The following information is at your disposal:

Units sold (base level) 10 000

Fixed operating costs R380 000
Variable operating costs R160 000
Sales R635 000

Required:
(a) Determine the operating breakeven point in units.
(5 marks: 4 minutes)
(b) Assuming sales decline by 1 000 units, calculate the percentage change in EBIT.
(7 marks: 7 minutes)
(c) Using your answer from (b), determine the degree of operating leverage (DOL) for KZN-Agri,
and briefly interpret your answer.
(3 marks: 3.5 minutes)
(d) You are also provided with information from projected financial statements which shows that a
10% decline in sales will result in a drop in EPS from R5 to R1 per share. Calculate the degree of
financial leverage and briefly interpret your answer.
(4 marks: 3.5 minutes)

Part B overleaf……
a)
PART B (20 marks: 18 minutes)
In your answer booklet match up the correct combination of the first column below (A-J) with the
second column (1-10) by stating ONLY the correct combination.
For example, if you believe that the term labelled “A” is best defined by “7” you only need to write
A-7 in your answer booklet (no need to write out all the information given below).
Each correct pair is worth 2 marks.
A Firms should use retained earnings first, then debt financing 1 Tax Benefit
second, and only then turn use external equity financing. 8
B The deduction of interest payments on debt when calculating 2 Static Theory
taxable income reduces the amount of the firm’s earnings paid
in taxes. 1
C The “Pie” Model of capital structure is otherwise known as the 3 Modigliani &
__________. 3 Miller No Tax Case
D The risk of not being able to cover financial obligations in 4 Marketed Claims
referred to as ___________. 10
E This theory identifies a mix of debt and equity where the 5 U-Shaped
decreasing WACC offsets the increasing financial risk to a Distribution
company. 2
F The claims of shareholders and bondholders are also known as 6 Agency Theory
_____ under the extended pie model. 4
G Where managers of a firm have more information about operations 7 Signal
and future prospects than do investors. 9
H Debt financing may be viewed as a positive _____ that 8 Pecking Order
management believes the stock to be “undervalued.” 7 Theory
I Graphical representation showing that when less debt is used 9 Asymmetric
WACC is smaller due to cheaper debt, and when a lot of debt is Information
used WACC is larger due to insolvency costs. 5
J Managers of firms do not necessarily have the same goals as the 10 Financial Risk
owners of the firm. 6
SUGGESTED SOLUTION TEST 2018
Question 2 [40 marks]
(a)
E+D=V
68M + 0.6M = 68.6M
E/V = 68 / 68.6 = 0.9913
D/V = 0.6 / 68.6 = 0.0087

Kd = 12%
After tax = 12 (1-0.45) = 6.6%

Ke = 11 + 0.75 (20-11) = 17.75

WACC = 0.9913 (17.75) + 0.0087 (6.6) = 17.5956 + 0.05742 = 17.65299%

[16]
OR
(b)
K e = 0.0842 = Do, D1 = 0.0943 (1.12) = 0.105616
0.0943 / 1.64 = 0.02937 + 0.12 = 18.44%

WACC = 0.9913 (18.44) + 0.0087 (6.6) = 18.2796 + 0.05742 = 18.33699%

[5]
(c) Firm A has a Beta of 0.75 while Firm B has a higher Beta of 1.24.
B has more systematic risk than A, and is riskier than the market.

Firm A has debt financing, B has no debt financing.

This makes B less exposed to things like default risk/insolvency costs, but does mean B is not
taking advantage of debt being a generally cheaper source of financing / not taking advantage of
the interest tax shield.
[6]
(d)
(1)
BP = 100 000 / 1 = 100 000
The firm is 100% equity financed, and to the weight into equity is 100% or 1.
[4]
(2) kn = Dj/Nn + g
0.024(1.19)
ks = + 0.19
3.03−0.5−0.72

ks = 0.02856 / 1.81 + 0.19 = 20.5779%

[6]
(3) Breakpoints and estimates of raising new additional capital relate to calculating a WMCC. This
looks at the increase in WACC as each component of new financing is considered. This allows
the firm to examine the cost of each stage, and plan around those findings.
[3]
Question 3 [40 marks]

PART A [20 marks]

(a)
P per unit = Sales / units sold = 35 000 / 10 000 = 63.5
VC per unit = Variable cost / units = 16 000 /10 000 = 16

FC 380 000
Q= = =8 000 UNITS
(P−VC ) (63.5−16)
[5]

(a) 635 000 /10000 = 63.5 * 9 000 = 571 500 etc.

10 000 units 9 000 units

Sales R635 000 R571 500
Less variables costs R160 000 R144 000
Less fixed costs R380 000 R380 000
EBIT R95 000 R47 500

47 500−95 000
% CHANGE IN EBIT = =−50 %
95 000
[7]
(c)
% ∆∈ EBIT −50
DOL= = =5
% ∆∈ SALES −10

OR
DOL=¿ ¿

For a 1% change in Sales, EBIT will change by 5%

[4]
(b)
% ∆∈EPS −80
DFL= = =1.6
% ∆∈EBIT −50

For a 1% change in EBIT, EPS will change by 1.6%

[4]
PART B [20 marks]
A-8
B-1
C-3
D-10
E-2
F-4
G-9
H-7
I-5
J-6
EXAM 2018
Question 4 (60 marks: 54 minutes)
Part A (44 marks: 40 minutes)
Nate Ltd is a South African stock feed production company based in Limpopo province. The
company has recently designed a unique product for cattle owners - special stock feed blends
designed for different breeds of cattle to enhance their growth and health. There are five of these
blended feeds, with the initial cost of bringing each blend to market being R2.0M. These are non-
divisible investments.
The current capital structure of Nate Ltd is considered to be optimal and will be maintained. At the
end of the most recent financial year the capital structure was:
CAPITAL STRUCTURE:
Debentures (R1 000 par value ) 30%
Preference Shares (R100 issue price) 10%
Ordinary Share Equity (1 million issued) 30%
Retained Earnings Equity 30%

Nate Ltd has a history and stated policy of distributing 25% of its after-tax earnings as dividends.
After-tax earnings were R4.00 per share, and estimated after-tax earnings for the next year are
expected to reflect the historical growth rate of 10% p.a. The tax rate for the company is 28%.
The company is planning to finance the investment proposal with retained earnings and other
sources of finance. New shares could be issued at the current market price of R50 per share; flotation
costs would be 10% of the current market price. Furthermore, the company can raise R3.0M from
the issue of non-redeemable debentures which have a par value of R1 000 and a coupon rate of 8%,
with no issue costs. The market-related interest rate for debentures in a similar risk class is 11%.
It is estimated that a total amount of R5.0M could be raised from the issue of 10% preference shares
and issue costs would be negligible (and so are ignored). Preference shares of a similar risk class are
presently offering yields of 10% p.a.
Required:
(a) Calculate the amount of retained earnings available for this project.
(8 marks: 7 minutes)
(b) Calculate the cost of each capital component.
(10 marks: 9 minutes)
(c) Determine the break(s) in the weighted-average cost of capital schedule.
(9 marks: 8 minutes)
(d) Calculate the weighted-average cost of capital between the break(s).
(11 marks: 10 minutes)
(e) Explain briefly how you would use your answer in (d) above to determine if this proposal should
be accepted or not.
(2 marks: 2 minutes)
(f) From the information provided in this question, you can identify the approach used by this firm
in paying their dividends. Name the approach and explain why you think this firm uses this
approach.
(4 marks: 4 minutes)
SUGGESTED SOLUTION EXAM 2018
Question 4 (60 marks)
Part A (44 marks)
(a)
Current EPS = 4.00
EPS next year = 4 (1 + 0.1) = 4.4
Payout 25% = (4.4 * 0.25) = 1.1
EPS - DPS = 4.4 - 1.1 = 3.3
Retained earnings = 3.3 * 1 000 000 shares = 3 300 000.
[8]
(b) Costs of each component
Cost of retained earnings:
D1 1.1
r e = + g= +10 %=12.20 %
P0 50
Cost of new issues:
Flotation cost = 10% * R50 = R5
D1 1.1
r e = + g= +10 %=12.44 %
Np 50−5

Cost of debentures (after tax):

11% x 72% = 7.92%

Cost of preference shares = 10%

[10]
(c) Breaks:
3300 000
Retained earnings = =5,500 000
0.6
Company will issue new equity if capital budget exceeds this amount.

3 000 000
Debentures = =10,000 000
0.3

5 000 000
Preference shares ¿ =50 000 000
0.1
[9]
(d) WACC between the breaks:
Before break After break
Source Weights Cost WACC Cost WACC
Equity 60% 12.2% 7.32% 12.44% 7.47%
Debentures 30% 7.92% 2.38% 7.92% 2.38%
Preference 10% 10% 1.00% 10.00% 1.00%
shares
10.7% 10.84%
[11]
(e) Use WACC as the discount rate to do a NPV analysis / RR greater than WACC, other techniques
which use the WACC
[2]
(f) 25% is a constant ratio: a policy that pays the same % of earnings each year.
Lets clients know they will get a set % of earnings
Regular – suits shareholders who expect a dividend [4]
TEST 2 2019

Question 2 (35 marks: 35 minutes)

Continental Furniture (CF) is a growing manufacturer of high quality and contemporary design
furniture. CF recently entered the outdoor furniture market which has proved to be profitable for the
business. CF’s net earnings for the coming financial year are expected to be R38 million. The
company has a target payout ratio of 25 percent of net profit. The current price of CF’s common
stock is R61.21 per share. The last dividend paid was R3.26 per share and it is expected that
dividends will grow at an annual rate of 6 percent for the foreseeable future. The company is
currently financed with shareholder’s equity and long-term debt. The company maintains capital
structure proportions of 31% long-term debt and 69% common stock equity. The tax rate for the
company is 35%.
Continental Furniture is considering several competing investment opportunities. However, due to
limited funds, CF must decide whether to undertake the proposed projects presented in the
investment opportunities schedule (IOS) below:

Investment opportunity IRR (%) Initial investment

(Rm)
D 11 40
E 9 10
F 8 22

Once the company’s retained earnings have been exhausted, it must issue new equity at a flotation
cost of R4 per share to meet its ordinary share equity needs. In addition, the firm can issue R20m of
debentures at a cost of 8%. Any additional debt finance raised will cost 9%. The current yield on
government bonds is 6% and the market risk premium is expected to be 8%. The company’s equity
beta is 1.15.
Required:
(a) Determine the break points associated with each source of capital.
Work in R millions and round off to four decimals e.g. 4.1673 million.
(7 marks: 7 minutes)
(b) Calculate the weighted-average cost of capital over each range of total new financing between the
break points determined in (a).
(22 marks: 22 minutes)
(c) Briefly explain how CF can use the costs of capital calculated in (b) and the IOS provided to
determine whether or not to invest in any of the projects under consideration.
(4 marks: 6 minutes)

Question 3
Part B (15 marks: 15 minutes)
Explain the following terms as they are used in capital structure theory:
 Asymmetric information (5 marks: 5 minutes)
 Static trade-off theory (5 marks: 5 minutes)
 Pecking-order theory (5 marks: 5 minutes)
TEST 2019 SUGGESTED SOLUTIONS

QUESTION 2 [35 marks

(a) Retention ratio = 1 – payout ratio = 1 – 0.25 = 0.75 or 75%
R/E = 0.75 x R38m = R28.5m
Break point = AFj / Wj
1st break point (Equity): 28.5 / 0.69 = 41.3043
nd
2 break point (debt): 20 / 0.31 = 64.5161
[7]
(b) DDM:
Expected dividend per share (D1) = 3.26 x (1 + 0.06) = 3.4556

Cost of retained earnings:

Rr or s or E = (D1 / P0) + g
= (3.4556 / 61.21) + 0.06
= 0.1165 or 11.65%

Cost of new stock:

Rn = Dj / Nn + g
Nn = 61.21 – 4 = 57.21
Rn = (3.4556 / 57.21) + 0.06 = 0.1204 or 12.04%

Cost of debt: 8% x (1 - 0.35) = 5.2%

Range of Financing Capital Cost of Weighted

& Source of Capital Structure % Capital Source Cost
(1) R0 - R41.3043 m
Long-term debt 0.31 5.2% 1.6120 %
Common stock equity 0.69 11.65% 8.0385 %
WACC = 9.6505%
(2) R41.3043 m – R64.52 m
Long-term debt 0.31 5.2% 1.6120 %
Common stock equity 0.69 12.04% 8.3076 %
WACC = 9.9196 %
New debt after tax = 9 x 0.65 = 5.85%
(3) R64.4538 m and above (new debt)
Long-term debt 0.31 5.85% 1.8135 %
Common stock equity 0.69 12.04% 8.3076 %
WACC = 10.1211 %
[22]
(c) The IOS presents a ranking of currently available investments from the highest return to the
lowest return. It is used in combination with the WMCC to find the level of
financing/investment that maximizes owner wealth. The firm accepts projects up to the point at
which the marginal return on its investment equals its weighted marginal cost of capital. CF
should consider accepting project D with the higher IRR as the return is greater than the WACC.
Projects E and F would be rejected because the investment return is less than the cost of capital.
[6]
QUESTION 3
Part B [15 marks]
Explanation of each of the following terms as they are used in capital structure theory:
 Asymmetric information:
It is the situation in which managers of a firm have more information about operations and future
prospects than do investors. Assuming managers make decisions with the goal of maximising the
wealth of existing shareholders, then asymmetric information can affect the capital structure
decisions that managers make. Asymmetric information could account for the pecking order
financing preferences as follows:
Suppose management have a + NPV investment which requires additional financing.
If belief is that prospects for the firm are good and that shares are undervalued it would be
advantageous to current shareholders if management raised the required funds using debt (not new
shares).
If the outlook for the firm is poor, management may believe the firm's shares are 'overvalued'. In that
case, it would be in the best interest of existing shareholders for the firm to issue new shares.
Investors often interpret the announcement of a share issue as a negative signal and the share price
declines.
[5]
 Static trade-off theory:
The static trade-off theory is a financial theory based on the work of economists Modigliani and
Miller. With the static trade-off theory, and since a company's debt payments are tax deductible and
there is less risk involved in taking out debt over equity, debt financing is initially cheaper than
equity financing. This means a company can lower its weighted average cost of capital (WACC)
through a capital structure with debt over equity. However, increasing the amount of debt also
increases the risk to a company, somewhat offsetting the decrease in the WACC. Therefore, the
static trade-off theory identifies a mix of debt and equity where the decreasing WACC offsets the
increasing financial risk to a company.
[5]
 Pecking-order theory
The pecking order theory is a hierarchy of financing that begins with retained earnings, which is
followed by debt financing and finally external equity financing. It states that a company should
prefer to finance itself first internally through retained earnings. If this source of financing is
unavailable, a company should then finance itself through debt. Finally, and as a last resort, a
company should finance itself through the issuing of new equity. This pecking order is important
because it signals to the public how the company is performing. If a company finances itself
internally, it means it is strong. If a company finances itself through debt, it is a signal that
management is confident the company can meet its monthly obligations. If a company finances itself
through issuing new stock, it is normally a negative signal, as the company thinks its stock is
overvalued and it seeks to make money prior to its share price falling.
[5]
EXAM 2019
Question 4 (55 marks: 55 minutes)
Part A (35 marks: 35 minutes)
Attacq Ltd has 12 million shares of common stock outstanding and the shares are currently trading at
R64 each. The company has just declared an annual dividend of R2.50 per share. The company’s
recent financial statements reported a price-earnings ratio of 10 and a return on equity (ROE) of
14%. The company is expected to maintain its current level of earnings in the foreseeable future.
The company’s 8.5% annual coupon bonds have 10 years to maturity. This bond issues’ face value is
R600 million (R1 000 per bond). The bonds are currently selling at R965 per bond and the yield to
maturity is 9%. The tax rate is 35%.
Required:
(a) Calculate the company’s cost of equity.
(8 marks: 8 minutes)
(b) Calculate the company’s WACC.
(12 marks: 12 minutes)
(c) Assuming that the firm has identified a profitable investment opportunity costing R82.08 million,
show using calculations that the dividend payout is consistent with the residual theory of
dividends.
(5 marks: 5 minutes)
(d) Briefly explain a circumstance under which a dividend would not be paid according to the
residual theory.
(2 marks: 2 minutes)
(e) Discuss two key arguments with regards to dividend relevance.
(8 marks: 8 minutes)
Work in millions for the large values, round off prices and dividends to the nearest cent, whole
interest rates to two decimal places and weightings and other calculations to four decimal places.
EXAM 2019 SUGGESTED SOLUTION
Question 4 (55 marks)

Part A (35 marks)

(a) Cost of equity:

PE = P / EPS
EPS = Share price / P/E ratio = 64 /10 = R6.40

b = (EPS - DPS) / EPS

= (6.40 – 2.50) / 6.40
= 0.6094

g = ROE x b
= 0.14 x 0.6094
= 0.0853

Re = (2.50 (1.0853) / 64) + 0.0853 = 0.12769 = 12.77%

[8]
(b) WACC:
Debt = (600m / 1 000 = 600 000) x 965 = 579m
Equity = 12m x 64 = 768m

Total market value of firm = 579m + 768m = 1 347m

E/V = 768 / 1 347 = 0.5702
D/V = 579 / 1 347 = 0.4298

WACC = (0.5702 x 12.77%) + (0.4298 x 9% (1 - 0.35))

= 7.28145 + 2.51433 = 9.8%
[12]
(c) Dividend policy:
Total earnings = EPS x number of shares
= 6.4 x 12m = R76.8 m
Retained earnings = R76.8 m x 0.6094 = R46.80192 m
Residual policy:
Equity capital needed for investment = 0.5702 x 82.08 = R46.802m
Retained earnings equal equity finance needs.
[5]
(d) As long as the firm’s equity need exceeds the amount of retained earnings, no cash dividend is
paid.
[2]
(e) Dividend relevance (any two arguments):
Bird-in-hand argument:
- suggests that investors see current dividends as less risky than future dividends or capital
gains.
- Gordon and Lintner argue that current dividend payments reduce investor uncertainty,
causing investors to discount the firm’s earnings at a lower rate and, all else being equal, to
place a higher value on the firm’s stock.
- Conversely, if dividends are reduced or are not paid, investor uncertainty will increase,
raising the required return and lowering the stock’s value.

The informational content of dividends:

- investors view a change in dividends, up or down, as a signal that management expects future
earnings to change in the same direction.
- Investors view an increase in dividends as a positive signal, and they bid up the share price.
- They view a decrease in dividends as a negative signal that causes investors to sell their
shares, resulting in the share price decreasing.

Agency cost theory:

- Managers sometimes have different interests from owners.
- Managers may want to retain earnings simply to increase the size of the firm’s asset base.
There is greater prestige and perhaps higher compensation associated with running a larger
firm.
- Shareholders worry that retained earnings may not be invested wisely.
- The agency cost theory says that a firm that commits to paying dividends is reassuring
shareholders that managers will not waste their money. Given this reassurance, investors will
pay higher prices for firms that promise regular dividend payments.
[8]
Test 2 2023
QUESTION 2 (40 MARKS)

New Café wish to calculate their weighted average cost of capital.

Below is an extract of the company’s most recent Income Statement:
R (000’s)
Profit before interest and taxes 65 000
Interest 7 500
Profit before Tax 57 500
Tax 16 100
Net profit after tax 41 400
Dividends paid 16 560

Below is an extract of the company’s most recent Balance Sheet:

R (000’s)
Equity and Liabilities
Shareholders’ equity 480 000
Preference share capital (par value R16 each) 320 000
Redeemable bonds (par value R1000 each) 460 000
670 000
Additional information:

1. The company has 4 million ordinary shares (par value of R100 per share) which are
currently trading at R140.00 per share on the JSE.
2. The company’s 8% semi-annual coupon bonds have five years to maturity. This bond
issue’s market value is R492 200 000. The current yield to maturity is 6.35%.
3. New Café’s preference shares makes an annual coupon payment of R1.20 per share and
are currently trading at R24 per share.
4. The prevailing tax rate is 28%.
Required:
(a) Calculate New Café’s cost of equity. (12 marks)

(b) Calculate New Café’s total market value. (12 marks)

(c) Calculate New Café’s Weighted Average Cost of Capital (WACC). (12 marks)
(d) Assume that New Café has used all of its R250 000 000 retained earnings and will have to
renegotiate its cost of debt when it exhausts R500 000 000 worth of debt. Calculate the
equity and debt breaking points. Round off your answer to the nearest million rand.
(4 marks)
Question 3 (28 marks)
You have recently received R10 000 cash for your birthday. You decided that it would be nice to
start investing and grow a nest egg for the future. You are considering investing R6 000 in
Protea Ltd and the balance in Springbok Ltd. You understand there are different expected
outcomes based on the possible future states of the economy, as given in the first table below.

State of Probability of Return Return

Economy State occurring Protea Ltd (%) Springbok Ltd (%)
Boom 0.3 25 18
Normal 0.7 5 8

As a Finance 202 student, you are able to calculate the following:

Protea Ltd (%) Springbok Ltd (%)
Expected Return (%) 11 11
Standard Deviation (%) 8.34 4.17

Your broker tells you that Protea Ltd has a Beta of 0.8 and Springbok Ltd has a beta of 1.2.
The risk-free rate is 5%.
Required:
(a) Calculate the total risk of the two-share portfolio you are considering.
(12 marks)
(b) Calculate the correlation between the two shares in your proposed portfolio.
(8 marks)
(c) Calculate the systematic risk of the portfolio you are considering.
(2 marks)
(d) Explain the difference between systematic risk and unsystematic risk.
(3marks)
(e) After completing your analysis above, you consider buying shares in Bafana Ltd. The
expected return for the Bafana Lts shares is also 11% with a beta of 1.2. Bafana Ltd and
Spingbok Ltd are in the same industry. Would you consider adding Bafana Ltd shares, or
would you look for an alternative? Explain why.
(3 marks)
Question 4 (12 marks)
Briefly discuss the effect of capital structure decisions on firm value and cost of capital under
the Modigliani and Miller (MM) theory – without taxes. Your discussion must include the
assumptions of the model.

Make use of relevant diagrams to illustrate your points, however, the majority of the marks for
this question are for the discussion, and not the diagrams themselves – you must explain how the
diagram supports your argument giving specific reference to parts of the diagram(s).
TEST 2 2023 SUGEGSTED SOLUTION
Question 2

(a)
ROE = R41 400 000 / R480 000 000 = 8.63%
Retention ratio = (R41 400 – R16 560) / R41 400 = 60%
g = 0.0863 × 0.6 = 0.052
8.63 * 0.6 = 5.178 = 5.18 (note for rounding)
Do = R16 560 000 / 4 000 000 = R 4.14
RE = 4.14 ×(1.052) / 140 + 0.052 = 8.31%
[12]
(b) Market value of Preference shares:
RP = 1.20 / 24
= 5%
No of pref shares = R 320 000 000 / R16 = 20 000 000
P = 20 000 000 × R24 = R480 000 000

Market value of Ordinary Shares:

Market value of = 4 000 000 × R140.00
equity
= R560 000 000
Market value of debt:
Bond value = R492 200 000

V = 560 000 000 + 492 200 000 + 480 000 000

= R 1 532 200 000

(c) Weightings:
E/V = 560 /1 532.2 = 36.55%
P/V = 480 /1 532.2 = 31.33%
D/V = 492.2 /1532.2 = 32.12%
WACC = (0.3655 × 0.0831) + (0.3133 × 0.05) + (0.3212 × (0.0635 × 0.72))
= 0.0603 or 6.03%
[12]
(d) Equity break point = 250 000 000 /0.3655 = 683 994 528.04
Debt break point = 500 000 000 /0.3212 = 1 557 000 000

[4]
QUESTION 3

(a) Weighting of Protea = 6 000 / 10 000 = 0.60

Weighting of Springbok = 4 000 / 10 000 = 0.40

Portfolio return in each state:

Boom: (0.6 x 25) + (0.4 x 18) = 15 + 7.2 = 22.2
Normal: (0.6 x 5) + (0.4 x 8) = 3 + 3.2 = 6.2

E(RP) = (22.2 x 0.3) + (6.2 x 0.7) = 6.66 + 4.34 = 11%

Check = 0.6* 11 + 0.4 * 11 = 11%

Var (Rp) = 0.3 (22.2 - 11)2 + 0.7 (6.2 - 11)2

√53.76
= 37.632 + 16.128 = 53.76
SD (Rp) = = 7.33% [12]

(b) Cov (RA, RB) = 0.3 (25 - 11) (18 - 11) + 0.7 (5 - 11) (8 - 11)
= 0.3 (14) (7) + 0.7 (-6) (-3)
= 29.4 + 12.6
= 42 42
Corr (RA, RB) =
8.34 x 4.17

42
= 34.7778

= 1.21
[8]
(c) p = (0.6 x 0.8) + (0.4 x 1.2)
= 0.48 + 0.48
= 0.96 [2]
(d)
 Systematic risk is that part of the total risk that is caused by factors beyond the control of a
specific company or individual.
 Systematic risk is caused by factors that are external to the organization. All investments
or securities are subject to systematic risk and, therefore, it is a non-diversifiable risk.
 Unsystematic risk is the risk that is inherent in a specific company or industry.
 By investing in a range of companies and industries, unsystematic risk can be drastically
reduced through diversification.
[3]

(e) Bafana and Springbok have the same Beta and return, which suggests that they react in the
same way in comparison to the market. Further, they are in the same industry. One of the
reasons for making a portfolio is to diversify, to lower risk. Therefore I would look for an
alternative, with a different relationship with the market, or operating within a different
industry.
[3]
QUESTION 4
Assumptions:
- No transaction costs
- No costs associated with financial distress
- No agency costs
- No difference in the cost of borrowing for individuals and companies

Assertions:
- Assets determine the value of the company and not how the assets are financed.
- That is, the value of the firm is independent from its capital structure, therefore
the value of levered firm will be equal to the value of an identical unlevered
firm. This can be seen in the straight-line showing value in the graph, which
does not change as D/E changes.
- The value of the ‘pie’ is not determined by how it is ‘sliced’. This may be
shown using a pie chart, where the value is the same regardless of the mix of
D and E.
- Argued that there is no optimal structure because irrespective of the level of
gearing, firm WACC will not change. This is seen in the diagram where
WACC is a horizontal line, not affected by increased leverage.
- This is because, debt increases risk and thus an increase in debt will result to
shareholders increasing COE to compensate increased risk. This is seen by a
rising cost of equity line, while WACC remains constant.

Link to Diagrams:
EXAM 2023
Question 4 (50 marks: 50 minutes)

Answer BOTH unrelated parts to this question

Part A (25 marks: 25 minutes)

Greenleaf Corporation is a manufacturing company, which is currently unlevered. The

management of Greenleaf has identified a great investment opportunity that they believe will
take the corporation to great heights within the industry. Because of this, Greenleaf is
considering sourcing additional capital through debt as this will ensure that their current
shareholding remains diluted. Currently, Greenleaf’s market return is 15%, a beta of 0.9
(unlevered) and the prevailing risk-free rate is 7%.

Greenleaf Corporation is considering issuing non-redeemable (perpetuity) coupon bonds with

a face value of R1000. These bonds will offer a coupon payment of 12% per annum while the
prevailing market-related interest rate is 10%. The total floatation costs add up to 3% of
market value and the prevailing tax rate is 28%. Greenleaf has a target debt ratio of 40%.

Required:

(a) Calculate the Greenleaf’s current cost of capital (without additional capital).
(3 marks: 3 minutes)
(b) Determine what Greenleaf’s levered beta would be if it were to be successful in raising
additional capital.
(5 marks: 5 minutes)
(c) Calculate the cost of equity that is inclusive of the additional capital.
(3 marks: 3 minutes)
(d) Calculate the market value of each bond.
(2 marks: 2 minutes)
(e) Determine the amount that Greenleaf will receive for each bond.
(2 marks: 2 minutes)
(f) Determine what Greenleaf’s cost of debt would be if additional capital were to be raised.
(4 marks: 4 minutes)
(g) Calculate Greenleaf’s WACC which is inclusive of additional capital.
(6 marks: 6 minutes)

Round off all calculations to two decimal places (four, if in decimalized format), and all
values to the nearest cent.

Part B overleaf……
Part B (25 marks: 25 minutes)

In their capital structure theory with taxes, Miller and Modigliani maintain that with an
increase in the amount of debt employed by the firm, the value of the firm goes up and the
weighted average cost of capital (WACC) goes down.

Required:

(a) Explain why the value of the levered firm is greater than an otherwise identical firm with
no debt.
(5 marks: 5 minutes)

(b) With the aid of an appropriate diagram, show and fully explain how the WACC falls
with the increased usage of debt, despite the increase in financial risk.
(14 marks: 14 minutes)

(c) In their last case, Miller and Modigliani acknowledge the presence of insolvency costs
and their impact on the value and cost of capital of firms. Explain why (a) and (b) above
will not hold in the presence of both corporate taxes and insolvency costs.
(7 marks: 7 minutes)
EXAM 2023 SUGGESTED SOLUTIONS
Question 4 (50 marks)

Part A (25 marks)

(a) Re (old) = 7 + 0.9 (15 - 7)

= 14.2% [3]
(b) D/E = 40/(100-40)
= 2/3
βL = 0.9*[1 + (1-0.28)2/3]
= 1.332 [5]
(c) Re (new) = 7 + 1.332(15 – 7)
= 17.656 [3]
(d) Vd = (12 / 9) x R1 000
= 1 200 [2]
(e) Vd (np) = 1 200(1 – 0.03)
= 1 164 [2]
(f) Coupon = 1 000* 0.12
= 120
Cost of Debt = (120 / 1 164)
= 0.1031 or 10.31% [4]

(g) WACC = (3/2+3) *(17.656) + (2/5) (10.31) (1 - 0.28)

= 13.56% [6]

Part B (25 marks)

(a) As the company becomes more and more leveraged, its value increases by the present
value of the interest tax shield.
The tax saving as a result of interest on debt is effectively a cash inflow hence the
increase in value.
Thus, the optimal capital structure is 100% debt because this is when the value of a firm
is maximized.
[5]

(b) As the leverage increases, the cost of equity (R E) increases due to the introduction of
financial risk.
However, this increase is perfectly offset by the relatively cheaper debt.
In addition, the additional benefit due to the interest tax shield makes the debt even
cheaper such that the resulting weighted average cost of capital falls.
 Re Ru Rd (1-t) WACC
WACC declines
Re increases
horizontal shows Debt / Equity
vertical shows Cost of Capital
[14]

(c) Taking insolvency costs into account, it can be noted that at very high levels of debt:
- Present value of the tax shield will be lower than present value of insolvency costs.
- The cost of debt will start to go up and as a result, WACC will also go up and the
actual value of the firm will start to fall.
- Thus, the value of the firm is maximised at the point where the marginal benefit of
additional debt is equal to the marginal increase in financial distress. This is the point
where WACC is minimised.
[6]