ASSIGNMENT 01
QUESTION 1
Xelo Ltd, whose current sales consist of fixed operating costs of R140 000 and variable operating costs equal to 22% of sales, has made the following two sales estimates with their noted probabilities.
|
Sales
|
Probabilities
|
|
R450 000
|
0.35
|
|
R710 000
|
0.65
|
Xelo Ltd is currently 100% equity financed with a total market value of R450 000, consisting of ordinary shares trading at R5 each. Xelo Ltd pays all its net income as dividends and is in a 15% tax bracket. The firm is considering using one of the following capital structures:
|
Debt ratio
|
Before-tax cost of debt (kd)
|
Required
|
|
30%
|
4%
|
17%
|
|
45%
|
7%
|
20%
|
REQUIRED
(a) Calculate the debt, equity and number of shares under each of the capital structures under consideration.
(b) Calculate expected earnings per share (E/EPS) for the proposed capital structures.
(c) Use the valuation model to estimate share value of both capital structures.
(d) Based on the long-term and short-term goals of financial management, which capital structure would you recommend?
(e) Based on the long-term goal, at what overall capitalisation rate would you capitalise the company and why?
QUESTION 2
ABC Ltd is attempting to project its financial requirements for the next 10-year period. The company is a relative newcomer to the industry, having been in the business for only three years. Initially the company was totally unknown and found financing, particularly of a permanent nature, quite difficult to obtain. As a result, the company was literally forced to structure its sources of financing as follows:
Trade credit payable R200000
Short-term borrowing R240000
Ordinary shares R440 000
R880 000
In the three years the company has been very successful, increasing its total capitalisation by R120 000 as a result of retained earnings. It is now in a position where it could obtain a long-term loan for ten years from a financing house at a rate of 10%, in place of all or any of its present short-term borrowings. Alternatively, it could renew its existing R240 000, or any part thereof, with a one year loan from the bank at a rate of 8%. The company has a tax rate of 32%.
The company's financial director is considering three possible financing plans:
1. Renew the one-year loan with the bank
2. Borrow R240 000 from a financing house
3. Borrow R120 000 from each of the 2 above alternatives
The financial director has estimated short-term riskless rates, the premiums that the company may have to pay over the riskless rate for the three possible states of the economy, and the probability of each. The average rates that the company would be likely to pay over the next ten years on its short-term borrowings are as follows:
|
State of the economy
|
EBIT (R)
|
Risk less rate (%)
|
Premium (%)
|
Joint Probability
|
|
Good
|
300 000
|
3
|
2
|
0.125
|
|
Good
|
300 000
|
5
|
2
|
0.125
|
|
Average
|
160 000
|
5
|
4
|
0.250
|
|
Average
|
160 000
|
7
|
4
|
0.250
|
|
Bad
|
20 000
|
7
|
10
|
0.125
|
|
Bad
|
20 000
|
9
|
10
|
0.125
|
REQUIRED:
(a) Calculate the expected value of the short-term interest rate.
(b) Calculate expected profit under each of the financial manager's three proposed financing plans (Ignore possible growth effects and assume an expected EBIT of R160 000 under each plan.)
(c) Determine the worst and best after-tax profit outcome which would result from each of the financing plans. Briefly interpret the results and recommend a financing plan for the company. Where applicable, use tabular formats to present your findings.