Calculate the expected value of the short-term interest rate

Assignment Help Financial Management

Reference no: EM131064379

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.

(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.

ASSIGNMENT 02

QUESTION 1

Use the statement of financial position and statement of comprehensive income for Amolatina Ltd to answer the questions that follow. Assume all sales are on credit and 365 days for 2015.

STATEMENT OF FINANCIAL POSITION FOR AMOLATINA LTD AS AT 31 DECEMBER 2015

Assets	(R)	Equity and liabilities	(R)
Cash	24 000 000	Accounts payable	15 000 000
Marketable securities	14 000 000	Notes payable	21 000 000
Accounts receivables	26 000 000	Other current liabilities	10 000 000
Inventories	81 000 000
Total current assets	145 000 000	Total current liabilities	46 000 000
Non-current assets	115 000 000	Long-term debt	25 000 000
Less depreciation	9 000 000	Total liabilities	71 000 000
Net non-current assets	106 000 000	Ordinary shares	80 000 000
		Retained earnings	100 000 000
		Total shareholders' equity	180 000 000
Total assets	251 000 000	Total liabilities and equity	251 000 000

STATEMENT OF COMPREHENSIVE INCOME FOR AMOLATINA LTD FOR YEAR ENDED 31 DECEMBER 2015

Net sales	410 000 000
Cost of goods sold	150 000 000
Gross profit	260 000 000
Selling expenses	24 000 000
Depreciation expense	5 000 000
EBIT	231 000 000
Interest expense	11 000 000
Net income before tax	220 000 000
Taxes (30%)	66 000 000
Net income	154 000 000

INDUSTRY AVERAGE RATIOS

Current ratio	3:1	Sales/fixed assets	4 times
Debt/total assets	25%	Sales/total assets	5 times
Times interest earned	5 times	Net profit margin	6%
Sales/Inventory	8 times	Return on assets	11%
Days' sale outstanding	20 days	Return on equity	13.5%

REQUIRED

(a) Calculate the Du Pont equation for Amolatina Ltd.

(b) Compare the Du Pont equation calculated in (a) with the composite equation for the whole industry.

(c) Briefly comment on a comparison between the Amolatina Ltd and industry with specific regard to liquidity, solvency and asset management.

1.2 Study BRIDS Ltd's statement of financial position and statement of comprehensive income are given below:

Statement of financial position for BRIDS Ltd as at 31 December 2015

Statement of comprehensive Income for BRIDS Ltd for the year ended 31 December 2015

	R		R
Cash	75 000	Accounts payable	160 000
Accounts receivable	110 000	Notes payable	140 000
Inventory	450 000
Total current assets	635 000	Total current liabilities	300 000

Net Non-Current assets	465 000	Long-term (12%)	350 000
		Ordinary shares equity (45 000 shares)	450 000

Total assets	1 100 000	Total liabilities & equity	1 100 000

Statement of comprehensive Income for BRIDS Ltd for the year ended 31 December 2015

Sales	800 000
Cost of goods sold	310 000
Earnings before interest and tax (EBIT)	490 000
Interest expense	65 000
Earnings before tax (EBT)	425 000
Taxes (10%)	42 500
Net income	382 500

The industry average inventory turnover is 8 and the interest rate on the firm's long- term debt is 12%. 45 000 shares are outstanding. BRIDS Ltd plans to change its inventory methods so as to operate at the industry average inventory turnover ratio. The funds generated from this change will be used to retire long-term debt and it is assumed that the company's sales, the cost of goods sold, and the share price will remain constant. Assume that inventory turnover is given as a ratio of sales to inventory.

REQUIRED

Determine the percentage change in the BRIDS's return on equity (ROE) once these changes are effected.

QUESTION 2

Xola Ltd is evaluating the feasibility of introducing a new product. They would have to invest R300 000 at time t = 0 for the design and testing of the new product. Management believes that there is a probability of 80% that this phase will be successful and that the project will continue. If stage 1 is not successful the project will have to be abandoned with zero salvage value.

The next stage, if undertaken, would consist of making moulds, and producing two prototypes. This would cost R2 500 000 at time t = 1. Production will commence if the tests are successful. The moulds and prototypes could be sold for R765 000 if the product fails the testing phase. Management estimates the probability of the product passing the testing phase as 90% and that phase 3 will then be undertaken.

Phase 3 consists of converting the unused production line to produce the new design. This would cost R3 500 000. If the economy is strong at this point, the value of sales of the final product would be R16 000 000. If the economy is weak, the sales value of the final product would be R2 500 000. Both sales values occur at time t = 3, and each state of the economy has a probability of 0.5. The required return of Xola Ltd is 8%. The firm only accepts investments if the coefficient of variation of the proposed project is less than 5.

REQUIRED

(a) Use a decision tree to determine the project's expected net present value (NPV).

(b) Calculate the project's variance and standard deviation of the NPV.

(d) Should the project be accepted or rejected? Substantiate your answer

ASSIGNMENT 03: SELF-EVALUATION ASSIGNMENT

QUESTION 1:

Suppose you manage a R4 million portfolio that consists of four stocks with the following investments.

Stock	Investment (R)	Beta
A	400 0000	1.5
B	600 000	-0.5
C	1 000 000	1.25
D	2 000 000	0.75

Required

If the market's required rate of return is 14% and the risk free rate is 6%, what is the portfolio's required rate of return? [10]

QUESTION 2

Assume asset A has an expected return of 10 per cent and a standard deviation of 20 per cent. Asset B has an expected return of 16 per cent and a standard deviation of 40 per cent.

Required

If the correlation between A and B is 0.35, what is the expected return and standard deviation for a portfolio comprised of 30 per cent asset A and 70 per cent asset B?

QUESTION 3

The earnings, dividends and stock price of FML Ltd are expected to grow at 7% per year in the future. FML Ltd's common stock sells for R23 per share, its last dividend was R2 per share and the company will pay a dividend of R2.14 per share at the end of the current year.

Required

(a) Calculate FML Ltd's cost of equity using the discounted cash flow approach.

(b) What would be the firm's cost of equity based on the CAPM approach if the firm's beta is 1.6, risk free rate is 9% and the expected return on the market is 13%?

QUESTION 4

Kay Ltd's current earnings per share (EPS) is R6.50. Five years ago, EPS was R4.42. The company pays out 40% of its earnings as dividends and the stock sells for R36.

Required

(a) Calculate the historical growth rate in earnings. (Hint: This is a 5-year growth period).

(b) Calculate the next expected dividend per share, D1. [Hint: D0 = 0.4(R6.50) = R2.60]. Assume that the past growth rate will continue.

QUESTION 5

Dube Scientific Products produces satellite earth stations which sell for R100 000 each. The firm's fixed costs, F are R2 million. Fifty earth stations are produced and sold each year while profits total R500 000 and the firm's assets (all equity financed) are R5 million. The firm estimates that it can change its production process, adding R4 million to investment and R500 000 to fixed operating costs.

This change will
- reduce variable costs per unit by R10 000 and,
- increase output by 20 units, but,
- the sales price on all units will have to be lowered to R95 000 to permit sales of the additional output.

The firm has a tax loss carried forward, meaning that its taxes are zero. Its cost of equity is 15 per cent and it uses no debt.

Required

Evaluate whether this firm should make this change.

Reference no: EM131064379

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