INSTITUTE OF CHARTERED SECRETARIES AND

ADMINISTRATORS IN ZIMBABWE

SUGGESTED SOLUTIONS: MAY 2016

CORPORATE FINANCIAL MANAGEMENT

QUESTION 1

Draft Report to Mr. Njainjai

Subject: Valuation of Consultancy Practice

Owner: Mr. Njonzi

Introduction

Based on the given information, a price in the range of $80,000 to $90,000 would be reasonable for the
consultancy practice.

Valuation

1 Asset basis:
Two bases or approaches can be used to value the firm’s assets namely the replacement cost, and
realisable value (break-up) method. If the consultancy business assets were to be assembled from
scratch the cost would be $92,800 (W1), whereas if Mr. Njonzi had to break-up the business the
assets would only realize $81,600 (W1). It is unlikely that Mr. Njonzi would accept less than the
break-up value of his assets if he is selling the business as a going concern, and therefore this gives
us an approximate minimum value for the business. The replacement cost valuation is not
particularly relevant but does give a maximum figure for the assets basis valuation.

2 Earnings basis:
As the business is being purchased with a view to making a profit it may be more valid to value the
business on an earnings basis; this produces a value of $80,000 (W2). The profit figure has been
calculated by taking a simple average of the past five years’ profits; as this figure is being used as a
prediction of future profits it may be more valid to weight the recent years’ profits.

Workings

1 Assets basis:

Replacement Cost Realisable Value

$ $
Freehold Premises 80,000 76,000
Office Equipment 7,600 2,000
Motor Car 4,600 3,000
Debtors 6,600 6,600
Current Liabilities (6,000) (6000)
Total 92,800 81,600
2 Earnings basis:
$[𝟏𝟗,𝟎𝟎𝟎+𝟏𝟓,𝟖𝟎𝟎+𝟏𝟖,𝟔𝟎𝟎+𝟏𝟔,𝟒𝟎𝟎+𝟏𝟖,𝟐𝟎𝟎]
Average net profits = 𝟓
=$17,600
Loss of earnings $(8,000)

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 Gain $ 9,600

As this gain is subject to a risk discount rate of 2% above the assumed risk-free rate of 10% is
$9 600
considered suitable. Value = 0.12
= $80 000

Assumptions and additional information

 The valuation of the freehold property is of vital importance, and therefore a professional
valuation should be obtained.
 Mr. Njonzi’s net profits do not appear to have increase over the last five years. If inflation is
running at 10% the business must have contracted in real terms.
 It should be ascertained whether Mr. Njinzi has any major clients, the loss of whose business
would severely affect the profits.
 Mr. Njonzi must guarantee that he will not set up a rival practice.
 Mr. Njonzi has presumably built up the business on his personal reputation and some clients
may move elsewhere if he sells the practice.
 Mr. Njainjai’s current salary of $8,000 p.a. His job prospects should be ascertained as this will affect the
gain that he is making on buying the consultancy practice. [Total: 20 Marks]

QUESTION 2
2014 ($Million) 2015 ($Million)
a) Operating Earnings = 200 250
Less Financial Charges:
20% on Loan of $30 (6) (6)
16% on Debentures of $50 (8) (14) (8) (14)
Earnings Before Tax 186 236
Less Tax (37.5%) (69.75) (88.50)
Earnings After Tax 116.25 147.50
Less Preference Dividends
30% × 100 (30.00) (30.00)
Earnings Attributed to Ordinary Shares 86.25 117.50
Less Ordinary Dividends ($4×10) (40.00) ($5× 10) (50.00)

Retained Earnings for the year 46.25 67.50

46.25
86.25
Retention Ratio for 2014, r = 86.25 = 0.5362, ROE= = 0.345)
250.00
67.50
117.50
Retention Ratio for 2015, r = 117.50 = 0.5745,ROE= = 0.470
250.00

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Therefore, growth rate (%) for 2014, g =0.5362 × 0.345=0.185.
The growth rate (%) for 2015, g = 0.5745×0.470 = 0.270.
Hence the growth rate in earnings rose from 18.5% in 2014 to 27.0% in 2015.

b) Total capitalisation of firm ($ million) = 250 +100 +30+50 = 430.

5
Cost of Ordinary Equity, 𝑘𝑒 = 25 + 27.0% = 47%.
250 100 30 50
WACC = 0.47×430 + 0.30×430+ 0.20 (1- 0.375) ×430 + 0.16 (1 − 0.375) × 430 = 36.34 %.

The report to the Board should be based on the following factors:

 Legal Requirements
Dividends may not be paid from share capital but from share profits and book values
must exceed liabilities. Losses in previous years may be disregarded.
 Dividend Payment Policies
Firms should have dividend payment policies in place based on its objectives.
 Contractual obligations
Payment of dividends can be restricted by some loan agreements borne by the firm.
 Internal Constraints
The firm’s ability to pay dividends may be influenced by availability of cash (some firms
may be profitable but may lack cash due to accrual concepts)
 Nature of Shareholders
The nature of a firm’s shareholders influences the dividend policy of a firm. Investors
who need cash require high dividend pay-out while those in high tax brackets may prefer
capital gains. Policy must maximise shareholders’ wealth.
 Market Considerations
An awareness of the market’s response to certain dividend policies is crucial in
maximising shareholders’ wealth. Most shareholders prefer a fixed or increasing
dividend to a fluctuating one.
 Shareholders’ Investment Opportunities
Firms should not retain funds to invest in projects yielding lower returns as compared to
external projects promising higher returns, but having some risk level.
 Information Content of Dividends
Investors use dividend information to judge the performance of firm`s high dividend as a
sign that the firm has prospects for future earnings. [Total: 20 Marks]

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QUESTION 3

The LCM Technique:

Analysis of project A:
Year 0 1 2 3 4 5 6
lo -120000 -132000
CF 67500 75000 90000 81000 90000 108000
Net CF -120000 67500 75000 -42000 81000 90000 108000

67 500 75 000 108 000

Therefore Net Present Value at 30% =−120 000 + + +−−−− +
1.301 1.302 1.306
= $32 159.80
Analysis of project B:
Year 0 1 2 3 4 5 6
lo -90000 -99000 -108900
CF 67500 90000 81000 108000 97200 129600
Net CF -90000 67500 -9000 81000 -900 97200 129600

67 500 −9 000 129 600

Therefore Net Present Value at 30% =−90 000 + + +−−−− +
1.301 1.302 1.306
= $46 179.80

On the basis of the LCM technique Project B is accepted because it has a higher NPV than
Project A. [Total: 20 Marks]

QUESTION 4
𝐸𝐵𝐼𝑇 $8500000
a) (i) Value of firm According to MM without Taxes = =
𝑘𝑢 0.25
=$34 000 000

(ii) Value of Firm with Taxes According to MM Theory

𝐸𝐵𝐼𝑇(1−𝑇𝑎𝑥) $8 500 000(1−0.375)

VL = + 𝑡𝐷 = + 0.375 × $15 000 000
𝑘𝑢 0.25
= $26 875 000
Cost of Geared Firm with Taxes According to MM Theory
$15𝑚
keg = 25% + (25- 16) %(1-0.375) ×$11.875𝑚 = 32.11%

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 (b) Implications of the MM Theory to the value of Text Limited
There are a number of issues to be considered by levered firms:

1. The Market Value of a levered firm equals the market value of an unlevered firm plus the
present value of the tax shield. The Implication of the Theory is that firm value is maximised
when it is financed entirely by debt, which is not attractive to investors.
2. There are institutional and legal restrictions facing a firm that has a debt-equity ratio which
is more than a certain limit.
3. There are costs imposed on a firm that goes bankrupt which may persuade it not to increase
its debt-equity ratio above a certain cap or limit.
4. Interest tax shield may exhaust all taxable income of a firm because it reduces firm value
while keeping the cost of capital constant.
5. The actual value of a firm facing corporate taxation in the country of operation is lower than
the value forwarded by the MM Theory.
6. The irrelevance capital structure theory may have more merit than the initially assumed value
by MM Theory. [Total: 20 Marks]

QUESTION 5
a) The motives to invest internationally that the Management of Matshuba Private Limited
could have put into consideration could include the need for:
 Diversification of investment risk
 Expansion of market base for company’s products
 Provision of services to foreign markets
 Attraction by foreign investment opportunities
 Increasing company’s sales/revenues and asset base
 Proximity to sources of raw materials needed in production.

b) Project viability in Zimbabwean currency terms:

1. Initial Investment
Securing of old building = P 500 000
Cost of equipment = P1 000 000
Installation = P 300 000
Total cost of project = P 1 800 000

2. Debt financing of the project

Debt amount in total capital = 40% x P1 800 000
= P 720 000
Annual interest on debt = 20% x P720 000

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 = P 144 000
3. Capital allowances on project
Equipment (40% x P1m) = P 400 000
Building (20% x P 0.5m) = P 100 000
Total capital allowances = P 500 000

4. Weighted average cost of capital (WACC)

WACC = Σwiki = 0.6 x 0.28 + 0.4 x 0.20 (1 – Tax)
= 0.6 x 0,28 + 0.4 x 0.20 (1 – 0.35)
= 22%
5. Botswana currency cash flow terms (Pula, P 000):
Year 0 1 2 3 4
Primecost (1 800)
Rev(Sales) - 6 000 6 900 8 000 9 200
Operating Costs - (5 000) (5 500) (6 450) (7 360)
Fees on Sales (2%) (120) (138) (160) (184)
EBIT 880 1 262 1 390 1 656
Capital Allowances (500)
Taxable Income 380 1 262 1 390 1 656
Corporate Tax (35%) (133) (441.7) (486.5) (579..6)
NCF 247 820. 3 903.5 1 076.4
Salvage Value 400
Working Capital 300

Net after tax cash flow (1 800) 2 47 8 20.3 903.5 1 776.4

6. Project cash flows in US Dollars
Year 0 1 2 3 4
Net tax cashflow in Pula (1 800 000) 247 000 820 300 903 500 1 776 400
Exchange/ Rate 0.125 0.124 0.126 0.128 0.130
Net after tax cash flows ($) 225 000 30 628 103 357.8 115 648 230 932

30 628 103 357.8 230 932

NPV at 28% ($) = (225 000) + + +-----------+
1.281 1.282 1.284
= $ 3 186.86.
Hence since the project has a positive NPV it should be accepted for implementation. (12
marks) [Total: 20 Marks]

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QUESTION 6
a)
Conversion Period Ratio 31-12-2014 Ratio 31-12-2015

100 000 70 000

For Raw Materials = 0.10 = 0.047
1 000 000 1 500 000

For Creditors 200 000 400 000

= 73
= 60. 2 000 000/365
1 200 000/365

70 000 130 000

For Work In Progress =12.775 =15.82
2 000 000/365 3 000 000/365

For Finished Goods 30 000 80 000

= 5.8 = 10
1 900 000/365 2 900 000/365

For Debtors 600 000

=54.75 900 000
4 000 000/365 = 66
5 000 000/365

Cash Operating Cycle for 2014= 0.10 - 60+12.775+5.8+54.75=13.425 days.

Cash Operating Cycle for 2015= 0.047-73+15.82+10.00+ 66=18.867days.

Therefore the firm took 13.425 and 18.867 days to pay cash for raw materials to until cash was
actually received from operations in 2014 and 2015 respectively. In other words the firm’s cash
operating cycle was better in 2014 than in 20145 because it took a shorter time period to
commit its finances to raw materials and receive cash from its operations.
(13marks)
b) The differences between the traditional (net income) view and MM (net operating income)
view are centred on:
Traditional view states that the mix between debt and equity in the capital structure of a firm;
1. Has an optimal level, which maximises leverage and minimises WACC.
2. Firm value is determined based on net or residual income after interest and tax have been
deducted.
The MM view on the other hand argues that the mix between debt and equity in the capital
structure of a firm;
1. Has no optimal level which maximises leverage because all benefits to be drawn from
leverage would be eroded by increases in the cost of debt to the firm.
2. The MM proposition with taxes has proved that taxation reduces market value of equity let
alone total value of the firm and its assets. In other words taxation reduces shareholders’
wealth.

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3. The valuation of the firm using EBIT shows that the market value of a levered firm is the same
as that of an unlevered one implying that debt does not add to equity. Hence incorporating
debt in the capital structure of a firm is not useful at all.
4. Worse still debt equity remains put implying that the firm will be exposed to business risk
since net market value of equity will be reduced significantly. [Total: 20 Marks]

“End of suggested Solutions”

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