PROBLEM-SOLVING SESSION

FINANCIAL MANAGEMENT

FOR MAY 2019 EXAMS

[SET 3]

Prepared By: Godson Mkaro (Jr): MSc Finance & Investment, BSc. Computer Science, ATEC II, CPBE, CPA (T) &
Emmanuel Christopher: MBA (Finance), B.Com Accounting (Hons), CPA (T) |Phone1: +255 717 / 769 348 616 |
Phone2: +255 714 965 564 | Email us to: [email protected] |Visit our Website at: www.covenantfinco.com
 COVENANT FINANCIAL CONSULTANTS PROBLEM SOLVING SESSION [SET 3]

QUESTION ONE []
MADENGE Co. Ltd is a company dealing with packaging and export of food products to a
number of countries in Europe. The company is based in Tanzania and uses TZS as its operating
currency. MADENGE is appraising the purchase of a new machine, costing TZS 1.5 billion, to
replace an existing machine which is becoming out of date and which has no resale value. The
forecast levels of production and sales for the goods produced by the new machine, which has a
maximum capacity of 400,000 units per year, are as follows:
Year 1 2 3 4
Sales volume (units/year) 350,000 380,000 400,000 400,000
The new machine will incur fixed annual maintenance costs of TZS 145 million per year. Variable
costs are expected to be TZS 3,000 per unit and selling price is expected to be TZS 5,650 per unit.
These costs and selling price estimates are in current price terms and do not take account of
general inflation, which is forecast to be 4.7% per year.
It is expected that the new machine will need replacing in four years’ time due to advances in
technology. The resale value of the new machine is expected to be TZS 200 million at that time,
in future value terms.
The purchase price of the new machine is payable at the start of the first year of the four-year life
of the machine. Working capital investment of TZS 150 million will already exist at the start of
the four-year period, due to the operation of the existing machine. This investment in working
capital is expected to increase in nominal terms in line with the general rate of inflation.
MADENGE Co pays corporation tax one year in arrears at an annual rate of 27% and can claim
25% reducing balance tax-allowable depreciation on the purchase price of the new machine. The
company has a real after-tax weighted average cost of capital of 6% and a nominal after-tax
weighted average cost of capital of 11%.
REQUIRED:
(a) Using a nominal terms net present value approach, evaluate whether purchasing the new
machine is financially acceptable. (10 marks)
(b) Discuss the reasons why investment finance may be limited, even when a company has
attractive investment opportunities available to it.

Prepared By: Godson Mkaro (Jr): MSc Finance & Investment, BSc. Computer Science, ATEC II, CPBE, CPA (T),
Emmanuel Christopher: MBA (Finance), B.Com Accounting (Hons), CPA (T) |Phone1: +255 717 / 769 348 616 |
Phone1: +255 714 965 564 | Email: [email protected] |Website: www.covenantfinco.com Page | 1
 COVENANT FINANCIAL CONSULTANTS PROBLEM SOLVING SESSION [SET 3]

QUESTION TWO []

The Board of Swema Ltd is considering the company’s capital investment options for the coming
year, and also evaluating the following potential investments:
Investment A
This investment is similar to its current investments and requires an investment of TAS 60,000
now, TAS 40,000 for new capital equipment and TAS 20,000 for increases in working capital. This
will be financed from Shareholders Funds. Sales next year would be 10,000 units, variable costs
would be TAS 6 and the product would be sold for TAS 10. But due to entry of new competitors
and technological improvements, the sales price would decline by 20% per annum thereafter,
sales volume would fall by 10% and variable costs would fall by 20% per annum. Overheads
attributed to the project would be TAS 15,000 per annum.
In year three the project would be wound up, working capital investment would be recovered
and capital equipment sold off for 25% of its purchase costs the following year. Fixed costs include
an annual charge of TAS 4,000 for depreciation.
Investment B
This is a long–term project in a totally new area, involving an immediate outlay of TAS 90,000,
which they intend to borrow from their lenders at 6%. They expect net profits of TAS 12,000 next
year, rising thereafter by 3% per annum in perpetuity.
Investment C
This is another long-term investment in a totally new area, involving an immediate outlay of TAS
25,000 which they intend financing by retained profits.
Expected annual net cash profits are as follows:
Years 1 to 4: TAS 3,000
Years 5 to 7: TAS 5,000
Year 8 onwards forever: TAS 7,000
The company discounts all projects lasting ten years duration or less at a cost of capital of 10%
and all other projects at a cost of 13%. You may ignore taxation.
Required: As a financial management analyst, you have been asked to advise the board of Swema
Ltd (in the form of a briefing report) which investment should be undertaken. In your report you
are to make use of the NPV method, as the members of the board believe this is the best to use
and have asked you to use it.

Prepared By: Godson Mkaro (Jr): MSc Finance & Investment, BSc. Computer Science, ATEC II, CPBE, CPA (T),
Emmanuel Christopher: MBA (Finance), B.Com Accounting (Hons), CPA (T) |Phone1: +255 717 / 769 348 616 |
Phone1: +255 714 965 564 | Email: [email protected] |Website: www.covenantfinco.com Page | 2
 COVENANT FINANCIAL CONSULTANTS PROBLEM SOLVING SESSION [SET 3]

QUESTION THREE [ ]
Meku ltd is an investment fund whose major holdings are its stocks and bonds acquired in
various companies listed at the DSE. The company has recently acquired shares issued by
Vodacom Plc which pays dividend of TZS 534 to its shareholders. The shares have a beta factor
of 1.2. The risk-free rate of return and the market return are 15% and 20% respectively.
REQUIRED:
(i) Calculate the return on the shares (4 marks)
(ii) Calculate the value of the shares (2 marks)

(b) Meku Limited also intends to invest its surplus funds in shares of Tanzania Breweries Limited
(TBL) with the following return expectations:
Economic condition Probability Share returns
Boom 0.20 40%
Average 0.60 15%
Recession 0.20 10%
REQUIRED:
Using the coefficient of variation, assess the risk level associated with the investment. (4 marks)
(c) Distinguish between "required rate of return" and "expected rate of return". (4 marks)

(d) Explain briefly what you understand by the following terms:

(i) Systematic risk
(ii) Unsystematic risk
(iii) Weak Form Efficient Market
(iv) Securities market line (6 marks) [Total 20 marks]
Suggested solution for part c and d
c. Required Rate of Return
Before an investor invests his/her money, he/she would probably want to know whether he/she
is making a good investment or a bad one. This is the main purpose of a required rate of return
(RRR). The RRR represents the absolute minimum return on investment that an investor would
accept for that investment to be worthwhile. If an investor requires to earn 4 percent return on
the money invested to make the investment advantageous, then this is the investor’s RRR. Any
investment that an investor takes on should yield a profit that’s above the RRR. For example, if
Prepared By: Godson Mkaro (Jr): MSc Finance & Investment, BSc. Computer Science, ATEC II, CPBE, CPA (T),
Emmanuel Christopher: MBA (Finance), B.Com Accounting (Hons), CPA (T) |Phone1: +255 717 / 769 348 616 |
Phone1: +255 714 965 564 | Email: [email protected] |Website: www.covenantfinco.com Page | 3
 COVENANT FINANCIAL CONSULTANTS PROBLEM SOLVING SESSION [SET 3]

the RRR is 4 percent and the investment returns 2 percent, then the investor will probably decline
or reject the investment.
Expected Rate of Return
An expected rate of return is the return on investment that an investor expects to collect when
investing in a security. So, for comparison purposes, the RRR is the minimum possible rate that
would attract the investor to invest, and the expected rate of return is what the investor actually
plan to make from that investment. This rate is calculated based on probability. The truth is, in a
volatile market it’s impossible to know what the exact rate of return will be on an investment.
However, using information on the securities history, its volatility and its overall market returns,
you can reasonably estimate what the rate of return will be over a period of time. This is the
expected rate of return: what you actually think you might make back on your investment.
d. Suggested answer
1. Systematic risk is the degree of uncertainty of an asset’s returns that cannot be eliminated
through diversification.
2. Unsystematic risk is the degree of uncertainty of an asset’s returns that can be eliminated
through diversification.
3. Weak form efficient market is a market efficiency whereby all past prices of an asset are
reflected in its current price. Strong form efficient market states that current share prices reflect
not only historical share price patterns and current public knowledge, but also all possible
information about the company.
4. Securities market line shows the relation between the expected return on an asset and the asset’s
beta. Capital market line shows the possible portfolios that can be formed by combining the risk-
free asset and the market portfolio in different proportions

Prepared By: Godson Mkaro (Jr): MSc Finance & Investment, BSc. Computer Science, ATEC II, CPBE, CPA (T),
Emmanuel Christopher: MBA (Finance), B.Com Accounting (Hons), CPA (T) |Phone1: +255 717 / 769 348 616 |
Phone1: +255 714 965 564 | Email: [email protected] |Website: www.covenantfinco.com Page | 4