FINANCIAL MANAGEMENT 3B

BSR3B01/ FNM03B3
ASSESSMENT OPPORTUNITY 1
19 August 2022

Time: 120 Minutes Marks: 80

Assessors: Mr S Modiba
Ms M Hlobo

Moderator: Ms A Mhlongo

INSTRUCTIONS:
• This paper consists of 11 pages (including this page).
• You have 15 minutes reading time and 105 minutes writing time.
• The reading time will be before the writing time begins during which you
should read the question paper and, if you wish, highlight and/or make notes on
the question paper. However, you will not be allowed, under any
circumstances, to open the answer book and start writing or use your
calculator during this reading time.
• Answer ALL questions in the answer book provided.
• Silent, non-programmable calculators may be used, unless otherwise instructed.
• Answers with Tippex will not be marked.
• Answers in pencil will not be marked.
• Round all answers to TWO decimal places.
• Scratch out all empty spaces.

SECTION Topic Marks Time

Reading time 15 Minutes

A Multiple Choice Questions 30 39 minutes
B Short Questions 25 33 minutes
C Scenario Questions 25 33 minutes

80 120 minutes
MODULE: Financial Management 3B (BSR3B01/FNM03B3) (AO1 – 19 AUGUST 2022)

SECTION A [30 MARKS]

REQUIRED:
Answer the following questions by choosing the correct answer. Please indicate the letter
you have chosen as your answer next to the correct question number on the answer sheet
that has been provided to you.

Question 1.1
Identify which one of the following states that the value of a firm is unrelated to the
firm's capital structure?

A Law of One Price

B M&M Proposition I
C M&M Proposition II
D Capital Asset Pricing Model (1)

Question 1.2
Identify which one of the following is the equity risk related to a firm's capital
structure policy?

A Systematic
B Business
C Extrinsic
D Financial (1)

Question 1.3
M&M Proposition II with taxes:

A has the same general implications as M&M Proposition II without taxes.

B states that a firm's capital structure is irrelevant.
C concludes that the capital structure decision is irrelevant to the value of a firm.
D supports the argument that business risk is determined by the capital structure
decision. (1)

Question 1.4
A group of individuals got together and purchased all of the outstanding shares of
ordinary equity of DL Smith plc. What is the return that these individuals require on
this investment called?

A Cost of equity
B Capital gains yield
C Dividend yield
D Cost of capital (1)

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MODULE: Financial Management 3B (BSR3B01/FNM03B3) (AO1 – 19 AUGUST 2022)

Question 1.5
The after-tax cost of debt…

A will generally equal the cost of preferred shares if the tax rate is zero.
B has a greater effect on a firm's cost of capital when the debt-equity ratio
increases.
C varies inversely to changes in market interest rates.
D is unaffected by changes in the market rate of interest. (1)

Question 1.6
The cost of preference shares…

A decreases when tax rates increase.

B is highly dependent on the dividend growth rate.
C is equal to the dividend yield.
D is independent of the stock's price. (1)

Question 1.7
The discount rate assigned to an individual project should be based on…

A an average of the firm's overall cost of capital for the past five years.
B the current risk level of the overall firm.
C the firm's weighted average cost of capital.
D the risks associated with the use of the funds required by the project. (1)

Question 1.8
Identify which of the following models determines the present value of an equity
based on its next annual dividend, the dividend growth rate, and the applicable
discount rate?

A Zero growth
B Dividend growth
C Capital pricing
D Discounted dividend (1)

Question 1.9
Identify which of the following is not an appropriate valuation methodology when
considering the valuation of equity shares that represents a majority shareholding?

A Gordon’s dividend growth model / dividend discount model.

B Net asset value (NAV)
C Free cash flow methodology
D Price/Earnings (P/E) ratio (1)

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MODULE: Financial Management 3B (BSR3B01/FNM03B3) (AO1 – 19 AUGUST 2022)

Question 1.10
Identify the model that determines the value of equity based on future expected cash
flows less the market values of debt?

A Net Asset value

B PE Valuation Method
C Free Cash Flow
D Dividend Growth Model (1)

Question 1.11
Milan Deli's has 7% preference shares outstanding that sells for R36 a share. This
equity was originally issued at R50 per share and have a par value of R100. Calculate
the cost of preference shares?

A 19.44%
B 13.68%
C 14.29%
D 19.80% (2)

Question 1.12
Chelsea Fashions is expected to pay an annual dividend of R0.80 a share next year.
The market price of the equity is R22.40 and the growth rate is 5%. Calculate the
firm's cost of equity?

A 7.58%
B 9.00%
C 8.57%
D 8.24% (2)

Question 1.13
Cookie Dough Manufacturing has a target debt-equity ratio of 0.5. Its cost of equity
is 15%, and its cost of debt is 11%. Calculate the firm's WACC given a tax rate of
31%?

A 13.48 %
B 12.78 %
C 13.67 %
D 12.53 % (2)

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MODULE: Financial Management 3B (BSR3B01/FNM03B3) (AO1 – 19 AUGUST 2022)

Question 1.14
Makubu has a bond issue that matures in 10 years’ time. The bond pays a coupon
rate of 8% semi-annually. The face value of the bond is R1 000 and the current
market value is R980,75. Calculate- the after tax cost of this bond assuming a
company tax of 27%.

A 8.29%
B 6.05%
C 8.48%
D 6.19% (2)

Question 1.15
Nelson's Landscaping has 1,200 bonds outstanding that are selling for R990 each.
The company also has 2,500 shares of preference shares at a market price of R28 a
share. The ordinary equity is priced at R37 a share and there are 28,000 shares
outstanding. Calculate the weight of the ordinary equity as it relates to the firm’s
weighted average cost of capital?

A 55.45%
B 43.08%
C 54.00%
D 45.16% (2)

Question 1.16
Hardwoods plc is a mature manufacturing firm. The company just paid a R10
dividend, but management expects to reduce the payout by 9% each year,
indefinitely. Calculate how much you will pay today, per share, to buy this equity if
you require a 15% rate of return?

A R34.79
B R37.92
C R38.27
D R41.33 (2)

Question 1.17
Miller Brothers Hardware paid an annual dividend of R1.15 per share last month.
Today, the company announced that future dividends will be increasing by 2.6%
annually. If you require a 12% rate of return, calculate how much you will pay to
purchase one share of this equity today?

A R12.23
B R12.55
C R12.67
D R12.88 (2)

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MODULE: Financial Management 3B (BSR3B01/FNM03B3) (AO1 – 19 AUGUST 2022)

Question 1.18
Abubaca’s share has a beta of 1.5. The share has a risk premium 10.5%. If the risk
free rate is 6%, calculate the cost of Abubaca’s share?

A 16.51%
B 17.18%
C 12.75%
D 16.50% (2)

Question 1.19
If Big Jims Ltd achieved a nominal return of 17.18% over the last year, while inflation
was 7.31%, the company achieved a real return of…

A 9.20%
B 16.51%
C 17.18%
D 14.3% (2)

Question 1.20
Shares of Hot Donuts ordinary equity are currently selling for R32.35. The last annual
dividend paid was R1.10 per share and the required return is 10.7%. Calculate at
what rate the dividend is growing?
A 7.06%
B 14.10%
C 12.60%
D 8.67% (2)

END OF SECTION A

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MODULE: Financial Management 3B (BSR3B01/FNM03B3) (AO1 – 19 AUGUST 2022)

SECTION B [25 marks]

QUESTION 2 (15 marks)

You are currently busy with the valuation of PCP (Pty) Ltd, a company that manufactures and
sells laptops. The following information was provided to you regarding the valuation.

• PCP Ltd has a cost of capital of 18% and a cost of equity of 22%
• Free cash flow for 2023 was calculated as R860 000. This amount is expected to grow by
5% for the next 2 years and thereafter growth will be 3% into perpetuity.
• Included in the free cash flow for 2023 is dividend income R80 000 received from a simple
investment in listed shares. The dividend is expected to grow by 2% into perpetuity. The
current market related yield on such an investment is 12%.
• PCP (Pty) Ltd has debt with a market value of R2 650 000 and annual interest expense of
R75 000 which was included in calculating the free cash flow amount for 2023.
• The prevailing company tax rate is 27%.

REQUIRED:

2.1 Calculate the value of 60% of the equity of PCP (Pty) Ltd on 1 January 2023
using Discounted Cash Flow method. (13)

2.2 Explain why the value of the listed investment is determined separately. (2)

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MODULE: Financial Management 3B (BSR3B01/FNM03B3) (AO1 – 19 AUGUST 2022)

QUESTION 3 (10 marks)

Diagram 1

Source: HILLIER/CLACHER/ROSS, Fundamentals of Corporate Finance, 3rd edition.

REQUIRED:

3.1 Identify the capital structure theory depicted by the Diagram 1 above. (1)

3.2 Explain the concept of optimal capital structure in relation to Diagram 1

above. (2)

3.3 Discuss three implications of the pecking-order theory on capital structure. (3)

3.4 Discuss two factors that are most relevant to the static theory on capital
structure. (4)

END OF SECTION B

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MODULE: Financial Management 3B (BSR3B01/FNM03B3) (AO1 – 19 AUGUST 2022)

SECTION C [25 marks]

QUESTION 4 (25 marks)

The Wagon Group (TWG) is a South African motor vehicle manufacturer headquartered in
Johannesburg. Founded in 1940 by Godfrey Warona, the group is known for its iconic G-
Wagon brand. The group is the largest motor vehicle manufacturer in Africa based on sales
figures for 2020 and 2021. The group's biggest market is in Nigeria, which delivers 35% of its
sales and profits.

The group consists of three divisions: Combustion Automotive Division, Electric Automotive
Division and Financial Services Division. The activities of Combustion Automotive Division
comprise the manufacturing and development of internal combustion engine motor vehicles.
The Electric Automotive Division is primarily involved in the manufacturing of Electric motor
vehicles. The Financial Services Division’s activities comprises of dealer and customer
financing, vehicle insurance and fleet management services.

CAPITAL STRUCTURE

Capital structure decision of the group are undertaken at a central level. The following
information was provided:

Extract from the statement of financial position as at 31 July 2022

Notes R’000
Share Capital 1 200 000
Share Premium 10 000
Retained Earnings 120 000
Preference shares 2 150 000
Debentures (10 % interest payable annually) 3 400 000
Bank Overdraft (8% interest) 3 000

The management of the group has set a target capital structure of 30% share capital, 10%
preference shares and 60% debt. Bank overdraft is not considered to be a permanent source
of financing. The group uses the weighted average cost of capital (WACC) as a hurdle rate for
evaluating all the divisions. Target capital structure is used when calculating WACC. The group
will generate no internal equity for the foreseeable future.

Notes.

1. The group shares were trading at R100 a share on 31 July 2022. The group has recently
declared and paid an ordinary dividend of R5,50 per share (from R5 declared and paid a
year ago) in line with its stable annual dividend growth rate. Issuing new ordinary shares
will cost approximately 7% in flotation costs. The company expects to maintain this stable
dividend growth rate for the foreseeable future. The shares have a beta of 1.25

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MODULE: Financial Management 3B (BSR3B01/FNM03B3) (AO1 – 19 AUGUST 2022)

2. Preference shares carry a fixed dividend rate of 10%. The shares are currently trading at
a yield of 9%. The flotation costs for issuing new preference shares are 4%.

3. The debentures were traded at R1 250 per debenture on 31 July 2022. The debentures
were issued two years ago and are redeemable in 8 years’ time at a premium of R50 per
debenture. The debentures have a par value of R1 000. The flotation costs for issuing new
debentures are 2%.

COMBUSTION AUTOMOTIVE DIVISION

The Combustion Automotive Division is currently considering accepting a project in Durban.

The project is will be financed through debentures only as it is the cheapest source of finance.
The project will require an initial capital investment of R50 million (excluding flotation costs)
funded through debentures only as they are the cheapest source of finance. The managing
director of the division decided that the project should be accepted based on the following
reasons:

• The project generates a return of 12%, which is higher than the cost of the debentures.
• Flotation costs of debentures are lower than all the other capital sources resulting in a
higher NPV.

ADDITIONAL INFORMATION

• Assume a constant corporate tax rate of 27%.

• Government bonds currently yield 8% per annum.

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MODULE: Financial Management 3B (BSR3B01/FNM03B3) (AO1 – 19 AUGUST 2022)

REQUIRED:

4.1 Calculate the weighted average cost of capital of TWG on 31 July 2022. (12)

4.2 Discuss the implications of using the overall firm WACC as the hurdle rate
for all the divisions. (3)

4.3 Discuss two approaches that can be used to estimate the hurdle rate of a
division. (4)

4.4 Evaluate the decision made by the Managing director of the Combustion
Automotive Division to accept the Durban project. (3)

4.5 Assuming WAFC of 5%, calculate the true initial cost figure that the
Combustion Automotive Division should use when evaluating the Durban
project. (2)

4.6 Explain the effect on WAFC if the group expects to generate internal equity
for the foreseeable future. (1)

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