Section A – Compulsory Scenario

Question 1 – WACC Evaluation for AVA Industries (50 marks)

(a) Cost of Equity

(i) Calculation using two models

1. Dividend Growth Model (DGM)

– Formula:

rₑ = (D₁ / P₀) + g

– Steps:

The most recent dividend is US$0.48. With a growth rate of 5% p.a., the next dividend is:

D₁ = 0.48 × 1.05 = 0.504

With a current share price (P₀) of US$6.00 and g = 5% (i.e. 0.05), then:

rₑ = (0.504 / 6.00) + 0.05

= 0.084 + 0.05

≈ 13.4%

2. Capital Asset Pricing Model (CAPM)

– Formula:
 rₑ = r_f + β (Market risk premium)

– Given:

Risk-free rate (r_f) = 4%

β = 1.3

Market risk premium = 6%

– Calculation:

rₑ = 4% + 1.3 × 6%

= 4% + 7.8%

= 11.8%

(ii) Discussion of the differences & appropriate choice

Differences:

The DGM is sensitive to the company’s dividend policy and growth assumptions. It projects an equity
cost based on expected future dividends relative to the current share price. Hence, if dividends do not
fully reflect the firm’s prospects or if the growth estimate is optimistic (or conservative), the resulting
cost may differ.

CAPM relies on market-determined risk factors (systematic risk captured by beta and the market risk
premium). It is independent of dividend policy and instead reflects the relationship between expected
return and systematic risk.

When choosing for WACC:

However, if the dividend payout is stable and the growth rate is well supported by historical
performance, then the DGM can also be useful.

Conclusion:

The CAPM (11.8%) is usually regarded as more reflective of the market’s risk-return trade-off and is thus
often more appropriate in a WACC context, especially when market values are used.

(b) Cost of Debt Components and WACC Calculation

(i) After-tax cost of each debt component

1. Irredeemable Preference Shares

These shares pay a fixed annual dividend.

Given that they are “6%,” the dividend is 6% of par.

They are trading at 95% of par so the cost is:

Cost = (Dividend / Current market price) = 6% / 95% ≈ 6.32%

Note: Dividends are not tax deductible so no adjustment is made.

These bonds have an annual coupon rate of 8% on par value.

They are redeemable at par in 6 years and currently trade at US$92 million versus a par (assumed
US$100 million).

Method: Solve for the yield using the IRR approach.

– Set up the equation:

92 = 8 × [1 – (1 + r)^(-6)]/r + 100/(1 + r)⁶

– Because the bond is trading below par, the yield will be higher than 8%.

– Approximation: A numerical estimate (by trial or using a financial calculator) gives an approximate
yield of about 10%.

After-tax cost:

After-tax yield = 10% × (1 – 0.30) = 7%

3. Bank Loan

The bank loan interest rate is 7%, and interest expense is tax-deductible.
After-tax cost:

7% × (1 – 0.30) = 4.9%

(ii) Calculation of the current WACC

1. Determine Market Value Weights

– Equity (ordinary shares): US$360 million

– Irredeemable Preference Shares: US$38 million

– Redeemable Bonds: US$92 million

– Bank Loan: US$60 million

– Total Capital = 360 + 38 + 92 + 60 = US$550 million

2. Weights:

Equity: 360/550 ≈ 65.45%

Preference: 38/550 ≈ 6.91%

Bonds: 92/550 ≈ 16.73%

Bank Loan: 60/550 ≈ 10.91%

Cost of Equity: Use CAPM at 11.8% (per part (a)(ii)).

Cost of Preference: 6.32%

Cost of Bonds (after tax): 7%

Cost of Bank Loan (after tax): 4.9%

4. WACC Calculation:

WACC = (Weightₑ × Costₑ) + (Weight_pref × Cost_pref)

+ (Weight_bonds × Cost_bonds) + (Weight_loan × Cost_loan)

– Equity: 0.6545 × 11.8% ≈ 7.72%

– Preference: 0.0691 × 6.32% ≈ 0.44%

– Redeemable Bonds: 0.1673 × 7.0% ≈ 1.17%

– Bank Loan: 0.1091 × 4.9% ≈ 0.53%

Total WACC ≈ 7.72% + 0.44% + 1.17% + 0.53% ≈ 9.86%

(c) Impact of New Debt Financing and Equity Repurchase

Scenario Details:

AVA Industries raises US$50 million via new 10-year bonds at 9% coupon (issued at par).

The new bonds’ cost:

After-tax cost = 9% × (1 – 0.30) = 6.3%

Effect on Capital Structure:

The US$50 million is used to repurchase equity.

New Equity Market Value = US$360 million – US$50 million = US$310 million

The new debt is added to existing debt. Assuming the other market values remain unchanged, the
revised market value mix becomes:

Equity: US$310 million

Redeemable Bonds: US$92 million

Bank Loan: US$60 million

New Bonds: US$50 million

Total Capital Remains ≈ US$550 million

New Weights (Approximate):

Equity: 310/550 ≈ 56.36%

Preference: 38/550 ≈ 6.91%

Redeemable Bonds: 92/550 ≈ 16.73%

Bank Loan: 60/550 ≈ 10.91%

New Bonds: 50/550 ≈ 9.09%

Cost of Equity remains (initially) at 11.8% (although note that increased leverage tends to raise the cost
of equity over time).

Cost for Preference and existing debt remain as before.

For the new bonds, cost = 6.3%.

Compute each contribution:

Equity: 0.5636 × 11.8% = 6.64%

Preference: 0.0691 × 6.32% = 0.44%

Redeemable Bonds: 0.1673 × 7.0% = 1.17%

Bank Loan: 0.1091 × 4.9% = 0.53%

New Bonds: 0.0909 × 6.3% = 0.57%

New WACC ≈ 6.64% + 0.44% + 1.17% + 0.53% + 0.57% ≈ 9.35%

The WACC falls slightly from approximately 9.86% to 9.35%, reflecting the benefit of issuing lower-cost
debt (after tax).

However, by increasing the financial leverage (i.e. a higher proportion of debt relative to equity), the
firm’s overall risk profile increases. Shareholders may demand a higher return in the future to
compensate for additional financial risk, and there is the potential for financial distress costs.

Thus, while there is a short-term reduction in WACC, the long-run impact on shareholder value will
depend on whether the investment generates returns that comfortably exceed the higher cost of
financial risk.

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(d) Assumptions Underlying the Use of WACC and Circumstances When It May Not Be Appropriate

Key Assumptions:

Constant Capital Structure: WACC assumes that the company’s capital structure remains constant over
the life of the investment.

Uniform Risk: It presumes that the project or investment has the same risk profile as the overall firm.

Stable Cost of Capital: The method assumes that costs of debt and equity, as well as tax rates, remain
unchanged.
Market Efficiency: It relies on the accuracy of market values and risk premiums, which may fluctuate.

Circumstances When WACC May Not Be Appropriate:

1. Projects with Different Risk Profiles: If the investment has risks that differ substantially from the
existing business (e.g. entering a new, volatile market), a project‐specific discount rate should be used.

2. Changing Capital Structures: In cases where a firm’s capital structure is expected to change
significantly over the project’s life, the assumption of constant weights breaks down.

3. Financial Distress or High Leverage: For companies close to financial distress or with highly variable
debt levels, the traditional WACC may not capture the additional costs associated with financial risk.

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(e) Achieving an Optimal Capital Structure

Discussion Points:

Theoretical Framework – Modigliani and Miller (M&M):

M&M’s Proposition I states that in a world without taxes, the value of the firm is independent of its
capital structure. Hence, the mix of debt and equity does not affect the overall firm value.

With Taxes:

When corporate taxes are considered, debt provides a tax shield because interest payments are tax
deductible. This gives rise to an advantage for debt financing and, according to M&M’s Proposition II
(with taxes), increases firm value up to a point. However, beyond an optimal level, the benefits are
offset by the increased financial risk and potential bankruptcy costs.

Practical Considerations:

Trade-off Theory:

Firms balance the tax benefits of debt against the costs of potential financial distress and agency costs.
The optimal capital structure minimizes the weighted average cost of capital.

Market Conditions and Flexibility:

In practice, a company will assess industry norms, investor sentiment, and its ability to service debt.
Maintaining flexibility for future investments and avoiding overleveraging are key considerations.

Strategic Objectives:

Firms like AVA Industries may adjust their capital structure to improve shareholder value in the short
term by taking advantage of favorable debt markets, but they must also consider the long-term
implications of increased risk and the possibility that the cost of equity may rise as leverage increases.
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Section B – Select Any Two (25 marks each)

Below are structured outlines for each of Questions 2, 3, and 4. You should select the two that best fit
your study preferences. Each outline identifies key points and the steps needed for a full answer.

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Question 2 – Exploring Capital Raising: Tekra Ltd

(a) Identification and Explanation of Long-term Finance Sources

Consider these four sources linked to the expansion context:

1. Rights Issue (Additional Equity):

Explanation: Allows existing shareholders to subscribe for additional shares at a discount.

Context Link: Raises capital without incurring debt; however, it may dilute control if not fully subscribed.

2. Syndicated Loan (Long-term Debt):

Context Link: Offers long-term funding and possibly lower rates due to risk sharing.

3. Lease Financing (Operational or Finance Lease):

Explanation: Enables the acquisition of equipment while preserving cash flow.

Context Link: Ideal for meeting equipment needs without heavy upfront expenditure.

4. Venture Capital (Equity/Quasi-equity):

Explanation: Provides capital in exchange for an ownership stake and often strategic guidance.

Context Link: Suitable for fast-growth firms needing both funds and expertise, though it may involve
giving up some control.

(b) Advantages and Disadvantages of Debt vs. Equity

Advantages:

• Interest is tax-deductible, lowering the effective cost.

• No dilution of ownership.

Disadvantages:

• Increases fixed financial obligations and the risk of insolvency.

• May lead to restrictive covenants.

Equity Finance:

Advantages:

• No mandatory repayments, easing cash flow pressures.

• Brings in new investors with potential strategic benefits.

Disadvantages:

• Dilution of control and potential conflicts with new shareholders.

• Possibly higher cost if investors demand a premium for risk.

(c) Effect on Cost of Capital, Control, and Financial Risk

– Debt is generally cheaper due to tax shields but may increase the overall risk when used in excess.

Control Structure:

– Equity issues dilute existing control, while debt maintains current control but increases leverage.

Financial Risk Profile:

– Increased debt heightens the firm’s fixed obligations and financial risk. The choice of financing will
therefore alter not only the cost of capital but also the risk profile and flexibility of the company.

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Question 3 – Liquidity and Credit Strategy: Omega Circuits Ltd

(a) Calculation of the Cash Operating Cycle

Definitions:

Inventory Conversion Period (Days Inventory Outstanding):

= (Average Inventory / Cost of Sales) × 365

Receivables Collection Period:

= (Average Receivables / Annual Credit Sales) × 365

= (Average Payables / Cost of Sales) × 365

Calculation using given figures:

Inventory: US$3 million; Cost of Sales: US$9 million

→ Inventory Period ≈ (3/9) × 365 ≈ 121.67 days

Receivables: US$2.4 million; Annual Sales: US$12 million

→ Receivables Period ≈ (2.4/12) × 365 ≈ 73 days

Payables: US$1.5 million; Cost of Sales: US$9 million

→ Payables Period ≈ (1.5/9) × 365 ≈ 60.83 days

Cash Operating Cycle:

= Inventory Period + Receivables Period – Payables Period

≈ 121.67 + 73 – 60.83 ≈ 133.84 days

(b) Impact on Liquidity and Profitability

Inventory Management:
– Lower inventory levels reduce holding costs and free up cash.

Receivables Management:

– Faster collection improves liquidity.

Payables Management:

– Delaying payments can improve short-term cash flow but might strain supplier relationships.

Overall:

– A more aggressive working capital policy can bolster liquidity, but if taken too far, may disrupt
operations and affect supplier credit terms.

(c) Advantages and Disadvantages of Factoring

Advantages:

– Immediate cash flow improvement by converting receivables to cash.

– Outsourcing credit management reduces administrative burdens.

Disadvantages:

– Factoring fees can be high, which may reduce overall profitability.

– It could signal financial weakness to the market if overused.

(d) Revised Working Capital Policy Recommendation

Tighten credit control and reduce receivables collection times.

Improve inventory management to avoid excess stock.

Negotiate improved credit terms with suppliers (extending payables reasonably).

Consider partial factoring if necessary, balanced by internal credit control improvements.

Justification:

– Such a policy balances profitability by reducing holding and financing costs while ensuring adequate
liquidity to support growth and meet operating needs.

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Question 4 – Strategic Finance and Governance: Qalema Agri Ltd

(a) Definition of Financial Management and Its Decision Areas

Financial Management:

– The planning, directing, monitoring, organizing, and controlling of the financial activities of an
enterprise.
Main Decision Areas:

1. Investment Decisions: Determining which long-term assets or projects to invest in.

2. Financing Decisions: Choosing the appropriate mix of debt and equity to finance investments.

3. Dividend Decisions: Deciding on the dividend payout versus retention for reinvestment.

(b) Contribution to Corporate Objectives

Effective financial management supports shareholder wealth maximization by ensuring that investment
decisions generate returns exceeding the cost of capital.

It aligns strategic goals with the efficient allocation of resources and risk management.

(c) Role in Identifying and Managing Financial Risks

Financial managers assess market, credit, operational, and liquidity risks.

(d) Importance of Aligning Practices with Development Stage and Stakeholder Expectations

Early-stage companies: May prioritize growth and accept higher financial risks, focusing on flexible
financing options.

Mature companies: Emphasize stability, predictable returns, and may use dividend policy and
conservative borrowing.

Stakeholder expectations: Different groups (investors, lenders, regulators) require transparency and
alignment between the firm’s risk tolerance and its financial strategies.