CFI - Past Exam Paper - August 2006

MILPARK BUSINESS SCHOOL
CORPORATE FINANCE EXAMINATION
DATE: AUGUST 2006
TIME: 3 HOURS
MARKS: 100
INSTRUCTIONS TO CANDIDATES:
1. Answer all questions.
2. This is a closed book examination. A formula sheet is provided.
3. Use of a financial calculator permissible.
4. You must hand the question paper back in with your script.
QUESTION ONE
The JayBird Company is considering replacing one of its machines that produces
widgets. The old machine was purchased 5 years ago at a cost of R1 000 000. It
also required installation costs of R200 000. It is being depreciated on a straight-
line basis to zero over a ten-year period. It can be sold now for R 400 000. The
new machine will cost R 2 000 000 and will require installation costs of
R200 000. It is estimated that the new machine will have a useful economic life
of 5 years.
As a result of the installation of the new machine, debtors will increase by

R100 000, stock by R150 000, creditors by R75 000 and cash will decrease by
R 50 000 (This will all occur at time period zero).
Each year working capital will increase by an additional 10% compounded

(including the increase at time period zero) with time period zero as the base. As
a result of the installation of the new machine, sales are expected to increase by
R 1 200 000 in year 1 and thereafter by 15% compounded per annum. Cost of
sales amount to 20% of sales in any given year. The new machine will also have
the effect that wages will be reduced by R 50 000 per annum.
It is expected that when the new machine reaches the end of its useful life, that it
will be scrapped for R200 000, but will also require R50 000 to be spent in order
to remove the machine and to fix the damage caused by its removal.
The CEO of the JayBird Company tells you that the target capital structure for the
company is 40% debt and 60% equity. Your research indicates that the market
return on the All Share Index is currently estimated at 20%, the return on
government bonds is 12% and the company’s beta is 1.1. JayBird Company’s
tax rate is 30%.
Milpark Business School – August 2006 Corporate Finance Examination
The company currently obtains its loan finance at an interest rate of 11%. Any
additional debt required by the company will command a 3% risk premium.
The JayBird Company currently has R10 000 000 in retained earnings and
R15 000 000 in debt available.
You are required to make a recommendation as to whether or not the installation

of the new machine will add to the value of the firm.
[30]
QUESTION TWO
The Milpark Corporation Ltd (MC) is a junior gold mining company that is listed
on the JSE. The company has had an uncertain existence due to the fact that
resource prices have been so volatile. However, the gold price has improved
over the last year and the management of MC expects the company to become
more profitable in the coming financial years. Due to anticipated profits
increasing significantly, management would like to amend its dividend policy and
pay out bigger dividends in order to reward those shareholders who have been
patient with the company and its progress.
Earnings per share (EPS) and dividends per share (DPS) for the last five years
were as follows:
2001 2002 2003 2004 2005

EPS in 70 80 76 83 88
cents
DPS in 17.5 20 19 20.75 22
cents
The management of MC has maintained a dividend cover of 4 times as indicated

in the table above. Due to increased earnings expectations, management wants
to reduce the dividend cover to 2.5 times and seeks your advice on this issue.
You also determine that current return on a government bond is 8.5%, the
company has a beta of 1.8 and the return on the All Share Index (ALSI) over the
last year has been 20%. Management expects EPS for the current financial year
(2006) to be 120 cents.
2
REQUIRED:
(1) Calculate the expected share price for MC Ltd if the company maintains a
dividend cover of 4 times based upon the coming financial year’s EPS.
(7)
(2) Calculate the expected share price for MC Ltd if the company changes its
dividend policy to a dividend cover of 2.5 times based upon the coming
financial year’s EPS.
(5)
(3) Discuss whether or not the share price will in fact react as you have
calculated in questions 1 and 2 above. What are the limitations of the
model that you used in questions 1 and 2 above?
(8)
(4) Discuss what impact a change in dividend policy will have on the
company’s (MC Ltd) capital structure.
(10)
(5) Assume that MC Ltd has 50 000 000 shares in issue. You may also
assume that MC Ltd wishes to sink a new shaft at a cost of R200 000 000
and that MC Ltd currently has a 40% debt ratio and MC Ltd pays out 40%
of earnings as dividends, based on the 2006 earnings forecast. Explain to
MC Ltd’s management what the impact will be on the financing of the new
shaft if management follows a dividend relevance versus a dividend
irrelevance policy.
(10)
(5) The management of MC Ltd is considering increasing the amount of debt
that the company has to finance future expansion plans. The company’s
bankers have advised the management of MC Ltd to change the
company’s capital structure to accommodate 100% debt and 0% equity.
The managing director wants to know how you would determine MC Ltd’s
optimal capital structure.
(10)
[50]
QUESTION THREE
The management of the Milpark Corporation Ltd (MC), which we already know is
a junior gold mining company that is listed on the JSE, has approached you for
advice. Management of the company is very concerned about the volatility of the
gold price as well as the rand dollar exchange rate. The managing director
wants to know what suggestions you can make to reduce these risks for the
company. Use suitable and relevant diagrams in your answer.
[20]
TOTAL: 100
3
FORMULA SHEET:
FVn = PV x (1 + k)n
FVn = PV x (FVIFk,n)
k
FVn = PV x (1 + m )m x n
k
k eff = (1 + m ) m – 1
FVAn = PMT x (FVIFAk,n)
FVIFAk,n (annuity due) = FVIFAk,n x (1 + k)
PV = FVn x (PVIFk,n)
PVAn = PMT x (PVIFAk,n)
PVAn
PMT = PVIFAk,n
1
PMT x (PVIFAk,x) = PMT x ( k )
Pt – Pt-1 + Ct
kt = Pt
n
k= ki x Pri
i =1
n
σk = √ (ki – k)² x Pri
i =1
n
σEPS = Σ (EPSi – EPS)² x Pri
i=1
4
σk
CVk = k
CVeps = σEPS
EPS
D1___
P0 = ks – g
ks = Rf + [b x (km – Rf)]
CFt__
n
NPV = (1 + k)t - II
t=1
n __CFt__ - II
0= (1 + IRR)t
t=1
n __CFt__
(1 + IRR)t = II
t=1
M – B0
I+ n
Approximate yield = M + B0
2
D1 D2 Dx
P0 = (1 + ks)1 + ( 1 + ks)2 +….... + (1 + ks)x
P0 = EPS
ks
Po = EPS
k
ki = kd x (1 - T)
kp = Dp
Np
ks = D1 + g
P0
5
kr = ks
D1 + g
kn = Nn
BPj = AFj
Wj
ER = EPS of target company___

EPS of acquiring company
ER max = EPSt + SE______

EPSa EPSa x Nt
ER min = EPSt x Na______

SE + (EPSa x Na)

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MILPARK BUSINESS SCHOOL

CORPORATE FINANCE EXAMINATION

DATE: AUGUST 2006

As a result of the installation of the new machine, debtors will increase by

Each year working capital will increase by an additional 10% compounded

You are required to make a recommendation as to whether or not the installation

2001 2002 2003 2004 2005

The management of MC has maintained a dividend cover of 4 times as indicated

FVAn = PMT x (FVIFAk,n)

FVIFAk,n (annuity due) = FVIFAk,n x (1 + k)

PVAn = PMT x (PVIFAk,n)

ER = EPS of target company___

ER max = EPSt + SE______

ER min = EPSt x Na______

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