MBA: Man Fin

Nov main exam (2013)

Marking Memo

Question 1 [25]

Ordinary Shares

Equity is the capital provided to a firm by its owners, thus equity’s most important
characteristic is that it represents an ownership claim. Equity is often defined as the residual
value of the company i.e. the difference between the value of a firm’s total assets and total
liabilities. Equity holders are entitled to the residual assets of a firm on dissolution, but
otherwise equity finance is not repayable.

In the process of ordinary business, shareholders have a claim on the residual earnings of a
firm, after all expenses, including interest, have been paid. Shareholders may receive these
residual earnings in the form of dividends, but a firm is not obliged to automatically pay
dividends.

Dividends are only payable after the firm has declared a dividend payment. The amount of
the dividend is neither fixed nor tax deductible and it is determined by the firm’s
management. Shareholders cannot force a firm into liquidation if it has not paid dividends.

Equity holders, being the owners of the company, have the right to control the firm and do so
through voting for and choosing directors/managers who run the company on their behalf. In
addition, shareholders have the right to vote on major decisions affecting the firm, such as
merger and take-over offers, or the sale of subsidiaries. The ownership of a significant
proportion of the total equity in a company allows a considerable control over the company.
For example, ownership above a specified percentage allows the blocking of special
resolutions, gives effective control over the Board of Directors and allows the passing of
special resolutions without restraint.

Preference Shares

In addition to ordinary shares, companies may also issue preference shares, which have
some of the characteristic of ordinary equity and some of the characteristics of debt.
Preference shares typically have stated fixed dividend and can be redeemable, thus
resembling debt as far as the firm has a fixed commitment and the original capital can be
repaid. Alternatively, preference shares may be participating, which means that preference

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shareholders are entitled to a share of the residual earnings of a firm. Some preference
shares may have a convertibility provision, which allows them to be converted into ordinary
shares under certain circumstances. For tax purposes, preference shares are treated, as
equity and preference dividends are not tax-deductible. Preference shares present an
ownership claim, but have a reduced risk in comparison to ordinary shares. The trade-off is
often a limitation on the amount of control preference shareholders have on the company.
As a general rule, preference shareholders have no voting rights. (10)

Debt Financing

Debt is generally referred to as the capital that a firm borrows for a limited period of time.
The most important characteristic of debt is that it does not constitute an ownership claim on
a firm. A debt obligation is a contractual agreement, which usually states the amount
borrowed, the interest payable and the dates at which interest payments and capital
repayments are due. An important feature of debt financing is that interest payments are
tax-deductible i.e. the firm’s tax liability is calculated only after interest payments have been
deducted from the firm’s earnings.

Debentures

A debenture is a document issued by a company containing an acknowledgement of debt. It

need not give, although it usually does, a charge on the assets of the company. The
Companies Acts define “debenture” as including debenture stock and bonds, it is quite
common for the expressions “debenture” and “bond” to be used interchangeably. Company
debentures can also be referred to as “loan share”.

Usually a debenture is a bond given in exchange for money lent to the company.
Debentures can be offered to the public only if the application form is accompanied by a
prospectus. The company agrees to repay the principal to the lender by some future date,
and in each year up to repayment it will pay a stated rate of interest in return for the use of
the funds. A debenture holder is a creditor of the company and the interest has to be paid
each year before a dividend is paid to any class of shareholder.

Secured or unsecured

Debentures and debenture share can be secured or unsecured. It is usual, however, to use
the expression “debenture” when referring to the more secure form of issue, and “loan
share” for less secure issues. When secured this is by means of a trust deed. The deed is
usually in favour of the trustees and may be the whole or part of the property of the

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company. The advantage of a trust deed are that a prior charge cannot be obtained on the
property without the consent of the debenture holders, the events on which the principal is to
be repaid are specified, and power given for the trustees to appoint a receiver and in certain
events to carry on the business and enforce contracts.

The debentures can be secured by a charge upon the whole or a specified part of a
company’s assets, or they can be secured by a floating charge upon the assets of the
company. In this latter case, the company is not precluded from selling its assets. The latter
case is known as a general lieu, whereas the debenture issued on the security of a specific
asset is a mortgage debenture or mortgage bond. With a floating charge, when the
company makes a default in observing the terms of the debentures, a receiver may be
appointed and the charge becomes fixed, with the power to deal in the assets passing into
the hands of the receiver. Such restrictions are referred to as “covenants”. (8)

Convertibles

Convertible loan share is a loan share, which, at the option of the holder, may be converted
into ordinary shares in the company under specific conditions.

One advantage, which is often quoted for convertible debt, is that it is cheaper than ordinary
debt finance since the conversion option allows the security to be issued with a lower
coupon rate than would otherwise be the case. Although it is true that the coupon on
convertibles is lower, this does not mean that the overall cost is lower since one must also
consider the expected cost of the conversion option.

The lower coupon rate of a convertible may, however, be advantageous from a liquidity point
of view. This form of finance may suit a project where the cash inflows are expected to be
low in the early years.

Prior to conversion, the security will represent debt finance and will therefore increase the
level of gearing of a company. However, the increase in gearing will not be as great as for
ordinary debt because of the lower coupon rate. It is for this reason that convertible
securities are often issued in cases of companies already being highly geared and not
wanting to raise straight equity finance.

Convertibles are seen as a way of issuing deferred equity. This may be particularly
advantageous if existing shareholders want to minimise any loss of control since the number
of shares issued via a convertible (assuming conversion takes place) will be smaller than if
straight equity were issued.

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A useful aspect of convertibles is that, assuming the company’s share price rises sufficiently
to force conversion, the debt is self-liquidating. Since it is replaced by equity, conversion will
reduce the level of gearing and thereby enable the company to issue further debt finance.

While convertibles remain as debt, the interest is tax deductible. This gives rise to the tax
advantage, which also accompanies other forms of debt finance. However, since the
coupon rate on this security is lower than that associated with normal debt, the tax
advantage is consequently reduced also.

Unlike most debentures, convertibles are often not secured upon the assets of the company.
When they exist in this form they are known as convertible unsecured loan shares. This
may be particularly advantageous if a company does not have assets appropriate for use as
security, or if the assets have already been used up with other debt finance. (7)

Question 2 [25]

2.1 Exchange ratio based on MV TC/AC

8.00/20.00

0.40 (2)

2.2 Exchange ratio based on EPS 0.90/1.25

0.72 (2)

2.3 Post-acquisition EPS:

No. of shares to be issued 2m x 0.72

1.44m shares

Total no. of shares 6m + 1.44m

7.44m

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 Combined value:

B 6m x R1.25 R7.5m

P 2m x 0.90 R1.8m

Synergy R10m

R19.3m/7.44m

=R 2.59 (6)

2.4 Benefits:

B R2.59 - R1.25

R 1.34

P R2.59 (0.72) - R0.90

R1.86 - R0.90

=R 0.96 (5)

2.5 Post acquisition EPS:

No. of shares to be issued 2m x 1

2m shares

Total no. of shares 6m + 2m

8m shares

R19.3m/8m

=R 2.41 (4)

P/E Ratio x EPS

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2.6 Expected post-acquisition MP

Therefore MP 13 x 2.59

R 33.67

Expected growth 6%

MP = R20 x 1.06

=R 21.20

Yes, MP with the acquisition is R33.67, compared with next year price of R21.20

without the acquisition. (6)

Question 3 [25]

3.1 Set up New division at home: Y1 to 10 Y0

Rm Rm

Cost of setting up premises (30.0)

Cost of machinery (18.0)

Annual sales 23

Less: annual variable costs (6.0)

additional head office expenses (1.0)

Annual cash flow 16 (48.0)

Annuity factor @ 12% for 10 years 5.6502 90.40

Net present value 42.40

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Acquisition: €m €m

Acquiring shares (11.0)

Redundancy costs (3.5)

Annual sales 19

Less: annual variable costs (9.5)

annual fixed costs (3.5)

Annual cash flow 6 (14.5)

Annuity factor @ 11% for 10 years 5.8892 35.33

Net present value 20.83

Exchange rate €20.83m x 13 = R270.80m (22)

3.2

Reject the set up at home, NPV of +42m

Accept the Acquisition (German) – higher of the 2 NPV’s,

positive NPV of R270.8m vs R42.40m. (3)

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Question 4 [25]

4.1 Calculation of market value of debenture:

1m x 0.5132 + 90 000 x 4.8684

513 200 + 438 156

951 356

Market value Amount Proportion

O/s 1.5m x R3 4 500 000 0.54

P/s 1m x R2 2 000 000 0.24

Debentures 951 356 0.11

Bank loan 900 000 0.11

8 351 356 1.00

Cost

D1 = 0.9(1.13) = R1.02

Ke = (1.02/3.00) + 0.13 47%

Kp = 0.12/2.00 6%

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Kd = 10 (0.7) 7%

Kbl = 14 (0.7) 9.80%

WACC

O/s 0.54 x 47% 25.38%

P/s 0.24 x 6% 1.44%

Debenture 0.11 x 7% 0.77%

Bank loan 0.11 x 9.80 1.078%

28.67% (22)

4.2 CAPM: Rf + B(Rm - Rf)

7 + 1.7 (15 – 7)

= 20.60% (3)

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Question 5 [25]

5.1 LEASE

Y0 Y1 Y2 Y3 Y4

Lease payment (380 000) (380 000) (380 000) (380 000) (380 000)

Tax shield 0.3 114 000 114 000 114 000 114 000 114 000

Net cash flow (266 000) (266 000) (266 000) (266 000) (266 000)

PV factor @
17.15 – 30% = 12% 1 0.8929 0.7972 0.7118 0.6355

PV cash outflows (266 000) (237 511) (212 055) (189 339) (169 043)

NPV (R1 073 948)

PURCHASE Y1 Y2 Y3 Y4

Loan payments (732 567) (732 567) (732 567) (725 637)

Dep. Tax shield 0.3 150 000 150 000 150 000 150 000

Int. tax shield 0.3 102 900 82 857 59 376 31 869

Net cash flows (479 667) (499 710) ( 523 191) (543 768)

PV factor @ 12% 0.8929 0.7972 0.7118 0.6355

PV cash outflows (428 295) (398 369) (372 407) (345 565)

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 NPV (R1 544 636)

(23)

5.2 Lease, because the cash outflows are lower by R470 688. (2)

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