Graduate School of Business Examinations

THE UNIVERSITY OF ZAMBIA

GRADUATE SCHOOL OF BUSINESS

MBA Finance/ MSc Accounting & Finance

Supplementary Examination
Wednesday 10th September 2020

MAFF 5120: CORPORATE FINANCE

Total Marks=100
Time Allowed: Reading Time: 5 minutes, Writing time: 3 hours

Instructions
1. Do not open paper until instructed by the supervisor
2. During reading and planning time only the exam paper can be annotated. You must not write
in your answer booklet until instructed by the supervisor.
3. Show all your workings and present neat work
4. Answer all questions in Section A for a maximum 40 marks and answer any three questions
in Section B, for a maximum of 60 marks.
5. The financial and formulae tables should not be removed from the exam room
6. Where market risk premium is not given use 6%.
SECTION A Compulsory -40 Marks

QUESTION 1

You have been engaged by Mulobezi Trades Plc, one of the leading companies in Zambia to assess
the financial viability of the proposed bookstore in Kaunda Square area of Lusaka. The company
plans to spend K1.7 million in 2020 on store equipment, fixtures and fittings. These investments
are expected to have a life of four years, at which point they will have no salvage value. The project
will also make use of other resources as follows:
 The store will use a van currently owned by the firm. Although the van is not currently being
used, it can be rented out for K20,000 a year for four years. The book value of the van is
K100,000 and it is being depreciated straight line (with four years remaining for
depreciation).
 Two employees of the firm, each with a salary of K20,000 a year, who are currently employed
by the Milling Division, will be transferred to the store. The Milling Division has no
alternative use for them, but they are covered by a union contract that will prevent them from
being fired for two years (during which they would be paid their current salary).
 The store shall be built on land which was bought by the company 5 years ago at a cost of
K30,000 (Current market value K150,000). The company had plans of constructing a hotel
on the land, however, the project was abandoned after it was found not to be financially
viable.

The revenues in the first year (2021) are expected to be K1.6 million, growing 20% in year two, and
10% in the two years following. The operating costs will be 50% of the revenues in each of the four
years.

The working capital, which includes the inventory of books needed for the service will be 10% of the
revenues; the investments in working capital have to be made at the beginning of each year. At the
end of year 4, the entire working capital is assumed to be salvaged. Mulobezi’s cost of capital is 20%.

Required:

Using Net Present Value (NPV) investment evaluation technique, advise Mulobezi whether it should
go ahead and open the store. (20 Marks)

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Solution

Mulobezi Trades Plc Kaunda Square store cashflows

(All amounts in ZK)

Details Year 0 1 2 3 4
Revenues 1,600,000.0 1,920,000 2,112,000 2,323,200.0
Operating costs (800,000) (960,000) (1,056,000) (1,161,600)
Depreciation (425,000) (425,000) (425,000) (425,000)
(K1,700,000/4)
Operating Income 375,000.00 535,000.00 631,000.00 736,600.00
Depreciation 425,000 425,000 425,000 425,000
Change in Working (160,000) (32,000) (19,200) (21,120) 232,320.0
Capital
Initial Investment (1,700,000)
Operating Cash flows (1,860,000) 768,000 940,800 1,034,880 1,393,920

Discount Factor 1.00 0.8333 0.6944 0.5787 0.4823

Operating cashflows (1,860,000) 640,000.00 653,333.33 598,888.89 672,222.22
Present Value
Net Present Value 704,444
(NPV) before
opportunity cost

Adjusting for PV of opportunity costs

NPV for Bookstore before opportunity costs K704,444

Opportunity costs adjustment:
PV of Salaries two employees (W1) (25,464)
PV of Lost sales-Land (W2) (150,000)
PV of Van rentals (W3) (31,064)
Adjusted NPV K 497,916

Advise

Mulobezi should invest in the bookstore as the estimated NPV is greater than zero. The project will add
K497,916 to the value of the firm , consequently increasing shareholder value.

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 Workings:

1. Salaries for two employees

Employees will be paid for the first two years when they under protection whether this project is accepted or
not. So only payments for year 3 and 4 are relevant

PV of expenditures = K40,000*(1-0.4)/(1+0.2)^3 + K40,000*(1-0.4)/(1+0.2)^4= 13,888 +11,575=K25,4642.

2. Van Rentals

PV of lost rentals = K20,000*(1-tax rate) *(PV of annuity, 20 %,4 yrs) = K12,000 * 2.5887=K31,064.40

3. Working capital

Working capital 160,000.0 192,000.0 211,200.0 232,320.0 0.2

(ZK) 5% of
Revenue
Increase/(Decrease) 160,000 32,000 19,200 21,120 (232,320)
(ZK)

QUESTION 2

a.) In corporate finance, the objective when making investing, financing and dividends decisions is to
maximize firm value. Some stakeholders have argued that this objective is ‘utopian’. Do you agree
with this statement? Explain. (12 marks)
Suggested Solution
I agree that the objective is utopian as the assumptions in most cases do not hold in practice.
Corporate finance assumes that managers of the firm always act in the interests of the shareholders
of the firm. It is assumed that the manager’s decisions are always intended to increase firm value. It
is also assumed that in case managers engage in acts that do not further the interest of the
shareholders; shareholders have the avenue of the annual general meeting or and the board of
directors to fire such under-performing managers. The objective is also underpinned on the
assumption that financial markets are efficient in the processing of information that comes out of the
firm. It is assumed the markets correctly incorporate this information into the value of the firm
shares. The objective also assumes that the managers timely relay all information that can affect the
value of the firm’s share. It is also expected that the financial institutions or the lenders be in a
position to protect themselves against any actions by the firm that can hurt them. It is also expected
that managers of the firm shall not invest the borrowed funds into risky project other than that that

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was agreed upon with the lenders. The objective of maximizing firm value also assumes that the
firm does not create any social costs and that if any costs are created by the firm it is easy to trace
these costs back to the firm.
However, in the real world, certain circumstances can make it difficult for the assumptions to hold.
Shareholders can find it difficult to fire non-performing managers using the avenue of the annual
general meeting and board of directors. This is because in most cases not all shareholders attend the
annual general meeting; as a result, a resolution to fire the managers may not meet the required votes
to pass. Secondly, the board of directors may be friends to the manager and thus will not act to
discipline the underperforming-manager. In certain instances, the board of directors may also lack
the necessary skills/experience to ask the right questions in a board meeting and may thus support
resolutions from the manager that are not good for the shareholders. The managers can also engage
in acts that expropriate the wealth of the lenders, such as issuing a huge cash dividend that leaves the
firm riskier. Regarding the relationship between the managers and the financial markets, in most
cases, the managers delay conveying bad news to the markets. Usually, the managers will look for a
better time to communicate this bad news when its impact on the share price will be minimal.
Managers also convey false information to the markets. It is also difficult in most cases to trace the
social costs to a specific firm and in certain circumstances, the firm may not know that the is
creating social costs. By the time the society discovers they act by shunning that firms; products.
For example, asbestos is known to cause cancers in human beings; however, the companies that
produced asbestos were not aware of this fact.
However, there are solutions to some of the shortcomings such as ensuring that managers are given
compensation in form of shares as a result when they work in their interests they are also working in
the interests of shareholders. Thus though this objective seems to have its shortcomings, the fact that
some remedial actions can be taken to remedy this shortcoming it makes this objective better than
alternatives.

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b.) A small manufacturing firm, which has limited access to capital, has a capital rationing constraint of
K150 million and is faced with the following investment projects (numbers in millions):
Project Initial Investment NPV
A K25 K10
B K30 K25
C K40 K20
D K10 K10
E K15 K10
F K60 K20
G K20 K10
H K25 K20
I K35 K10
J K15 K5

Required

i. Which of these projects would you accept? Why? (6 marks)

ii. What is the cost of the capital rationing constraint? (2 marks)

[ Total 8 Marks]

Solution

Initial Cum Initial

Profitability
Project investment NPV (K) Investment Decision
Index
(K) (K)
D 10.00 10 1 10.00 Accept
B 30.00 25 0.83 40.00 Accept
H 25.00 20 0.8 65.00 Accept
E 15.00 10 0.67 80.00 Accept
C 40.00 20 0.5 120.00 Accept
G 20.00 10 0.5 140.00 Accept
A 25.00 10 0.4 165.00
F 60.00 20 0.33 225.00
J 15.00 5 0.33 240.00
I 35.00 10 0.29 275.00

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b. Cost of Capital Rationing Constraint = SUM of NPV of rejected projects =

K45 million

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 SECTION B- 60 Marks

There are 4 questions in section, answer any 3

QUESTION 3.

a. The figure below shows the output results of the regression of M Corporation’s monthly returns
against the Stock index returns for five years:

SUMMARY OUTPUT

Regression Statistics
Multiple R 0.582730945
R Square 0.339575354
Adjusted R Square 0.335865103
Standard Error 0.076904771
Observations 180

ANOVA
df SS MS F Significance F
Regression 1 0.541301791 0.541302 91.52356 9.34006E-18
Residual 178 1.052753209 0.005914
Total 179 1.594055

Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%
Intercept 0.023011046 0.005842701 3.938426 0.000118 0.011481171 0.034540921 0.011481171 0.034540921
0.07 1.187812055 0.124159879 9.566795 9.34E-18 0.942797321 1.432826788 0.942797321 1.432826788

Required:

i. What is the intercept (alpha) and slope (beta) of the regression? (2 marks)
ii. If you bought stock in M Corp today, how much would you expect to make as a return
over the next year? [The six-month T. Bill rate is 6%] (1mark)
iii. Looking back over the last five years, how would you evaluate M Corp's performance
relative to the market? (The risk-free rate during the period was also 6% on an annual
basis) (4 marks)
iv. Assume now that you are an undiversified investor and that you have all of your money
invested in M Corporation. What would be a good measure of the risk that you are
taking on? How much of this risk would you be able to eliminate if you diversify? (2
marks)

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 b. Explain a firm’s investment, financing and dividend decisions choices at different stages in
the growth life cycle. You should give reasons for each of the choices (12 marks)

[ Total 20 Marks]

Solution

(a)

i. .
Intercept= 0.023
Slope= 1.189
ii.
Return on equity= Risk free rate + beta (equity risk premium)
= 6% + 1.189(6%) = 13%
iii.
Since returns are monthly, we use the monthly risk free rate
= 6%/12= 0.5%
Monthly performance using Jensen Alpha
𝛼 − Rf (1 − 𝛽)
= 0.023-0.5 % (1-1.189)
= 2.39%
The analysis shows that the stock performed 2.39% better than expected.
Annualized excess returns= (1 + monthly rate) 12-1
= (1 + 0.0239)12-1= 33%
iv.
If you were undiversified, you would be much more interested in the total standard deviation in the
stock, since you cannot eliminate the firm specific risk.
67% (1-0.33) of this risk is diversifiable.

(b) guiding points put them in essay form

Stage Investment decisions Financing decisions Dividend decisions

Start-up High investment in projects  External financing no capacity to pay
needs are high but dividends
they are
constrained by
infrastructure
 Internal financing
is negative or low
 External financing
is through owners’
equity or bank debt

Expansion High investment in projects  External funding no capacity to pay

needs are high dividends

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 relative to firm
value
 Internal financing
is negative or low
 External financing
through venture
capital and or/
common stock

High-growth Investment in projects is  External financing Capacity to pay dividends is

moderate needs are moderate low
relative to firm
value
 Internal financing
is Low relative to
funding needs
 External financing
through common
stock, warrants,
convertibles
Mature growth Investment is projects is low  External financing Capacity to pay dividends is
as they dry up needs are declining increasing
relative to firm
value
 Internal financing
needs are high
relative to funding
needs
 External financing
is done through
debt
Decline Low as projects dry up  External financing Capacity to pay dividends is
needs are low as high
projects dry up
 Internal funding
more than funding
needs
 External financing
retire debt and
repurchase stock

QUESTION 4

a.) You are the owner of a small hardware store, and you are considering opening a gardening store in a
vacant area in the back of your present store. You estimate that it will cost you K50,000 to set up the
new store and that you will generate K10,000 in after-tax cash flows from the store for the life of the
store (which is expected to be ten years). The one concern you have is that you have limited parking;
by opening the gardening store you run the risk of not having enough parking for customers who shop

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 at your hardware store. You estimate that the lost sales from such occurrence would amount to K3,000
a year and that your after-tax operating margin on sales at the hardware store is 40 percent.

Required:
If your discount rate were 14 percent, would you open the gardening store? (8 marks)

Solution

b.) You own a rental building in the city and are interested in replacing the heating system. You are faced
with the following alternatives:
i.A gas heating system, which will cost K5,000 to install and K1,000 a year to run and
will last twenty years.
ii.An oil heating system, which will cost K3,500 to install and K1,200 a year to run and
will last fifteen years.
Required:
If your opportunity cost is 10 percent, which of these three options is best for you? (8 marks)

Solution

𝑟
𝐸𝐴 = 𝑁𝑃𝑉 𝑋
(1 − (1 + 𝑟)−𝑛
𝑟
𝐸𝐴 = 𝑁𝑃𝑉 𝑋
(1 − (1 + 𝑟)−𝑛

NPV(I) = -5,000 - 1,000(1-(1.1)-20)/0.1 = -13,514 Annualized cost (II) = -1,587

(Annuity, given PV = -K13,514, n = 20 years and r = 10%)

NPV(II) = -3,500 -1,200(1-(1.1)-15)/0.1 = -12,627 Annualized cost(III) = -1,660

(Annuity, given PV = -K12,627, n = 15 years and r = 10%)

CHOOSE OPTION I (GAS HEATING SYSTEM) AS ITS

EQUIVALENT ANNUAL COST IS LOWER THAN
THAT OF OPTION (II)

c.) Explain the meaning of reinvestment risk? ( 4 marks)

Solution
It is a risk that at the maturity of a security, due to a drop in the level of interest in the economy, the
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proceeds may be reinvested at a lower interest leading to a reduction in income.

[Total 20 Marks]

QUESTION 5

a.) You have been asked to assess the net present value of a project analysis done by
analysts at Mulobezi Trading Ltd, a firm that operates in both retailing and apparel
production. The project, which is in the apparel business, has a 10-year life with equal
annual cash flows over the period and an initial investment of K 1 billion. You notice
two problems with the analysis:

 The analyst used a cost of capital of 10% (which is the company’s cost of
capital) in computing the net present value of K 100 million. The cost of capital
for the apparel business is 12%. The analyst expensed the entire investment in
year 0; you believe that you need to depreciate the investment straight line over
10 years to a salvage value of zero. The company tax rate is 30%.

Required
Estimate the correct net present value of the project. ( 10 Marks)

Solution

As set up by the analyst,

Stated NPV = - 1,000( 1-0.3) + CF (PVA, 10 years, 10%) = 100

-700 + 𝑋 ∗ 6.145 = 100 (6.145 is the annuity factor 10 years, 10%)

X= 130.20

Annual Tax benefits = 30% x K1,000= K300/10 = K30

Correct initial investment =1000
Correct after-tax annual cashflow = K160.20 = K130.20 + K30
Correct NPV = -1000 + 160.20 (PVA, 10 years, 12%) = (94.86) = -1000+160.20*5.650 (5.650
is the annuity factor 12%, 10 years)
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 b.) You have been engaged by Maamba Milling Plc, a major producer and supplier of mealie-meal,
in Maamba District of Zambia, to estimate the company’s cost of capital. Table 1 contains
information about the company, whilst Table 2 has information on other milling companies in
the country.
Table 1: Selected financial information Mamba Milling Plc

Description Rate
Debt to equity ratio 20%
Debt to capital ratio 10%
Pre-tax cost of Debt 15%
Tax rate 40%

Table 1: The selected financial information for Milling Companies in Zambia

Company Levered Tax rate Debt to

Beta equity
Ratio
Mushe Milling Ltd 0.98 40% 30%
Choma Milling Ltd 0.57 40% 25%
Kasama Milling Ltd 0.26 40% 23%
Kachana Millers Ltd 1.68 40% 30%

Ten- year Treasury bonds issued by the Government of the Republic of Zambia had a yield of 12%.
Moody’s sovereign rating for Zambia is Caa, with a related default spread of 2%. The market equity
risk premium is estimated at 10%.
Required:
Estimate Maamba Milling’s cost of capital. (10 marks)

[Total 20 Marks]

Solution
Debt to
Company Levered Beta Tax rate equity Ulevered Beta
ratio Median Number
Mushe milling 0.98 40% 30% 0.8305 0.3621 =(E7+E8)/2
CHOMA
Milling 0.57 40% 25% 0.4957
Kasama Milling 0.26 40% 23% 0.2285
Kachana
Millers 1.68 40% 30% 1.4237

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 Maamba Milling Levered Beta calculation = BU*(1+(1-t)(D/E)=0.362062 /(1+(1-0.40)(0.2)= 0.32 0.32
Risk free rate= Bond yield less default spread= 12%-2%=8%
Cost of Equity = Riskfree rate + Beta(equity Risk premium)= 8% + 0.32(10%) =11.23%
Cost of Debt = Kd*(1-t)=15%*(1-0.4) =9.00%
Cost of Capital = Kd*(debt to capital ratio)) + Ke * (1-debt to capital ratio)
Cost of Capital =9%(0.1) + 11.23%(1-0.9) = 9.89%

Workings:
1. Unlevered beta= BL/(1 + (1-t)(D/E)
Mushe milling = 0.98/(1 + (1-0.4)(0.3)=0.83
Geraldo milling = 0.78/(1 + (1-0.4)(0.37)=0.64
Kachana millers = 1.68/(1 + (1-0.4)(0.30)=1.42

2. Pure play beta= Unlevered Beta/(1 -(cash/firm value)

Mushe milling = 0.83/(1- 0.1)=0.92
Geraldo milling = 0.64/(1 -0.05)=0.67
Kachana millers = 1.42/(1-0.1)=1.58

QUESTION 6
You are analyzing the dividend policy of Mulobezi Ltd, a major agricultural trading company, and
you have collected the following information from the past five years.
Year Net Income Capital Expenditure Depreciation Noncash Working Capital Dividends
(Million) (Million) (Million) (Million) (Million)
2015 K240 K314 K307 K35 K70
2016 K282 K466 K295 K(110) K80
2017 K320 K566 K284 K215 K95
2018 K375 K490 K278 K175 K110
2019 K441 K494 K293 K250 K124

The average debt ratio during this period was 40 percent, and the total noncash working capital at
the end of 2014 was K10 million.
Required:
a. Estimate how much Mulobezi could have paid in dividends during this period. (5
marks)
b. If the average return on equity during the period was 13.5 percent, and Mulobezi
had a beta of 1.25, what conclusions would you draw about their dividend policy?

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 (The average Treasury bond rate during the period was 7 percent, and the average
return on the market was 12.5 percent during the period.) (5 marks)
c. Explain the three schools of thought on dividend policy (10 marks)
[Total 20 marks]

SOLUTION

Year Net Income Cap. Exp. Depr. Noncash WC Change in Noncash WC Dividends FCFE
1991 240 314 307 35 25 70 220.8
1992 282 466 295 -110 -145 80 266.4
1993 320 566 284 215 325 95 -44.2
1994 375 490 278 175 -40 110 271.8
1995 441 494 293 250 75 124 275.4

FCFE = Net Income – (Cap Ex – Depr) (1-0.4) – Change in Working capital (1-0.4)

a. Mulobezi could have paid dividends each year equal to its FCFE, at least on average.

b. The average accounting return on equity that Mulobezi is earning = 13.5%,

compared to a required rate of return = 0.07 + 1.25(0.125-0.07) = 13.875. Hence,
Mulobezi’ s projects have done badly on average. Its average dividends have been
much lower than the average FCFE. Hence, it would seem that Mulobezi would come
under pressure to pay more in dividends.

c. Dividends is the act of distributing profits to shareholders. The three plicies are as
follows:

(i) The Dividends don’t matter school The Miller Modigliani Hypothesis
The Miller-Modigliani Hypothesis: the MM proposition argues that your total returns on a stock will
be unaffected by dividend policy.If a firm's investment policies (and hence cash flows) don't change,
the value of the firm cannot change as it changes dividends. If a firm pays more in dividends, it will
have to issue new equity to fund the same projects. By doing so, it will reduce expected price
appreciation on the stock but it will be offset by a higher dividend yield. If we ignore personal taxes,
investors have to be indifferent to receiving either dividends or capital gains.
Underlying Assumptions:
(a) There are no tax differences to investors between dividends and capital gains.
(b) If companies pay too much in cash, they can issue new stock, with no flotation costs or signaling
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consequences, to replace this cash.
(c) If companies pay too little in dividends, they do not use the excess cash for bad projects or
acquisitions.
(ii) The Dividends are “bad” school
This applies where dividends are taxed at much higher rates than capital gains. Based on this tax
disadvantage, the second school of thought on dividends argued that dividend payments reduce the
returns to shareholders after personal taxes. There are several markets where capital gains are not
taxed at all and some where neither dividends nor capital gains are taxed.
(iii) Dividends are good School
Dividends now are more certain than capital gains later. Hence dividends are more valuable than
capital gains. Stocks that pay dividends will therefore be more highly valued than stocks that do not.
When a firm has excess cash on its hands and has no investment projects, the best option is to give
the money back to shareholders.

--------------------------END OF EXAM………………..............................

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