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SCHOOL OF BUSINESS

DEPARMENT OF ACCOUNTING & FINANCE

DFI 305: CORPORATE FINANCE MODULE III JULY 2012

ASSIGNMENTS

DO ALL QUESTIONS AND SUBMIT DURING THE NEXT

RESIDENTIAL SESSION

QUESTION ONE

SEBULE Enterprises Ltd. is a manufacturer of high quality running shoes. The Finance Manager

Ms. Daisy is considering computerizing the company’s ordering, inventory and billing

procedures. She estimates that the annual savings from computerization include a reduction of

ten clerical employees with annual salaries of sh. 15,000,000 each, sh. 8,000, 000 from reduced

production delays caused by raw materials inventory problems, sh. 12,000 from lost sales due to

inventory stock outs, and sh. 3,000, 000 associated with timely billing procedures. The purchase

price of the system is sh. 200,000,000 and installation costs are sh 50,000,000. These outlays will

be capitalized (depreciated) on a straight-line basis to a zero book salvage value which is also its

market value at the end of five years.

Operation of the new system requires two computer specialists with annual salaries of sh.

40,000,000 per person. Also annual maintenance and operating (cash) expenses of sh. 12,000,000

are estimated to be required. The company’s tax rate is 40% and its required rate of return for this

project is 12%.

Required to:

a) Find the project’s initial net cash outlays. (3 marks)

b) Find the project’s operating and terminal value cash flows over its 5 year life.

(2 marks)

c) Evaluate the project using NPV method. (3 marks)

d) Evaluate the project using PI method. (2 marks)

e) Calculate the project’s payback period. (2 marks)

f) Find the project’s cash flows and NPV [(parts (a) through (c)] assuming that the system

can be sold for sh. 25,000,000 at the end of the five years even though the book salvage

value will be zero. (4 marks)

g) Find the project’s cash flows and NPV [parts (a) through (c) assuming that the book

salvage value for depreciation purposes is sh. 20,000,000 even though the machine is

worthless in terms of resale values. (4 marks)

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Question Two

Mr. RAWOO, the Finance Director of Modern Synthetics Limited, called Mr. Dingo, the in

charge of Management services Division of the company to explore ways and means of

improving the management Information System in the company. On the basis of their discussion

it became obvious that the company needed a computer system for processing efficiently and

accurately the growing volume of information generated in the business. It was felt that the

computer system would also facilitate the timely preparation of control reports needed by the

management.

Mr. RAWOO asked Mr. Dingo to find out which computer system would be suitable for the

needs of the company and estimate the costs and benefits expected from it. Mr. Dingo talked to

the representatives of a few computer manufacturing companies. On the basis of his discussion

with them he felt that the Alpha III System supplied by Computronics Limited was quite suitable

for the needs of Modern Synthetics Limited. He estimated the costs and benefits associated with

this system as follows:

Operation and maintenance cost sh. 2.5 million per annum

Savings in clerical cost sh. 6 million per annum

Savings in space cost sh. 1 million per annum

The computer would have an economic life of five years and it would be depreciated at the rate

of 33⅓ per cent per year as per the written down value method. After five years, it would be

disposed of for a value equal to its book value. On examining the above information, Mr.

RAWOO asked Mr. Dingo to prepare a capital budgeting proposal for submission to the

Executive Committee of the Company.

Required:

Calculate the internal rate of return of the investment. (20 marks)

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Question Three

CHENIDU Wanderers is a professional football club that has enjoyed considerable success in both

national and international competitions in recent years. As a result, the club has accumulated sh10

million to spend on its further development. The board of directors is currently considering two

mutually exclusive options for spending the funds available.

The first option is to acquire another player. The team manager has expressed a keen interest in

acquiring ‘Bazaar’, a central defender, who currently plays for a rival club. The rival club has agreed

to release the player immediately for sh. 10 million if required. A decision to acquire ‘Bazaar’ would

mean that the existing central defender, ‘Veneto’ could be sold to another club. CHENIDU wanderers

have recently received an offer of sh. 2.2 million for this player. This offer is still open but will only

be accepted if ‘Bazaar’ joins CHENIDU Wanderers. If this does not happen, ‘Veneto’ will be

expected to stay on with the club until the end of his playing career in five years’ time. During this

period, ‘Veneto’ will receive an annual salary of sh.400, 000 and a loyalty bonus of sh.200, 000 at the

end of his five-year period with the club.

Assuming ‘Bazaar’ is acquired, the team manager estimates that the gate receipts will increase by

sh2.5 million in the first year and sh1.3 million in each of the four following years. There will also be

an increase in advertising and sponsorship revenues of sh1.2 million for each of the next five years if

the player is acquired. At the end of five years, the player can be sold to a club in a lower division and

chesterfield Wanderers will expect to receive sh 1 million as a transfer fee. During his period at the

club, ‘Bazaar’ will receive an annual salary of sh. 800,000 and a loyalty bonus of sh. 400,000 after

five years.

The second option is for the club to improve its ground facilities. The west stand could be extended

and executive boxes could be built for businesses wishing to offer corporate hospitality to clients.

These improvements would also cost sh.10 million and would take one year to complete. During this

period, the west stand would be closed, resulting in a reduction of gate receipts of sh1.8 million.

However gate receipts for each of the following four years would be sh. 4.4 million higher than

current receipts. In five years’ time, the club has plans to sell the existing grounds and to move to a

new stadium nearby. Improving the ground facilities is not expected to affect the ground’s value when

it comes to be sold. Payment for the improvements will be made when the work has been completed

at the end of the first year. Whichever option is chosen, the board of directors has decided to take an

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additional ground staff. The additional wages bill is expected to be sh. 350,000 a year over the next

five years.

The club has a cost of capital of 10 per cent.

Ignore taxation.

Required

a) Calculate the incremental cash flows arising from each of the options available to the club

(8

marks)

b) Calculate the net present value of each of the options ( 5 marks)

c) On the basis of the calculations made in (b) above, which of the two options would you

choose and why? (2 marks)

d) Discuss the validity of using the net present value method in making investment decisions for

a professional football club. (5 marks)

Question Four

The president of Ellis Construction Company, headquartered in Toledo, has asked you to

evaluate the proposed acquisition of a new earthmover. The move’s basic price is shs.50m and it

will cost another shs.10m to modify it for special use by Ellis Construction. Assume that the

mover will be depreciated on a straight line basis It will sold after 3 years for shs.20m and it will

require an increase in net operating working capital (spare parts inventory) of shs.2m. The

earthmover purchase will have no effect on revenues, but it is expected to save Ellis shs.20m per

year in before-tax operating costs; mainly labor. Ellis’s marginal corporate tax rate is 40 percent.

Required

a) What is the company’s net investment if it acquires the earthmover?What are the

annual operating cash flows in Years 1, 2 and 3?

b) What is the terminal cash flow?

c) If the project’s cost of capital is 10%, should the earthmover be purchased?

d) Suppose that the firm’s management is unsure about the savings in before-tax

operating costs and the earthmover’s salvage value.

1. What is the earthmover’s net present value if the savings in before-tax operating

costs increase by 15% above the firm’s original expectations? Would this change

the firm’s decision to acquire the earthmover from the decision made in part d?

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2. What is the earthmover’s net present value if the earthmover’s salvage value

increases by 10% above the firm’s original expectation? Assume no other change in

data from the original problem. Would this change the firm’s decision to acquire the

earthmover from the decision made in d?

a) Suppose the firm’s capital budgeting manager suggests that the firm do a

scenario analysis for this project because of the sensitivities of both the equipment’s cost

savings and its salvage value. After an extensive analysis, he comes up with the following

probabilities and values for the scenario analysis:

(shs.m)

Before-tax Salvage

SCENARIO Probability Savings Value

Worst case 30% 15 18

Base case 40 20 20

Best case 30 25 24

What is the projects expected net present value (NPV), the standard deviation of the NPV, and

the coefficient of variation of the NPV? (Total 30 marks)

Question Five

WADADA MENGI ENDELEA (WME) has just developed a solar panel capable of generating

200 percent more electricity than any solar panel currently on the market. As a result, WME is

expected to experience a 15% annual growth rate for the next 5 years. By the end of 5 years,

other firms will have developed comparable technology, and WME’s growth rate will slow to 5

% per year indefinitely. Stockholders require a return of 12 percent on WME’s stock. The most

recent annual dividend (Do), which was paid yesterday, was shs.1.75 per share.

Required

a Calculate WME’s expected dividends for 2007,2008,2009,2010, and 2011.

c Calculate the expected dividend yield, D1/Po, the capital gains yield expected in 2007,

and the expected total return (dividend yield plus capital gains yield) for 2007.

Calculate these same three yields for 2011.

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d How might an investor’s tax situation affect his or her decision to purchase stocks of

companies in the early stages of their lives, when they are growing rapidly, versus

stocks of older, more mature firms? When does WME’s stock become “mature” in

this example?

e Suppose your boss tells you she believes that WME’s annual growth rate will be only

12% during the next 5 years and that the firm’s normal growth rate will be only 4%.

Without doing any calculations, what general effect would these growth rate changes

have on the price of WME’s stock?

f Suppose your boss also tells you that she regards WME as being quite risky and that

she believes the required rate of return should be 14% not 12%. Again without doing

any calculations, how would the higher required rate of return affect the price of the

stock, its capital gains yield, and its dividend yield? Again, assume that the firm’s

normal growth rate will be 4%. (Total 30 marks)

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