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UNIVERSITY OF NAIROBI

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:

 Cost of the computer along with accessories sh.15 million


 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.

b Calculate the theoretical value of the stock today, Po.


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)