Financial Management for Accountants

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QUESTION 1:  (40 MARKS)

EQUITY VALUATION

Spark Electricals Limited was founded ten years ago by Keith and Jane Taylor. The company manufactures and installs both traditional and contemporary models of lights for residential and commercial purposes. Spark Electricals Ltd has experienced rapid growth because of the new technology that increases the energy efficiency of its systems, and the introduction of new models of LED integrated lights. The company is equally owned by Keith and Jane holding 100,000 shares each.

In April 2020, Keith and Jane have decided to value their holdings in the company for financial planning purposes. To accomplish this, they have gathered the following information about their main competitors in the Industry.

EPS ($) DPS ($) Share Price ($)

ROE (%) Required rate (%)

Colonial Lighting 0.42 0.08 7.65 10.5 9.5

Reliable Lighting Plus 0.46 0.26 6.25 11.5 10.5

FullBright Electricals -0.24 0.27 24.3 12.5 11.5

Industry Average 0.36 0.27 8.24 11.0 10.5

Last year, Spark Electricals Ltd had an EPS of $0.52 and paid dividends to Keith and Jane of $31,200 each. The company also had a return on equity of 15%. Keith and Jane believe a required rate of return of 12% for the company is appropriate.

Required:

  1. Assuming the company continues its current growth rate (growth rate should be inferred from the data given) into the infinite period, what is the share price of the company?

(8marks)

  1. To verify their calculations, Keith and Jane have hired Felix Wang, a consultant. Felix was previously an equity analyst, and he has a good understanding of the electrical Industry. Felix has examined the financial statements of Spark Ltd and its competitors. Although Spark Ltd currently has a technological advantage, Felix’s research indicates that Spark Ltd’s competitors are investigating other methods to improve efficiency. Given this, Felix believes that Spark Ltd’s technological advantage will last for only the next five years. After that period, the company’s growth is likely to slow down to the industry average. Additionally, Felix believes that the company’s required return currently is high, and so after year 5, the industry average required return is a more appropriate rate for valuation. Taking Felix’s assumptions into consideration, calculate the estimated share price of Spark Ltd.

(16 marks)

  1. What is the industry average price-earnings ratio? What is Spark Ltd’s price-earnings ratio based on Felix’s estimation in part (2) above? Comment on the differences, if any, and explain why these differences exist?

(8 marks)

  1. After discussion with Felix, Keith and Jane agree that they wanted to increase the value of the company’s equity. Like many small business owners, they want to retain control of the company and do not want to sell shares to outside investors. They also feel that the company’s debt is at a manageable level and do not want to borrow more money. What steps can they take to increase the share price? – justify each of your suggestions.

(8 marks)

QUESTION 2:  (60 Marks)

WEIGHTED AVERAGE COST OF CAPITAL

2.1. NewGen Industries Limited is a large public listed company and is the market leader in vacuum cleaner manufacturing in New Zealand. The company is looking to set up a manufacturing plant overseas to produce a new line of commercial vacuum cleaners. This will be a six-year project.

The company bought a piece of land four years ago for $8 million in anticipation of using it for its proposed manufacturing plant. If the company sold the land today, it would receive $9.75 million after taxes. In six years, the land can be sold for $14 million after taxes and reclamation costs.

Now the company wants to build a new manufacturing plant on this land. The plant will cost $275 million to build. The following market data on NewGen Industries Ltd are current:

Debt $120,000,000,7.25% coupon bonds outstanding with 20 years to maturity redeemable at par, selling for 95 per cent of par; the bonds have a $1000 par value each and make semi-annual coupon payments.

Equity 15,000,000ordinary shares, selling for $55 per share

Non-redeemable Preference shares

12,000,000 shares (par value $ 10 per share) with 6.5% dividends (after taxes), selling for $32 per share

The following information is relevant:

  • NewGen Industries Ltd’s tax rate is 28%
  • The company had been paying dividends on its ordinary shares consistently. Dividends paid during the past five years is as follows

Year (-4) ($) Year (-3) ($) Year (-2) ($) Year (-1) ($) Year (0) ($)

4.6 4.8 5.3 5.5 6.0

  • The project requires $7.95 million in initial net working capital investment in year 0 to become operational.

Required:

  1. Calculate the project’s initial (time 0) cash flows. (4 marks)
  2. Calculate the weighted average cost of capital (WACC) of NewGen Industries Ltd. Show all workings and state any assumptions underlying your computations.

(12 marks)

  1. Using the WACC computed in part (2) above and assuming the following, calculate the project’s Net Present Value (NPV), Internal Rate of Return (IRR) and the Profitability Index (PI).
  2. The manufacturing plant has a ten-year tax life, and NewGen Industries Ltd uses Diminishing value method of depreciation for the plant using a 20% depreciation rate per annum. At the end of the project, (i.e., at the end of year 6), the plant can be scrapped for $22 million.
  3. The project will incur $250 million per annum in fixed costs c. The company has estimated that it will manufacture 300,000 commercial vacuum

cleaners per year for six years and sell them at $ 2,200 per vacuum cleaner. d. The variable production costs are $ 950 per vacuum cleaner. e. At the end of year 6, the company will sell the land.

Note: Work all solutions to the nearest two decimals. (36 marks) 2.2. What are the pros and cons of using risk-adjusted costs of capital for individual investments?

(8 marks)

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