MAC4865/A02/0/2018

Assignment 2/0/2018 
 
Financial Strategy 
MAC4865 
 
Year module 
 
Department of Management Accounting 
 
   

 
Dear Student

This document contains compulsory assignment 2.

This assignment will assess Part 1: Formulation of financial strategy and Part 2: Financing and
Dividend Decision, Topic 1-Financing – Equity Finance and Topic 2-Financing – Debt Finance.

Answer all the questions. All new questions must be commenced on a separate page.

Due date: 7 May 2018

Unique Number: 645165

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Question 1 (25 marks)

Blush is a privately owned company with a number of shares available on an invitation basis only.
The company produces creams, soaps, shampoos, shower gels, lotions, moisturizers, scrubs,
masks and other cosmetics for the face, hair, and body using only vegetarian or vegan recipes.

Blush products are 100% vegetarian, and often contain fruits and vegetables such as grapefruit
juice, vanilla beans, avocado butter, rosemary oil, fresh papaya and coconut. However, some
products contain lanolin, milk, eggs, honey, and beeswax.

Blush is based in Hungary, a country in the European Union, but which is not in the European
Common Currency Area (ECCA). It trades internationally both as a supplier and a customer.
Although Blush is privately owned, it has revenue and assets equivalent in amount to some public
listed companies. It has a large number of shareholders, but has no intention of seeking a listing
at the present time. In fact, the major shareholders have often expressed a wish to buy out some
of the smaller investors.

The entity has a long history of sound, if unspectacular, profitability. The directors and
shareholders are reasonably happy with this situation and are averse to adopting strategies that
they think might involve a substantial increase in risk, for example, acquisition or setting up

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manufacturing capability overseas, as some of Blush’s European competitors have done. As a
consequence, Blush accepts its growth rate will be relatively low, compared with some of its
competitors.

The entity is financed 70% equity and 30% debt (based on book values). The debt is a mixture of
secured and unsecured bonds carrying interest rates of between 3.9% and 5.9% and repayable
in 5 to 10 years’ time. Inflation in Hungary is 1.9% (therefore you can assume near zero) and
interest rates are low and possibly falling. The Company Treasurer is investigating the
opportunities for, and consequences of, refinancing.

Blush’s main financial objective is simply to increase dividends each year. It has one non-financial
objective, which is to treat all stakeholders in the organisation with “fairness and equality”. The
Board has decided to review these objectives. The new Finance Director believes maximization
of shareholder wealth should be the sole objective, but the other directors do not agree and think
a range of objectives should be considered, for example profits after tax and return on investment
and performance improvement across a number of operational areas.

Required:

1. Evaluate the appropriateness of Blush’s current objectives and the Finance Director’s
suggestion, and discuss the issues that the Blush Board should consider when
determining the new corporate objectives. Conclude with a recommendation. (15)
2. Discuss the factors that the treasury department should consider when determining
financing, or re-financing strategies in the context of the economic environment described
in the scenario and explain how these might impact on the determination of corporate
objectives. (10)
[25]

Hint:
What is a 'Bond'

A bond is a fixed income investment in which an investor loans money to an entity (typically
corporate or governmental) which borrows the funds for a defined period of time at a variable or
fixed interest rate. Bonds are used by companies, municipalities, states and sovereign
governments to raise money and finance a variety of projects and activities. Owners of bonds
are debtholders, or creditors, of the issuer.

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Question 2 (25 marks)

This question consists of 2 parts.

Part A

Local government in South Africa consists of municipalities (Tswana: bommasepala; Sotho:

bomasepala; Northern Sotho: bommasepala; Afrikaans: munisipaliteite; Zulu: ngomasipala;
Southern Ndebele: bomasipala; Xhosa: ngoomasipala; Swazi: bomasipala; Venda: vhomasipala;
Tsonga: vamasipala) of various types. The largest metropolitan areas are governed by
metropolitan municipalities, while the rest of the country is divided into district municipalities, each
of which consists of several local municipalities.

The Gouga Local municipality, situated in the Sarah Baartman District Municipality, Eastern Cape
is a local municipalities government entity. It is financed almost equally by a combination of central
government funding and local taxation. The funding from central government is determined largely
on a per capita (per head of population) basis, adjusted to reflect the scale of deprivation (or
special needs) deemed to exist in Gouga’s region. A small percentage of its finance comes from
the private sector, for example from renting out City Hall for private functions.

Gouga’s main objectives are:

 To make the region economically prosperous and an attractive place to live and work;
 To provide service excellence in health and education for the local community.

Pick n Cash is a large, listed entity with widespread commercial and geographical interests. For
historic reasons, its headquarters are in Gouga’s region. This is something of an anomaly as most
entities of Pick n Cash’s size would have their headquarters in a capital city, or at least a city
much larger than where it is.

Pick n Cash has one financial objective: To increase shareholder wealth by an average 10% per
annum. It also has a series of non-financial objectives that deal with how the entity treats other
stakeholders, including the local communities where it operates.

Pick a Cash has total net asset value – cents per share (property value based on directors'
valuation) of 910 cents and a gearing ratio of 45% (debt to debt plus equity), which is typical for
its industry. It is currently considering raising a substantial amount of capital to finance an
acquisition.

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Required:

Discuss the criteria that the two very different entities described above have to consider when
setting objectives, recognising the needs of each of their main stakeholder groups. Make some
reference in your answer to the consequences of each of them failing to meet its declared
objectives. (13)

Part B

Mactech is a private entity in a computer-related industry. It has been trading for six years and is
managed by its main shareholders, the original founders of the entity. Most of the employees are
also shareholders, having been given shares as bonuses. None of the shareholders has
attempted to sell shares in the entity so the problem of placing a value on them has not arisen.

Dividends have been paid every year at the rate of 60 cents per share, irrespective of profits. So
far, profits have always been sufficient to cover the dividend at least once but never more than
twice.

Mactech is all-equity financed at present although R15 million new finance is likely to be required
in the near future to finance expansion. Total net assets as at the last balance sheet date were
R45 million.

Required:

Discuss and compare the relationship between dividend policy, investment policy and financing
policy in the context of the small entity described above, Mactech, and Pick n Cash, the large
listed entity described in Part A. (12)
[25]

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Question 3 (25 marks)

Synergy Systems (SS) is a company based in Johannesburg, South Africa that provides
information systems consulting and project management services.

Often it is difficult to make use of ICT (Information Communications Technology) in an effective

way specifically in alignment with business strategy. Information Systems Optimisation is the act
of improving alignment of IT Strategy and Business Strategy.

SS specialises in providing information systems solutions to large corporates. Currently the

company is going through a period of rapid expansion and requires additional funds to finance
the long-term working capital needs of the business.

SS has issued one million R1 ordinary shares, which are listed on the Johannesburg Stock
Exchange (JSE) at a current market price of R15, with typical increases of 10% per annum
expected in the next five-year period. Dividend pay-out is kept constant at a leveI of 10% of after
taxation profits. SS also has R10 million of bank borrowings.

It is estimated that a further R3 million is required to satisfy the funding requirements of the
business for the next five-year period beginning 1 July 2018. Two major institutional shareholders
have indicated that they are not prepared to invest further in SS at the present time and so a rights
issue is unlikely to succeed. The directors are therefore considering various forms of debt finance.

Three alternative structures are under discussion as shown below:

 Five-year unsecured bank loan at a fixed interest rate of 7% per annum;
 Five-year unsecured bond with a coupon of 5% per annum, redeemable at par and issued
at a 6% discount to par;
 A convertible bond, issued at par, with an annual coupon of 4.5% and a conversion option
in five years’ time of five shares for each R100 nominal of debt.

There have been lengthy boardroom discussions on the relative merits of each instrument and
you, as Finance Director, have been asked to address the following queries:

Ms. Abdul: “The bank loan would seem to be more expensive than the unsecured bond. Is this
actually the case?”
Mr. Balewa: “Surely the convertible bond would be the cheapest form of borrowing with such a
low interest rate?”
Mr. Coetzee: “If we want to increase our equity base, why use a convertible bond, rather than a
straight equity issue?”

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Required:

1. Write a response to Ms. Abdul, Mr. Balewa and Mr. Coetzee, directors of SS, discussing
the issues raised and advising on the most appropriate financing instrument for SS. In
your answer, include calculations of:
o expected conversion value of the convertible bond in five years’ time;
o yield to maturity (redemption yield) of the five-year unsecured bond.

You may ignore tax. Maximum of 8 marks for calculations. (18)

2. Advise a prospective investor in the five-year unsecured bond issued by SS on what

information he should expect to be provided with and what further analysis he should
undertake in order to assess the creditworthiness of the proposed investment. (7)
[25]

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Question 4 (25 marks)

Question 4 comprises of 18 short answer and multiple choice questions.

Answer the short questions by reading the questions carefully and confine your responses to
an analysis of the questions as written and select the best answer to the multiple choice
question.

Please answer question 4 in your assignment answer script book

1. Easycare Linens Co made a profit before interest and taxation for the year of $950,000.
Net interest payable was $50,000. Tax was $100,000. In addition to a nominal issued
share capital of $3m there are one million 10% preferred shares in issue, each with a
nominal value of $1.

Calculate the profit figure to be used in the EPS calculation (2)

a. $950,000
b. $900,000
c. $800,000
d. $700,000

2. Anthony Inc achieved earnings per share of £0.25 and paid a dividend of £0.05 per share
for the year just ended. Anthony’s P/E ratio is currently 13. Its comparative data for the
previous year was as follows:

EPS £0.20
DPS £0.04
P/E ratio 12.5
Dividend yield 1.6%

Calculate the total shareholder return (TSR), to the nearest %, that Anthony has
achieved in the current year (2)

TSR =          %  

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3. The figures in the table below are an extract from the income statement of Arnold Co.
Arnold has 3.5m ordinary shares in issue (nominal value 50 cents each) with a market
price of R2.

Profit before tax R2.5 million

Less tax R0.75 million
Profit after tax R1.75 million
Ordinary dividend R0.5 million
Preference dividend R0.25 million

Calculate the dividend yield (to the nearest %) (2)

a. 4%
b. 5%
c. 7%
d. 11%

4. The projected income statement of a SD Co for the year ended on 30 June 2018 shows
the following figures (in Japanese Yen).

Operating profit ¥100,000

Interest payable ¥40,000
Profit before tax ¥60,000
Corporation tax (effective 30%) ¥18,000
Profit after tax ¥42,000

The directors of SD Co estimate that the additional purchase of new equipment on

1 July 2018 for ¥140,000 would increase the projected profit before interest and tax for
the year by ¥18,000.
The machine would be financed by a new loan raised on 1 July 2018 with a coupon rate
of 5%.
SD Co has a covenant on an existing loan that interest cover will remain above 2.2.

What would be the outcome if the directors purchased the new machine? (2)

a. Interest cover is 2.95, the debt covenant is broken

b. Interest cover is 2.51, the debt covenant is not broken
c. Interest cover is 1.06, the debt covenant is broken
d. Interest cover is 2.95, the debt covenant is not broken

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5. A steady increase in earnings is MOST likely to be financial objective of: (1)

a. A publicly owned postal delivery service

b. A public listed pharmaceuticals company
c. A public sector library that is struggling for government funding
d. A not-for-profit charity

6. Which of the following ratios would be most appropriate to use to compare the
profitability of two companies that operate in the same line of business? (1)

a. Interest cover
b. Earnings per share (EPS)
c. Price/Earnings multiple (P/E)
d. Return on capital employed (ROCE)

7. Which two of the following are likely to be the main focus of financial decision-making
for a company that is in the early stages of its life cycle? (1)

a. Social and environmental reporting.

b. Deciding on the level of dividend to be paid.
c. Generating and evaluating investment proposals.
d. Planning and obtaining suitable sources of finance.

8. Which of the following parties is least likely to benefit from risky strategies that increase
risk and expected return for a company? (1)
a. Creditors
b. Shareholders
c. Chief financial officers
d. Chief executive officers

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9. Managers of businesses sometimes exploit the agency problem to pursue their own
rather than the business’s interests.

In doing so, which of the following pairs of factors are likely to have enabled managers
to have run the company in their own interests? (1)

a. Low levels of management accountability and shareholder access to the same

information as management
b. High levels of management accountability and management access to better
information than the shareholders
c. High levels of management accountability and shareholder access to the same
information as management
d. Low levels of management accountability and management access to better
information than the shareholders

10. Your manager has asked you to calculate the Return on Equity for your company.

Which of the following profit figures would you use in the calculation? (1)

a. EBITDA
b. Net profit
c. Gross profit
d. Operating profit

11. Chmura Co has the following accounting ratios, based on its most recent financial
statements:

Operating profit margin 18%

Interest cover 2 times
Gross profit margin 35%
Asset turnover 1.0

Calculate the return on capital employed of Chmura Co (2)

a. 17.5%
b. 18.0%
c. 35.0%
d. It is impossible to tell from this limited information

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12. Maximisation of shareholder wealth is MOST likely to be the primary objective of a:
(1)

a. Private sector, for-profit entity

b. Private sector, not-for-profit entity
c. Public sector, for-profit entity
d. Public sector, not-for-profit entity

13. Given the following information about a company:

Sales $1,000
Cost of goods sold $600
Operating expenses $200
Interest expenses $50
Effective tax rate 34%

What are the gross and operating profit margins, respectively? (2)

a. 20%; 15%
b. 40%; 20%
c. 40%; 10%
d. 20%; 10%

14. Paragon Co’s operating profit is AU$100,000, interest expense is AU$25,000, and
earnings before tax is AU$75,000.

Compete Paragon Co’s interest cover ratio (2)

a. 1
b. 3
c. 4
d. 7

15. All else equal, an entity’s sensitivity to swings in the business cycle is higher when:
(1)
a. The firm has low operating leverage
b. Fixed costs are the highest portion of its expenses
c. Variable costs are the highest portion of its expenses
d. Variable and fixed costs are roughly in the same proportion

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16. What is the effect on prices of US imports and exports when the US dollar depreciates?
(1)
a. Import prices will increase and export prices will decrease
b. Import prices and export prices will increase
c. Import prices will decrease and export prices will increase
d. Import prices and export prices will decrease

17. When financial managers are planning financial strategy for entity, the impact of
regulatory requirements should be considered.

Which of the following is NOT normally an objective of regulatory body? (1)

a. The protection of customers

b. The promotion of competition
c. The protection of shareholders
d. The promotion of social objectives

18. Which of the following statements regarding futures and forward contracts is FALSE?
(1)
a. Forwards require no cash transactions until the delivery date, while futures require a
margin deposit when the position is opened
b. Both forward contracts and future contracts trade on an organised exchange
c. Futures contracts are highly standardized
d. Forwards have default risk
[25]
[100]
(CIMA ADAPTED) 

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