Chapter 13 Sources of Finance:

Class exercise solutions

13-4

A firm will prefer to borrow on a variable rate basis if the firm expects interest rates to fall over the
term of the loan.

A firm will prefer to borrow on a fixed rate basis, if interest rates are low and the firm expects interest
rates to rise over the term of the loan.

A firm will prefer to borrow on a fixed rate basis if it wishes to fix its borrowing costs. The firm may
have purchased plant and equipment, which is providing a certain return and the company wishes to
ensure that the project remains profitable by entering into a fixed rate loan. This is particularly
relevant for companies that purchase equipment and lease the equipment to companies at a fixed lease
charge over the term of the lease. The firm wishes to fix its interest costs as its revenue is fixed.

Assume that interest rates follow the state of the economy so that the Reserve Bank reduces interest
rates when the economy is struggling. If the firm’s sales are linked to the state of the economy, then
the firm may wish to borrow on a variable rate basis.

13-5

The suppliers of loan finance have a right to fixed income whereas the fortunes of shareholders
fluctuate more directly with those of the company.

From the company's point of view the fixed commitment to meet the interest on loan finance adds to
the risk to equity holders. However this is a relatively inexpensive form of finance.

13-6

a) EPS is arrived at after deducting interest; therefore if the return on assets is higher than the
interest rate (as it should be) higher financial leverage will increase the EPS.

b) The higher interest burden, which is a fixed cost, will cause the earnings stream to become
more volatile.

c) Operating leverage is calculated before taking into account the costs of financing the
business, therefore there is no effect. However, there may be indirect effects. Companies with a high
level of financial leverage may be motivated to reduce the level of operating leverage when investing
in projects.
13-7

The primary market is where firms obtain funds to finance an expansion in operations. For example,
a firm may make a rights issue or undertake an initial public offering to raise funds. In a secondary
market, firms are not directly involved and shareholders will buy and sell shares without any
transaction having a direct effect on the company. Of course, if a company’s shares have risen in
price in the secondary market, then this will mean that the company can raise finance in the future at a
lower cost in the primary market.

However, the question refers to primary and secondary issues and this relates to how a company
obtains funds in the capital markets. A primary issue relates to an initial public offering by the
company where the company issues shares to the public and obtains a listing on the JSE. A secondary
issue refers to either a rights issue or placement that a company undertakes after the initial listing. For
example, if Comair wishes to obtain funds to finance the investment in new aircraft, then it will make
a secondary issue by going to the market and making a rights issue to existing shareholders, a
placement or public offering of shares.
13-8
Moqhaka Ltd is considering two loan alternatives. In terms of the first alternative, the
company would repay the full loan in equal instalments over the machine’s useful life of 5
years. This would result in the amortisation of the loan and the payment of interest over the
5 year period.

Using Excel to determine a loan amortisation schedule, we get the following;

C D E F G H
3 Pmt determination I nterest = beg.
4 Loan 15,000,000 $D$4/((1-(1/(1+$D$5)^$D$6))/$D$5 Balance x interest
5 Interest 9% rate
6 Term 5 +D9*$D$5
7
8 Year Beg.Bal Payment Interest Principal End. Bal.
9 1 15,000,000 3,856,387 1,350,000 2,506,387 12,493,613
10 2 12,493,613 3,856,387 1,124,425 2,731,962 9,761,651
11 3 9,761,651 3,856,387 878,549 2,977,838 6,783,813
12 4 6,783,813 3,856,387 610,543 3,245,844 3,537,970
13 5 3,537,970 3,856,387 318,417 3,537,970 0
14 Total 19,281,934 4,281,934 15,000,000

We can use a formula, Table D or a financial calculator to determine the equal instalment. In
terms of using the formula, this is what we have done in the above table.

Using formula: Using tables:

( )
PV = PMT x PVIFA5, 9% (Table D)
1−1 n
(1 + r ) 1500,000 = PMT x 3.8897
PV=PMT×
r PMT = 15000,000  3.8897

( )
1
1−  3 856 339
( 1. 09 )5
1 5000,000=PMT×
0. 09
1 5000,000=PMT×3 .88965
1 5000,000
PMT=
3 . 88965
PMT≈3 856388

Using a financial calculator to determine the annual instalment.

N I/YR PV PMT FV
5 9% -15,000,000 3,856,387 0
13-8 (continued)
What would the payments be if the loan principal was repayable in a bullet payment at the
end of the loan period? Although this is not required in terms of the question, it indicates the
very different cash flow streams from either repayment schedule.

A B C D E F G H
17 Cash Flows 0 1 2 3 4 5
18 Loan with equal instalments -3,856,387 -3,856,387 -3,856,387 -3,856,387 -3,856,387
19 or
20 Loan with capital payable at end of term -1,350,000 -1,350,000 -1,350,000 -1,350,000 -16,350,000
21
22 Workings
23 Final repayment + interest
24 Loan capital 15,000,000
25 Interest for the year 1,350,000 [9% x R15m]
26 16,350,000

In terms of the 2nd alternative indicated in the question, the company will match the cash flow
from the sale of the plant at the end of its useful life to the loan repayment, so that the
residual value will be used to pay the capital balance outstanding at the time. This will
reduce the annual instalment over the life of the plant as the company is only paying off a
part of the cost. [The same principle applies to the purchase of a motor vehicle whose
instalments take into account the residual value at the end of the term of the loan].

In terms of the 2nd alternative, we need to repay the capital and interest on R9000 000 plus
the interest on the capital of R6000 000 outstanding over the term of the loan.

C D E F G H
3 Pmt determination I nterest = beg.
4 Loan 9,000,000 $D$4/((1-(1/(1+$D$5)^$D$6))/$D$5 Balance x interest
5 Interest 9% rate
6 Term 5 +D9*$D$5
7
8 Year Beg.Bal Payment Interest Principal End. Bal.
9 1 9,000,000 2,313,832 810,000 1,503,832 7,496,168
10 2 7,496,168 2,313,832 674,655 1,639,177 5,856,991
11 3 5,856,991 2,313,832 527,129 1,786,703 4,070,288
12 4 4,070,288 2,313,832 366,326 1,947,506 2,122,782
13 5 2,122,782 2,313,832 191,050 2,122,782 0
14 Total 11,569,161 2,569,161 9,000,000

Residual Interest rate Interest

Annual interest on the residual 6,000,000 9% 540,000

Instalment 2,313,832
Interest on the residual 540,000
Annual amount 2,853,832

We are able to reduce the annual instalment by about R100 000 per year by including the
expected residual value into the determination of the annual instalment. This will assist
companies in terms of cash flow and reducing the risk of not making a repayment within the
period of the loan.
13-9

No. of shares Price R

Existing 9,000,000 x 6.00 = 54,000,000

New 1,000,000 x 5.00 = 5,000,000
10,000,000 59,000,000

Theoretical value of shares after the rights issue = 59,000,000

10,000,000

= 5.90

Subscription price 5.00

Value of each right 0.90

Dorothy currently owns 900 shares.

The rights issue is one share for every 9

What is her wealth if she takes up the rights?

Value of shares No. shares Ex-rights price Value
Number of shares 900
Shares received in terms of rights offer 100
1000 x 5.90 = 5,900.00

Less: cost of shares in terms of rights issue 100 x 5.00 = 500.00

5,400.00

What is her wealth if she does not take up the rights and sells the rights?

Value of shares will be 900 x 5.90 = 5,310.00

Value of rights sold 100 x 0.90 = 90.00
5,400.00
Dorothy's wealth will not change whether she sells the rights or takes up her rights.
13-10

a Number of shares to be issued

Funding from rights issue 42,000,000
Subscription price 9.00
Number of shares to be issued 4,666,667

b Number of shares to 1 right

Number of shares to be issued 4,666,667 a
Total no. of shares prior to rights issue 30,000,000 b
Number of shares to 1 right 6.4286 b/a

No. of shares
c Ex-rights price Share price
per right
Value of shares prior to rights issue 12.00 6.429 77.14
Subscription price 9.00
86.14

No. of shares held after the rights issue 7.43

Estimated ex-rights price 11.60

Alternatively, we can determine the ex-rights price as follows;

Share price No. of shares Total Value
Value of shares prior to rights issue 12.00 30,000,000 360,000,000
Financing from rights issue 42,000,000
Total value 402,000,000 c
Prior to issue Rights issue
Total no. of shares after the rights issue 30,000,000 4,666,667 34,666,667 d

Estimated ex-rights price 11.60 c/d

d Estimated ex-rights price 11.60

Subscription price 9.00
Value of Right 2.60