COPPERRBELT UNIVERSITY

SCHOOL OF GRADUATE STUDIES

GAF 520: ADVANCED CORPORATE FINANCE

ASSIGNMENT ONE

INSTRUCTIONS:
ANSWER ALL QUESTIONS AS FULLY AS POSSIBLE

DUE DATE: 20 JUNE, 2014

Mr. Donald Mwenya

donmwenya@yahoo.com

Question 1.
The Treasurer of a new venture is trying to determine how to
raise K6,000,000 of long-term capital. Her investment advisor
has devised the following capital structure:

Alternative A:

Alternative B

K2,000,000

9%debt

K4,000,000

K4,000,000

Equity

K2,000,000

12% debt
Equity

If alternative A is chosen, the company would sell 200,000 shares

of common stock to net K20 per share. Shareholders would
expect an initial dividend of K1 per share and a dividend growth
rate of 7 percent.
If alternative B is chosen, 100,000 shares of common stock would
be sold to net K20 per share. The expected dividend would be
K0.90 per share and the expected dividend growth rate would be
12 percent.
Assume that the company earns a profit under either capital
structure and that the effective tax rate is 35 percent. What is
the cost of capital to the company under each alternative? What
alternative should the Treasurer adopt and why?
In general, other than the cost of capital, what considerations
should be taken into account when a company wants to use debt,
preferred stock and/or equity in its capital structure.
(25 marks)

Question 2.
(a) Explain both the traditional and the Modigliani-Miller
(M &M) theories of capital structure.

(b) How does leverage or gearing affect the cost of capital

under both theories?
(c) Clearly describe M & M
propositions 1 and 2 with respect to the value of the firms,
the cost of equity and the overall cost of capital.
(d)How can the Capital Asset Pricing Model (CAPM) be
used to estimate a companys cost of capital?
(25 marks)
Question 3.
a

Describe the major methods used in capital investment

decisions specifically stating how projects are analysed
under such methods.
(20 marks)

What are the most critical problems that arise in calculating

a rate of
return for a prospective investment? What other factors
should be

considered
(15 marks)
c

in

determining

capital

expenditures?

It is argued that leasing (instead of buying to own) is an

alternative way for a company to have the economic use of a
capital asset. What types of leases are there and what are
their main features? What advantages, if any, does leasing
have over owning?
(15
marks)

REVIEW OF BASIC CONCEPTS IN CORPORATE FINANCE

QUESTION 1

a Zulu is 55 years old and recently retired. He wishes to provide

retirement income for
himself and is considering an
annuity contract with ZSIC. Such a contract pays him an equal
amount each year he lives. ZSIC expects Zulu to live another
20 years and that is the duration it bases its calculations.
i

If ZSIC uses an interest rate of 14% in its calculations,

what must Zulu pay at the outset for an annuity of
K24,000,000 per year? (Assume payments are at the end
of the year).
(8
marks)

ii

What if Zulu had K200,000,000 to put into the annuity,

how much would he receive each year at 14%?
(8 marks)

b Two individuals are each offered K20,000,000 in 5 years time.

They are both trying to assess its value to them now. The first

individual states that her current cash equivalent is

K12,400,000 while the other states that his current cash
equivalent is K13,600,000. Explain how such differences might
arise.
(9 marks)

(Total: 25 marks)
QUESTION 2
a

Tusha Ltd is currently growing much faster than the economy. Expected growth of
the company is 12 percent for the next 3 years, then it is expected to settle down
to a constant 5 percent growth rate thereafter. The dividend last year was K2.50
and investors require a 12 percent return on the stock.
What is the present price of the stock, assuming you want to hold it even after
the period of supernormal growth?
(10 marks)

(b) The Tusha Investment Fund has a total investment of K400 million in five stocks:
Stock

Investment

Stock's Beta Coefficient

K120 million

0.5

100 million

2.0

60i million

4.0

80 million

1.0

40 million

3.0

The current risk-free rate is 7 percent, while expected market returns have the following
estimated probability distribution for the next period:
Probability

Market Return

0.1

8%

0.2

10

0.4

12

0.2

14

0.1

16

(i) What is the estimated equation for the security market line (SML)?

(10 marks)

(ii) Compute the fund's required rate of return for the next period.

(5 marks}

(Total: 25 marks)

QUESTION 3
a

Sakala promises to pay you K240,000 in a years time for lending him
K225,000 now. The market rate of interest for risk-free assets is 8 percent.
How much is the promise worth to you? Would you take the offer? Why or
why not? Show calculations in your answers.
(6 marks)

A bank trust officer needs to include fixed income securities in a portfolio for
a client. As an analyst for the trust department, you are asked to provide the
following information on two independent securities.
i

What is the current yield and yield to maturity on Zeko bond with a
coupon rate of 10 percent which matures in 10 years? The bond
recently traded for 110 percent of its K1,000 par value on the LuSE.
Interest is paid annually.
(8 marks)

ii

What should be the market price of a K1,000 par value Safeway bond
trading on LuSE which has a 10 percent coupon rate, matures in 5
years, and the market rate is currently 10 percent? Interest is paid
semi-annually.
(5 marks)

(Total: 19 marks)
QUESTION 4

Trends Ltd has developed the following data regarding the rates of return
available on a project (A) and on the market (M):

State of Economy
Ra
Depression
0.10
Average
0.20
Boom
0.30

Probability

0.20

Rm

0.15

0.50

0.20

0.30

0.25

Financial analysts estimate the risk free rate at 10%.

i

What are the expected rates of return on the market and the project?
(6 marks)

ii

What is the markets beta? The projects?

(4 marks)

iii

What is the required rate of return on the project according to the

CAPM?
(3 marks)

iv

Should the project be accepted? Explain.

(4 marks)
(Total: 25 marks)

QUESTION 5
a

You can buy a note for K2,283,500. If you buy it, you will receive ten annual
payments of K355,800, the first payment to be made one year from today.
What rate of return, or yield, does the note offer?
(5 marks)

ABCs 5 percent coupon rate bonds have exactly 10 years remaining to

maturity. The current price of one of these K1,000-par-value bonds is K850.
Interest is paid semi-annually. You place a required rate of return of 12
percent on these bonds. What price should you place on each of these

bonds? Would you buy the bond? Explain.

(5 marks)
c

Assume that it is December 2011. On January 1,2012, you will deposit

K1,000,000 into a bank account that pays 12 percent interest.
i

If interest is compounded quarterly, how much will you have in your

account on January1, 2016?
(5 marks)

ii

Suppose you deposited 4 equal payments in your account on January

1,2012, 2013, 2014 and 2015. How large would each of your payments
be for you to obtain the same ending balance you calculated in (i)
above? Interest is still compounded quarterly.
(5 marks)

d A treasury note is available in the market. It pays interest of K100 per year
and K1,000 at maturity two years from now. If the note is currently selling at
K1,150, what is the approximate yield to maturity?
(5 marks)
(Total: 25 marks)

END OF ASSIGNMENT