CORPORATE FINANCE CASE STUDY 2021

Namib Mills, an established manufacturer of consumer goods, expects its sales to remain flat for the next three to five years due to both weak economic outlook and an expectation of little new industrial technology development over that period. Based on that scenario the firm's management has been instructed by the Board of directors to institute programs that will allow it to operate more efficiently, earn higher profits, and most importantly maximize shareholder wealth. In this regard, the firm's chief financial officer (CFO), Theo van Zyl, has been tasked to evaluate the firm's capital structure, dividend policy, inventory management strategy, and possible capital projects as well as measuring the corporation's cost of capital. Currently the firm has a fixed total capital of $10, 000,000, which is made up of 20 percent debt and 80 percent equity. The firm has 100,000 outstanding ordinary shares and no preference shares. Although Theo feels that the firm's current policy of paying out 60 percent of each year's earnings in dividends is appropriate, he believes that the current capital structure may lack adequate financial leverage. In order to evaluate the firm's capital structure, Theo is considering three alternative capital structures - A (30 percent debt ratio), B (50 percent debt ratio), and C (60 percent debt ratio). The interest rate on current debt is 10 percent and is believed to remain the same up to a borrowing limit of $1,000,000. Theo expects the firm's current earnings before interest and taxes (EBIT) to remain at $1,200,000. The firm expects to have $200,000 of retained earnings available in the coming year. The firm has a tax rate of 40 percent.

Namib Mills is considering replacing one of its milling machines with either of two machines -A or B. Machine A is highly automated, computer controlled; machine B is less expensive and uses standard technology. In order to analyze these alternatives, Theo prepared estimates of the initial investment and the relevant incremental cash inflows associated with each machine.

These are summarized in the following table:

Machine A Machine B

Initial investments $360,000 $160,000

Year Profits after tax Cash inflows Profits after tax Cash Inflows

1 $165,000 $200,000 $45,000 $88,000

2 $350,000 $482,000 $65,000 $120,000

3 - - $160,000 $220,000

At the end of their life spans each machine will be sold, thus accounting for the final year cash inflow. The possible returns on the two machines will depend on the economic conditions.

Suppose the corporation has made the following estimates of the rates of return and probabilities for pessimistic, most likely, and optimistic results:

Machine A Machine B

Annual rate of return Probability Probability

Pessimistic 20% 0.25 15% 0.20

Most likely 25% 0.50 25% 0.55

Optimistic 30% 0.25 35% 0.25

Required:

Question 1 (20 marks)

a)How much interest will be paid on debt in the current and proposed capital structures? (3 marks)

b)What is the current share price? (2 marks)

c)Assuming that the share price stays the same, calculate the earnings per share for the three financing alternatives. (9 marks)

d)What is the level of EBIT at the point of indifference? (3 marks)

e)Find the dividend cover for the three financing alternatives (3 marks)

Question 2 (15 marks)

(a) Calculate the NPV for each machine. (3 marks)

(b) Use the common life approach to evaluate the two machine. (4 marks)

(c) Determine the expected value of return for each machine. (4 marks)

(d) Calculate the coefficients of variation for the returns of the two machine. (4 marks)

Question 3 (15 marks)

In assessing the cost of capital, Theo has the following information which has been compiled about the company's current costs of two sources of capital:

Source of capital Range of new financing Cost

Long-term debt $0 to $1,000,000 10%

$1,000,001 and above 11%

Common stock equity $0 to $2,000,000 13%

$2,000,001 and above 14%

Retained earnings

12%

In terms of inventory management, Namib Mills uses 2,500 tones of maize per week and then reorders another 2,500.

(a)Calculate the breakpoints associated with the firm's financial situation for the current and proposed capital structures? (3 marks)

(b)Calculate the weighted cost of capital associated with the current and the proposed capital structures below the breakpoints in (a). (6 marks)

(c)Calculate the weighted cost of capital associated with the current and the proposed capital structures above the breakpoints calculated in (a). (6 marks)