MZUMBE UNIVERSITY
SCHOOL OF BUSINESS
FIN 223 SELF TEST QUESTIONS
QUESTION ONE
The HEEKS Associates Company Ltd. purchased a special machine one year ago at a cost of
TZS.12 million. At that time the machine was estimated to have a useful life of 6 years and no
salvage value. The annual cash operating cost is approximately TZS.20 million. The HEEKS
Associates Company Ltd is planning to replace the old machine with a new machine which has
just come in the market and will do the same job but with an annual cash operating cost of only
TZS.17 million. This new machine costs TZS.21 million and has an estimated life of 5 year with
zero salvage value. The old machine can be sold for TZS.10 million. Straightline depreciation is
used, and the company’s income tax rate is 40%. Assume a cost of capital of 8% after taxes.
Required: Calculate:
i. The cost of initial investment of the new machine
ii. The incremental cash inflow after taxes
iii. The Net Present Value (NPV) of the new investment; and
iv. The Internal Rate of Return (IRR) of the new investment.
QUESTION TWO
Zahra Entertainment Company has developed a new type of digital recorder. If the firm directly
goes to the market with the product, there is only a 50% chance of success. On the other hand, if
the firm conducts test marketing of the recorder, it will take a year and will cost TZS.4 million.
Through the test marketing, however, the firm is able to improve the product and increase the
probability of success to 75%. If the new product proves successful, the present value of the payoff
(at the time when the firm starts selling it) is TZS.40 million, while if it turns out to be a failure,
the present value of the payoff is TZS.10 million.
Required: If the discount rate is 15% should the firm conduct the test marketing or go directly to
the market?
QUESTION THREE
The Financial Director of RIQUE General Ent. Industries is reviewing two alternative schemes for
building and running new laboratories. The choice is between a low cost conventional building
and a high tech building. Features of the latter option included: optimum orientation of the
Building structures; less glazing; north facing roof lights; photo sensitive override controls for the
lighting windows; double glazing; cavit wall installation. Estimates of the building costs and
running costs (in terms of present day prices) for the estimated 50 years life of the laboratory are
as follows:
Conventional Hi-tech
(TZS ‘000’) (TZS‘000’)
Design, construction and installations 14,000 16,000
Annual running costs:
Labour 260 260
Energy 100 50
Materials 10 10
Depreciation 280 320
Maintenance costs:
Labour 160 120
Material 70 50
Demolition and disposal costs 100 100
Required: Assuming a four per cent cost of capital, which alternative is cheaper for RIQUE
General Ent.?
QUESTION FOUR
Malaet Ltd is considering manufacturing a new product. This requires machinery costing TZS 20
million with a life of four years and a terminal value of TZS 5 million. Profits before depreciation
from the project will be TZS.8 million per annum. An investment of working capital of TZS 2
million will be required for the duration of the project. Tax allowances on the machine are 25%
p.a. on reducing balance. At the end of the project’s life a balancing charge or allowance will arise
equal to the difference between the scrap proceeds and the tax written down value.
Tax is payable at a rate of 35%. Tax cash flows on profits occur in the same year as the profits
giving rise to the tax charge. The cost of capital is 15%.
Required: Evaluate whether the project should be accepted or not.
QUESTION FIVE
Angumiliki Ltd has in issue 8 million shares with an ex-dividend market value of TZS.716 per
share. A dividend of TZS.62 per share for 2015 has just been paid. The pattern of recent dividends
is as follows:
Year 2012 2013 2014 2015
Dividends per share TZS 55.1 57.9 59.1 62.0
Angumiliki Ltd also has in issue 8.5% bonds redeemable in five years’ time with a total nominal
value of TZS.500 million. The market value of each TZS.10,000 bond is TZS.10,342. Redemption
will be at nominal value.
Angumiliki Ltd is planning to invest a significant amount of money into a joint venture in a new
business area. It has identified a proxy company with a similar business risk to the joint venture.
The proxy company has an equity beta of 1.038 and is financed 75% by equity and 25% by debt,
on a market value basis.
The current risk-free rate of return is 4% and the average equity risk premium is 5%. Angumiliki
Ltd pays profit tax at a rate of 30% per year and has an equity beta of 1.6.
Required:
(a) Calculate the cost of equity of Angumiliki Ltd using the dividend growth model.
(b) Discuss whether the dividend growth model or the Capital Asset Pricing Model (CAPM)
should be used to calculate the cost of equity.
(c) Calculate the weighted average after-tax cost of capital of Angumiliki Ltd using a cost of
equity of 12%.
(d) Discuss whether changing the capital structure of a company can lead to a reduction in its
cost of capital and hence, to an increase in the value of the company.
QUESTION SIX
It is rightly argued that the principal objective of a corporate firm is maximizing shareholder’s
wealth. However, the actions taken by a company are decided upon by its managers (directors).
Typically, managers will have their own objectives which could conflict with those of the
shareholders and other interested parties.
Required: Enumerate and discuss any five specific examples of the conflicts of interest that might
occur between managers and shareholders.
QUESTION SEVEN
The Thompton Company Ltd is facing an option to develop two models of the same product:
Model A and Model B. Both models are expected to be hot sellers for the next two years. The
capital expenditure involved in the development of model A is TZS.2,250 million while Model B
costs TZS.2,500 million. Because of familiarity of the existing users, Model A which is an
improved version of the existing one, it offers a certain cash flow of TZS.1,400 million in the first
year and TZS.1,800 million for the next year.
In respect of Model B, Thompton Ltd is not very sure of the cash inflows. It expects a cash inflow
of TZS.1,500 million in the first year with 70% probability. However, the product may do better
to yield a cash in flow of TZS.1,800 million with the probability of 30%. The cash inflows in the
second year are dependent upon what happens in the first year. If the firm faces a normal cash
inflow of TZS.1,500 million in the first year, the chances are that it would repeat with probability
of 30%, improve to TZS.1,800 million with a probability of 40%, and do exceptionally well with
cash inflow of TZS.2,200 million with a probability of 30%. If the firm faces better prospects in
the first year, the chances are that it would have second year cash inflows of TZS.2,200 million,
TZS.2,300 million and TZS.2,500 million with probabilities of 50%, 30% and 20% respectively.
Required: Examine both models and recommend to Thompton Company Ltd which of the two
models they should go ahead with. Assume a cost of capital of 12%.
QUESTION EIGHT
Mr. Rique is a local entrepreneur doing business in Dar es Salaam. For long time, Rique has been
considering investing his money in the stock market. He approaches a stockbroker about investing
in stocks. The stockbroker gave Rique two stock options that he can invest in; Stock X and Stock
Y. The stockbroker further tells Rique that the economy can either go in recession or it will boom.
Upon further enquiry Mr. Rique established that the likelihood of observing an economic boom is
two times as high as observing an economic recession. He also learnt the following regarding the
possible returns of the two stocks:
State of the Economy Rx Ry
Boom 10% -2%
Recession 6% 40%
REQUIRED:
a) For each stock calculate the expected returns and total risk (variance and standard
deviation).
b) Calculate the covariance of the returns of the two stocks.
c) Mr. Rique is considering to create two different portfolios. Portfolio I consists of 10%
invested in X and the reminder in Y, while Portfolio II has equal proportions in both stocks.
Compute the expected returns and risk of each portfolio and explain the risk-return
characteristic of each portfolio.
QUESTION NINE
WAMBALI Co. plans to buy a new machine. The cost of the machine, payable immediately, is
TZS.80,000,000 and the machine has an expected life of five years. At the end of the five years,
the machine will have no salvage value and will not be replaced.
Production and sales from the new machine are expected to be 100,000 units per year. Each unit
can be sold for TZS.1,600 and will incur variable costs of TZS.1,100. Incremental fixed costs
arising from the operation of the machine will be TZS.16,000,000 per year.
WAMBALI Co. has an after-tax cost of capital of 12% which it uses as a discount rate in
investment appraisal. The company pays tax on profit at an annual rate of 30%. Capital
allowances and inflation should be ignored.
REQUIRED:
Calculate and comment on the sensitivity of the investment in the new machine to a change in the
following variables:
(i) Sales revenue
(ii) Sales volume
(iii) Variable costs
(iv) Fixed costs
(v) Economic life
QUESTION TEN
Safari Company wishes to calculate its Weighted Average Cost of Capital (WACC) and the
following is the current information relating to the company.
Number of ordinary shares 2 million
Number of 5%, Tshs.100 non-callable preferred stock 1 million
Book value of 10%, Tshs.1,000, irredeemable bonds Tshs. 20 million
Market price of ordinary shares Tshs. 50 cum dividend
Market price of 5%, Tshs.100 non-callable preferred stock Tshs. 43 ex dividend
Total dividend just paid Tshs. 4 million
Market price of 10% Tshs. 1,000, irredeemable debt 105 percent ex interest
Equity beta of Safari company 1.5
Treasury bill rate 5%
Expected return on the market 12%
Additional information:
1. The corporate tax rate applicable to Safari company is 35%.
2. The dividends of Safari Company are expected to grow at an average rate of 6%.
REQUIRED:
(a) Estimate the Safari Company’s equity risk premium and the cost of equity using the Capital
Asset Pricing Model (CAPM). (3 marks)
(b) Calculate the market value Weighted Average Cost of Capital of Safari Company using:
(i) The dividend growth model
(ii) The Capital Asset Pricing Model (12 marks)
(c) Discuss whether the dividend growth model or the CAPM offers the better estimate of the
cost of equity of a company. (3 marks)
(d) Discuss the circumstances under which the weighted average cost of capital can be used in
investment appraisal.