MAC3702_ Exam_ Practice_ Questions With Answers.

MAC3702_ Exam_ Practice_ Questions With Answers ( October 2021). MAC3702 - Application Of Financial Management Techniques. Management is of the opinion that the company should manufacture its own brand of lenses and has decided to invest in a new, state-of-the-art spectrophotometer. The new investment by the company is considered to be a very high risk, as success is dependent on the ability to export a high proportion of manufactured lenses. The spectrophotometer costs R2 400 000 and has an expected useful life of six years and nil scrap value. The machine will be written off in equal annual instalments, as allowed by the SARS, over three years. The maintenance costs are expected to be nil in the first year and R25 000 in the second year, rising by R25 000 in each of the subsequent years. These costs can be assumed to be paid at the end of the year in which they are incurred. The following purchase options have been identified by management: 1 A six-year bank loan at a before tax cost of 20%. 2 Issue 10% preference shares that will be converted to ordinary shares at the end of six years. 3 As an alternative to purchasing the spectrophotometer, the company could lease it. Two types of leasing agreements have been proposed: Type 1 This lease would run for six years at a cost of R550 000 per annum, payable at the beginning of each year. After six years, Optical Illusion Ltd could purchase the asset for a nominal amount. Optical Illusion Ltd would not be responsible for the maintenance of the machine and the lease would not be cancellable. Type 2 This lease would run initially for three years at a cost of R750 000 per annum, payable at the start of the year. At the end of the three years, the lease could be renewed for a further three years at a cost of R450 000 per annum, payable at the start of the year. The leasing company would be responsible for the maintenance of the machine. The lease would be cancellable by Optical Illusion Ltd at any time after the first twelve months. There would be no cancellation charges. The current company tax rate is 40%. The asset is to be purchased or leased on 1 October 20X0. The company’s year-end is 31 December and company tax is paid nine months after the end of the accounting period to which it relates. MAC3702/Exam Practise Questions 2 Required: Prepare a report for the directors of Optical Illusion Ltd advising them on – (i) how the financing decision should be evaluated; (ii) the advantages and disadvantages of each proposed finance option; and (iii) how the spectrophotometer should be financed. Solution: Report on acquisition of spectrophotometer To: Board of Directors, Optical Illusion Ltd From: Subject: Financing of spectrophotometer 1 Purpose of report The acquisition of the spectrophotometer has been approved by the Board of Directors. This report will concentrate on – (i) an evaluation of the financing decision; (ii) the advantages and disadvantages of the different forms of finance; and (iii) advice on the best form of finance. 2 Evaluation of the financing decision Once a company has evaluated the investment of a project and found that it yields a positive NPV, the next step is to decide on the best form of finance. There are two options that a company must choose from – (a) finance the asset using equity finance; or (b) finance the asset using debt finance. One cannot simply finance an asset using the cheapest form of finance, as consideration must be given to the current D:E ratio in relation to the target D:E ratio. Where a company already has too much debt in its capital structure, it will have no option but to finance expansion through equity finance. No information is given in this case, and the options available are: Equity finance – (i) issue equity shares; or (ii) issue preference shares with conversion rights; or (iii) raise equity finance annually, and purchase the asset via the operating lease option. MAC3702/Exam Practise Questions 3 Debt finance – (i) a long-term loan at 20% per annum interest; or (ii) a financial lease; or (iii) borrow annually, and purchase the asset via the operating lease option. Conclusion: The company must evaluate its asset gearing and choose whether the equity route or the debt route is in the best long-term company interest. Note: The operating lease is not a form of finance. It is simply the cost of an investment that, if selected, will have to be financed either by equity or by debt. 3 Advantages and disadvantages of the finance options (a) 10% preference shares The use of preference shares in this instance is the same as financing through an ordinary share issue, as the preference shares have conversion rights to ordinary shares. Advantages The cost of financing the preference shares for the first six years is relatively low, at 10% after tax. If the investment proves to be a failure, the risk and potential loss will be shared by the new issuers of finance. It will improve the existing D:E ratio. Disadvantages Should the investment prove to be a success, all future profits will be diluted, as the new shareholders will have an equal stake in future profits. (b) Loan finance Loan finance should only be considered where the company has the capacity to finance new projects through debt. In this situation, it is not known whether the company has the capacity. Advantages The after-tax cost of finance is lower than financing through equity. Disadvantages The high risk of acquiring the machine means that there is a high probability that the investment will be a failure and the company will be stuck with both an asset that will be hard to re-sell and a high annual debt. Therefore, the company must be sure that it will have a real need for this machine for the duration of its useful life. In addition, maintenance costs escalate rapidly. As a result, the company must be sure that it has been provided with reasonable estimates of these costs. It would be advisable to determine whether a long-term maintenance contract can be obtained to allow the company to control this important cost. The new loan required for the acquisition will affect the balance sheet ratios of the company, and insofar as these influence potential providers of capital in the future, the company’s ability to raise new finance may be adversely affected. MAC3702/Exam Practise Questions 4 (c) Type 1 lease The calculations in Appendix I of this report show that the decision to finance via this arrangement will have a present value cost of R1 628 330. This alternative has the typical feature of a finance lease, that is all the risks and rewards of the ownership of the asset are transferred to the lessee. The lease is non-cancellable. It makes very little difference whether the company chooses to borrow or to arrange a finance lease. The same risks are involved, with the same effect on the balance sheet of the company. It is a matter of comparing the two alternatives simply on a cost basis. Although no writingdown allowances are available, the lease payments are allowable as tax deductions; thus the tax liability of the company is reduced. One argument for leasing the machine rather than buying it may be that there is some likelihood of public liability arising from its operation which could be left with the lessor under a lease agreement. Equally, the company would need to be sure that there are adequate taxable profits to absorb all the lease payments. Type 2 lease This option has the features of an operating lease, that is it is cancellable, provides for maintenance and the risk of ownership is left with the lessor. This form of lease is attractive to the lessee when acquiring assets that have a high risk associated with ownership, for example assets that are subject to rapid technological change – this may be the case with the spectrophotometer, as indicated above. Thus, although this appears the most expensive of the options, this point alone may lead to the choice of this form of lease. There is no logic for making short-term apparent savings if it leads to an incorrect long-term decision. In addition, there is no requirement to capitalise operating leases in the same way as finance leases, that is they remain ‘off the balance sheet’. Therefore, the possible complications raised in the gearing discussion above do not apply. Once again, it must be mentioned that this type of investment decision will require finance, which may be debt or equity. It should be noted that there is no difference in the tax treatment of rental payments made under financial or operating leases; therefore this is not a factor to consider in deciding between them. 4 Financing of the spectrophotometer Where the company does not have the capacity to take on debt, it should finance the project through preference shares. Should the company choose to go the debt route, the best option would be to choose the Type 1 lease, but the possibility that the spectrophotometer may be obsolete before the end of its useful life should be borne in mind. As the investment carries a high risk of failure, it would in our opinion be wise to use the operating lease finance option, as it is cancellable. However, the increased costs amount to R222 000. This option should only be considered if the investment NPV is positive by an amount greater than the incremental cost of using the finance rather than the operating lease. MAC3702/Exam Practise Questions 5 Appendix I Loan finance Year R’000 PV Factor PV R’000 Investment 0 -2 400 1 -2 400,000 Wear-and-tear 1 800 × 40% 320 0,893 285,760 2 800 × 40% 320 0,797 255,040 3 800 × 40% 320 0,712 227,840 Maintenance 2 -25 0,797 -19,925 3 -50 0,712 -35,600 4 -75 0,636 -47,700 5 -100 0,567 -56,700 6 -125 0,507 -63,375 Tax allowance on maintenance 3 25 × 40% 10 0,712 7,120 4 50 × 40% 20 0,636 12,720 5 75 × 40% 30 0,567 17,010 6 100 × 40% 40 0,507 20,280 7 125 × 40% 50 0,452 22,600 NPV -1 774,93 Lease finance Type 1 PV factor PV Year R’000 12% R’000 Annual payment 0–5 – 550 *4,605 – 2 532,75 Tax allowance 1–6 550 × 40% 220 4,111 904,42 – 1 628,33 *Annuity factor for 5 years 3,605 + 1(PV for 1 year) = 4,605 MAC3702/Exam Practise Questions 6 Lease finance Type 2 (assuming that debt finance is accepted for this investment option) PV factor PV Year 12% R’000 Annual payout 0 – 750 1 – 750,00 1 – 750 0,893 – 669,75 2 – 750 0,797 – 597,75 3 – 450 0,712 – 320,40 4 – 450 0,636 – 286,20 5 – 450 0,567 – 255,15 Tax allowance 1 750 × 40% 300 0,893 267,90 2 750 × 40% 300 0,797 239,10 3 750 × 40% 300 0,712 213,60 4 450 × 40% 180 0,636 114,48 5 450 × 40% 180 0,567 102,06 6 450 × 40% 180 0,507 91,26 -1 850,85