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1)Consider two firms L and U which are identical in all aspects except for capital structure

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1)Consider two firms L and U which are identical in all aspects except for capital structure. The EBIT and cost of capital for each firm is Sh. 900,000 and 10% respectively. U is an all-equity financed firm while L has 7.5% of Sh.4, 000,000 debt.

a. Estimate the value of levered firm (L) and Unlevered firm (U) using Net Income (NI) approach;

b. Establish whether there is an arbitrage opportunity

c. Estimate the arbitrage profits if any by considering an investor who holds 10% of the stock of overvalued firm

2)Identify and discuss four inherent operational risk factors in terms of the business exposures and potential consequences that Mr Baloyi will face according to the business strategy. Explain possible mitigating measures that can be taken to minimise/eliminate the risk (The maximum length of your answer should be one page).

Scenario

The cement industry in South Africa is currently undergoing mixed sentiments by various economic and financial specialists. From an economic perspective, this industry should grow, especially in view of the growing property markets. There are several initiatives surrounding new housing and shopping complexes across the country, which is ensuring a growing market for building cement and related products. There are also opportunities to develop cement production facilities in African countries such as Ethiopia, Zimbabwe, Botswana and Rwanda. From a financial perspective, there seems to be a growing (bullish) trend in cement shares; however, this market might be influenced by cheap importers of cement from other countries such as Pakistan. Notwithstanding, it seems that this market will show a steady increase in the future, providing local and foreign investment opportunities. Due to these potential views of the cement market, there might be ample work opportunities, including for small and medium enterprises (SMEs).

In this regard, Mr Baloyi decided to investigate an SME to provide ready mixed cement to builders. He is aware that all SMEs are subject to specific risk exposures. As such, it is essential to determine if such an investment would be worth the risk. As a risk specialist, he approached you to analyse the following business and make recommendations.

The business involves the use of cement mixing trucks to provide ready mixed cement to builders for building purposes. To start such a business, it is imperative to get a licence from the appropriate government department and be a registered supplier of this product and service. Due to the price of these cement-mixing trucks, it will be an expensive business to start. The cost of one truck is R1.5m, and usually, two trucks are required to start such a business. It is also imperative to confirm a customer base to ensure that there is a market for the business. This would mean a detailed marketing campaign to advertise the business and to establish a customer base. The cost for such a campaign will amount to R500 000 and after that R50 000 per annum (This will only come into effect the second year after establishing the business). Furthermore, it is crucial that the business must have skilled employees. Firstly, skilled to ensure that the mixed cement consists of the correct volume of sand, stone, cement and water. Secondly, the drivers of the trucks must be trained and have a special license to drive these trucks and thirdly have the skill to operate the mechanics of the truck’s mixing machines. Training is thus, essential to ensure a successful business. The average training cost per employee will be R65 000, which will include the required license fees. In order to operate two cement trucks, the following staff members are required with an annual compensation package:

2 x truck drivers R470 000 per driver
2 x machine operators R350 000 per operator
2 x Cement mixing specialists R225 000 per specialist
1 x Administration officer R300 000

To employ the above staff members, it is required that the total annual compensation must be available upfront in order to protect the employees for at least a year should the business fail.
The trucks require a maintenance service after 20 000 km. A normal service costs approximately R8 500 and the average distance per month for a truck is about 10 000 km. To ensure that the trucks operate at their full capacity, these maintenance services are crucial. Should a truck break down, it will cause a major problem for Mr Baloyi in the sense that he will incur penalties for not delivering cement on specified times.

One truck can provide three loads of cement per day which will ensure a net income of R16 000 (after the cement, sand and water costs). Mr Baloyi envisaged that he would provide cement for only 20 days per month, which will allow him time for the maintenance of the trucks on a monthly basis. The building industry closes during the months of December and January each year, meaning that there are only ten months available for business.

A potential problem that Mr Baloyi will face is the availability of cement which could be influenced by strikes at the cement factories. As such, Mr Baloyi must make provision for these incidents should they occur. Another potential threat to this business is the exposure to road accidents involving the trucks. Since the trucks form the basis of this enterprise, Mr Baloyi must be insured against accidents. This is also essential to cover any third-party claims against the business such as the non-delivery of cement as per agreed times as well as claims from other accident victims. Potential monthly insurance premiums are:

· R5 500.00 per month (12 x months) per truck (including third party costs) for accidents.
· R2 500.00 per month (12 months) to insure against claims for non-delivery.

The availability of skilled and trained drivers on these cement trucks are scarce in South Africa and should one of the drivers fall ill or want to go on leave. Mr Baloyi will have a serious problem to achieve his business objectives. Furthermore, the availability of diesel could be a problem if the country experiences a shortage. This is a high possibility which could also negatively influence the business. The safety of the trucks also requires attention, and they must be parked in a safe environment when they are not in use. In this instance, Mr Baloyi will have to rent buildings with adequate parking facilities and office space. These rental costs (including water and electricity) for a suitable building is R20 000 per month. Security is also vital to safeguard the equipment, which will cost R6 500 per month (including a 24-hour security guard) and rapid response from ABS Security. It is also imperative to ensure that there is a process to clean the trucks when not in use to ensure the longevity thereof. In addition, the trucks must be monitored in terms of its fuel usage; the oil services and the kilometres travelled to ensure that the trucks are serviced when it is due. It is therefore imperative that those above be technologically supported. A system for the business will cost R50 000 and R2 000 per month.

Due to the fact that the trucks make use of the public roads, it is eminent that the drivers are exposed to traffic fines resulting in possible legal action against the business. This should also be adequately addressed during the business strategy.

Mr Baloyi envisaged that to make the business worth his while, he must, at a minimum, receive a monthly income, before tax, of R90 000. The total tax implications for the business can be calculated at 28% on the gross income per annum. To ensure the continuity and the growth of the business, a minimum annual amount of R1 000 000 must be invested. Should this target not be achieved, the business will not grow and go bankrupt after five years (this is also the lifetime of the trucks and must be replaced after five years).

To start the business, Mr Baloyi is prepared to invest R5 000 000 into the business for ten years at 5% interest per year. The monthly amount for this loan is R67 870.

Question 2 (12 x Marks)
Identify and discuss four inherent operational risk factors in terms of the business exposures and potential consequences that Mr Baloyi will face according to the business strategy. Explain possible mitigating measures that can be taken to minimise/eliminate the risk (The maximum length of your answer should be one page).

3) What disclosure documents does a firm need to give potential investors when they would like to raise capital in the Australian financial market? Briefly explain the content of each document.

4)What are the benefits and challenges for a firm to be listed and traded on ASX?

5)What are the benefits and challenges for a firm to be listed and traded on ASX?