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1)Consider two firms L and U which are identical in all aspects except for capital structure
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?
Expert Solution
1)As per Net Income approach, the cost of equity will remain the same for both Levered and unlevered firms.
Value of Unlevered Firm U = EBIT / Cost of equity = Sh900000/0.1 = Sh. 9,000,000
In case of Levered firm,
EBIT = Sh.900000
Less Interest = Sh.400000 *7.5% =Sh.300000
EBT = Sh. 600000
PAT = Sh. 600000 (as there is no tax)
So, Value of Equity = Sh. 600000/0.1 =Sh. 6,000,000
Value Of Levered Firm L = Value of Equity + Value of Debt = Sh. 6000000 + Sh. 4000000 =Sh. 10,000,000
b)As per MM approach, the value of Levered firm and Unlevered firm should be the same in the absence of Taxes. As the value of Levered firm is higher than Unlevered firm, there is an arbitrage opportunity by selling the Levered firm and purchasing the Unlevered firm.
c) The arbitrage process works as below :
1) Sell 10% stock in the overvalued ie. Levered firm for Sh.600,000
2) Borrow 10% of Firm L's Debt i.e. Sh 400.000 at 7.5%, thus have a total of Sh. 1,000,000
3) Purchase 10% stock in the unlevered firm for Sh 900,000 and invest the remaining Sh 100,000 can be lent at 7.5%
Income resulting from the above = 10% of Firm U's earnings - interest on Sh400000 + interest on Sh 100000
= Sh 90000- Sh30000 + Sh7500 = Sh.67500
The 10% stock in Firm L provides annual earnings of Sh. 60,000
Thus, the investor is better off by an amount of Sh.7500 every year by the above arbitraage strategy which is the arbitrage profit
2)Business operational risks include:
1. Risk due to substitute product - Threat of substitute , as defined in porters five forces, plays as one of the major risks tge business is exposed to. As The market may be affected by cheap cement importers from other countries, such as Pakistan.
2 Risks faced due to potential legalizations in FDI rules - It appears that this sector will continue to expand in the future, offering local and foreign investment opportunities. Due to these possible views of the cement industry, there may be enough job opportunities, including for small and medium-sized enterprises ( SMEs). Regulatory obligations may hinder the same.
3. Costs of human resource- advance compensation package including
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
4. Insurance and additional overhead and maintainenece costs
The exposure to road accidents involving trucks is another potential threat to this company. Since the trucks form the foundation of this undertaking, Mr. Baloyi must be covered against accidents. This is also necessary to cover any claims raised by third parties against the company, such as non-delivery of cement as agreed times, as well as claims made by other accident victims.
The monthly armotization payment for the loan stands at 67870 for a 5Milln loann.
So The yearly payments goes upto
67870*12= 814,440.
So in order to achieve breakeven this point Mr Baloyi must have an Operating income of this amount considering the deferring of further tax obligations of 28% to next year in order to mitigate the operational risk.
3)
There are four types of disclosure document:
- a prospectus
- an offer information statement
- a profile statement, and
- a two-part simple corporate bonds prospectus.
Prospectuses
A prospectus is the most common type of disclosure document and has the broadest information requirements. If your prospectus offers securities listed on a prescribed financial market, it may not need to contain as much information as otherwise needed because much of the information will already been released to the market as part of your continuous disclosure obligations. For more information see Regulatory Guide 254 Offering securities under a disclosure document (RG 254).
Offer information statements
An offer information statement has lower disclosure requirements but can only be used for fundraising up to $10 million in aggregate - that is, including any earlier fundraising under an offer information statement. If you want to use an offer information statement you must be able to include with it a copy of an audited financial report with a balance date within the last six months. For more information, see RG 254.
Profile statements
A profile statement is a document setting out limited key information about the company and the offer. Companies can only use profile statements where ASIC has approved their use. There are currently no approved uses for profile statements.
Two-part simple corporate bonds prospectuses
Following amendments introduced by the Corporations Amendment (Simple Corporate Bonds and Other Measures) Act 2014, a specific disclosure regime applies to offers of 'simple corporate bonds', which must be offered under a two-part simple corporate bonds prospectus.
A two-part simple corporate bonds prospectus consists of:
- a base prospectus with a life of three years, which must include general information about the issuer that is unlikely to change over the three-year life of the document (and that may be released in advance of an actual offer of simple corporate bonds); and
- an offer-specific prospectus for each offer, which must include details of the offer and may update information contained in the base prospectus.
4)
PROSPECTUS is the document that a firm need to get ASIC's approval before they couduct IPO.
As a general rule, if you are a public company offering securities for sale (for example, shares or debentures) then you must provide a disclosure document to potential investors.
A disclosure document is the broad term used to describe all regulated fundraising documents for the issue of securities. THE DOCUMENT INCLUDE PROSPECTUS
All companies entitled to fundraise can use a prospectus. You may also be able to use an offer information statement or a profile statement depending on the type of fundraising you intend to do and whether you satisfy the restrictions imposed on using those documents. You must use a two-part simple corporate bonds prospectus for offers of simple corporate bonds. The type of information you'll be required to provide in each of these disclosure documents is different in certain respects.
Prospectuses
A prospectus is the most common type of disclosure document and has the broadest information requirements. If your prospectus offers securities listed on a prescribed financial market, it may not need to contain as much information as otherwise needed because much of the information will already been released to the market as part of your continuous disclosure obligations. For more information see Regulatory Guide 254 Offering securities under a disclosure document (RG 254).
Lodging prospectuses and other disclosure documents
You must lodge your disclosure document with ASIC before it can be used to raise funds. For more information see Regulatory Guide 254 Offering securities under a disclosure document (RG 254).
Lodge through the ASIC Regulatory Portal
You should lodge your fundraising disclosure documents with ASIC through the ASIC Regulatory Portal.
Applications for relief should also be submitted through the ASIC Regulatory Portal. Fees will apply to an application and details about payment options are provided in the portal. For more information see, how you apply for relief.
The portal features structured online transactions with mandatory fields and questions that make it easier for you to provide the information ASIC requires. Links to the relevant ASIC regulatory guidance are included.
You can no longer use ‘OFFERlist Entry’ to record summary information about your offer for exposure to the public.
Details of your offer will be shown on the public Offer Notice Board, as part of the portal lodgement process.
Offer Notice Board was formerly known as ‘OFFERlist’.
When will my document be accepted for lodgement?
Unless you are otherwise notified that ASIC has refused acceptance pursuant to s1274(8), your document is taken to have been lodged with ASIC at the time we receive your portal transaction and the required attached documents. The ASIC Regulatory Portal User Agreement has more information.
5)
Benefits of firms for listed and traded in Australian Stock Exchange-
A. it will be helping this Firms in order to generate higher amount of equity capital from the market.
B. It will also help this firms in order to you have high amount of liquidity in their shares and they can easily sale shares in order to generate more capital.
C. It will also help this Firms in order to expand their reach and increase the marketplace as business will be gaining reputation after it has been listed on the stock exchanges.
D.it will also help in raising of capital through further offers like right offers and bonus issue can also be done through the stock exchange
E. it will also help this company in order to maximize the value of the shareholders and increase their market capitalisation.
F. It will also help this Newer company to have a reach to the other market as well
Challenges associated with the listing on the Australian stock exchanges-
A. there will be higher regulations and higher documentations which would be followed by these companies.
B. There will also be a cost related to initial public offering in case of underwriting and underpricing
C. companies will be required to reveal more of their information as public informations and they will have to disclose their quarterly earnings on the stock exchanges.
D. They will also be regulated strictly by various shareholders and they will have to follow by various investor interest protection norms
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