Question 1 With the discovery of oil in commercial quantities in Ghana, more and more oil exploration companies are troo
Posted: Wed Jul 06, 2022 6:28 pm
Question 1
With the discovery of oil in commercial quantities in Ghana,more and more oil exploration companies are trooping into Ghana.You have been appointed as a Financial Analyst by one such company,Tulara Ltd, based in Volta Basin. At a meeting to brief you on yourduties, management indicated Tulara has just started operation, andis operating on its target debt-to-equity ratio of 0.9. It was alsoclear that Tulara’s discount rate is 45%, which managementjustified on grounds of riskiness of the business and country risk.You were not satisfied with the rate as it will make your work verydifficult to even breaking-even in the five years. “Well, if youthink the rate is high, provide us with alternate rate withjustification” the CEO said. Although Tulara Ltd borrows at8.5% above government of Ghana 2-year fixed rate note, its shareprices are not readily available because it is not listed for quickcomputation of the discount rate. A comparable company, TokonLtd, listed on the Ghana stock exchange operates on debt-to-equityratio of 1.55 and levered beta of 1.45. The nominal risk-freerate is represented by the yield on the long-term 2-year fixed ratenote of Ghana Government, which at the valuation date was 18.5% andthe average long-term historical equity risk free premium in Ghanais assumed at 10.7%. The corporate tax rate in Ghana is 35%. Tomake your argument robust, you have decided to draw comparablecompany in other West African countries with similar sovereign riskinto your computation as shown in Table 1.
Table 1
Comparable company's
Country
Corporate Tax rate (%)
D/E
Beta (estimates from CAPM)
Tunde Oils MorrisonLtd Nigara Ltd
Nigeria Liberia Niger
32.5 38.5 37.5
1.33 1.94 1.13
1.45 1.75 1.08
Average
1.13
1.08
Required:
Present a memo to management justifying:
Question 2
Pizza Nubuke Limited has experienced a recent surge in demandfrom UCC students. The company is contemplating building anaddition to the restaurant that will cost GHS50,000. The companybelieves that they can project cash flows from the addition foronly 5 years. The company estimates that the addition will enableit to sell 15,000 more pizzas per year. The average price of apizza is GHS8 and the average cost of labour and ingredients isGHS4. Ignore depreciation. Pizza Nubuke Limited’s required rate ofreturn on the addition is 10% and corporate tax rate is 25%.
Required:
Question 3
A junior executive is fed up with the operating policies of hisboss. Before leaving the office of his angered superior, the youngman suggests that a well-trained baboon could handle the triviaassigned to him. Pausing a moment to consider the import of hisclosing statement, the boss seized by the thought that this musthave been in the back of her own mind ever since she hired thejunior executive. She decides to consider replacing the executivewith a bright young baboon. She figures that she could arguestrongly to the board that such ‘capital deepening’ is necessaryfor the cost-conscious firm. Two days later, a feasibility study iscompleted and the following data are presented to thepresident:
Required:
On the basis of the net present value criterion, should thebaboon be hired? (10 marks)
Question 4
You are considering buying shares in two companies that operatein the same industry; they have very similar characteristics exceptfor their dividend payout policies. Both companies are expected toearn GHS6 per share this year. However, Company D (for ‘dividend’)is expected to pay out all of its earnings as dividends, whileCompany G (for ‘growth’) is expected to pay out only one third ofits earnings, or GHS2 per share. D’s share price is GHS40. G and Dare equally risky. Which of the following is most likely to betrue? Explain your answer.
i. Company G will have a faster growthrate than Company D. Therefore, G’s share price should be greaterthanGHS40. (2marks)
ii. Although G’s growth rate shouldexceed D’s, D’s current dividend exceeds that of G, and this shouldcause D’s price to exceedG’s. (2 marks)
iii. An investor in stock D will gethis money back faster because D pays out more of its earnings asdividends. Thus in a sense, D is like a short-term bond, and G islike a long-term bond. Therefore if economic shifts cause bondsmarket interest rate and the required rate of return on shares toincrease and if the expected streams of dividend from D and Gremain constant, both Shares D and G will decline, but D’s priceshould decline further. (2 marks)
iv. D’s expected and required rate ofreturn is 15%. G’s expected rate of return will be higher becauseof its higher expected growthrate. (2 marks)
v. If we observe that G’s price isalso GHS40, the best estimate of G’s growth rate is10%. (2 marks)
With the discovery of oil in commercial quantities in Ghana,more and more oil exploration companies are trooping into Ghana.You have been appointed as a Financial Analyst by one such company,Tulara Ltd, based in Volta Basin. At a meeting to brief you on yourduties, management indicated Tulara has just started operation, andis operating on its target debt-to-equity ratio of 0.9. It was alsoclear that Tulara’s discount rate is 45%, which managementjustified on grounds of riskiness of the business and country risk.You were not satisfied with the rate as it will make your work verydifficult to even breaking-even in the five years. “Well, if youthink the rate is high, provide us with alternate rate withjustification” the CEO said. Although Tulara Ltd borrows at8.5% above government of Ghana 2-year fixed rate note, its shareprices are not readily available because it is not listed for quickcomputation of the discount rate. A comparable company, TokonLtd, listed on the Ghana stock exchange operates on debt-to-equityratio of 1.55 and levered beta of 1.45. The nominal risk-freerate is represented by the yield on the long-term 2-year fixed ratenote of Ghana Government, which at the valuation date was 18.5% andthe average long-term historical equity risk free premium in Ghanais assumed at 10.7%. The corporate tax rate in Ghana is 35%. Tomake your argument robust, you have decided to draw comparablecompany in other West African countries with similar sovereign riskinto your computation as shown in Table 1.
Table 1
Comparable company's
Country
Corporate Tax rate (%)
D/E
Beta (estimates from CAPM)
Tunde Oils MorrisonLtd Nigara Ltd
Nigeria Liberia Niger
32.5 38.5 37.5
1.33 1.94 1.13
1.45 1.75 1.08
Average
1.13
1.08
Required:
Present a memo to management justifying:
Question 2
Pizza Nubuke Limited has experienced a recent surge in demandfrom UCC students. The company is contemplating building anaddition to the restaurant that will cost GHS50,000. The companybelieves that they can project cash flows from the addition foronly 5 years. The company estimates that the addition will enableit to sell 15,000 more pizzas per year. The average price of apizza is GHS8 and the average cost of labour and ingredients isGHS4. Ignore depreciation. Pizza Nubuke Limited’s required rate ofreturn on the addition is 10% and corporate tax rate is 25%.
Required:
Question 3
A junior executive is fed up with the operating policies of hisboss. Before leaving the office of his angered superior, the youngman suggests that a well-trained baboon could handle the triviaassigned to him. Pausing a moment to consider the import of hisclosing statement, the boss seized by the thought that this musthave been in the back of her own mind ever since she hired thejunior executive. She decides to consider replacing the executivewith a bright young baboon. She figures that she could arguestrongly to the board that such ‘capital deepening’ is necessaryfor the cost-conscious firm. Two days later, a feasibility study iscompleted and the following data are presented to thepresident:
Required:
On the basis of the net present value criterion, should thebaboon be hired? (10 marks)
Question 4
You are considering buying shares in two companies that operatein the same industry; they have very similar characteristics exceptfor their dividend payout policies. Both companies are expected toearn GHS6 per share this year. However, Company D (for ‘dividend’)is expected to pay out all of its earnings as dividends, whileCompany G (for ‘growth’) is expected to pay out only one third ofits earnings, or GHS2 per share. D’s share price is GHS40. G and Dare equally risky. Which of the following is most likely to betrue? Explain your answer.
i. Company G will have a faster growthrate than Company D. Therefore, G’s share price should be greaterthanGHS40. (2marks)
ii. Although G’s growth rate shouldexceed D’s, D’s current dividend exceeds that of G, and this shouldcause D’s price to exceedG’s. (2 marks)
iii. An investor in stock D will gethis money back faster because D pays out more of its earnings asdividends. Thus in a sense, D is like a short-term bond, and G islike a long-term bond. Therefore if economic shifts cause bondsmarket interest rate and the required rate of return on shares toincrease and if the expected streams of dividend from D and Gremain constant, both Shares D and G will decline, but D’s priceshould decline further. (2 marks)
iv. D’s expected and required rate ofreturn is 15%. G’s expected rate of return will be higher becauseof its higher expected growthrate. (2 marks)
v. If we observe that G’s price isalso GHS40, the best estimate of G’s growth rate is10%. (2 marks)