Revision questions
Question 1
Study the scenario below and answer the question that follows:
A company wants to invest in a new machine at a cost of R3.5 million in order to
manufacture a new product line. The expected residual value of the machine is R250
000 in 4 years’ time. It is expected that the new product line will generate savings of
R800 000 in the first year, which will then increase by 15% p.a. (on a yearly basis) for
the next 3 years. The investment in working capital will amount to 5% of the cost of
the machine and is recoverable at the end of year 4. Depreciation is calculated on a
straight-line basis (do not include residual value in depreciation calculation).
The investment in the new machine is a replacement decision. The following
information relates to the machine being replaced:
• Purchased three years ago at a cost of R2 million.
• Current market value is R900 000.
• Residual value at the end of its lifetime (in two (2) years) will be R80 000.
• Depreciation per year is equal to R400 000 calculated on a straight-line basis.
• Any scrapping allowance/recoupment will occur one year after the sale.
The cost of capital is 18% and the company tax rate is 28%.
Required:
Determine the NPV and IRR of the investment and indicate whether the company
should invest in the new machine.
(43 Marks)
Note: Round your amounts to the nearest rand and percentages to two decimals.
Question 2
Plain Jane is a listed clothing company. They need to raise funds for the expansion of their
Young Working Adult range; they need to consider the sources that are available. The current
tax rate is 29%.
Ordinary shares
550 000 ordinary shares were issued 5 years ago at 285c per share. These shares currently
trade at R 4.17 per share. A dividend of 117c per share is expected and the dividend growth
rate is 4% per year. The current risk-free rate is 8%.
9% Preference shares
The current market value of 750 000 shares is R 770 000. These shares were issued at
R0.77 per share.
Long term loan @ 17%
A loan to the value of R 1 500 000 has been raised 4 years ago. The current outstanding
balance is R 900 000.
Debentures
The debentures have been issued 20 years ago at a par value of R100. A debenture currently
trades at R90 and has 5 years to maturity. Interest is paid annually at 10%. The company
raised R 7 000 000 with the issuing of these debentures.
Required:
Calculate the weighted average cost of capital (WACC) using market values (20 Marks)