SBS CASE STUDY – ROYAL’S FINANCIAL OBJECTIVES

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CASE STUDY PROJECT ON

ROYAL’S FINANCIAL OBJECTIVES

 MBA STUDY ASSIGNMENT QUESTIONS

This paper consists of two sections. Section A carries 40 marks and section B carries 60 marks

 Section A [40 marks]

Unseen Material for case study

Suppose today is 1 September 2021. The Royal ltd has 140 million R10 ordinary shares in issue. On 31 August 2021 the shares were trading at R28.30 cents ex-dividend. The dividends for royal ltd for the year ended 31 December 2021 are expected to be R2.20 per share. The company maintains the 4% increase in dividends that has been achieved in recent years. The declared dividends are paid on 31 December each year.

Investment opportunity

The Newspaper division has identified an investment opportunity. They would print an African wide sports only Magazine. The Magazine would be called the African sports fan. It will be commenced on 1 January 2022. The Magazine would be in English and it would report on a range of popular African sports. The proposal for the project has been under consideration since December 2020.

The project is expected to be initially launched in South Africa. It will then be extended to other African countries over time. The new printing facilities will be added to Chronicle ltd ’s site to support the investment in this project. The project will be evaluated over six years beginning 1 January 2022. The net operating cash flows of the project have been estimated as follows:

Year                                  Rand                        Pula

1                                       30 000 000            -10 000 000

2                                       80 000 000             110 000 000

3                                      130 000 000                               190 000 000

4-6                                   150 000 000  230 000 000

Assume that all cash flows arise on 31 December each year. You must also assume that annual cash flows are paid across to South Africa on the final day of each year.

The cost of the initial investment in plant and equipment at the beginning of January 2022 is P900 000 000. The plant and equipment is depreciated at 5% per annum using the straight line method. An amount of P50 000 000 would be required to finance working capital at the beginning of January 2022.

In addition to the cash flows above, the company hopes to develop mobile phone apps. This would generate further revenue, which could add up to 5% of the net operating cash flows from year 4 of the project. The estimates are based on the “gut feeling” of the sales director. The gut feeling has not been verified though.

Exchange rates

At 1 January 2022 the spot exchange rate is expected to be R1/P1.1 (that is R1=P1.1). The Pula is expected to weaken against the Rand. This is in line with the differential in the long term interest rates between the two countries over the life of the project. The interest rates are expected to remain stable at 0.5% per annum in South Africa and 1.5% per annum in Botswana for the foreseeable future.

Funding the project              

The initial investment of P950 000 000 will be funded by a rights issue at the beginning of January 2022. The realisable value for the plant and equipment is estimated at P630 000 000. This amount will be repaid in full to South Africa. In December 2021 the Royal ltd announced a rights issue of 1 for 4 to fund the proposed P950 000 000 capital investment project. The proposal for the new Magazine was accepted a week ago. Royal ltd would like to proceed without delay. The company will temporarily reduce the dividend growth rates during the development stage of the project.

Investment criteria

Criterion 1

T Royal ltd assesses international projects using the NPV criterion. A risk adjusted discount rate of 12% is used.

Criterion 2            

The royal requires international projects to generate an accounting rate of return of at least 25% per year. ARR is defined as follows:

Average accounting profit before interest and taxes /average annual investment

Ignore taxes in your calculations

Required:

  1. Discuss the reasons for the volatile movements in Royal’s share price (no calculations required)[5 marks]
  2. Discuss the risks that should be considered by Royal in evaluating the project(show calculations where necessary)[7 marks]
  3. Determine the fair market price of the shares after acceptance of the project and after the rights issue [7 marks]
  4. Determine the impact of the project on Royal’s financial objectives[6 marks]
  5. Evaluate the project using the NPV criterion [10 marks]
  6. Evaluate the project using the ARR criterion[5 marks]

Section B: Short Cases[60 marks]

  1. Suppose that an investor selects companies; A and B from the Johannesburg stock exchange. He observes that for the past ten years company A yielded an average investment return that is twice that of B. Explain whether this contradicts the efficient market hypothesis.                                                 [3 marks]
  • John is a sophomore (second year student) at the North West University business school. He has just finished lectures on investment management in his financial management module. He borrowed R500 000 from the bank and invested in a portfolio of equities listed on the Johannesburg stock exchange. He believes that his investment in the portfolio of shares should be actively managed otherwise he will suffer great losses.Explain whether his belief is justifiable according to the efficient market hypothesis [3 marks]
  • Are there any advantages that can be obtained from insider trading if the market is strong form efficient? Explain               [2 marks]
  • In South Africa the national lottery is run weekly. In this lottery the purchaser of a ticket selects six different numbers from 1 to 50 inclusive. If those same six numbers are then drawn randomly from a hat on live television, the ticket holder wins a share of a large cash sum equal in value to the total ticket sales. Explain whether the South African market for lottery tickets is weak form efficient.[4 marks]
  • During the MBA study school atthe North West University last summer, four students decided to form an investment club. They made the following proposals for the new equity investment for the club:
  1. George proposes that they buy shares in South32 ltd because it has performed poorly during the past two years and so they are due for an upturn.
  2. Grace wants to invest in Sibanye Gold ltd. There is a rumour that they have appointed the head of marketing. This new employee is believed to have had success at other companies. So Grace felt that this new employee will have a positive effect at Sibanye Gold ltd.
  3. Tshepo believes in selecting shares at random. He recommended that they buy shares in FNB ltd.
  4. Peter wants to buy shares in Dischem ltd. His brother works for Discovery health ltd and has insider information that Dischemltd’s shares will rise sharply in the near future when it is announced that Discovery health ltd has appointed Dischem ltd as its pharmacy of choice.

Describe how the share selection strategy of each member would work in strongly efficient, semi-strongly efficient, weakly efficient and inefficient markets [12 marks]

  • An investor can invest in only two risky assets A and B. Asset A has an expected rate of return of 10% and a standard deviation of 20%. Asset B has an expected rate of return of 15% and a standard deviation of 30%. The correlation coefficient between the returns of asset A and the returns of asset B is 0.6.
  • Calculate the expected rate of return if 20% of an investor’s wealth is invested in Asset A and the remainder is invested in asset B. [2 marks]
  • Calculate the standard deviation of return on the portfolio if 20% of an investor’s wealth is invested in asset A and the remainder in asset B.[3 marks]
  • Explain why an investor who invests 20% of his wealth in Asset A and the remainder in asset B is risk averse. [3marks]
  • Consider a security A, which has a standard deviation of investment returns of 4%. If:
  • the standard deviation of the market return is 5%;
  • the correlation between A’s return and that of the Market is 0.75;
  • the risk free rate is 5%;
  • and the expected return on the market is 10%;

then calculate:

  1. the beta of security A [3 marks]
  2. security A’s expected return.[3 marks]
  • A woman who has won a prize is offered either:
  • a lump sum of $100 000 to invest now, or
  • $55 000 to invest in one year’s time and another $55 000 to invest in two years’ time.

If all investments are assumed to earn interest at a rate of 7% pa effective, determine which option she should choose if she intends to withdraw the money after:

  1. 4 years [4 marks]
  2. 2 years [ 3 marks]
  • Calculate the effective annual interest rate for:
  • a transaction in which R200 is invested 18 months to give R350 [3 marks]
  • a transaction in which R100 is invested for 24 months and another R100 is invested for 12 months (starting 12 months after the first investment) to give a total of R350 [4 marks]
  1. A treasury bill, redeemable at $100, was purchased for $96.50 at the time of issue and later sold to another investor for $98 who held it to maturity. The rate of return received by the initial purchaser was 4% per annum effective.
  2. Calculate the length of time in days for which the initial purchaser held the bill [4 marks]
  3. Calculate the annual effective rate of return achieved by the second investor. [4 marks]

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