Question

ANSWERS ARE PROVIDED FOR QUESTIONS 6 - 12 . SPECIFICALLY WANT ANSWERS TO QUESTIONS 13 THROUGH TO 20

Melrose is a major retail clothing shop based in South Africa. It caters for all individuals, ranging from kids’ wear to corporate wear. Recently Melrose’s receivables book has been growing excessively due to a higher demand for shopping on credit. Melrose’s management is happy with the current credit facilities, as it keeps the stock on the floor moving, but the financial management team is concerned, as there is a growing number of defaults in credit payments. The management team is therefore considering tightening their credit standards in order to mitigate the risk of loss in income from customers defaulting on their credit balances. All sales by Melrose are on credit.

The average selling price of an item of which Melrose sells 2 million items a year is R250. The average variable cost per item is R100. Total fixed costs of Melrose amount to R50 million per year. Melrose currently allows a 90-day interest-free credit period. Any unpaid amounts after 90 days are written off as bad debts. The proposed tightening of credit standards is a 60-day interest-free credit period. This proposal will result in an estimated 10% loss in sales. However, bad debts will be reduced from 10% of credit sales to 2%. There are 365 days in a year. Melrose has a WACC of 16%.

6. 6 Calculate the impact of the change in sales revenue due to the new credit policy:

(2)

6. 1. a) R30 000 000 profit gain.
   2. b) R30 000 000 profit loss.
   3. c) R20 000 000 profit gain.
   4. d) R20 000 000 profit loss.
7. 7 Calculate the investment in accounts receivable under the current policy: (2)
   1. a) R1 369 863,01
   2. b) R123 287 670,90
   3. c) R13 698 630,10
   4. d) R15 000 540
8. 8 Calculate the investment in accounts receivable under the new policy: (3)
   1. a) R1 369 863,01.
   2. b) R123 287 670 90.
   3. c) R73 972 602,60.
   4. d) R1 232 876,71.
9. 9 Calculate the cost of marginal investment in accounts receivable: (3)
   1. a) R13 767 663,29
   2. b) R60 273 972,50
   3. c) -R7 890 410,93.
   4. d) R7 890 410,93.
10. 10 Calculate the bad debts under the current policy: (2)
    1. a) R50 000 000
    2. b) R9 000 000
    3. c) R500 000 000
    4. d) R90 000 000

11. 11 Calculate the bad debts under the new policy: (2)
    1. a) R50 000 000
    2. b) R9 000 000
    3. c) R500 000 000
    4. d) R90 000 000
12. 12 Calculate the cost of marginal bad debts: (2)
    1. a) R410 000 000
    2. b) -R41 000 000
    3. c) R41 000 000
    4. d) -R410 000 000
13. 13 Calculate the overall effect of tightening credit standards for Melrose Ltd: (4)
    1. a) R78 273 972,50
    2. b) R119 273 972,50
    3. c) R18 890 410,93
    4. d) R331 726 027,50
14. 14 Advise Melrose Ltd in the light of the calculations you conducted from Question

6–13: (2)

1. a) Should not implement the proposed credit policy
2. b) Reject both policies
3. c) Sunk costs are difficult to access, therefore irrelevant to the decision
4. d) Should implement the proposed credit policy

Use the following information to answer questions 15–20

The existing capital structure of Leeds (Ltd) is as follows:

Notes:

• · The ordinary shares are currently trading at R46,45. A dividend of 80 cents per share has just been paid and the directors estimate that the dividends will increase by 8% each year in perpetuity.
• · Preference shares are trading at R2,75 and have a par value of R2,40.
• · The debentures have a par value of R50 and are currently trading at R45. The

debentures are redeemable at R55 in ten years’ time.

• · The company tax rate is 28%.

As an alternative to the existing capital structure for Leeds (Ltd), an outside consultant has suggested the following modifications:

Ordinary shares (equity)	R500 000
11% non-redeemable preference shares	R150 000
Debt (10% debentures)	R350 000

Ordinary shares (equity)	35%
Preference shares	5%
Debt	60%

Under this new and more debt-orientated arrangement, the after-tax cost of debt is 10,8%, the cost of preference shares is 11% and the cost of equity is 15,6%.

15. 15 Under the CURRENT capital structure (before the suggested change) of Leeds Ltd, calculate the cost of equity: (3)
    1. a) 10,00%
    2. b) 9,86%
    3. c) 9,00%
    4. d) 9,43%
16. 16 Under the CURRENT capital structure (before the suggested change) of Leeds Ltd, calculate the cost of preference shares: (3)
    1. a) 9,43%
    2. b) 9,60%
    3. c) 10,00%
    4. d) 12,67%
17. 17 Under the CURRENT capital structure (before the suggested change) of Leeds Ltd, calculate the cost of debt. (3) a) 11,68%
    2. b) 9,67%
    3. c) 9,40%
    4. d) 9,43%
18. 18 Using your calculated cost of capital calculated in Question 1.15–1.17, calculate Leeds’s weighted average cost of capital (WACC) using the current capital structure. (3)
    2. a) 9,40%
    3. b) 9,60%
    4. c) 9,67%
    5. d) 9,00%
19. 19 Calculate Leeds’s weighted average cost of capital (WACC) using the ALTERNATIVE capital structure and alternative costs of capital. (3)
    1. a) 12,49%
    2. b) 13,00%
    3. c) 12,50%
    4. d) 20,00%
20. 20 If you owned your own organisation that was funded by your own capital, would the concept of WACC apply to you? (2)
    1. a) There would be no WACC as there would not be any form of a pool of

external capital that would exist. However, your ‘own’ cost of funding (equity)

will need a return level that will be set by yourself.

1. b) Yes, there will be WACC as there would a pool of external capital that would

exist.

2. c) WACC is irrelevant to how capital is funded.
3. d) Not necessarily, it depends on the company in question.

Answer 1

Since, multiple questions have been posted and each question has multiple subparts, I have answered all the parts of the first question with complete details and first two parts of second question.

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Question 6:

The impact of the change in sales revenue due to the new credit policy is credit as below:

	Current Policy	New Policy
Sales Revenue	500 000 000	450 000 000
Less Variable Cost	200 000 000	180 000 000
Fixed Cost	50 000 000	50 000 000
Profit	R250 000 000	R220 000 000

Impact of Change in Sales Revenue due to New Credit Policy = Profit under New Policy - Profit under Current Policy = 220 000 000 - 250 000 000 = -R30 000 000 or R30 000 000 profit loss.

Answer for Question 6 is R30 000 000 profit loss (which is Option b).

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Question 7:

The investment in accounts receivable under the current policy is determined as follows:

Investment in Accounts Receivable under Current Policy = Total Sales Revenue under Current Policy*Credit Period under Current Policy/365

Here, Total Sales Revenue under Current Policy = R500 000 000 and Credit Period under Current Policy = 90 days

Substituting these values in the above formula, we get,

Investment in Accounts Receivable under Current Policy = (500 000 000)*90/365 = R123 287 671,23 which is closest to R123 287 670,90

Answer for Question 7 is R123 287 670,90 (which is Option b).

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Question 8:

The investment in accounts receivable under the new policy is arrived as follows:

Investment in Accounts Receivable under New Policy = Total Sales Revenue under New Policy*Credit Period under New Policy/365

Here, Total Sales Revenue under New Policy = R450 000 000 and Credit Period under New Policy = 60 days

Substituting values in the above formula, we get,

Investment in Accounts Receivable under New Policy = (450 000 000)*60/365 = R73 972 602,74 which is closest to R73 972 602,60

Answer for Question 8 is R73 972 602,60 (which is Option c) .

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Question 9:

The cost of marginal investment in accounts receivable is calculated as below:

Cost of Marginal Investment in Accounts Receivable = (Investment in Accounts Receivable under New Policy - Investment in Accounts Receivable under Current Policy)*WACC

Substituting values in the above formula, we get,

Cost of Marginal Investment in Accounts Receivable = (73 972 602,60 - 123 287 670,90)*16% = -R7 890 410,93

Answer for Question 9 is -R7 890 410,93 (which is Option c).

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Question 10:

The value of bad debts under the current policy is determined as follows:

Bad Debts under Current Policy = Total Sales Revenue under Current Policy*Bad Debts Percentage under Current Policy

Substituting values in the above formula, we get,

Bad Debts under Current Policy = (500 000 000)*10% = R50 000 000

Answer for Question 10 is R50 000 000 (which is Option a).

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Question 11:

The value of bad debts under the new policy is determined as follows:

Bad Debts under New Policy = Total Sales Revenue under New Policy*Bad Debts Percentage under New Policy

Substituting values in the above formula, we get,

Bad Debts under New Policy = (450 000 000)*2% = R9 000 000

Answer for Question 11 is R9 000 000 (which is Option b).

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Question 12:

The cost of marginal bad debts is calculated as follows:

Cost of Marginal Bad Debts = Bad Debts under New Policy - Bad Debts under Current Policy = 9 000 000 - 50 000 000 = -R41 000 000

Answer for Question 12 is -R41 000 000 (which is Option b).

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Question 13:

The overall effect of tightening credit standards for Melrose Ltd is arrived as below:

Overall Effect of Tightening Credit Standards = Cost of Marginal Investment in Accounts Receivable + Cost of Marginal Bad Debts - Impact of Change in Sales Revenue due to New Credit Policy

Substituting values in the above formula, we get,

Overall Effect of Tightening Credit Standards = 7 890 410.93 + 41 000 000 - 30 000 000 = R18 890 410,93

Answer for Question 13 is R18 890 410,93 (which is Option c).

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Question 14:

Should implement the proposed credit policy. (which is Option D)

_____

Explanation:

The company should implement the new credit policy as it has an overall positive effect of R18 890 410,93. The reduction in marginal cost of investment in accounts receivable and marginal cost of debts is more than sufficient to cover the decrease in profits resulting from change in credit policy.

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Question 15:

The cost of equity is calculated as follows:

Cost of Equity = Last Dividend*(1+Growth Rate)/Current Stock Price + Growth Rate = .80*(1+8%)/46,45 + 8% = 9.86%

Answer for Question 15 is 9.86% (which is Option b).

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Question 16:

The cost of preference shares is arrived as below:

Cost of Preference Shares = Current Dividend/Current Share Price*100 = (11%*2,40)/2,75*100 = 9.60%

Answer for Question 16 is 9.60% (which is Option b).