Question

QUESTION ONE Case Study Litumezi Enterprise is a local private agro business run as a cooperative in Western Province of Zambia. The business was an initiative of the local Member of Parliament (MP) to encourage rice and cashew nut production, so that locals can tap into the economic benefit of the export markets in the region. Litumezi Enterprise is seeking to expand its operations as it has reached a critical stage in its life cycle. Since its initial Loan funding through Citizen Economic Empowerment Commission (CEEC) of K5, 000,000.00 the business has seen positive growth in the last 12 years and the Debt has since been settled. The business has put together an aggressive investment plan to expand the current project which includes increasing its current output of rice and cashew nuts to 3,000 hectares from 500 hectares as well as diversifying its operations to include Beef and dairy production. The Business plans on purchasing 500 herd of beef cattle and 100 dairy cows. Further there is a plan to add sugarcane production to its portfolio. All these investments will require huge investment in land, labor and equipment and logistics. Management has been advised by the Finance Manager that the business will need adequate and appropriate finance of about K20, 000,000.00 for both Asset acquisition and working capital. The project is expected to take 2-6 years before it breaks even and becomes profitable. Currently Management is debating on how to finance this project looking at the nature of operations and risks involved. Currently its net profit per year is K600, 000.00 while the K2, 000,000.00 of cash reserves in the bank fixed deposit account and has a finance lease for an equipment that will be fully paid off in the next 6 months freeing up K50, 000.00 of cash flow which is being paid each month. Purchasing the traditional land will cost K 8,000,000.00. Some of the local villagers however, are not happy giving up ancestral land and are demanding explanations on how this project will benefit them and their children. The K8, 000,000.00 will be used to purchase the livestock, trucks and equipment while the other K4, 000,000.00 is expected to be used as working capital. At this stage only preliminary studies have been done and many assumption have been used which could change. However, an investment appraisal was conducted and the project is viable even though management is still not very certain regarding climate and economic situation in the country and region.

Required

i. As a Corporate Finance expert discuss how the business could benefits from Financial Markets in the context of this project.

ii. What consideration should management take in choosing between long term Debt and Equity in financing this new project?

iii. In your opinion how best can the above project be best financed. What would be the sources of finance and how much would you be looking to raise internally and externally. You are free to make relevant assumptions. Total [25 Marks]

Answer 1

i. Litumezi Enterprise is seeking to expand its operations as it has reached a critical stage in its life cycle. Management has been advised by the Finance Manager that the business will need adequate and appropriate finance of about K20,000,000.00 for both Asset acquisition and working capital. So, by entering into financial markets the benefits that the organization will be getting are:

• They can raise capital by issuing bonds and stocks (IPO)
• The company can also go for long-term finance as well as for short-term also
• On issuing Stocks, the company doesn't have any fixed obligation as it is in debt. And stocks can only be issued in financial markets
• They need not have to disclose the future financials of the project to raise money which might be required in sanctioning loans from banks
• Financial markets have many buyers and sellers so it's a perfect competion and proper price discovery would happen

ii. The blend of Long Term Debt and Equity is also known as Debt-Equity ratio which is otherwise known as capital structure ratio.More specifically, it reflects the ability of shareholder equity to cover all outstanding debts in the event of a business downturn.

Higher the Debt-Equity ratio, higher the risk associated with the firm and firms stock, as fixed obligations i.e interest payment are increasing. So, companies with a debt-equity ratio higher than 2:1 are meant to be very aggressive and have very high financial leverage.

But if we go below 1:1 ratio then the company is less levered. As we get a tax benefit from the debt instruments on its interest payment, it lowers the post-tax cost of debt. Hence this gives an advantage in boosting our cash inflows and reducing the weighted average cost of capital.

Here the company doesn't have any debt pending as the previous loan has been settled. So, going with a debt-equity ratio of 1:1, i.e. K10,000,000 raised each by debt and issue of IPO will be the best option for the organization.

iii. Additional Fund Requirement = K20,000,000 for the project expansion as mentioned in the case

There are three sources of funds:

1. Internal Equity/Funds
2. External Debt
3. External Equity

In the above-mentioned source, the preference would be first given to the internal equity i.e. the extra cash company has by retaining a part of profit every year. As the cost of internal equity is cheap compared to external sources of funds as well as there is no flotation cost attached to it.

For having a lesser aggressive approach company can opt for a 1:1 D/E ratio but it is also mentioned that in past the company had an aggressive approach and had grown to repay all its debt obligations. So maintaining that strategy, going by an aggressive approach, and maintaining a D/E ratio of 1.5:1 so that the firm takes the advantage of financial leverage to boost its profits the firm should raise 3/5th of the required capital post using the internal equity.

• All the avalaible internal Equity should be used first to finnace the project as it is the cheapest form of avalaible fund.
• From the rest of the required fund i.e. K2,000,000-Internal Equity, 60% will be raised in the form of debt and 40% will be raised by issuing IPOs.