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CPA
Intermediate Leval
Financial-Management-May 2016
ANSWERS

Financial Management
Revision Kit

QUESTION 1a

Q Explain four principles of capital budgeting.
A

Solution


Principles of Capital Budgeting


Capital budgeting involves evaluating potential projects based on their expected future cash flows and benefits. This requires a thorough analysis of each project's feasibility, potential returns, and adherence to several key principles.

1. Project Evaluation


Decisions are based on cash flow, not accounting income. The evaluation process focuses on the actual cash generated or consumed by a project.


2. Time Value of Money


The time value of money is a crucial principle. It acknowledges that a sum of money today is worth more than the same amount in the future. Techniques like Net Present Value (NPV) and Internal Rate of Return (IRR) consider this in their calculations.


3. Risk Assessment


Risk assessment is integral. Decision-makers consider uncertainties and assess the risk-return trade-off. Sensitivity analysis and scenario planning address project risks.


4. Capital Rationing


Capital rationing involves allocating limited resources among competing projects. This principle prioritizes projects based on expected returns, budget constraints, and optimal resource allocation.


5. Payback Period


The payback period, while not as sophisticated, indicates the time required for a project to recover its initial investment. It provides a quick assessment of liquidity and risk.


6. Profitability Index


The profitability index (PI) compares the present value of a project's future cash flows to its initial investment. A PI greater than 1 indicates a potentially profitable project, aiding in ranking and selection.


Considerations for Financial Analysis


  • Timing of cash flow is crucial in assessing project viability.
  • Opportunity cost should be considered in evaluating potential benefits.
  • Cash flow should be adjusted for taxes to reflect the actual financial impact.
  • Financing costs should be ignored in the initial project evaluation.

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QUESTION 1b

Q Required:
(i) Rank the projects using payback period method.

(ii) Rank the projects using net present value (NPV) method.
A

Solution


(i) Rank the projects using payback period method.


Pay back period project A
Year
0
1
2		 Cashflows
(1,000,000)
500,000
500,000		 Cummulative cashflows
(1,000,000)
(500,000)
0


Pay back period project A = 2 years

Pay back period project B
Year
0
1
2
0		 Cashflows
(1,000,000)
0
650,000
850,000		 Cummulative cashflows
(1,000,000)
(1,000,000)
(350,000)
0


Pay back period project B = 2 years + 350,000 / 850,000 = 2.41 yrs

Pay back period project C
Year
0
1
2
0		 Cashflows
(1,000,000)
300,000
500,000
1,000,000		 Cummulative cashflows
(1,000,000)
(700,000)
(200,000)
0


Pay back period project C = 2 years + 200,000 / 1,000,000 = 2.2 yrs

Pay back period project D
Year
0
1
2
0		 Cashflows
(1,000,000)
800,000
400,000
400,000		 Cummulative cashflows
(1,000,000)
(200,000)
0
0


Pay back period project D = 1 years + 200,000 / 400,000 = 1.5 yrs

Projectr
A
B
C
D		 Payback period
2 yrs
2.41 yrs
2.2 yrs
1.5 yrs		 Rank
2
4
3
1


(ii) Rank the projects using net present value (NPV) method


Net present value is the difference between the present value of cash inflows and the initial outlay

NPV A
Year
1-2

Cashflows
500,000

D.F 15%
1.6257

Pv
812,850
(1,000,000)


NPV B
Year
2
3



Cashflows
650,000
850,000



D.F 15%
0.7561
0.6575
PV of cash inflows
Less:Initial outlay
NPV		 Pv
491,465
558,875
1,050,340
(1,000,000)
50,340


NPV C
Year
1
2
3



 Cashflows
300,000
500,000
1,000,000



D.F 15%
0.8696
0.7561
0.6575
PV of cash inflows
Less:Initial outlay
NPV		 Pv
260,880
378,050
675,500
1,296,430
(1,000,000)
296,430


NPV D
Year
1
2-3



 Cashflows
800,000
400,000



D.F 15%
0.8696
1.4136
PV of cash inflows
Less:Initial outlay
NPV		 Pv
695,680
565,440
1,261,120
(1,000,000)
261,120


Projectr
A
B
C
D		 Payback period
-187,150
50,340
296,430
261,120		 Rank
4
3
1
2



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QUESTION 1c

Q Chigiri Ltd. is a private company which intends to be listed in the securities exchange. The company has recently made a dividend issue of Sh.3.20 per share. This dividend is expected to grow at the rate of 15% per annum for 2 years and then drop to 12% per annum for the next 3 years. Thereafter, the dividend will grow at 6% per annum indefinitely. The required rate of return is 11%.

Required:
The intrinsic value of the share.
A

Solution


Year
1
2
3
4
5
6 ∞

Dividends
3.20 x 1.15¹ = 3.68
3.20 x 1.15² = 4.23
4.23 x 1.12¹ = 4.74
4.23 x 1.12² = 5.31
4.23 x 1.12³ = 5.94
125.93
Intrinsic value		 PVIF,11%
0.9009
0.8116
0.7312
0.6587
0.5935
0.5935

 PV
3.32
3.43
3.47
3.50
3.53
74.74
91.99


Dividend to perpetuity
6 to ∞ = (Ds(1 + g)) / (r - g)

Where;
Ds = Dividend last year = Sh.5.94
g = growth rate = 6%
r = required rate of return = 11%

5.94(1 + 0.06) / (0.11 - 0.06) = Sh.125.93

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QUESTION 2(a)

Q Required:
The weighted average cost of capital (WACC).
A

Solution


(i) Cost of Equity(Ke)

Ke
=
Do(1 + g)
Po
+ g
x 100%


Where;

Ke = Cost of equity
Do = Dividend per share = sh.2
Po = Current share market price = sh.80
g = growth rate = 10%.


Ke
=
[
2.0(1 + 0.1)
80
+ 0.1
]
x 100% = 12.75%


(ii) Cost of debenture (Kd)

Kd
=
I(1 - T)
Mpd
x 100%


Where;

I = interest rate
T = tax rate = 30%
Mpd = market price of debenture.

Kd
=
(12% x 100)(1 - 0.3)
90
x 100% = 9.33%


(iii) Cost of 10% preferred shares (Kp)

Kp = Dp / Po x 100%

Where:-

Kp = cost of preference stock
Dp = Dividend of preferred share
Po = market price of preference share=sh. 30.

Kp
=
10% x 20
30
x 100% = 6.67%


Weighted average cost of capital (WACC)
SOURCE
Ordinary share capital
12% debenture capital
10% preference share capital

 Market value Sh.000
40,000 / 100 x 80 = 32,000
25,000 / 100 x 90 = 22,500
20,000 / 20 x 30 = 30,000
84,800		 Market value weight
0.38
0.27
0.35

Cost of each item
12.75%
9.33%
6.67%
WACC		 Weighted cost
4.85%
2.52%
2.33%
9.70%


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QUESTION 2(b)

Q The following it ormation relates to the dividend per share (DPS) for Zomollo Ltd.:

Earnings per share (EPS) for year 2016
Dividend per share (DPS) for year 2015
Target payout ratio
Adjustment rate		 Sh.6.00
Sh.2.40
0.60
0.70

Required:
Using the Lintner model, predict the dividend per share for the year ended 31 December 2016.
A

Solution


Lintner model is a basic model that incorporate dividend decisions

D₁ = Do + af [ (E1 x tp) - Do ]

Where:

D₁ = Dividend per share in year 1

af = Adjustment factor

tp = Target pay-out ratio

E₁ = Earnings per share for year 1

Do = Dividend per share for year 0

D₁ = 2.4 + 0.7[(6 x 0.6) - 2.4]

= 2.4 + 0.7[3.6 - 2.4] = Sh.3.24

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QUESTION 2(c)

Q James Chiwende is considering the purchase of a 4-year Sh.1,200,000 par value bond. The bond has a coupon interest. rate of 10% per annum..

The investor's required rate of return is 8%.

Required:
The current value of the bond
A

Solution


Value of bond

Annual coupon payment = 10% x 1,200,000 = 120,000

Year
1-4
4

Cashflows
120,000
1,200,000

DF 8%
3.3121
0.7350

PV
397,452
882,000
1,279,452


Current value of the bond = Sh.1,279,452

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QUESTION 2(d)

Q Mwatata Ltd. currently operates with terms of net 80 days. The firm's average investment in accounts receivable amount to Sh.4,400,000 per annum. Eighty per cent of the firm's sales are always on credit. The company is considering introducing terms of 2 / 20 net 90 days.

The relaxation of terms of sale will increase the firm's total sales bv 60%. All cash customers and 40% of the credit customers will take advantage of the cash discount. The average collection period will increase to 80 days up from the current average collection period of 72 days. Bad debts are expected to remain at 3% of credit sales.

Inventory levels are estimated to be 5% of the firm's turnover and creditors will increase by Sh. 1,000,000.

Gross margin on sales is 40%. The cost of capital is 16%. Corporate tax rate is 30%.

Assume 360 days in a year.

Required:
Advise the management of Mwatata Ltd. on whether to switch to the new credit policy.
A

Solution


Credit sales = (Average debtors ÷ Average collection period) x 360

Credit sales = (4,400,000 ÷ 72) x 360 = 22,000,000

80% of sales are always on credit

80% = 22,000,000

Therefore 100% = 100 / 80 x 22,000,000 = 27,500,000

New sales amount 160 / 100 x 27,500,000 = Sh. 44,000,000

New Credit sales 80 / 100 x 44,000,000 = Sh. 35,200,000

Discount offer Credit sales 40 / 100 x 35,200,000 = sh. 14,080,000

Credit customers who will not take advantage of discount

60 / 100 x 35,200,000 = sh. 21,120,000

Discount allowed

2 / 100 x [14,080,000 + (44,000,000 - 35,200,000)] = sh. 457,600

Average debtors

i. Current policy = sh.4,400,000

ii. New policy

➢ Average debtors discount offer = 20 / 360 x 14,080,000 = sh. 782,222.22

➢ Average debtors no discount = 80 / 360 x 21,120,000 = sh. 4,693,333.33

Total average debtors new policy

= 782,222.22 + 4,693,333.33 = sh. 5,475,555.55

Inventory

i. Current policy = 5 / 100 x 27,500,000 = sh. 1,375,000

ii. New policy = 5 / 100 x 44,000,000 = sh. 2,200,000

Bad debts

i. Current policy = 3 / 100 x 22,000,000 = sh. 660,000

ii. New policy = 3 / 100 x 35,200,000 = sh. 1,056,000

Contribution

i. Current policy = 40 / 100 x 27,500,000 = sh. 11,000,000

ii. New policy = 40 / 100 x 44,000,000 = sh. 17,600,000

Opportunity cost

Debtors current policy = 16 / 100 x 4,400,000 = sh. 704,000

Debtors new policy = 16 / 100 x 5,475,555.55 = sh. 876,088.89

Inventory Current policy 16 / 100 x 1,375,000 = sh. 220,000

Inventory new policy = 16 / 100 x 2,200,000 = sh. 352,000

Creditors new policy = 16 / 100 x 1,000,000 = sh.160,000

Details
Contribution
Less: Discount
Less: Bad debts
Opportunity costs
Less: Debtors
Less: Inventory
Less: Creditors
Profit before tax
Less tax 30%
Profit after tax		 New policy
17,600,000
(457,600)
(1,056,000)

(876,088.89)
(352,000)
(160,000)
14,698,311.11
(4,409,493.33)
10,288,817.78		 Current policy
11,000,000
0
(660,000)

(704,000)
(220,000)
0
9,416,000
(2,824,800)
6,591,200		 Change
6,600,000
(457,600)
(396,000)

(172,088.89)
(132,000.00)
(160,000.00)
5,282,311.11
(1,584,693.33)
3,697,617.78



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QUESTION 3(a)

Q The following data was extracted from the financial statements of Jaribuni Limited for the year ended 31 December 2015:


Cash and cash equivalents
Fixed assets
Sales (credit)
Net income
Current liabilities
Notes payable to bank
Current ratio
Debtors collection period
Return on equity		 Sh."millions"
200
567
2,000
100
211
40
3:1
40.55 days
12%

Assume 365 days in a year.

Required:
(i) Accounts receivable.

(ii) Current assets.

(iii) Return on total assets

(iv) Equity.

(v) Quick ratio.
A

Solution


(i) Accounts receivable


Debtors period = Debtors / credit sales x 365

Debtors (Accounts receivable) = (Debtors period x credit sales) / 365

(40.55 x 2,000) / 365 = 222.19178082

Sh. 222,191,780.82

(ii) Current assets


current ratio = current assets / current liabilities

current ratio = 3:1

1 = 211
3 = ?

211 x 3 = Sh. 633 million

(iii) Return on total assets


Return on total assets = Net income / Total assets

Return on total assets = 100 / (567 + 633)

8.33%

(iv) Equity


Return on Equity (ROE) = (Net Income / Equity) x 100.

Equity = Net Income / ROE x 100

(100 / 12% ) x 100 = Sh. 833 million

(v) Quick Ratio


Quick ratio = (Current assets - Inventory) / Current liabilities

Inventory = Crrent assets - cash - debtors

633,000,000 - 200,000,000 - 222,191,780.82

210,808,219.18

Quick Ratio = (Current assets - Inventory) / Current Liabilities

(633,000,000 - 210,808,219.18) / 211,000,000 = 2:1

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QUESTION 3b

Q Manjewa Limited maintains a minimum cash balance of Sh.2,000,000. The standard deviation of its daily net cash flow is estimated at Sh.22.000. The transaction cost of buying and selling of marketable securities is Sh.60 per transaction. The rate of interest for the marketable securities is 5% per annum.

Assume 365 days in a year.

Required:
Using the Miller-Orr cash management model, determine:

(i) The spread.

(ii) The upper cash limit.

(iii) The return point.
A

Solution


(i) The spread.


Spread
=
3
[
3/4 x C x δ²
i
]
1/3


Where:

C = Transaction cost = 60

δ² = Variance of daily cash flows = 22,000²

i = Daily interest rate = 0.05 / 365

Spread
=
3
[
3/4 x 60 x 22,000²
0.05 / 365
]
1/3


Spread = 162,523

OR


The spread = UL - L

2,162,523 - 2,000,000 = 162,523

(ii) The upper cash limit (UL).


UL = 3RP - 2L

3 x 2,054,174.33 - 2 x 2,000,000

2,162,523

(iii) The return point.


RP =
3
√
3Cδ2
4i
+ L


Where:

RP = Return point

C = Transaction cost = 60

δ² = Variance of daily cash flows = 22,000²

i = Daily interest rate = 0.05 / 365

L = Minimum cash balance sh. 2,000,000

RP =
3
√
3 x 60 x 22,000²
4 x 0.05 / 365
+ 2,000,000


54,174.33 + 2,000,000 = 2,054,174.33

OR


Return point = Lower limit + ( 1 / 3 x spread)

2,000,000 + (1 / 3 x 162,523) = 2,054,174.33
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QUESTION 4(a)

Q Highlight four shortcomings of financial deepening.
A

Solution


Shortcomings of Financial Deepening


While financial deepening can have numerous benefits, it also comes with its share of challenges and shortcomings. Some of the notable ones include:

  • Increasing Inequality: Financial deepening may exacerbate income inequality as access to financial services and benefits might not be distributed evenly across different socioeconomic groups.
  • Financial Fragility: A highly developed financial system can be more susceptible to systemic risks, leading to financial instability and crises that can have far-reaching economic consequences.
  • Excessive Risk-Taking: Financial institutions, in pursuit of higher returns, might engage in excessive risk-taking behavior, leading to asset bubbles and financial market distortions.
  • Dependency on External Factors: Countries heavily reliant on foreign capital inflows for financial deepening may be vulnerable to global economic downturns, affecting their financial stability.
  • Lack of Inclusivity: Despite efforts to deepen financial markets, segments of the population, particularly in developing countries, may still face challenges in accessing financial services, perpetuating financial exclusion.
  • Regulatory Challenges: As financial systems become more complex, regulators may struggle to keep pace with evolving technologies and financial instruments, potentially leading to regulatory gaps and lapses.


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QUESTION 4(b)

Q (i) Define the term "franchising".

(ii) Suggest four reasons why franchising could be considered as an alternative source of finance to a company.
A

Solution


(i) Definition of Franchising


Franchising is a business model where a company (the franchisor) grants individuals or groups (the franchisees) the right to operate their own business using the franchisor's brand, products, and business model. In exchange, the franchisee pays fees or royalties to the franchisor.

(ii) Franchising as an Alternative Source of Finance


Franchising can be considered as an alternative source of finance for a company due to several reasons:


  • Capital Infusion: Franchising allows a company to expand without the need for significant capital investment. Franchisees typically provide the necessary funds for opening and operating their individual franchises.
  • Risk Sharing: By franchising, a company can share the risks associated with business expansion with franchisees. Each franchise operates independently, reducing the financial burden on the company.
  • Quick Expansion: Franchising enables rapid expansion as franchisees are responsible for establishing and managing their units. This can lead to faster market penetration and increased revenue for the company.
  • Local Expertise: Franchisees often have local knowledge and connections, which can be valuable for a company looking to enter new markets. This local expertise can contribute to the success of the franchised units.
  • Steady Income Stream: Franchise agreements typically involve ongoing fees or royalties paid by franchisees to the franchisor. This provides a steady and predictable income stream for the company.

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QUESTION 4(c)

Q Ngoba Ltd. has just paid an annual dividend of Sh.38 per share. The management of the company has a target to increase the market share value to Sh.800 per share by considering appropriate investment policies. Shareholders expect a return on investiment of 12%.

Required:
The annual expected growth rate.
A

Solution


Dividend valuation model
Vo = Do(1 + g) / (r - g)

Where;

Vo = Current value of the share

g = growth rate

r = expected rate of return (cost of equity) = 12%

Do = current dividend per share = sh.38

800 = 38(1 + g) / (0.12 - g)

800(0.12 - g) = 38(1 + g)

96 - 800g = 38 + 38g

838g = 58

g = 58 / 838 = 0.0692 = 6.92%

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QUESTION 4(d)

Q Laika Ltd has identified five investment projects with the following details:

Investment
project
A
B
C
D
E		 Initial outlay
(Sh. "millions")
120
160
100
90
110		 Net present value of investment
(Sh. "millions")
24.0
43.2
17.0
21.6
19.8

Additional information:
1. None of the investment projects could be delayed.

2. Amount available for investment is limited to Sh.300 million. therefore, the company canno undertake the investment projects.

3. All the five projects are divisible.

Required:
Advise the management of Laika Ltd. on the most appropriate investment projects to undertake.
A

Solution


Profitability index: = NPV / Initial outlay

Project
A
B
C
D
E		 Profitability index
24 / 120 = 0.20
43.2 / 160 = 0.27
17 / 100 = 0.17
21.6 / 90 = 0.24
19.8 / 110 = 0.18		 Rank
3
1
5
2
4


Capital limit of investment - Sh.300 millions

Investment projects to undertake based on sh.300 millions.

Investment
B
D
A(balance)

 Initial outlay
160
90
50
300 		NPV
43.2
21.6
50 / 120 x 24 = 10.0
74.8


Advice:
Laika ltd should undertake project B,D and the balance on project A

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QUESTION 5a

Q Discuss four principles of Islamic financing.
A

Solution


Principles of Islamic Financing


Islamic financing principles are rooted in Sharia, emphasizing ethical and socially responsible financial transactions. Key principles include:

  • Mudarabah: A profit-sharing partnership where one party provides funds (Rab-ul-mal) and the other manages the investment (Mudarib). Profits are shared based on pre-agreed ratios, but losses are borne by the investor.
  • Murabahah: A cost-plus-profit arrangement where the financial institution purchases an asset and sells it to the customer at a marked-up price. The cost and profit margins are disclosed upfront.
  • Ijarah: A leasing arrangement where the financial institution purchases an asset and leases it to the customer for a specified period and rental amount. Ownership may or may not be transferred at the end of the lease.
  • Sukuk: Islamic bonds representing ownership in a tangible asset or service. Sukuk holders receive a share of profits generated by the underlying asset or service.
  • Qard al-Hasan: An interest-free loan extended for benevolent purposes. The borrower is obligated to repay only the principal amount borrowed, and there is no predetermined return for the lender.
  • Islamic Insurance (Takaful): A cooperative system where participants contribute to a fund to help each other in times of need. Takaful operates on the principles of mutual assistance and shared responsibility.

These principles aim to promote fairness, transparency, and social justice in financial transactions, aligning with Islamic values and principles.

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QUESTION 5b

Q Highlight four factors that could be taken into account when making dividend decisions.
A

Solution


Factors in Dividend Decisions


When making dividend decisions, various factors should be taken into account to ensure an effective and sustainable distribution of profits to shareholders. Key considerations include:

  • Profitability: Assess the company's profitability and financial health to determine the ability to generate sufficient earnings for dividend payouts.
  • Dividend History: Consider the company's track record of dividend payments. Consistent and growing dividends can signal financial stability.
  • Future Cash Flow: Evaluate the expected future cash flows to ensure the company can sustain dividend payments without compromising its operational needs or growth opportunities.
  • Debt Levels: Examine the company's debt levels. High debt may limit the capacity for dividend payments, as servicing debt obligations takes precedence.
  • Industry and Economic Trends: Consider the current economic climate and industry-specific trends that may impact the company's ability to maintain dividends.
  • Investment Opportunities: Assess potential investments or projects that require capital. Retaining earnings for reinvestment may be preferable in certain growth situations.
  • Shareholder Expectations: Understand the expectations of shareholders regarding dividends. Balancing shareholder interests with the company's financial goals is crucial.
  • Legal and Regulatory Requirements: Comply with legal and regulatory obligations related to dividend distributions in the relevant jurisdictions.
  • Tax Implications: Consider the tax implications for both the company and shareholders when determining dividend payout policies.
  • Market Conditions: Evaluate the overall market conditions and investor sentiment, as this can influence the impact of dividend decisions on the company's stock price.

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QUESTION 5c

Q (i) The agency problem could be resolved using goal congruence.

Explain the term "goal congruence".

(ii) One of the ways creditors could protect themselves against the inherent risk that might arise from agency conflict is through adopting restrictive covenants.

With reference to the above statement, describe three restrictive covenants in a debt contract.
A

Solution


(i) Goal Congruence in Resolving the Agency Problem


Goal congruence refers to a situation in which the objectives and interests of different parties align or are in harmony with each other. In the context of resolving the agency problem, goal congruence is particularly relevant in ensuring that the interests of the agents (managers or employees) align with the interests of the principals (owners or shareholders).

When there is goal congruence, both parties share common goals, and the actions of the agents are in line with the best interests of the principals. Achieving goal congruence involves designing incentive structures, compensation plans, and performance metrics that motivate managers to make decisions and take actions that are beneficial to the overall objectives of the organization and its stakeholders.


(ii) Restrictive Covenants in Debt Contracts


One of the ways creditors protect themselves against the inherent risk that might arise from agency conflict is through adopting restrictive covenants in debt contracts.


Restrictive covenants are clauses included in debt agreements that impose certain limitations or restrictions on the actions of the borrowing party. These covenants serve to protect the interests of creditors by mitigating the agency problem and reducing the risk of default.


Here are common restrictive covenants in a debt contract:


  • Leverage Ratio: The borrower agrees to maintain a specified maximum level of debt relative to its equity or assets. This helps ensure that the company does not become overly leveraged, reducing the risk of financial instability.
  • Dividend Restrictions: The borrower may be restricted from paying dividends above a certain amount or ratio, preventing the depletion of funds that could be used to repay debt. This protects creditors' interests by ensuring a steady source of repayment.
  • Asset Sale Restrictions: The borrower may be prohibited from selling a significant portion of its assets without the consent of creditors. This prevents the company from divesting valuable assets that serve as collateral or a source of repayment.


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