CPA
Intermediate Leval
Financial-Management-May 2017
ANSWERS

1. Interest Costs:

   Fixed Obligations: Long-term debt often involves fixed interest payments. This means that the organization must make these payments regardless of its financial performance. In periods of economic downturn or financial stress, meeting these fixed obligations can be challenging and may strain the organization's cash flow.

2. Risk of Insolvency:

   Default Risk: If an organization fails to meet its debt obligations, it may face serious consequences, including legal actions, downgrades in credit ratings, and, in extreme cases, bankruptcy. The risk of default is higher with long-term debt compared to short-term debt.

3. Impact on Credit Rating:

   Creditworthiness: Depending on the amount of debt an organization carries, its credit rating may be adversely affected. A lower credit rating can lead to higher interest rates on future debt issuances and may limit the organization's ability to attract additional financing.

4. Limited Financial Flexibility:

   Commitment of Resources: Long-term debt represents a significant commitment of future cash flows. This commitment can limit an organization's financial flexibility, restricting its ability to invest in new opportunities, respond to changing market conditions, or weather economic downturns.

5. Market Conditions:

   Interest Rate Fluctuations: Changes in interest rates can impact the cost of servicing long-term debt. If interest rates rise, the organization may face higher interest expenses, potentially affecting profitability and financial stability.

6. Asset Encumbrance:

   Collateral Requirements: Lenders often require collateral to secure long-term debt. This means that specific assets of the organization may be pledged as security. In the event of default, these assets may be seized by lenders, limiting the organization's ability to use them for other purposes.

7. Covenant Compliance:

   Stringent Terms: Long-term debt agreements often come with covenants that impose restrictions on the organization's activities. Failure to comply with these covenants can lead to default. The strict terms may limit the organization's ability to make strategic decisions or respond quickly to market changes.

8. Market Perception:

   Investor Perception: A high level of long-term debt on the balance sheet may be perceived negatively by investors. It can signal financial risk and may lead to a decrease in the organization's stock price.

9. Inflexibility in Repayment:

   Rigid Repayment Schedules: Long-term debt typically comes with fixed repayment schedules. While this provides predictability, it can also be inflexible. If the organization's cash flows are not aligned with the repayment schedule, it may face challenges in meeting its debt obligations.

1. Capital Budgeting and Investment Decisions:

   The cost of capital is used as a benchmark for evaluating the profitability of potential investments. Businesses compare the expected return on an investment with their cost of capital to determine whether the investment is financially viable. This aids in making informed capital budgeting decisions and allocating resources efficiently.

2. Setting Financial Goals:

   Determining the cost of capital helps businesses establish realistic financial goals. It provides a basis for setting target rates of return that align with the company's risk tolerance and market conditions. This, in turn, guides financial strategies and ensures that the business pursues projects that contribute to shareholder value.

3. Capital Structure Planning:

   The cost of capital influences decisions regarding the capital structure of a business— the mix of debt and equity. By analyzing the cost associated with various sources of funding, companies can optimize their capital structure to minimize overall financing costs while maintaining an appropriate level of financial risk.

4. Setting Competitive Prices:

   Understanding the cost of capital is vital for pricing products and services. Businesses need to incorporate the cost of capital into pricing models to ensure that prices cover not only production costs but also the cost of financing. This contributes to achieving profitability and sustaining competitiveness in the market.

5. Attracting Investors:

   Investors assess a company's cost of capital as part of their decision-making process. A reasonable cost of capital signals financial stability and competence, making the company more attractive to potential investors. It influences the company's ability to raise funds from the capital markets at favorable terms.

6. Performance Measurement:

   The cost of capital serves as a yardstick for evaluating the financial performance of a business. By comparing the actual return on investment with the cost of capital, businesses can assess their efficiency in generating returns for shareholders. This performance measurement is crucial for maintaining and improving overall financial health.

or

1. Conversion Value:
   Conversion Value = Conversion Ratio x Current Market Price
   Conversion Value = 30 x Sh.4.15 = Sh.124.5
2. Market Value of Bond:
   Market Value of Bond = 142% x Par Value
   Market Value of Bond = 142% x Sh.100 - Sh.142
3. Conversion Premium:
   
   
   Conversion Premium

   =

   Conversion Value − Market Value of Bond

   ---

   Conversion Value

   
   
   

   Conversion Premium

   =

   124.5 − 142

   ---

   124.5

   = -14.06%
   
   

• Profitability:

  Companies with consistent and sustainable profits are more likely to have a stable dividend policy. Profitability is a key determinant of a company's ability to generate cash flows to pay dividends.

• Cash Flow:

  The availability of cash is crucial for paying dividends. Even profitable companies may face challenges if their cash flow is insufficient to cover dividend payments.

• Debt Levels:

  High levels of debt may limit a company's ability to pay dividends. Companies need to balance distributing profits to shareholders with meeting debt obligations and maintaining financial stability.

• Investment Opportunities:

  Companies might retain earnings instead of paying dividends if they have significant investment opportunities that could generate higher returns for shareholders in the long run.

• Industry Norms:

  Industry standards and norms play a role in shaping a company's dividend policy. Some industries may be more inclined to pay dividends, while others may prioritize reinvesting in the business.

• Tax Considerations:

  The tax implications for both the company and its shareholders can influence the dividend policy. Tax-efficient strategies may be considered to maximize returns for shareholders.

• Shareholder Expectations:

  Companies often consider the expectations of their shareholders. If investors rely on consistent dividend income, the company may strive to maintain or increase dividend payments.

• Legal and Regulatory Environment:

  Legal and regulatory requirements, including restrictions on the distribution of profits, can influence a company's dividend policy. Compliance with local and international regulations is essential.

• Economic Conditions:

  Economic factors, such as inflation rates, interest rates, and overall economic stability, can impact a company's dividend decisions. Unfavorable economic conditions may lead companies to reconsider dividend payments.

• Company Life Cycle:

  Companies in different stages of their life cycle may adopt different dividend policies. Young and growing companies might reinvest earnings, while mature companies might distribute more profits to shareholders.

• Competitive Pressures:

  The competitive landscape can influence a company's dividend decisions. If competitors have attractive dividend yields, a company may adjust its policy to remain competitive.

• Currency Considerations:

  For multinational companies, currency fluctuations can affect dividend decisions. Companies need to consider the impact of exchange rates on their ability to pay dividends in various currencies.

• Corporate Governance:

  The company's governance structure and commitment to shareholder value may influence its dividend policy. Transparent communication and alignment with shareholder interests are essential.

• Market Conditions:

  Overall market conditions, including investor sentiment and market trends, can impact a company's dividend policy. Companies may adjust their policies based on prevailing market conditions.

• Prices of financial assets already reflect all historical market information, including past prices and trading volumes.

• Technical analysis, which involves using historical price and volume data to predict future price movements, is considered ineffective.

• Prices of financial assets reflect all publicly available information, including both historical information and all public announcements and news.

• Fundamental analysis, which involves analyzing public information and financial statements, is considered ineffective in consistently outperforming the market.

• Prices of financial assets reflect all information, including both public and private information. Insiders and individuals with access to private information cannot consistently achieve higher-than-average returns.

• Even with insider information, it is assumed that individuals cannot consistently beat the market, as all relevant information is already reflected in asset prices.

• Investors are assumed to be rational and will make decisions based on all available information.

• Irrational behavior, such as persistent market anomalies, is not expected to persist in an efficient market.

• Investors can buy and sell assets without incurring transaction costs.

• In the absence of transaction costs, investors can easily adjust their portfolios to new information, contributing to market efficiency.

• There are no tax implications for buying or selling assets.

• Tax considerations are not expected to impact investor decisions in an efficient market.

• Investors have similar expectations about future market movements and potential returns.

• Differences in opinion among investors are limited, reducing the likelihood of consistently mispricing assets.

• Future price movements are unpredictable and follow a random walk.

• Technical analysis and other methods attempting to predict short-term price movements are not expected to consistently outperform the market.

• Financial Stability and Survival: Profit maximization ensures financial stability and the long-term survival of a business. Continuous profitability is necessary for covering operating expenses, servicing debt, and reinvesting in the company's growth.

• Resource Allocation for Growth: Profits provide the necessary resources for a firm's growth. Reinvesting profits allows a business to expand operations, enter new markets, invest in research and development, and remain competitive in the industry.

• Shareholder Value Maximization: Profit maximization is often associated with maximizing shareholder wealth. Shareholders, as the owners of the company, benefit from increased profits through dividends and capital appreciation of their shares.

• Ability to Meet Obligations: Profitable operations ensure that a company can meet its financial obligations, including payments to suppliers, employees, and lenders. Profitability is crucial for maintaining a positive relationship with stakeholders.

Arguments Against Profit Maximization:

• Risk of Sacrificing Quality or Ethics: Pursuing profit maximization may lead to compromises in product quality or ethical standards to cut costs. This can harm the reputation of the business and result in long-term negative consequences.

• Neglect of Other Stakeholders: Focusing solely on profit may lead to neglecting the interests of other stakeholders, such as employees, customers, and the broader community. This can result in a strained relationship with these groups and may impact the company's social responsibility.

• Short-Term Orientation: Profit maximization can encourage a short-term orientation, where businesses prioritize immediate gains over long-term sustainability. This may hinder investments in innovation and sustainable practices that benefit the company in the long run.

• Market Share vs. Profitability: Emphasizing profit maximization may lead to a focus on pricing strategies that maximize short-term profits but do not necessarily contribute to market share growth. Long-term success may require a balance between profitability and market share expansion.