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CPA
Intermediate Leval
Financial Management May 2018
ANSWERS

Financial Management
Revision Kit

QUESTION 1(a)

Q Explain three working capital financing policies and their implications in an organisation. (6 marks)
A

Solution


Working capital financing policies and their implications in an organisation.

Working capital financing policies, it deals with the sources and amount of working capital that a corporation should maintain.

(i) Aggressive financing policy
➫ The utilization of short-term financing to fund the company's permanent and seasonal working capital requirements.
➫ It reduces the company's profitability and causes a reduction in the company's liquidity position.

(ii) Conservative financing policy
➫ The utilization of long-term finances to finance the company's permanent and seasonal working capital requirements. It is a less expensive alternative because long-term funds are paid over a longer period of time.

(iii) Matching policy
➫ Refers to the use of long-term funds to finance the company's permanent working capital needs and short-term funds to finance the company's seasonal working capital needs.

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QUESTION 1(b)

Q (i) The current value of the bond. (3 marks)
(ii) The par value of the bond. (2 marks)
A

Solution


Year
1-10
10

 Cashflows
100
1000

 DF 18%
4.4941
0.1911

 PV
449.41
191.10
640.51

Current bond value

50,000,000 / 1,000 x 640.51 = 32,025,500

(ii). Par value of bond Sh.1000

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QUESTION 1(c)

Q (i) The optimal cash balance. (3 marks)
(ii) The upper cash limit. (2 marks)
(iii) The average cash balance, (2 marks)
(iv) The spread (2 marks)
A

Solution


3
√
3Cδ2
4i
+ L

Where:
C=Transaction cost = 20
δ²= Variance of daily cash flows = 2500²
i = Daily interest rate = 0.092 / 365
L = Minimum cash balance sh. 10,000

3
√
3 x 20 x 2,500²
4 x 0.092 / 365
+ 10,000


7191.60 + 10,000 = shs. 17,191.60

(ii) Upper cash limit (H)

H = 3Z - 2L
(3 x 17,191.60) - (2 x 10,000)
51,574.80 - 20,000 = shs. 31,574.80

(iii) Average Balance

(4Z - L) / 3

(4 x 17,191.60 - 10,000) / 3

(68,766.60 - 10,000) / 3 = sh. 19,588.80

(iii) The spread

Spread H - L = 31,574.80 - 10,000 = shs. 21,574.80

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QUESTION 2(a)

Q Explain three assumptions of the Gordon's dividend model. (6 marks)
A

Solution


Assumptions of the Gordon's dividend medel

(i). The business model of the company is steady, which means that there are no substantial changes in its operations.
(ii). The company's free cashflow is paid as dividends
(iii) The company grows at a constant rate
(iv). The company has stable financial leverage
(v). The firm is an all equity financed company. (k)
(vi). The life of a firm is indefinite
(vii). Cost of capital (k) is greater than rate of return
(viii). Once determined, the retention ratio remains constant.
(ix). The rate of return (r) and cost of capital is constant

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QUESTION 2(b)

Q Using the net present value (NPV) technique, advise the management of Kubusa Ltd. on whether to replace the existing machine with the new machine. (14 marks)
A

Solution


Depreciation of old machine pre-critical analysis

(8,000,000 - 0) / 5 = sh. 1,600,000

Current book value of existing machine before contemplation of disposal

8,000,000 (1,600,000 x 2) = shs. 4,800,000

Depreciation of existing machine post critical analysis

(4,800,000 - 1,500,000) / 5 = sh. 660,000 per year

Step 1: Incremental outlay
Purchase cost new machine
Add: investment working capital
Less: Disposal value new machine
Less: Tax shield benefit disposal loss (0.3 x 800,000)


Step 2: Incremental depreciation
Depreciation new machine (12,560,000 - 4,000,0000.) / 5
Less: Depreciation old machine


Step 3: Incremental salvage value
Salvage value new machine
Less: Salvage value old machine


Step 4: Incremental terminal benefit
Recovery working capital (Step 1)
Add: Incremental Salvage value(step 3)


12,560,000
2,600,000
(4,000,000)
(240,000)
10,920,00


1,712,000
(660,000)
1,052,000


4,000,000
(1,500,000)
2,500,000


2,600,000
2,500,000
5,100,000


Step 5: Incremental operating cash in flows

Year
1
2
3
4
5		 EBIT sh.000
New machine
5,400
5,400
5,400
5,400
5,400		 EBIT sh.000
Old machine
3,200
2,800
3,000
2,400
2,000		 Change EBIT
sh.000
2,200
2,600
2,400
3,000
3,400


Cash flows per year

Cashflows EBDT(1-T)+TxDepreciation

Year 1 = (2,200 x 0.7) + 0.3 x 1052 = 1855.60
Year 2 = (2,600 x 0.7) + 0.3 x 1052 = 2135.60
Year 3 = (2,400 x 0.7) + 0.3 x 1052 = 1995.60
Year 4 = (3,000 x 0.7) + 0.3 x 1052 = 2415.60
Year 5 = (3,400 x 0.7) + 0.3 x 1052 = 2695.60

Year
1
2
3
4
5



Cashflows (000)
1855.60
2135.60
1995.60
2415.60
7795.60



 D.F 13%
0.8850
0.7831
0.6931
0.6133
0.5428
PV of cash inflows
Less: initial outlay (Step 1)
NPV		 PV (000)
1642.206
1672.388
1383.150
1481.487
4231.452
10,410.683
(10.920.000)
(509.317)


Advice:

Management should not replace existing machine with new machine since doing so will result to a negative NPV thus destruction of shareholders wealth.

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QUESTION 3(a)

Q Argue three cases for and three cases against the use of market values for various components of cost of capital in determining the weighted average cost of capital (WACC) of a firm (6 marks)
A

Solution


Argument for use of market values in WACC computation
(i). They reflect current market conditions in which new funds may be obtained.
(ii). Assets are valued at market
(iii). By presenting the entire balance sheet at market value, capital strength is shown as liquidated value
(iv). Investors also want a market required rate of return on the market value of the capital rather than the book value of the capital.
(v). Weightings based on book values are unreliable

Argument against use of market values in WACC computation

(i). It is difficult to determine the market value of equity and debt, particularly for unlisted companies.
(ii). The market must be efficient and reasonable in order for market price to equal market value.
(iii). Market value also requires the aspect of "special value" to be ignored.
A special value is a synergy that exists between two parties that raises the fair price of a transaction.

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QUESTION 3(b)

Q Weighted average cost of capital (WACC) for the company. (8 marks)
A

Solution


Weighted average cost of capital (WACC) for the company

Cost of ordinary shares
Ke = D1 / Po + g x 100%

1.2 / 30 + 0.1 x 100% = 14%

Cost of retained earnings

Kr = D₁ / Po + g x 100%

1.2 / 30 + 0.1 x 100% = 14%

Cost of Debentures (Kd)

Kd
=
[
1 +(MV - MPS) / n
(MV + MPS) / 2
]
x (1 - t) x 100%


Where;-
I = interest paid 0.06 x 150 = 9
t = tax rate 30% or 0.3
MPS Market price per debenture
Maturity value
n = number of years - 100 years

Kd
=
[
9 + (100 - 110) / 100
(100 + 110) / 2
]
x (1 - 0.3) x 100%


8.9 / 105 x 0.7 x 100% = 5.93%

Cost of preference shares

Kp = Dp / Po x 100%

Dp = 10 / 100 x 20 = Sh.2

Po = 20,000,000 / 1,000,000 = 20

Kp = 2 / 20 x 100 = 10%

Source
Ordinary shares
Retained earnings
10% preference shares
6% debentures

Amount 000
3,000 x 30 = 90,000
20,000
20,000
30,000 / 150 x 110 = 22,000
152,000		 Weight
90,000 / 152,000 = 0.59
20,000 / 152,000 = 0.13
20,000 / 152,000 = 0.13
22,000/152,000 = 0.14

Cost of capital
14%
14%
10%
5.93%

WACC
8.26%
1.82%
1.3%
0.83%
12.21%

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QUESTION 3(c)

Q Determine whether the shares of Muhendato Ltd. are currently fairly valued, undervalued or overvalued for an investor expecting to sell them after 5 years. (6 marks)
A

Solution


Dividend paid = 40 / 100 x 6,500,000 = 2,600,000

Dividend per share = 2,600,000 / 1,000,000 = Sh 2.6

Year
1
2
3
4 to ∞

 Dividend per share
2.6 x 1.15¹ = 2.99
2.6 x 1.15¹ = 2.99
2.6 x 1.15¹ = 2.99
3.95(1.08) / (0.12 - 0.08) = 106.65

 D.F 12%
0.8929
0.7972
0.7118
0.7118

 PV
2.67
2.74
2.81
75.91
84.13


Since the price of sh.65 five years from now is less than the intrinsic value of sh.84.13 then muhendato shares are undervalued

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QUESTION 4a(i)

Q (i) Ijara. (2 marks)
(ii) Sukilk. (2 marks)
A

Solution


(i) Ijara
➫ It is a sharia-compliant mortgage comparable to conventional rent
➫ It requires supplying commodities or services on a lease or rental basis.

(ii) Sukuk
➫ Is an Islamic financial instrument /certificate similar to a bond in conventional finance.
Basically sukuk is a sharia compliant bond

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QUESTION 4(b)

Q Distinguish between the terms "capital market" and "money market" (2 marks)
A

Solution


Distinguishing between the terms "capital market" and "money market"

(i). Money market finance is more expensive than capital market finance, which is secured by fixed assets.
(ii). In the money market, the borrower's goodwill qualifies him for the financing, whereas in the capital market, the borrower's ability to raise securities is more significant.
(iii). Finance in the money market is received in cash, but finance in the capital market is gained in kind, such as through the use of fixed assets.
(iv). Finance in the money market is raised quickly, whereas finance in the capital market takes longer to raise due to the formalities.
(v). Finance in the money market is often unsecured, as opposed to finance in the capital market, which is secured against fixed assets. involved

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QUESTION 4(c)

Q (i) Describe two types of capital rationing in capital budgeting. (4 marks)

(ii) Advise on the optimal project combination. (5 marks)
A

Solution


Capital rationing
Capital rationing is a technique that businesses use to determine which investment possibilities to pursue. The typical purpose of capital rationing is to focus a company's limited capital resources to the most profitable ventures.

(i) Types of capital rationing in capital budgeting
(a). Hard capital rationing
(b). Soft capital rationing

➫ Hard capital rationing refers to external constraints imposed on a corporation by institutions such as banks or other lenders.
➫ Soft capital rationing is caused by a company's own policy governing how it want to utilise its capital.

(ii) Advise on the optimal project combination.

Project
A
C
Surplus funds

 Initial outlay(M)
30
60
0

 Net present Value(M)
20
40
0.14 x 0 / 0.1 = 0
60


Optimal project is to invest in A&C and invest surplus funds at rate of 14%


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QUESTION 4(d)

Q The total present value of the project. (5 marks)
A

Solution


Year
1-5
6-10
11-15

 Cashflows
5,000
9,000
4,000

Factor 10%
3.7908
6.1446 - 3.7908 = 2.3538
7.6061 - 6.1446 = 1.4615

 P.V (sh.000)
18,954
21,184.2
5,846
45,984.2


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QUESTION 5(a)

Q Distinguish between "financial planning" and s•financial forecasting". (2 marks)
A

Solution


Distinguish between "financial planning" and "financial forecasting"
➫ Financial planning is an instrument for building a specific financial plan for how a company or individual will afford to fulfill its strategic goals and objectives.
➫ Financial forecasting is the process of estimating a company's future performance, for example, using the percentage of sales technique to estimate future sales.

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QUESTION 5(b)

Q Explain four benefits that might accrue from demutualisation of securities exchange of your country. (4 marks)
A

Solution


Benefits that might accrue from demutualisation of securities exchange

(1). Demutualization allows for a more thorough and timely evaluation of stock exchanges in order to maximize available synergies.
(2). Demutualization results in a better platform in response to possible competitors in the form of alternative trading systems.
(3). It leads to a more adaptable governance structure that encourages decisive action in response to changes in the business environment.
(4). Demutualization increases investor engagement in exchange governance.
(5). It ensures greater access to resources for capital investment raised through equity offerings.
(6). Demutualization gives you more freedom and access to global markets.

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QUESTION 5(c)

Q (i) Cost or sales. (2 marks)
(ii) Gross profit. (2 marks)
(iii) Total sales. (2 marks)
(iv) Total purchases, (2 marks)
(v) Net profit. (2 marks)
(vi) Debtors value. (2 marks) (vii) Creditors value. (2 marks)
A

Solution


(i) Cost of sales
Gross profit margin 20 / 100 = 1 / 5
Mark up
1 / (5 - 1) or 25%
Stock turnover = Cost of sale / Average stock

Cost of sales = Stock turnover x average stock

Average stock = (Opening stock + closing stock) / 2

(450,000 + 510,000) / 2 = 480,000

Cost of sales = 480,000 x 10 = shs. 4,800,000

(ii) Gross profit
Mark up = Gross profit / Cost of sales x 100%

Gross profit = Mark up / 100 x cost of sales

25/ 100 x4,800,000 = sh. 1,200,000

(iii) Total sales
Gross profit margin = Gross profit / sales x 100%

Sales = Gross profit / Gross profit margin x 100%

1,200,000 / 20 x 100% = sh. 6,000,000

(iv) Total Purchases
Cost of sales Opening stock + closing stock - Closing stock

Purchases Cost of sales + closing stock - Opening stock

4,800,000 + 510,000 - 450,000 = Sh. 4,860,000

(v) Net profit
Net profit = Net profit margin / 100 x sales

15 / 100 x 6,000,000 = shs.900,000

(vi) Debtors' value
Debtors value = Average debt collection period/12months x Credit sales

Credit sales = 3 / 4 x 6,000,000 = sh. 4,500,000

Debtors value
2 / 12 x 4,500,000 = Sh. 750,000

(vii) Credit value
Credit value = Current period / 12months x Credit Purchases

1 / 12 x 4,860,000 = sh. 405,000

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