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CPA
Intermediate Leval
Financial Management May 2019
ANSWERS

Financial Management
Revision Kit

QUESTION 1a

Q (i) Information si unallin o theory. (2 marks)
(ii) Tax differential theory, (2 marks)
(iii) Bird-in-hand theory. (2 marks)
(iv) Agency theory. (2 marks)
A

Solution


1. Information signaling theory - According to this theory, a management decision to raise, hold steady, or lower the dividend indicates how they expect the business to perform going forward. When management increases the amount of dividends to be paid, it shows they have confidence in the company's future growth potential. The management anticipates challenging times for the company if they cut payouts.

2. Tax differential theory - People prefer capital gains to dividends and income. The reason is that dividend income is taxed at a higher rate than capital gains. Therefore, investors opt for capital gains to reduce their tax burden

3. Bird-in-hand theory - Dividends take priority over capital gains. This is because the dividend is certain and investors can say with certainty when and how much they will receive. For capital gains, there is an element of uncertainty, so investors don't know how much capital gains they may earn

4. Agency theory - Is a theory that attempts to explain possible conflicts between principals (such as shareholders) and agents (such as management) that may not be in the principal's best interest. Some methods that can be used to reduce this agency conflict include:

(i). Hiring of auditors
(ii). Firing of non-performing directors at annual general meeting

(iii) Threat of takeover

(iv) .Share options.

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QUESTION 1b

Q Using the yield to maturity (YTM) valuation model, advise Clare Mwatata in making the investment decision* (6 marks)
A

Solution


Option 1

YTM = [(1,600/875)1/5 - 1 ] = (1.1283 - 1) x 100% = 12.83%

Option 2

YTM
=
[
1 + (Mv-Mps)/n
(Mv + Mps)/2
]
(1 - t) x 100%


Where;

I= 16/100 x 100 = 16%
n=5 years
MV = 100
MPS = 95
T=0.3 =30%

YTM
=
[
16 + (100-95)/5
(100 + 95)/2
]
(1 - 0.3) x 100%


17/97.5 x 0.7 x 100% = 12.21%

Not invest in any options.


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QUESTION 1c

Q Using the discounted cash flow valuation method, determine the current value of the 1 ,000 ordinary shares of Upendo Ltd. (6 marks)
A

Solution


Year
1
2
3
4
5
6 to ∞

 Dividends
1.5 × 1.11 = 1.65
1.5 × 1.12 = 1.815
1.5 × 1.13 = 1.9965
1.9965 x 1.081 = 2.1562
1.9965 × 1.082 = 2.3287
(2.3287(1.05))/( 0.12 - 0.05) = 34.9305

 Discount factor 12%
0.8929
0.7972
0.7118
0.6355
0.5674
0.5674

 Present value
1.4733
1.4469
1.4211
1.3703
1.3213
19.8196
26.8525


Current value of 1,000 Upendo shares

= 1,000 × 26, 8525 = Ksh. 26,852.50

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QUESTION 2a

Q (a) Propose four reasons that might make a firm use reserves to finance its operations. (4 marks)
A

Solution


Reasons that make a firm use reserves to finance its operations
1. Costs associated with flotation are avoided, making it less expensive.

2.Easily accessible. It can be made accessible for use to finance activities with a swift resolution.

3.It doesn't raise the gearing ratio for the company

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QUESTION 2b

Q (i) The current theoretical value of the firm-s ordinary shares using dividend growth model. (6 marks)

(ii) The theoretical value per share using the super-profit model. (4 marks)
A

Solution


Amani limited

(i) Book value per share = equity capital ÷ number of shares

200,000,000 ÷ 10,000,000 = Sh. 20

Return on equity

(Earnings per share/Book value per share) x 100

4/20 x 100 = 20%

Sustainable growth rate (g) = Return on equity (1- payout ratio)

20 (1 - 0.4)= 12%

Value of share =(Do(1 + g))/(r + g)

Where, Do = 40/100 x 4 = 1.6

Value of share= (1.6(1.12))/( 0.18 - 0.12) = Shs. 29.87

(ii) Theoretical value of share (P) = Net tangible assets + goodwill/Number of shares

Net tangible assets = 48 million

Ordinary shares = 2 million

Where Goodwill = super profits × number of years of purchase
Super profits = 10,000,000 - 12/100 x 48,000,000

4,240,000

Goodwill = 4,240,000 x 5 = 21,200,000

Po = (21,200,000 + 48,000,000)/2,000,000 = Shs. 34.60

Note: Super profits = expected profits - expected return

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QUESTION 2c

Q Advise the management of Chizingo Manufacturing Limited on whether to offer the cash discount to customers. (6 marks)
A

Solution


Old sales = 200,000 x 2,500 = Sh. 500,000,000
New sales = 220,000 x 2,500 = Sh. 550,000,000

Average debtors = average collection period/ 365 x credit sales
Average debtors old policy = 60/365 x 500,000,000 = Shs. 82,191,780.82
Average debtors under new policy will be categorized under:
i. Discount after debtors
ii. Non-discount after debtors

Average debtors discount offer = 15/365 x 0.6 x 550,000,000 = 13,561,643.84
Average debtors non-discount offer
15/365 x 0.4 × 550,000,000 = Shs. 9,041, 095.89

Total average debtors new policy

13,561,643.84 +9,041,095.89 = 22,602,739.73

Opportunity cost

Old policy = 15/100 x 82, 191, 780.82 = Shs. 12,328,767.12

New policy 15/100 x 22,602,739.73 = Shs. 3,390,410.96

Discount allowed new policy 2/100 x 60/100 x 550,000,000 = 6,600,000

Details
Rates
Less: variable costs
Contribution
Less: other costs
Less: discount allowed
Less: opportunity cost debtors
Profit before tax
Less: tax 30%
Profit after		 New policy
550,000,000
(462,000,000)
88,000,000
(44,000,000)
(6,600.000)
(3,390,410.96)
34,009,589.04
(10,202,876.71)
23,806,712.33 		Old policy
500,000,000
(420,000,000)
80,000,000
(40,000,000)
0
(12,328,767.12)
27,671,232.88
(8,301,369.86)
19,369,863.02 		Change
50,000,000
(42,000,000)
8,000,000
(4,000,000)
(6,600,000)
8,938,356.16
6,338,356.16
(1,901,506.848)
4,436,849.312


The management of Chizingo manufacturing Limited should change credit policy since it's profitable to do so.

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QUESTION 3a

Q (i) The cost of ordinary share capital (3 marks)

(ii) The cost of 12% irredeemable debenture capital (2 marks)

(iii) The cost of 14% irredeemable preference share capital. (2 marks)

(iv) The firm's weighted average cost of capital (WACC). (5 marks)
A

Solution


(i) Cost of OS(Ke)

Ex-div price = 45 - 5 = 40

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

g = ROE x (1 - DPR)

Where: Return on equity (ROE) -20%

Dividend payout ratio (DPR) - 60%

g = 20% (1 - 0.6) = 8%

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

Do = 5, g = 8%, Po = 40%

(5(1.08)/40 + 0.08) x 100 = 21.5%

ii. Cost of 12% irredeemable debenture capital

ex-interest price = 112 - 12/100 x 20 = 112 - 2.4 = Sh.109.6,

Ki = I(1-t)/Po x 100% = 12/100 x 20 = 2.4%

T = tax rate 30% , Po = 109.60

Ki= 2.4(1 - 0.3)/ 109.6 x 100% = 1.53%

iii. Cost of 14% irredeemable preference share capital

Dividend per share (Dp) = 14/100 x 25 = Sh.3.5

Ex-dividend price = 33.5 - 3.5 = Sh. 30

Kp = Dp/Po x 100% = 3.5/30 x 100% = 11.67%

Cost of retained earnings

Kr = Do(1+g)/Po + g x 100%

Where; Do = 5, g = 8% and P = 40

Kr = (5(1 + 0.08))/40 + 0.08 x 100% = 5.4/40 + 0.08 x 100%

(0.135 + 0.08) 100% = 21.5%

iv. WACC

Number of ordinary shares = ordinary share capital/ par value

50,000,000/20 = 2,500,000

Number of debentures debenture capital /par value

25,000,000/20 = 1,250,000

Number of preference shares = preference share capital/ par value

15,000,000 ÷ 25 = 600,000

Source
Ordinary shares
Retained earnings
Preference shares
Debentures

 Amount
2,500,000 x 40 = 100,000,000
30,000,000 = 30,000,000
30 x 600,000 = 18,000,000
1,250,000 × 109.6 = 137,000,000
285,000,000
 Weight
0.35
0.11
0.6
0.48

 Cost of source
21.5%
21.5%
11.67%
1.53%

 Weighted cost
7.53%
2.37%
0.70%
0.73%
11.33%


WACC = 11.33%

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QUESTION 3b

Q ( i) Return on capital employed (ROC E). (2 marks)
( ii) Interest coverage ratio. (2 marks)
(iii) Earnings per Share (EPS). (2 marks)
(iv) Dividend yield (2 marks)
A

Solution


i. Return on capital (ROCE)

operating profit/ capital employed x 100%

2018 = 29,490 / 107,800 x 100% = 27.36%

2017 = 27,012 / 105,174 x 100% = 25.68%

In 2018 for every Sh. 100 of capital employed generated Shs.27.36 as operating profit.
In 2017 every Sh 100 of capital employed generated Shs 25.68 as operating profit

ii. Interest coverage ratio

operating profit/interest paid

2018 = 29,498,000 / 3,106,000 = 9.50

2017 = 27,012,000 / 3,726,000 = 7.25

In 2017, for every Sh. 100 of interest to be paid there was Sh 725 as operating profit to cater for it.
In 2018, for every Sh. 100 of interest to be paid, there was Sh. 950 as operating profit to cater for it.

iii. Earnings per share (EPS)

earnings after tax/ number of outstanding shares

2018 = 17,698,000 / 28,000,000 = 0.63

2017 = 15,834,000 / 28,000,000 = 0.57

iv. Dividend yield (DY)

P/E ratio = Market price per share/ Earnings per share

Market price per share = Earnings per share x P/E ratio

2018 market price per share 14 x 0.63 = Sh.8.82

2017 market price per share 13 x 0.57 = Sh. 7.41

Dividend per share = dividend payable/number of ordinary shares

2018 dividend per share = 9,600,000 / 28,000,000 = 0.34

2017 dividend per share = 6,200,000 / 28,000,000 = 0.22

Dividend yield = dividend per share/market price per share x 100%

2018 dividend per share = 0.34 / 8.82 x 100% = 3.85%

2017 dividend yield 0.22 / 7.41 x 100% = 2.97%

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QUESTION 4a(i)

Q (i) Highlight fòur reasons behind the fast growth of credit card finance in your country.
A

Solution


Reasons behind fast growth of credit cards finance

1. Employers who commit fraud and theft have compeled businesses to utilize credit cards because they reduce the need for actual cash.

2. Reduces the hazards associated with carrying large sums of cash

3.Increases the holder companies' credit score

4. Middle-class and wealthy people are using credit cards more frequently because they see them as status symbols.l

5. Financial companies and banks have used these cards to increase deposits and draw in loyal customers, such as Royal Card Finance and Standard Chartered.

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QUESTION 4a(ii)

Q (ii) Evaluate four limitations ot using credit cards as a source of finance. (4 marks)
A

Solution


Limitations of using credit cards as a source of finance

1. The usage of such cards may be terminated by the credit card company without prior notification.

2. Entail a lot of formalities to obtain e.g bank statement presentation

3. It is a short term financing source.

4. Danger of abuse, such as from dishonest workers

5. They cause excessive spending on the part of the holder, which may cause the organization's cash budget and cash planning to become disorganized.

6. Risk of credit card theft

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QUESTION 4b

Q Using the net present value (NPV) method, advise the management of Juhudi Industries on whether to replace the existing machine with the new one. ( 12 marks)
A

Solution


Depreciation of old machine = (original cost - salvage value) / useful life

(4,000,000 - 0) / 5 = 800,000

Book value of old machine today

Cost - accumulated depreciation

4,000,000 - (800,000 x 2) = Sh. 2,400,000

Gain on disposable old machine

Sh. (2,500,000 - 2,400,000) = Sh. 100,000

Step 1: incremental outlay
Cost of new machine
Add: installation cost
Effective cost of new machine
Investment working capital
(320,000 + 140,000 - 300,000)
Capital gain tax disposal gains (0.3 × 100,000)
Less: disposal value of old machine
Incremental initial outlay		 8,000,000
400,000
8,400,000

160,000
30,000
(2,500,000)
6,090,000


Step 2: incremental depreciation

Depreciation of new machine.

(8,400,000 - 0) / 10 = 840,000 per annum

Less depreciation recalculated old machine
(2,400,000 - 500,000) / 10 = 190,000 per annum

Incremental depreciation

840,000 - 190,000 = Sh. 650,000 per annum

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

 Sh. 0
Sh. 500,000
Sh. (500.000)


Step 4: incremental terminal benefits
Recovery working capital (step 1)
Incremental salvage value (step 3)

 Sh. 160,000
Sh. (500,000)
Sh. (340.000)


Step 5: incremental operating cash inflows

1. (350,000 - 280,000) x 0.7 + 0.3 × 650,000 = 244,000

2. (400,000 - 300,000) 0.7 + 0.3 x 650,000 = 265,000

3. (420,000 - 320,000) x 0.7 + 0.3 x 650,000 = 265,000

4. (410,000 - 340,000) x 0.7 +0.3 x 650,000 = 244,000

5. (410,000 - 340,000) x 0.7 + 0.3 x 650,000 = 244,000

6. (380,000 - 320,000) x 0.7 + 0.3 x 650,000 = 237,000

7. (380,000 - 310,000) x 0.7 + 0.3 x 650,000 = 244,000

8. (350,000 - 280,000) x 0.7 + 0.3 x 650,000 = 244,000

9. (300,000 - 260,000) x 0.7 + 0.3 x 650,000 = 223,000

10. (280,000 - 240,000) x 0.7 + 0.3 x 650,000 = 223,000

Step 6: determination of net profit value
Year
1
2
3
4
5
6
7
8
9
10



 Cash flows
244,000
265,000
265,000
244,000
244,000
237,000
244,000
244,000
223,000
223,000 - 340,000 = (117,000)



 Discount factor 10%
0.9091
0.8264
0.7513
0.6830
0.6209
0.5645
0.5132
0.4665
0.4241
0.3855
PV of cash flows
Less initial outlay
NPV		 PV
221,820.4
218,996.0
199,094.5
166,652.0
151,499.6
133,786.5
125,220.8
113,826.0
94,574.3
(45,103.5)
1,380,366.6
(6,090,000)
(4,709,633.40)


You should not replace old machine

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QUESTION 5a

Q (a) Summarise four main features of Islamic insurance mortgage (takaful). (4 marks)
A

Solution


islamic insurance mortgage

1. Each policyholder contributes a portion of the premium as a charitable donation to support those in need of assistance

2. Policyholders work together for the benefit of their collective interests.

3. It does not seek to derive advantage at the cost of others

4. Eliminate uncertainty about subscription and compensation

5. According to the community pooling system, losses are distributed and liabilities are spread.

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QUESTION 5b

Q The number of ordinary shares that must be sold in order to raise the required equity capital (6 marks)
A

Solution


Source
Ordinary share capital
Retained earnings
15% preference shares
16% debenture capital

 Amount(000)
90,000
75,000
45,000
90,000
300,000 		Weight
30%
25%
15%
30%
100%


Amount that needs to be raised
(500,000,000 - 360 000 000) = Sh 140,000,000

Amount to be raised from equity capital
140,000,000 x (25% + 30%) = 77,000,000

Amount to be raised from share capital
(77,000,000 - 29,700,000) = 47,300,000

New ordinary shares issued

47,300,000 / (90 / 100 x 25) = 2,102,222.22 shares


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QUESTION 5c(i)

Q (i ) Explain the term "abandonment" as used in capital budgeting decisions. (2 marks)
A

Solution


Capital budgeting

Abandonment means discounting a project even when it's profitable to continue operating it. NPV of abandonment should exceed NPV without abandonment for this to be viable

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QUESTION 5c(ii)

Q Advise the management of Palakumi Agribusiness Ltd. on the optimal time to abandon the project. (5 marks)
A

Solution


Abandon year 1
Year
1


 cashflows
20,000,000


 DF 10%
0.9091
Less:initial outlay
Net present value		 PV
18,182,000
(16,000,000)
2,182,000


Abandon year 2
Year
1
2



 Cashflows
8,000,000
14,000,000



 DF 10%
0.9091
0.8264
PV of cash inflows
Less:initial outlay
Net present value		 PV
7,272,800
11,569,600
18,842,400
(16,000,000)
2,842,400


Abandon year 3
Year
1
2
3



 Cashflows
8,000,000
6,000,000
11,000,000



 DF 10%
0.9091
0.8264
0.7513
PV of cash inflows
Less:initial outlay
Net present value		 PV
7,272,800
4,958,400
8,264,300
20,495,500
(16,000,000)
4,495,500


Do not abandon option
Year
1
2
3
4



 Cashflows
8,000,000
6,000,000
5,000,000
4,000,000



DF 10%
0.9091
0.8264
0.7513
0.6830
PV of cash inflows
Less:initial outlay
Net present value		 PV
7,272,800
4,958,400
3,756,500
2,732,000
18,719,700
(16,000,000)
2,719,700


Advice:
The management of Palakumi agribusiness Ltd Should abandon the project
in year 3 because that is where the project net present value is highest


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QUESTION 5d

Q The modified internal rate of return (MIRR) of the project (3 marks)
A

Solution


Year
1
2
3
4

 Total cash flow
140,000x1.143
120,000x1.142
80,000x1.141
60,000x1.140
207,416.16
155,952.00
91,200.00
60,000.00
514,568.16


MIRR = [(514,568.16/300,000)1/4 - 1] x 100% = 14.44%


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