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CPA
Intermediate Leval
Financial-Management-November 2016
ANSWERS

Financial Management
Revision Kit

QUESTION 1a

Q Explain four disadvantages of public private partnerships (PPPs).
A

Solution


Disadvantages of Public-Private Partnerships (PPPs)


  1. Cost Overruns and Delays:

    PPP projects can be susceptible to cost overruns and delays. The complexity of negotiating and managing partnerships between public and private entities may lead to extended project timelines and increased costs, impacting the overall value for money.

  2. Risk Transfer Issues:

    There is a risk that some projects may transfer an excessive amount of risk to the private sector. If risks are not allocated appropriately, it can lead to disputes, legal challenges, and increased costs. Some risks, such as regulatory changes or unforeseen events, may be difficult to accurately allocate.

  3. Financial Viability and Profit Motivation:

    Private sector partners in PPPs are profit-driven entities. In some cases, this profit motive may lead to conflicts of interest with the public sector's goal of delivering affordable and accessible public services. The focus on financial viability may also result in higher user charges or fees for the public.

  4. Public Perception and Opposition:

    PPP projects can face opposition from the public due to concerns about transparency, accountability, and the potential for private entities to prioritize profits over public welfare. Lack of public support can lead to political and social challenges, making it difficult to implement and sustain PPP initiatives.

  5. Complex Contractual Arrangements:

    The negotiation and implementation of PPP contracts can be highly complex. Crafting agreements that balance the interests of both public and private partners, specifying performance metrics, and addressing unforeseen circumstances require sophisticated legal and financial expertise. Poorly structured contracts can lead to disputes and operational challenges.

  6. Political Sensitivity and Interference:

    PPP projects are often subject to political influence and changes in government priorities. Shifts in political leadership or public sentiment may lead to changes in project scope, funding, or even cancellation, affecting the stability and continuity of PPP initiatives.

  7. Lack of Competition:

    In some cases, there may be limited competition in the procurement of PPP projects, especially if only a few private entities are capable of undertaking large-scale projects. This lack of competition can hinder the achievement of value for money and may lead to inflated costs.

  8. Long-Term Commitments and Rigidity:

    PPP agreements often involve long-term commitments, and the rigid nature of contracts may make it challenging to adapt to changing circumstances, technological advancements, or shifts in public needs over the life of the project.

    9.

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QUESTION 1b

Q Describe six steps involved in personal financial planning
A

Solution


Personal Financial Planning Steps


  1. Establish Financial Goals:

    Begin by defining your financial objectives. These could include short-term goals like creating an emergency fund or paying off debt, as well as long-term goals such as saving for education, buying a home, or planning for retirement. Clear and specific goals provide direction for the financial planning process.

  2. Gather Data:

    Collect comprehensive information about your current financial situation. This involves examining your income, expenses, assets, and liabilities. Understand your spending habits, sources of income, outstanding debts, and any existing investments. Gathering accurate data is crucial for making informed decisions.

  3. Analyze Data:

    Evaluate the data you've collected to gain insights into your financial position. Identify areas where you can cut costs, increase savings, or optimize investments. Assess your risk tolerance, time horizon, and financial capacity. The analysis phase helps in identifying opportunities and potential challenges.

  4. Develop a Plan:

    Based on the analysis, formulate a personalized financial plan. This plan should outline specific strategies for achieving your established financial goals. Include details about budgeting, savings, investment allocations, and debt management. The plan serves as a roadmap to guide your financial decisions.

  5. Implement the Plan:

    Put your financial plan into action. This involves executing the strategies outlined in the plan. For example, start following a budget, contribute to savings and investment accounts, and make necessary adjustments to your spending habits. Implementation is a crucial step in turning your financial goals into reality.

  6. Monitor the Plan:

    Regularly review and monitor the progress of your financial plan. Keep track of changes in income, expenses, and market conditions. Assess whether you are on track to meet your goals and make adjustments as needed. Monitoring ensures that your plan remains relevant and effective over time.

    7.

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QUESTION 1c

Q (i) Book value per share.

(ii) Market price per share.

(iii) Market value to book value ratio.
A

Solution


(i) Book value per share


Total equity = total assets - Total liabilities

7,000,000 - 4,000,000 - 500,000 = Sh. 2,500,000

Book value per share =: Total equity/ No. of shares

2,500,000 / 400,000 = 6.25

(ii) Market price per share


Market price per share (MPS) = P / E ratio x E.P.S
1.10 x 15 = Sh. 16.50

(iii) Market value to book value ratio


Market value to book value ratio = Market price per share/ Book value per share

16.50 / 6.25 = 2.64

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QUESTION 2(a)

Q Discuss three possible solutions to adverse selection.
A

Solution


Adverse Selection


Adverse selection refers to a situation where one party in a transaction has more information than the other, leading to a distortion in the market. This information asymmetry can result in negative consequences, particularly in financial markets or insurance markets.

Possible solutions to address adverse selection:

  1. Information Disclosure:

    Encourage or mandate information disclosure to reduce information asymmetry and promote transparency in transactions.

  2. Underwriting and Screening:

    Conduct thorough risk assessments through underwriting and screening processes to identify and exclude high-risk individuals.

  3. Risk-Based Pricing:

    Implement pricing models that reflect the actual risk, charging different prices based on the risk profile of individuals or entities.

  4. Government Regulations:

    Enforce regulations to address adverse selection, including disclosure requirements, standards for underwriting practices, and rules against discriminatory practices.

  5. Pooling and Diversification:

    Create pools of diverse risks to offset the impact of adverse selection, particularly in insurance markets.

  6. Mandatory Participation or Insurance:

    Require individuals to participate in certain markets or purchase insurance to spread risks across a broader population.

  7. Continuous Monitoring and Adjustments:

    Regularly monitor market conditions and risk factors, making adjustments to underwriting criteria or pricing models as needed.

  8. Incentives and Discounts:

    Provide incentives or discounts for individuals with favorable risk characteristics to attract low-risk participants.

  9. Educational Campaigns:

    Educate consumers about the consequences of adverse selection and the importance of providing accurate information.

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QUESTION 2(b)

Q (i) The weighted average cost of capital (WACC).

(ii) Explain four reasons why the cost of equity could be greater than the cost of debt
A

Solution


(i) The weighted average cost of capital (WACC).


Growth rate model = [(Dn / Do)1/n - 1] x 100%

[(3.63 / 3.09)1/4 - 1] x 100%

(1.04109 - 1) x 100% = 4.109%

Cost of ordinary shares (Ke)

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

[(3.63(1.04109)) / 47] + 0.04109 x 100% = 0.1215 or 12.15%

Cost of preference shares(Kp)

Kp = Dr / Po x 100

Dp = Dividends per preference share = 4 / 100 x 1 = 0.04

Po = Market price per share = Sh.0.4

0.04 / 0.4 x 100% = 10%

Cost of bonds(Kd)


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


I = Interest paid 7% x 100 = sh.7

MV = Maturity value 105 / 100 x 100 = sh 105

Mps = Market price per share = sh 104

t = 30%

n = 6 years


YTM
=
[
7 + (105 - 104.5) / 6
(105 + 104.5) / 2
]
(1 - 0.3) x 100% = 4.73%


Cost of loan(KI)

KI = I(1 - T) x 100%

4(1 − 0.3) x 100% = 2.8%

Number of ordinary shares → 800,000 ÷ 5 = 160,000

Number of preference shares → 600,000 ÷ 1 = 600,000

Number of bonds → 600,000 ÷ 100 = 6,000

Market value ordinary shares → 800,000 / 5 x 47 = 7,520,000

Market value preference share → 600,000 x 0.4 = 240,000

Market value bonds → 104.5 x 6,000 = 627,000


Equity
Preference shares
Redeemable bonds
Bank loan

 Market value
7,520,000
240,000
627,000
200,000
8,587,000		 Weight
0.88
0.03
0.07
0.02

 Cost of source
12.15%
10%
4.73%
2.80%

 Weighted costs.
10.69%
3.00%
0.33%
0.06%
14.08%




WACC = 14.08%

(ii) Explain four reasons why the cost of equity could be greater than the cost of debt


The cost of equity is the return required by equity investors (shareholders) to compensate them for the risk they undertake by investing in a particular company. On the other hand, the cost of debt is the interest rate a company pays on its debt, representing the cost of borrowing. The cost of equity is often greater than the cost of debt for several reasons:

  1. Risk Premium:

    Equity investors demand a risk premium to compensate for the higher risk associated with ownership in a company.

  2. Uncertainty and Volatility:

    Equity investments are more volatile, leading to higher perceived risk and a greater cost of equity.

  3. No Fixed Obligations:

    Equity investors lack fixed obligations, making equity riskier and contributing to a higher cost.

  4. Residual Claimants:

    Equity investors are residual claimants, exposed to greater risk in the event of financial distress or bankruptcy.

  5. Lack of Tax Shield:

    Unlike debt, dividends paid to equity investors are not tax-deductible, increasing the effective cost of equity.

  6. Perpetuity of Equity:

    Equity represents a perpetual claim, contributing to a higher cost compared to the finite life of debt.

  7. Market Conditions:

    Market conditions and economic factors can influence the cost of equity, especially during periods of uncertainty.

  8. Opportunity Cost:

    Equity investors have alternative investment opportunities, requiring companies to offer a competitive return.

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QUESTION 3(a)

Q (i) The amount of external 12% long term debt financing that would be required for the year ending 31 December 2016.

(ii) A forecast statement of financial position as at 31 December 2016.

(iii) Comment on two weaknesses of the method of forecasting applied in (a)(i) and (a)(ii) above
A

Solution


(i) The amount of external 12% long term debt financing that would be required for the year ending 31 December 2016.


Amount of external financing required for the year ended 21 December 2016:

Profit margin (2015) = Profit / Sales

18,000,000 / 120,000,000 x 100% = 15%

Incremental sales:

Sales (2016) = 110 / 100 x 120,000,000 = Sh. 132,000,000

Profit after tax

15 / 100 x 132,000,000 = Sh. 19,800,000

Retained Earnings 2016:

20 / 100 x 19,800,000 = Sh. 3,960,000

% of sales method

Plant and machinery = Plant and machinery / x 100

31,200 / 120,000 x 100 = 26%

Furniture and fittings = Furniture and fittings / sales x 100

18,720 / 120,000 x 100 = 15.6%

Motor vehicles = Motor vehicles / sales x 100

12,480 / 120,000 x 100 = 10.4%

Inventory = Inventory / sales x 100

19,200 / 120,000 x 100 = 16%

Accrued Receivables = Accrued Receivables / sales x 100

14,400 / 120,000 x 100 = 12%

Cash and Bank = Cash and Bank / sales x 100

3,600 / 120,000 x 100 = 3%

Accounts payable = Accounts payabl / sales x 100
18,000 / 120,000 x 100 = 15%

10% Accrued expenses = Accrues expenses / sales x 100
12,000 / 120,000 x 100 = 10%

Incremental in assets
Plant and machinery 0.26 x 12,000,000
Furniture and fittings 0.156 x 12,000,000
Motor vehicles 0.104 x 12,000,000
Inventory 0.16 x 12,000,000
Account Receivables 0.12 x 12,000,000
Cash and Bank 0.03 x 12,000,000
Increase in total assets
Less: Accounts payable 0.15 x 12,000,000
Less: Accrued expenses 0.1 x 12,000,000
Less: Retained earnings for the year
External 12% long-term debt finance
3,120,000
1,872,000
1,248,000
1,920,000
1,440,000
360,000
9,960,000
(1,800,000)
(1,200,000)
(3,960,000)
3,000,000


(ii) A forecast statement of financial position as at 31 December 2016.



Georgina Ltd.
Forecasted statement of financial position as at 31 December 2016:

Plant and machinery
Furniture and fittings
Motor vehicles
Total fixed assets:
Current assets:
Inventory
Accounts receivable
Cash and bank
Total current assets
Total assets
Financed by:
Ordinary share capital
Retained profit
Shareholder's funds
14% debenture capital
12% long term debt
Total long term capital
Current liabilities
Accounts payable
Accrued expenses
Current liabilities

 Sh."000"
31,200 + 3,120
18,720 + 1,872
12,480 + 1,248


19,200 + 1,920
14,400 + 1,440
3,600 + 360




17,600 + 3,960





15 / 100 x 132000
10 / 100 x 132000


 Sh. "000"
34,320
20,592
13,728
68,640

21,120
15,840
3,960
40,920
109,560

42,000
21,560
63,560
10,000
3,000
76,560

19,800
13,200
33,000
109,560


(iii) Comment on two weaknesses of the method of forecasting applied in (a)(i) and (a)(ii) above


  1. Assuming a constant net profit margin is impractical as it fluctuates from year to year.

  2. Assuming that dividends can only be paid in cash is unrealistic since other forms, such as bonus issues, exist.

  3. The assumption that the value of money remains constant is unrealistic; its value changes over time.

  4. Imagining a direct link between sales and balance sheet items is unrealistic.

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QUESTION 3b

Q (i) The operating cycle in days.

(ii) The amount of working capital required.
A

Solution


(i) The operating cycle in days.


Debtors period = Average debtors / credit sales x 365

48,000 / 1,600,000 x 365 = 10.95days

Raw material period = Average raw material / Raw material consumption x 365

32,000 / 440,000 x 365 = 26.55days

WIP conversion period = Average work in progress / production cost x 365days

35,000 / 1000,000 x 365 = 12.78 days

Finished goods holding period = Average finished goods / cost of sales x 365 days

26,000 / 1,050,000 x 365 = 9.04 days

Creditors period = Average Creditors/purchases x 365days

Creditors period = 16 days

16 = Average creditors / (440,000 + 32,000) x 365

∴ 16 = (365 x Average creditors) / 472,000

∴ Average creditors = (16 x 472,000) / 365

∴ Average creditors = 7,552,000 / 365 = 20,690

Length of operating cycle
Raw materials holding period
WIP conversion period
Debtors period
Finished goods holding period
26.55
12.78
10.95
9.04
59.32


Operating cycle in days = 59.32

(ii) The amount of working capital required


Average Raw materials
Average Work In Progress
Average Finished goods
Average Debtors

Less: Average creditors
Amount of working capital required		 32,000
35,000
26,000
48,000
141,000
(20,690)
120,310



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QUESTION 4(a)

Q The current intrinsic value of the share.
A

Solution


Dividends = Dividend payout ratio x profit after tax

40 / 100 x 50,000,000 = Sh. 20,000,000

Dividend per share (DPS) = Dividends paid/ Issued ordinary shares

20,000,000 / 10,000,000 = Sh.2per share

Year
1
2
3
4 ∞

 Future Cashflows
2(1.1) = 2.2
2(1.1)² = 2.42
2(1.1)³ = 2.662
21.5008
Intrinsic value		 PVF,n,18%
0.8475
0.7181
0.6086
0.6086

 Present value
1.86
1.74
1.62
13.09
18.31


Dividends to perpetuity = (Do(1 + g))/(r - g)

(2.662(1.05)) / (0.18 - 0.05) = 21.5008

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QUESTION 4(b)

Q Explain whether the share is overvalued or undervalued by the market.
A

Solution


Capitalize the preference dividends

Kp = Preference dividends / Mps of preference

Mps of Preference = Preference dividend / Kp

Preference dividend = 10% x 100 = 10

Therefore Mps = 10 / 0.08 = 125

The current market price of the stock, set at Ksh. 110, is below its intrinsic value or theoretical worth of Ksh. 125, indicating that the shares are presently undervalued by the market. Potential investors are recommended to consider purchasing the company's shares as they are priced below their actual value, presenting an opportunity for favorable returns.

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QUESTION 4(c)

Q Using the net present value (NPV) technique, advise the company's management on whether to replace the existing machine.
A

Solution


Net present value (NPV) of the replacement decision:

Depreciation of existing machine before critical evaluation:

2,000,000 / 5 = sh.400,000 perannum

Book value of existing machine

2,000,000 - (400,000 x 2) = Sh. 1,200,000

Gain if existing machine sold now

1,250,000 - 1,200,000 = Sh. 50,000

Step 1:Incremental initial outlay
Purchase cost of new machine
Add:Additional investment working capitai
Loss:Disposal value existing machine
Add:Tax on disposal gains(0.3 x 50,000)
Initial outlay
3,140,000
650,000
(1,250,000)
15,000
2,555,000


Step 2:Incremental Depreciation

Depreciation new machine

(3,140,000 - 1,000,000) / 5 = Sh. 428,000

Depreciation new machine after critical evaluation

(1,200,000 - 250,000) / 5 = Sh. 190,000

Incremental depreciation = 428,000 - 190,000 = Sh. 238,000

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


Step 4: Incremental terminal befits
Recovery of working capital
Add: Incremental salvage value
1,000,000
(250,000)
750,000


650,000
750,000
1,400,000


Step 5: Incremental operating cash inflows
Year
1
2
3
4
5

 New machine
1,400,000
1,350,000
1,300,000
1,450,000
1,200,000

 Old machine
800,000
700,000
750,000
650,000
600,000

 Change
600,000
650,000
550,000
800,000
600,000

 Cash inflows
(600,000 x 0.7) + (0.3 x 238,000) = 491,400
(650,000 x 0.7) + (0.3 x 238,000) = 526,400
(550,000 x 0.7) + (0.3 x 238,000) = 456,400
(800,000 x 0.7) + (0.3 x 238,000) = 631,400
(600,000 x 0.7) + (0.3 x 238,000) = 491,400
1,400,000


NPV of the project
YEAR
1
2
3
4
5 (490,400 + 1,400,000)
Sum discounted cash flow
Incremental initial cost N.P.V

 Cashflows Sh."000"
491,400
526,400
456,400
631,400
1,891,400



 FVIFn,10%
0.9091
0.8264
0.7513
0.6830
0.6209



 Present value
446,731.74
435,016.96
342,893.32
431,246.20
1,174,370.26
2,830,258.48
(2,555,000.00)
275,258.48


Advice:

Management of Mwarakaya limited company should replace existing machine due to positive NPV

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QUESTION 5a

Q (i)Yield-to-maturity (YTM).

(ii) Yield-to-call (YTC).
A

Solution


(i) Yield-to-Maturity (YTM):


Yield-to-Maturity (YTM) is a measure of the total return anticipated on a bond if it is held until it matures. In other words, YTM represents the annualized rate of return an investor can expect to receive by holding a bond until it matures and receives all its cash flows. This measure takes into account the bond's current market price, par value, coupon interest rate, and the number of years remaining until maturity.

The YTM calculation considers the following components:

  • Coupon Payments: The periodic interest payments the bondholder receives.
  • Par Value: The face value of the bond, which is returned to the bondholder at maturity.
  • Current Market Price: The present value of future cash flows, including both coupon payments and the par value.

YTM is expressed as an annual percentage rate (APR) and is used by investors to compare the potential returns of different bonds. If the bond is purchased at par (its face value), the YTM will be equal to the coupon rate. If the bond is purchased at a discount, the YTM will be higher than the coupon rate, and if the bond is purchased at a premium, the YTM will be lower than the coupon rate.


(ii) Yield-to-Call (YTC):


Yield-to-Call (YTC) is similar to YTM but focuses on the yield an investor would receive if a callable bond is called by the issuer before its maturity date. Callable bonds give the issuer the option to redeem (call back) the bonds before the scheduled maturity date, typically when interest rates have declined, allowing the issuer to reissue bonds at a lower interest rate.


The YTC calculation takes into account the call price (the price at which the issuer can redeem the bond) and the remaining period until the call date. Like YTM, YTC considers the present value of future cash flows, including coupon payments and the call price.


Investors use YTC to assess the potential return if the bond is called before maturity. If the bond is called early, the investor may not receive the expected interest payments over the entire life of the bond. YTC allows investors to evaluate the yield under both the possibility of the bond being held until maturity and the possibility of it being called before maturity.

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QUESTION 5b

Q (i) Yield-to-maturity of the bond.

(ii) Yield-to-call of the bond.
A

Solution


(i) Calculation for YTM


To compute YTM we will compute it using trial and error method.
Par value = Sh. 10,000

Coupon rate = 12% / 2 = 6%

YTM
=
[
Interest + (Pv - Mv) / n
(Pv + Mv) / 2
]
x 100%

Interest(I) = 6% x 10,000

YTM
=
[
600 + (10,000 - 8,830) / 10
(10,000 + 8,830) / 2
]
x 100%

Note: tax rate is not given

YTM = 0.0762 = 7.62% semi annual

15.24% per annum

(ii) Calculation of yield to call (YTC)


YTM
=
[
Interest + (Pv - Mv) / n
(Pv + Mv) / 2
]
x 100%

Interest(I) = 6% x 10,000

YTM
=
[
600 + (10,000 - 10,500) / 10
(10,000 + 10,500) / 2
]
x 100%



YTC = 0.0536 = 5.36% semi-annual

10.72% per annum

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QUESTION 5c

Q (i) The percentage taxable income if EBIT increases by 6%.

(ii) The percentage EBIT if there is a 10% increase in sales.

(iii) The percentage taxable income if sales increase by 8%.
A

Solution


(i) The percentage taxable income if EBIT increases by 6%.


DFL = Operating profit(EBIT) / Profit before tax = 600,000 / 525,000 = 1.15

Percentage change in taxable income if operating profit increases by 6% → 6% x 1.15 = 6.9%

(ii) Degree of operating leverage


DOL = Contribution/ Operating profit = 2,100,000 / 600,000 = 3.5

If sales increase by 10%, operating profit increases by 10% x 3.5 = 35%

(iii) Degree of combined leverage


DCL = Contribution/Profit before tax = 2,100,000 / 525,000

If sales increase by 8%, profit before tax increases by 8% x 4 = 32%

Or


Degree of combined leverage Degree of financial leverage x Degree of operating leverage

1.15 x 3.5 = 4.025

Percentage change in taxable income if sales increase by 8%

4.025 x 8 = 32.2% → 32%

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