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CPA
Intermediate Leval
Financial-Management-November 2018
ANSWERS

Financial Management
Revision Kit

QUESTION 1a

Q Examine four assumptions of the Modigliani and Miller (MM) dividend irrelevance Theory. (4 marks)
A

Solution


Assumptions of Modigliani and miller dividend theory.

1. No taxes.

2. Existence of perfect capital market

3. The dividend policy does not affect capital budgeting

4. All the investors are certain about the future market prices and the dividends.

5. The cost of equity is constant at any dividend payout rate

6. There are neither floatation nor transaction costs

7. The company does not change its existing investment policy

8. Investors are indifferent between dividend income and capital gain income

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QUESTION 1b

Q (i). "Operating leverage" and "financial leverage" (2 marks)

(ii). "Cum-right" and "ex-right" market price per share. (2 marks)

(iii). "Time value of money" and "time preference for money" (2 marks)
A

Solution


(i). "Operating leverage" is the use of fixed operating costs to increase a company's profitability. It is measured using the degree of operating leverage (D.O.L)

D.O.L = % Change in EBIT / % change in sales

or

Contribution/(contribution-fixed cost)

"Financial leverage" refers to the use of fixed financing cost in order to improve earnings per share. It is measured using the Degree of Financial leverage (D.F.L)

D.F.L = (Q(SP - VC) - FC) / (Q(SP - VC) - FC - 1 - Pd / (1 - T))

or

D.F.L = EBIT / EBT - Pd ÷ (1 - t)

Where;

Q = units sold

SP = Selling price per unit

VC = Variable cost

FC = Fixed cost

I = interest

Pd = Preference dividends

T = corporate tax rate

(ii). The "Cum-right" Market Price allows registered shareholders to participate in a company's public rights issue. Eligible shareholders may purchase shares at a discount to the current market price per share.
The "ex-right" is the stock price after the right issue.

(iii). The "time value of money" refers to the idea that a shilling today is worth more than a shilling tomorrow.
"Time preference of money refers" to the desire for present consumption as compared to future compensation. Therefore, to induce people to save, high interest has to be charged for money not consumed today.


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QUESTION 1c

Q (i) The degree of operating leverage. (4 marks)

(ii) The degree of financial leverage. (3 marks)

(iii) The degree of combined leverage. (3 marks)
A

Solution


(i) Degree of operating leverage

Degree of operating leverage = Contribution / (Contribution - Fixed operating costs)

(1 - 0.2) x 8,000,000 = 6,400,000

D.O.L = 6,400,000 / (6,400,000 - 5,800,000) = 10.67

(ii) Degree of financial leverage

=
Contribution - Fixed cost
Contribution - Fixed operating costs - Interest paid- Preference dividend / (1 - t)


=
6,400,000 - 5,800,000
6,400,000 - 5,800,000 - 8 / 100 x 2,000,000 - 30,000 x 2 / (1 - 0.3)
= 1.69


(iii). Degree of combined leverage

D.C.L = Degree of operating leverage x Degree of financial leverage

10.67 x 1.69 = 18.07

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QUESTION 2a

Q Describe four limitations ot the net present value (NPV) method of investment appraisal. (4 marks)
A

Solution


Limitations of NPV

1. Cannot be used to compare projects of different sizes

2. Requires some speculation regarding a project's capital cost

3. Entails speculation regarding projected future cash flows

4. Ignores sunk costs e.g research and development costs incurred before project start.

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QUESTION 2b

Q Using the discounted payback period method, recommend to the management of Bundacho Limited on which project to undertake. (8 marks)
A

Solution


Depreciation per year alpha = (3,800,000 - 0) / 4 = sh. 950,000

Depreciation per year Beta = (800,000 - 0)/ 6 = sh. 1,333,333.33

For working capital it will be utilized in first year and recovered at end of project life.

Project Alpha
Year
Pretax cash flows (000)
Less: Depreciation (000)
Profit before tax (000)
Tax rate at 30%
Profit after tax
Add: Depreciation
Add: Recovery working capital
Cash flows		 1
2,590
(950)
1,640
(492)
1,148
950
0
2,098		 2
2,880
(950)
1,930
(579)
1,351
950
0
2,301		 3
3,050
(950)
2,100
(630)
1,470
950
0
2,420		 4
2,950
(950)
2,000
(600)
1,400
950
825
3,175


Discount payback period
Year

1
2
3
4		 Cashflows
"000"
2,098
2,301
2,420
3,175		 DF 12%

0.8929
0.7972
0.7118
0.6355		 Discounted cashflows
"000"
1,873.30
1,834.36
1,722.56
2,017.71		 Cumulative cashflows
"000"
1,873.30
3,707.66
5,430.22
7,447.93


Initial outlay project Alpha

3,800,000 + 825,000 = 4,625,000

Discount payback period

2yrs + (4,625 - 3,707.66) / 1,722.56 x 12months

2yrs6.39months

Project Beta
Year

PBDT
Less: Depreciation
PBT
Less tax
PAT
Add: Depreciation
Add: Recovery WC
Cashflows		 1
"000"
4300
(1,333.333)
2,966.667
(890.000)
2,076.667
1,333.333
0
3,409.333		 2
"000"
3,290
(1,333.333)
1,956.667
(587.000)
1,369.667
1,333.333
0
2,703		 3
"000"
3,200
(1,333.333)
1,866.667
(560.000)
1,306.667
1,333.333
0
2,640		 4
"000"
3,700
1,333.333
2,366.667
(710.000)
1,656.667
1,333.333
0
2,990		 5
"000"
4,850
(1,333.333)
3,516.667
(1,055.000)
2,461.667
1,333.333
0
3,795		 6
"000"
4,420
(1,333.333)
3,086.667
(926.000)
2,160.667
1,333.333
825
4,319


Year
1
2
3
4
5
6		 cashflows(000)
3,409,333
2,703,000
2,640,000
2,990,000
3,795,000
4,319,000		 D.F 12%
0.8929
0.7972
0.7118
0.6355
0.5674
0.5066 		PV
3,044,193.44
2,154,831.60
1,879,152.00
1,900,145.00
2,153,283.00
2,188,005.40


Project Beta Discounted payback period
Year
1
2
3
4
5
6		 Discount Cashflows
3,044,193.44
2,154,831.60
1,879,152.00
1,900,145.00
2,153,283.00
2,188,005.40		 Cumulative Cashflows (000)
3,044,193.44
5,199,025.04
7,078,177.04
8,978,322.04
11,131,605.04
13,319,610.44


Discount payback period

3yrs + (8,825,000 - 7,078,177.04) / 1,900,145 = 3.92yrs

Advise:
Management of Bundaaho limited should undertake project Alpha because it has the lowest discounted payback period"


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QUESTION 2c

Q Advise the investor on whether to buy the shares of Maraba Ltd. using Gordon's model. (8 marks)
A

Solution


g = [(Dn / Do)1/n - 1] x 100

Where:

Dn = 1.8

Do = 1
n = 4years

g = [(1.8 / 1)1/4 - 1] x 100

(1.1583 - 1) x 100 = 15.83%

Theoretical value of shares

V = Do(1 + g) / (r - g)

Where

Do = 1.8 , r = 20% , g = 15.83%

(1.8(1 + 0.1583)) / (0.2 - 0.1583) = 50

Advice:

Investor should not buy shares of Maraba limited since they are over-valued. Current market price of 55 is more than the intrinsic value of 50 shillings


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QUESTION 3a

Q (a) Propose four factors that might lead to soft capital rationing in a limited company (4 marks)
A

Solution


Factors that might lead to soft capital rationing in a limited company

1. Reliance on internally generated revenues as a policy

2. when a desired investment exceeds the firm's size.

3. Higher cut off ration: setting the firm at rate for investments higher than the firms cost of money.

4. Capital rationing for units of the organization: Fixed allocation from the headquarters to departments

5. Dilution effect: To prevent outsides from gaining control of the firm

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QUESTION 3b

Q Explain four roles that are plaved by insurance companies in the financial market of your country. (4 marks)
A

Solution


Roles that are played by insurance companies in the financial market of your country

1. Risk management

2. pooling of funds for investment in shares of multiple businesses

3. Financial intermediaries

4. Asset management services

5. Financial advisory services

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QUESTION 3c

Q The theoretical value of the company's share. (4 marks)
A

Solution


Year
1
2
3
4
4 ∞

4 x 1.21 = 4.8
4 x 1.22 = 5.76
5.76 x 1.11 = 6.336
5.76 x 1.12 = 6.970
(6.970(1.06)) / (0.16 - 0.06) = 73.88

Discount factor 16%
0.8621
0.7432
0.6407
0.5523
0.5523

PV
4.14
4.28
4.06
3.85
40.80
Sh.57.13


Theoretical value of company's shares = Sh. 57.13


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QUESTION 3d

Q Advise the management of Bahati Enterprises on whether to adopt the proposed credit policy. (8 marks)
A

Solution


New sales

120 / 100 x 6,000,000 = sh.7,200,000

Average debtors:

Average collection period / 360 x credit sales

Average debtors new policy

60 / 360 x 7,200,000 = sh. 1,200,000

Average debtors old policy:

45 / 360 x 6,000,000 = sh. 750,000

Opportunity cost:

Debtors new policy

12 / 100 x 1,200,000 = sh.144,000

Debtors old policy

12 / 100 x 750,000 = sh.90,000

Bad debts:

New policy

2.5 / 100 x 7,200,000 = sh.180,000

Old policy:

2 / 100 x 6,000,000 = sh.120,000

Variable cost:

New policy

75 x 7,200,000 = sh. 5,400,000

Old policy

75 / 100 x 6,000,000 = sh.4,500,000

Details
Sales
Less: variable costs
Contribution
Less: Bad debts
Less: opportunity cost
Less: collection cost
Profit before tax
Less: tax
Profit after tax 		New policy
7,200,000
(5,400,000)
1,800,000
(180,000)
(144,000)
(84,000)
1,392,000
(417,600)
974,400 		Old Policy
6,000,000
(4,500,000)
1,500,000
(120,000)
(90,000)
0
1,290,000
(387,000)
903,000 		Change
1,200,000
(900,000)
300,000
(60,000)
(54,000)
(84,000)
102,000
(30,600)
71,400


The management of Bahati enterprises should adopt new policy


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QUESTION 4a

Q (i) Vertical common size statements of income for the year ended 30 September 2018 (6 marks)

(ii) Vertical common size statements of financial position as at 30 September 2018 (6 marks)
A

Solution


(i) Vertical common size statements of income for the year ended 30 September 2018

W1

ABC LTD
Common size income statement For year ended 30 September 2018

Revenue
Cost of sales
Gross profit
Expenses:
Distribution costs
Administrative expenses
Finance costs
Profit before tax
Tax paid
Profit after tax
Dividend paid
Retained profit for the year
Retained profit brought forward
Retained profit carried forward		 Sh "Million"
4,000
(3,000)
1,000

200
290
10
500
120
380
150
230
220
450		 As % sales
4,000/4000 x100% = 100%
3,000/4000 x100% = 75%
1000/4000 x100% = 25%

200/4,000 x100% = 5%
290/4000 x100% = 7.25%
10/4000x100% = 0.25%
500/4000 x100% = 12.5%
120/ 4,000 x100% = 3%
380/4000 x100% = 9.5%
150/ 4,000 x100% =3.75%
230/ 4,000 x100%= 5.75%
220/ 4,000 x100% = 5.5%
450/4,000 x100%= 11.25%


W2

XYZ LTD
Common size income statement For year ended 30 September 2018

Revenue
Cost of sales
Gross profit
Expenses:
Distribution costs
Administrative expenses
Finance costs
Profit before tax
Tax paid
Profit after tax
Dividend paid
Retained profit for the year
Retained profit brought forward
Retained profit carried forward		 Sh "Million"
6,000
4,800
1,200

150
250
400
400
90
310
100
210
2,480
2,690		 As % sales
6,000/6000x100% = 100%
4800/6000 x100% = 80%
1,200/6000 x100% = 20%

150/6000 x100% = 2.5%
250/6000 x100% = 4.17%
400/6000 x100% = 6.67%
400/6000 x100% = 6.67%
90/6000 x100% = 1.5%
310/6000 x100% = 5.17%
100/ 6,000 x100% = 1.67%
210/6,000 x100% = 3.5%
2,480/6000 x100% = 41.33%
2,690/ 6,000 x100% = 44.83%


Common size income statement
For year ended 30 September 2018

Revenue
Cost of sales
Gross profit
Expenses:
Distribution costs
Administrative expenses
Finance costs
Profit before tax
Tax paid
Profit after tax
Dividend paid
Retained profit for the year
Retained profit brought forward
Retained profit carried forward		 ABC LTD
100%
75%
25%

5%
7.25%
0.25%
12.50%
3%
9.5%
3.75%
5.75%
5.5%
11.25%		 XYZ LTD
100%
80%
2.5%

6.67%
4.17%
1.5%
5.17%
1.5%
5.17%
1.67%
3.5%
41.33%
44.83%


(ii) Vertical common size statements of financial position as at 30 September 2018

W1

Common size Balance sheet
For year ended 30 September 2018


Non-current Assets:
Land and buildings
Furniture and fittings
Total non-current assets
Current assets:
Inventories
Trade receivables
Financial assets
Cash at Bank
Total current assets
Financed by:
Equity and liabilities:
Ordinary share capital
Retained profits
Total equity
Non-Current liabilities:
Bank loan
Current Liabilities:
Trade payables
Bank overdraft
Total current liabilities 		ABC Ltd
Sh"million"

1,200
600
1800

400
850
100
0
1350


1000
450
1450

500

1080
120
200
%Total assets

1200 / 4950 x 100% = 24.24%
600 / 4950 x 100% = 12.12%
1,800 / 4,950 x 100% = 36.60%

400 / 4,950 x 100% = 8.08%
850 / 4,950 x 100% = 7.17%
100 / 4,950 x 100% = 2.02%
0 / 4,950 x 100% = 0%
1,350 / 4,950 x 100% = 27.27%


1,000 / 4,950 x 100% = 20.20%
450 / 4,950 x 100% = 9.09%
1,450 / 4,950 x 100% = 29.29%

500 / 4,950 x 100% = 10.10%

1,080 / 4,950 x 100% = 21.82%
120 / 4,950 x 100% = 2.42%
200 / 4,950 x 100% = 24.24%		 XYZ Ltd
Sh."million"

5,000
1,000
6,000

800
750
230
100
1,880


1,600
2,690
4,290

3,000

590

590
% Total Assets

5,000 / 13,880 x 100% = 36.02%
1,000 / 13,880 x 100% = 7.20%
6,000 / 13,880 x 100% = 43.23%

800 / 13,880 x 100% = 5.76%
750 / 13,880 x 100% = 5.40%
230 / 13,880 x 100% = 1.66%
100 / 13,880 x 100% = 0.72%
1,880 / 13,880 x 100% = 13.54%


1,600 / 13,880 x 100% = 11.53%
2,690 / 13,880 x 100% = 19.38%
4,290 / 13,880 x 100% = 30.91%

3,000 / 13,880 x 100% = 21.61%

590 / 13,880 x 100% = 4.25%

590 / 13,880 x 100% = 4.25%


Vertical Common size Balance sheet
For year ended 30 September 2018

Non-current Assets:
Land and buildings
Furniture and fittings
Total non-current assets
Current assets:
Inventories
Trade receivables
Financial assets
Cash at Bank
Total current assets
Financed by:
Equity and liabilities:
Ordinary share capital
Retained profits
Total equity
Non-Current liabilities:
Bank loan
Current Liabilities:
Trade payables
Bank overdraft
Total current liabilities 		ABC Ltd

24.24%
12.12%
36.6%

8.08%
7.17%
2.02%
0%
27.27%


20.20%
9.09%
29.29%

10.10%

21.82%
2.42%
24.24% 		XYZ Ltd

36.02%
7.20%
43.23%

5.76%
5.40%
1.66%
0.72%
13.54%


11.53%
19.38%
30.91%

21.61%

4.25%

4.25%


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QUESTION 4b

Q (i) The total capital to be raised net of floatation costs. (2 marks)
(ii) The weighted marginai cost of capital (W MCC) for the company. (6 marks)
A

Solution


Source
Ordinary shares
12% preference shares
18% debentures
Loan

Market Value
200,000 x 16 = 3,200,000
75,000 x 18 = 1,350,000
50,000 x 80 = 4,000,000
5,000,000
13,550,000		 Floatation
200,000 x 1 = 200,000
75,000 x 2 = 150,000
0
200,000
550,000		 Net float
3,000,000
1,200,000
4,000,000
4,800,000
13,000,000


Cost of OS(Ke)

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

Do = 28 / (100 x 10) = 2.8

g = 4% ,Po = 16 , f = 1

[(2.8(1 + 0.04)) / (16 - 1) + 0.04] x 100

[2.912 / 15 + 0.04] x 100 = 23.41%

Cost of preference shares (Kp)

Kp = Dp / (Po - f) x 100

Where

Dp = 12% x 20 = 2.4

Po = 18

f = 150,000 / 75,000 = 2

Kp = 2.4 / (18 - 2) x 100% = 15%

Cost of debenture (Kd)

Where

Kd = I(1 - 0.3) / (Po - f) x 100

I = 18 / 100 x 100 = 18

t = 30% , Po = 80 , f = 0

Kd = (18(1 - 0.3)) / (80 - 0) x 100 = 15.75%

Cost of longterm loan (Kl)

Kl = (I(1 - t)) / Mv x 100

I = 18 / 100 x 5,000,000 = 900,000

Kl =(900,000(1 - 0.3)) / 4,800,000 x 100% = 13.125%

Source
Ordinary shares
12% preference shares
18% debentures
18% Loan

 Amount
3,000,000
1,200,000
4,000,000
4,800,000
13,000,000		 Weight
3,000 ÷ 13,000 = 0.23
1,200 ÷ 13,000 = 0.09
4,000 ÷ 13,000 = 0.31
4,800 ÷ 13,000 = 0.37

 Cost of capital
23.41%
15%
15.75%
13.125%

 Weighted Cost
5.38%
1.35%
4.88%
4.86%
16.47%


WMC = 16.47%


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QUESTION 5a

Q Highlight four circumstances under which investors might find it suitable to use an Islamic equity fund. (4 marks)
A

Solution


Reasons why investors find it suitable to use an Islamic Equity fund

(i) Financial screening: The financials of a company, particularly how much debt it has, are taken into account as part of the screening process for figuring out whether an equity asset is sharia-compliant. Islamic equity funds avoid investing in firms that carry very high levels of debt.

Therefore, Islamic funds may be considered more conservative and slightly less risky than some conventional equity funds.

(ii) Transparency: Islamic equity fund investors demand a high degree of transparency. Since one of the main goals of the fund is to adhere to sharia, the fund managers must be completely transparent about which industries and companies they invest in.

(iii) Liquidity: Liquidity is an advantage of investing in a fund over a fixed-term investment for the Islamic investor. As circumstances change and the investor needs or wants to cash out, it is considerably simpler to do so when the money is invested in a fund. Yet generally speaking, Islamic investments, particularly Islamic funds, have a lower level of liquidity than their conventional counterparts.

(iv) Diversification: The risk of losing money when calamity hits and a business files for bankruptcy or shuts its doors is reduced by investing in any fund, whether it be Islamic or conventional, that buys assets from multiple companies.

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QUESTION 5b

Q Advise Witham Mgunya on whether to invest in the debentures. (4 marks)
A

Solution


Annual interest paid = 12 / 100 x 100 = sh.12

Year
1 - 10
10

Cashflows
100
1000

DF 18%
4.4941
0.1911

PV
449.41
191.10
640.51


Since current market price of sh.80 is less than intrinsic value of
debenture of shs.104.9728, then William Mgunya should invest in the debentures.


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QUESTION 5c

Q (i). The expected return for each security. (2 marks)

(ii). The standard deviation tòr each (2 marks)

(iii). The correlation coefficient between the two securities' returns, (3 marks)

(iv). Determine the expected return of a portfolio constituting 60 0/6 or Security A and 40% of Security B state of economy Probability (PO Security returns ( 0/0) (2 marks)

(v). Compute the risk of the porttòlio in (c) (iv) above, (3 marks)
A

Solution


(i). The expected return for each security.

➪ Expected return A = (Ā)

A = 0.3 x 12 + 0.4 x 15 + 0.3 x 10

3.6 + 6 + 3 = 12.6%

➪ Expected return B = (B̄)

B = 0.3 x 6 + 0.4 x 7.5 + 0.3 x 5

1.8 + 3 + 1.5 = 6.3%

(ii) Standard deviation of A

δA = √(122 x 0.3 + 152 x 0.4 + 102 x 0.3) - 12.62

√(43.2 + 90 + 30) - 158.762

√4.44 = 2.11

Standard deviation of B

δB =√(62 x 0.3 + 7.52 x 0.4 + 52 x 0.3) - 6.32

√(10.8 + 22.5 + 7.5) - 39.69

√1.11 = 1.05

(iii) Coefficient of correlation

P
0.30
0.40
0.30

 A
12
15
10

 Ā
12.6
12.6
12.6

 (A-Ā)
-0.6
2.4
-2.6

 B
6
7.5
5

 B̄
6.3
6.3
6.3

 (B-B̄)
-0.3
1.2
-1.3

 (A-Ā)(B-B̄)
0.18
2.88
3.38
6.44


TA&B
=
COVA&B
δAδB
=
6.44
2.11 x 1.05
= 2.9068


(iv) Portfolio return

0.6 x 12.6 + 0.4 x 6.3 = 10.08%

(v) Portfolio risk

δp =√WA2δA2 + WB2δB2 + 2(WA WBCOVA&B)

√0.62 x 2.112 + 0.42 x 1.052 + 2[0.6 x 0.4 x 6.44]

2.2069

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