CPA
Intermediate Leval
Financial-Management-November 2019
ANSWERS

A
(i) Explanation of Principal agent problem
This is a priority conflict between an individual or group and an agent authorized to act on their behalf. Representatives may act in ways that adversely affect key interests.

(ii) Ways of addressing the principal-agent problem
1. Shareholders intervention: Shareholders vote for incompetent directors at the annual shareholders' meeting.

2. They may have arrangements related to funding decisions. For example, we may require representation at annual meetings or board meetings where credit decisions are made..

3. Creditors can protect themselves by creating covenants in debt agreements to limit the disposal of assets, debt financing, and the company's ability to share and indemnify.

4. Incur agency cost such as:

• Oversight costs, such as audit costs and compliance costs.

• Restructuring costs for structuring the organization to limit the potential for undesirable management behavior.

• Opportunity costs associated with lost revenue opportunities arising from structures in which managers are unable to take timely action, such as when managers are also owners.

5. A stock option program for managers may be introduced. This forces managers to take actions that increase shareholder wealth.

6. Labor market measures to hire only professional managers with a proven track record.

7. Lenders may refuse to lend to the company or charge higher than market rates to compensate for the increased risk.

8. Application of corporate governance principles that dictate how a company should be managed and controlled.

9. Threat of hostile takeover: Underperformance leads to a situation where the stock is undervalued in the stock market. This presents the risk of a company takeover with the consequence that the management of the current company will be changed. Only good performance helps.

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A
Total new sales 140/100 x 6,000,000 = Sh. 8,400,000........

New credit sales =60/100 x 8,400 000 = Sh. 5,040,000

Old credit sales 80/100 x 6,000,000 = Sh. 4,800,000

New bad debts =5/100 x 5,040 000 = Sh. 252,000

Old bad debts = 3/10 x 4,800 000 = Sh. 144,000

Discount allowed 5/100 x 5,040,000 = sh. 252,000

Old debtors = 45/365 x 4,800,000 sh.591,781

New debtors =15/365 x 5,040,000 = sh. 207,123

Sales Less: Variable costs - Gross profit Bad debts Discount allowed Consultant pay Opportunity cost debtors Profit before tax Less: Tax 30% Profit after tax

New 8,400,000 (1,680,000) 6720 000 (252 000) (252 000) (500 000) (24,855) 5,691,145 (1,707,344) 3,983,802

Old 6000,000 (1,500,000) 4,500,000 (144,000) - - (71,014) 4,284,986 (1,285,500) 2,999,490

Change 2,400,000 (180,000) 2,220,000 (108,000) (252 000) (500 000) 46,159 1,406,159 (421,848) 984,311

Advice
Company should adopt new policy.

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A
Cost of OS(ke)



Where Do → Dividend per share 60 / 100 x 6 = 3.6

g → growth rate dividends = 7%
Po → market price per share = Sh.50

Therefore;

Ke = 3.6(1.07) / 50 + 0.07 x 100%
= 14.7%

Cost of preference shares (Kp)

Kp = Dp / Po x 100%

Where; Dp → Dividend per preference share

12 / 100 X 20 = 2.4

Po → market price per share = Sh. 30

Therefore,

Kp = 2.4/ 30 × 100% = 8%

Cost of 10% debentures (Kd)

Kd

=

I(1-T)

---

Po

× 100%

Where:
I → interest = 10/100 x 100 = sh10
T → Tax rate = 30% or 0.3
PO → market price per debenture = 120

Therefore;

Kd

=

10(1 - 0.3)

---

120

× 100% = 5.83%

Number of ordinary shares = Ordinary share capital/ Par value

30,000,000/10 = 3,000,000

Market value ordinary shares = 3,000,000 × 50 = Sh.150,000,000

Number of debentures 15,000,000 / 100 = 150,000

Market value 10% debentures 150,000 x 120 = 18,000,000

Number of 12% preference shares = 5,000,000 / 20 = 250,000

Market value = 250,000 × 30 = 7,500,000

Source Ordinary shares 10% debentures 12% preference shares

Amonat (000) 150,000 18,000 7,500 175,500

Weight 0.85 0.10 0.05

Cost of capital% 14.7 5.83 8.00 WACC

Weighted cost % 12.50% 0.58% 0.40% 13.48%

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A
(i) Explanation of the term "cross-border" listing

Cross borders listing explanation.. Cross bordering listing Includes companies traded on the stock exchange of the country and on the stock exchanges of other countries.

(ii) Benefits of cross-border listing to a quoted company

• Market Consolidation: Securities of similar risk have the same expected return when traded on the two markets. Global market integration is hampered by direct and indirect obstacles

• Liquidity: Liquid stocks have lower expected returns and lower trading costs. This increases overall trading volume and reduces bid-ask spreads in the domestic market.

• Corporate governance signal: Indirect barriers can be removed through corporate governance. Entering the market with better investment protection reduces costs and commitments.

• Capital needs and growth Opportunities: Companies in emerging markets will need to use cross-listings to raise capital to continue growing beyond their home markets.

• Wider shareholder base: A wider shareholder base means less risk, lower expected returns and higher prices.

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A

A
ii) Total cost of working capitai înance for the company under an aggressive financing policy, conservative financing policy and matching financing policy........

Cost of aggressive financing policy

20/100 x (71,250,000 + 35,000,000) = 21,250,000

Cost of conservative financing policy
25/100 x (71,250,000 + 35,000,000) = 26,562,500

Cost of marching policy
20/100 x 71,250,000 + 25/100 × 35,000,000

= 14,250,000 + 8,750,000 = Sh. 23,000,000

iii) Advise to the company on the appropriate working capital financing policy to adopt

Best policy to adopt is the aggressive financing policy because it costs less.

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A

A
Mean Y 0.1 x 1.0 + 0.2 x 12 + 0.35 x 8 + 0.05 x 15 + 0.15 x 14 + 0.15 x 9 =10.4%

Standard deviation of security Y

δ_y = √0.1(10)² + 0.2(12)² + 0.35(8)² + 0.05(15)² + 0.15(14)² + 0.15(9)² - 10.4²

√114 - 108.6

√5.4 = 2.32%

Mean Security z

0.10 × 8 + 0.2 x 10 + 0.35 x 7 + 0.05 × 12 + 0.15 + 11 + 0.15 x 8

= 0.8 + 2 + 2.45 + 0.6 + 1.65 + 1.2 = 8.7%

Standard deviation z

δ_y = √0.1(8)²+0.2(10)²+0.35(7)² + 0.05(12)² +0.15(11)² + 0.15(8)² — 8.7².

√78.5c- 75.69

√2.81 = 1.68%

ii) The relative risk of security Y and security Z

Coefficient of variation = Standard Deviation / Mean × 100%

Coefficient of variation = 2.32 / 10.4 × 100% = 22.31%

Coefficient of variation = 1.68 / 8.7 x 100% = 19.31%

iii) Advise to the investor on which of the two securities to invest in

Invest insecurity z because it has the least risk.

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A
(i) Determine the market price per share (MPS) using the dividend growth model

Intrinsic value before change in financial policy

g = [(7.3/5.0)^1/4 - 1 ] x 100%

(1.0992-1) x 100% = 9.22%

Value of share

=

Do(1+g)

---

r - g

Value of share

=

7.3(1.0992)

---

0.16 - 0.992

= sh.131.98

(ii) The market price per share (MPS) as at 31 December 2018 under the new financing policy.

Value of share

=

5

---

0.16 - 0.14

= Shs.2.50

(iii) Break-even growth rate in DPS

Po = 133/ 0.16 - g = 5

133.83(0.16 - g) = 5

Thus, g = 0.1226 = 12%.

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A
Common financial products provided by Islamic finance institutions and how each differs from that provided by non-Islamic financial institutions.

➢ Musharakah financing: Investors and clients are considered partners.

• Under non conventional lenders are institutions and borrowers are customers.

➢ Murabaha: The party is considered the lender (seller) and the buyer (customer) enters into the contract.

• In non-islamic financial institutions parties involved are borrower and lender.

➢ Savings account is based on Shari'ah compliant mode of 'Mudaraba'. : Only profit sharing is allowed for Islamic financial institutions

• For non-Islamic financial institutions interests is paid to depositors.

➢ Sukuk Islamic bond Issuers of sukuk sell it to investors, issue certificates, and later lease it for a fee. The issuer also commits to repurchase the certificates at the par value of the securities in the future.

• under conventional, banks, bonds pay interest.

➢ Ijarah: Assets owned by the customer can be sold and leased back to the seller. Here, the seller receives the proceeds from the sale and has the right to continue using the asset at the rental rate. Interest is not predetermined.

• under non-Islamic financial institutions rental fee is interest predetermined

➢ Mudaraba: An instrument that allows banks to purchase assets, machinery, or appliances. The customer agrees to acquire the asset and will repay the asset at a mutually agreed premium on top of the cost acquired through the bank's hire purchase.

• Under conventional finance interest is charged .

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A
(i) Subscription price right issue price

75/100 x 100 = Sh.75

Number of shares issued

= initial outlay / subscription price

= 4,500,000 / 75

60,000 ordinary shares.

(ii) The number of rights required to subscribe for one new ordinary share

120,000 ordinary shares = 60,000 rights issue shares

Ordinary share = ?

Therefore:

2 / 120000 x 60,000 = 0.5

Therefore

1 ordinary share is equivalent to 0.5 right issue shares

(iii) The theoretical ex-right market price per ordinary share

(Po + So) + (Ps x S)

---

So + S

Po → Cum right market price per share = Sh 100
So → Existing number of shares
P → Offer price
S → New issued shares

Therefore;

1 x 100 + 0.5 x 75

---

1 + 0.5

137.5 / 1.5 = Sh.91.67.

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A
Portfolio's expected rate of return

Expected return Coral Ltd
= 0.2 x 16 + 0.6 x 12 + 0.2 x 8

= 3.2 + 7.2 + 1.6 = 12%

Expected retuni reef Ltd
0.2 x 14 + 0.6 × 10 + 0.2 × 6

= 2.8 + 6 + 1.2 = 10%

Portfolio return

(300,000 / 500,000 x 12%) + (200,000/500,000 x 10%)

7.2% + 4.0% = 11.2%

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A


Standard deviation reef Ltd B = √7.84 = 2.8
Standard deviation coral ltd A = √6.4 = 2.53
Weight securtity A (WA) = 300,000 / 500 000 = 0.6
Weight Security B (WB) = 1 - 0.6 = 0.4

Actual portfolio risk

= √W_A²δ_A² + W_B²δ_B² + 2W_AδW_BCOV_A&B

√0.62² x 6.4 + 0.4² x 7,84 + 2 x 0.4 × 0.6 x 6.4

√2.304 + 1.2544 + 3.072 = 2.57%

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A
i) The link between interest rates and availability of credit to small and medium size enterprises (SMEs)

When the interest rate is set too low, commercial banks cannot be able to price in risk, this forces them to deny SMEs loans to finance their activities. When rates are left to forces of supply and demand rather than capping them, commercial banks can be able to effectively price in risk which encourages lending more to SMES.

ii) Case for interest rate capping in an economy.

• Interest rate caps can be used to support a specific sector of the economy where;

Market failure exists or where there is need for more financial institutions to differentiate between risky and safe clients

• They can be used to protect consumers from exploitation by guaranteeing access to credit on reasonable terms.

• Interest rate caps protect the public interest by ensuring fair and reasonable interest rates on loans.

• The price charged for access to credit is unpredictable and anti-competitive, and may therefore be higher than the actual cost of credit. Setting a lower interest rate cap gives lenders a better operating environment.

• Interest rate caps protect the public interest from predators by ensuring fair and reasonable interest rates on loans.

• Help the economy deal with rising inflation

• Reduce the risk behavior of lenders in the form of subsidies to specific groups

• Bring discipline to the banking industry by making information about expected loan repayments publicly available.

Reasons against interest capping

• The interest rate cap undermines the central bank's independence enshrined in Kenya's constitution.

• Elevated risks to financial stability

• Reduced access to financial services

• Reduced transparency: Increased overall cost of credit due to additional fees and charges observed in nations such as The United States, Nicaragua,and Zambia.

• Decreased diversity of products for low income households-witnessed in France and Germany.

• Riskier borrowers have restricted their use of credit from alternative sources not regulated by the caps, which charge much higher rates.

• Impairment of monetary policy transmission

• Negative impact on credit growth

• Reduced banking competition witnessed in Itally.

• An increase in illegal lending-Evident in Japan and the United states
• Shifting to expensive loans:

•It leads to unemployment e.g layoffs witnessed in the banking sector.

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A
(i) Conversion value

• The term conversion value refers to the monetary value of a security obtained by exchanging the convertible security for the underlying asset.
• Convertible bonds are a class of financial instruments, such as convertible bonds and preferred stocks, that can be exchanged for underlying assets such as common stock.

(ii) Liquidation value

•Liquidation value can also represent the total amount of a company's physical assets if the company goes bankrupt and sells assets.

•The amount that could be realized by selling an asset or group of assets separately from the parent company

• Liquidation value is typically lower than book value and higher than residual value

• Intangible assets are exceeded when calculating liquidation value.

(iii) market value

The general market value of securities is determined by the forces of supply and demand.

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A


Dividend per share = Dividend paid/ Number of shares
=180 million/ 72 million
=Sh 2.5

Therefore;

Value of share= 2.5 +20% = Sh. 12.50

(ii) The value of the company as at 3 April 2019 assuming that the management made a decision to undertake the investment

Profit after tax =25/100 x 720, 000, 000
= Sh. 180,000,000

Present value of dividends payable in four years

=180,000,000 X (1-1.2^-4)/0.2
= 180,000,000 × 2.5887
= Sh 465,966,000

Current value of company as at 3 April 2019
= (72,000,000 x 12.5) + 465,966,000
= Sh 1,365,966,000..

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