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CPA
Intermediate Leval
Financial-Management-November 2020
ANSWERS

Financial Management
Revision Kit

QUESTION 1a

Q Islanuc banking is grounded on Sharia Law. To earn money, Islamic banks use equity participation system.

Required:
With reference to the above statement:

(i) Explain the term "equity participation system".

(ii) Discuss three principles of Islamic finance.

(iii) Describe two types of financing arrangements that could be adopted under Islamic finance.
A

Solution


(i) Equity participation system".

Islamic banks use equity investment schemes to make money without the typical practice of charging interest........ Equity participation means that when a bank lends money to a company, the company will repay the loan without interest, but the bank will share the company's profits. If the company goes bankrupt or doesn't make a profit, the bank won't make a profit either.

(ii) Principles of Islamic finance.

➢ Paying or charging interest (riba): Islam regards lending with interest as an exploitative practice that favors the lender at the expense of the borrower. Under Sharia law, interest is usury (riba), which is strictly prohibited.

➢ Profit/Loss sharing: Parties who enter into a contract in Islamic finance share the profit,Losses and risks associated with trading. No one can benefit from the transaction more than the other party

➢ Material finality of the transaction: Each transaction must be related to a real underlying economic transaction.

➢ Speculation (Maisir): Sharia strictly prohibits speculation and gambling known as Maisir. Therefore, Islamic financial institutions cannot be involved in contracts in which the ownership of the product depends on future uncertain events..

➢ Investing in business involved in prohibited activities: Islam prohibits some activities such as the production and sale of alcohol and pork. These activities are considered haram or prohibited. Therefore, investment in such activities is always prohibited

➢ Uncertainty and risk (Gharar): Islamic finance rules prohibit participation in contracts involving undue risk or uncertainty. The term gharar measures the justification, risk, or uncertainty of an investment. Galar is observed in derivative contracts and short sales prohibited in Islamic finance

(iii) Types of financing arrangements that could be adopted under Islamic finance.

➢ Leasing (jarah): In this type of financing arrangement, the lessor (who must own the property) leases the property to the lessee who makes rental and purchase payments, and finally transfers ownership of the property to the lessee. .

➢ Profit-and-loss sharing joint venture (musharakah): This includes both parties participating in the joint venture product or property by investing capital and entrepreneurial spirit. Both parties will share the profits or bear the losses arising from the activities

➢ Murabahah: The concept refers to the sale of goods such as motor-cars, real estate, commodities etc. for which the sale and profit margin are clearly stated at the time of the sales contract.

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QUESTION 1b(i)

Q Distinguish between "commodities markets" and "derivatives markets".(4 marks)
A

Solution


Distinction between "commodities markets" and "derivatives markets".

Commodities market - This is where traders and investors buy and sell natural resources and commodities such as corn, oil, meat and gold. A separate market is created, as the price of such resources is unpredictable. There is a commodity futures market where the price of a commodity to be delivered at a certain...... future date is specified and sealed today.

Derivative market involves derivatives or contracts whose value is based on the market value of the assets being traded

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QUESTION 1b(ii)

Q (ii) Summarise four functions of financial markets.(4 marks)
A

Solution


Functions of financial markets.

- Reduced transaction costs: In the financial markets, it is possible to obtain various types of information about securities at no cost.......

-Increase the liquidity of financial assets: Buyers and sellers can decide to trade securities at any time. They can use the financial markets to sell securities or invest as they please.

- Determining the price of a security: Investors aim to make a profit on a security. However, unlike goods and services whose prices are determined by the laws of supply and demand, the prices of securities are determined by the financial markets.

- It reduces risk by allowing investors and traders to make information public.

- These markets calm the economy by giving investors confidence. Investor confidence keeps the economy stable.

- Help to connect those who have money and those who need it.

- save time and money

-Stabilize your savings: Avoiding wasting money is critical to economic success. This allows buyers and sellers to easily find each other in the financial markets without wasting a lot of effort or time.These markets process so many transactions that they have economies of scale. This reduces transaction costs and fees for investors

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QUESTION 2a(i-ii)

Q (i) The theoretical ex-rights price of an ordinary share (3 marks)
(ii) The price at which the rights are likely to be traded (1 marks)
A

Solution


Number of shares
=
Ordinary share capital
Par value per share
= 60 / 0.25 =
240

EPS
=
Profit after tax and preference dividend
No of shares


21/240 = 0.0875

Market price per share

EPS x P/E = 0.0875 x 16 = Sh.1.4

Right issue price

70/100 x sh 1.4 = sh. 0.98

theoretical ex right price


=
(5 x 1.4)+(1 x 0.98)
1 + 5
= Sh 1.33



(ii) The price at which the rights are likely to be traded.
Value of right = cum right price-theoretical ex right price

1.40 - 1.33 = Ksh 0.07

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QUESTION 2a(iii-iv)

Q (iii) Evaluate each of the three options available to theinvestor with 10,000 ordinary shares. (6 marks)
(iv) Comment on the wealth of the investorbased on each of the options evaluated in (a) (iii) above.(2 marks)
A

Solution


Evaluation of the three options available to the investor with 10,000 ordinary shares

a. Impact of exercising the right issues

New right issue shares 1/5 x 10,000 =2,000 shares

New number of shares 10,000+2,000 = 12,000

Value of wealth before right issue

(12,000 x 1.33)-(2,000 0.98)

15,960-1,960 = Ksh 14,000

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QUESTION 2b

Q Assess the working capital requirements for the company. (8 marks)
A

Solution


(a) Working capital requirements for Nderu Suppliers Ltd.

Direct material cost
30/100 x 15,000,000 = Sh 4,500,000

Direct ...... labour cost
25/100 x15,000,000 = Sh 3,750,000

Variable overheads
10 /100 x 15,000,000 = Sh 1,500,000

Fixed overheads
15/ 100 x 15,000 = Sh 2,250,000

Selling and distribution overheads
5/100 x 15,000,000 = 750,000

Account receivables = Debtors collection period/ 12 x credit sales

2.5 /12 x 15,000,000 = Sh 3,125,000

Raw materials = Raw materials holding period/ 12 x direct material cost

3 /12 x 4,500,000 = 1, 125,000

Cost of production
Material + Labour + Variable overheads

4,500,000+ 3, 750,000+ 1, 500,000 = 9,750,000

Cost of work in progress

1/12 x 9,750,000 = Sh 4, 875,

Value of work in progress inventory
2/12 x 4,875,000 = Sh 812,500

Value of finished goods inventory
1/12 x 9,750,00000= Sh 812,500

Direct material accruals
2/12 x 4,500,000 =750,000


Direct labour accruals
1/50 x3,750,000 = 75,000

Variable overhead accruals
1/12 x 1,500,000 = Sh 125, 000

Fixed overhead accruals
1/12 × 2,250,000 = Sh 187, 500

Selling and distribution overheads accruals
0.5/ 12 x 750,000= Sh. 312, 500

Nderu suppliers Ltd
Statement of working capital requirement For the period ended 31 March 2020
Current assets:
Account receivables
Raw materials
Work in progress
Finished goods
Total current assets:
Current liabilities:
Direct material accruals
Direct labour accruals
Variable overhead accruals
Fixed overhead accruals
Selling and distribution overhead accruals
Total current liabilities
Working capital requirement		 Sh






750,000
75,000
125,000
187,500
312,500


 Sh
3,125,
1,125,000
812,500
812,500
5,875,000






1,450,000
4,425,000


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QUESTION 3a

Q Using Miller-Orr Model of managing cash, determine the following:
(i) The spread. (2 marks)
(ii) Upper cash limit. (2 marks)
(iii) Return point(2 marks)
(iv) Propose a decision rule for cash management to the company based on your calculations in (a) (i) to a(iii) above (2 marks)
A

Solution


Miller-Orr Model of managing cash

(i) The spread (S)

S = H-L......

= 13,451.36 - 8,000

= 5,451.36

(ii) Upper cash limit (H)

H=3Z-2L
(39,817.12)-(28,000) =29,451.36-16,000 = Sh 13, 451.36

(iii) Return point.

Z
=
3
√
3bδ2
4 x i/365
+ L


Where:
b= transaction cost = Sh 50

δ2 = variance of daily cash flows Sh 4,000,000
i=interest rate daily = 0.025
L= minimum cash balance = 8,000

Z= (3x50 x4,000,000/4x0.025)1/3 +8,000

6,000,000,0001/3+8,000 = Sh. 9, 817.12

(iv) Decision rule for cash management to the company based on calculations in (a) (i) to (a) (iii) above.
Optimal cash to hold is Sh 9,817.12, when cash rises to Sh 13, 451.36, Bawabu traders should deploy Sh. 3,634.24 (Sh 13, 451.36-9817.12) to buy marketable securities. When cash reaches minimum balance of Sh 8,000, Bawabu traders should sell securities worth Sh 1,817.12 to restore cash to target level of sh 9,817.12

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QUESTION 3b

Q The weighted average cost of capital (WACC) that the company should use as a discount rate when appraising new investment opportunities. (12 marks)
A

Solution


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

g = [(810,000/620,000)1/4 - 1 ] x 100%

(1.0691-1)x100%

g = 6.91%

Dividend per share 2019 = Dividends paid/Number of shares = 810,000/3,000,000 = sh 0.27

...... Cost of ordinary shares(Ke)

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


Where:

Do = Dividend paid = Sh.0.27
g = growth rate dividends = 6.91%
Po= Market price per share = Sh. 3

Ke = (0.27 (1.0691))/3 + 0.0691 x 100%

(0.096219+0.0691) 100% = 16.53%

Cost of 7% bond redeemable

Krd
=
(
1
+
Pv - Po
n
Pv-Po
2
)
(1-T) x 100%


I = interest paid = 7/100 × 100 = Sh. 7
Pv-maturity value current = Sh. 100
Po= market value current = Sh. 770
n = period to maturity = 10 years
T= corporate tax rate = 30%

Krd
=
(
7
+
100 - 77.1
10
100+77.1
2
)
(1-0.3) x 100%


(7+2.29)/88.55 x 0.7 x 100% = 7.34%

Market value of ordinary shares-3,000,000 x 3 = Sh 9,000,000
Market value of bond

1,300,000/100 x 77.1

Sh 1,002,300

Weighted average cost of capital
Source
OS
7%bond

Amount
9,000,000
1,002,300
10,002,300		 weight
1-0.1=0.9
1,002,300/10,002,300 =0.1

Cost of capital
16.53%
7.34%
WACC		 weighted cost
14.877
0.734%
15.611%


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QUESTION 4a(i)

Q The incremental initial cash outlay.
A

Solution


(i) The incremental initial cash outlay.

Book value of old machine before critical analysis

500,000-(500,000/5 X2)

500,000-200,000 = Sh300,000

Depreciation ...... for the next 5 years

(300,000-100,000)/5 = Sh 40,000 per year

Incremental initial outlay
Cost of new machine
Add:
Installation costs
Import duty
Freight charges
Effective cost new machine
Tax effect on disposal
Disposal value of old machine
Book value
Trading balance charge
Tax rate 30%

Less: Disposal value of old machine

Add: investment working capital
(250,000+200,000-3000,000)
Incremental initial outlay

50,000
150,000
100,000


200,000
(300,000)
(100,000)
30%






600,000



300,000
900,000




0
900,000
(200,000)
700,000
150,000

850,000
.

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QUESTION 4a(ii)

Q (ii) The incremental net operating cash flows associated with the proposed machine replacement. (6 marks)
A

Solution


1) Incremental depreciation

Depreciation of new machine
(900,000-250,000)/5 = Sh 130,000 per year

Depreciation of old ...... machine
(300,000-100,000)/5 = Sh. 40,000 per annum

Incremental depreciation
Sh 130,000-40,000=Sh. 90,000

2) Incremental salvage value
Salvage value of new machine
Less: Salvage value of old machine


3) Incremental terminal cash flows
Incremental salvage value
Recovery working capital (250,000+200,000-300,000)
250,000
100,000
150,000


150,000
150,000
300,000


4) Amortization of overhaul cost

100,000/2 = Sh50,000

5) Incremental profit before depreciation and tax (PBDT)
Year
1
2
3
4
5		 New machine
260,000
280,000
250,000
240,000
270,000		 Old machine
120,000
150,000
130,000
145,000
135,000		 Incremental PBTD
140,000
130,000
120,000
95,000
135,000


Year
Incremental PBDT
Less: Depreciation
Profit before tax
Less: Amortization
Profit before tax
Less: Tax 30%
Profit after tax
Terminal cash flow
Incremental net operating Cash flows		 1
140,000
90,000
50,000
0
50,000
(150,000)
35,000
0
35,000		 2
130,000
90,000
40,000
0
40,000
(12,000)
28,000
0
28,000		 3
120,000
90,000
30,000
0
30,000
(9,000)
21,000
0
21,000		 4
95,000
90,000
5,000
(50,000)
(45,000)
(13,000)
(31,000)
0
(31,000)		 5
135,000
90,000
45,000
(50,000)
(5,000)
(1,500)
(3,500)
300,000
296,500


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QUESTION 4a(iii)

Q Should the existing machine be replaced? Justify your answer.(4 marks)
A

Solution


Year
1
2
3
4
5



 Cash flows
35,000
28,000
21,000
(31,500)
296,500



 D.F 13%
0.8850
0.7831
0.6931
0.6133
0.5428
PV of cash flows
Less initial outlay
NPV		 PV
30,975
21,926.8
14,555.1
(19,318.95)
160,940.2
209,078.15
(850,000)
(640.921.85)


Advice:
Should not replace the machine since NPV is negative.


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QUESTION 4b

Q (i) The theoretical ex-right price of Upendo Ltd's share (4 marks)
(ii) The theoretical value of a right of Upendo Ltd before the shares sell ex-right.(2 marks)
A

Solution


(i) The theoretical ex-right price of Upendo Ltd.'s share.
((4 x 25)+(1 x 20))/( 4+1)......

(100+ 20)/ 5 = 120/5 = Sh. 24

(ii) The theoretical value of a right of Upendo Ltd. before the shares sell ex - right

Value of right = cum right price - theoretical ex-right price

25-24 = Sh. 1.

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QUESTION 5a

Q Calculate the earnings before interest and tax (EBIT) and earnings per share (EPS) at the point of indifference in firm's earnings under financing option (1) and (2) above. (8 marks)
A

Solution


EPS at indifference point interest is 15% debentures
15/100 x 150 = Sh.22.5million

Number of ordinary shares
450+20=22.5 million

Financing ...... option 1

Interest on 12% debenture
12/100 x20= Sh 2.4 million

Total interest
2.4 + 22.5 = Sh 24.9 million

EPS option 1

EPS
=
(EBIT-1)(1-T)
Number of shares


EPS
=
(EBIT-24.9)(1-0.3)
22.5


EPS
=
(EBIT - 22.9)0.7
22.5


EPS
=
0.7EBIT-17.43
22.5


Financing Option 2

New ordinary shares issued
20/ 20 = 1 million

Newshares
22.5+1=23.5 million shares

EPS option 2
EPS
=
(EBIT-I) (1-T)
Number of shares


EPS
=
(EBIT - 22.5)0.7
23.5


EPS
=
0.7EBIT - 15.75
23.5


0.7EBIT - 15.75
23.5
=
0.7EBIT - 17.43
22.5



23.5(0.7EBIT - 17.43)=22.5 (0.7EIBT - 15.75)

16.45EBIT-409.605 = 15.75EBIT-354.375

16.45EBIT-15.75EBIT = 409.605 - 354.375

0.7BIBT/0.7 = 55.23/ 0.7

EBIT = Sh 78.9million

Operating profit at indifference point is sh 78.9million.

Now, earnings per share at indifference point is:-

((0.7 x78.9)-15.75)/23.50

(55.23-15.75)/ 23.5 = Sh 1.68

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QUESTION 5b(i)

Q Discuss four assumptions of Walter's model. (8 marks)
A

Solution


Assumptions of Walter's model.

➢ Companies have perpetual life

➢ All profits are retained or fully distributed to shareholders

➢ Earnings per share and dividend per share are constant. Should not change from year to year, but should be stable

➢ All the funding is done through retained earnings. No external financing is used.

➢ The rate of return (r) and the cost of capital (k) remain constant irrespective of any changes in the investments

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QUESTION 5b(ii)

Q (ii) Explain the risk-return trade off in the context of investments. (4 marks)
A

Solution


Asserts that for a rational investor, the higher the risk, the higher the return demanded to...... compensate for additional risk assumed. The lower the risk, the lower the return demanded from the investment

Risk Return Tradeoff

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