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CPA
Intermediate Leval
Financial-Management- September Pilot 2015
ANSWERS

Financial Management
Revision Kit

QUESTION 1(a)

Q "Provision for depreciation is an internally generated source of finance to a company". Explain the basis upon which provision for depreciation is a source of finance to an organisation.
A

Solution


Understanding Depreciation as a Source of Finance


Depreciation is the allocation of a business asset's cost to expense over its useful life. In accounting, it involves debiting Depreciation Expense and crediting Accumulated Depreciation, without involving the Cash account. This makes depreciation expense a noncash expense.

Basis upon which provision for depreciation is a source of finance to an organisation.:


  1. Depreciation is an expense representing expired costs, recovered in cash as part of the production cost. Treating the sale of a fixed asset as a fund source logically extends to treating depreciation in a similar manner.

  2. When determining "Trading Profit (Adjusted)" or "Funds from Operation," depreciation is added back to net profit, emphasizing its consideration as a source.

  3. Funds typically refer to (net) Working Capital. Profits and depreciation increase Working Capital, contributing to the overall financial health of a firm.

  4. Depreciation plays a crucial role in financing a firm's funds, constituting a significant source or inflow of funds.

  5. For net profit, depreciation is deducted, reducing the resultant amount. If this net profit is distributed as dividends, the real figure is reduced by the amount of depreciation, which remains in the firm and serves as a source of funds.

  6. Depreciation, charged against revenue to create a fund, differs from expenses like salary or wages, as it does not result in a cash reduction of the capital fund. Therefore, it can be treated as a source of finance.

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QUESTION 1(b)

Q MM Company Ltd. is contemplating raising additional finance for an expansion programme. The company is considering Sh.50 million for this expansion programme. The company's existing capital structure is given below:


Ordinary share capital (Sh.20 par)
10% debenture capital
12% preference share capital
Reserves

 Sh."000"
60,000
25,000
15,000
50,000
150,000

Two alternative financing options available to the company are given as follows:

Option 1
Issue new ordinary shares at par to raise all the desired funds.

Option II
Issue new ordinary shares at par to raise Sh.30 million and the balance will be raised through the issue of 15% debentures.

The management are optimistic that this investment will enable the company to generate annual operating profit (EBIT) whose forecasted values in different states of nature and their probability of occurrence are given as follows:

State of Nature
Good
Moderate
Poor		 Probability
0.40
0.25
0.35		 Operating profit (EBIT)
20,000
15,000
10,000

The firm pays corporation tax at the rate of 30%.

Required:
(i) Determine the level of expected operating profit (EBIT) and expected earnings per share at the point of indifference between the firm's earning under financing options I and II.

(ii) Determine the range of expected operating profit within which each financing option will be recommended (Hint: a graph may be used to answer this question).
A

Solution


(i) Level of expected operating profit (EBIT) and expected earnings per share at the point of indifference


Expected operating profit

(0.4 × 20) + (0.25 × 15) + (0.35 × 10) = 15.25

15.25 x 1,000 = 15,250

Number of ordinary shares = Ordinary share capital / par value

60,000 / 20 = 3,000

10% debenture interest ("000")

10% x 25,000 = 2,500

12% Preference dividends ("000")

12% x 15,000 = 1,800

15% debenture interest("000") - Option 2

50,000 - 30,000 = 20,000

15% x 20,000 = 3,000

EPS = (EBIT - Debenture interest) / Weighted Average Number of Ordinary shares

EPS option 1

New Ordinary shares ("000")

50,000 / 20 = 2,500

EPS1 = [(EBIT - 2,500)0.7 - 1,800] / (3,000 + 2,500)

(0.7EBIT - 1,750 - 1,800) / 5,500

EPS1 = (0.7EBIT - 3,550) / 5,500

EPS option 2

New ordinary shares ("000")

30,000 / 20 = 1,500

EPS2 = (0.7(EBIT - 5,500) - 1,800) / (3,000 + 1,500)

(0.7EBIT - 3,850 - 1,800) / 4,500

EPS2 = (0.7EBIT - 5,650) / 4,500

At indifference point

EPS1 = EPS2

(0.7EBIT - 3,550) / 5,500 = (0.7EBIT - 5,650) / 4,500

4,500 (0.7EBIT - 3,550) = 5,500(0.7EBIT - 5,650)

3,150EBIT - 15,975,000 = 3,850EBIT - 31,075,000

-700EBIT / -700 = -15,100,000 / -700

EBIT = 21,571.429

EBIT = 21,571.429 x 1,000 = Sh. 21,571,429

Earnings per share at indifference points

EPS = (0.7EBIT - 3,550) / 5,500

((0.7 x 21,571.429) - 3,550) / 5,500 = 210

(ii) Range of expected operating profit


EPS1 =( 0.7EBIT - 3,550) / 5,500

Assume

EBIT
EPS		 0
-1.26		 1000
-1.10		 21,571.429
2.10


EPS2 = (0.7EBIT - 5,650) / 4,500

EBIT
EPS		 0
-1.26		 1,000
-1.10		 21,571.429
2.10




For operating profits ranging from 0 to 21,571,429, it is advisable to opt for Plan 1. Beyond an operating profit threshold of Sh. 21,571,429, it is recommended to implement Plan 2.




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QUESTION 1(c)

Q With reference to (b) above, indicate the financing option you would recommend assuming that the company's expected operating profits are:

(i) As forecasted by the organisation.

(ii) Sh.6,000,000 per annum.

(iii) Sh.15,000,000 per annum.
A

Solution


i. As forecasted by the organization


=(0.4 x 20,000) + (0.25 x 15,000) + (0.35 × 10,000)

8,000 + 3,750 + 3,500 = 15,250

Earnings per share 1

(0.7EBIT - 3,550) / 5,500

(0.7 × 15,250 - 3,550) / 5,500 = Sh. 1.3

Earnings per share 2

(0.7EBIT - 5,650) / 4,500

(0.7 × 15,250 - 5,650) / 4,500 = Sh. 1.12

If operating profit is as predicted best plan to adopt is Option I

ii. Sh. 6,000,000 per annum.


Earnings per share option I

(0.7 x 6,000 - 3,550) / 5,500 = Sh.0.12

Earnings per share option II

(0.7 x 6,000 - 5,650) / 4,500 = Sh.-0.32

Option I is the best

iii. Sh. 15,000,000 per annum


Earnings per share option I

(0.7 x 15,000 - 3,550) / 5,500 = Sh. 1.26

Earnings per share option II

(0.7 x 15,000 - 5,650) / 4,500 = 1.08

Option I is the best

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QUESTION 2(a)

Q In relation to financing of firm's activities, distinguish between the term "capital structure" and financial structure".
A

Solution


Distinguishing Capital Structure and Financial Structure


When discussing the financing of a firm's activities, it's essential to differentiate between "capital structure" and "financial structure," as they refer to distinct aspects of a company's financial framework.

Capital Structure:


Capital structure pertains to the composition of a company's long-term capital, encompassing various sources such as equity and debt. It reflects the proportion of debt and equity used to finance the firm's assets. Capital structure decisions involve finding the right balance between debt and equity to optimize the cost of capital and maximize shareholder value.


Financial Structure:


Financial structure, on the other hand, is a broader term that includes both long-term and short-term sources of funds. It covers not only the mix of equity and debt but also considers current liabilities and other obligations. Financial structure provides a comprehensive view of how a company funds its operations, investments, and other financial activities.


Summary


While capital structure specifically addresses the long-term financing mix of a firm, financial structure encompasses a wider spectrum, taking into account both long-term and short-term sources of funds, offering a holistic perspective on a company's financial framework.

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QUESTION 2(b)

Q The management of Swara Ltd. is considering replacing an existing machine which was bought 3 years ago at a cost of Sh.20 million. The machine was expected to have a useful life of 5 years with no resale value at the end of this period. A critical evaluation of this asset shows that the existing machine is usable for another five years at the end of which resale value is estimated at Sh.2 million. The current disposal value of the existing machine is estimated at Sh.10 million.

The new machine is not locally available. The management expect to import this machine at a cost of Sh.40 million. Installation cost of this machine is estimated at Sh.500,000.

Import duty payable and freight charges are estimated at Sh.300,00 and Sh.200,000 respectively. This machine is expected to have a useful life of five years, at the end of which resale value is estimated at Sh.5 million.

This investment is expected to lead to increased sales. To support increase in sales, the firm will require an extra investment in working capital at the beginning of the new machine's useful life. Inventory balance is expected to increase by Sh.800,000, debtors balance will increase by Sh.700.000 and creditors balance will increase by Sh. 1,000,000.

However, the firm will require an extra investment in working capital at the end of the second year of Sh.250.000. The total investment in working capital will be recovered at the end of the machine's useful life.

The earnings before depreciation and tax to be generated by each asset during each year are given as follows:

Earning before depreciation and tax(EBDT)
Year

1
2
3
4
5		 New machine
Sh."000"
70,000
75,000
85,000
80,000
70,000		 Existing machine
Sh."000"
50,000
55,000
60,000
55,000
65,000

Additional information:
  1. The new machine shall require an overhaul at the end of third year. The overhaul cost is estimated at Sh.2 million. The cost will be amortised separately on a straight line basis.
  2. The firm provides for depreciation on all their non-current assets on a straight line basis.
  3. The firm pays corporation tax at the rate of 30%.
  4. The firm's capital structure which is optimal comprises of 70% equity and 30% debt. The cost of equity is 10% and before tax cost of debt is 8%.

Required:
Using the net present value technique, advise on whether the firm should replace the existing machine.
A

Solution


Incremental cash outlay

Step 1
Import cost of new machine
Add: installation cost of new machine
Add: import duty payable
Add: freight charges
Effective cost of new machine
Working capital investment
(800,000 + 700,000 - 1,000,000)
Tax recapture on disposal gains 0.3(10,000,000 - 8,000,000)
Less: disposal proceeds old machine
Incremental initial outlay

Step 2: depreciation incremental
Depreciation new machine = (41,000,000 - 5,000,000) / 5
Depreciation old machine = (8,000,000 - 2,000,000) / 5
Incremental depreciation

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

Step 4: incremental terminal benefit
Incremental salvage value
Recovery of working capital (year 1):
Recovery of working capital (year 2):
Incremental terminal benefits
40,000,000
500,000
300,000
200.000
41,000,000

500,000
600,000
(10,000,000)
32,100,000


7,200,000
(1,200,000)
6,000,000


5,000,000
(2,000,000)
3,000,000


3,000,000
500,000
250,000
3,750,000


Step 5: incremental operating cash inflows
Year

EBDT
Less: depreciation
Less: amortization
overhaul cost
EBT
Less: tax
Profit after tax
Add: depreciation
Add: amortization
Less: working capital
Less: overhaul cost
Add: terminal benefits
Cashflows		 1
("000")
20,000
(6000)
0

14,000
(4,200)
9,800
6000




15,800		 2
("000")
20,000
(6,000)
0

14,000
(4,200)
9,800
6,000

(500)


15,300		 3
("000")
25,000
(6,000)
0

19,000
(5,700)
13,300
6,000


(3,000)

16,300		 4
("000")
25,000
(6,000)
(1,000)

18,000
(5,400)
12,600
6,000
1,000



19,600		 5
("000")
5,000
(6,000)
(1,000)

(2,000)
600
(1,400)
6,000
1,000



5,600


WACC = (70 / 100 x 10%) + (30 / 100 x 8% x 0.7) = 8.68%

Year
1
2
3
4
5



Cash flows
15,800
15,300
16,300
19,600
5,600
PV of cash inflows
Less: initial outlay
NPV		 D.F 8.68%
0.9201
0.8466
0.7790
0.7168
0.6596



 P.V (000)
14,537.58
12,952.98
12,697.70
14,049.28
3,693.76
57,931.30
(32,100.00)
25,831.30


Swara Ltd should replace the existing machine because of the positive net present value

Workings


1. Depreciation old machine

(20,000,000 - 0) / 5 = 4,000,000

2. Book value of old machine at contemplation of replacement date

20,000,000 - (4,000,000 x 3) = 8,000,000

3. Amortization of overhaul cost

2,000,000 / 2 = Sh. 1,000,000

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QUESTION 2(c)

Q State two limitations of the net present value method.
A

Solution


Net Present Value


The Net Present Value (NPV) method is a financial evaluation technique used to assess the profitability of an investment or project.

Limitations of Net Present Value Method:


  • Does not account for varying project sizes, making it challenging to compare projects of different scales.
  • Assumes reinvestment of cash flows at the project's discount rate, which may not reflect real-world investment opportunities.
  • May not provide clear insights when comparing mutually exclusive projects with significantly different cash flow patterns.
  • Does not consider the impact of managerial flexibility or options that may arise during the project's life.
  • Relies on accurate estimation of cash flows and discount rates, making it sensitive to uncertainties and potential errors.
  • Does not account for differences in project duration, potentially favoring projects with shorter payback periods.
  • Does not consider non-monetary factors such as environmental or social impacts, limiting its holistic assessment.
  • Assumes that cash flows are immediately reinvested, which may not align with the actual project dynamics.
  • May not be suitable for projects with unconventional cash flow patterns, such as multiple internal rates of return.
  • Does not address the timing of cash flows within a specific period, potentially overlooking cash flow distribution.

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QUESTION 3(a)

Q Briefly explain how Islamic finance differs from conventional finance.
A

Solution


Islamic Finance vs. Conventional Finance


1. Basis of Transactions:

  • Islamic Finance operates based on Shariah principles, prohibiting the payment or receipt of interest (riba).
  • Conventional Finance typically involves the payment and receipt of interest as a fundamental part of transactions.

2. Asset-Backed Financing:

  • Islamic Finance encourages asset-backed financing, ensuring that transactions are backed by tangible assets or services.
  • Conventional Finance may involve transactions that are not necessarily tied to specific assets.

3. Risk and Profit-and-Loss Sharing:

  • Islamic Finance promotes risk-sharing and profit-and-loss sharing arrangements, fostering a more equitable distribution of risks and rewards.
  • Conventional Finance often relies on fixed interest rates, with risks and returns borne by lenders and borrowers in a predetermined manner.

4. Speculation and Uncertainty:

  • Islamic Finance discourages excessive speculation and investments in activities deemed harmful or involving excessive uncertainty (gharar).
  • Conventional Finance may engage in speculative activities, and uncertainty is often a part of certain financial instruments.

5. Social and Ethical Considerations:

  • Islamic Finance incorporates social and ethical considerations into financial transactions, aligning with Shariah principles.
  • Conventional Finance may not explicitly integrate social and ethical considerations into decision-making processes.

6. Debt Financing:

  • Islamic Finance emphasizes equity-based financing, avoiding excessive reliance on debt, which is discouraged in Shariah principles.
  • Conventional Finance commonly involves debt financing as a standard practice for raising capital.

7. Monetary Value Over Time:

  • Islamic Finance considers the time value of money but focuses on the real economic impact, encouraging fair and just transactions.
  • Conventional Finance often places a greater emphasis on monetary returns over time without explicit consideration of ethical or social aspects.

8. Origin and Foundation:
  • Conventional finance lacks a divine origin, while
  • Islamic finance is rooted in principles outlined in the Quran.

9. Contractual Framework:
  • In conventional finance, installment amounts, principal repayments, and interest for a specific period are explicitly outlined.
  • Islamic finance involves one-time contracts.
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QUESTION 3b

Q Ruiru Tanners Ltd. has a total of Sh.100 million invested in net assets as at the end of December 2014. The firm intends to increase its production capacity during the year 2015 by Sh.100 million. The company utilises debt, preferred stock and equity capital within its capital structure. Several alternative financing arrangements are available, namely;

  • The company can issue 9% debentures with a par value of Sh.100 each at an issue price of Sh.90 each (market price). Maximum amount available is Sh.20,000,000. Any extra debt finance will be raised through the issue of 12% debentures at Sh.960 each. The par value of this debenture is Sh.1,000 each.
  • The company can issue additional 15% preference shares with a par-value of Sh.50 at Sh.75 each.
  • The company can issue new ordinary shares at the current market price of Sh.88 per share. Floatation cost equal to Sh.8 per share sold. The company's ordinary shareholders have consistently enjoyed a dividend whose annual growth rate on average has been 10% and this is expected to continue into the foreseeable future. The company's earning per share this year is Sh.10 and adopts a constant dividend payout ratio of 40% each year.
  • The company can generate Sh. 10 million from the internal sources to finance this expansion programme.

Additional information:
  1. The company pays corporation tax at the rate of 30%.
  2. The firm's existing capital structure which is considered to be optimal is given below:

    Debt capital:
    6% debenture capital
    8% term loan
    Preference shares (Sh.50 par value)
    Ordinary shares (Sh.5 par value)
    Retained earnings

    		 Sh."000"

    10,000
    20,000

    15,000
    25,000

    		 Sh. "000"


    30,000
    30,000

    40,000
    100,000

Required:
(i) The amount of funds to be raised from each source during the year 2015 so as to maintain the firm's existing optimal capital structure.

(ii) The number of ordinary shares to be issued to raise desired external equity.

(iii) The levels of financing at which marginal cost of capital changes (Hint: break points in weighted marginal cost of capital curve).

(iv) The firm's weighted marginal cost of capital if it we were to raise only Sh.20 million.

(v) The firm's weighted marginal cost of capital for the funds to be raised during the year 2015 for the three levels of financing.
A

Solution


i. Amount of funds to be raised


Current capital structure

Source
6% debenture capital
8% term loan
Preference shares
Ordinary shares
Retained earnings

 Amount
10,000
20,000
30,000
15,000
25,000
100,000		 Weight
0.10
0.20
0.30
0.15
0.25
1.00


Amount to be raised from each source

9% debenture capital = 0.1 x 100,000,000 = 10,000,000

15% preference shares = 0.3 x 100,000,000 = 30,000,000

Ordinary shares = 0.15 x 100,000,000 = 15,000,000

Retained earnings = 0.25 x 100,000,000 = 25,000,000

8% term loan = 0.20 x 100,000,000 = 20,000,000

ii. The number of ordinary shares


(15,000,000 + 15,000,000) / 80 = 375,000 ordinary shares

iii. The levels of financing


Breakpoint = amount / proportion in capital structure

Breakpoint ordinary shares = ∞ / 0.15 = ∞

Breakpoint retained earnings = 10,000,000 / 0.25 = 40,000,000

Breakpoint 9% debentures = 20,000,000 / 0.1 = 200,000,000

Breakpoint 12% debentures = > 20,000,000 / 0.1 = ∞

Breakpoint 15% preference shares = ∞ / 0.30 = ∞

iv. Firm's weighted marginal cost of capital


Cost of retained earnings (Kr)

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

Where:

Do = dividend per share = Sh.40 / 100 × 10 = 4

g = growth rate = 10%

Po = current market price per share = Sh. 88

Kr = 4(1.1) / 88 + 0.1 x 100% = 15%

Cost of ordinary shares (Ke)

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

(4(1.1)) / (88 - 8) + 0.1 x 100% = 15.5%

Cost of 9% debenture (Kd)

I = 9% x 100 = 9

Kd = 1(1 - T) / Po × 100%

Kd = (9 x 0.7) / 90 × 100% = 7%

Cost of 12% debenture Kd

I = 12% x 1,000 = 120

Kd = 120(1 - 0.3) / 960 x 100% = 8.75%

Cost of 15% preference shares

Dp = 15% x 50 = 7.5

Kp = Dp / Po × 100%

7.5 / 75 x 100% = 10%

v. Firms weighted marginal cost of capital


Therefore, weighted marginal cost of capital if firm, plans to raise 20 million

WACC = KeWe + KdWd + KpWp

(0.4 x 15.5) + (0.3 x 8.75) + (0.3 x 10)

6.2 + 2.625 + 3 = 11.825%

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QUESTION 4(a)

Q A Ltd. is considering taking over B Ltd. The forecasted annual net operating cash flows to be generated by the target firm are given as follows:

Year

1
2
3 - 7
8 - 10
11 - α 		Net cash flow (NCF)
Sh."million"
5
8
10
15
12

The firm's minimum required rate of return is 5% above the risk free rate of return. The risk free rate of return 15%.

Required:
The maximum price payable by A Ltd. to acquire B Ltd.
A

Solution


Required rate of return is 5% + 15% = 20%
Year
1
2
3 - 7
8 - 10
11 to ∞

Cashflows(millions)
5
8
10
15
12

D.F 20%
0.8333
0.6944
3.6046 - 1.5278 = 2.0768
4.1925 - 3.6046 = 0.5879
0.1615

 P.V (million)
4.1665
5.5552
20.768
8.8185
1.938
41.2462


A limited should pay a maximum of Sh. 41.2462 million to acquire B

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QUESTION 4(b)

Q Shafana Ltd. currently operates with terms of net 72 days. The firm's average investment in accounts receivable is Sh.2,400,000 per year. Eighty percent of the firm's sales are always on credit. The company is considering introducing terms of 2/20 net 90 days

The firm's total sales per annum will increase by 50%. All cash customers and 40% of credit customers will take advantage of the cash discount.

Average collection period will increase to 80 days. Gross margin on sales is 40% while the cost of capital is 16%.

Required:
Advise the company on whether to switch to the new credit policy (Assume a year has 360 days).
A

Solution


Average collection period = average debtors/credit sales x 360

Credit sales = average debtors/credit collection period x 360

(2,400,000 x 360) / 72 = 12,000,000

If 80% = 12,000,000
100% = ?

100 / 80 x 12,000,000 = Sh. 15,000,000

New sales = 150 / 100 x 15,000,000 = Sh. 22,500,000

New credit sales = 80 / 100 x 22,500,000 = Sh.18,000,000

Discount offer credit sales

40 / 100 x 18,000,000 = 7,200,000

Non discount offer credit sales

60 / 100 x 18,000,000 = Sh. 10,800,000

Total discount offer sales

7,200,000 + 20 / 100 x 22,500,000 = 11,700,000

Discount allowed to customers

2 / 100 x 11,700,000 = Sh. 234,000

Average debtors proposed policy

average collection period / 360 x credit sales

Average debtors discount offer credit sales = 20 / 360 x 7,200,000 = Sh. 400,000

Average debtors no discount credit sales

80 / 360 x 10,800,000 = Sh. 2,400,000

Total average debtors new policy

2,400,000 + 400,000 = Sh. 2,800,000

Opportunity cost

Current policy 16 / 100 x 2,400,000 = Sh.384,000

Proposed policy 16 / 100 x 2,800,000 = Sh. 448,000

Contribution

Current policy = 40 / 100 x 15,000,000 = 6,000,000

Proposed policy = 40 / 100 x 22,500,00 = 9,000,000

Details
Contribution
Less: discount allowed
Less: opportunity cost debtors
Profit before tax
Less: tax 30%
Profit after tax		 Proposed policy
9,000,000
(234,000)
(448,000)
8,318,000
(2,495,400)
5,822,600		 New policy
6,000,000
0
(384,000)
5,616,000
(1,684,800)
3,931,200		 Change
3,000,000
(234,000)
(64,000)
2,702,000
(810,600)
1,891,400


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QUESTION 4(c)

Q The shares of Bidii Ltd. are currently selling at Sh.60 each at the securities exchange. Bidii Ltd.'s price earning ratio is 6 times. The company adopts a constant 40% payout ratio as its dividend policy. It is predicted that the company's dividends will grow at an annual rate of 20% for the first three years, 15% for the next 2 years and thereafter at a constant rate of 10% per annum in perpetuity. The investor's minimum required rate of return is 12%.

Required:
(i) Current intrinsic value of the shares of Bidii Ltd.

(ii ) Advise a prospective investor whether or not to buy shares of Bidii Ltd.
A

Solution


i. Intrinsic value


Earnings per share = Market price per share / P/E ratio = 60 / 6 = 10

Then dividend per share = dividend payout ratio x earnings per share = 10 x 0.4 = Sh. 4

Year
1
2
3
4
5
6 to ∞

Dividend per share
4 x 1.2¹ = 4.80
4 x 1.2² = 5.76
4 x 1.2³ = 6.91
6.91 x 1.15¹ = 7.95
6.91 x 1.152 = 9.14
502.7
Intrinsic value		 D.F 12%
0.8929
0.7972
0.7118
0.6355
0.5674
0.5674

 P.V
4.29
4.59
4.92
5.05
5.19
285.23
309.27


Dividends to perpetuity

(Do(1 + g)) / (r - g) = (9.14(1.1)) / (0.12 - 0.1) = Sh.502.7

(ii ) Advise a prospective investor whether or not to buy shares of Bidii Ltd.


An investor should buy shares of Bidii Ltd since current market price per share is less than the intrinsic value of Sh. 309.27

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QUESTION 5a

Q The most recent statement of financial position for Upendo Ltd. is presented below:

Upendo Ltd.
Statement of financial position
As at 30th November 2014

Inventory
Debtors
Cash at bank
Fixed assets (NBV)


 Sh."000"
2,000
3,000
3,800
13,200

22,000
Trade creditors
Accrued expenses
Long-term debt
Ordinary shares
Retained profit

 Sh."000"
2,200
2,200
8,800
2,200
6,600
22,000

The company is about to embark on an advertising campaign which is expected to raise sales from their present level of Sh.27.5 million to Sh.38.5 million by the end of the next financial year ended 30 November 2015.

The firm is presently operating at full capacity and therefore will have to increase its investment in both current and fixed assets to support the projected level of sales. It It is estimated that both categories of assets will rise in direct proportion to the projected increase in sales.

For the year just ended, the firm's after tax profit margin was 6% but is expected to rise to 7% of projected sales. The firm adopts a stable predictable dividend policy. The ordinary dividend payable for the year ended 30 November 2015 is expected to increase by 10% from the last year's dividend of Sh.1 million.

Upendo Ltd's trade creditors and accrued expenses are expected to vary directly with sales. In addition, long term debt financing will be used to finance next year's operations that are not forthcoming from other sources.

Required:
(i) Estimate the amount of additional funds to be raised through long term debt financing.

(ii) Prepare a forecast statement of financial position as at 30 November 2015.

(iii) Using the results obtained in (a) (i) and (ii) above, compute and interpret the following financial ratios for the year ended 30 November 2015:

(a) Return on equity.

(b) Total assets turnover.

(c) Capital gearing ratio.
A

Solution


i. Estimated amount of additional funds


Profit after tax 2015

7 / 100 x 38,500,000 = Sh. 2,695,000

Total dividend share 2015

110 / 100 x 1,000,000 = Sh. 1,100,000

Retained earnings 2015

Sh. 2,695,000 - 1,100,000 = Sh. 1,595,000

Additional funds required

Total assets as percentage of sales

22,000 / 27,500 x 100% = 80%

Current liabilities (creditors and accrued expenses) as percentage

(2,200 + 2,200) / 27,500 = 16%

Increase in sales ("000")

38,500 - 27,500 = Sh. 1,100

Additional funds required
Increase in total assets 80 / 100 x 11,000
Less: increase in current liabilities 16 / 100 x 11,000
Less: retained earnings
Long term debt issued
8,800
(1,760)
(1,595)
5,445

ii. Forecast statement of financial position


Upendo Ltd statement of financial position 2014.

Percentage of sales

Inventory

2,000 / 27,500 x 100% = 7.27%

Increase in inventory 2015

7.27 / 100 x 11,000 = 800

Debtors

3,000 / 27,500 x 100% = 10.91%

Increase debtors 2015

10.91 / 100 x 11,000 = 1,200

Cash at bank

3,800 / 27,500 x 100% = 13.82

Increase cash 2015

13.82 / 27,500 x 11,000 = Sh. 1,520

Fixed assets

13,200 / 27,500 × 100% = 48%

Increase in fixed assets

48 / 100 x 11,000 = Sh. 5,280

Trade creditors

2,200 / 27,500 × 100% = 8%

Increase in trade creditors 2015

8 / 100 x 11,000 = Sh. 880

Accrued expenses

2,200 / 27,500 × 100% = 8%

Increase in accruals 2015

8 / 100 x 11,000 = Sh. 880

UPENDO LTD
STATEMENT OF FINANCIAL POSITION AS AT 30TH NOVEMBER 2015

Inventory
Debtors
Cash at bank
Fixed assets (NBV)


 Sh. (000)
2,800
4,200
5,320
18,480

30,800
Trade creditors
Accrued expenses
Long term debt
Ordinary shares
Retained profit

 Sh. (000)
3,080
3,080
14,245
2,200
8,195
30,800


(iii) Interpretation of the following financial ratios:


a) Return on equity

Profit after tax / Equity x 100

2,695 / 10,395 x 100% = 25.939%

Every Sh. 100 of equity in Upendo Ltd generated Sh. 25.93 as profit after tax in 2015

b) Total assets turnover

Total sales / Total assets

38,500 / 30,800 = 1.25

Every Sh. 100 invested in total assets in 2015 generated Sh. 125 as sales

c) Capital gearing ratio

(Fixed charge capital / (fixed charge capital + equity)) x 100%

14,245 / (14,245 + 2,200 + 8,195) × 100% = 57.81%

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QUESTION 5b

Q (i) Define the term financial innovation.

(ii) Highlight any three factors responsible for financial innovation.
A

Solution


(i) Define the term financial innovation:


Financial innovation refers to the creation and introduction of new financial instruments, products, services, or processes that aim to improve efficiency, accessibility, and effectiveness within the financial industry.

(ii) Highlight any three factors responsible for financial innovation:


  1. Rapid Technological Advancements: Continuous advancements in technology drive the development of innovative financial products and services.
  2. Market Demand and Competition: Changing market dynamics and competition stimulate financial institutions to innovate and meet customer demands.
  3. Regulatory Changes and Reforms: Evolving regulatory frameworks create opportunities for new financial products and services.
  4. Globalization: Increased global interconnectedness encourages the adoption of innovative financial solutions to meet international demands.
  5. Demographic Changes: Shifts in demographics, such as changing consumer preferences and the aging population, influence financial innovation.
  6. Access to Big Data: The availability of big data allows financial institutions to make data-driven decisions and create tailored financial solutions.
  7. Fintech Startups: The emergence of fintech startups introduces disruptive technologies and encourages traditional financial institutions to innovate.
  8. Risk Management Needs: Growing complexities in financial markets drive the development of innovative risk management tools and strategies.
  9. Environmental and Social Considerations: Increasing awareness of environmental and social issues encourages the development of sustainable financial products.
  10. Collaboration and Partnerships: Collaborations between financial institutions, technology companies, and other stakeholders foster financial innovation.

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