q and as-corporate financial management- june 2010 dec 2010 and june 2011
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ZAMBIA INSTITUTE OF CHARTERED ACCOUNTANTS
LICENTIATE LEVEL
L 6: Corporate Financial Management
June 2010
December 2010
June 2011
QUESTION PAPERS AND SUGGESTED SOLUTIONS
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Table of Contents
JUNE 2010 CORPORATE FINANCIAL MANAGEMENT .............................................. 3
SUGGESTED SOLUTIONS ..................................................................... 13
DECEMBER 2010 CORPORATE FINANCIAL MANAGEMENT ............................................ 28
SUGGESTED SOLUTIONS .................................................................... 36
JUNE 2011 CORPORATION FINANCIAL MANAGEMENT ........................................ 49
SUGGESTED SOLUTIONS ..................................................................... 59
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ZAMBIA INSTITUTE OF CHARTERED ACCOUNTANTS
CHARTERED ACCOUNTANTS EXAMINATIONS
LICENTIATE LEVEL
L6: CORPORATE FINANCIAL MANAGEMENT
SERIES: JUNE 2010
TOTAL MARKS – 100
TIME ALLOWED: THREE (3) HOURS
INSTRUCTIONS TO CANDIDATES
1. You have ten (10) minutes reading time. Use it to study the examination paper carefully so that
you understand what to do in each question. You will be told when to start writing.
2. This paper is divided into TWO sections:
Section A: Attempt BOTH questions in this section.
Section B: Attempt THREE questions only in this section.
3. Enter your student number and your National Registration Card number on the front of the answer
booklet. Your name must NOT appear anywhere on your answer booklet.
4. Do NOT write in pencil (except for graphs and diagrams).
5. The marks shown against the requirement(s) for each question should be taken as an indication
of the expected length and depth of the answer.
6. All workings must be done in the answer booklet.
7. Present legible and tidy work.
8. Graph paper (if required) is provided at the end of the answer booklet.
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9. Formulae, Present Value and Annuity tables are attached at the end of this question paper.
Section A
Attempt both questions in this Section
Question 1
G Ltd is a well established food processing company. One of its key products is a famous traditional
spice called ABALE SAMALA which is processed using a machine which it purchased 3 years ago. This
machine will have to be scrapped off on 31st December 2010 because the Environmental Council of
Zambia has rejected the company’s application for a certificate to use the same machine in the forth
coming year.
The company is now investigating the possibility of buying a new machine at a cost of K500 million which
has a capacity to replace the current machine. This machine will have a life of five years and a scrap
value of K50 million.
The forecast income statement for the current year which ends on 31st December 2010 is as follows:
K'million
Sales 600
Production Costs:
Variable Costs 220
Fixed Overheads* 160
Non Production Costs:
Fixed Administration Overheads 90
470
Profit Before tax 130
* includes K20 million depreciation
Sales
Sales volumes are expected to grow in line with the following index numbers
(2010 = 100)
Year 2011 2012 2013 2014 2015
Index Number 102 105 107 109 111
The selling price inflation is expected to be 4% per year.
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Cost
Production costs are expected to increase by 5% per year while non production costs inflation is expected to be 3% per year.
Taxation
Capital allowances are available at a rate of 25% reducing balance and company is liable to corporation tax at 30% payable one year in arrears.
Required
(a) Using the money cost of capital of 10%, calculate the Net Present Value of the proposed
investment and comment on your results. (16 marks)
(b) Identify two advantages and two disadvantages of using the Pay Back Period method of
Investment appraisal (4 marks)
Question 2
The recent internal audit report prepared for JK Ltd, a wholesaler of Tangy drinks has indicated
deterioration in the liquidity position of the company. The management has called an emergency
meeting to seek solutions to the problem and several alternatives are being considered which includes
factoring, use of cash discounts and invoice discounting. The following are some of the current
practices by the company:
Accounts receivables
Customers are allowed a credit period of 30 days but they take 75 days on average to settle their
accounts and this has resulted into a huge bad debt figure standing at 3% of the total annual turnover.
Inventory management
The annual inventory requirement is 3,000,000 units. The current policy is to order 50,000 units at
regular interval throughout the year. The cost of placing an order is K150,000 while the purchase price
per unit is K75,000. The annual storage cost per unit is 1 % of the purchase cost.
Accounts Payable
JK normally pays its suppliers after 35 days and the company has been offered a discount of 5% for
invoice settlement within 10 days. The company has a short term debt of 8% and operates 365 working
days per annum.
(All answers to the nearest K1,000)
Required
(a) Calculate the cost of the current inventory ordering policy. (5 marks)
(b) Calculate the savings the company will make if it switched to the Economic Order Quantity model.
(7 marks)
(c) Evaluate whether the company should accept the supplier discount being offered (4 marks)
(d) Outline the benefits of using factoring in managing trade receivables to a business. (4 marks)
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SECTION B Attempt any three questions in this Section
Question 3
CEC Plc one of the companies listed on the LUSE wishes to calculate its updated Weighted Average Cost of Capital for use in their investment appraisal process.
ZMK' Million
Issued share capital (K100 shares) 2,000
Share Premium 1,300
Reserves 145
Share Holders funds 3,445
6% Irredeemable Debentures 1,400
9%Redeemable Debentures 1,450
Bank loan 500
Total Long term Liabilities 3,350
The current cum interest market value per K100 unit is K103 and K105 for the 6% and 9% debentures respectively. The 9% debenture is redeemable at par in 10 years time. The bank loan bears interest rate of 2% above the Base rate (current base rate is 15%). The current ex-div market price of shares is K1,100 and a dividend of K100 per share which is expected to grow at a rate of 5% per year has just been paid. The effective corporation tax rate for CEC is 30 %.
Required
(a) Calculate the effective after tax Weighted Average Cost of Capital (WACC) for CEC. 16 marks)
(b) Using the traditional theory of capital structure explain what would happen if the company took
on additional debt finance. (4 marks)
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Question 4
The following is a summary of financial information for Kumalundu PLC for the years 2008 and 2009
K' Million K' Million
2009 2008
Revenue 84,500 78,000
Cost of sales 37,256 34,822
Labour Costs 29,100 27,500
Admin and other overheads 15,400 14,200
Earnings before interest and Tax 2,744 1,478
Interest 800 800
Taxation 583 203
Profit after tax 217 597
Dividends Payable 163 447
Shareholders funds 39,900 35,200
Long term debt 14,000 17,200
Number of shares 9,000 9,000
PE ratio (average for the year)
Kumalundu PLC 8 6
Industry 10 10
Required
As a management consultant engaged by the company management, write a report to management to evaluate the performance of the company. Your report should cover the following
1. At least 2 Ratios in the following areas
● Profitability (2 marks)
● Gearing (2 marks)
● Investors ratios (2 marks)
2. Comments on these ratios (6 marks)
3. Evaluation of the financial management implication of the current dividend policy and a
suggestion on alternative dividend policy. (5 marks)
4. Limitation of focusing on accounting profits in evaluating the performance of an entity. (3 marks)
(20 marks)
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Question 5
(a) At a recent annual business conference which your managing director attended, one of the
facilitators presented on the topic of corporate objective development. During his presentation he
briefly contrasted the private sector objective of shareholders wealth maximization and public
sector value for money assessment. Being a non finance individual the managing director did not
fully grasp the idea and he wants your help.
Required
Briefly explain the concept of shareholders wealth maximization and contrast it with the public
sector value for money assessment concept. (10 marks)
(b) Zain Ltd has issued a 10% K1000 bond which is either convertible into 10 ordinary shares or
redeemable at par in 5 years time. The shares are currently priced at K600 and they are expected
to grow at 2% per year. Given a redemption yield of 15% and corporation tax rate of 30% ,
estimate the floor value of the bond. (6 marks)
(c) Mason investment finance is considering the purchase of a commercial building at a cost of
K1.4 Billion. The property would be rented immediately to tenants at annual rent of K160 Million
payable in arrears in perpetuity.
Required
Calculate the Net present Value of the investment assuming that the company has cost of capital
of 10% (4 marks)
Question 6
Zega Ltd, a company which grows and sales flowers and vegetables to the European markets has recently been a victim of foreign exchange rate fluctuations.
Required
(a) In relation to currency risk define the following terms:
● Transaction risk
● Translation risk
● Economic risk (6 marks)
(b) Identify and explain three internal methods that can be used to manage the transaction risk.
(6 marks)
(c) A Zambian company which exports rose flowers to the UK expects the following payments and
receipts in three months time:
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Payments
Invoice No US 001 $15,000.
Invoice No US 005 $5,000
Invoice No ZM 006 K 50Million
Receipts
Invoice No US 011 $65,000.
Invoice No US 015 $5,000
Exchange rates ZMK/1 U$D
Spot rate ZMK/$ 4,700 – 4,850
3-months forward rate 4,765 – 4,920
Annual interest rates ZMK/1 U$D
Borrowing rates 22% 9%
Lending rates 8% 6%
Required
Using the following hedging methods calculate the expected net receipt
1. Forward Contract market
2. Money market (8 marks)
END OF PAPER
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JUNE 2010
L6: CORPORATE FINANCIAL MANAGEMENT
SUGGESTED SOLUTIONS
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Solution 1
NPV COMPUTATION 2011 2012 2013 2014 2015
Sales Revenue 636,480 681,408 722,163 765,087 810,291
Production Variable cost 235,620 254,678 272,505 291,478 311,668
Production Fixed cost 147,000 154,350 162,068 170,171 178,679
Fixed Admin cost 92,700 95,481 98,345 101,296 104,335
475,320 504,509 532,918 562,945 594,682
Net cash flow b/tax 161,160 176,900 189,245 202,142 215,609
Tax @30% (48,348.0) 53,070) (56,773) (60,643) 64,683)
Tax Saving @30% 37,500 28,125 21,094 15,820 47,461
Asset 50,000
Net cash flow a/tax (500,000) 161,160 166,052 164,300 166,463 220,786 (32,222) Discounting Factors @10% 1
0.909 0.826 0.751 0.683 0.621 0.564
Present Value (500,000) 146,509 137,233 123,441 113,696 137,108 (18,173)
NPV 139,814 WORKINGS
W1 Sales revenue( K'000)
Year 2011 2012 2013 2014 2015
Sales revenue 600,000 600,000 600,000 600,000 600,000
volume Index factor 1.02 1.05 1.07 1.09 1.11
Selling price inflation 1.04 1.04^2 1.04^3 1.04^4 1.04^5
Inflated Values 636,480 681,408 722,163 765,087 810,291
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W2 Variable costs
Variable costs 220,000 220,000 220,000 220,000 220,000
volume Index factor 1.02 1.05 1.07 1.09 1.11
Cost price inflation 1.05 1.05^2 1.05^3 1.05^4 1.05^5
Inflated Values 235,620 254,678 272,505 291,478 311,668
W3 Production Fixed Costs 160,000 160,000 160,000 160,000 160,000
Less Depreciation 20,000 20,000 20,000 20,000 20,000
Relevant cost 140,000 140,000 140,000 140,000 140,000
Cost Inflation factor 1.05 1.05^2 1.05^3 1.05^4 1.05^5
Inflated Values 147,000 154,350 162,068 170,171 178,679
W4 Fixed Admin cost 90,000 90,000 90,000 90,000 90,000
Cost Inflation factor 1.03 1.03^2 1.03^3 1.03^4 1.03^5
Inflated Values 92,700 95,481 98,345 101,296 104,335
W5 Tax Saving on C/allowances
Opening Tax WDV 500,000 375,000 281,250 210,938 158,203
Capital Allowance (125,000) (93,750) (70,313) (52,734) (108,203)
Closing Tax WDV 375,000 281,250 210,938 158,203 -
Tax Saving @30% 37,500 28,125 21,094 15,820 32,461
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1b A summary of the advantages (any two) and disadvantages (any two) of the pay back method are as follow:
Pay back method
Advantages Disadvantages
1. Cash flow based method Ignores time value of money
2. Simple and easy to understand and explain
Does not consider cash flows beyond the payback
3. Can be used when there in making a choice when there is capital rationing
Encourages short-termism by favoring investments with shorter pay back.
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Solution 2
(a) Ordering cost
Annual Demand 3,000,000
Size of order 50,000
Number of orders per year 60
Cost per order 150,000
Ordering Cost 9,000,000
Holding Cost
Average stock level = order Quantity/2 25,000
Holding cost per unit p.a 750
Holding cost 18,750,000
18,750,000
Total cost 27,750,000
(b) 2CoD/ChEoQ = 34,641
Ordering cost
Annual Demand 3,000,000
Size of order 34,641
Number of order per year 87
Cost per order 150,000
Ordering Cost 13,050,000
Holding Cost
Average stock level = order Quantity/2 17,321
Holding cost per unit p.a 750
Holding cost 12,990,750
12,990,750
Total cost 26,040,750
Net saving Current Policy 27,750,000
Proposed Policy 26,040,750
Saving 1,709,250
The switch in policy is worthwhile as it results in a positive net saving as shown above.
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(c) Cost of lost Supplier discount = (100/100-d)^ 365/t 15.36%
Where t = 35 – 10 = 25
d = 55
The company is advised to accept the supplier discount as rejecting it translates to an annual cost
of about 16% which is higher than the current borrowing costs.
The benefits of factoring include the following:
● The business will be able to pay its suppliers promptly.
● The company will be able to maintain optimum inventory levels.
● The business would not incur the costs of running its own sales ledger department.
● The company would be able to finance growth through sales rather than through a fresh
injection of finance.
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Solution 3
a WACC COMPUTATION
Fund Cost Market Values Wacc
Equity 14.55% 22,000 0.12677
Irredeemable debt 4.33% 1,358 0.0023288
Redeemable debt 7.17% 1,392 0.00395
Bank Loan 11.90% 500 0.00236
25,250 13.54% WACC = 13.54 WORKINGS W1 Cost of Equity Ke = d1/Sp + g * 100 14.55%
Cost of Irredeemable bond
Kd = Interest/Mkt Value * 100 4.33%
Note: unit value should be ex-interest
Cost of bank loan = interest rate (1-t) 11.90%
W2
Cost of Redeemable bond = IRR of the bond cash flows Cash flow AF@10% PV
0 -(96) 1 (96.00) 1 - 10 6.3 6.145 38.71
10 100 0.386 38.60
(18.69)
Years Cash flow AF@5% PV 0 -96 1 (96.00)
1 - 10 6.3 7.772 48.96 10 100 0.614 61.40
14.36
a = 5% P = - 18.69 b = 10% N = 14.36 IRR = a + P/P-N * (b -a) 7.17% W3 Market Values
Finance Book Value Market Value K'million
Equity 2000 22000
Irredeemable debt 1400 × 94 1358 Redeemable debt 1450 × 0.96 1392 Bank Loan 500 500
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(b) According to the traditional theory of capital structure the following should be expected when the
company increases its levels of gearing:
● The cost of equity would increase due to increased financial risk.
● The WACC would drop due to the increase in the debt finance which is cheaper.
● The cost of debt would remain constant unless the debt levels become very significant
● The market value of the company is expected to increase.
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Solution 4
REPORT
To : Management, KUMALUNDU PLC
From : Finance Manager
Date : 25 June 2010
Re : Appraisal of financial performance of KUMALUNDU PLC
Introduction
Following your instruction directing me to evaluate the performance of KUMALUNDU, it is my pleasure to
present this report including the working in the appendix to you for adoption. In line with my terms of
engagement this report has covered the following items.
1. Evaluation of financial performance on the basis of the ratios in the following areas:
● Profitability
● Market ratios
● Financial risk
● Investor confidence
2. Comment on the dividend policy pursued by the company
3. Limitations of ratio analysis
Financial performance
Profitability
The ROCE indicates that the profitability of the organisation has slightly declined from 5% to 3% and a
further analysis was undertaken by calculating the profit margin and asset turnover ratios. The drop in
profitability was thus attributable to reduction in profit margins and reduced utilization of assets.
Market ratios
The earnings per share which is a key market indicator shows an increase and this is a positive signal to
current and prospective investors. The dividend cover is generally low due to the company’s high
dividend payout policy.
Financial Risk
The gearing ratio and the interest cover show an increase in the financial risk burden faced by the
company. This is of concern to the company as in a worst case scenario high financial risk may result in
the company’s liquidation.
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COMMENT ON THE CURRENT DIVIDEND POLICY
The company seems to be pursuing a constant dividend payout policy which is currently in the range of
75%. This payout appears to be on the high side. The financial management implication of this policy is
that the company would not be in a position to fund its operations from internal reserves which are
traditionally an attractive source of finance. Should and investment opportunity arise, the company is
more likely to look to outside sources of finance.
An alternative dividend policy that we may suggest is one where the company pays out a constant
dividend per share.
LIMITATIONS OF FOCUSING ON PROFITS AS A MEASURE OF PERFORMANCE
The following are some of the limitations of using profits as a measure of performance:
● Profits can easily be manipulated.
● Profit figures tend to be influenced by choice of accounting policies.
● Profit tends to over emphasize the short term benefits at the expense of long term objectives.
● Some organizations do not have profit as their key objective.
Conclusion
In undertaking this analysis we would have been limited by the availability of information such as
competitor or industry information which could have enabled us to offer more comprehensive advice. But
should you be in need of clarification I would be glad to attend to you.
APPENDIX TO THE REPORT
Profitability
ROCE
EBIT 2,744 1,478
CE 53,900 52,400
5% 3%
Profit Margin
EBIT 2744 1478
Revenue 84,500 78,000
3% 2%
Asset Turnover
Revenue 84500 78000
CE 53900 52400
1.57 1.49
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Market Ratios
EPS
EAT 217 597
# shares 9,000 9,000
EPS 0.02 0.07
Dividend Cover
EAT 217 597
Dividend 163 447
Cover 1.33 1.33
Payout ratio 75% 75%
Financial Gearing
Debt 14,000 17,200
Equity 39,900 35,200
Debt : Equity 35% 49%
Interest Cover
EBIT 2744 1478
Interest 800 800
Cover 3.43 1.85
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Solution 5
(a) A private sector organisation has as its primary objective the making of sufficient profits to provide
a satisfactory return for its owners and to keep the business operating.
So, it is job of senior management to maximise the market value of the company. Specifically, the
main financial objective of a company should be to maximise the wealth of its ordinary
shareholders. Within this context, the financial manager seeks to ensure that investments earn a
return, for the benefit of shareholders. Part of this job will involve attracting funds from the market,
such as new investors, but as with public sector organisations it is also important that the
operations of the company are run economically and efficiently.
Public sector organisations are generally set up with a prime objective which is not related to
making profits. These organisations exist to pursue non-financial aims, such as providing a
service to the community. However, there will be financial constraints which limit what any such
organisation can do. A not-for-profit organisation needs finance to pay for its operations, and the
major financial constraint is the amount of funds that it can obtain. Having obtained funds, a not-
for-profit organisation should seek to get value for money from use of the funds:
(i) Economy: not spending K20,000 when the same thing can be bought for K10,000
(ii) Efficiency: getting the best use out of what money is spent on
(iii) Effectiveness: spending funds so as to achieve the organisation's objectives
Since managing government (for example) is different from managing a company, a different
framework is needed for planning and control. This is achieved by:
● setting objectives for each
● careful planning of public expenditure proposals
● emphasis on getting value for money
(b)
Floor Value of a convertible bond
Year Cash flow AF@15% PV 1 - 5 70 3.352 234.64
5 K600 10 (1.02)5 = 6,624 0.497 3,292.37
Floor Value 3,527.01
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(c)
K’million Present Value of a perpetuity:
Present value of cash inflow
0.1
160
1 600 Investment Cost (1 400)
NPV 200
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Solution 6
(a) Types of risk
Translation Risk
This is the risk that the organization will make exchange losses when the accounting results of its
foreign branches or subsidiaries are translated into the home currency. Translation losses can
result, for example, from restating the book value of a foreign subsidiary's asset's at the exchange
rate on the balance sheet date.
Transaction Risk
This is the risk of adverse exchange rate movements occurring in the course of normal international
trading transactions. This arises when the prices of imports or exports are fixed in the foreign
currency terms and there is movement in the exchange rate between the date when the price is
agreed and the date when the cash is paid or received in settlement.
Economical Risk
This refers to the effect of exchange rate movements on the international competitiveness of a
company and refers to the effect on the present value of longer term cash flows. For example, a UK
company might use raw materials which are priced in US dollars, but export its products mainly
within the EU. AS depreciation of sterling against the dollar or an appreciation of sterling against
other EU currencies will both erode the competitiveness of the company.
(b) Internal risk management methods include the following:
(1) Currency of Invoice
One way of avoiding exchange risk is for an exporter to invoice his foreign customer in his
domestic currency, or for an importer to arrange with his foreign supplier to be invoiced in his
domestic currency.
(2) Matching receipts and payments
A company can reduce or eliminate its foreign exchange transaction exposure by matching
receipts and payments. Wherever possible, a company that expects to make payments and
have receipts in the same foreign currency should plan to offset its payments against its
receipts in the currency.
(3) Leading and Lagging
Company might try to:
● Lead payments (payments in advance)
● Lagged payments (delaying payments beyond their due date)
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In order to take advantage of foreign exchange rate movements. With a lead payment, paying in
advance of the due date, there is a finance cost to consider. This is the interest cost on the money
used to make the payment, but early settlement discounts may be available.
(c) Calculation of net exposure
Receipts Amounts $ # 001 65,000 # 005 5,000
Payments 70,000 #001 (15,000) #005 (5,000)
(20,000)
Net receipt 50,000
Forward contract Net amount $ 50,000 Forward rate K4765
Expected receipt in ZMK 238,250,000
Money Market Borrow an amount say x x(1+ (9%*3/12) = 50,000 x = $ 48,900 Convert @spot ZMK 4700 Net receipt (ZMK) 229,828,851 Invest for 3 months @8% pa 3 months = 3/12 * 8% 1.02
Net receipt (ZMK) after 3 months 234,425,428
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ZAMBIA INSTITUTE OF CHARTERED ACCOUNTANTS
CHARTERED ACCOUNTANTS EXAMINATIONS
LICENTIATE LEVEL
L6: CORPORATE FINANCIAL MANAGEMENT
SERIES: DECEMBER 2010
TOTAL MARKS – 100
TIME ALLOWED: THREE (3) HOURS
INSTRUCTIONS TO CANDIDATES
1. You have ten (10) minutes reading time. Use it to study the examination paper carefully so that
you understand what to do in each question. You will be told when to start writing.
2. This paper is divided into TWO sections:
Section A: Attempt BOTH questions in this section.
Section B: Attempt THREE questions only in this section.
3. Enter your student number and your National Registration Card number on the front of the answer
booklet. Your name must NOT appear anywhere on your answer booklet.
4. Do NOT write in pencil (except for graphs and diagrams).
5. The marks shown against the requirement(s) for each question should be taken as an indication
of the expected length and depth of the answer.
6. All workings must be done in the answer booklet.
7. Present legible and tidy work.
8. Graph paper (if required) is provided at the end of the answer booklet.
9. Formulae, Present Value and Annuity tables are attached at the end of this question paper.
29
SECTION A Attempt both questions in this Section.
Question 1
Kaka Bwalya has been a successful businessman dealing in general sports wear trading as a company
called Kaka Bwalya Ltd. He is considering opening a new shop which will specialize in making and
selling football jerseys for adults and children. Having spent K2 million on market research, Kaka is
impressed with the findings and intends to go ahead with the proposed business.
The shop expects to sell 15 jerseys per day over a four year period after which an additional new major
investment would be required. The selling prices for adults and children jerseys are K35, 000 and K25,
000 respectively. It is expected that 2/3 of sales would be for adults’ jerseys. All cash flows (except for
Initial Investment) are shown at current prices; it’s expected that all cash flows would rise by 4% per year
from current values.
The total cost of investment is K300 million and trading would start in one year‘s time after completing
construction of the new shop. Three quarters of total investment cost will be made immediately while the
balance will be made one year later. An annual operational cost which includes depreciation is expected
to be K100 million. Advertising costs will be saved as KAKA has well established promotional campaigns
for his existing business. The non current assets are expected to have a realizable value of K150 million.
Ten new members of staff each earning K500, 000 per month (at current prices) are expected to be
employed.
Other Information
1. Capital allowances are available only on the initial capital investment at 25% reducing balance basis per annum.
2. The company is expected to depreciate only the initial capital expenditure on straight line basis.
3. Average stock market return is 9% and corporation tax of 30% is expected to be paid in the same year as that of the transaction.
4. The company’s Debt to Equity ratio is 30:70.
5. The company’s equity beta is 1.25.
6. The company has a 6% bank loan.
7. Government treasury bills rate is 5%.
8. Assume there are 365 days in the year.
Required:
(a) Estimate the discount rate to be used in appraising this project. (4 marks)
(b) Calculate the expected NPV and comment on the viability of the proposed business. (12 marks)
(c) Discuss any two (2) Advantages and any two (2) Disadvantages of discounted payback as a
method of investment appraisal. (4 marks)
(Total: 20 marks)
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Question 2
(a) Yokosa PLC requires K6,000,000 cash per annum. Any cash raised will have an associated fixed
cost of K300,000 and an interest rate of 15%. The interest rate on short-term securities is 10%.
What is the optimum level of finance that Yokosa should raise at any one time? (4 marks)
(b) Pata Pata Limited faces an interest rate of 0.002% per day and its brokers charge K75,000 for
each transaction on short-term securities. The managing director has stated that the minimum cash
balance that is acceptable is K2 million and that the variance of cash flows on a daily basis is K16
million.
What is the maximum level of cash that the firm should hold, and at what point should it start to
purchase or sell securities? (4 marks)
(c) Balendo PLC is a manufacturer in the clothing industry and their Sales in the current year have
been K5.2 million. The company grants its customers 4 weeks credit period and offers 2% cash
discount for payment made within 2 weeks. Fifty percent of the customers take the cash discount,
while the rest take 9 weeks to settle their accounts. The current level of debtors is K500,000. 1% of
credit sales become bad debts. The net operating margin (excluding bad debts and discounts) for
Balendo is 25% of sales.
The company is considering a change in its terms of sale by increasing the cash discount to 4% for
payment made within 2 weeks, while the credit limit remains the same. It anticipates the following
effects from this change:
Sales to increase by 10% per annum.
75% of customers to take advantage of the discount.
The period of time before payment for customers not taking the discount to increase by one week.
Bad debts to fall to 0.5% of sales.
Balendo’s cost of finance is 12%.
Required:
Calculate the implications of this change in credit policy on profitability and give your advice on the
proposed change. (12 marks)
(Total: 20 marks)
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SECTION B: Attempt any three questions in this section.
Question 3
(a) (i) Sumina Limited’s shareholders expect a dividend yield of 10% and have been told that
dividends per share for the foreseeable future will be K400. Calculate the market value of
Sumina’s shares. (2 marks)
(ii) Bukwebo Limited has been involved in selling stationery and repairs of office equipment for
the past five years. The shareholders have a required return of 25% and the dividends paid
have been as follows:
YEAR Number of shares (000) Dividends (K’ million)
2009 150 75
2008 150 60
2007 100 45
2006 100 46
2005 100 40
Assume to day is 31st December 2009.
Required:
Calculate the current market price per share and discuss four (4) limitations of the method
used. (10 marks)
(b) A company has 600,000 ordinary shares and decides to make a 1 for 3 rights issue. The current
market price is K4,000. Just before the issue the current market price moved to K3,000. The
shareholders were offered the right to subscribe for one new share at K2,000.
Required:
(i) Calculate the ex-rights price. (2 marks)
(ii) Outline four (4) possible courses of actions open to shareholders. (4 marks)
(c) A company has 8% K1,000 convertible loan stock quoted at par which gives the holder a right to
convert each unit of stock into 10 ordinary shares. The current share price is K90.
Required:
Calculate the conversion value and the conversion premium. (2 marks)
(Total: 20 marks)
32
Question 4
The Statement of financial position and extracts from the statement of comprehensive income and
expenditure accounts of Hamwela Limited are given below for years 2008 and 2009:
2008 2009 K’000 K’000 K’000 K’000 Fixed Assets 80, 000 120, 000 Current Assets Inventory 20, 000 40, 000 WIP 20, 000 50, 000 Debtors 50, 000 80, 000
Cash 5, 000 -
95, 000 170, 000
Current Liabilities
Creditors 45, 000 118, 000
Bank overdraft 20, 000 60, 000
65, 000 178, 000
30, 000 (8, 000)
110, 000 112, 000
Financed By:
Share Capital 100, 000 100, 000
Profit & Loss Account 10, 000 12, 000
110, 000 112, 000
Extracts from Profit and Loss accounts:
K’000 K’000
Sales K500,000 K1,000,000
Gross Profit K100,000 K100, 000
Gross Profit % 20% 10%
Net Profit K30,000 K2, 000
Net Profit % 6% 0.2%
Required:
(a) Analyse the performance of Hamwela Limited in terms of its profitability and liquidity over the last two years. (15 marks)
(b) Discuss any ethical issues that might affect the financial statements. (5 marks)
(Total: 20 marks)
33
Question5
(a) Identify and explain briefly any two (2) methods of financing in international trade. (4 marks)
(a) Differentiate the following terms used in international trade:
(i) Cross rate and Offer rate. (3marks)
(ii) Spot and Forward rate of exchange. (3marks)
(c) The following spot rates are observed in the foreign currency market:
$1 = K4700/4750;
$1 = Indian rupees 48.00/48.50
Kantemba is a businessman based in Lusaka and he has ordered goods worth 100,000 Indian Rupees. Calculate how much it would cost him in Kwacha to pay for the goods. (5marks)
(d) Discuss briefly what is meant by the term economic risk in the context of foreign currency risk, and explain two (2) methods that can be used to manage it. (5marks)
(Total:20 marks)
Question 6
(a) Kawayawaya Plc has K10 million of 8% debentures in issue which are redeemable in four years time and have a current market price of K9,200 per K10,000 of nominal value. If the corporation tax rate is 33%, calculate the cost of the debt capital. (6 marks)
(b) Balance Sheet Extract from Makwebo PLC.
K’000
K500 ordinary shares 10,000
8% K1,000 Preference shares 5,000
10% K1,000 debentures 7,500
Total 22,500
Additional information
1. The debt is irredeemable.
2. The company expects to pay an annual dividend of K200 for the foreseeable future.
3. The cost of equity is 10% and the after-tax cost of debt is 5% and corporation tax is 30%.
Required:
Calculate gearing ratio (Debt : debt + Equity) of the company using:
(i) Book value approach; and (2 marks)
(ii) Market value approach. (6 marks)
(c) Evaluate the relative advantages of issuing preference shares compared with debt finance. (6 marks)
(Total: 20 marks)
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35
36
DECEMBER 2010
L6: CORPORATE FINANCIAL MANAGEMENT
SUGGESTED SOLUTIONS
37
Solution 1
(a) Cost of equity = RF+ B (E(Rm) – RF)
= 5% + 1.25 (9% - 5%)
=10%
Cost of debt = 6% (1 – 0.3)
= 4.2%
Cost of Capital = 0.7 10% + 0.3 42%
= 8.26 say 8%
(b) Financial Analysis for proposed new shop by Kaka Bwalya Ltd.
Year 0 1 2 3 4 5
K’000 K’000 K’000 K’000 K’000 K’000
Sales (W1) 187,610 195,093 202,575 210,970
Operational Cost W2 (67,600) (70,304) (73,116) (76,041)
Labour Cost W3 (64,896) (67,492) (70,192) (72,999)
Capital allowance (W4) (75,000) (56,250) (42,187) (31,641)
Operating Cash flow (19,886) 1,047 17,080 30,289
Tax @ 30% 5,966 (314) (5,124) (9,087)
Add back CA 75,000 56,250 42,187 31,641
Realisable value
Initial Cash flow (225,000 (75,000)
Net Cash flow (225,000) (75,000) 61,080 56,983 54,143 202,843
Discount factor *8% 1.000 0.926 0.857 0.794 0.735 0.681
(225,000) (69,450) 52,346 45,245 39,795 138,136
NPV = (18 928)
The project has a negative NPV and therefore on financial ground it should not be undertaken.
Workings
1. Adult
15
3
2 = 10
Children
15
3
1 = 5
Total No. Sold per day 15
38
Sales – Adult
Year 1 2 3 4 5
K’000 K’000 K’000 K’000 K’000
Selling Price (4%) 37.9 39.4 40.9 42.6
Jersey sold per annum 3 650 3 650 3 650 3 650
Total Sales 138,335 143,810 149,285 155,490
Sales – Children
Year 1 2 3 4 5
K’000 K’000 K’000 K’000 K’000
Selling Price (4%) 27 28.1 29.2 30.4
Jersey sold per annum 1 825 1 825 1 825 1 825
49,275 51,283 53,290 55,480
Total Sales 187,610 195,093 202,575 210,970
2. Operational costs
1 2 3 4 5
K’000 K’000 K’000 K’000 K’000
Cost = 100,000
Depreciation (37,500)
Net Cost 62,500 67,600 70,304 73,116 76,041
3. Labour Cost
1 2 3 4 5
K’000 K’000 K’000 K’000 K’000
Annual Cost (10 500 12
= 60,000 64,986 67,492 70,192 72,999
4. Capital Allowances
Year WDC CA @ 25% Year available
K’000
1 300,000 75,000 2
(75,000)
2 225,000 56,250 3
(56,250)
3 168,750 31,641 4
42,187
126,562 31,631 5
39
The project is not viable because it has a negative NPV and therefore should not be undertaken on
financial grounds.
(b) Advantage
* Unlike payback it takes into account time value of money.
* It uses cash flows rather than accounting profits which can easily be manipulated.
Disadvantages
* Does not consider cashflow after payback period.
*It may lead to choosing project with highly negative terminal cash flows because of their
initial favourable cash flows.
40
Solution 2
Q = L
2FS
(a) Q =0.100.15
6,000,000*300,000*2
= K8,485,281.37
(b) Spread = 3
13*
interest
ns)Transactio*CshflowofVariance*(0.75
313 *
0.0002
75,000)*16,000,000*(0.75
= K1,067,068
= K1, 694,000.00
Upper Limit = K2, 000,000 + K1, 067,068 = K2,355,689.3
(c) (i) Increase/Decrease in net operating Margin:
Current Sales = 25% * K5, 200,000 = K1,300,000.00
Proposed change in policy = 25% * K5, 720,000.0 = K1,430,000.00
Net margin increase = K130,000.00
(ii) Increase/decrease in discount allowed
Current level = K5,200,000 * 2%*50% = K52,000.00
Proposed Change = K5,720,000 * 4% *75% = K171,600.00
Increase in cost of discount K119,600.00
(iii) Bad debts
Current level 1% of 5,200,000 = 52,000
Proposed 0.5% 5,720,000 = 28,600
Savings 23,400
41
New Situation= (75% * 5,720,000/52*2) + (25%*5,720,000/52*10) = K412, 500
Reduction in Debtors = K500, 000 – K440, 000 =K 60,000
Savings are 12% * 87,500 = K10, 500
Savings: Net operating margin K130,000.00
Debtors K7,200
Bad debts (52,000 – 28,600) K23,400.00
Cost: Discount allowed (K119,600.00)
K41,000.00
It is a marginal improvement and therefore may not be viable.
42
SECTION B
Solution 3
(a) (i) Divided yield = Divided per share
Market value per share
0.10 = K400
Market value
` = K4000
(ii) Po = Do (1+g)
re – g
= 500(1+5.7%)
25%- 5.7%
= K2, 738.34
Workings
1. Growth
Year Dividend per share
2009 75,000/150 500
2008 70,500/150 470
2007 46,000/100 460
2006 45,000/100 450
2005 40,000/100 400
G= 14 500/400
= 5.7%
Limitations
Divided do not grow constantly in reality and therefore g is just an estimation
It does not take into account transaction costs and issue cost
It does not consider the effects of taxation although the model can be modified to
incorporate tax
It does not incorporate risk
(b) Cum rights Value 3 shares * K3,000 = K9,000.00
New Shares 1 share * K2, 000 =K2, 000.00
4 shares 11,000
4
11,000 = K2,750
43
Possible Courses of Action
*To take up or exercise the rights (shareholders maintains their percentage holding in the
company
*To renounce the rights and sell on the market (lower percentage holding in the company
after issue than before then issue.
*To renounce part of the rights and take up reminder (keeps the percentage of shareholding
in the company unchanged
*To do nothing (shares may be sold on behalf of the shareholder to protect him from losing
wealth.
(c) Conversion value = 90 10 = K900
Conversion premium = K1,000 K900
= K100.
44
Solution 4
WORKINGS 2008 2009
K’000 K’000
Current Ratio = Current assets 95,000.00/6,5000 = 1.5 170,000/178,000 = 0.95
Current liabilities
Quick Ratio =C.Assets-WIP-Stock 55,000/65,000 = 0.85 80,000/178,000 = 0.45
Current liabilities
Debtors days = Debtors*365 50,000/500,000*365 = 36.5 80,000*1m*365 = 29.2
Sales
Creditors day = Creditors *365 45,000/400,000*365 = 41.1 118,000/0.9m*365 = 47.9
Cost of sales
Inventory days = Inventory *365 20,000/0.4m*365 =18.25 40,000/0.9m*365 = 16.2
Cost of sale
Asset Turn over = Sales/Total assets 500,000/175000=2.9 1m/29,000=3.4
Comments
Profitability
The sales has increased by 100%;this could be as a result of cash discounts for early settlement
and lower sales price. The growth in gross profit has remained unchanged; variable cos of
production could have increased in line with the sales.
The net profit margin has reduced drastically from 6% to 0.2%. This could be as a result of poor
cost control leading to increased operating costs.
The turnover has improved from 2.9 to 3.44 ; this is as a result of increased sale and
undercapitalization.
Liquidity
The current ratio has reduced from 1.5 to 0.95 possibly because of the increase in overdraft and
the quick ratio has worsen from 0.85 to 0.45. However, this depends on the nature of the industry.
Some industries have lower current ratios and quick ratios.
Debtor days have reduced from 36.2 to 29.2; this means the debtors are settling quicker due to
may be cash discounts and lower sales prices.
Creditor days have increased from 41.1 days to 47.9 days; meaning that Hamwela is taking longer
to pay creditors and this may affect the relationship with suppliers. Inventory have reduced may be
due to may increase in sale demand.
45
The company appears to be overtrading and some of the typical symptoms of overtrading present
in Hamwela are as follows:
Fall in liquidity ratios
Sharp increase in asset turnover ratio
Increase in creditor payment period
Rapid increase in turnover
Decline in cash balances and increase in short term borrowing
Decrease in profit margins.
(c) Financial statements are supposed to give a true and fair view of the financial position of a
company. However, sometimes management may try to give a position that may be
favourable to them in order to achieve there intentions. This act may be referred to as
window dressing. This may be done in a number of ways such or manipulating of accounting
standards and policies.
46
Solution 5
(a) (i) Bill of Exchange
A bill of Exchange is the Instrument normally used in International trade to effect
payment. It is a draft that is simply an order written by an exporter instructing an
importer or an importer’s agent, to pay a specified amount of money at a specified
time.
(ii) Factoring
Factoring is another resource for short- term working capital financing. Once you have
filled an order an international factoring can buy the receivable and handles the
collections.
(iii) Counter Trade
The term ‘Counter Trade’ is used to describe an arrangement where an exporter
receives payment from the proceeds of exports of goods from the buyer’s country. By
and large, ‘counter trade’ refers to all forms of barter systems in their varying forms.
(b) (i) Cross rate exchange is the rate between three currencies while offer rate is the selling
rate between two currencies.
(ii) Spot rate is the rate on a given day applying for immediate transactions while forward
rate is the rate agreed upon by both parties to be used for specific transaction on a
specified date.
(c) 100,000/48.00=$2,083.33
2,083.33*4,750= K9, 895, 833.00
(d) Economic risk relates to the change in the value of a company as a result of unexpected
changes in exchange rates
Its difficult to hedge economic risk because the amount of exposure is unknown.
Its normally managed by international diversification of activities such as vary production
locations, supply of raw materials an customers base across different countries.
47
Solution 6
(a) Year Cashflow D.F *% PV D. 5% P.V
0 M. Value (9,200) 1.000 (9,200) 1,000 (9,200)
1 4 Interest (8% 10,000 0.67)536 3.392 2,775 3.546 1,901
Redemption 10,000 0.735 7350 0.823 8,230
(75) 931
IRR = 5 +
75931
931 (8 – 5)
= 7,78%
(b) (i) Book value approach
= 0K22,500,00
K7,500,000K5,000000
= 9
5 = 5:9
= 56%
(ii) Market value approach
Market value of equity = 0.1
K200 = 2,000 per share
= K500
00K10,000,00 K2,000 per share.
= K40,000,000
Market of preference shares = K5,000,000
Cost of debt = Po
t) - (1 i
Market value of debenture = 0.05
0.7 K750,000
= K10,500,000
48
Creaming ratio = 111
31
K40mK5mK10.5
K5m K10.5m
= 31 : 111
= 28%
(c) Advantages
There is no requirement to repay the capital
There is no requirement to raise security.
In the event of non = payment of dividends it can not result into liquidation.
Disadvantages
The dividend is not tax deductible when compares with interest on debentures
Debt capital is cheaper than preference shares because of tax shied.
49
ZAMBIA INSTITUTE OF CHARTERED ACCOUNTANTS
CHARTERED ACCOUNTANTS EXAMINATIONS
LICENTIATE LEVEL
L6: CORPORATION FINANCIAL MANAGEMENT
SERIES: JUNE 2011
TOTAL MARKS – 100 TIME ALLOWED: THREE (3) HOURS
INSTRUCTIONS TO CANDIDATES
1. You have ten (10) minutes reading time. Use it to study the examination paper carefully so
that you understand what to do in each question. You will be told when to start writing.
2. There are SEVEN questions in this paper. You are required to attempt any FIVE questions.
ALL questions carry equal marks.
3. Enter your student number and your National Registration Card number on the front of the
answer booklet. Your name must NOT appear anywhere on your answer booklet.
4. Do NOT write in pencil (except for graphs and diagrams).
5. The marks shown against the requirement(s) for each question should be taken as an
indication of the expected length and depth of the answer.
6. All workings must be done in the answer booklet.
7. Present legible and tidy work.
8. Graph paper (if required) is provided at the end of the answer booklet.
9. Formulae, Present Value and Annuity tables are attached at the end of this question paper.
50
SECTION A
Attempt both questions in this section.
Question 1
(a) Doda Limited is considering four investment projects, details of which are given below:
Project MS BR HA HH
K’000 K’000 K’000 K’000
Initial outlay 100,800 67,200 115,200 28,800
Net present value 48,472 17,906 30,096 19,824
Sales 216,000 144,000 96,000 288,000
The total available funds for investment are limited to K249.6 million. Working capital
requirements for each project will amount to 25% of the expected annual sales value and will
be made immediately.
Required:
Calculate the Profitability Index for each project and advise the company which of the
projects, if any, to undertake. You may assume that projects are divisible.(5 marks)
(b) ATM (Adult Teaching Magazine) is considering whether or not to invest in a new product
called SILLA, which would have an expected market life of four years. The following
information is available:
1. Costs incurred in market research amounted to K23.04 million.
2. Production of SILLA will require purchase of new machine at a cost of K115.2 million
payable immediately. The machine has a maximum production capacity of 50,000 units
per year and production life of four years. This machine is specific to the production of
SILLA and will be obsolete and valueless when that production ceases.
3. Selling price and production costs per unit of the Silla are estimated as follows:
ZMK
Selling price 3,840
Variable materials 384
Variable Labour 576
Variable Overheads 565
51
3. The expected demand for SILLA is 80% of production capacity per annum for four
years. Fixed costs including straight line depreciation on new machine are estimated at
K38.4 million per annum.
4. The selling price and all costs are given at year one prices. The RPI (Retail Price
Index) is expected to increase at 9% per annum and the selling price is expected to
increase at the same rate. Annual Inflation rates for production costs are expected to
be as follows:
Variable Materials 6%
Variable labour 12%
Variable overheads 5%
Fixed Costs 4%
5. Capital allowance is available against the taxable profits of the investment, at 25% per
year straight line. The rate of corporation tax on taxable profits is 30% and tax is paid
one year in arrears. The nominal weighted average cost of capital is estimated to be
17.2% before tax.
6. All costs and revenues should be assumed to rise at the end of each year. Ignore
working capital.
Required:
Evaluate whether or not ATM should undertake the investment on financial grounds. State
clearly any assumptions. (15 marks)
(Total: 20 marks)
Question 2
(a) Perdita Company is a local successful manufacturing company involved in producing
assorted plastic containers, which are later used by other companies for packaging. The
annual sales are K560 million of which 30% represents cash sales. Its current assets
comprises accounts receivable and inventory while the current liabilities comprises accounts
payable and an overdraft with interest rate of 15% per year on average. The company credit
policy is to give customers three months credit, however, its trade suppliers only allow two
months credit on average.
52
Other relevant information
Annual cost of sales: K240 million.
Cost of Long term finance of Perdita Company: 21%
Current ratio: 1.58
Operating Cycle: 4 months
Required:
(i) Discuss the two (2) main objectives of working capital management and the conflicts
that might arise between them. (6 marks)
(ii) From the above details, calculate the following:
1 The size of the overdraft; (4 marks)
2 The net working capital; and (2 marks)
3 The total cost of financing Perdita Company’s current assets. (2 marks)
(b) Perdita Company owes one of its major supplier K60 million. The company has been offered
credit terms cash discount 3% if payment is made within 15 days of the invoice (paying
before day 15 would be irrelevant), and payments must be made within 60 days of the
invoice. Perdita has the choice of accepting the discount or to invest 97 ngwee per K1 for the
additional days and eventually pay the supplier K1 per K1. Perdita can invest cash at an
annual return of 29%.
Required:
Evaluate whether Perdita should accept the discount offered from the supplier. (6 marks)
(Total: 20 marks)
SECTION B
Attempt any three questions in this section.
Question 3
(a) State four (4) factors that management in a listed company should take into account when
choosing a source of long term finance. (4 marks)
(b) Gesh is a limited liability company listed on Lusaka Stock market and it is planning to expand
its business operations. Management has estimated that this expansion will require a capital
injection of about K200 million. Gesh has a share capital of K500 million (K5,000 nominal
value), share premium of K40 million and a 12% convertible loan stock worth K250 million to
be converted in three (3) years time or redeemable in thirty (30) years time at par (K10, 000).
Each loan stock may be converted into 20 ordinary shares of the company. The market value
53
of a straight Loan stock is K12,000. Gesh’s shareholders consider the company to be highly
geared and therefore relatively riskier than its competitors.
Required:
(i) Calculate Gesh’s current market price per share. (2 marks)
(ii) Assuming Gesh decides to raise the required funds from a rights issue at K400 less
than the current market price per share, in what ratio should the announcement be
made to maintain the current level of control? (2 marks)
(iii) Calculate the theoretical ex-rights price. (4 marks)
(iv) Calculate the conversion price and explain two (2) advantages of a convertible loan
stock to a company. (6 marks)
(v) Contrast a convertible bond and a warrant. (2 marks)
(Total: 20 marks)
Question 4
(a) Explain three (3) main weaknesses of the dividend valuation model.(6 marks)
(b) Lyensh Limited, a manufacturing company listed on a stock market, is looking at its cost of
capital as it prepares to restructure its capital structure. Lyensh has 1 million K100 ordinary
shares and K50 million credited to its share premium account. The company has maintained
a dividend payout ratio of 25% of its earnings for several years. For the last four years the
earnings per share has been K102. The 10% Loan stock of the company are trading at K90
(total market value of K90 million) per K100 stock redeemable in four years time at par.
Lyensh is in the 30% tax rate category.
Required:
(i) Calculate the Weighted Average Cost of Capital (WACC) of Lyensh Limited on a
market value weighted basis. 10 marks)
(ii) Explain why the Capital Asset Pricing Model (CAPM) is considered to be the best
model to use when estimating the discount rate used in appraising capital projects.
(4 marks)
(Total: 20 marks)
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Question 5
The financial statements of Nyendo Ltd for the year that has just ended contain the following
statement of financial position:
K’000 K’000
Non-current assets 22,000
Current assets:
Inventory 2,400
Trade receivables 2,200
4,600
Total assets 26,600
Equity finance: K’ 000 K’ 000
Ordinary shares 5,000
Reserves 7,500
12,500
Long-term bank loan 10, 000
22,500
Current liabilities:
Trade payables 1,900
Overdraft 2,200
4,100
Total Equity and liabilities 26,600
Additional information
Nyendo Limited achieved a turnover of K16 million and expects turnover growth of 8·4% in the
next year. Cost of sales was K10·88 million and other expenses were K1·44 million.
The long-term bank loan has a fixed annual interest rate of 8% per year. Nyendo Limited pays
taxation at an annual rate of 30% per year.
The following accounting ratios have been provided for similar companies of the same size in the
same industry as Nyendo Limited for the same period:
Gross profit margin: 30%
Operating profit margin: 20%
Dividend payout ratio: 50%
Inventory turnover period: 110 days
55
Trade receivables period: 65 days
Trade payables period: 75 days
Required:
(a) Discuss three (3) limitations of ratios as a tool for performance evaluation. (6 marks)
(b) Suggest two (2) other additional information apart from ratios that may be necessary when
analyzing the performance of a company. (4 marks)
(c) Evaluate and discuss the liquidity position of Nyendo Limited. (10 marks)
(Total 20 marks)
Question 6
Jings Limited is a well established Zambian company based in the Central Province involved in
supplying various materials to local mining companies. Recently the managing director,
Mr.Haachitwe, proposed to the board of directors to consider going into mining coal and exporting
to Europe and other countries. However, one of the directors opposed this idea stating that the
company would be exposed to foreign currency risk. The board chairperson, Mrs. Mulenga, didn’t
understand what foreign currency risk meant.
(a) Explain briefly the three (3) types of currency risks that Jings Limited would be exposed to if the
proposal is accepted. (6 marks)
(b) Assuming the proposal is accepted and Jings Limited is due to receive and make payments as
follows:
Receipts (3 months time) Receipts (6 months time)
Customer 1 K100 million
Customer 2 $400,000.00
Customer 3 $150,000.00
Payments (3 months time) Payments (6 months time)
Supplier 1 $200,000.00
Supplier 2 $150,000.00
Exchange rates
Spot rate (ZMK/$) 4,610 ± 60
3 months forward rate (ZMK/$) 4,690 ± 75
6 months forward rate (ZMK/$) 4,730 ± 80
56
Borrowing Deposit
Annual Dollar ($) interest rates 5.7% 4.9%
Annual Kwacha (ZMK) interest rates 10% 8%
Required:
(i) Using the information above, evaluate whether the transactions can be hedged using
the money market or forward markets. (10 marks)
(ii) Discuss briefly the two (2) advantages and two (2) disadvantages of Exporting.
(4 marks)
(Total: 20 marks)
END OF PAPER
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58
59
JUNE 2011
L6: CORPORATE FINANCIAL MANAGEMENT
SUGGESTED SOLUTIONS
60
Solution 1
(a) The Profitability Index measures the ratio of the present value of cash flows to the initial
outlay and represents the net present value per K1 invested. It provides a means of
optimizing the NPV when there is more than one project available which yield a positive
NPV.
Project PV of inflows initial outlay Ratio Raking
K’000 K’000
MS 149, 272 154,800 0.962
BR 85, 106 103,200 0.823
HA 145, 296 139,200 1.041
HH 48, 624 100,800 0.484
Project HA has the highest PI raking and is therefore the first choice of investment followed
by MS and Half of BR as detail below:
Project initial outlay total NPV % taken cum outlay actual NPV
K’000 K’000 K’000 K’000
HA 115,200 30,096 100 115,200 30,096
MS 100,800 48,472 100 216,000 48,472
BR 67,200 17,906 50 249,600 8,953
HH 28,800 19,821 0 249,600 0
Total NPV obtained 87,521
(b) INVESTMENT EVALUATION
Year 0 1 2 3 4 5
K’m K’m K’m K’m K’m K’m
Sales (w1) 153.6 167.42 182.5 198.9
Direct Costs (w2):
Variable Material (15.36) (16.28) (17.26) (18.3)
Variable Labour (23.04) (25.8) (28.9) (32.37)
Variable overhead (22.6) (23.73) (24.92) (26.16) -
Fixed costs (w 3) (9.6) (9.98) (10.38) (10.8) -
Capital allowance (w4) (28.8) (28.8) (28.8) (28.8)
61
Taxable profits 54.2 62.83 72.24 82.47
Tax @30% (16.26) (18.85) (21.67) (24.74)
Add back CA 28.8 28.8 28.8 28.8
Net Cash flow 83 75.37 82.19 89.6 (24.74)
New Machinery (115.2)
Discount (w) @12% 1.000 0.893 0.797 0.712 0.636 0.567
Present Values (115.2) 74.12 60.1 58.52 57 (14.03)
NPV K120.51 million
The NPV for the investment is positive and therefore it should be undertaken on financial
grounds.
NOTES
1 Year 1 2 3 4
Sales volumes (80%*50,000) 40,000 40,000 40,000 40,000
Selling price (Increase by 9%) 3,840 4,185.6 4,562.3 4,972.9
2 Production unit cost
Production units 40,000 40,000 40,000 40,000
Variable Materials (by 6%) 384 407 431.5 457.4
Variable Labour (by 12%) 576 645.1 722.5 809.2
Variable Overheads (by5%) 565 593.3 622.9 654.1
K’m K’m K’m K’m
3 Fixed Production (by 4%):
Fixed Costs 38.4
Depreciation (28.8)
9.6 9.98 10.38 10.8
4.Capital allowance (25%*115.2) 28.8 28.8 28.8 28.8
5. WACC = 17.2%*0.7 = 12%
62
Solution 2
(a) (i) Liquidity and Profitability
The two main objectives of working capital management are to ensure that a business
has sufficient liquid resources to continue in business and to increase its profitability.
The objective of liquidity ensures that a business has adequate liquid resources to
maintain the day to day cash flow. A business needs adequate liquid to meet its
liabilities as they fall due and thus remain in business. The objective of profitability
ensures that the primary objective of financial management is achieved, which is
maximization of shareholders wealth.
However, maintaining a higher level of cash holding will harm profits in that cash do not
earn a return and near liquid assets such as short term investments only earn a small
return. Therefore, the opportunity to make a return on the assets is tied up as cash and
will have been missed.
In conclusion, meeting the objective of liquidity will conflict with the objective of
profitability; which can be met by investing over a longer term in order to achieve
higher returns. A business working capital policy should strive to achieve a balance
between the objectives of profitability and liquidity in order to maximize shareholder
wealth.
(ii) Size of overdraft
Inventory period = operating cycle + accounts payable period - accounts receivable
= 4 + 2 – 3 = 3 months
Inventory = 3/12*K240 million = K60 million
Credit sales = 0.7 *K560 million = K392 million
Accounts receivable = 3/12*K392 million = K98 million
Current assets = K60m + K98m =K158 million
Accounts payable = 2/12* K240 million = K40 million
Current liabilities = currents assets/current ratio = K158m/1.58 = K100 million
Overdraft = Current liabilities – Accounts payable = K100m – K40m = K60 million
Net working capital = Current assets – Current liabilities = K158m – K100m = K58 million
Short term financing cost = K60m * 15% = K9 million
Long term financing cost = K60m * 21% = K12.6 million
Total cost of financing current assets K21.6 million
63
(b) Refuse discount Accept discount
K’000 K’000
Payment to supplier 60,000 (60,000*0.97) 58,200
Return from investing K58.2m
(45/365*K58.2m *0.29) (2,100)
Net payment 57,900 58,200
It is slightly cheaper (by K0.3m) not to accept the discount and instead invest the cash for the
additional days at the rate of return available to Perdita Company. However, in this case
delaying the payment until the final day may be inadvisable because this might affect the
relationship with the major supplier and may cause difficulties in obtaining additional credit.
The cost of obtaining additional credit might go beyond the marginal savings calculated
above.
64
Solution 3
(a) The cost of funds. Equity is considered to be more costly than debt.
Accessibility to the funds. Listed companies generally have access to all funds than private
limited companies.
The duration for which the funds are needed. Borrowing in the long term will be more
costly than in the short-term as in the long term the risk is higher than in the short-term.
The level of gearing. If a company is already highly geared it may not be appropriate to
raise funds from debt capital.
(b) (i) Nominal value K5, 000
Share premium per share K400
Market price per share K5, 400
Note: Total No of shares = K5,000
millionK500 = 100,000
Share premium per share = K100,000
millionK40 = K400
(ii) No of new shares = 40,000K400)-(K5,400
millionK200
Ratio: New shares: old shares
40,000 100,000
2 5
Therefore the announcement should be 5
2rights issue at K5,000.
(iii) 5 old shares @ K5, 400 = K27, 000
2 new shares @ K5, 000 = K10,000
7 shares K37,000
Theoretical ex-rights =7
K37,000 = K5, 286 per share
(iv) Conversion price = sharesordinary 20
K10,000 = K500 loan stock per ordinary shares
65
(v) Advantages of convertible loan stock
1. A company might be unwilling to issue new straight long-term debt capital
because market interest rates on straight long-term debt seem too high,
2. A high-risk company might find it difficult to raise long-term finance whatever the
coupon rate, because investors might be reluctant to buy stock in a company that
might go out of business before the stock reaches maturity. Convertible loan
stock would be more attractive because investors would be able to benefit from
the upside potential as well as having to bear some downside risk.
3. A company might find it difficult to raise share capital at a reasonable issue price
if shares in the market sector are currently depressed and the issue would flood
the market with shares, and so tend to keep share prices low.
No Convertible Bond Warranty
1 Rights are not separable from the security.
The rights can be sold separately from the security
2 Company does not raise extra cash when holders exercise their rights
Company raises cash when rights are exercised by the holders
66
Solution 4
(a) Weaknesses of the dividend valuation model
The dividend from projects for which the funds are required will be of the same risk
type or quality as dividends from existing operations currently in progress.
There would be no increase in the cost of capital, for any other reason besides (a)
above, from a new issue of shares.
All shareholders have perfect information about the company’s future, there is no delay
in obtaining this information and all shareholders interpret it in the same way
Tax can be ignored
There would be no issue costs for new shares.
(b) (i) COST OF EQUITY
Market price of a share = K100 +million 1
million K50,000 = K150 per share
Dividend per share = K102 25% = K25.50 per share
Cost of equity =K150
K25.50 100% = 17%
COST OF DEBT
After tax interest = K100 10% (1 – 0.30) = K7 per stock.
YEAR Cash flow (K) D.Factor (5%) PV D.Factor (15%) PV
0 (90) 1.0000 (90.000) 1.0000 (90.000)
1 – 4 7 3.5460 24.822 2.8550 19.985
4 100 0.8227 82.27 0 0.5718 57.180
17.092 (12.835)
Cost of debt = 5% + 12.8357.092
17,092
(15% 5% ) = 10.711% = 11%
WACC
Capital Market values Weights Cost Average
K’m
Equity 150 0.625 17% 10.625%
Debt 90 0.375 11% 4.125%
240 1.00 14.75%
Therefore weighted average cost of capital = 15%
67
(ii) It provides a market-based relationship between risk and return and assessment of
security risk and rates of return give that risk.
It provides a basis for establishing risk-adjusted discount rates for capital investment
projects.
68
Solution 5
(a) inconsistent definitions of ratios
financial statements may have been deliberately manipulated (creative accounting)
different companies may adopt different accounting policies (e.g. use of historical costs
compared to current values)
different managerial policies (e.g. different companies offer customers different
payment terms)
statement of financial position figures may not be representative of average values
throughout the year (this can be caused by seasonal trading or a large acquisition of
non-current assets near the year end)
the impact of price changes over time/distortion caused by inflation
(b) market shares
key employee information
sales mix information
product range information
the size of the order book
the long term plans of management.
(c) Working capital management
Financial analysis shows deterioration in key working capital ratios. The inventory turnover
period is expected to increase from 81 days to 110 days, the trade receivables period is
expected to increase from 50 days to 65 days and the trade payables period is expected to
increase from 64 days to 75 days. It is also a cause for concern here that the values of these
working capital ratios for the next year are forecast, i.e. Nyendo Ltd Co appears to be
anticipating a worsening in its working capital position.
The current and forecast values could be compared to average or sector values in order to
confirm whether this is in fact the case. Because current assets are expected to increase by
more than current liabilities, the current ratio and the quick ratio are both expected to
increase in the next year, the current ratio from 1·12 times to 1·26 times and the quick ratio
from 0·54 times to 0·58 times. Again, comparison with sector average values for these ratios
would be useful in making an assessment of the working capital management of Nyendo Ltd
Co. The balance between trade payables and overdraft finance is approximately the same in
both years (trade payables are 46% of current liabilities in the current statement of financial
position and 47% of current liabilities in the forecast statement of financial position), although
reliance on short-term finance is expected to fall slightly in the next year. The deteriorating
working capital position may be linked to an expected deterioration in the overall financial
performance of
69
Nyendo Ltd Co. For example, the forecast gross profit margin (30%) and net profit margin
(20%) are both less than the current values of these ratios (32% and 23% respectively), and
despite the increase in turnover, return on capital employed (ROCE) is expected to fall from
16·35% to 14·83%.
INDEX
Gross profit margin (100 5·12/16·00) 32%
Net profit margin (100 3·68/16·00) 23%
ROCE (100 x 3·68/22·5) 16·35%
Inventory period (365 2·4/10·88) 81 days
Receivables period (365 x 2·2/16·00) 50 days
Payables period (365 1·9/10·88) 64 days
Current ratio (4·6/4·1) 1 12 times
Quick ratio (2·2/4·1) 0·54 times
70
Solution 6
(a) Any dealing in foreign currency presents the problem of the risk of changes in the exchange
rates. There are three types of currency risks that Jing Ltd might be exposed to namely,
Transaction risk, Translation (accounting risk) and economic risk.
Transaction risk
This is the risk that a transaction in a foreign currency at one exchange rate is settled at
another rate because the rate has changed. This change might be adverse and would cause
great danger to the profit margins.
Translation risk
This relates to the exchange profit loses that result from converting foreign currency
balances for the purpose of preparing the accounts. Most business have foreign branches or
subsidiaries and accounting results are supposed to be translated into the home currency,
for example restating the book values of a foreign subsidiary’s assets at the exchange rate
on the balance sheet date.
Economic risk
This refers to the change in the present value of future cash flow due to unexpected
movements in foreign exchange rate and this has effects on the international
competitiveness of a company. For example a UK company might use raw materials which
are priced in the Zambia Kwacha but exports its products mainly within the European Union.
A depreciation of sterling against the Kwacha or an appreciation of the sterling against other
EU currencies will both erode the competitiveness of the company.
(a) (i) Receipts: 3 months ($400,000 + $150,000) = $550,000.00
Payments: 3 months = $200,000.00
Net receipts $350,000.00
Therefore net receipts of $ 350,000.00 in three months and a payment of $150,000.00
in 6 months time will be considered.
FORWARD MARKET:
Forward rate = K4, 690 – 75 = K4, 615
Value of 3 months forward market hedged = $350,000*4615 = K1, 615.25 million
Forward rate in 6 months time = K4, 730 + 80 = K4, 810 per dollar
Cost of using 6 months forward market hedged =$150,000*K4, 810 = K721.5 million
71
MONEY MARKET:
Receipts
3 months dollar borrowing rate = 5.7%*3/12 = 1.425%
Current spot buying rate = K4, 610 – 60 = K4, 550 per dollar
3 months Zambian depositing rate = 8%*3/12 = 2%
Borrow dollars now = 350,000/1.01425=$345,082.57
Value of these dollars now at spot = 345,082.57*4,550= K1, 570,125.69 million
Value investing in Zambia in 3 months time = K1, 570,125.69*1.02=K1, 601,528.20
million
Payment
6 months dollar deposit rate = 4.9%*6/12 = 2.45%
Current spot selling rate = K4, 610+60 = K4, 670
6 months Zambia borrowing rate = 10%*6/12=5%
Deposit dollars now = $150,000/1.0245 = $146,412.88
Cost of these dollars at spot = $146,412.88*K4, 670=K683.75 million
Value of loan in 6 months time = K683.75million*1.05 = K717.94 million
Conclusion:
Using the forward market to hedge 3 months receipts offers a higher value when
compared with the money market. However, the forward market gives an expensive
hedge for the 6 months payment than the money market. Therefore, Jings Ltd should
use forward market for receipts and money market for the payment.
ii) Advantages of exporting
Exporting will help enhance domestic competitiveness, in that, to be world beating you
have to be really good at home and this home excellence will allow the business to
compete against world class. It will also help the business to increase sales and profit
because of increase customer base. Exporting enables a business to sell excess
production to other countries who have shortages.
Disadvantages of Exporting
The exporting company may have to wait longer for payments to be received and this
may cause liquidity problems for small businesses especially. Exporting may be
discouraging because of tariffs, quotas or other restrictions such us special export
licenses in overseas market. It leads to a business incurring additional administrative
costs.
END