MAY 2018 PROFESSIONAL EXAMINATIONS FINANCIAL ..., Summaries of Financial Management

Download MAY 2018 PROFESSIONAL EXAMINATIONS FINANCIAL ... and more Summaries Financial Management in PDF only on Docsity! Page 1 of 19 MAY 2018 PROFESSIONAL EXAMINATIONS FINANCIAL MANAGEMENT (PAPER 2.4) CHIEF EXAMINER’S REPORT, QUESTIONS AND MARKING SCHEME STANDARD OF THE PAPER The standard and quality of the paper was generally satisfactory. The questions generally covered the major subject areas and also appeared balanced for both quantitative and essay type aspects of the syllabus. The questions were easy to understand and apply. No difficult questions were noticed except the (a) part of Question 2 where the dividend per share stated in the question appeared to be unusually high relative to the price per share stated in the question creating unusual cost of equity rates or numbers as high as over 700% which created some confusion in the minds of students. Additionally, question 5 (b) appeared to have used historical years to represent forecast years and to calculate the present values for business valuation purposes. It was also observed that generally no sub-standard questions were set in the paper and all questions were considered normal and standard for that level. Mark allocations appeared generally satisfactory relative to the nature of questions. PERFORMANCE OF CANDIDATES The performance of the students in the paper was generally better as the pass rate improved to 36% compared to the 28% in the November exams sitting. Overall pass rate even though improved but still required further improvement for the paper which historically has been experiencing low pass rates. The possible reasons for the improved performance were as follows:  Generally better preparations by students as answers provided showed some level of improvement.  Improved tuition services provided especially at the Accra and Institute cantres.  Better knowledge by students on exam preparation and questions answering techniques.  Better access to study materials especially the out of Accra centres. • No evidence of copying in the exams was noticed. NOTABLE STRENGTHS & WEAKNESSES The over 30% students who did well exhibited the following strengths:  Reading and understanding of the questions  Well planned responses to the questions in line with the requirements of questions  Very legible handwriting making reading and marking easier and better  Well prepared and showed strengths in both quantitative and written questions  Avoidance of mixing different answers to different questions and scattering of answers across difference pages mixed with answers of different questions. Page 2 of 19 Observed weaknesses demonstrated by students  Poor understanding of Finance principles.  Poor exam preparation.  Failure to comprehend the requirements of the questions.  Wrong numbering of answers to questions making it difficult for examiners.  Writing on areas not required by the questions.  Poor arrangement of answers to questions with answers to some questions scattered across different pages haphazardly. Page 5 of 19 QUESTION THREE a) Okechukwu Ltd is financed by three types of capital: i) 1 million 50p ordinary shares each having current market value of GH¢5.20 cum div. The current dividend, which is due to be paid shortly, is 20p per share. The dividend has grown steadily in the past at a compound annual rate of 15% and is generally expected to continue doing so indefinitely. ii) 200,000 GH¢1 irredeemable 8% preference shares, each having a current market value of 50p ex. Div. iii) GH¢2 million 10% debentures, redeemable in 20 years at a price of 110. The current market value is 80 ex int. Okechukwu is considering a new project having the same risk characteristics as existing projects, which would require an immediate outlay of GH¢150,000 and would produce annual net cash inflow of GH¢30,000 indefinitely. Required: Evaluate the viability of the new project using appropriate computations. (15 marks) b) Foreign currency risk can be managed, in order to reduce or eliminate the risk. Measures to reduce currency risk are known as hedging. Required: i) Explain Transaction and Economic Exposure. (5 marks) ii) Explain FIVE ways of mitigating transaction exposure. (5 marks) (Total: 25 marks) QUESTION FOUR Adjaye Ltd has current sales of GH¢1.5m per year. Cost of sales is 75 per cent of sales and bad debts are one per cent of sales. Cost of sales comprises 80 per cent variable costs and 20 per cent fixed costs, while the company’s required rate of return is 12 per cent. Adjaye Ltd currently allows customers 30 days credit, but is considering increasing this to 60 days credit in order to increase sales. It has been estimated that this change in policy will increase sales by 15 per cent and bad debts will increase from one per cent to four per cent. It is not expected that the policy change will result in an increase in fixed costs and creditors and stock will be unchanged. Required: Advice whether Adjaye Ltd should introduce the proposed policy. Support your answer with relevant computations. (15 marks) Page 6 of 19 QUESTION FIVE a) The directors of Clear Tel Ltd, a private telecommunication company, are considering a proposed resolution for converting the company to a public company and listing its equity stock on the stock exchange. The directors expects that the stock market listing can enhance Clear Tel’s ability to raise large amounts of capital from the public. However, they fear that stock market inefficiencies could have a negative effect on the price of Clear Tel’s equity stock. Required: Explain the THREE degrees of stock market efficiency, and how the price of Clear Tel is expected to move in each case. (6 marks) b) Restwell Ltd, a hotel leisure company, is currently considering taking over a smaller private limited company, Staygood Ltd. The board of Restwell is in the process of making a bid for Staygood, but first needs to place a value on the company. Restwell has gathered the following data: Year 2011 2012 2013 2014 GH¢ GH¢ GH¢ GH¢ Profit after tax 6,000,000 6,200,000 6,300,000 6,300,000 The company’s earnings yield is 12%. Required: i) As a Finance Manager, calculate the value of the company based on the present value of expected earnings. (6 marks) ii) Explain THREE problems associated with using P/E method for valuing firms.(3 marks) (Total: 15 marks) Page 7 of 19 SOLUTION TO QUESTIONS QUESTION ONE a)  Changes in interest rates affect the public's demand for goods and services and, thus, aggregate investment spending.  A decrease in interest rates lowers the cost of borrowing, which encourages businesses to increase investment spending.  Lower interest rates also give banks more incentive to lend to businesses and households, allowing them to spend more.  Higher interest rates may make the corporate sector pessimistic about future business prospects and confidence in the economy. This ay further reduce investment in the economy.  Higher interest rates will increase mortgage payments and will thus reduce the amount of disposable income in the hands of home buyers for discretionary spending.  Higher interest rates encourage savers to save as more interest will be earned from their savings or investments (Any 4 points for 6 marks) b) i) The agency problem is a conflict of interest inherent in any relationship where one party is expected to act in another's best interests. Within the context of limited liability company, the agency problem usually refers to a conflict of interest between a company's management and the company's stockholders. The manager, acting as the agent for the shareholders, or principals, is supposed to make decisions that will maximize shareholder wealth even though it is in the manager’s best interest to maximize his own wealth. (2 marks) ii) Causes of Agency Problem  Managers prefer greater levels of consumption and less intensive work, as these factors do not decrease their remuneration and the value of the company’s shares that they own;  Managers prefer less risky investments and lower financial leverage, because in this way they may decrease the danger of bankruptcy, and avoid losses on their managerial capital and portfolios;  Managers prefer short-term investment horizon;  Managers avoid problems stemming from reductions in employment levels, which increase with the changes in control of a company.  Managers also fear rocking the boat to deliver shareholder value and will rather choose operating in their comfort zones. (2 points for 2 marks) Page 10 of 19 WACC = ((ke x Ve) + (kd(1 – T) x Vd)/(Ve + Vd)) = ((901.16 x 250m) + (7 x 62·4m))/312·4m = 7.2256 x 100% =722.56% The weighted average after-tax cost of capital before the new issue of bonds is 722.56%. (3 marks) WACC after new issue of bonds takes place After-tax cost of debt of new bond issue After-tax interest rate = 8 x (1 – 0·3) = 5·6% per year Using interpolation: After-tax cost of debt = 5 + [((6 – 5) x 7·71)/(7·71 + 0·19)] = 5 + 0·98 = 5·98% or 6% WACC after new issue of bonds The market value of the new issue of bonds is GH¢40 million The total market value of Sevista Hotel increases to 312·4 + 40 = GH¢352·4 million WACC = ((901.16 x 250m) + (7 x 62·4m) + (6 x 40))/352·4m = 641.5% or 642% After the new issue of bonds, the weighted average after-tax cost of capital has decreased from 722.56% to 641.5% because the proportion of debt finance, which has a lower required rate of return than equity finance, has increased. Gearing on a market value basis has increased from 20% (62·4/312·4) to 29% (102·4/352·4). The WACC calculation assumes that the cost of equity has not changed, when in reality the cost of equity might be expected to rise in response to the increase in financial risk caused by the new issue of debt. The share price of the company has also been assumed to be constant. (3 marks) b) i) Theoretical ex-right price GH¢ 4 existing shares @ ¢3 12 1/5 Right share @ ¢2 2 14 Year Cash flow ¢ Discount at 5% PV 0 Market price -100 1.0 -100 1.-10 Interest 5.6 7.722 43.24 10 Redemption 105 0.614 64.47 7.71 Year Cash flow ¢ Discount at 6% PV 0 Market price -100 1.0 -100 1.-10 Interest 5.6 7.36 41.22 10 Redemption 105 0.558 58.59 0.19- Page 11 of 19 Theoretical ex-right value of the shares = 14 5 = ¢2.80 (4 marks) ii) Value of a right = Theoretical ex-right prices – rights prices = ¢2.80 - ¢2.0 = ¢0.80 (3 marks) Value of an existing share required to purchase a right = ¢0.80 4 = ¢0.20 c) (i) Sells the rights = Pre-rights wealth = 1,000 shares @ ¢3.00 = ¢3,000 GH¢ Cash from selling rights = 1,000 x ¢0.20 = 200 Value of shares ex-rights = 1,000 x 2.80 = 2,800 Total wealth = 3,000 (3 marks) (ii) Exercise half and sells the other half Allowed 1,000/4 = 250 rights; purchases 125 @ ¢2.00; sells half and gains 125 x ¢0.80. Pre-rights wealth 1,000@¢3.00 = 3,000 After rights issue: = GH¢ Old shares 1,000@¢2.80 = 2,800 New shares 125 @ ¢2.80 = 350 Cash from sale 125 @¢0.80 = 100 Total wealth after right issue 3,000 (3 marks) (iii) Does nothing GH¢ Pre-rights wealth after rights issue 3,000 After rights wealth GH¢ Old shares 1,000 @¢2.80 2,800 Total wealth 2,800 It is only if the shareholder does nothing that his wealth position will be reduced. As long as all the rights are either sold or exercised his wealth position will be unchanged. This is not surprising because the theoretical Page 12 of 19 ex-rights price has been calculated as a weighted average of the old price and the price of the right. (2 marks) (Total: 25 marks) EXAMINER’S COMMENTS Question 2 was one of the longest and most comprehensive questions in the paper which covered (a) to (c). The (a) part which covered the calculation of cost of equity and weighted average cost of capital before and after the introduction of debt (bonds) into the capital structure. This part created uncertainty among students as the dividend per share provided in the question was almost 8 times the price of the share. Dividend per share varied between 19.38 cedis per share to 21.8 cedis per share for the listed years compared to the share price of 2.5 cedis per share thereby producing unusual rates of return on equity and weighted average cost of capital. This development confused students as most students left their answers unconverted to percentages. The marking process took into consideration to ensure fair assessment of students. The (b) and (c) parts covered rights issue and determination of the value of rights and the various scenarios and implications in the exercising or not exercising of the rights on shareholders. This was a straight forward question which was well answered and helped students perform well in this question. The question carried a total of 25 marks. The overall performance was fairly good. QUESTION THREE a) Calculation of Cost of Capital (i) Cost of equity capital Ke = D(1+g) Mv + g Where D = Dividend proposed g = Growth rate of dividend Mv = Ex div market value of shares = ¢0.20(1.15)+ g ¢5.20−0.20 + 0.15 = 19.6% (3 marks) Page 15 of 19 Risk Shifting − The most obvious way is to not have any exposure. By invoicing all parts of the transactions in the home currency, the firm can avoid transaction exposure completely. However, it is not possible in all cases.  Currency risk sharing − The two parties can share the transaction risk. As the short-term transaction exposure is nearly a zero sum game, one party loses and the other party gains%  Leading and Lagging − It involves playing with the time of the foreign currency cash flows. When the foreign currency (in which the nominal contract is denominated) is appreciating, pay off the liabilities early and collect the receivables later. The first is known as leading and the latter is called lagging.  Reinvoicing Centers − A reinvoicing center is a third-party corporate subsidiary that uses to manage one location for all transaction exposure from intra-company trade. In a reinvoicing center, the transactions are carried out in the domestic currency, and hence, the reinvoicing center suffers from all the transaction exposure.  Netting (Any 5 points for 5 marks) (Total: 25 marks) EXAMINER’S COMMENTS The question consisted of two parts (a) and (b) with the (a) portions covering project evaluation which was averagely answered attracting average marks. The computation of costs of equity, preference shares, redeemable debentures and overall weighted average cost of capital were well answered by most students but some students struggled in the final computation of the NPV of the project. Few students did very well. The (b) part was essay type question was on transaction and economic exposures on exchange risk and ways or strategies to mitigate transaction exposures. This was straight forward and well answered by majority of students. The question on overall basis attracted some good answers from students Page 16 of 19 QUESTION FOUR New level of sales will be 1,500,000 x 1.15 = ¢1,725,000 Variable costs are 80% x 75% = 60% of sales Contribution from sales is therefore 40% of sales (3 marks) GH¢ GH¢ Proposed investment in debtors = 1,725,000 x 60/365 = 283,562 Current investment in debtors = 1,500,000 x 30/365 = 123,288 Increase in investment debtors 160,274 Increase in contribution = 15% x 1,500,000 x 40% = 90,000 New level of bad debts = 1,725,000 x 4% = 69,000 Current level of bad debts = 1,500,000 x 1% = 15,000 Increase in bad debts (54,000) Additional financing costs = 160, 274 x 12% = (19,233) Savings by introducing change in policy 16,767 (10 marks evenly spread using ticks) Decision The financing policy is financially acceptable, although the savings are not great. (2 marks) (Total: 15 marks) EXAMINER’S COMMENTS Question four which was on debtor’s management and policy on increasing debtor days to boost sales. Students generally struggled to answer the question well with most students struggling hard to work out some of the required numbers to get some few marks. The question was poorly answered except the few students who understood the question and scored the maximum marks. The overall marks were 15 with majority getting below the average. Page 17 of 19 QUESTION FIVE a) The Three Basic Forms of the EMH The efficient market hypothesis assumes that markets are efficient. However, the efficient market hypothesis (EMH) can be categorized into three basic levels: Weak-Form EMH The weak-form EMH implies that the market is efficient, reflecting all market information. This hypothesis assumes that the rates of return on the market should be independent; past rates of return have no effect on future rates. In this event that the stock market has weak-form efficiency, the price of Clear Tel will move in line with historical changes. Semi-Strong EMH The semi-strong form EMH implies that the market is efficient, reflecting all publicly available information. This hypothesis assumes that stocks adjust quickly to absorb new information. The semi-strong form EMH also incorporates the weak-form hypothesis. Given the assumption that stock prices reflect all new available information and Clear Tel purchase stocks after this information is released, Clear Tel cannot benefit over and above the market by trading on new information. Strong-Form EMH The strong-form EMH implies that the market is efficient: it reflects all information both public and private, building and incorporating the weak-form EMH and the semi-strong form EMH. Given the assumption that stock prices reflect all information (public as well as private) Clear Tel would not be able to profit above the average investor even if he was given new information. (2 marks for 3 points = 6 marks) b) Restwell Ltd i) Year GH¢000 DF(12%) GH¢000 2011 6,000 0.893 5,358 2012 6,200 0.797 4,941.4 2013 6,300 0.712 4,485.6 2014 6,300 0.636 4,006.8 18,791.8 The value of the company based on the present value of expected earnings is GH¢18,791,800. (6 marks)