FIN 213 REVIEW QUESTIONS

Question one Omega Parl company has in issue two debentures. The debentures holders are strong companies with a good profit record. The debentures are: (i) 5 of irredeemable in four years time at par (ii) 7% debentures redeemable in four years time at par The current rate of interest on investment of this kind is 9% p.a. The debentures are stated at Sh. 10,000 nominal Required Calculate the value of the debentures. i) Irredeemable debentures earn an interest in perpetuity. The value of an irredeemable debenture is given by the present value of interest perpetuity is given by: Perpetuity Interest rate Interest = 10,000 X 5% = 550 Value of 5 irredeemable debenture .09 = 6,111 ii) Value of redeemable debentures is given by the present value of both the debenture value and interest values as follows: Debenture value = 10,000 + 700 + 700 +700 + 700 (1.09)4 (1.09)1 (1.09)2 (1.09)3 (1.09)4 = 7,084.25 + 642.20+ 589.18 + 540.53 + 495.90 = 9,352.06 Question two In 1950, your grandmother decided to put Kshs. 10,000 into a special trust to be paid to a future grandchild (you) 60 years later, in the year 2010. How much will this trust be worth in the year 2010 if it has been earning 8%? Suppose that the fund earns 12% how much will the fund grow to. FV = P x CVF
= 550

=
=

P(1+i)n 10,000(1.08)60 1,012,570

12% FV =
=

10,000(1.12)60 8,975,969

Question three Com-Tech Company Ltd. is in the Telecommunications Industry. companys balance sheet as at 31March 2000 is as below: The

Liability and Owners Equity

Assets Sh.00 0 12,500 Current assets 16,000 Net fixed assets 6,250 12,500 28,125 75,375 _____ 75,375 Sh.00 0 32,500 42,875

Current liabilities 18% debentures (sh.1,000 par) 10% preference shares Ordinary shares (Sh.10 par) Retained earnings

Additional information

The debentures are now selling at Sh.950 in the market and will be redeemed 10 years from now. By the end of last financial period, the company had declared and paid Sh.5.00 as dividend per share. The dividends are expected to grow at an annual rate of 10% in the foreseeable future. Currently, the companys shares are trading at Sh.38 per share at the local stock exchange. The preference shares were floated in 1995 and their prices have remained constant. Most banks are lending money at an interest of 22% per annum. The Corporation tax rate is 40% per annum.

Required Calculate the market weighted cost of capital for this firm.

Solution Compute the % cost of each capital component. Cost of debentures Kd Since debentures are redeemable in 10 years time, the cost is called yield to maturity (YTM) or redemption yield (RY). If debentures are not redeemable (perpetual) Kd is called running or flat yield.

YTM = RY = K d =

Using approximation method for YTM,

Int ( 1 T ) + ( M Vd )1/ n ( M + Vd ) 12

Int = Interest charges = 18% x 1,000 = Sh.180

= Tax rate = 40%

M Vd n

= Maturity or par value = sh.1,000 = Current market value = Sh.950 = Number of years = 10 years

( 1 0.4 ) + ( 1,000 ) 110 180 950 Kd= ( 1,000 ) 12 + 950

= 113 x100 = 11.6% 975

Cost of equity

d (1+ g) K e= 0 +g P0
Ke=

) _0.10 5(1+ 0.10 = 0.245 24.5% 38

d0 = Sh.5.00 P0 = MPS = Sh.38 g = growth rate = 10%

Cost of preference share capital Kp Since MPS = Par value, then KP = Coupon rate = 10% NB: The prices of preference shares have not changes since floatation hence MPS = par value

Capital Equity

Market Value
Sh.12,500 Sh.38x = 47,500 Sh.10

% Cost 24.5

Monetary Cost 11,637.5

Debt

Sh.16,000 Sh.950x = 15,200 Sh.1,000

11.64

1,763.2

Preference share capital = Par value Total

6,250 68,950

10

625.0 14,025.7

WACC=

14,025.7 = 20.3% 68,950

647,500 15,200 6,250 +11.6 +10 = 0.203 WACC= 24.5 20.3% 68,950 68,950 68,950

Question four The Weka Company Ltd. has been considering the criteria that must be met before a capital expenditure proposal can be included in the capital expenditure programme. The screening criteria established by management are as follows: No project should involve a net commitment of funds for more than four years. Accepted proposals must offer a time adjusted or discounted rate of return at least equal to the estimated cost of capital. Present estimates are that cost of capital as 15 percent per annum after tax. Accepted proposals should average over the life time, an unadjusted rate of return on assets employed (calculated in the conventional accounting method at least equal to the average rate of return on total assets shown by

the statutory financial statements included in the annual report of the company. A proposal to purchase a new lathe machine is to be subjected to these initial screening processes. The machine will cost Sh.2,200,000 and has an estimated useful life of five years at the end of which the disposal value will be zero. Sales revenue to be generated by the new machine is estimated as follows: Year 1 2 3 4 5 Revenue (Sh.000) 1,320 1,440 1,560 1,600 1,500

Additional operating costs are estimated to be Sh.700, 000 per annum. Tax rates may be assumed to be 35% payable in the year in which revenue is received. For taxation purpose the machine is to be written off as a fixed annual rate of 20% on cost.

The financial accounting statements issued by the company in recent years shows that profits after tax have averaged 18% on total assets.

Required Present a report which will indicate to management whether or not the proposal to purchase the lathe machine meets each of the selection criteria. Solution Depreciation p.a. = 20% x 2,200,000 = 440,000

Prepare a cash flow schedule:

Year

1 Sh.00 0

2 Sh.00 0 1,440 700 740 440 300 105 195 440 635

3 Sh.00 0 1,560 700 860 440 420 147 273 440 713

4 Sh.00 0 1,600 700 900 440 460 161 299 440 739

5 Sh.00 0 1,500 700 800 440 360 126 234 440 674

Sales Less operating costs EBOT Less depreciation EBT Less tax @ 35% EAT = profits accounting back

1,320 700 620 440 180 63 117 440 557

Add depreciation Cash flows

Screening Criteria

1.

The net commitment of funds should not exceed 4 years i.e the payback period should at least be 4 years. Therefore, compute the payback period.

Year 1 2

Cash flows 557 635

Accumulated Cash flows 557 1,192

3 4 5

713 739 674

1,905 2,644 3,318

The initial capital of Sh.2,200,000 is recovered after year 3. After year 3 (during year 4) a total of Sh.295,000 (2,200 1,905) is required out of the total year 4 cash flows of Sh.739,000. Therefore payback period = 3yrs +
295 = 3.4 yrs 739

2.

The time adjusted or discounted rate of return is the I.R.R of the project. Discount the cash flows at 15% cost of capital given:

n Recall discounting factor (PVIF) = (1 + r ) =

(1 + r )n

Year

Cash flows 000

PVIF15%

P.V

PVIF14%,n

P.V.

1 2 3 4 5 Total P.V.

557 635 713 739 674

0.870 0.756 0.658 0.572 0.497

484.59 0.877 480.06 0.770 469.15 0.675 422.71 0.592 334.98 0.519 2,191.49 2,200.00 (8.51 )

488.49 488.95 481.28 437.49 349.81 2,246.30 2,200.00 46.30

Less initial capital N.P.V.

Since the NPV is negative at 15% cost of capital rediscount the cash flows again at a lower rate, say 14%, to get a positive NPV.

NPV @ 14% = NPV @ I.R.R. NPV @ 15% =

46.3 = -8.51 0

I.R.R. =

14% +

46.3 0 46.3 8.51

(15% 14%)

14% +

46.3 (1%) 54.81

14.85%

3.

The unadjusted rate of return on assets employed is the accounting rate of return.

ARR =

Average accounting profits (EAT) x 100 Average investment

Average accounting profits

117 +195 + 273 + 299 + 234 5yrs

223.6 p.a.

Average investment value)

(Initial

capital

Salvage

(2,200 + 0)

1,100

A.R.R =

223.6 x100 1,100

20.3%

Question Five A comparative study of the records of two oil companies, A Ltd and B Ltd., in terms of their asset composition, capital structure and profitability shows that they have been very similar for the past five years. The only significant difference between the two firms is their dividend policy. A Ltd. maintains a constant dividend per share while B Ltd maintains a constant dividend payout ratio. Relevant data is as follows:

Year Earnin Dividen Price gs per d per range share share in stock exchang e Shs. Shs. Shs. 199 6 199 7 199 8 199 9 1.89 1.50 2.00 2.60 3.90 0.45 0.45 0.45 0.45 0.45 16 18 12 15 14 20 21 26 26 40

Earning Dividen Price s per d per range share share in stock exchang e Shs. Shs. Shs. 2.05 1.45 2.07 2.55 4.08 0.35 0.25 0.36 0.45 0.69 11 15 6 - 14 7 - 16 15 23 21 44

200 0

Required a) For each company, determine the dividend pay-out ratio and the price earnings ratio for each of the five years. B Ltds management is surprised that the shares of this company have not performed as well as A Ltd.s in the stock exchange. What explanation would you offer for this state of affairs?

b)

Comment on the applicability of the Simple Price/Earnings (P/E) ratio to the typical technology (IT) company with a high valuation and heavy losses.

Solution Dividend payout ratio =

DPS x100 EPS

B Ltd Year 1996 A Ltd.

0.45 x100 = 23.8% 1.89 0.35 x100 = 17.1% 2.05

1997

0.45 x100 = 30.0% 1.50

0.35 x100 = 17.2% 1.45

0.45 x100 = 22.5% 2.00

0.35 x100 = 17.4% 2.08

1998

0.45 x100 = 17.30% 2.60

0.35 x100 = 17.7% 2.55

1999

0.45 x100 = 11.5% 3.90

0.35 x100 = 16.9% 4.08

2000

Price earning ratio =

MPS EPS

Year 1996

A Ltd.

B Ltd
= 9.0 yrs / times

(16 +18)
1.89

(11 +15)
2.05

= 6.34 yrs / times

1997

(12 +15)
1.50

= 9.0 yrs

( 6 +14)
1.45

= 6.9 yrs

(14 + 20)
2.00

= 8.5yrs

( 7 +16)
2.08

= 5.56 yrs

1998

( 21 + 26 )
2.60

= 9.0 yrs

(15 + 23)
2.55

= 7.45yrs

1999

( 26 + 40 )
3.90

= 8.46 yrs

( 21 + 44)
4.08

= 7.97 yrs

2000

b) The shares of B Ltd. are not performing well because of uncertainty of DPS compared to certainty of DPS for A Ltd. This uncertainty leads to higher required rate of return by ordinary shareholders thus lower market value of a share.

c) If a firm is making heavy losses, the EPS would be negative. With a positive P/E ratio the MPS would be negative i.e. MPS = -EPS x P/E ratio A negative MPS cannot be interpreted hence the P/E ratio model collapses. Question six At a recent seminar on Gender Empowerment in Business the invited financial consultant, Madame Hesabu Advised the participants that extending credit is one of the comerstone of modern business. Madame Biashara, the managing director of Biashara Limited took note of this important fact. After the seminar, she authorised a review of the credit system of her company. The following facts are relevant. a) b) c) d) e) f) Annual sales of the company are Sh.5,000,000 Credit sales are 25 per cent of all sales Bad debts average 2% of all credit sales Average collection period for debtor is 40 days The companys cost of capital is 14 per cent per annum Net profit on sales is 15 per cent.

Based on these facts, she is recommending a thorough revamping of the credit policy of the company. The expected outcome of this action will be: a) b) c) d) Increase in total sales by 30 per cent Credit sales will be 40 per cent of all sales Average collection period will decrease to 35 days Bad debts will increase to 3 per cent of credit sales

e) An additional part time credit control assistant will be hired for Sh.50,000 per annum. Required Comment on the effectiveness or otherwise of the proposed revamping of credit policy. Who should determine credit policy?

Solution Analysis Since net profit margin is given, analyse the net benefits on the basis of net profits

Current policy Sales Credit sales Bad debts Credit period NP Margin 5,000,000 = 25%x5000,000 = 1,250,000 = 2% of credit sales = 40 days 15%

New policy 5M x 1.30 = 6,500,000 40%x6,500,000=2,600,0 00 3% of credit sales 35 days 15%

Analysis Net profits New policy = Old policy = 15% x 2,600,000 = 15% x 1,250,000 = 390,000 187,500

Net benefit

202,500

Bad debts New policy = Old policy = 3% x 2,600,000 2% x 1,250,000 = = 78,000 25,000 (53,000)

Net benefit (cost)

Debtors New policy = Old policy =

35 x 2,600,000 360 40 x1,250,000 360

= = =

252,778 138,880 113,889

Increase in debtors

Forgone benefits on tied up capital = 14% x 113,889 = (15,945)

Credit controller salary New policy Old policy (50,000) Net benefits 83,555 50,000 0

The credit policy should be determined by the Board of directors of the firm with advice from finance manager and credit controller.