EXAMINATION : INTERMEDIATE LEVEL
SUBJECT : FINANCIAL MANAGEMENT
CODE : B1
EXAMINATION DATE : TUESDAY, 5THMAY 2015
TIME ALLOWED : THREE HOURS (2:00 P.M. – 5:00 P.M.)
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GENERAL INSTRUCTIONS
1. There are TWO sections in this paper. Section Aand Bwhich comprise SEVENquestions.
2. Answer question ONEin section A.
3. Answer any FOURquestions in Section B.
4. In total answer FIVEquestions.
5. Marks are shown at the end of each question.
6. Calculate your answers to the nearest two decimal points.
7. Show clearly all your workings in respective answers where applicable.
8. This question paper comprises 8 printed papers
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SECTION A
Compulsory Question
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QUESTION 1
Safari Company wishes to calculate its Weighted Average Cost of Capital (WACC) and the following is the current information relating to the company.
Number of ordinary shares | 2 million |
Number of 5%, Tshs.100 non-callable preferred stock | 1 million |
Book value of 10%, Tshs.1,000, irredeemable bonds | Tshs. 20 million |
Market price of ordinary shares | Tshs. 50 cum dividend |
Market price of 5%, Tshs.100 non-callable preferred stock | Tshs. 43 ex dividend |
Total dividend just paid | Tshs. 4 million |
Market price of 10% Tshs. 1,000, irredeemable debt | 105 percent ex interest |
Equity beta of Safari company | 1.5 |
Treasury bill rate | 5% |
Expected return on the market | 12% |
Additional information:
2. The dividends of Safari Company are expected to grow at an average rate of 6%.
REQUIRED
(a) Estimate the Safari Company’s equity risk premium and the cost of equity using the Capital Asset Pricing Model (CAPM). (3 marks)
(b) Calculate the market value Weighted Average Cost of Capital of Safari Company using:
(i) The dividend growth model
(ii) The Capital Asset Pricing Model (12 marks)
(c) Discuss whether the dividend growth model or the CAPM offers the better estimate of the cost of equity of a company. (3 marks)
(d) Discuss the circumstances under which the weighted average cost of capital can be used in investment appraisal.(2 marks)
(Total: 20 marks)
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SECTION B
There are SIXquestions. Answer ANY FOUR questions
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QUESTION 2
(a) Mabruk Company is considering investing Tshs. 35 million in a new machine with an expected life of five years. The machine will have no scrap value at the end of the five years. It is expected that 20,000 units will be sold each year at a selling price of Tshs. 2,100 per unit. Variable production costs are expected to be Tshs. 1,150 per unit, while incremental fixed costs, mainly the wages of a maintenance engineer, are expected to be Tshs. 7,000,000 per year. Mabruk Company uses a discount rate of 12% for investment appraisal purposes and expects investment projects to recover their initial investment within two years.
REQUIRED:
Calculate the Net Present Value (NPV) of the project and evaluate the sensitivity of the project’s NPV to a change in the following project variables:
(i) Sales revenue
(ii) Sales price
(b) Tangwi plc is considering investing in one of two proposed short-term portfolios of four short-term financial investments. The correlation between the returns of the individual investments is believed to be negligible in both options proposed. The market return is estimated to be 15%, and the risk free rate 5%.
Portfolio 1 |
|
|
|
|
Investment | Amounts invested | Expected return | Total risk | Beta |
| Tshs. (million) |
|
|
|
a | 10 | 20% | 8 | 0.7 |
b | 40 | 22% | 10 | 1.2 |
c | 30 | 24% | 11 | 1.3 |
d | 20 | 26% | 9 | 1.4 |
Portfolio 2 | ||||
Investment | Amounts invested | Expected return | Total risk | Beta |
| Tshs. (million) |
|
|
|
a | 20 | 18% | 7 | 0.8 |
b | 40 | 20% | 9 | 1.1 |
c | 20 | 22% | 12 | 1.2 |
d | 20 | 16% | 13 | 1.4 |
REQUIRED
(i) Calculate the risk and return of the two portfolios using the principles of both portf (8 marks)
(Total: 20 marks)
QUESTION 3
(a) You have been recently appointed as the Finance Director of Haneti Company, a company specializing in processing milk products. The Managing Director of Haneti Company has approached you for advice. On 31stDecember 2015 the company will be replacing its three existing company cars with brand new vehicles. The Managing Director wishes to know whether he should replace these new vehicles after every one year, two or three years from now on. He has provided the following background information:
1. Each new car will cost Tshs. 22 million
2. Resale values for each car (assumed to be received in cash on the last day of the year to which they relate) are estimated to be Tshs. 14 million after one year, Tshs. 8.4 million after two years and Tshs. 3.6 after three years.
5. For the purpose of advice to be given to the Managing Director, taxation and inflation can be ignored.
Using appropriate calculations, advice the Managing Director of the optimal replacement policy for these new company cars. (10 marks
(b) Korongo Mbaka wishes to choose the best of two equally costly cash flow streams: Annuity X and annuity Y. X is an annuity due with a cash inflow of Tshs. 9,000 for each of 6 years. Y is an ordinary annuity with a cash inflow of Tshs. 10,000 for each of 6 years. Assume that Korongo can earn 15 per cent on his investments.
(i) On a purely subjective basis, which annuity do you think is more attractive? Why? (3 marks
(ii) Find the future value at the end of year 6 for both annuity X and Y. (3 marks)
(iii) Use your findings in part b(ii) to indicate which annuity is more attractive. Compare your findings to your subjective response in part b(i). (4 marks)
(Total: 20 marks)
QUESTION 4
You have been hired as a Financial Analyst by Hesley Company. The company is considering investing in one of two projects and the Managing Director of the firm has approached you for an immediate advice. Returns on the two projects are very much influenced by the weather.
State of Nature |
Probability | Project I Mwanza Poultry | Project II Arusha Mining |
Market |
Possible Return | Possible Return | Estimated Return | ||
Rainy | 0.4 | 10% | 15% | 30% |
Sunny | 0.4 | 20% | 20% | 20% |
Cloudy | 0.2 | 10% | -5% | -10% |
The Tanzania Treasury bill rate is currently 9%.
By making necessary computation and analysis, advise the Managing Director whether the company should invest in Project I [Mwanza Poultry] or Project II [Arusha Mining] or neither.
QUESTION 5
(a) Benbera Enterprise has carried on business in Zanzibar for a number of years as a retailer of a wide variety of consumer products and it operates from a number of stores throughout Zanzibar. Summary financial information for Benbera Enterprise is given below, covering the last two years.
STATEMENT OF INCOME (EXTRACT)
Current Year Tshs. ‘000’ | Previous Year Tshs. ‘000’ | |
Revenue Cost of sales Salaries and wages Other costs | 74,500 28,300 20,000 11,500 | 68,000 25,700 19,600 9,200 |
Profit before interest and tax Interest | 14,700 1,600 | 13,500 1,900 |
Tax | 4,300 | 3,700 |
Profit after interest and tax | 8,800 | 7,900 |
Dividend payable | 4,800 | 3,100 |
STATEMENT OF FINANCIAL POSITION (EXTRACT)
Current Year Tshs. ‘000’ | Previous Year Tshs. ‘000’ | |
Shareholders’ fund Long term debt | 39,900 14,000 | 35,100 17,500 |
Additional Information Number of ordinary shares in issue (‘000’) P/E Ratio (average for the year) Benbera Enterprise Industry | 14,000 14.0 15.2 | 14,000 13.0 15.0 |
REQUIRED:
Evaluate the performance of Benbera Enterprise over the last two years using the following ratios:
(i) Net Profit Margin (3 marks)
(ii) Return on Equity (3 marks)
(iii) Debt/Equity Ratio (3 marks)
(iv) P/E Ratio Assume 365 day year.
(Total : 20 marks)
(a) Umoja Company has annual sales of Tshs. 120,000,000 and all sales are on 30 days’ credit, although customers on average take ten days more than this to pay. Contribution represents 60% of sales and the company currently has no bad debts. Accounts receivable are financed by an overdraft at an annual interest rate of 7%.
Umoja Company plans to offer an early settlement discount of 2% for payment within 15 days and to extend the maximum credit offered to 60 days. The discount is expected to be taken by 30% of customers, with the remaining customers taking an average of 60 days to pay. The company expects that these changes will increase annual credit sales by 10%, while also leading to additional incremental costs equal to 1% of turnover.
REQUIRED:
Assuming a 360-day year, evaluate whether the proposed changes in credit policy will increase the profitability of Umoja Company. Advice the company on the key factors to be considered when formulating working capital funding policy.
(10 marks)
Other details are as follows:
Dividend Tshs. 375 million
Number of equity shares 20,000,000 @ Tshs. 250 per The firm is estimated to maintain the current rate of earnings on investment.
REQUIRED:
By applying Walter’s dividend model:
(Total: 20 marks)
QUESTION 7
Rafiq Company, a medium – sized company specializing in the manufacture and distribution of textile products for women, is evaluating a new capital expenditure project. The details of the proposed investment project are set out below:
(i) The project has an immediate cost of Tshs. 42,000,000
· Year 1 through 3: Tshs. 31,000,000 per annum
· Year 4 and 5: Tshs. 13,000,000 per annum
(iii) Variable Costs:
· Cost of sales: 40% of Sales
· Distribution cost 10% of sales
(iv) Fixed cost (rent, utility bills and other fixed expenses) amounted to Tshs. 4,000,000 per annum
(v) Depreciation is not tax allowable
(vi) The corporate tax rate applicable to the firm is 35%
(vii) The company’s cost of capital is 6% while the risk adjusted cost of the project is 5%.
The Directors of Rafiq Company require that all investment projects should be evaluated using either payback period or return on capital employed (accounting rate of return). The target payback period of the company is two years and the target return on capital employed is 20%. A project is accepted if it satisfies either of these investment criteria.
REQUIRED:
(a) Evaluate the economic viability of the proposed investment project using the Net Present Value (NPV) Method. (8 marks)
(b) Calculate the project’s Internal Rate of Return (IRR) and discuss the strengths and weaknesses of the IRR in appraising capital investments. (4 marks)
(c) Calculate the return on capital employed (accounting rate of return) and the payback period of the company and assess the economic viability of the project if the project is to be appraised using these methods. (4 marks)
(d) Critically discuss the Directors’ view on investment appraisal. (4 marks)
(Total: 20 marks)
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