SOLUTION: FINANCIAL MANAGEMENT, NOV 2007 QUESTION 1 (a) Agency problem is potential conflict of interest between agents, who

are managers of a company, and the outside stakeholders. The problem arises whenever the managers of firms own less than 100 of the firms! common stock. The fact that the manager will neither gain all the benefits of wealth created by his effort nor bear all the costs of per"uisites will increase the incentive to take actions that will conflict with the interest of shareholders. #our ($) ways to deal with agency problem are% (i) (ii) (iii) (iv) b) Threat of firing &anagerial compensation 'irect intervention by shareholders Threat of takeovers

()*T )# +,A*-./ 0 13,000 2,730 11,130 1 18,000 2,730 11,130 1 13,000 2,730 11,130 2 13,000 2,730 11,130 $ 13,000 2,730 11,130 3 13,000 2,730 11,130 4 13,000 2,730 11,130

0ear +ease 5ayment Ta6 *aving

+ease payment (onstitute annuity (ost of 'ebt to the (ompany :. 5; of +ease 5ayments 9 9 9 9 9 10 7.3 (1.73)4 : 1 0.073 (1.073) 11,130 6 3.0$3883 34,744.11
4

(1 : 0.13) 6 1.073

11,130 6

(ost of )wing% 0
.et 5urchase 5rice &aintenance (ost &aintenance cost saving Ta6 savings <esidual ;alue 5; of )wing >>>>>>> (=0,000) 9 (=0,000) ? ? (1,082) (1.073)3 5; (=0,000) =,000 : 4,730 4,730 (1.073)1 ? 1,4$= (=0,000) (2,000) (2,000) 730 3,$00 : 2,130 ? 2,130 (1.073)1 (2,000) 730 2,1$0 : ==0 ? ==0 (1.073)2 (2,000) 730 1,=$$ : (204) ? (204) (1.073)$ (2,000) 730 1,147 : (1,082) (2,000) 730 700 $,1== 1,4$=

(1.073)4

9 (=0,000) ? 4,17=.07 ? 1,713.80 ? 7=4.=1 : 11=.12 : 73$.27 ? 1,714.$3 9 (@7=,$43.17)

(ost of +easing (ost of owing 'ecision%

9 9

@34,744.11 @7=,$43.17

The e"uipment should be leased.

QUESTION 2 (urrent profit margin% *ales (ost of sales &arketing A &argin

100 40 13 13

This translates to 13 6 /B@4,000 9 =00 : . &inimum &argin under new policy should also be /B=00. (ost% (i) <unning credit department for 1 year 9 11 6 /B@1 9 /B@1$ (ii) +osses from bad debits 9 1.3 of C C 9 new sales level 20 day collecting period means 20D243 of annual sales will be outstanding :. &ust finance this at 11 p.a. :. Annual cost 9 11 6 20D243 6 C Thus &argin on new sales level must at least e"ual /B@=00 That s 13 6 E 1.3 6 E 11 6 20D243 6 C E 1$ 9 =00 *olving, C 9 /B@7,28$

QUESTION 3 a) The dollar cash flow associated with lease two spread E syndicate fee combinations are as follows% #ee F 1,300,000 730,000 -nterest *pread 0ears 1 E 3 F 1,000,000 1,300,000

+oan 1 (1.3 fee, 1 spread) +oan 1 (0.73 fee 1.3 spread)

Gsing a 10

discount rate we can compare the present values of these two combinations. 3 +oan 1 F1,300,000 ? H 1,000,000 t91 (1.1) 5resent value 10 for 3 years 9 2.7=08 F1,300,000 ? 1,000,000 6 2.7=08 F4,1=0,800 3 +oan 1 F730,000 ? H 1,300,000 t91 (1.1) F730,000 ? 1,300,000 6 2.7=08 9 F4,$24,100 Iased on these computations +oan 1 appears cheaper than +oan 1

b)

*peedy communication and processing E Iy% (i) (ii) transmitting data to central location from around the world the government can respond immediately to changes in its finances. *ystems e6pertise centraliJed E This eliminates redundant offshore systems, personnel and facilities while increasing the level of e6pertise at which these functions are performed. Ietter overall picture of where government finances stand. /overnment has a more complete view of its current assets and liabilities and cash flows. This enables the government to better manage these positions. (entraliJing government foreign e6change management will help to reduce costs and lower transfer charges.

(iii)

(iv)

QUESTION 4 &arket values 66 yy (ost savings 9 (i) (ii) (ost cash offer /ains 9 /B@30 /B@100 *ynergies /B@13 9/B@43 : /B@30 /B@13 $

9 9@13

/A-.

*ynergies 9

(iii)

(ost under cash offer : : :. :. ;alue of merged firm .o of shares 9 ;alue of share 9 9 9 9 173 120 /B@1.11

100 ? 20 173 120

(iv) (v) (vi)

(ost of share offer 9 1.11 6 20 E 30 9 42.$4 E 30 .5; 9 /A-. : ()*T (ash offer 9 13 : 13 9 10 *hare offer .5; 9 13 : 12.$4 9 11.3$

/B@12.$4

*ynergies may arise because of : : : : (ost reductions due to economies of scale Attaining market power /aining unused ta6 shields /aining hands on surplus funds etc.

QUESTION 5 (a) The implications of ,fficient &arket Bypothesis for investors and firms are as follows% : *ince information is reflected in prices immediately, investors should e6pect to obtain a normal rate of return. Awareness of information when it is released does an investor no good. The price adKusts before the investor has time to trade. *imilarly firms should e6pect to receive the fair value for securities that they sell. #air means that the price they receive for the securities they issue is the present value.

(b)

A futures contract is most valuable when the "uantity of foreign currency being hedged is known. An option contract however is most valuable when the "uantity of foreign currency is unknown. All things being e"ual, a company should use futures contracts to hedge its currency risk when it knows the amount involved. #utures contracts must be honoured even if the spot rate settlement is less than the futures price. -n contrast a company can choose not to e6ercise currency call options if the call 3

prices e6ceed the spot prices. Although this feature is an advantage of currency options it is fully priced out in the market via the call premium. Bence options are not unambiguously better than futures. (c) (i) Iased on the interest rate profiles of the two companies, there is an anomaly between the two markets. )ne Kudges that the difference in credit "uality between the two companies is worth 100 basis points whereas the other determines that this difference is worth only 100 basis points. The parties can share among themselves the difference of 100 basis points by engaging in currency swap. This transaction will involve Asaba +td borrowing floating:rate funds and IeJec +td borrowing fi6ed rate funds and then swapping the proceeds.

(ii)

-f the two companies split the cost savings the resulting cost to Asaba +td would be 11.30 .ormal (ost after (ompany #unding (ost *wap 'ifference Asaba +td 12.00 11.30 .30 IeJec +td 5rime <ate ? L 5rime <ate .30 1.00