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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 ½ 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 5½% = 550 Value of 5½ 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

375 _____ 75.000 par) 10% preference shares Ordinary shares (Sh.000(1.= = P(1+i)n 10.250 12.000(1.08)60 1.1.012.’00 0’ 32.500 28.000 Net fixed assets 6.10 par) Retained earnings Additional information .875 Current liabilities 18% debentures (sh. company’s balance sheet as at 31March 2000 is as below: The Liability and Owners Equity Assets Sh.570 = 12% FV = = 10. is in the Telecommunications Industry.500 Current assets 16.500 42.375 Sh.’00 0’ 12.125 75.969 Question three Com-Tech Company Ltd.12)60 8.975.

the company’s shares are trading at Sh.38 per share at the local stock exchange.00 as dividend per share. The preference shares were floated in 1995 and their prices have remained constant.5.950 in the market and will be redeemed 10 years from now. YTM = RY = K d = Using approximation method for YTM. The Corporation tax rate is 40% per annum.The debentures are now selling at Sh. Currently. the company had declared and paid Sh. The dividends are expected to grow at an annual rate of 10% in the foreseeable future. By the end of last financial period. Most banks are lending money at an interest of 22% per annum. Solution Compute the % cost of each capital component. Required Calculate the market weighted cost of capital for this firm.000 = Sh. Int ( 1 − T ) + ( M − Vd )1/ n ( M + Vd ) 12 Int = Interest charges = 18% x 1. Cost of debentures Kd Since debentures are redeemable in 10 years time. If debentures are not redeemable (perpetual) Kd is called running or flat yield.180 T = Tax rate = 40% . the cost is called yield to maturity (YTM) or redemption yield (RY).

then KP = Coupon rate = 10% NB: The prices of preference shares have not changes since floatation hence MPS = par value .6% 975 Cost of equity d (1+ g) K e= 0 +g P0 Ke= ) _0.5% 38 d0 = Sh.000 ) 110 180 − 950 Kd= ( 1.38 g = growth rate = 10% Cost of preference share capital Kp Since MPS = Par value.5.000 ) 12 + 950 = 113 x100 = 11.000 = Current market value = Sh.M Vd n = Maturity or par value = sh.1.10 = 0.245 ≈ 24.10 5(1+ 0.950 = Number of years = 10 years ( 1− 0.4 ) + ( 1.00 P0 = MPS = Sh.

500   15.025.203 WACC= 24.250 68.7 = 20.200 Sh.950   68. Present estimates are that cost of capital as 15 percent per annum after tax.5 Monetary Cost 11.3%  68.637.250    +11. Accepted proposals must offer a time adjusted or discounted rate of return at least equal to the estimated cost of capital.64 1.10 % Cost 24.6   +10   = 0.Capital Equity Market Value Sh. Accepted proposals should average over the life time.950 10 625.950x = 15.0 14. 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 .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.2 Preference share capital = Par value Total 6.950   68.38x = 47.7 WACC= 14. The screening criteria established by management are as follows: No project should involve a net commitment of funds for more than four years.500 Sh.5 ≈ 20.5 Debt Sh.500 Sh.025.16.000 Sh.000 11.12.763.200   6.950  647.3% 68.1.

000 per annum. A proposal to purchase a new lathe machine is to be subjected to these initial screening processes.000 .a.200. Tax rates may be assumed to be 35% payable in the year in which revenue is received. Solution Depreciation p.440 1.500 Additional operating costs are estimated to be Sh. = 20% x 2.2.’000’) 1.700.560 1.000 and has an estimated useful life of five years at the end of which the disposal value will be zero.320 1.600 1. For taxation purpose the machine is to be written off as a fixed annual rate of 20% on cost. Sales revenue to be generated by the new machine is estimated as follows: Year 1 2 3 4 5 Revenue (Sh. The financial accounting statements issued by the company in recent years shows that profits after tax have averaged 18% on total assets.200.the statutory financial statements included in the annual report of the company. 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.000 = 440. The machine will cost Sh.

e the payback period should at least be 4 years.600 700 900 440 460 161 299 440 739 5 Sh.320 700 620 440 180 63 117 440 557 Add depreciation Cash flows Screening Criteria 1.’00 0’ 2 Sh.560 700 860 440 420 147 273 440 713 4 Sh.’00 0’ 1. The net commitment of funds should not exceed 4 years i.440 700 740 440 300 105 195 440 635 3 Sh.Prepare a cash flow schedule: Year 1 Sh.’00 0’ 1. Year 1 2 Cash flows 557 635 Accumulated Cash flows 557 1. compute the payback period.’00 0’ 1. Therefore.500 700 800 440 360 126 234 440 674 Sales Less operating costs EBOT Less depreciation EBT Less tax @ 35% EAT = profits accounting back 1.192 .’00 0’ 1.

00 46.756 0.519 2.15 0.30 2.644 3. 557 635 713 739 674 0.200. The time adjusted or discounted rate of return is the I.3 4 5 713 739 674 1.497 484.V.200.572 0.200.06 0.49 488.V PVIF14%.28 437.246.n P.2.51 ) 488.R.770 469.318 The initial capital of Sh.95 481.870 0.71 0.200 – 1. Therefore payback period = 3yrs + 295 = 3.V. Discount the cash flows at 15% cost of capital given: −n Recall discounting factor (PVIF) = (1 + r ) = 1 (1 + r )n Year Cash flows ‘000’ PVIF15% P.30 Less initial capital N.000 is recovered after year 3.905) is required out of the total year 4 cash flows of Sh.592 334.191. After year 3 (during year 4) a total of Sh.905 2.4 yrs 739 2.00 (8.P.59 0.295.000.000 (2.V. .98 0.49 2.675 422.R of the project.81 2.658 0.49 349.877 480.739. 1 2 3 4 5 Total P.

Since the NPV is negative at 15% cost of capital rediscount the cash flows again at a lower rate. to get a positive NPV.3 = -8. = 14% + 46. NPV @ 14% = NPV @ I.51 (15% − 14%) = 14% + 46.3 − 0 46.R.85% 3.3 (1%) 54.51 0 I. ARR = Average accounting profits (EAT) x 100 Average investment Average accounting profits = 117 +195 + 273 + 299 + 234 5yrs = 223.R. Average investment value)½ = (Initial capital + Salvage . The unadjusted rate of return on assets employed is the accounting rate of return. NPV @ 15% = 46.3 − − 8.R. say 14%.6 p.a.81 = 14.R.

6 x100 1. 2.05 1..45 0.45 0.55 4. Shs.50 2.200 + 0)½ = 1. A Ltd. Shs.08 0.3% Question Five A comparative study of the records of two oil companies.45 0. capital structure and profitability shows that they have been very similar for the past five years.100 = 20.45 2.25 0.36 0. in terms of their asset composition.89 1.60 3.R.14 7 . Relevant data is as follows: Year Earnin Dividen Price gs per d per range share share in stock exchang e Shs.45 0. maintains a constant dividend per share while B Ltd maintains a constant dividend payout ratio.69 11 – 15 6 .100 A. Shs.16 15 – 23 21 – 44 .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.35 0. A Ltd and B Ltd. 199 6 199 7 199 8 199 9 1.= (2. Shs.45 0.R = 223.90 0.07 2.00 2. The only significant difference between the two firms is their dividend policy.

35 x100 = 17.35 x100 = 17.45 x100 = 22. Solution Dividend payout ratio = DPS x100 EPS B Ltd Year 1996 A Ltd.05 1997 0.35 x100 = 17. 0.8% 1.0% 1.50 0.45 0.200 0 Required a) For each company.00 0.2% 1. determine the dividend pay-out ratio and the price earnings ratio for each of the five years.08 .1% 2.45 x100 = 23.5% 2. B Ltd’s management is surprised that the shares of this company have not performed as well as A Ltd.45 x100 = 30.4% 2.’s in the stock exchange.89 0. 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.

30% 2.55 = 7.60 0.45 = 6.08 = 5.35 x100 = 17.50 = 9. B Ltd = 9.1998 0.0 yrs ( 6 +14)½ 1.08 2000 Price – earning ratio = MPS EPS Year 1996 A Ltd.46 yrs ( 21 + 44)½ 4.56 yrs 1998 ( 21 + 26 )½ 2.60 = 9.5yrs ( 7 +16)½ 2.45 x100 = 11.45 x100 = 17.00 = 8.34 yrs / times 1997 (12 +15)½ 1.90 = 8.90 0.35 x100 = 16.55 1999 0.9 yrs (14 + 20)½ 2.89 (11 +15)½ 2.9% 4.7% 2.97 yrs .5% 3.08 = 7.45yrs 1999 ( 26 + 40 )½ 3.0 yrs / times (16 +18)½ 1.0 yrs (15 + 23)½ 2.05 = 6.

Question six At a recent seminar on “Gender Empowerment in Business’ the invited financial consultant. a) b) c) d) e) f) Annual sales of the company are Sh. MPS = -EPS x P/E ratio A negative MPS cannot be interpreted hence the P/E ratio model collapses. Madame Biashara.000. are not performing well because of uncertainty of DPS compared to certainty of DPS for A Ltd. With a positive P/E ratio the MPS would be negative i.5. Based on these facts. the EPS would be negative. the managing director of Biashara Limited took note of this important fact. c) If a firm is making heavy losses. she authorised a review of the credit system of her company. This uncertainty leads to higher required rate of return by ordinary shareholders thus lower market value of a share.e. The following facts are relevant. After the seminar.2000 b) The shares of B Ltd.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 company’s cost of capital is 14 per cent per annum Net profit on sales is 15 per cent. 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 . Madame Hesabu Advised the participants that extending credit is one of the comerstone of modern business. she is recommending a thorough revamping of the credit policy of the company.

250.000=2.000 = 15% x 1.000 40%x6. analyse the net benefits on the basis of net profits Current policy Sales Credit sales Bad debts Credit period NP Margin 5.500.600. Who should determine credit policy? Solution Analysis Since net profit margin is given.000 = 2% of credit sales = 40 days 15% New policy 5M x 1.000 187.50.000 = 25%x5000.e) An additional part time credit control assistant will be hired for Sh.500 .250.000.600.000 = 390. Required Comment on the effectiveness or otherwise of the proposed revamping of credit policy.30 = 6.500.0 00 3% of credit sales 35 days 15% Analysis Net profits New policy = Old policy = 15% x 2.000 per annum.000 = 1.

Net benefit 202.600.778 138.600.000 2% x 1.889 Increase in debtors .000 (53.000 25.880 113.000 360 40 x1.250.500 Bad debts New policy = Old policy = 3% x 2.250.000 360 = = = 252.000 = = 78.000) Net benefit (cost) Debtors New policy = Old policy = 35 x 2.

Forgone benefits on tied up capital = 14% x 113.555 50.945) Credit controller salary New policy Old policy (50.889 = (15.000) Net benefits 83. .000 0 The credit policy should be determined by the Board of directors of the firm with advice from finance manager and credit controller.