THE COPPERBELT UNIVERSITY

DIRECTORATE OF DISTANCE EDUCATION AND OPEN LEARNING (DDEOL)

JUNE 2016 – SESSIONAL EXAMINATIONS

DBA 320 – FINANCIAL MANAGEMENT

INSTRUCTION:

a) TIME ALLOWED THREE HOURS

b) MARKS ALLOCATED INDICATE THE LENGTH AND DEPTH OF EXPECTED
ANSWER
SECTION A: ANSWER BOTH QUESTIONS
QUESTION ONE
MOSKA ltd is considering investing K1, 400,000 in a machine; 5 years life span with zero scrap
value. Expected net cash flows after depreciation are as follows:
Year K’000
1 200
2 350
3 250
4 200
5 150
Working capital of K450, 000 is needed immediately. Depreciation at 25% reducing balance
method is provided and tax is paid one year in arrears at 35%. Cost of capital is 10% and capital
allowances are available at 20%.
Required:
Is the project viable using:
I. Net present value [8 marks]
II. Payback period( MOSKA’s Benchmark PBP is 3 years) [ 5 marks]
III. Accounting rate of return (MOSKA’s Benchmark ARR is 25%) [5 marks]
IV. Internal rate of return [8 marks]
V. Should MOSKA undertake the project or not [4 marks]

QUESTION TWO
HOPE enterprise currently is facing working capital challenges. There is debate on the best
model to use in cash management; the following information is provided:
 The minimum cash balance is K10,000
 Average monthly period of holding inventory is 3.0
 Average cost for liquidating and investing short term investments is K25 per transaction
 Average payables period in months is 2.0
 Standard deviation of cash flows is K20,000 per day
 Average monthly receivables period is 2.5
 Daily interest is 0.025%
Required:
 a. Determine:
I. The spread [6 marks]
II. Upper limit [3 marks]
III. Return point [3 marks]
b. Explain the relevance of the values calculated in cash management [6 marks]
c. Calculate the company’s cash cycle [6 marks]
d. List six ways the cash operating cycle can be reduced [6 marks]

SECTION B: ANSWER ANY TWO QUESTIONS

QUESTION THREE
Below is the financing section of WILPAT’s financial statement as at 31st December, 2015:
K’000
Ordinary share capital K0.5 each 2,500
Share premium 1,000
Retained earnings 1,300
TOTAL EQUITY 4,800
9% preference share capital K0.25 each 1,500
10% redeemable debt K100 each 2,000
EQUITY & LIABILITIES 8,300

Each ordinary, preference share and debt priced at K2.5, K0.2 and K95 respectively. Debt
is redeemed in five years at par. Ordinary divided of K0.25 has been declared and finance
director projects dividends growth rate of 8% indefinitely. Tax at 35%

Required:
Compute the following

a. Market values for capital elements [3 marks]

b. Cost ordinary share capital [4 marks]
c. Cost of preference share capital [4 marks]
d. Cost of debt [6 marks]
e. Weighted average cost of capital [3 marks]
QUESTION FOUR
ZICA Co is a medium-sized company whose ordinary shares are all owned by the members of
one family. It has recently begun exporting goods hence expects to receive €50,000 in six
months’ time. The prospect of increased exports means existing business operations’ expansion
in order to be able to meet future orders. The company is therefore seeking to raise external
finance of approximately K2 million. At the same time, the company plans to take action to
hedge the exchange rate risk.
ZICA Co could put cash on deposit in the euro account at an annual interest rate of 3%, and
borrow at 5% per year respectively. The company could put cash on deposit in its home country
at an annual interest rate of 4%, and borrow at 6% per year. Inflation in the European country is
3% per year, while inflation in the home country of ZICA Co is 4·5% per year.
The following exchange rates are currently available to ZICA Co:
 spot exchange rate €/K 10.00
 Six-month forward exchange rate €/K 10.03
 One-year forward exchange rate €/K 10.99

Required:
a. Discuss the reasons why small and medium-sized entities (SMEs) might experience less
conflict between the objectives of shareholders and directors than large listed companies.
[ 5 marks]
b. Discuss the factors that ZICA Co. should consider when choosing a source of debt
finance and the factors that may be considered by providers of finance in deciding how
much to lend to the company. [ 5 marks]
c. Calculate whether a forward exchange contract or a money market hedge would be
financially preferred by ZICA Co to hedge its future euro receipt. [6 marks]
d. Calculate the two-year expected (future) spot rates predicted by purchasing power parity
theory [4 marks]
QUESTION FIVE
The financial manager in a commercial organization deals with the following key issues, among
other things:
i. Investment decision [5 marks]
ii. Financing decision [5 marks]
iii. Dividend decision [5 marks]
iv. Risk management [5 marks]
Required:
For each explain how the financial manager realizes the objective of maximizing the
shareholders wealth
SUGGESTED SOLUTIONS
QUESTION ONE

DEPRECIATION
YEA K'00
R DETIALS 0

1 Annual Depreciation 350.0

2 Annual Depreciation 262.5
3 Annual Depreciation 196.9
4 Annual Depreciation 147.7
5 Annual Depreciation 442.9

CAPITAL ALLOWANCES

YEAR DETIALS K'000 K'000

Allowance
1 s 280.0
Allowance
2 s 280.0 98.0
Allowance
3 s 280.0 98.0
Allowance
4 s 280.0 98.0
Allowance
5 s 280.0 98.0
6 98.0
 PAY BACK PERIOD
YEA
R DETIALS K'000 K'000
Annual Cash
0 flows (1,400.0) (1,400.0)
Annual Cash
1 flows 550.0 (850.0) PBP=2+(237.5/446.9)
Annual Cash
2 flows 612.5 (237.5) PBP = 2.5 YEARS
Annual Cash
3 flows 446.9 209.4
Annual Cash
4 flows 347.7 557.1
Annual Cash
5 flows 592.9 1,150.0

RETURN ON CAPITAL EMPLOYED

YEA
R DETIALS K'000
1 Annual Profits 200.0
2 Annual Profits 350.0
3 Annual Profits 250.0
4 Annual Profits 200.0
5 Annual Profits 150.0
TOTAL
PROFITS 1,150.0
AVERAGE
PROFIT 1150/5

230.0

AVERAGE CAPITAL
EMPLOYED PROJECT COST+RESDUAL VALUE/2
1400+0/2
700
AVERAGE PROFIT/AVERAGE
ROCE= CAPITAL *100
ROCE= 230/700*100
ROCE= 33%
 NET PRESENT VALUE
0 1 2 3 4 5 6
ANNUAL
INFLOWS 550.00 612.50 446.90 347.70 592.60

TAX -35%     192.50 214.38 156.42 121.70 207.41

(207.41
AFTER TAX - 550.00 420.00 232.53 191.29 470.91 )

TAX SAVINGS 98.00 98.00 98.00 98.00 98.00

PROJECT COST (1,400.00)

WORKING
CAPITAL (450.00)         450.00  

NET 1,018.9 (109.41

CASHFLOWS (1,850.00) 550.00 518.00 330.53 289.29 1 )
COST OF
CAPITAL -10% 1.00 0.91 0.83 0.75 0.68 0.62 0.56

PV (1,850.00) 499.95 427.87 248.22 197.58 632.74 (61.71)

NPV 94.66

INTERNAL RATE OF RETURN

0 1 2 3 4 5 6
ANNUAL
INFLOWS 550.00 612.50 446.90 347.70 592.60

TAX -35%     192.50 214.38 156.42 121.70 207.41

(207.41
AFTER TAX - 550.00 420.00 232.53 191.29 470.91 )

TAX SAVINGS 98.00 98.00 98.00 98.00 98.00

PROJECT COST (1,400.00)

WORKING
CAPITAL (450.00)         450.00  

NET 1,018.9 (109.41

CASHFLOWS (1,850.00) 550.00 518.00 330.53 289.29 1 )
 COST OF
CAPITAL -12% 1.00 0.89 0.79 0.69 0.61 0.54 0.48

PV (1,850.00) 486.75 410.77 229.05 177.33 553.27 (52.52)

NPV (45.34)

IRR=a%+(A/(A-B)*b-a)%
IRR =10%+94.7/(94.7+48.7)*15-
10)%
IRR = 13.3%

The project is viable as it pays back before the standard period, the ROCE is above the
benchmark, and NPV is positive and the projects breaks even at about 13%.

QUESTION TWO

a
SPREAD =3(3/4*TRANSACTION
COST*VARIANCE/INTEREST)^1/3
SPREAD =3(3/4*25*400,000,000/0.00025)^1/3
SPREA K93,216.9
D= 8

UPPER LIMIT =MIMINUM LIMIT+SPREAD

UPPER LIMIT =10,000+93216.98

UPPER
LIMIT K103,216.98

RETURN POINT =MIMIMUM LIMIT+(1/3*SPREAD)

RETURN POINT =10,000+(1/3*93,216.98)
RETURN
POINT K41,072.33

b. these values are important because the upper limit is the maximum cash balance the company
should hold at any time beyond which there will be too much cash hence opportunity cost and
cash misuse. Therefor when this limit is reached, the company has to buy short term securities
amounting to K62, 144.65(103,216.98-41072.33) in order to return to the normal cash flow level.
Also when cash balance reaches the minimum level of K10, 000 securities worth K31,
072.33(41,072.33-10,000) are to be sold in order to increase solvency.
Hence these are parameters for cash management.
CASH OPERATING MONTH
c CYCLE S
INVENTORY
PERIOD 3
RECIEVABLES
PERIOD 2.5
PAYABLES
PERIOD -2
CASH CYCLE 3.5

d.
The cash operating cycle can reduced as follows
1. Reduce the receivables collection period
2. Increase the payables payment period
3. Reduce the production period
4. Reduce the inventory holding period
5. Formulate and tighten the credit control systems
6. Reduce, or if possible, stop credit sales

QUESTION THREE

a Market values
K'000
10% irredeemable
1,900
loan(2000/100*95)
9% preference
1,200
(1500/0.25*0.20/1.5*2)
ordinary shares (2500/0.5*2.5) 12,500
 TOTAL 15,600
[6 marks]

b 10% redeemable debt

After tax repayment 6.5 (10(1-35%)

DF
Year cash flows DF (5%) PV PV
(10%)
1.
0 -95 1.000 -95 -95
000
3.
1 -5 years 6.5 4.329 28 25
791
0.
5 100 0.784 78 62
621
NPV 12 NPV -8
[8 marks]
using IRR, cost of debt is:
kd = 8%

c 9% preference share capital

dividend=9%*1500/(1500/0.25)
=K0.0225/share
ke=i/po*100
ke=0.0225/0.2*100
ke = 11%
[5 marks]

d ordinary share capital

using the DGM
D1=D0(1+g)
D1 =0.25(1+0.08)
D1 = 0.27
[2 marks]

Ke =D1/Po+g
Ke = 0.27/2.5+0.08
Ke = 18.8%
[3 marks]

WACC %
10% redeemable loan 1.0
 (1900/15600*8%)
9% preference (1200/15600*11%) 0.8
Ordinary shares
15.1
(12500/15600*18.8%)
WACC 16.9
[6 marks]

QUESTION FOUR
a.
Conflict between the objectives of shareholders and directors in a listed company is associated
with the agency problem, which has three main causes. First, the objectives of shareholders and
directors may be different. Second, there is asymmetry of information, so that shareholders have
access to less information about the company than directors, making it hard for shareholders to
monitor the actions and decisions of directors. Third, there is a separation between ownership
and control, as shareholders and directors are different people.
One reason why small and medium-sized entities (SMEs) might experience less conflict between
shareholders and directors than larger listed companies is that in many cases shareholders are not
different from directors, for example in a family-owned company. Where that is the case, there is
no separation between ownership and control, there is no difference between the objectives of
shareholders and directors, and there is no asymmetry of information. Conflict between the
objectives of shareholders and directors will therefore not arise.
Another reason why there may be less conflict between the objectives of shareholders and
directors in SMEs than in larger listed companies is that the shares of SMEs are often owned by
a small number of shareholders, who may be in regular contact with the company and its
directors. In these circumstances, the possibility of conflict is very much reduced.

b. Factors to consider when choosing a source of debt finance

There are a number of factors that should be considered when choosing a suitable source of debt
finance. Essentially a company should look to match the characteristics of the debt finance with
its corporate needs.
ZICA Co should consider both issue costs and the rate of interest to be charged on the funds
borrowed. The company should also consider the repayment terms. With a bank loan, for
example, there may be an annual capital payment in addition to the annual interest payment.
Additionally, some types of debt have early repayment penalties.
Maturity
The period over which the debt is taken should be matched against the period for which the
company needs the finance and the ability of the company to meet the financial commitments
associated with the debt finance selected.
Flexibility
Another factor to consider is that short-term finance can be more flexible than long-term finance.
If a company takes on long-term debt finance it takes on a long-term commitment to which it has
a contractual obligation.
Financial risk
Debt will increase gearing and hence the financial risk of ZICA Co. The company should
consider how gearing will change over the life of the debt finance selected and how the company
will be viewed from a risk perspective by future investors.
Availability
The kinds of debt finance available to ZICA Co will depend upon the relative size of the
company, its relationship with its bank and the capital markets to which it has access. It is likely
that a bank loan, rather than any other kind of debt finance, will be selected by ZICA Co, since
very few SMEs are able to issue traded bonds.

Factors to be considered by providers of finance

There are a number of factors that may be considered by providers of finance in deciding how
much to lend to a company.
Risk and the ability to meet financial obligations
When considering the amount and the terms of the funds to be made available to ZICA Co,
providers of debt finance will assess the ability of the company to meets its future financial
obligations and the risk of the company. The previous record of the company can be used as a
guide to the ability of its board of directors to manage its finances in a responsible and effective
manner. The business plan of ZICA Co relating to the proposed business expansion will be
carefully scrutinized by potential investors in order to make sure that it rests on reasonable
assumptions and that the forecast cash flows can be achieved. This helps to reduce the
uncertainty associated with the proposed expansion.
Security
The amount of funds made available to ZICA Co will also depend on the availability of assets to
offer as security. Debt investors will expect security in order to reduce the risk of the investment
from their point of view. If security is not available or is limited, ZICA Co will have to pay a
higher rate of interest in compensation for the higher level of risk.
Legal restrictions on borrowing
 Another factor to consider is whether there are any legal restrictions on the amount of debt that
the company can take on, for example in existing debt contracts (restrictive or negative
covenants), or in the company’s memorandum or articles of association.

c.
Forward contract hedging
K10.03*50,000
RECIEPT = K501, 500
Money market hedging
1. Borrow (€50,000/1.025) €48,780
2. Convert into local currency at spot rate (K10.00*48,780) K487,800
3. Invest in local bank K487,800*1.02) K497,556
4. Effective exchange rate (K497,556/€50,000) €/K9.95
5. RECIEPT k497,556
Therefore, a forward contract is better than a money market hedging.

SOLUTION FIVE
Financing decisions and the shareholder wealth maximization:
1. Investment decision
This is the first key decision that the fiancé manager and his team have to address. It looks at all
the possible investment opportunities available to the firm and appraising each one using the set
appraisal techniques. Usually the payback period, accounting rate of return, internal rate of return
and the net present value methods are used in order to select the best project that will maximize
the shareholders wealth; gives maximum profit, good pay back and with manageable risks.
2. Financing decision
Having select the best investment option, the next step is to look for finance to start the project
with. The finance manager has to choose between debt and equity finance and the choice
depends on the risks involved and the one that will maximize the shareholders wealth. Wealth is
maximized if the capital employed is cheaper but reliable.
3. Dividend decision
The finance manager makes a policy on how to reward the providers of equity finance –the
ordinary shareholders. As this policy is entirely management’s, it’s the finance manager who has
much say on what is to be given to shareholders as dividends out of the distributable profits
bearing in mind all factors such as future reinvestment, signaling effect of dividends, legal
provisions, taxation etc. cash dividends payout is one way of maximizing shareholders wealth
however, future growth is also considered when formulating this policy.
4. Risk management
Risk is inevitable; it’s in everything we do and everywhere we are as humans. Risk is just that
possibility of a negative event happening. As business investment are costly (capital budgeting
for example) if a well-coordinated risk management system is not devised and implemented, the
company may lose grossly and collapse ultimately. Look at a commercial for example, huge loan
given out to client are after a thorough risk analysis because if the customer defaults; the banks
liquidity may be affected negatively.