Ac419 Questions & Solutions (2021)

FM QUESTIONS & SOLUTIONS
Question 1
What role can ethics play to ensure sound financial management in modern business set up?
Suggested Solution 1
Your answer should include (as a MINIMUM) the following: definition of ethics, examples of
ethical principles (PICCO), roles in financial management (investment decision, financing
decision & dividend decision) and how ethics (PICCO) can help in managing investing, financing
& dividend decisions)
PICCO = Professional behaviour, Integrity, Confidentiality, Competence & Objectivity
In today’s business world financial management is an essential part of a firm. Financial
management is the process of managing money and maintaining a set of books that provides
insights on how a company earns and spends its cash. It is responsible for the area of finance
that deals with sources of funding. Furthermore, it controls the actions that managers take to
increase the value of the firm to shareholders, without having selfish thoughts behind them.
And lastly financial management provides tools and analysis to allocate financial resources. Due
to the fact that these roles involve a lot of decision making and risks, there can be a lot of
incentives to choose unethical procedures. Also, costs and benefits are allocated to different
parties, which can create conflicts of interests. For this reason, ethics will be crucial in
preventing such misdemeanors. In the corporate world unethical behavior has led to the
collapse of several companies. Attending to financial management process with honesty and
integrity allows the finance department to present the company’s financial situation accurately,
both internally and externally and therefore avoid corporate failures.
Ethics is a set of moral principles of a particular person has. It is there to decide what is right
and what is wrong. Ethical principles include: Professional behaviour, Integrity, Confidentiality,
Competence & Objectivity. Ethics are there to help us and provide guidance for our behavior
that affects others. Our morals, norms and values are a big part of ethics. If people stop
1 Compiled by T T Herbert (0773 038 651 / 0712 560 772) www.herbertmentor.com

following their own morals, they will act unethical, which can lead to job loss, jail, huge fines or
reputational damage.
The investment decision involves selecting appropriate investment opportunities that will help
to fulfill the company’s primary objectives. The financial executive will need to identify
investment opportunities, evaluate them and decide on the optimum allocation of scarce funds
available between investments. In such investment decisions, there may be various investment
opportunities and finance executives may be tempted to turn down more financially
worthwhile projects for those that are less financially viable or even not financially worthwhile.
His advice might not be impartial-as he may be tempted to advice against a worthwhile project
in order to get kickbacks. This is where the ethical principle of integrity (being straightforward
and honest in all business matters) and objectivity (not allowing bias, conflicts of interest or
undue influence of others to override professional or business judgments) comes into play. If a
finance executive is of unquestionable integrity he has to be partial (being objective) for
company interests to prevail over self-interest.
Investments decisions may also be on the undertaking of new projects within the existing
business or in a new line of business (diversification), the takeover of, or the merger with
another company or the selling off a part of the business. With diversification the business
might be starting to expand into areas where there are complex corporate finance & other
issues. The finance executive might have no direct experience of this area, but might be
tempted to think that he can get himself up to speed quite quickly. This is where the ethical
principle of competence (a continuing duty to maintain professional knowledge and skill at a
level required to ensure that the employer receives competent professional service based on
current developments in practice, legislation and techniques) becomes useful. If the finance
department lacks competence to effect such an investment decision they would have to avoid
this kind of diversification, unless they take professional advice.
In investment decisions the finance team may also fail to recognise the risk and uncertainty
associated with certain projects. Shareholders tend to be very interested in the level and

maximizing profits may be achieved by raising risk to unacceptable levels. Risk appetite of the
shareholders may be low but if bonuses of employees are linked to profit, there may be an
incentive to undertake high risk projects just because of their high profits. This is where the
ethical principles of integrity (being straightforward and honest in all business matters) and
objectivity (not allowing bias, conflicts of interest or undue influence of others to override
professional or business judgments) comes into play one again. If a finance team is of
unquestionable integrity they have to objective by rejecting projects not aligned to
shareholders risk appetite even though this may result in loss of bonuses.
Financial decisions include both long-term decisions (capital structure) and short-term decisions
(working capital management).The finance executive will need to determine the source, cost
and effect on risk of the possible sources of long-term finance. A balance between profitability
and liquidity (ready availability of funds if required) must be taken into account when deciding
on the optimal level of short-term finance. A further issue with financing is that the finance
executive will be wanting to minimise the cost of capital for an organisation as this means a
lower return is required by the providers of capital. Desperation to raise funding for projects
can result in creative accounting. Showing a crooked set of books may help to secure financing
that will be convenient and expedient but may not be in best interest of the lending company if
the company business model is not sound enough for it to repay what it would have borrowed.
By borrowing money that is secured via false information, the finance executive may not even
be acting in the best interest of his company, especially if the company is pledging collateral for
a loan. He exposes his company to the risk of losing valuable assets. This is where the ethical
principles of integrity and professional behaviour can be applied to ensure sound financial
management. With good morals the company can be spared loss of valuable assets resulting in
sound financial management.
One of the roles in financial management is the dividend decision. Distributing a dividend is one
of the best way of increasing shareholder’s wealth and finance executives may be tempted to
appease the shareholders by violating company law which stipulates that a dividend cannot be

paid out of capital. This is where the ethical principle of professional behaviour (not indulging in
illegal behaviour) and objectivity (not allowing bias, conflicts of interest or undue influence of
others to override professional or business judgments) can be applied. If there are no sufficient
earnings to pay the dividend, company law should not be violated to manufacture a dividend
(at the detriment of creditors) and the finance executive should not accede to the demands of
shareholders as it will be tantamount to allowing their undue influence to take precedence over
professional judgement.
Company financial reports represent the profit and loss, net worth and cash flow situation.
When they are used to understand and improve operations, it is an ethical imperative to
present this information in ways that are clear and honest (integrity). Whether there is an
assessment of efficiency and profitability or evaluating whether it makes sense to invest in
future growth, approaching these documents with a sound moral compass helps in providing
the people who review them with the information they need to make the best possible
decisions.
The finance executive should respect the confidentiality of information acquired as a result of
his position and should not disclose any such information to third parties without proper and
specific authority or unless there is a legal or professional right or duty to disclose. Confidential
information acquired should not be used for the personal advantage of the recipient or third
parties. A major area where confidentiality plays a crucial role is in insider trading or dealing.
Finance executives are usually in receipt of share price sensitive information such as
unpublished interim financial results, profit forecasts and there is always a temptation to pass
the information to their friends or relatives who may use such information to engage in insider
trading or dealing. Confidentiality as an ethical principle which can help in avoiding such
unethical practice.
Ethical finance executives understand that, whilst the principal objective is the maximisation of
shareholders’ wealth, they should not be pursuing this at any cost. They should not be taking

unacceptable business and financial risks with shareholders’ funds and must act within the law.
They also ensure that all stakeholders (internal and external) are always kept informed of
financial policy and corporate goals through effective communication channels. They are aware
that any actions that undermine their company’s reputation are likely to be very expensive in
terms of adverse effects on share price and public trust.
Question 2
What are the assumptions of CAPM? Are the assumptions relevant or irrelevant in today's
context?
Assumption Comment on relevant in modern day
Assumes that investors are rational and risk The assumption that the investors will prefer
averse lower risk to higher risk and that at a certain
level of risk investors will prefer higher
returns to lower one may not always hold
true.
Assumes that investors have homogenous This is not true in the modern world because
expectations and the same planning horizon. there is massive trading of stocks and bonds
by investors with different expectations.
Investors also have different risk preferences.
Again, it may be that the capital market line
is a blurred amalgamation of many different
investors' capital market lines.
Assumes that the CAPM is a one period A return for three months cannot be
model compared with returns for five years. Hence,
it is assumed that the investments occur over
a single standardised period. It allows
comparison among various securities on the

basis of their returns. Usually, a period of one
year is used.
Assumes that investors hold diversified Many investors do not diversify in a planned
portfolios and therefore the only relevant manner. This important result may seem
risk is systematic risk. inconsistent with empirical evidence that,
despite low-cost diversification vehicles such
as mutual funds, most investors do not hold
adequately diversified portfolios. Consistent
with CAPM, however, large investors such as
the institutions that dominate trading on the
New York Stock Exchange do typically hold
portfolios with many securities.
There is unlimited lending and borrowing by This assumption is unattainable in reality. In
institutional and individual investors at the the modern world, individual investors are
risk free interest rate. unable to borrow (or lend) at the same rate
as their governments.
It assumes that returns are normally However, it has been found that returns in
distributed random variables. equity and other markets are not normally
distributed. Instead, there are large swings
(sometimes 3 to 6 standard deviations from
the mean). The CAPM does not explain the
variations in returns.
The variance of returns is taken as a normal However, this can be true only for normally
measurement of risk. distributed returns.
There is a perfect capital market. This implies In practice there are several imperfections
that all the securities are correctly valued and i.e. taxes, regulations, restriction on short
their returns can be plotted on the security selling etc. the assumption of a perfect
market line (SML). There is perfect market does not hold true.
competition in capital markets. There are no

market imperfections such as taxes,
regulations, or restrictions on short selling.
There are no transactions costs e.g. brokers This is not true because in the modern
fees environment, many investments involve
transaction costs.
There is no taxation The CAPM assumes investment trading is tax-
free and returns are unaffected by taxes. Yet
we know this to be false: (1) many
investment transactions are subject to capital
gains taxes, thus adding transaction costs; (2)
taxes reduce expected returns for many
investors, thus affecting their pricing of
investments; (3) different returns (dividends
versus capital gains, taxable versus tax-
deferred) are taxed differently, thus inducing
investors to choose portfolios with tax-
favored assets; (4) different investors
(individuals versus pension plans) are taxed
differently, thus leading to different pricing
of the same assets.
Question 3
What are the two aims of working capital management?
The two aims of working capital management are liquidity and profitability. The financial
manager will advise on the optimum level of working capital to ensure debts can be paid off as
and when they fall due, and also to ensure that investment opportunities are not lost because
of cash being tied up in idle assets.

Profitability (Avoiding excessive working capital)
An aim of working capital management should be to avoid excessive investment in working
capital. Working capital is financed by long-term capital (equity or debt) which has a cost. It can
be argued that it is essential to hold inventory and to offer credit to customers, so investment
in current assets is unavoidable. However, the investment in inventory and trade receivables
does not provide any additional financial return. So investment in working capital has a cost
without providing any direct financial return.
Liquidity (Avoiding liquidity problems)

On the other hand, a shortage of working capital might result in liquidity problems due to
having insufficient operational cash flows to pay liabilities when payment is due. Operational
cash flows come into a business from the sale of inventories and payment by customers:
inventory and trade receivables are therefore a source of future cash income. These must be
sufficient for the payment of liabilities. A company that has insufficient working capital might
find that it has to make payments to suppliers (or other short-term liabilities) but does not have
enough cash or bank overdraft facility to do so, because its current assets are insufficient to
generate the cash inflows that are needed and when payment falls due. Liquidity problems,
when serious, can result in insolvency.
Question 4
When does capital rationing arise?
Capital rationing arises when an organisation’s potential to invest is limited because of
restrictions on funding. In such a case projects will have to be ranked according to profitability,
and invested in accordingly.
There are two situations which may lead to capital rationing, namely hard and soft capital
rationing. Hard capital rationing or “external” rationing occurs when the company faces
problems in raising funds in the external equity markets. This can lead to the shortage of capital
to finance the new projects in the company.
On the other hand, soft capital rationing or “internal” rationing is caused due to the internal
policies of the company. The company may voluntarily have certain restrictions that limit the
number of funds available for investments in projects. However, these restrictions can be
modified in the future; hence, the term ‘soft’ is used for it.
Question 5
Whilst the financial plans of the business are based on a single objective, it faces a number of
constraints that put pressure on the company to address more than one objective
simultaneously.
Required:
What types of constraints might the company face when assessing its long-term plans? In
your answer, refer specifically to:
(a) Responding to various stakeholder groups; and
(b) The difficulties associated with managing organisations with multiple objectives.
(a) Responding to various stakeholder groups
Generally, when we look at the long-term goals of a company, we can say that there is no
conflict of interest. However in the short run there is a possibility of a conflict between the
various stakeholder objectives.
Conflicts with the financial objective of stockholder wealth maximisation

In recent times, there has been a controversy regarding the primary goal of corporate
governance i.e. “Stockholders vs. Stakeholders”. If we look at the primary financial objective of
shareholders’ wealth maximisation, there are possible conflicts with the objectives of other
stakeholders.
Employees, managers, suppliers, contractors and the financial community would like to get a
higher income from the company. However, paying higher amounts to these stakeholders
means lower profits and hence lower wealth creation for the shareholders. Similarly, charging

lower amounts to customers or spending higher amounts on the product reduces profits.
Therefore, the two objectives conflict with each other, at least in the short run.
We can generally say that the claims of the other stakeholders can be judiciously considered
within the overall long-term objective of shareholder wealth maximisation.
Other possible conflicts

There may be other possible conflicts, for instance:
 Customers may demand new high tech products that have the latest features. The
employees may be afraid of the effects of new technology on their jobs. Shareholders may
be concerned about the possible effect on the return on their investments. Management
may be worried about the huge capital expenditure required.
 The government may want the organisation to pay high direct and indirect taxes. The
customer may not be willing to share the burden of additional indirect taxes, nor may
management be eager to bear the additional direct taxes.
 The CEO and other managers will want to have higher remuneration, but the shareholders
may want to put a cap on it.
 The local community may want the entity to install environmentally friendly equipment, but
the shareholders and management may be opposed to this due to the exorbitant costs.
 The financial community may want to raise the interest rates. However, management may
wish to repay the loans if the interest costs are raised, and opt for a share issue.
 The financial community may want the company to invest in safe projects. However,
management may wish to invest in a risky but more profitable project.
(b) Difficulties associated with managing organisations with multiple objectives.

The following are the difficulties associated with managing organisations with multiple
objectives:
 Every organisation has a number of stakeholders such as shareholders, directors, employees
etc. The objectives of each stakeholder are different. Furthermore, the objectives of the

various stakeholders are not congruent. This can lead to opportunity cost, which in turn will
lead to a reduction in profits.
 Due to multiple objectives, each managerial decision will also face many limitations since
the process of goal congruence is complex.
 High cost may be incurred by a company to satisfy the needs of various stakeholders other
than shareholders.
 The objectives of stakeholders may conflict. For example, the shareholders objective is to
maximise profits whereas the employee’s objective is to increase their remuneration.
 Therefore, stakeholders need to be ranked in order of importance.
 Sometimes, when new stakeholders emerge, it can create a difficulty of long-term strategic
management i.e. the demands of the stakeholders have to be taken into account.
 When objectives are not clearly identified, the organisation will not be able to easily
ascertain whether or not they have met their objectives.
Question 6
Explain the relationship between corporate objectives and strategy.
Objectives and strategy are both related to the mission of an organisation or its long term
purpose. Objectives tell managers and employees precisely what they must achieve while the
strategy explains how to go about achieving it.
Illustration of the relationship between corporate objectives
Even though the question requires you to link corporate objectives with strategies, the mission
should be mentioned because it is at the apex of the hierarchy of the strategic plan & therefore
indispensable. In addition, a tabular approach has only been taken for ease of presentation
hence there is no obligation to use it.

Element Explanation of the relationship
Mission: the “why” The mission of a company should provide a top level answer to
the essential question: Why does the company exist? What is it
trying to accomplish?
For example, a mission statement for an investment co. might be:
We are building a leading international middle market investment
bank and institutional securities firm.
When a company’s mission is well understood and properly
integrated, it makes it easier to define objectives, strategies, and
tactics in the long term.
Objectives: the “where to” Objectives determine what the company wants to achieve. The
objectives which are in tandem with the mission of the
investment co. can be:
1. Increase market share by 20% by the end of year 1,
2. Grow brand awareness by 10% in a particular region by the
end of year 1
Strategies: the “how” Each objective should have associated strategies: what
approach(es) will you use to reach your objective?
1. To increase market share a market penetration strategy can
be employed (lowering prices to lure more clients)
2. To increase brand awareness the promotional strategy can be
put in motion through use of social media
Take note that there should be a coherent link among the elements: mission, objectives and
strategy (including examples) as you attempt to explain the relationship between corporate
objectives and strategy.

Question 7
List four objectives, other than shareholder wealth maximisation, that companies may
choose to pursue.
Objectives Explanation
Maximising profits Maximizing profits requires a business to sell its products or services at
the highest possible profit margin, by either reducing costs or increasing
prices. Targets can be set for profit growth over a strategic planning
period.
Growth in EPS A financial objective might be to increase the earnings per share each
year, and possibly to grow EPS by a target amount each year for the next
few years. If there is growth in EPS, there will be more profits to pay out
in dividends per share, or there will be more retained profits to reinvest
with the intention of increasing earnings per share even more in the
future. EPS growth should therefore result in growth in shareholder
wealth over the long term.
Sales maximisation Sales maximization is an objective that a company sets when it wants to
focus on generating as much revenue as possible. Revenue
maximization often involves reducing prices to increase the total
number of sales.
Satisficing Satisficing behaviour is an alternative business objective to maximising
profits. It means a business is making enough profit to keep
shareholders happy or it is sufficient for investors to maintain
confidence in the management they appoint.
Increase market To increase its market share, a company resorts to sales maximization,
share which subsequently puts it in a position to focus on profit maximization
in the long run. A high market share gives companies more pricing
power, increased control over industry advancements, and the ability to

create barriers to entry for possible competitors.
Question 8
It is said that failing to plan is planning to fail. Discuss this statement in the context of corporate
and financial objectives.
The objectives of an entity, relate directly to the organisation’s main goals and, ultimately, to its
mission. The objectives tell the managers and employees precisely what they are supposed to
achieve. The objectives of an entity can be broadly classified as corporate objectives and
financial objectives.
(a) Corporate Objectives

Corporate objectives relate directly to the organisation’s goals and indirectly to its mission.
Some examples of corporate objectives are:
i) Towards customers: to provide products, services and solutions of the best quality.
ii) Market Leadership: to provide useful and significant products, services and solutions to
markets and expand into new areas that build on existing technologies, competencies
and customer interests.
iii) Employees: to provide employees with employment opportunities based on
performance; to ensure a safe and comfortable work environment that values their
diversity and recognises individual contributions; and to help them gain a sense of
satisfaction and accomplishment from their work.
It can be seen that corporate objectives tend to be quite varied.
(b) Financial objectives

Financial objectives are mostly linked to measures of profit and aim at the maximisation of
shareholder wealth.

Examples of financial objectives include maximisation of ROCE, ROI and EPS. Alternatively,
financial objectives can refer to objectives pursued by the financial manager. Other examples
would therefore include maintaining optimal cash balances, specific gearing ratios and
inventory turnover periods.
Corporate objectives are more business or commercially-oriented, as opposed to financially-

oriented. Once the objectives of an organisation have been clearly defined the entity has to
develop a strategy to achieve these objectives. Strategies are usually associated with long-term
planning and thinking. A strategy can be defined as a course of action, including the
specification of resources, necessary to achieve an objective. In other words, a strategy tells
managers how to go about achieving the objectives.
For example, if an entity has the corporate objective of market leadership as stated above, it
will have to devise strategies to retain the existing customers and expand the existing market.
Therefore it will have to plan:

 the number of employees, dealer and distributors required in each region to cater to the
market
 market research to analyse the customer needs so as to attract new customers, etc.
 some attractive marketing schemes
Only if the company systematically plans each of the above aspects will it be able to meet its
goals of market leadership.
On the other hand, if the company does not construct a plan to achieve its objectives, it will not
be able to meet the set goals. In other words, failing to plan is planning to fail.
Question 9
What is meant by the ‘principal-agent’ relationship that exists between managers and
shareholders, and how does this give rise to the ‘agency problem’?

Agency theory was developed by Jensen and Meckling (1976) who defined the agency
relationship as a form of contract between a company’s owners and its managers, where the
owners appoint an agent (the managers) to manage the company on their behalf. As a part of
this arrangement, the owners must delegate decision-making authority to the management.
The owners expect the agents to act in the best interests of the owners. Ideally, the ‘contract’
between the owners and the managers should ensure that the managers always act in the best
interests of the shareholders. However, it is impossible to arrange the ‘perfect contract’,
because decisions by the managers (agents) affect their own personal interests as well as the
interests of the owners. Managers will give priority to their personal interests over those of the
shareholders.
Agency conflicts (or problems) are differences in the interests of a company’s owners and
managers. For example directors may seek to further their own interests rather than
shareholder wealth, in the following ways:
The mnemonic “METRE” has been coined to help you remember matters giving rise to the
agency problem. Your answer may not necessarily be in tabular format but this will only help
you remember the main points of discussion to earn marks.
Factor giving rise Explanation
to agency problem
Moral hazard. A manager has an interest in receiving benefits from his or her position as
a manager. These include all the benefits that come from status, such as a
company car, lunches, attendance at sponsored sporting events, and so
on. Jensen and Meckling suggested that a manager’s incentive to obtain
these benefits is higher when he has no shares, or only a few shares, in
the company. The biggest problem is in large companies.
Effort level. Managers may work less hard than they would if they were the owners of
the company. The effect of this ‘lack of effort’ could be lower profits and a

lower share price. The problem will exist in a large company at middle
levels of management as well as at senior management level. The
interests of middle managers and the interests of senior managers might
well be different, especially if senior management are given pay incentives
to achieve higher profits, but the middle managers are not.
Time horizon Shareholders are concerned about the long-term financial prospects of
their company, because the value of their shares depends on expectations
for the long-term future. In contrast, managers might only be interested in
the short-term. This is partly because they might receive annual bonuses
based on short-term performance, and partly because they might not
expect to be with the company for more than a few years. Managers
might therefore have an incentive to increase accounting return on capital
employed (or return on investment), whereas shareholders have a greater
interest in long- term share value.
Risk aversion Executive directors and senior managers usually earn most of their
income from the company they work for. They are therefore interested in
the stability of the company, because this will protect their job and their
future income. This means that management might be risk-averse, and
reluctant to invest in higher-risk projects. In contrast, shareholders might
want a company to take bigger risks, if the expected returns are
sufficiently high.
Earnings retention The remuneration of directors and senior managers is often related to the
size of the company, rather than its profits. This gives managers an
incentive to grow the company, and increase its sales turnover and assets,
rather than to increase the returns to the company’s shareholders.
Management are more likely to want to re-invest profits in order to make
the company bigger, rather than payout the profits as dividends.

Question 10
Identify four ratios that can be used to measure the achievement of financial corporate
objectives.
Four ratios that can be used to measure the achievement of corporate objectives are as follows:
Ratio Explanation
ROCE It measures profits before interest and tax, as a proportion of sales
EPS It illustrates earning attributable to each share in issue, after paying interest and tax.
DPS It illustrates the dividend to be paid per share in issue.
ROE It illustrates to shareholders what their funds in the company have generated in
earning attributable to them.
Question 11
How can mismanagement of working capital affect the survival of a business?
Working capital management seeks to find the ideal level of working capital to ensure liquidity
and maximize profitability. Managers use their companies' working capital to cover everyday
expenses and keep their organizations running. If a management team does not keep an
organization's working capital within certain levels, it can have crushing consequences (as
shown in the table below) to the organization's financial health.
The mnemonic “PILL” has been coined to help you remember consequences of mismanaging
working capital in relation to the survival of a business. Your answer may not necessarily be
in tabular format but this will only help you remember the main points of discussion to earn
marks.

Consequence Explanation
Penalties Mismanaging of working capital will result in the firm falling behind in its
payments to creditors. Lenders and service providers will start charging
penalties and interest on the amounts due, which will further worsen the
working capital situation. Persistent failure to fix the working capital issues will
result in service providers cancelling their services altogether and the collapse
of the business.
Insufficient Working capital is especially important for businesses that sell products
inventory because they need a well-stocked inventory. If their working capital is low, they
may not have enough cash flow to replenish their inventory before running out
of products. In such a case, client satisfaction and sales will suffer. As a
consequence the entity would collapse.
Low liquidity If working capital is too low, the smallest emergency or unexpected expenses
can leave the business with no liquidity. This means they may not have enough
cash on hand to pay for wages, utility bills and other regular running expenses.
Workers will usually resent working without pay and utility companies make a
habit of disconnecting clients who do not pay their bills. This will also have a
detrimental effect on the operational existence of the business.
Liquidation The final outcome for an organization that mismanages its working capital and
cannot pay for its debts and other running expenses is liquidation. Even if the
company has enough assets to pay its creditors, if the money is not at hand, the
organization might have to sell its assets or even declare bankruptcy/insolvency
to cover its debts.
Question 12
The following information is extracted from the financial statements of D Ltd

Average production period is 30 days.
Required
(a) Calculate current ratio and quick ratio and give your comments.
(b) Calculate sales revenue / Net working capital ratio
a) Calculation of the current and quick ratios
Ratios 20X8 20X9
$000 $000
Current ratio
𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐀𝐬𝐬𝐞𝐭𝐬
1,600 1,805
970 940
𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐋𝐢𝐚𝐛𝐢𝐥𝐢𝐭𝐢𝐞𝐬
= 1.65 : 1 = 1.92 : 1
Quick ratio
𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐚𝐬𝐬𝐞𝐭𝐬 − 𝐢𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲 1,600 − 650 1,805 − 700
𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐥𝐢𝐚𝐛𝐢𝐥𝐢𝐭𝐢𝐞𝐬 − 𝐛𝐚𝐧𝐤 𝐨𝐯𝐞𝐫𝐝𝐫𝐚𝐟𝐭 970 − 480 940 − 530
= 1.94 : 1 = 2.70 : 1
Quick assets should exclude inventory. Similarly, quick liabilities should exclude the bank
overdraft.

Comment
From 20X8 to 20X9 both the current and the quick ratios have improved indicating better
liquidity for D Ltd. This means D Ltd’s ability to cover its current liabilities has improved.
b) Calculation of sales revenue/net working capital

20X8 20X9
$000 $000
Sales Revenue 6,200 7,300
Current Assets 1,600 1,805
Less: Current Liabilities (970) (940)
Net Working Capital 630 865
Sales Revenue 6,200 7,300

Net Working Capital 630 865
= 9.84 times = 8.44 times
Comment
Working capital is essential for conducting the day to day operations of a business. Generally, as
a business activity increases, working capital requirements also increase. The sales/working
capital ratio shows the relationship between sales and working capital. Once the optimal level
of working capital is achieved the ratio should remain constant as sales increase. If this occurs it
would mean that the right level of working capital is being maintained.
In this question, the ratio has decreased. This indicates that the investment in working capital
has increased more proportionately than the increase in sales. D Ltd has too high a level of
working capital in 20X9. The danger of overcapitalization may be imminent.

Question 13
N ltd provides the following information:
Required:
a. Calculate the EOQ for Z.
b. Calculate the total cost of holding and the total cost of ordering.
c. Prove that EOQ is the cheaper option.
a) Calculation of the EOQ
EOQ = √2Co. D
h
Where Co. = cost per order

D = Demand per annum
h = holding cost
EOQ = √2 x 50,000 x 6
0.02
EOQ = 5,478 whole units
b) Calculation of the total costs of holding and ordering using EOQ

Holding costs (Q2 x h) (5,478
2
x 0.02) 54.78
Ordering costs (DQ x c) (50,000

5,478
x 6) 54.76
Total Costs 109.54
N.B. The holding costs and ordering costs for an EOQ should always be identical. Here the slight
difference of 0.02 is as a result of the earlier rounding of the EOQ to whole units.

c) Proof that the EOQ is the cheaper option
Tip: When seeking to prove that the EOQ is the cheaper option use TWO different order
quantities (one below the EOQ & the other above the EOQ) to calculate the total costs
and compare with the total costs for the EOQ.
Calculation of the total costs of holding and ordering for an order quantity of 8,333

2
x 0.02) 83.33

8,333
x 6) 36.00
Total Costs 119.33
Calculation of the total costs of holding and ordering for an order quantity of 4,167

2
x 0.02) 41.67

4,167
x 6) 71.99
Total Costs 113.66
It has been proven that the EOQ is the cheapest option.
Question 14
A supplier allows cash discount of 3 % if payment is made within 10 days.
The terms stipulate that payment must be made within 40 days.
The company has a choice of paying 97 cents per $1 on day 10.
Or else, the company can hold 97 cents for additional 30 days and pay the supplier $1 for
every $1 it owes to the supplier.
Required:
Should the company accept the discount if alternative investments yield a 30% return?
Take note that there are two options when attempting to answer this question. They are both
acceptable.

Option 1
Annual benefit of accepting the discount =
D 365 / 52 /12
X
100−D 𝑛o.of days / weeks/months earlier the money is paid
Key points to note

 D should be recorded as a straight percentage in the above formula. If you want to put it as
a decimal fraction, make sure you substitute 100 in the formula above with 1.
 Days were used in the question, this means everything should be in days including 365 days
in a year.
3 365
Annual benefit of accepting the discount = X 40−10
100−3
Annual benefit of accepting the discount = 37.63%
Comment
The company should accept the discount and benefit return of 37.63% compared to what
alternative investments yield (a 30% return).
Option 2
The second option involves setting a hypothetical invoice amount and then demonstrating
whether it will be worthwhile to accept the discount.
Suppose invoice from supplier is for $100,000.
If the discount is accepted the payment to the supplier will be as follows:
$100,000 x 97% or $100,000 – 3% = $97,000
If the discount is refused the payment to the supplier will be as follows:

Full payment 100,000
Return on investment (97,000 x 30% x 30/365) (see below for explanation) (2,392)
Net cost 97,608
It is cheaper for the company to accept the discount and pay $97,000 compared to $97,608.

Explanation on return on investment
It has been stated that when the entity is not taking up the discount it will pay on the 30 th day.
This means the company will have the opportunity to invest the amount it could have used for
early payment ($97,000) at a prevailing rate of 30% for the 30 days and then use the return to
reduce the amount of payment ($100,000) as shown above.
Overall comment
As shown above the two methods above arrive at the same outcome (of accepting the
discount) and are equally acceptable.
Question 15
Wodart Company expects to disburse a total of $60,000,000 in cash per year. It costs $125 on
an average, every time securities are sold for cash. Assume that the cash balance is to be kept
in the form of short-term securities that earn 5% income. Interest cost of new funds is 11%
p.a.
Required:
Calculate the finance to be raised at a time, using Baumol model.
The opportunity cost of holding cash is 11% minus 5% = 6%.
The optimum level or finance to be raised at a time (Q) =
√2CS
i
Where S = the amount of cash to be used in each time period

C = the cost per sale of securities
i = the interest cost of holding cash or near cash equivalents
Q = √2 x 60,000,000 x 125
0.06

Q = $500,000
Question 16
Identify different policies that can be used for financing working capital.
Please take note that you have to understand the DISTINCTION BETWEEN PERMANENT AND
FLUCTUATING CURRENT ASSETS, if you are to identify different working capital policies and
successfully explain them. As you are aware, current assets, by their very nature, are assets
which are held by the business for periods of twelve months or less. These assets, in total,
fluctuate depending on the level of business activity. However, in most businesses a
particular base level of inventory is always held and cash balances are never allowed to fall
below a certain level. These represent the proportion of current assets permanently held i.e.
the proportion of current assets which are fixed (hence the term ‘permanent current assets’).
Fluctuating current assets are the variations in the current assets that arise out of normal
business activities.
Policy Explanation
Conservative This policy uses long-term finance to fund non-current assets, permanent
working capital and a proportion of fluctuating working capital. Minimal short-
term finance is used. Higher proportion of long term sources reduces the risk
that short term obligations will not be met. However, since long term funds
are relatively more expensive, it reduces profitability.
Aggressive This policy relies heavily on short term sources of finance. Short-term funds
are used to finance fluctuating current assets as well as part of permanent
current assets. Since a higher proportion of cheaper funds are used, it
enhances profitability. However, this is the most risky policy from the point of
view of solvency. When repayments of short term liabilities fall due and the
company is not able to convert sufficient current assets into cash, it may
create cash flow pressures. In extreme cases it may lead to insolvency.

Matching or Here the maturity of funds is roughly matched by the maturity of assets.
moderate Hence, a moderate level of risk is taken by the organisation. Matching funding
policies use long-term finance to fund non-current assets and permanent
working capital. Fluctuating working capital is funded using short- term
finance.
Question 16
Compute the operating cycle from the information given below:
The average credit period allowed by the suppliers is 16 days. All these transactions occur
over a period of one year.
Days
Raw materials conversion period
Average inventory of raw materials 480,000 27
x 365 = x 365 days
Cost of Raw materials consumed 6,600,000
WIP conversion period

Average inventory of WIP 525,000 13
x 365 = x 365 days
Total production cost 15,000,000
Finished goods conversion period

Average inventory of finished goods 390,000 9
x 365 = x 365 days
Total production cost 15,000,000

Debtors conversion period
Average Receivables 720,000 11
x 365 = x 365 days
Credit sales 24,000,000
Creditors conversion period (given) (16)

Cash operating cycle 44
Question 17
The current sales of BW Ltd are $200,000. The company grouped its customers into four
categories A to D. Credit rating falls as one goes from category A to D. BW Ltd presently extends
unlimited credit to customers in category C and D, limited credit to customers in category A and
no credit to customers in category B. As a result of this credit policy, the BW Ltd is foregoing
sales to the extent of $2,000 to customers in category D. The firm is considering the adoption of
a liberal policy under which customers in category A would be extended unlimited credit and
customers in category B would be extended limited credit. Such relaxation would increase the
sales by $30,000 on which bad debts losses would be 8%. The contribution margin ratio (1-V)
for the firm is 15%, average collection period (ACP) is 35 days, and the after-tax cost of capital
(k) is 12%. The tax rate is 30%.
Required:
Advise whether BW Ltd should change its credit standards.
When seeking to advise on change of credit standards pertaining to RELAXATION OF CREDIT
POLICIES we calculate the CHANGE IN RESIDUAL INCOME (RI) as follows:
RI = [S(1 – V) - S bn] (1 – t ) – k I
𝐀𝐂𝐏
 I = S x 𝟑𝟔𝟎 x V
Where: S = increase in sales

V = ratio of variable cost to sales (as a decimal fraction)
bn = bad debts (as a decimal fraction)
t = tax (as a decimal fraction)
k = after tax cost of capital (as a decimal fraction)
k I = post-tax opportunity cost of additional funds locked in receivables
ACP = average collection period

Therefore:
S = $30,000
V = 0.85
bn = 0.08
t = 0.30
k = 0.12
ACP = 35 days
Therefore
35
RI = [$30,000 (1 – 0.85) – $30,000 x 0.08] (1 – 0.3) – 0.12 x $30,000 x x 0.85
360
RI = [$4,500 – $2,400] (0.7) – $297.50

RI = $1,470 – $297.50
RI = $1,172.50
Comment
Since the impact of change in credit standards on net profit is positive, the proposed change is
desirable.
Question 18
The following information relates to Velm Plc, a company involved in selling stationery and
office supplies.
Velm Plc: SOFP as at 31 December 2002

Required:
(a) Discuss the relative merits of short-term and long-term debt sources for the financing of
working capital.
(b) Discuss the different policies that may be adopted by a company towards the financing of
working capital needs and indicate which policy has been adopted by Velm Plc.
(c) Outline the advantages to a company of taking steps to improve its working capital
management, giving examples of steps that might be taken.
a) Merits of short term and long term debt sources for the financing of working capital
Short-term sources of debt finance include overdrafts and short-term debts. An overdraft is
more flexible and can be increased or decreased (within its limit) on a day-to-day basis. Its main
purpose is to fund day-today shortfalls in cash rather than long-term projects. However, the
interest rates payable on an overdraft are often higher than the interest rates payable on a
loan. This is because an overdraft is a flexible arrangement. However the flexibility comes at a
cost. A company could experience liquidity problems if the lender immediately demands the
repayment of the overdraft if it has any cause for concern.
The risk with a short-term loan as a source of finance is that it may be renewed on less
favourable terms if the risk perception of the lender increases. This might leave the company
open to any increase in the short-term interest rate. There is also a risk that lenders may refuse
to extend further credit.

Long-term sources of debt finance include long-term debts, loan stock and debentures. With
long-term borrowing, the finance is assured for the duration of the loan, as long as the
borrower does not breach the debt covenants involved. The risk for the company is therefore
lower if it finances working capital from a long-term source.
Generally, short-term borrowing is cheaper than long-term borrowing. This is because many
lenders equate time with risk. The longer they lend for, the higher is the risk involved.
b) Working capital policies

Working capital policies on the method of financing working capital can be characterised as
conservative, moderate and aggressive. In the case of a conservative policy, a company uses
long-term funds to finance noncurrent assets, permanent current assets and some fluctuating
current assets. A higher proportion of long-term sources reduces the risk that short-term
obligations will not be met. However, since long term funds are relatively more expensive, it
reduces profitability.
Since, for Velm Plc, long-term debt only accounts for 2.75% (40,000/1,450,000) of non-cash
current assets, it cannot be following a conservative financing policy. On the contrary, Velm Co
clearly seems to be following an aggressive financing policy, characterised by short-term
finance ($1,530,000) being used for all of the fluctuating current assets and most of the
permanent current assets as well. Such a policy will result in a decrease of interest costs and an
increase in profitability, but at the expense of an increase in the amount of higher-risk finance
used by the company.
Between these two extremes in policy terms lies a moderate or matching policy. In this, short-
term borrowing is used for financing fluctuating current assets and long-term finance is used for
financing permanent current assets. This is an expression of the matching principle, which holds
that the maturity of the finance should roughly match the maturity of the asset.

c) Advantages of taking steps to improve working capital management
The objectives of working capital management are often stated to be profitability and liquidity.
Liquidity describes how easily an investor can access the cash he has invested. However, it is
important to note that some investments are much more liquid than others. The objectives of
liquidity and profitability are often in conflict, since an investment that is highly liquid, such as a
sight deposit, will generally result in a lower return on the investment. On the other hand, an
investment with a low level of liquidity will generally provide a higher return. However, in order
to meet the liabilities promptly, liquidity is essential. Hence, cash is often called the lifeblood of
a company.
Sound working capital management helps in minimising the cost of investing in current assets.
Efficient credit management, for example, helps in minimising the risk of bad debts and
accelerating the collection of receivables in accordance with the agreed terms of trade. This in
turn will reduce the costs of managing receivables.
In order to ensure better management of stock, Velm Co should have a wide range of
stationery and office supplies so that the customers’ needs are met promptly. The costs of
holding and ordering stock can be minimised by efficient stock management, for example using
techniques such as the EOQ model, ABC analysis, stock rotation and buffer stock management.
Following the Just-In-Time approach can reduce the cost of investing in stock.
Cash budgets help to determine the transactions motive for cash in each budget control period.
In addition, the optimum cash position will also depend on the precautionary and speculative
need for cash. The Baumol model and the Miller-Orr model can help to ascertain optimum cash
levels.

Question 19
Grey Ltd is evaluating an expansion project that is expected to cost $5 000 000 and generate
an annual after tax cash flow of $1 000 000 for the next 5 years. The corporate tax rate is
25%. Grey Ltd has a target debt to equity ratio of 1:1. Its cost of capital is 12% and it’s before
tax cost of debt is 10%. The floatation cost of equity is 8% whilst the floatation cost of debt is
3%.
Required:
Determine the NPV of the expansion project
Here there is need to calculate an adjusted net present value (commonly known as APV)
instead of the traditional net present value (NPV). The expansion project is financially viable
and should be undertaken if its adjusted present value (APV) is positive. The APV of a project
contains three elements, and is calculated as follows:
Adjusted NPV = Base case NPV minus PV of issue costs plus PV of tax shield
To calculate the APV of a project, we must therefore calculate three amounts: the base case
NPV, the PV of other costs (issue costs) and the PV of tax relief on interest.
Step 1: Calculation of the base case NPV

KEY POINT: The base case NPV involves calculating the NPV ignoring entirely the way in which
the project will be financed. The cost of capital should therefore be the cost of equity and this
is the discount rate. The base case NPV is therefore calculated assuming the project is financed
entirely by equity, so that the method of financing is ignored.
The base case NPV will be calculated as follows:
Year Details Cash flows D.F.@12% DCF/PV
0 Initial investment (5,000,000) 1.000 (5,000,000)
1-5 After tax cash inflows 1,000,000 3.605* 3,605,000
Base case NPV (1,395,000)

1−(1+𝑟)−𝑛
*Annuity factor =
𝑟
1−(1+0.12)−5
=
0.12
= 3.605
Step 2: Calculation of the issue (floatation) costs

First of all, establish the financing mix. The target debt to equity ratio is 1:1 which means the
initial investment of $5,000,000 will be split equally as follows:
Equity (5,000,000 x ½) 2,500,000 (These are net proceeds after 8% floatation costs)
Debt (5,000,000 x ½) 2,500,000 (These are net proceeds after 3% floatation costs)
Calculation of issue (floatation) costs on equity

As the floatation costs would absorb 8% of the gross proceeds of equity this means $2,500,000
(net proceeds) will be equivalent to 92% (100% - 8%). So calculate the floatation costs on equity
as follows:
8
2,500,000 x = = 217,391 (This is a shortcut)
92
Alternative calculation of floatation costs on equity

A longer route will be to calculate the total gross proceeds (commonly known as grossing up)
and then subtract the net proceed to determine the floatation costs.
100
Gross proceeds = 2,500,000 x = = 2,717,391
92
Floatation costs = Gross proceeds – Net proceeds

Floatation costs = 2,717,391 – 2,500,000
Floatation costs = 217,391

Calculation of issue (floatation) costs on debt
As the floatation costs would absorb 3% of the gross proceeds of debt this means $2,500,000
(net proceeds) will be equivalent to 97% (100% - 3%). So calculate the floatation costs on debt
as follows:
3
2,500,000 x = = 77,320 (This is a shortcut)
97
Alternative calculation of floatation costs on debt

A longer route will be to calculate the total gross proceeds (commonly known as grossing up)
and then subtract the net proceed to determine the floatation costs.
100
Gross proceeds = 2,500,000 x = = 2,577,320
97
Floatation costs = Gross proceeds – Net proceeds

Floatation costs = 2,577,320 – 2,500,000
Floatation costs = 77,320
Step 3: Calculation of the present value of the tax shield

First calculate interest and tax shield as follows:
Year Opening loan liability Interest @10% Tax shield @25%
1 2,500,000 250,000 62,500
2 2,000,000 200,000 50,000
3 1,500,000 150,000 37,500
4 1,000,000 100,000 25,000
5 500,000 50,000 12,500

Calculation of the present value of the tax shield
Year Tax shield Discount factor @10%* Present value (PV)
1 62,500 0.909 56,813
2 50,000 0.826 41,300
3 37,500 0.751 28,163
4 25,000 0.683 17,075
5 12,500 0.621 7,762
Present value of tax shield 151,113
*The tax relief should be discounted to a present value, using the pre-tax (before-tax) rate of
interest on the debt as the discount rate.
*Discount factor = (1 + r) – n OR 1__
(1 + r)n
Calculation of the adjusted net present value (APV)

Base case NPV (1,395,000)
Floatation costs on equity (217,391)
Floatation costs on debt (77,320)
Present value of tax shield 151,113
Adjusted Net Present Value (APV) (1,538,598)
As the adjusted NPV is negative it is not financially viable to undertake the expansion project.
Question 20
Discuss the stages of the capital budgeting process in relation to corporate strategy.
Stages in the Capital Budgeting Process in relation to corporate strategy
The capital budgeting process consists of six (6) distinct but interrelated stages:
Your answer may not necessarily be in tabular format but this will only help you remember
the main points of discussion to earn marks.

Stage Explanation
1 Corporate strategy The investment proposal that furthers the corporate strategy will be
taken into account. The corporate strategy is the direction and scope
of an organisation over the long-term. Corporate strategies do not
change often. Hence, along with the other criteria for investment, an
investment proposal should also match the corporate strategy. If
there is an excellent investment opportunity, the corporate strategy
may be changed.
2 Determination of Any capital project can be put to the capital market. The project
budgets should raise the required money from the capital market. If this is
possible then, in theory, budgetary limits do not exist. In practical
terms, however, there are budgetary limits. All the acceptable
projects cannot be implemented by the company because of the
limited funds. So the company has to determine what it can spend
on capital expenditure and has to allocate these funds to the best
possible projects.
3 Identification of This is a very important stage in the capital budgeting process. If the
investment best possible project is not identified then the company may lose its
opportunities chance to pursue it. This would have a negative effect on the
company. It may not be in a position to maximise the shareholders’
value. All the remaining stages only select the best of the identified
projects. There are internal and external sources of proposals.
Employees are the internal sources and customers, consultants and
suppliers are the external sources. There may be special divisions for
this purpose in some firms. Some investments may be discretionary
while others may be mandatory. A clear definition of the project and
its costs and benefits is required.
4 Investment This stage involves quantifying the cost and benefits, comparing
appraisal and them to appropriate techniques, evaluating the risks involved in the

authorisation light of changing situations, considering qualitative factors and
finally, taking a decision.
5 Project Projects involving capital expenditure take place over a significant
implementation period of time. It is necessary to monitor the progress of a project by
and monitoring: checking whether or not it is on schedule. Any delays in the
implementation of a project invariably increase the cost of the
project. It is also necessary to check whether or not the cost of the
project is within the budget.
6 Post Capital budgeting does not end with the implementation of a
implementation project. A post implementation audit is also carried out. This
audit investigation points whether or not the project is performing in line
with expectations, and what lessons can be drawn for future
appraisals.
Question 21
Machine Support Ltd is planning to install equipment at its plant. The finance manager is
asked to evaluate the alternatives either to purchase or acquire the equipment on lease
basis.
Capital allowances @ 20% p.a. can be claimed immediately with the benefit received one
year later
Corporate tax rate 35%.
After Tax cost of debt is 15%.
Required
Based on the above information, analyse the lease or buy decision
Option 1: Outright purchase
Year 0 1 2 3 4 5

Initial investment (650,000)
Tax savings on WDAs (w1) 45,500 36,400 29,120 23,296 20,384
Residual value 208,000
Net cash flow (650,000) 45,500 36,400 29,120 23,296 228,384
DF @ (15%) 1.000 0.870 0.756 0.658 0.572 0.497
PV (650,000) 39,585 27,518 19,161 13,325 113,507

(1 + r)n
NPV of buying = ($436,904)
(w1) – working for tax savings on writing down allowances (WDAs)

Note: The equipment will be purchased immediately and the first capital allowance will also be
claimable immediately (year 0). However, the tax benefit is available in the next year since tax is
settled one year in arrears.
Year Details Amount Tax savings @35% Timing of tax effect
0 Cost 650,000
WDA (650,000 x 20%) (130,000) 45,500 (130,000 x 35%) Year 1
520,000
1 WDA (520,000 x 20%) (104,000) 36,400 (104,000 x 35%) Year 2
416,000
2 WDA (416,000 x 20%) (83,200) 29,120 (83,200 x 35%) Year 3
332,800
3 WDA (332,800 x 20%) (66,560) 23,296 (66,560 x 35%) Year 4
266,240
4 Residual value (208,000)
Balancing allowance 58,240 20,384 (58,240 x 35%) Year 5
No capital allowance given in the year of disposal.
Option 2: Leasing
0-4 Lease payments (195,000) 3.855* (751,725)
1-5 Tax savings ($195,000 x 35%) 68,250 3.352 228,774
NPV of leasing (522,951)
*Discounting factor for 0 period is 1.00. The cumulative present value factor (or annuity factor)
for period 1 to 4 is 2.855. So, total is 3.855.
1−(1+𝑟)−𝑛
*Annuity factor =
𝑟
1−(1+0.15)−4
=
0.15
= 2.855
Use the same formula (as a matter of practice) to calculate the annuity factor applicable to tax
savings.
Since the lease payment occurs at the beginning of the first year, for discounting purposes, the
cash flow will be shown in the previous year therefore will run from years 0-4. From a tax
perspective, tax savings will begin in year one.
Alternatively the leasing option can be presented as follows:

Year 0 1 2 3 4 5
Lease payment (LP) (195,000) (195,000) (195,000) (195,000) (195,000)
Tax savings on LP 68,250 68,250 68,250 68,250 68,250
Net cash flow (195,000) (126,750) (126,750) (126,750) (126,750) 68,250
DF @ (15%) 1.000 0.870 0.756 0.658 0.572 0.497
PV (195,000) (110,273) (95,823) (83,402) (72,501) 33,920
NPV of leasing = ($523,079)
Conclusion
The machine should be purchased as this is the cheaper option.
Question 22

The amount available with the company is $150,000:
Required:
Determine the optimal combination of projects assuming that the projects are:
(a) Divisible
(b) Indivisible
(a) Assumption: projects are divisible
Project Initial investment (a) NPV (b) Profitability index (a/b) Ranking order
P 50,000 10,000 0.20 3
Q 150,000 17,500 0.117 5
R 25,000 8,000 0.32 1
S 100,000 12,500 0.125 4
T 50,000 15,000 0.30 2
PV of cash inflows or NPV
Take note that the profitability index can be calculated as . Therefore,
Initial investment
in this question it is more convenient and appropriate to use the NPV as a numerator to
calculate the profitability index. Suppose you decide to use present value of cash inflows
(instead of the NPV) as a numerator (though not recommended in this case) the same ranking
order will still come out which will still culminate into the same optimal combination of projects
being undertaken.
Ranking Project Capital amount allocated

1 R 25,000
2 T 50,000
3 P 50,000

4 S 25,000 (balance)
Total capital available 150,000
Conclusion
Therefore the optimal combination of projects is R, T, P and 25% of S.
S required 100,000 but a balance of 25,000 will be allocated.
(b) Assumption: projects are indivisible
In this case ranking by profitability index will not necessarily indicate the optimum investment
schedule, since it will not be possible to invest in part of a project. In this situation, the NPV of
possible combinations of projects must be calculated.
Unfortunately with indivisible projects there is no model to help us! We simply have to look at
all the possible combinations by trial and error work out which would be the most profitable.
(Highest NPV). Surplus funds may be left over, but since the highest-NPV combination would
have been selected, the amount of surplus funds is irrelevant to the selection of the optimal
investment schedule.
Feasible combinations Total capital utilised Aggregate of NPV

Q only 150,000 17,500
P,R 75,000 (50,000 + 25,000) 18,000 (10,000 + 8,000)
P,S 150,000 (50,000 + 100,000) 22,500 (10,000 + 12,500)
P,T 100,000 (50,000 + 50,000) 25,000 (10,000 + 15,000)
R,S 125,000 (25,000 + 100,000) 20,500 (8,000 + 12,500)
R,T 75,000 (25,000 + 50,000) 23,000 (8,000 + 15,000)
S,T 150,000 (100,000 + 50,000) 27,500 (12,500 + 15,000)
P,R,T 125,000 (50,000 + 25,000 + 50,000) 33,000 (10,000 + 8,000 + 15,000)
Conclusion

By inspection of the feasible combinations, we can say that the optimal project mix is P, R and
T, as the aggregate of their NPVs is the highest.
Question 23
How does an operating lease differ from borrowing to buy from a taxation perspective?
From a tax perspective, when a company purchases an asset it becomes the legal owner, and
therefore, is allowed to claim capital allowances against the asset. If, however, the asset is
leased in the eyes of the taxman, the lessee is not the legal owner, and hence is not entitled to
capital allowances. Lease payments, however, will be tax deductible.
Question 24
Does the residual value affect the EAC? If yes, how?
PV of cost for one replacement cycle
Equivalent annual cost (EAC) = Cumulative PV factor for the no.of years in the cycle
Yes, residual value affects EAC, as the assets grow older, maintenance as well as operating costs
may increase and the assets become less efficient. Residual values are used in NPV calculations
and NPVs are used in EAC calculations, hence residual values will definitely affect EACs.
Question 25
How does a profitability index differ from NPV?
The mnemonic “DEAF” has been coined to help you remember the differences between the
profitability index and NPV. Your answer may not necessarily be in tabular format but this
will only help you remember the main points of discussion to earn marks.

Base of difference Profitability index (PI) Net Present Value (NPV)
Definition It is a benefit to cost ratio that The present value of all future cash
calculates the present value of all flows less the initial investment
future cash flows as the number of
times of the initial investment
Expressed as Expressed in form of a ratio i.e. in Expressed in the form of currency
relative terms returns i.e. in absolute terms
Application in Useful only when projects are Useful only when projects are
capital rationing divisible indivisible
Focuses on Focuses on determining the Focuses on determining whether
returns per unit of initial capital the investment is generating surplus
invested returns
Question 26
Cubic Ltd has decided to acquire an asset worth $2,000,000. The following two options are
available:
(a) Acquire the asset by taking a bank loan @ 15% p.a. repayable in five yearly installments of
$400,000 each plus interest or
(b) Lease the asset at yearly rentals of $648,000 for five years starting from the end of year 1.
In both cases, the instalment is payable at the end of the year. The rate of capital allowances
applicable to the company is 15% using the reducing balance method. The corporate tax rate
is 35% and tax is paid one year after the end of the accounting year in which the transaction
occurs. Use the cost of borrowing as the company’s cost of capital.
Suggest which method would be more financially viable for Cubic Ltd.
Note: The cash flows relating to interest and capital repayment will NOT appear in the NPV
calculation as they are non-relevant cash flows.
Option 1: Borrow to buy

NPV calculation
Note: Cash flows must be discounted using the after tax cost of capital i.e.

kd = rd (1 – T)
kd = post-tax (after tax) cost of debt
rd = pre-tax (before tax) cost of debt

T = tax
kd = 15% x (1 - 0.35) = 9.75%, say 10%
Take note that figures in this question have been rounded to the nearest $1,000.
Year 0 1 2 3 4 5
Initial investment (2,000,000)
Tax savings on WDAs (w1) 105,000 89,000 76,000 64,000 365,000
Net cash flow (2,000,000) 105,000 89,000 76,000 64,000 365,000
DF @ (15%) 1.000 0.909 0.826 0.751 0.683 0.621
PV (2,000,000) 94,000 74,000 57,000 44,000 227,000

(1 + r)n
NPV of buying = $1,505,000 (rounded off to nearest thousand)
(w1) – working for tax savings on writing down allowances (WDAs)

Note: The asset will be purchased immediately and the first capital allowance will also be
claimable immediately (year 0). However, the tax benefit is available in the next year since tax is
settled one year in arrears.
$000 $000
Year Details Amount Tax savings @35% Timing of tax effect
0 Cost 2,000
WDA (2,000 x 15%) (300) 105 (300 x 35%) Year 1
1,700
1 WDA (1,700 x 15%) (255) 89 (255 x 35%) Year 2
1,445
2 WDA (1,445 x 15%) (217) 76 (217 x 35%) Year 3

1,228
3 WDA (1,228 x 15%) (184) 64 (184 x 35%) Year 4
1,044
4 Residual value (nil)
Balancing allowance 1,044 365 (1,044 x 35%) Year 5
Figures have been rounded to the nearest $1,000. No capital allowance given in the year of
disposal.
Option 2: Lease
Note: the after tax cost of capital is used and tax is lagged by one year.
NPV calculation
1-5 Lease payments (648,000) 3.791 (2,456,568)
2-6 Tax savings ($648,000 x 35%) 226,800 *3.446 781,553
NPV of leasing (1,675,015)
* Cumulative present value discount factor (annuity factor) for 6 years at 10% = 4.355
Present value discount factor for 1 year at 10% = 0.909
4.355 – 0.909 = 3.446
1−(1+𝑟)−𝑛
*Annuity factor =
𝑟
1−(1+0.10)−6
=
0.10
= 4.355
You can use the same formula to calculate the annuity factor applicable to the lease payments.
NPV of leasing = $1,675,000 (rounded off to nearest thousand)
Alternatively the leasing option can be presented as follows:

Year 1 2 3 4 5 6
Lease payment (LP) (648,000) (648,000) (648,000) (648,000) (648,000)

Tax savings on LP 226,800 226,800 226,800 226,800 226,800
Net cash flow (648,000) (421,200) (421,200) (421,200) (421,200) 226,800
DF @ (10%) 0.909 0.826 0.751 0.683 0.621 0.564
PV (589,032) (348,000) (316,000) (288,000) (262,000) 128,000
NPV of leasing = $1,675,000 (rounded off to nearest thousand)
Conclusion
It would be cheaper to buy the asset.
Question 27
Sunshine Private Limited has recently received an order where they will sell 50 TV sets of 32
inches for $200 each in the first year of the contract, 100 air condition of 1 tonne each for
$320 each in the second year of the contract and in third year they will sell 1,000
smartphones valuing at $500 each. But in order to fulfil this requirement they need to
increase the production and for that they are looking for cash flow of $35,000 to hire people
on contract and all this will be deposited in a separate escrow account create specifically for
this purpose and cannot be withdrawn for any other purpose but company will earn a 2% rate
on the same for the next 3 years as the same will be paid at the end of 3rd year to the
contract employees. Further, the cost of production that will be incurred in the 1st year will
be $6,500, in the 2nd year it will be 75% of the gross revenue earned and in the last year will
be 83% of the gross revenue as per the estimates.
You are required to calculate the benefit-cost ratio and advise whether the order is
worthwhile? Assume the cost of the project is 9.83%.
In all material respects the cost benefit ratio is the same as the profitability index.
PV of cash inflows (benefits)

Cost-Benefit Ratio = PV of cash outflows (costs)
To do the cost-benefit analysis first, we need to bring both costs and benefit in today’s value
(discounting). Since here the costs are also incurred in different years we need to discount
them as well.
Before discounting, we need to compute total cash flows for the entire project life.

There is no cash outflow or inflow in the 0 years as the company is making a deposit and in fact
it is earning interest on the same at the rate of 2% and in the final year, the company will make
payment of $35,000 which has been included in the cash outflow.
Calculation of cash inflows

Calculation of revenue
Year Calculations $
1 50 32 inch TVs x $200 10,000
2 100 air conditioners x $320 32,000
3 1,000 smart phones x $500 500,000
Calculation of interest earned on escrow account
Year Calculations $
1-3 $35,000 x 2% 700
Calculation of the total cash inflows

Year Revenue Interest earned Cash inflow
1 10,000 700 10,700
2 32,000 700 32,700
3 500,000 700 500,700
Calculation of the present value of cash inflows

Year Cash inflows Discount factor @9.83 Present value
1 10,700 0.910 9,742.33
2 32,700 0.829 27,108.52
3 500,700 0.755 377,932.85
Present value of cash inflows 414,783.70
N.B. To calculate present values the full discount factors which appear in your calculator have
been used to multiply with the cash flows.
(1 + r)n
Alternative method of calculation of the present value of cash inflows

PV of Cash inflows = CF1 + CF2 + CF3
(1 + r)1 (1 + r)2 (1 + r)3
PV of Cash inflows = 10,700 + 32,700 + 500,700

1 2
(1 + 0.0983) (1 + 0.0983) (1 + 0.0983)3

PV of cash inflows = 9,742.33 + 27,108.52 + 377,932.84
= 414,783.70
Calculation of cash outflows

Year Calculations $
1 Given 6,500
2 32,000 x 75% 24,000
3 (500,000 x 83%) + 35,000* 450,000
*Hiring costs of $35,000 will be paid at the end of year 3 and therefore should be part of cash
outflows.
Calculation of the present value of cash outflows

Year Cash inflows Discount factor @9.83 Present value
1 6,500 0.910 5,918.24
2 24,000 0.829 19,896.16
3 450,000 0.755 339,664.03
Present value of cash outflows 365,478.03
N.B. To calculate present values the full discount factors which appear in your calculator have
been used to multiply with the cash flows.
Alternative method of calculation of the present value cash outflows

PV of Cash outflows = CF1 + CF2 + CF3
(1 + r)1 (1 + r)2 (1 + r)3
PV of Cash outflows = -6,500 + -24,000 + -450,000

1 2
(1 + 0.0983) (1 + 0.0983) (1 + 0.0983)3
PV of cash outflows = -5,918.24 + -19,896.16 + -339,664.03

= 365,478.03
Calculation of the benefit-cost ratio
Present value of cash inflows (benefits)

Benefit-cost ratio =
Present value of cash outflows (costs)
414,783.70
Benefit-cost ratio =
365,478.43

Benefit-cost ratio = 1.13
Comment
Since the benefit-cost ratio is greater than 1, the mega order appears to be financially
worthwhile. In other words, for every $1 of cash outflows the company will get $1.13 from the
mega order.
Question 28
The following details of a market portfolio are provided:
Required
(a) Calculate expected rate of return on market portfolio.
(b) Using the CAPM, calculate expected return of each security excluding government bonds.
(a) Calculation of expected return on market portfolio
Capital appreciation Dividends (b) Total Investment (or
(or gain) (a)* shareholders initial) price
returns (a + b)
Textile Ltd 35 3 38 90
Chemicals Ltd 35 4 39 110
Metals Ltd 25 2 27 70
7% Government 4 35 39 500
bonds
Total 99 44 143 770
*Capital gain or appreciation = Year end price less initial price

′
Total Shareholders Returns (TSR)
Expected rate of return on market portfolio = x 100
Total Investment Price
143
Expected rate of return on market portfolio = 770 x 100
Expected rate of return on market portfolio = 18.57%
(b) Calculation of expected return of each security

Use the CAPM formula to calculate return for each security
Re = Rf + 𝛽e (Rm – Rf)
CAPM calculation Return (Re)
Textile Ltd (7% + 0.70 (18.57% - 7%)) 15.10%
Chemicals Ltd (7% + 0.80 (18.57% - 7%)) 16.26%
Metals Ltd (7% + 0.60 (18.57% - 7%)) 13.94%
Question 29
Giga Ltd’s WACC is 10% and its tax rate is 30%. Giga Ltd’s before tax cost of capital is 14% and
its debt-to-equity ratio is 0.8:1. The risk free rate is 8% and the market risk premium is 6%.
Required:
Compute the beta of Giga Ltd’s equity.
First use the WACC (ko) formula to calculate cost of equity (same as return on equity) as a
missing figure.
ko = [wdrd (1 – T)] + [weke]
ko = WACC
we = proportion of equity in capital structure
wd = proportion of debt in capital structure
rd = return on debt (pre-tax or before tax cost of debt)

ke = return on equity or cost of equity
T = Tax rate
0.8 1
0.10 = [1.8 x 0.14 (1 – 0.30)] + [1.8 x ke]
0.10 = 0.043555555 + 0.555555555ke
0.10 - 0.043555555 = 0.555555555ke

0.056444445
ke =0.555555555
ke = 0.1016 (say 10%)

Having obtained the return on equity now use the CAPM formula to calculate the equity beta
Re = return on equity
Rf = risk free rate of return
𝛽e = equity beta
Rm = return on the market
0.10 = 0.08 + 𝛽e x 0.06

0.10 - 0.08 = 0.06 𝛽e
0.02
𝛽e = 0.06
𝛽e = 0.333
Question 30
SKF Plc a company that manufactures ball bearings has received a proposal for diversifying into
the automobile manufacturing business from its business development manager. It needs to
calculate an appropriate discount rate for the new venture, which has an expected return of 19
per cent. SKF Plc will use the Capital Asset Pricing Model to establish this discount rate, and has
the following information about suitable surrogate companies:
Speed Automobiles Plc

This company has an equity beta of 1.89 and is wholly involved in automobile manufacturing. It
is financed by 45 per cent debt and 55 per cent equity.
Wheels Automobiles Plc

This company has an equity beta of 1.91 and is also wholly involved in automobile
manufacturing. It is financed by 35 per cent debt and 65 per cent equity.
Other information
 SKF Plc has traditionally adopted a financing mix of 50 per cent debt and 50 per cent
equity, although the project, if accepted, will be financed entirely by equity finance.
 The current yield on treasury bills stands at 6 per cent, whereas the return on the stock
exchange is 11 per cent.
 30 per cent corporation tax is applicable for all companies.
 It can be assumed that there is no risk involved in corporate debt.
Required:
With the information given, calculate an appropriate discount rate for appraising the project
and advise the company whether or not to accept the proposal of diversification.
Step 1: Convert the beta values of other companies in the industry to ungeared betas, using the
formula:
This is known as “de-gearing”
E
βa = βe x
E+D(1−T)
βa = asset beta
βe = equity beta
E = proportion of equity in capital structure
D = proportion of debt in capital structure
T = tax rate
55
Speed Automobiles Plc βa = 1.89 x = 1.20
55+[45(1−0.3)]
65
Wheels Automobiles Plc βa = 1.91 x = 1.39
65+[35(1−0.3)]
Step 2: Take an average of the two asset betas:
1.20+1.39
Surrogate (or proxy) asset beta =
2
Surrogate (or proxy) asset beta = 1.30

Step 3: Having obtained an ungeared beta value βa, convert it back to a geared beta βe, which
reflects the company’s own gearing ratio, using the formula:
This is known as “re-gearing”
E+D(1−T)
Surrogate (or proxy) equity beta (βe) = βa x E
50+[50(1−0.3)]
Surrogate (or proxy) equity beta (βe) = 1.30 x = 2.21
50
Step 4: Insert the surrogate (or proxy) equity beta into the Capital Asset Pricing Model to
calculate the required return (Re):
Re = return on equity
Rf = risk free rate of return
𝛽e = equity beta
Rm = return on the market
Re = 6% + 2.21(11% – 6%)
Re = 17%
The expected rate of return of the project (19%) is greater than the discount rate (17%) and
hence it is advisable to accept the project.
Put in another way, investors require a minimum return of 17% (as calculated by the CAPM) yet
the project will give a return of 19% (above what they require) therefore it is financially
worthwhile.
Question 31
Explain the limitations of business valuations.

The mnemonic “SHOELACES” has been coined to help you remember the limitations of
business valuations. Your answer may not necessarily be in tabular format but this will only
help you remember the main points of discussion to earn marks.
Limitation Explanation
Sources of In valuing a business a great deal of information comes from internal
information sources. If these internal resources have not been audited then it’s difficult
to rely on the information they provide. If we use external sources of
information, which depend upon the national, regional, as well as the
economic condition of the market industry at the time of valuation, then the
reliability of the information gathered for the valuation of a business is
questionable.
Historical data Often the information for the valuation process is based on the historical
data of the company. The historical data, as well as the process value drivers,
are subjective and open to interpretation.
Overlooks Most of the valuation methods do not take into account intangible assets of
intangibles the company such as brand loyalty, customer retention and ownership of
intangible assets. These assets are invaluable to any company, and the value
of these assets are going to increase in future. By not considering these
assets, we are ignoring an important asset class of a company. This results in
flawed valuation & wrong investment decisions.
Economic Gathering information from economic indicators such as stock market
indicators trends, gross domestic product, employment, inflation, interest rates and
consumer spending is difficult.
Latest While valuing the business we consider only those facts that are known or
information knowable on the valuation date.
Accounting Sometimes a company changes its accounting policies and normalises its
policies financial statements by carrying out many adjustments. The company’s
financial analysis depends upon generally accepted accounting principles
(GAAP) which depend, in turn, on the management of the company.

Costly & vague The information provided by the government departments and industrial
associations are sometimes too vague and expensive.
Estimations One significant downside to valuations is the degree of estimation involved
in the calculations. These estimations often involve a high degree of
professional judgment, which can subject the valuation to debate from other
parties.
Several As there are several methods of valuing a business and each method has a
methods different perspective, it sometimes becomes difficult for an analyst to
determine which method is suitable. It gets even more difficult if each
method results in a different value, and analysts must decide which value to
follow.
Question 32
What are the different approaches to valuing a business?
The mnemonic “CAME” has been coined to help you remember the four different approaches
to valuing a business. Your answer may not necessarily be in tabular format but this will only
help you remember the main points of discussion to earn marks.
Approach Explanation
Cash flow based The theoretical premise here is that the value of the company should be
(also known as equal to the discounted value of future cash flows. Examples of cash flow
discounted cash based methods include: the dividend valuation model (DVM), free cash flow
flow basis) & economic value added (EVA).
Asset based The traditional asset based valuation method is to take as a starting point
the value of all the firm's balance sheet assets less any liabilities. Intangible
assets (including goodwill) should be excluded, unless they have a market
value (for example patents and copyrights, which could be sold). Asset
values used can be: book value, replacement value and net realisable value.

 Book value (Historical cost basis) is unlikely to give a realistic value, as it
is dependent on the business's depreciation and amortisation policy in
the business's use
 Replacement basis is suitable if the assets are to be used on an ongoing
basis
 Realisable basis is suitable if the assets are to be sold, or the business as
a whole broken up.
Market based Market value approaches to business valuation attempt to establish the
(also known as value of a business by comparing it to similar ones or “rule of thumb”
comparison averages for an industry by looking at trading multiples like P/E, EV/EBITDA,
based approach) or other ratios. These multiples become the foundation for the valuation of
the company. Market based methods include PER method, Earnings Yield &
Tobin Q’s market book ratio & stock market values.
Earnings/income Under the earnings/income approach, the valuation is based on the
based economic benefit stream (typically a form of net income) produced by the
business. This benefit stream is either capitalized or discounted to a present
value, and this amount becomes the foundation for the valuation of the
company. Earnings/income based methods include the, Earnings Yield,
Dividend Yield, PER method & super profits method.
Question 33
Explain the sources of information required for valuation
Information required for valuation is collected from internal and external sources of the
business. Valuation includes planning, identifying critical factors, documenting specific
information, and analysing the relevant information.
The mnemonic “CLICKFASTER” has been coined to help you remember the different sources
of information required for valuation. Your answer may not necessarily be in tabular format
but this will only help you remember the main points of discussion to earn marks.

Source Explanation
Cash flow & Profit These are valuable sources where a business is being valued on the
forecasts, budgets & basis of future expectations. These are useful when using a cash flow
projections or income based approach.
Legal Documents These comprise of all existing contracts of any kind including but not
limited to: distribution agreements, employee contracts, covenants
not to compete, supplier & franchise agreements, customer
agreements, leases, loan agreements, articles & memorandum of
association.
Industry commentaries These can prove to be valuable when using a market-based approach
since the approach will be to identify a comparable firm (same
industry, similar business and markets) and apply a suitable multiple
to value a business.
Certificates by This is a reliable source because it is provided by a professional valuer
independent valuers who possess the necessary qualification, ability and experience to
execute a valuation in an objective, unbiased & competent manner.
Key ratio analysis Reviewing financial ratios could help an analyst/valuer to spot the
company’s strengths and weaknesses, and compare its performance
to industry peers. One can uncover important trends in company’s
financial performance by examining the ratios over time. Such trend
analysis can help demonstrate how the company has improved or
fallen back within the period. Since business value is a forward
looking concept, such trends help in identifying significant business
risks likely to impact what the business is worth.
Financial Statements These include the SOP/L, SFP, SOCIE, SOCF & notes. These are the
basis upon which the business valuation is built.
Aged These help in determining or verifying values of debtors, creditors
receivables/payables & and inventories as elements of a business valuation exercise.
inventory summary

Stock Exchange The public equity markets represent an important source of market
capitalisation for many companies. These values can then be applied
to similar companies (subject to certain adjustments).
Tax Returns Tax returns are documents filed with a tax authority that report
income, expenses, and other pertinent tax information. Tax returns
allow taxpayers to calculate their tax liability which helps in the
establishment of the value of the business.
Economic data These include guides to economic analysis and forecasts and related
financial and economic data; and inflation data; bond yields and
interest rates; cost of equity capital data and related measures such
as equity risk and size premiums; and royalty rates and license fees
for intangible assets and intellectual property such as patents and
trademarks.
Registers for fixed These are valuable as information pertaining to the book values or
assets revalued amounts of non-current assets held by the business being
valued.
Question 34
A company earned $12m last year, with one million shares outstanding, had earnings per
share of $10 ($12m /1.2m). The current market price quoted at $120. Calculate earnings per
share, earnings yield and capitalised earnings value.
Profit after tax $12,000,000
Earnings per share = =
No.of shares 1,000,000
Earnings per share = $12 per share
Earnings per share (EPS) $12

Earnings yield = x 100 = x 100
Market price per share (MPS) $120
Earnings yield = 10%

If we assume that the company will maintain the same level of earnings, then the annual
maintainable expected earnings will be $12m.
Expected maintainable earnings

Capitalised earnings value =
Earnings yield
$12,000,000
Capitalised earnings value =
10%
Capitalised earnings value = $120
Question 35
What do you understand by the following debt management techniques?
i) Risk In Debt
ii) Rating of Debt Securities
iii) Design of Debit Issues
iv) Innovations in Debt Securities
v) Securitisation
vi) Bond Covenants
vii) Bond Refunding
viii) Duration
ix) Term Structure of Interest Rates
Debt management Explanation
technique
i Risk In Debt Investing in debt funds carries various types of risk. These risks
include Credit risk, Interest rate risk, Inflation risk, reinvestment
risk etc. But the key risks which needs be considered before
investing in Debt funds are Credit Risk and Interest Rate Risk.
Credit (default) risk is the chance that a borrower might not repay
the interest or principle on the committed date. It is measured by
“Credit ratings”. Credit rating agencies like CRISIL, ICRA, CARE etc.

rate the issuer of the bond on their ability to repay by assessing
their overall financial health. Interest rate risk which is the chance
that the interest rate will change thereby affecting the market
price of the debt instrument is measured using “Modified
Duration”. Modified duration measures the price sensitivity of the
bond for a given change in interest rate.
ii Rating of Debt Rating organisations evaluate the credit worthiness of an issuer
Securities with respect to debt instruments or its general ability to pay back
debt over the specified period of time. The rating is given as an
alphanumeric code that represents a graded structure or
creditworthiness. See separate table below for ratings of debt
securities.
iii Design of Debt There are three main types of factors that affect the design of debt
Issues issues: First, firm specific factors such as leverage, growth
opportunities and cash holdings are related with the convertibility,
maturity and security structure of issued bonds. Second, economy-
wide factors, in particular the state of the macro-economy, affect
the quality distribution of securities offered; in particular, during
recessions, firms issue fewer poor quality bonds than in good
times but similar numbers of high-quality bonds. Finally,
controlling for firm characteristics and economy-wide factors,
project specific factors appear to influence the types of securities
that are issued. Consistent with commonly stated ‘maturity-
matching’ arguments, long-term, nonconvertible bonds are more
likely to be issued by firms investing in fixed assets, while
convertible and short-term bonds are more likely to finance
investment in R&D.
iv Innovations in Debt One example of an innovation in debt securities has been inflation
Securities based/indexed debt instruments. Inflation-linked bonds are tied to

the costs of consumer goods as measured by an inflation index,
such as the consumer price index (CPI). Each country has its own
method for calculating those costs on a regular basis. The United
States, UK, India & Canada, have issued inflation-linked bonds.
v Securitisation Securitisation is the process of converting illiquid assets into
marketable securities. When a bank lends money to borrowers
they invariably try to lay off their risk exposure by a process of
securitisation. This involves selling the assets from the bank’s
statement of financial position to a company called a “special
purpose vehicle” (SPV) (these are usually institutional investors).
This sale generates cash for the bank in the short-term which can
be lent again, in an expanding cycle of credit information.
Securitisation started with banks converting their long-term loans
such as mortgages into securities and selling them to institutional
investors. Securitisation of loans and sale to investors with more
long-term liabilities reduces the mismatch problem and a bank's
overall risk profile.
vi Bond Covenants In the bond or debt market, a covenant will usually be a “financial
covenant” which specifies that, for example, the issuer will
maintain an interest coverage ratio over a certain level or a
leverage ratio (debt/equity) under a specific level. These ratios are
meant to constrain the issuer to financial prudence. Covenants can
also be “non-financial” in nature, such as providing financial
information to bondholders, protecting against the selling of
assets, or changes of control, or making sure the assets of the
company have adequate insurance. Both types of covenants are
utilised to restrict the borrowing firm from making decisions which
will deteriorate its financial health from the time of borrowing.
Covenants can also reward investors or punish borrowers based on

their financial health. Covenants can add coupon step-ups based
on credit metrics or credit ratings.
vii Bond Refunding Bond refunding is the concept of paying off higher-cost bonds with
debt that has a lower net cost to the issuer of the bonds. This
action is usually taken to reduce the financing costs of a business.
Bond refunding is particularly common under the following
circumstances:
 The bond issuer has experienced a credit rating increase, and
so can expect to obtain debt at a lower cost than had been the
case when the existing bonds were issued at a lower credit
rating.
 There is a substantial period of time over which the bond
issuer will have to continue paying interest on the existing
bonds, so refunding them will easily offset any related
transaction fees associated with the refunding.
 Interest rates are now at a lower level than they were when
the bonds were issued.
 The bond issuer can obtain replacement debt that carries
fewer restrictions than are imposed in the bond agreements.
For example, a bond agreement may state that no dividends
can be issued for as long as the bonds are outstanding.
Shareholders may pressure management to recall these bonds
in order to issue them a dividend.
viii Duration Duration is the average time taken to recover the cash flow from a
bond investment is not only affected by the maturity date of the
bond but also by the coupon rate (which determines the interest
payments). To be able to compare bonds quickly – this is where
duration is useful. Duration gives each bond an overall risk
weighting that allows two bonds to be compared. In simple terms,

it is a composite measure of the risk expressed in years. Duration is
the weighted average length of time to the receipt of a bond's
benefits (coupon and redemption value), the weights being the
present value of the benefits involved. If the duration of the fund
is high, the volatility of the fund is considered to be high and the
opposite is true.
ix Term Structure of The term structure of interest rates, also called the yield curve, is a
Interest Rates graph that plots the yields of similar-quality bonds against their
maturities, from shortest to longest. It shows the various yields
that are currently being offered on bonds of different maturities. It
enables investors to quickly compare the yields offered on short-
term, medium-term and long-term bonds. Main patterns created
by the term structure of interest rates are: Normal yield curve, Flat
yield curve, Inverted yield curve and Steep yield curve. If short-
term yields are lower than long-term yields, the curve slopes
upwards and the curve is called a positive (or "normal") yield
curve. A flat term structure of interest rates exists when there is
little or no variation between short and long-term yield rates. If
short-term yields are higher than long-term yields, the curve
slopes downwards and the curve is called a negative (or
"inverted") yield curve. A steep yield curve is a variation of the
normal yield curve, possessing the same basic properties; whereby
the interest rates paid on securities with shorter maturities is
lower than rates paid on debt with longer maturities. The shape of
the curve changes over time. Investors who are able to predict
how term structure of interest rates will change can invest
accordingly and take advantage of the corresponding changes in
bond prices.

Rating of debt securities
Symbol Rating Definition
AAA (Highest Safety) Instruments with this rating are considered to have the highest degree
of safety regarding timely servicing of financial obligations. Such
instruments carry lowest credit risk.
AA (Highest Safety) Instruments with this rating are considered to have high degree of
safety regarding timely servicing of financial obligations. Such
instruments carry very low credit risk.
A (Adequate Safety) Instruments with this rating are considered to have adequate degree
instruments carry low credit risk
BBB (Moderate Safety) Instruments with this rating are considered to have moderate degree
instruments carry moderate credit risk.
BB (Moderate risk) Instruments with this rating are considered to have moderate risk of
default regarding timely servicing of financial obligations.
B (High Risk) Instruments with this rating are considered to have high risk of default
regarding timely servicing of financial obligations.
C (Very High Risk) Instruments with this rating are considered to have very high risk of
default regarding timely servicing of financial obligations.
D (Default) Instruments with this rating are in default or are expected to be in
default soon.
Question 36
The following is the SOFP of Sliver Crest Ltd as at 31 March of the current year:

Additional information
i. Valuers have provided market estimates of the various assets as non-current assets
(FA) $16m, inventory $10.5m, debtors $5.5m. All the other assets are to be taken at
their SOFP values.
ii. The valuers also estimate the current sale proceeds of the firm’s assets in the event of
its liquidation as FA $13.5m, inventory $9m, debtors $5m. The firm is to incur $1.8 m
as liquidation costs.
iii. The company is yet to declare and pay dividend on preference shares.
Required:
Calculate the net asset value per share using the book value, market value and liquidation
value bases.
Book Value Market Value Liquidation Value
Basis Basis Basis
Non- Current assets (net) 15.00 16.00 13.50
Current assets
Inventory 10.00 10.50 9.00
Debtors 6.00 5.50 5.00
Cash & bank 1.50 17.50 1.50 17.50 1.50 15.50
Total assets 32.50 33.50 29.00
Less: Liabilities
10% Debentures 2.00 2.00 2.00
Trade creditors 8.50 8.50 8.50

Provision for tax 0.70 0.70 0.70
11% Preference share capital 5.00 5.00 5.00
Dividend on preference shares
(11% x 5.00) 0.55 (16.75) 0.55 (16.75) 0.55 (16.75)
Less: Liquidation costs - - (1.80)
Net assets available for equity
shareholders 15.75 16.75 10.45
Number of equity shares 0.14 0.14 0.14
Net assets value per equity share $112.50 119.64 74.64
Question 37
L Ltd agrees to acquire M Ltd based on its profit for the last 3 years. An earning yield is of
25%.
Required:
Calculate the value of the business on earning yield basis.
Average annual earnings
Value of business =
Earnings yield
Total profits
Average annual earnings =
No.of years
$29,400,000
Average annual earnings =
3 years
Average annual earnings = $9,800,000

Earning yield = 25% = 0.25

$9,800,000
Value of business =
0.25
Value of business = $39,200,000
ABOUT THE COMPILER OF SUGGESTED SOLUTIONS
Tawanda. T. Herbert is the Co-Founder and Managing Partner of Herbert and Co. Chartered
Accountants. Among other qualifications, he is a holder of the following qualifications:
ACCA, CIMA, CIS, M.Com in Applied Accounting and B.Sc. in Applied Accounting. He is also a
PHD in Accounting candidate.
For more information visit my website: www.herbertmentor.com

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FM QUESTIONS & SOLUTIONS

1 Compiled by T T Herbert (0773 038 651 / 0712 560 772) www.herbertmentor.com

2 Compiled by T T Herbert (0773 038 651 / 0712 560 772) www.herbertmentor.com

3 Compiled by T T Herbert (0773 038 651 / 0712 560 772) www.herbertmentor.com

4 Compiled by T T Herbert (0773 038 651 / 0712 560 772) www.herbertmentor.com

5 Compiled by T T Herbert (0773 038 651 / 0712 560 772) www.herbertmentor.com

6 Compiled by T T Herbert (0773 038 651 / 0712 560 772) www.herbertmentor.com

7 Compiled by T T Herbert (0773 038 651 / 0712 560 772) www.herbertmentor.com

Liquidity (Avoiding liquidity problems)

Conflicts with the financial objective of stockholder wealth maximisation

9 Compiled by T T Herbert (0773 038 651 / 0712 560 772) www.herbertmentor.com

Other possible conflicts

(b) Difficulties associated with managing organisations with multiple objectives.

10 Compiled by T T Herbert (0773 038 651 / 0712 560 772) www.herbertmentor.com

11 Compiled by T T Herbert (0773 038 651 / 0712 560 772) www.herbertmentor.com

12 Compiled by T T Herbert (0773 038 651 / 0712 560 772) www.herbertmentor.com

13 Compiled by T T Herbert (0773 038 651 / 0712 560 772) www.herbertmentor.com

(a) Corporate Objectives

(b) Financial objectives

14 Compiled by T T Herbert (0773 038 651 / 0712 560 772) www.herbertmentor.com

Corporate objectives are more business or commercially-oriented, as opposed to financially-

Therefore it will have to plan:

15 Compiled by T T Herbert (0773 038 651 / 0712 560 772) www.herbertmentor.com

16 Compiled by T T Herbert (0773 038 651 / 0712 560 772) www.herbertmentor.com

17 Compiled by T T Herbert (0773 038 651 / 0712 560 772) www.herbertmentor.com

18 Compiled by T T Herbert (0773 038 651 / 0712 560 772) www.herbertmentor.com

19 Compiled by T T Herbert (0773 038 651 / 0712 560 772) www.herbertmentor.com

20 Compiled by T T Herbert (0773 038 651 / 0712 560 772) www.herbertmentor.com

b) Calculation of sales revenue/net working capital

Sales Revenue 6,200 7,300

= 9.84 times = 8.44 times

21 Compiled by T T Herbert (0773 038 651 / 0712 560 772) www.herbertmentor.com

Where Co. = cost per order

EOQ = 5,478 whole units

b) Calculation of the total costs of holding and ordering using EOQ

Ordering costs (DQ x c) (50,000

22 Compiled by T T Herbert (0773 038 651 / 0712 560 772) www.herbertmentor.com

Holding costs (Q2 x h) (8,333

Ordering costs (DQ x c) (50,000

Holding costs (Q2 x h) (4,167

Ordering costs (DQ x c) (50,000

It has been proven that the EOQ is the cheapest option.

23 Compiled by T T Herbert (0773 038 651 / 0712 560 772) www.herbertmentor.com

Key points to note

Annual benefit of accepting the discount = 37.63%

If the discount is refused the payment to the supplier will be as follows:

24 Compiled by T T Herbert (0773 038 651 / 0712 560 772) www.herbertmentor.com

Where S = the amount of cash to be used in each time period

25 Compiled by T T Herbert (0773 038 651 / 0712 560 772) www.herbertmentor.com

26 Compiled by T T Herbert (0773 038 651 / 0712 560 772) www.herbertmentor.com

WIP conversion period

Finished goods conversion period

27 Compiled by T T Herbert (0773 038 651 / 0712 560 772) www.herbertmentor.com

Creditors conversion period (given) (16)

Where: S = increase in sales

28 Compiled by T T Herbert (0773 038 651 / 0712 560 772) www.herbertmentor.com

RI = [$4,500 – $2,400] (0.7) – $297.50

Velm Plc: SOFP as at 31 December 2002

29 Compiled by T T Herbert (0773 038 651 / 0712 560 772) www.herbertmentor.com

30 Compiled by T T Herbert (0773 038 651 / 0712 560 772) www.herbertmentor.com

b) Working capital policies

31 Compiled by T T Herbert (0773 038 651 / 0712 560 772) www.herbertmentor.com

32 Compiled by T T Herbert (0773 038 651 / 0712 560 772) www.herbertmentor.com