Financial Management Problem Solving

PROBLEM SOLVING SESSION
FINANCIAL MANAGEMENT (B1)
FOR NOV 2019 EXAMS
[SET 3]
Prepared By: Godson Mkaro (Jr): MSc Finance & Investment, BSc. Computer Science, ATEC II, CPBE, CPA (T) &
Emmanuel Christopher: MBA (Finance), B.Com Accounting (Hons), CPA (T) |Phone1: +255 717 / 769 348 616 |
Phone2: +255 714 965 564 | Email us to: info@covenantfinco.com |Visit our Website at: www.covenantfinco.com
FINANCIAL MANAGEMENT (B1) PROBLEM SOLVING SESSION FOR NOV 2019 [SET 3]
QUESTION ONE [INVESTMENT APPRAISAL WITH SENSITIVITY ANALYSIS]

Tutachomoka Ltd is considering investing $50,000 in a new machine with an expected
life of five years. The machine will have no scrap value at the end of five years. It is
expected that 20,000 units will be sold each year at a selling price of $3.00 per unit.
Variable production costs are expected to be $1.65 per unit, while incremental fixed costs,
mainly the wages of a maintenance engineer, are expected to be $10,000 per year.
Tutachomoka Ltd uses a discount rate of 12% for investment appraisal purposes and
expects investment projects to recover their initial investment within two years.
REQUIRED:
(a) Evaluate the sensitivity of the project’s net present value to a change in the
following project variables:
(i) Sales price
(ii) Sales volume
(iii) Variable cost
(iv) Discount Rate
(v) Identify the critical variable of the investment discuss the use of sensitivity
analysis as a way of evaluating project risk. (15 marks)
(b) Upon further investigation it is found that there is a significant chance that the
expected sales volume of 20,000 units per year will not be achieved. The sales manager of
Tutachomoka Ltd suggests that sales volumes could depend on expected economic states
that could be assigned the following probabilities:
Economic state Poor Normal Good

Probability 0.3 0.6 0.1
Annual sale volume (units) 17,500 20,000 22,500
REQUIRED:
Calculate and comment on the expected net present value of the project (5 marks)
QUESTION TWO [COST OF CAPITAL]

Geti Maji Company wishes to calculate its Weighted Average Cost of Capital (WACC)
and the following is the current information relating to the company.
Number of ordinary shares 2 million

Number of 5% Tshs 100 non-callable preferred stock 1 million
Book value of 10%, Tshs 1,000 irredeemable bonds Tshs 20 million
Market price of ordinary shares Tshs 50 cum dividend
Market price of 5% Tshs 100 non-callable preferred stock Tshs 43ex dividend
Total dividend just paid Tshs 4 million
Market price of 10% Tshs 1,000, irredeemable debt 105 percent ex interest
Prepared By: Godson Mkaro (Jr): MSc Finance & Investment, BSc. Computer Science, ATEC II, CPBE, CPA (T),
Phone1: +255 714 965 564 | Email: info@covenantfinco.com |Website: www.covenantfinco.com Page | 1
Equity beta of Geti Maji company 1.5

Treasury bill rate 5%
Expected return on the market 12%
Additional information
1. The corporate tax rate applicable to Geti Maji company is 15%
2. The dividends of Geti Maji Company are expected to grow at an average rate of 6%
REQUIRED
(a) Estimate the Geti Maji Company’s equity risk premium and the cost of equity using
the Capital Asset Pricing Model (CAPM) (3 marks)
(b) Calculate the market value Weighted Average Cost of Capital of Geti Maji Company
using
(i) The dividend growth model (6 marks)
(ii) The Capital Asset Pricing Model (6 marks)
(c) Discuss whether the dividend growth model of the CAPM offers the better estimate
of the cost of equity of a company (6 marks) [Total: 20 marks]
QUESTION THREE [FINANCIAL STATEMENTS ANALYSIS AND INTERPRETATION]

(a) NASACO Ltd. was completely destroyed by fire and all accounting and financial
information was burnt. However, on-going through the Director of Finance’s briefcase
which was salvaged by the owner, the following key data for the accounts for the year
ended June 30, 2019 were found:
i) Current ratio 1.75
ii) Liquid Ratio 1.25
iii) Stock Turnover (Cost of Sales / Closing Stock) 9
iv) Gross Profit Ratio – 25% of sales
v) Debt Collection Period – 1 1 months
2
vi) Reserves and Profit and Loss to Capital – 2
vii) Turnover to Fixed Assets – 1.2
viii) Capital Gearing Ratio – 0.6
ix) Fixed Assets to Net Worth – 1.25
x) Sales for the year Shs. 1,200,000,000
REQUIRED:
Reconstruct the Balance Sheet of NASACO Ltd., as at June 30, 2019 using the above
information. (12 Marks)
(b) Business A and Business B are both engaged in retailing, but seem to take a different
approach to this trade according to information available. This information consists of
ratios, as shown in the table below:
Business A Business B
Current Ratio 2:1 1.5:1
Quick Ratio 1.7:1 0.7:1
Return on Capital Employed 20% 17%
(ROCE)
Return on Owners’ Equity (ROE) 30% 18%
Debtors’ Turnover (days) 63 days 21 days
Creditors’ Turnover (days) 50 days 45 days
Gross Profit Margin 40% 15%
Net Profit Margin 10% 10%
Stock Turnover (days) 52 days 25 days
REQUIRED:
Describe what this information indicates about the differences in approach between the
two businesses. If one prides itself on personal services to its clients and one of them on
competitive prices, which do you think is which and why?
Your answer should include a discussion on profitability, liquidity, efficiency and
gearing of the two businesses. (8 Marks) (Total:20 Marks)
BONUS QUESTION [INTRODUCTION TO FINANCIAL MANAGEMENT]
(a) Explain the term Agency problem in relation to a Public Limited Liability Company?
(b) As a Finance expert, explain THREE practical steps to manage agency problem in
public limited liability companies.
(c) Profit maximization is the core objective of shareholders in Public limited Liability
Companies.
(i) Identify and explain THREE other non-financial objectives that can be pursued by
a Public limited liability Company.
(ii) Why is shareholders wealth maximization the central goal of the firm in finance
and not profit maximisation?
ANSWER TO BONUS QUESTION

(a) Agency problem occurs when managers or management take decisions that are not
consistent with the objectives of shareholder value maximization. Contributors to this
agency problem are: divergence of ownership and control, goals of managers differing from
those of shareholders because of personal interest and asymmetry of information between
managers and shareholders.
(b) Use of performance related reward scheme: in the form of pay and bonuses based on
satisfactory performance of managers in delivering shareholder value
• Executive share option scheme: where managers or executives are allowed to buy the
shares of the company at a fixed price within a particular period. The option will only
have value if the market price is better than the price, they will pay for exercising the
option. This will encourage goal congruence between managers and shareholders.
• Threat of firing or dismissal: Managers or directors can be forced out by the
shareholders if they are unhappy with their performance through shareholder
meetings. This method can put pressure on managers or directors to perform.
• Key Market participants like institutional investors such as fund managers, pension
houses, insurance companies who have larger shareholdings can exercise that to push
managers to perform or be voted out.
• Monitoring and control of managers performance through the use of external and
internal auditors, Board committees and review consultants.
(c) Goal of the firm
(i) The following are other objectives:
• Staff motivation
• Top service to customers
• Growth
• Market leadership in research and development
• Social responsibility
• Environmental sustainability
• Diversification purposes etc.
(ii) Why not aim at profit maximization?
• Prospects- two firms with identical profits may be valued differently by
shareholders due to their growth potential. Recent profit figures fails to display the
growth potential
• Risk- variability of returns is not displayed in profit figures and two firms with
identical profits may be exposed to different risk scenarios and hence different value
before the eyes of shareholders
• Accounting problems- judgment and guesswork, it hinges on accounting principles
• Communication-profit does not communicate strategies and sources of future
income as well as investment plans.
• Profit is a vague term – gives rise to ambiguity
• Profit ignores timing (time value of money)
• it ignores risk – quality of expected benefits

Financial Management Problem Solving

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Financial Management Problem Solving

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PROBLEM SOLVING SESSION

FINANCIAL MANAGEMENT (B1)

FOR NOV 2019 EXAMS

QUESTION ONE [INVESTMENT APPRAISAL WITH SENSITIVITY ANALYSIS]

Economic state Poor Normal Good

QUESTION TWO [COST OF CAPITAL]

Number of ordinary shares 2 million

Equity beta of Geti Maji company 1.5

QUESTION THREE [FINANCIAL STATEMENTS ANALYSIS AND INTERPRETATION]

BONUS QUESTION [INTRODUCTION TO FINANCIAL MANAGEMENT]

ANSWER TO BONUS QUESTION

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