of = 0 Tak {Ne a \ cp 4 y DG oe we si Y v awe We gy ht gr =< bee Fay Erol) wee dt DVR fa - Ree mooie Erp). NB tuk Br 3 wasp nie > oe Khe ty The Institute of Chartered Accountants (Ghana)‘Appendix Rp = Rax + Re(1— x) = Pam B= Om Modigliani and Miller No tax With tax Dt WACGe = WACCy WACC, = wace,[1 eal Vo=Vy+Dt Keg D Kyu + (105 (Kau ~ Ko) Modigliani and Miller and CAPM aac x D(1-t) Px Bese pty * Expat Pn = Bes * Annuities — compounding factors Ordinary annuity ‘Annuity due xd +n*- XQtnP—1 sna sn = * 5 x(Q+r) Annuities - cumulative discount factors Method 1 Method 2 aig) (ease Internal rate of return NPV, IRR = A% + (wn) x (B-A)% Economic order quantity Miller Orr 3 -ansaction cost x Variance of cash re) see ax Spread = 3 x Interest rate (as a proportion) ‘© Emile Woot Intemational 259 The institut of Chartered Accountants (Ghana)Financial Management FORMULAE Dividend valuation model wv=% ae : -¢ weed Dividend valuation model with growth _ da +8) aa +g) ee ev +8 Geometric mean growth rate value at end of period of n years Geometric mean growth rate -1 value at start Valuation and cost of irredeemable debt i "= a ima Posttax rg = “C=O wacc wace = "is ot Covariance ZE-HY-7 Covariance, = =&- 9-9 _ Govarianceyy Pay = Say Correlation coe! n&ay-Exdty V (nd? = (2x))nLy? — (Ly) Portfolio theory Op = Jon?x? + o92(1 — x)? + 2x(1 — X)PqgFaoR ‘GEmile Woo! iniemational —— 288, ~The institute of Chartered Accountants (Ghana)Appendix CUMULATIVE DISCOUNT FACTORS TABLE This table shows the annuity factor for an amount at the end of each year for n years at r%. Interest rates (@) Periods (o) 2% 3% Mh 5% 7% 8% 8% 10% 1 0.980 0.971 0.962 0.952 0.943 0935 0926 0917 0.908 2 1.942 1913 1886 1.859 1833 1.808 1.783 1.759 1.736 3 2.884 2.829 2778 «2.723 2673 2.624 2577 2531 2.487 4 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170 5 4713 4.580 4.452 4,329 4.212 4.100 3.993 3.890 3.791 6 5795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355 7 6728 6472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868 8 7652 7.325 7.020 6.733 6.463 6.210 5971 5747 5535 5.335 9 | 8566 8.162 7.786 7.435 7.108 6.802 6515 6.247 5.995 5.759 10 9471 8.983 8630 8.111 7.722 7.360 7.024 6710 6418 6.145 1 10.368 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 8.495 12 11.285 10875 9.954 9,385 8.863 6.384 7.043 7.536 7.161 6.814 3 12.194 11.348 10635 9.986 9.304 8.853 8.358 7.904 7.487 7.103, 14 13.004 12.106 11.296 10.563 9.899 9.295 8745 8244 7.786 7.367 18 13.865 12.849 11.938 11.118 10.380 9.712 9.108 8.559 8061 7.606 16 14.718 13.578 12.561 11.652 10838 10.106 9.447 8851 8313 7.824 7 15.562 14.292 13.166 12166 11.274 10477 9.763 9.122 8.544 8.022 18 16398 14.992 13.754 12659 11.690 10828 10.059 9372 8756 8201 19 17.226 15679 14.324 13.134 12.085 11.158 10.336 9,604 8.950 8.365 20 18.046 16.351 14.878 _13.590_12.462_11.470 10.594 9.818 9.129 8.514 Interest rates (@) Periods oo) 11% 13% 14% 15% 16% 7% 8% ——t9% 20% | 1 0.901 0885 0877 0.870 0.862 0685 0.847 0.840 0.833, 2 1.713 1.668 1.647 1.626 1.605 1.585 (1.568 1.547 1.528. 3 2444 2361 2322 2283 2248 2210 2174 2140 2.106 4 3.102 2974 2.914 2.855 2798 2743 2690 2639 2.589 5 3.698 3517 3433 3.352 3274 3.199 3.127 3.058 2.991 6 4231 4.111 3998 3.889 3784 3685 3589 3498 3.410 3.326 7 A712 4.564 4423 4,288 4.160 4.039 3922 3812 3.706 3.605 8 5.146 4.968 4799 4639 4.487 4344 4.207 «4.078 «3.954 3.837 8 8537 5.328 6.132 4.946 4772 4607 4451-4303 4.163 4.031 10 5889 5.650 5425 5216 5019 4833 4.659 4.494 4.399 4.192 1 6207 5.938 5687 5453 5.294 5.029 4.836 4.656 4.486 4.327 2 6492 6.194 5.918 5660 5421 5.197 4.968 4793 4611 4.439 3 6750 6424 6.122 5842 5583 5.342 5.118 4910 4715 4533 “4 6.982 6.628 6.302 6.002 5.724 5.468 5.229 5.008 4.802 4611 15 7191 6811 6462 6.142 5847 5575 5.324 5.092 4.876 4.675 16 7379 6874 6604 6265 5.954 5668 5405 5.162 4.938 4.730 7 7549 7.120 6720 6373 6047 5.749 5475 5.222 4.990 4775 18 7.702 7.250 6840 6467 6128 5818 5534 5.273 5.033 4.812 19 7.839 7.366 6938 6550 6198 5877 5584 5316 5.070 4.843. 20__| 7.963 __7.469_7.025 6.623 6.259 5.929 5.628 5.353 5.101 4.870 Emile Woo! international 257 "The Insitute of Gharlred Accountants (Ghana)Financial Management SINGLE PERIOD DISCOUNT FACTORS TABLE This table shows the discount factor for an amount at the end of n periods at r% Interest rates @) Periods | | 4% am me ESSER Oy NS THESE AN RE ORT +) “980-9807 2943985 G26 917 09 2 980 961943925 g07 80073 a5? mana 3 | e742 915889 aed dS 7847? get 4 | 961 94 p88 85523 792703735708 5 | 91 905863 gze 78a 47713681680 gt S | 2 88 37790748705 66860598 7 | 933 97113750711 6656235035? 8 | 923 853789731677 627502 a0 se a7 9 | 94 B37 766703645592 544 500 a0 nd 10 | 905 820744 67614558508 aes azo 1 896 804 722 650, 585 527 475 429 388 350 12 | sar 788 701625557497 ada 30788 gt 13 | 879773 est 601530488 a8 368 06200 14 | 870758 6815775054238 34020063 16 [ser 4s aee seed at? ges 278 208 ee Oe 7 844 714 605 513 436 371 317 270 231 198 18 | 696 700587 498416350 208.50 i280 19 | 28 688570475306 331 ar? 202 08a 20 |_s20 673 sss 4585773122885 17814 interest rates Periods i) | 11% 13% __14% 18% 106% 17% 10% 19% 20% | 4 ~ 901 885, 877 870 855 847 840 833, ae area 783769756 731718705 694 3) 71 693 675658 624 609593579 4 | 650 613 592672 so 51649982 5 | ss S43 519497 45643741940 5 | 535 sor 480 ase 49210300 a7) a2 as 7 | 482 4582 4254003765433 at 208279, 8 434 404376851327 305205268 249209 Cpe el Sy to | 352 a2 295270 2a? 22720 to1 te t82, || ee ee A eT ial ae |e 200 ba 207 game 2s ee 20 ee 127m ca ee ico eae Tat marae ee Ce yy a 4 232205 t81 160 tat 25 111009088078 18 | 2a 483160 uo 23408008) 0et ark 005 16 | 188 163, 144 123 407 093 081 074 062 054 17 | 170 146 125 108 093 080 069 060 052 045 18 453.130 111095081 0690580510008 19 | 198 416.098 083.070 060-051 04307 oat 20__| 14104 087073 061051043097 03008 ‘© Emile Woolf international ——— “The Insitute of Chattored Accountants (Ghana)Professional level Financial Management Appendix Contents 1 Single period discount factors table 2 Cumulative discount factors table 3. Formulae ~The institute of Chartered Accountants (Ghana)Financas Management © Emile Woo int 254 ‘The Institute of Chartered Accountants (Ghana)Answers to ICAG past exams little help to the investor during a period where economic conditions have changed significantly in a short period of time. Quality of earnings not considered — The last several months have been the perfect example of how a company can really inflate their earnings to look better than they really are. Many banks were able to do this for months, and because of that investors that solely used the P/E ratio would have thought they were great buys. In retrospect if the investor had been looking at other parts of the balance sheet they may have seen inflated earnings as a real issue. The price doesn't consider debt ~ Companies with major debt issues are obviously higher risk investments, but the P in the P/E ratio only considers the equity price and does nothing with the debt that the business has to continue with operations. As we have found out over time, excess debt can be a real problem, and the market price of a stock isn’t always a good gauge of fair value. Uses profit which is not cash. ‘@ Erle Woof Intemational 253, ‘The Inefitute of Chartered Accountants (Ghana)CLEAR TEL LTD (a) The Three Basic Forms of the EMH ‘G Emile Wool iniematonal 352 Te insite 0 ‘The efficient market hypothesis assumes that markets are efficient. However, the efficient market hypothesis (EMH }) can be categorized into three basic levels: Weak-Form EMH ‘The weak-form EMH implies that the market is efficient, reflecting all market information. This hypothesis assumes that the rates of return on the market Should be independent; past rates of return have no effect on future rates. In this event that the stock market has weak-form efficiency, the price of Clear Tel will move in ine with historical changes. ‘Semi-Strong EMH The semi-strong form EMH implies that the market is efficient, reflecting all Publicly available information. This hypothesis assumes that stocks adjyet Quickly to absorb new information. The semi-strong form EMH also incorporates the weak-form hypothesis. Given the assumption that stock Prices reflect all new available information and Clear Tel purchase stocks after this information is released, Clear Tel cannot benefit over and above the market by trading on new information, ‘Strong-Form EMH The strong-form EMH implies that the market is efficient: it reflects all information both public and private, building and incorporating the weak- form EMH and the semi-strong form EMH. Given the assumption that stock Prices reflect all information (public as well as private) Clear Tel would not be able to profit above the average investor even if he was given new information. Restwell Ltd @ Year GHg000 DF (12%) — GH¢o00 20x1 6,000 0.893 5,358 20x2 6,200 0.797 4,941.4 20x3 6,300 o7i2 4,485.6 20x4 6,300 0.636 4,006.8 The value of the company based on the present value of expected earings is GH¢18,791,800. (ii) Problems associated with P/E method for valuing firms * Doesn't account for growth — The price to earings ratio doesn't account for any type of growth or the lack of growth. The fact that growth isn't factored in means that older more mature stocks are typically going to appear cheaper even if they aren't growing if you use the P/E ratio. For many investors growth is a variable they do not want to exclude. * Backward looking ~ The P/E ratio is actually a backward looking indicator if you use the company’s most recent full year earnings number. A backward looking number can be of very ‘Chartered Accountants (Ghana)‘Answers to IGAG past exams financing the foreign currency transaction. It converts the obligation to a domestic-currency payable and removes all exchange risks. + Options ~ A foreign currency option is a contract that has an upfront fee, and offers the owner the right, but not an obligation, to trade currencies in a specified quantity, price, and time period. Risk Shifting - The most obvious way is to not have any exposure. By invoicing all parts of the transactions in the home currency, the firm can avoid transaction exposure completely. However, itis not possible in all cases. * Currency risk sharing - The two parties can share the transaction risk. As the short-term transaction exposure is nearly a zero sum game, one party loses and the other party gains% + Leading and lagging - It involves playing with the time of the foreign currency cash flows. When the foreign currency (in which the nominal contract is denominated) is appreciating, pay off the liabilities early and collect the receivables later. The first is known as leading and the latter is called lagging. + Reinvoicing centers ~ A reinvoicing center is a third-party corporate subsidiary that uses to manage one location for all transaction exposure from intra-company trade. In a reinvoicing center, the transactions are carried out in the domestic currency, and hence, the reinvoicing center suffers from all the transaction exposure. = Netting 4 ADJAYE LTD New level of sales will be 1,500,000 « 1.15 Variable costs are 80% x 75% = 60% of sales Contribution from sales is therefore 40% of sales 1,725,000 GHE GHe Proposed investment in debtors = 1,725,000 x 60/365 283,562 Current investment in debtors = 1,500,000 « 30/365 123,288 Increase in investment debtors 160,274 Increase in contribution = 15% x 1,500,000 x 40% “90,000 New level of bad debts = 1,725,000 4% 69,000 Current level of bad debts = 1,500,000 x 1% 15,000 Increase in bad debts ~~ (54,000) Additional financing costs = 160,274 * 12% (19,233) Savings by introducing change in policy 16,767 Decision The financing policy is financially acceptable, although the savings are not great. ‘© Emile Woolf Intemational 251 ‘The Institute of Chartered Accountants (Ghana)Financial Management ‘B Emile Woot Intemational Weighted average cost of capital 1,203.52 “S700 = 17-965% or 18% Calculation of the net present value of project GH¢ PV of annual net cash inflow 30,000/0.18 166,667 Less PV of initial outlay (150,000) NPV 16,667 Decision Based on NPV criterion, the acceptance of the project is worthwhile. Transaction exposure — This arises from the effect that exchange rate fluctuations have on a company's obligations to make or receive Payments denominated in foreign currency. This type of exposure is short-term to medium-term in nature. Transaction exposure is driven by transactions which have already been contracted for and hence they are of short term nature. For example: if Company A, based in the US has already supplied goods worth $100 Mio to another Company B in the UK and has agreed to receive the payment in GBP, it has already undertaken transaction risk on cash flows. Economic (or operating) exposure — This is lesser-known than the Previous two, but is a significant risk nevertheless. It is caused by the effect of unexpected currency fluctuations on a company's future cash flows and market value, and is long-term in nature. The impact can be substantial, as unanticipated exchange rate changes can greatly affect a company's competitive position, even if it does not operate or sell overseas. For example, a Ghanaian furniture manufacturer who only sells locally still has to contend with imports from Asia and Europe, which may get cheaper and thus more competitive if the dollar strengthens markedly. Ways of mitigating transa The most common methods for hedging transaction exposures are ~ n exposure + Forward contracts - Ifa firm has to pay (receive) some fixed amount of foreign currency in the future (a date), it can obtain a contract now that denotes a price by which it can buy (sell) the foreign currency in the future (the date), This removes the uncertainty of future home currency value of the liability (asset) into a certain value, + Futures contracts - These are similar to forward contracts in function. Futures contracts are usually exchange traded and they have standardized and limited contract sizes, maturity dates, initial collateral, and several other features. In general, is not possible to exactly offset the position to fully eliminate the exposure, * Money market hedge ~ Also called as synthetic forward contract, this method uses the fact that the forward price must be equal to the current spot exchange rate multiplied by the ratio of the given currencies’ riskless returns. Itis also a form of 250 ‘The Institute of Chartered Accountants (Ghana)Answers to IGAG past exams Itis only if the shareholder does nothing that his wealth position will be reduced. As long as all the rights are either sold or exercised his wealth position will be unchanged, This is not surprising because the theoretical ex-rights price has been calculated as a weighted average Of the old price and the price of the right. 3 OKECHUKWU LTD (a) Calculation of cost of capital (i) Cost of equity capital D(1+g) = + Ke= yy +9 Where D = Dividend proposed 9 rowth rate of dividend Mv x div market value of shares GH¢0.20(1.15) GHEE 20 — O20 + 9-15 = 0.196 oF 19.6 % (ii) Cost of preference shares 08 _ 0.16 or 16% os0 10°" (iii) Cost of redeemable debentures: ‘Year Value DF at PV DF at PV 12% 14% 0 Current (80) 1 (80) 1 (80) 1-12 Interest 10 TAT 74.7 6.62 66.2 20 Redemption value 110 o10 44 007 7.70 NPV 570 (6.10) Cost of redeemable debentures = By interpolation: 57 126 + eyez (14 — 12)% = 12.97% (iv) Calculation of weighted average cost of capital Market value Cost of Weighted capital cost GH¢e % GH¢ Ordinary shares 5,000 19.6 980 Preference shares “ 100 16 16 Debentures 1,600 12.97 207.56 6,700 1,203.52 ‘© Erle Woot international 28 ‘The Institute of Chartered Accountants (Ghana)Financial Management (ii) © @ (ii) (iy ‘GE mile Wool niemational has increased from 20% (62-4/312-4) to 29% (102:4/352:4). The WACC calculation assumes that the cost of equity has not changed, when in reality the cost of equity might be expected to rise in response to the increase in financial risk caused by the new issue of debt. The share price of the company has also been assumed to be constant, Theoretical ex-right price GH¢ 4 existing shares @ ¢3 12 1/5 Right share @ ¢2 2 14 Theoretical ex-right value of the shares = = GH¢2.80 Value of a right = Theoretical ex-right prices — rights prices = GH¢2.80 — GH¢2.0 = GH ¢0.80 Value of an existing share required to purchase a right = 588080 — GHg0.20 Sells the rights Pre-rights wealth = 1,000 shares @ ¢3.00 43,000 GH¢ Cash from selling rights = 1,000 x ¢0.20 200 Value of shares ex-rights = 1,000 x 2.80 2,800 _ Total wealth 3,000 Exercise half and sells the other half Allowed 1,000/4 = 250 rights; purchases 125 @ ¢2.00; sells half and gains 125 * ¢0.80. F re-rights wealth = 1,000 shares @ ¢3.00 43,000 GH¢ After rights issue: Old shares 1,000@ ¢2.80 2,800 New shares 125 @ ¢2.80 350 Cash from sale 125 @ ¢0.80 100 Total wealth after right issue __ 3,000 Does nothing GH¢ Pre-tights wealth after rights issue 3,000 After rights wealth GH¢ Old shares 1,000 @ ¢2.80 2,800 Total wealth 2,800 Bae ‘The inslute of Chantred Accountants (Ghana)Answers to ICAG past exams 2 VISTA HOTEL (a) (i) (ii) ‘© Emile Woolf Intemational Cost of equity Geometric average dividend growth rate = (21-8/19-38)0.25 ~ 1 = 0-0298 or 3% Using the dividend growth model, ke = 0-03 + ((21-8 x 1-03)/2.5) = 0-03 + 8.9816 = 9.0116 x 100% = 901.16% Market values of equity and debt. Market value of equity = Ve = 100m x 2-50 = GH¢250 million Market value of bonds = Vd = 60m x (104/100) = GH¢62°4 million Total market value = Ve + Vd = 250 + 62-4 = GH¢312-4 million WACC before new issue of bonds takes place The current after-tax cost of debt is 7% WACC = (ke Ve) + (kd(1 - T) x Va)/(Ve + Vd)) = ((901.16 x 250m) + (7 x 62:4m))/312-4m = 7.2256 x 100% = 72.56% The weighted average after-tax cost of capital before the new issue of bonds is 722.56% WACC after new issue of bonds takes place After-tax cost of debt of new bond issue After-tax interest rate = 8 x (1 — 0-3) = 5-6% per year Using interpolation: Year Cash flow ¢ Discount at 5% Pv 0 Market price -100 1.0 -100 1-10 Interest 56 7722 43.24 10 Redemption 105 0614 64.47 771 Year Cash flow ¢ Discount at 6% PV oO Market price -100 1.0 -100 1-10 Interest 5.6 7.36 41.22 10 Redemption 105 0.558 58.59 0.19 After-tax cost of debt = 5 + [((6 ~ 5) x 7-71)(7-71 + 0-19)] = 5 + 0-98 = 5:98% or 6% WACC after new issue of bonds The market value of the new issue of bonds is GH¢40 million The total market value of Sevista Hotel increases to 312-4 + 40 = GH¢352-4 million WACC = (901.16 * 250m) + (7 x 62:4m) + (6 x 40))/352-4m = 641.5% or 642% After the new issue of bonds, the weighted average after-tax cost of capital has decreased from 722.56% to 641.5% because the proportion of debt finance, which has a lower required rate of return than equity finance, has increased. Gearing on a market value basis "247 “The institute of Chartered Accountants (Ghana)Financial Management (c) Reasons for ma: finan ‘© Emile Wool ntemational Several measures are used to evaluate managers’ performance. Some of the most common are sales, profit, current value of expected cash flows and value added. * Shareholder control and interference Shareholders can influence the company's management in two ways. Firstly, they can influence management directly as to how the company should be managed. Secondly, any shareholder can make a proposal which is voted on at the annual general meeting (AGM). * Threat of dismissal In the past it seldom happened that a senior manager or chief executive officer was dismissed by shareholders. The reason for this was possibly that the ownership of a great number of companies was dispersed, as well as the fact that the agency problem was only brought to the attention of shareholders (and management) over the past two decades. * Threat of take-overs The threat of a take-over serves to monitor the actions of management. If the actions or decisions of management decrease the future earnings or value of shareholders, the share price usually decreases as well. In some instances, the company can become a take-over target. If the management of such a company is replaced, the move can benefit the shareholders. The threat of take-overs can thus serves as an external control mechanism which ensures that the decisions and actions of management maximize shareholders’ wealth. ization of a company’s share price as preferred objective It serves the interests of owners, (shareholders) as well as other stakeholders in the firm; i.e. suppliers of loaned capital, employees, creditors and society. I" is consistent with the objective of owners’ economic welfare. The objective of wealth maximization implies long-run survival and growth of the firm, It takes into consideration the risk factor and the time value of money as the current present value of any particular course of action is measured. ‘The effect of dividend policy on market price of shares is also considered as the decisions are taken to increase the market value of the shares. ‘The goal of wealth maximization leads towards maximizing stockholder’s utility or value maximization of equity shareholders through increase in stock price per share. 243 ~The Institute of Chartered Accountants (Ghana)MAY 2018 1 xx (a) iy (il ‘© Emile Woo! Intemational ‘Answers to IAG past exams Changes in interest rates affect the public's demand for goods and services and, thus, aggregate investment spending. A decrease in interest rates lowers the cost of borrowing, which encourages businesses to increase investment spending Lower interest rates also give banks more incentive to lend to businesses and households, allowing them to spend more. Higher interest rates may make the corporate sector pessimistic about future business prospects and confidence in the economy. This ay further reduce investment in the economy. Higher interest rates will increase mortgage payments and will thus reduce the amount of disposable income in the hands of home buyers for discretionary spending, Higher interest rates encourage savers to save as more interest will be eared from their savings or investments The agency problem is a conflict of interest inherent in any relationship where one party is expected to act in another's best interests. Within the context of limited liability company, the agency problem usually refers to a conflict of interest between a company's management and the company's stockholders. The manager, acting as the agent for the shareholders, or principals, is supposed to make decisions that will maximize shareholder wealth even though it is in the manager's best interest to maximize his own wealth. Causes of agency problem + Managers prefer greater levels of consumption and less intensive work, as these factors do not decrease their remuneration and the value of the company’s shares that they own; + Managers prefer less risky investments and lower financial leverage, because in this way they may decrease the danger of bankruptcy, and avoid losses on their managerial capital and portfolios; + Managers prefer short-term investment horizon; . Managers avoid problems stemming from reductions in employment levels, which increase with the changes in control of a company, + Managers also fear rocking the boat to deliver shareholder value and will rather choose operating in their comfort zones. Remedies of agency problem + Managerial Compensation: Managerial compensation refers to the incentive mechanism for the good performance of the management. Their objectives are to attract and retain able managers and to harmonize managerial actions with the interest of shareholders, 245 ‘The Institute of Chartered Accountants (Ghana)Financial Management (b) ‘Summary Company Per Share GH¢ GH¢ Net asset value 247,500 0.025 P:E (Low) 2,100,000 0.210 P:E (High) 2,394,263, 0.239 Dividend yield (no growth) 666,666.67 0.067 Dividend yield (with growth) 750,000.00 0.075 Standard devi Standard deviation, or total risk, is the square root of the weighted average deviation of the returns on the individual stocks in a portfolio from the mean return, E.g. for a two asset portfolio, the Standard Deviation (= the total risk of the portfolioll) = a, = y{Xzo0? + X30} + 2X,XpPi2} The standard deviation or total risk can be broken down into two forms, namely: unsystematic risk which is diversifiable and systematic risk which is undiversifiable. Beta Beta is the slope of a regression line, and it equals the covariance of the return on a security with the return on the market divided by the variance of, the market return: n Betai = covim / « m2 Beta measures the sensitivity of a stock's retum to the retum on the market portfolio. The market portfolio is a portfolio of all assets in the economy. In practice a broad stock market index, such as the S&P Composite, is used to represent the market. By definition the Beta of the market portfolio is one and that of the risk free asset is zero. While beta does not directly measure risk, itis a crucial risk indicator, reflecting the extent to which the returns on the single asset move with the market. Appropriate measure For an investor with an undiversified portfolio, it is total risk or standard deviation which is the most appropriate measure of risk. Unlike standard deviation, Beta is not a measure of total risk but a measure of relative risk, the risk of an asset relative to the market. Beta is also a measure of market risk. Market risk accounts for most of the risk of a well- diversified portfolio. ‘© Emile Wool international 2a The Insitute of Chartered Accountants (Ghana)(ii) (ii) (iv) ‘Answers to ICAG past exame PIE Ratio: Choosing the appropriate earnings figure: As a company with significant growth since its start up, it would not be correct to believe that past earnings are an appropriate measure for valuation. Future earings should be used. Usually if no other information about the future is available one would use the latest earnings figure and forecast that next year equals this year, i.e. GH¢250,000. We could however take the average of forecast earnings based on the directors’ assessment of growth prospects for the next three years: Year 200 20Y1 20Y2 Average Profits GH¢262,500 GH¢275,625 GH¢316,969 GH¢285,031 Choosing the appropriate rati The only P/E ratio for an earnings basis valuation given is that of 14 times for the quoted company. This should be reduced by about 40%, to about 8.4, to allow for unquoted status. A share valuation on an expected earnings basis might be as follows: P:E Ratio Eamings Valuation #of Shares Value per Share 84 GH¢250,000 GH¢2,100,000 10,000,000 GH¢0.210 84 GH#285,031 GH¢2,394,263 10,000,000 GH¢0.239 Dividend yield with no growth The gross dividend yield for shareholders in the quoted company was 10%, and it is reasonable to suppose that investors in LHW Ltd Would require at least this yield, (perhaps increased to allow for unquoted status, e.g. 14%). Again, usually if no other information about the future is available or one is unhappy with the forecasts given, one would use the latest dividend figure and forecast that next year equals this year, i.e. GH¢ 100,000. A yield basis valuation would therefore be: GH¢ 100,000 / 0.1= GH¢1,000,000 = GH¢0.10 per share. (Or GH¢100,000 / 0.14 ="GH¢666,666.67 = GH¢0.067 per share, (to allow for unquoted status) Dividend yield with growth If one wished to use the forecast earnings, then as earnings are expected to increase by 5% a year for the next three years, with no further information we can assume g = its capital gains yield = 5%. The dividend yield for the quoted companies was only 10%. For LHW, an unquoted company, this could be increased by about 40% to 14%. Since the required return for LHW = its dividend yield + its capital gains yield That is to say: r= (Divi / PO) +g Thus r= 14% + 5% = 19% Therefore using Gordon's dividend growth model: PO= DO (1#g) / (r~ G) — g) = 100,000(1.05) / (0.19 - 0.05) = ‘GH¢105,000 / 0.14 = GH4750,000 or GH¢0.075 per share. 243 ~The insituta of Chartered Accountants (Ghana)Financial Managy ‘© Emile Woolf Intemational — Change in the value of fixed assets: \twe assume that both buyer and seller would accept the revaluation of assets by the independent valuer, an assets valuation of equity would be as follows: Adjusted net assets of LHW Ltd GH¢’m — GH¢'m Balance sheet figure 26 Estimated values of fixed assets 2.0 Land & buildings 40 Plant & machinery 12 Fixtures and fitting 0.35 Motor vehicles _ 90 Less fixed assets in balance sheet (1.45) ‘Current Assets: Nominal value of debtors in balance sheet 25 20% reduction of value of debtors (0.5) Nominal value of 8% of debentures in balance sheet (5.0) Redemption cost (4) ae (0.4) Adjusted net assets of LHW Ltd 0 Alternative solution Adjusted net assets of LHW Ltd GHg'm —GH¢'m Fixed assets: Land and buildings 2.0 Plant and machinery 4.0 Fixtures and fittings 12 Motor vehicles 0.35 7.55 Current assets: Stock Debtors Cash Prepayments Current liabilities: Creditors 24 Taxation 15 Bank overdraft 0.4 40 Debenture (6.4) Deferred taxation __ (13) (6.7) Adjusted net assets of LHW LTD 025 7 a ‘The institute of Chartered Accountants (Ghana)ti (iii) 5 LHW LTD f@) Answers to ICAG past exams support the level of sales is reduced (i. better inventory control, credit policy and debt collection). The long-term solution is to provide more long-term funds for working capital purposes — i.e. improve the Net Working Capital position of the firm. Economic Order Quantity of dints yo 9,487 units Total inventory costs = Annual holding costs + Annual order costs = (Fo xen) + (gog*%) )+ Saar) = 37,048 + 37,947 = GH¢75,895 Number of times per year inventory should be ordered (2,800,000) —GaaT — = 190times or approximately every two days Net asset (liquidation) basi: PV of bond: As interest is paid semi-annually: The total number of periods over which the cash flows will be paid is 10 (2X 5 years remaining). The required rate of return on assets of this risk level is 12% / 2 = 6% semi-annually. The formula for the present value of a non-callable redeemable bond is: = PV of the coupon payments + the PV of the redemption value of the debt PV = GH¢250,000 x (8.11) + GH¢5,000,000 x (0.675) (From PV annuity tables, n = 10, r= 4% and PV tables and) = GH¢2,027,500 + GH¢3,375,000 = GH¢5,402,500 ‘@ Erne Wool international 2a ‘The Institute of Chartered Accountants (Ghana)Financial Management 4 ASUO LTD (2) Overtrading refers to a situation where turnover is increased without a maiching increase in equity of other long-term sources of funds: as a result, Saerrpany which is earning good profits can run into a liquidity crisis and default in payment of its current liabilities, ‘Symptoms of Overtrading : ‘The financial backers of the tenanted-pub firms might have noticed the following symptoms; . The increased investment in current assets needed to support the increased sales are financed mainly form short-term sources like Creditors and bank overdraft, resulting in a declining current ratio and quick ratio. * Sales tend to increase very quickly in relation to equity, resulting in sharp increases in the ratio of sales to equity. * The increase in debt would lead to higher gearing ratios * The net working capital will tend to decline, and may even become negative. A negative net working capital implies a current ratio less than equity (current assets less than current liabilities), and a business in such a pdbition is likely to face considerable difficulty in meeting its current liabilities. Even where the current ratio is satisfactory, any erosion of net working capital would worsen the liquidity of the business and make it more vulnerable to cyclical risk. Various possible causes However over trading is not the only cause of these symptoms: Situations similar to overtrading can be caused due to other reasons as well: + Itis not only physical increase in sales that can strain liquidity, In periods of high inflation, sales turnover and the corresponding working capital requirements can increase very sharply in nominal terms, resulting in the symptoms of overtrading, + Repayment of a loan without raising sufficient long-term funds (either in the form of profit accruals or a fresh loan) can drain cash form the firm, creating symptoms, + Excessive dividend payout can result in depressing the equity and creating similar symptoms. + Using short-term sources of funds to finance long-term investments will depress net working capital, resulting in overtrading symptoms. Overcoming overtrading + However if the management of the tenanted-pub firms feel that overtrading is the root cause of their condition then they must as a matter of urgency tackle the situation. + The instant solution for an overtrading situation is to take more trade credit and bank overdraft finance; however this is likely to be only a short-term fix that ultimately exacerbates the situation and worsens the liquidity crisis + Better short-term solutions would be to either restrict the growth in turnover to manageable proportions; or improve working capital management so that the investment in current assets required to ‘© Emile Woolf intemational 240 The institute of Chartered Accountants (Ghana)‘Answers to ICAG past exams + The accounting system in large firms are more sophisticated and are able to provide a greater quantity of more reliable information which can be incorporated into annual reports or profit forecast + Investments in larger companies are more easily marketable. + The smaller business will find it particularly difficult to attract venture capital, + Small forms tend to faok the financial expertise to prepare adequate cash flow projections or proper forecasts. * The cost of finance to small firms will probably be higher than that for large business. In order to attract capital in the first place, the small firm may be forced to pay a greater rate of interest. + Some governments supported schemes (e.g., agricultural loan guarantee scheme) specify minimum qualifying levels which exclude the smaller firms. 3 Wax Ltd As projects 2 and 8 are mutually exclusive, only the most profitable need be considered, i.e. project 8. Project 2 can be completely omitted from the selection process, As projects 1 and 5 are mutually dependent both must be either selected or rejected, and to ensure this a weighted profitability index is needed Outlay * Profitability index 1 200,000 1.20 240,000 2. 200,000 1.15 230,000 400,000 Weighted profitability index 212 400 1.175, The projects can then be ranked in descending order of profitability: Project dex Outlay 9 100,000 8 100,000 7 400,000 145 _ 400,000 1,000,000 3 1.47 100,000 10 1.16 100,000 6 1.13 200,000 4 1.10 300,000 Thus, projects 9, 8, 7, 1 and 5 are accepted ‘Emile Woo! Intemational “The Institute of Chartered Accountants (Ghana)*ial Management = 120,000 149 = 594 ~ 800,000 * 100 = 15% Issue of ordinary shares Ifnew shares were issued today Marginal cost after tax Dividend per share eee t growth rate net proceeds of currentissue * °™ (GH¢6,000,000 2,000,000 she 0.5 =¢ SATE) 4 506 = 25 4 505 = 13% GHe7 — 0.25 - 0.75 + 9% = B35 Cost of retained earnings = dividend yield + growth rate 50 +005 = 12.1% Weighted average marginal cost of capital Source of finance Capital Weight _ Component Weighted structure Cost cost GH¢ 1 million % Ordinary shares 12 0.50 13.0 6.50 Retained earnings 4 0.17 12.4 2.06 Debentures 6 0.25 75 1.88 Preference shares 2 0.08 15.0 1.20 24 «4.00 11.64 Alternative solution WACC Capital Component structure cost Weighted Source of finance GH¢ 1 million Weight % cost Ordinary shares (6.25@12m) 75 0.928 13.0 12.0 Debentures (0.9@6m) 54 0.067 75 0.50 Preference shares (0.4@2m) fO.B wes 0.01 15.0) 0.15, Total 81.2 00 12.65 WACC formula can also be used to arrive at the 12.65% (b) Small firms encounter the following problems in their efforts to raise capital in the Ghanaian financial market. + The high cost of obtaining a quotation on the stock market. For most, ‘small forms a quotation has become impracticable. * Large firms are better known and provide more financial information than smaller firms. “BEmile Woof Intemational 238 "The Institute of Chartered Accountants (Ghana)Answers to ICAG past exams (ii) The methods of marketing a company are as follows: + Public issue by prospectus: This is a direct issue to the public by means of prospectus and advertisements detailing the number, class and price of the shares offered. + Anoffer for sale: This is made by an issuing house to the public, of the shares which it has previously bought from the owner of the business. Sometimes the owner offers the shares on his own behalf. * Offer for sale by tender: This method, which has been used on a number of occasions in recent years for the issue of ordinary shares is similar to the offer for sale, except that the suing house (instead of offering the shares at a fixed price) invites the public to send in tenders at a fixed price) invites the public to send tenders for the shares at or above a minimum, price, stating the maximum number of shares they would take. In the light of the tenders received, the issuing house then fixes a price (the striking price) at which the shares will be allotted. + APlacing: This occurs when shares brought onto a Stock Exchange for the first time are sold privately. A stock broker or issuing house may arrange for the issue to be taken up by the alients or contracts. * An Introduction: This is not a method of raising new capital, but of getting permission to deal. i.e. introducing the shares of a small company to the market. ZAYTUNA LTD (a) Note: Students will be awarded marks based on the cost of capital as determined by them. The following calculations will be relevant to this. Debentures A debentures with a nominal value of GH¢ 100 issued now would raise GH¢ 90 in retum for a future interest stream of GH¢ 9. Marginal cost after tax coupon rate ——_ one rat 4 — tax rate proceeds of current issue (1 ~ ‘@* ate) 9 Fat — 0.25) = 7.5% Alternative solution (based on total values associated with the current level of debentures = 6,000 @ 90 = 5,400) 540,000(1 — 0.25) “5,400,000 x 100 = 0.075 x100 = 7.5% Preference shares coupon rate proceedsof current issu: Alternative solution ‘© Emile Woolf international 237 ‘The institute of Chartered Accountants (Ghana)Financial Management iy ‘© Emile Woolf international in the longer term this could be good for the achieving the financial objectives of companies. Perhaps some technology and engineering companies might be spending more time and effort on improving the technical aspects of their product or develop new technologies that will improve the environment rather than spending time in maximising shareholder wealth. However once again it is possible that this could also lead to better motivated ‘employees. And if the company's reputation improves, attracting and keeping customers will be easier. Thus in the longer term this could be good for the achieving the financial objectives of companies cely reasons for seeking a quotation are listed below: To provide an immediate basis of valuation for the share and a market in which they can be readily exchanged for cash. ‘A quotation gives access to the savings of the public, when a ‘company wishes to recruit further capital for expansion. ‘Amalgamation between companies is easier if part of the price to be paid is in shares, quoted in a stock exchange. The fact that shares of the enlarged company are marketable will facilitate the merger. After a quotation, the shareholders have a ready market for their shares. They can exchange them for cash or use them more easily as a form of security. The prior considerations to obtaining a stock exchange quotation are as follows: The company must meet the requirements of the Ghanaian ‘Stock Exchange. Depreciation must have been sufficient in the past, and the accounts must have been drawn up in a proper manner. The records of the past profits must be such that the public will be eager to invest in the company. There must be a degree of certainty that profits will continue at or above this level into the future. Consideration must be given to the fact that a more generous dividend policy will have to be pursued in the future. Before obtaining a quotation the board must consider the best method to bring the Firm to the market, how much money to raise by the issue, the price at which the offer is made to the public, and whether the offer is to be underwritten. The interest of the present shareholders must be considered. Thought must be given as to whether they can maintain control after the issue. The assets of the company must be revalued, and the surplus distributed as bonus shares. The type of new capital to be raised. The pros and cons of debentures, preference and ordinary shares must be considered. 236 ‘The institute of Chartered Accountants (Ghana)“© Emile Woolf Intemational ‘Answers to ICAG past exams customers markets or even where the product / service is sourced in for example a third world country can be advantageous in the short term. However it is possible that this could lead to de-motivated employees and angry customers. If the company's reputation suffers attracting and keeping customers will be more difficult. Thus in the longer term this, could hinder achieving the financial objectives of companies. It would be hard to imagine how excessive pay and perquisites could be in the best interests of shareholders. Thus this would be expected to reduce profit and dividend growth. Similarly while management might argue that increasing market share or increasing the size of the company by either organic growth or through mergers and acquisition might be good for the shareholders this is often not the case, (as often witnessed by the fallin the share price of a predator firm when it announces it intends to engage in the takeover of another firm). This can lead to earings per share and dividends per share falls even though total profit and dividends may rise. Not taking on risks would be expected to reduce profit and dividend growth and would not be in the interests of shareholders unless it was argued that financial distress costs are higher than is usually estimated in finance theory, Most firms now accept that they everyone has a part to play in ensuring sustainable development and reducing their impact on the environment. Also many firms choose to help society in many other ways too such as contributing to the local economy J community not engaging in illegal activities such as illegal pollution or bribing local and national officials. This could increase costs, particularly in the short term. Hence it could reduce profit and dividend growth. However itis possible that this could lead to increasing the reputation of the company. This could lead to better motivated employees and again attracting and keeping customers could be easier. Thus in the longer term this could be good for the achieving the financial objectives of companies. Often firm provide a service such as assisting access to their Products for the disabled or those in remote areas. In many cases this is done purely to fulfil statutory obligations but often it is done for “humanitarian” reasons too. This would be expected to reduce profit and dividend growth. While in the short term getting around these regulations might appear to be a good idea, should this be expose, this legal but “unethical” behaviour might do irreversible damage to a company's reputation. Hence providing such services could be interest of achieving the financial objectives of companies. Offering excellent customer service or only dealing with “Fair Trade” suppliers and other form of “ethical behaviour” can increase costs and hence could reduce profit and dividend growth. However a reputation for always acting ethically could also lead to better motivated employees. And if the company’s reputation improves, attracting and keeping customers will be easier. Thus 235) ~The Institute of Chartered Accountants (Ghana)Financial Management NOVEMBER 2017 a xx @ (i (i) Non-finan: | objectives of private companies The maximisation of long term shareholder wealth should be the objective of all profit seeking private companies. Often companies try to achieve this through a series of primary financial objectives. In addition to these primary financial targets even profit seeking private companies often have other secondary non-financial targets. Non-financial objectives could be + The welfare of employees. Examples of this could be health and safely in the work place, social and recreational services, the provision of accommodation or other services and pay and perquisites beyond what might be deemed necessary to attract and hold the appropriate staff. led at: + The welfare of management. Examples of this could be excessive pay and perquisites, “empire building” or increasing market share by either organic growth or through mergers and acquisition beyond what is in the best interests of shareholders for the benefit of management or not taking on risks that would be in the interests of shareholders but could jeopardise the survival of the firm and hence the welfare of the management. + The welfare of society. Examples of this could be acting in an environmentally sustainable way, not testing products on animals, respecting human rights, being a “good neighbour” and contributing to the local economy / community. . The provision of a service. Examples of this could be providing a service which could not be justified on purely profit grounds such as assisting access to their products for the disabled or those in remote areas. + The fulfilment of responsibilities towards customers and suppliers. Examples of this could be excellent customer service or only dealing with “Fair Trade” suppliers. + Technology / quality improvements. Many technology and engineering companies are said to spend more time and effort on improving the technical aspects of their product or service than in maximising their commercial value + Market leadership + Growth The effect of non-financial objectives on the achievement of the financial objectives of companies can include: + By trying to improve health and safety in the work place, social and recreational services, the provision of accommodation or other services and pay and perquisites beyond what might be deemed necessary to attract and hold the appropriate staff will increase costs and hence could reduce profit and dividend growth. However the contrary is not always advisable either. Not following acceptable health and safety standards or paying below minimum acceptable or legal standards either in the ‘© Emile Woot Intemational 34 ‘The institute of Chartered Accountants (Ghana)‘Anwors to ICAG past exams 5 FCH BANK LTD (a) (i) Net asset valuation In the absence of any information about realisable values and replacement costs, net asset value is on a book value basis. It is the sum of non-current assets and net current assets, less long-term debt, ie. 595 + 125 — 70 — 180 = GH¢490 million. (i) Dividend growth model Total dividends of GH¢40 million are expected to grow at 4% per year and FCH Bank Ltd. has a cost of equity of 10%. Value of company (40m x 1-04)/(0-1 — 0:04) = GH¢693 million (ii) Earnings yield method Profit after tax (earings) is GH¢66-6 million and the finance director of FCH Bank Ltd. thinks that an earnings yield of 11% per year can be used for valuation purposes. Ignoring growth, value of company = 66-60-11 = GH¢606 million Alternatively, profit after tax (earings) is expected to grow at an annual rate of 5% per year and earnings growth can be incorporated into the earnings yield method using the growth model. Value of company = (66:6m x 1-05)/ (0-11 — 0-05) = GH¢1, 166 million (b) Katamanso Ltd ()__ Dividend cover Earnings / Dividend 4600/6, 750 =3.64 (li) Earnings per share Earnings available to equity holdersino of ordinary shares 24,600/15,000 = 1.64 = 0.0484 (iii) Pricefearnings ratio Price per share/eaming per share = 45/2.18 = 20.64 G Emile Woot international "233 The insti of Chartered AcoountantFinancial Management GH¢ Assessment of new policy by ATA Ghana Ltd. Increased contribution (9,000,000 — 7,200,000) = 1,800,000 Increased bad debts (315,000 - 168,000) = (147,000) Increased cost of debtors (700,000 — 280,000) = (420,000) Net benefit, _1,233,000 Decision: The company should pursue the policy of taking in the new customers, Alternative solution to Question 4b Old policy GH¢'000 GH¢'000 Sales 24,000 VC of Sales 16,800 Contribution 7,200 Cost of debtors: Int. foregone (1/12*24m*20%) 400 Bad debt (1%"24m) 240 640 Net contribution - 6,560 New policy GH¢'000 GH¢'000 Sales 30,000 VC of sales __21,000 Contribution 9,000 Cost of debtors: Int. foregone (2/12*30m*20%) 4,000 Bad debt (1.5%*24m) 450 1,450 Net contribution 7,550 Analysis Net contribution of new policy 7,550 Net contribution of old policy __ (6,560) Net benefit from new policy _ 990 Alternatively Increased contribution 1,800 Increased cost of bad debt (210) Increased financing cost (interest) (600) Net benefit from new policy 990 Decision: The company should pursue the policy of taking in the new customers. ‘G Emile Wool international 232 ~The insiitute of Chartered Accountants (Ghana)‘Angwors to IGAG past exams 4 ATA GHANA LTD (a) Differences between Factoring and invc e Discounting + The essential difference between Factoring and Invoice Discounting lies in who takes control of the sales ledger and responsibility for collecting payment: With Factoring, the provider takes the role of managing the sales ledger, credit control and chasing customers for settlement of their invoices whilst with Invoice Discounting, your business retains control of its own sales ledger and chases payment in the usual way. + Another difference between Factoring and Invoice Discounting is in the area of confidentiality: With Factoring, the customer settles their invoice directly with the Factoring Company; so customers are more likely to be aware of your Factoring arrangement. With Invoice Discounting, your customers still pay you directly; there is no need for them to know that a third party is involved. (b) Present Position GHe Sales 24,000,000 30% contribution 7,200,000 Cost: Bad debts 1% x 24,000,000 x 70% 168,000 Cost of debtors: Variable cost of debtors: 24,000,000/12 x 1 = 2,000,000 x 70% 1,400,000 Hence cost of debtors = 20% x 1,400,000 280,000 NBI/ Debtors could also be valued at selling price. Proposed policy GH¢ Sales 30,000,000 30% contribution 9,000,000 Cost: Bad debts 1.5% * 30,000,000 x 70% 315,000 Cost of debtors: Variable cost of debtors: 30,000,000/12 x 2 = 5,000,000 x 70% 3,500,000 Hence cost of debtors 20% = 3,500,000 x 20%, 700,000 ‘G Erle Wool! international 231 “The Insitute of Ghariored Accountants (Ghana)Financial Management Calculation of net present value Year 0 1 2 3 4 Sales 2,205,000 3,505,480 5,209,500 2,625,840 Total VC (1,335,600) _(2,143,320) (3.216.000) (1,635,840) Taxable cash flow 869,400 1,363,160 1,993,500 990,000 Tax @25% (217,350) (340,790) (498,375) (247,500) Tax Savings on depn. 125,000 125,000 125,000 125,000 Capital investment Initia! investment (2,000,000) Working capital (220,500) (130,148) (170,302) 258,368 __262,584 Free cash flow (2,220,500) 646,902 «977,068 7,878,491 1,130,084 Discount factor @15% 1 0.870 0.756 0.658 0.572 Discounted cash flows (2,220,500) 562,805 738,663 1,236,047 646,980 NPV 963,995 The decision is to recommend that the project be undertaking based on the positive NPV results. This will add value to share holders’ wealth. (©) (i) The original expectation would have been that the amount to payback would be $280,000 x GH¢4.2 = GH¢1,176,000. However, during the time that it was exposed to the currency risk, the exchange rate has moved in an adverse direction, and the actual payments are $280,000 x GH¢4.6 = GH¢1,288,000. The “FX loss” has been GH¢112,000. (li) Curreney risk arises from exposure to the consequences of a rise or fall in an exchange rate. Here, the Ghanaian company was exposed to the risk of a fall in the value of the cedi. Curreney risk is a two-way risk, and exposure to risk can lead to either losses or gain from movements in an exchange rate. In this example, the exchange rate could have moved the other way. For example, if the exchange rate after three months had been $1= GH¢4.0, the Ghanaian company would have paid GH¢1,120,000 instead of GH¢1,288,000. (iii) Transaction risk arises only when the settlement of the transaction (and receiptipayment) will occur at a future date. An exposure lasts for a period of time. Here, the exposure lasts from when the goods were sold on credit until the time that the customer eventually pays. (iv) Trading profits for companies engaged in foreign trade can be significantly affected by currency movements. When exchange rates. are volatile and unpredictable, the gain or loss on currency exchange could possibly be even bigger than the expected gross profit from the transaction. “© Emile Woolf international 230 ‘The Institute of Chartered Accountants (Ghana)Answers to ICAG past exams (b) InGHg Year Sales revenue Variable cost Contribution Capital allowance Taxable profit Tax @ 25% Profit after tax Capital allowance After tax cash flows Initial Investment Working capital Net cash flow Discount factor @ 15% Present value NPV The dec (2,210,000) 877,248 ¢ 1 2 3 4 2,100,000 3,339,000 4,962,000 2,600,560 1,260,000) (2,022,480) (3,033,000) (1,543,680) 840,000 1,316,620 1,929,000 956,880 _ (500,000) _ (500,000) _(500,000) _ (500,000) 340,000 816,520 1,429,000 456,880 (85,000) (204,130) (357,250) (114,220) 255,000 612,390 4,071,750 342,660 500,000___500,000 500,000 _500,000 (2,000,000) (210,000) 10,000) 755,000 112,390 1,571,750 842,660 (123,900) (162,300) 246,144 250,056 631,100. 950,090 1,817,894 4,092,716 08696 «0.7561 06575 «8718 548,805 718,363 1,195,265 624,815 nis to recommend that the project be undertaking based on the positive NPV results. This will add value to share holders’ wealth. Alternative solution to question 3b using year 0 (zero) as the current year Year Selling price Inflation (1+g)4n Sales Units Sales value (GH¢) Velunit Inflation (1+g)8n Total ve Working capital (10%*Sales) Working capital Investment cost Depreciation @25% Tax savings on depn. @25% “© Emile Woo! Intemational 1 2 3 4 30 30 30 30 4.05 4.10 1.16 1.22 “31.500 33.08 34,73 36.47 70,000 106,000 __150,000__72,000 72,205,000 3,506,480 5,209,500 2,625,840 18 (220,500) a 18 18 18 18 1.08 4.12 4.19 1.26 7908 —«022~=« ad —~=«D TR 1,335,600 2,143,320 3,216,000 1,635,840 220,500 350,648 520,950 262,584 (130,148) (170,302) 258,366 262,584 2,000,000 2,000,000 2,000,000 2,000,000 500,000 500,000 500,000 500,000 125,000 125,000 125,000 125,000 ~The Institute of Chartered Accountants (Ghana)Financial Management (c) The theoretical ex-rights price can be calculated as follows. wi) Market value of 5 existing shares (5 x GH¢3.70) 18.50 Issue price of 2 shares in the rights issue (2 x GH¢3.00) 6.00 Theoretical value of 7 shares 24.50 Theoretical ex-rights price (= GH¢24.50/7) GH¢3.50 (li) The value of rights In theory, the holder of five shares in the company in the previous example could buy two new shares in the rights issue for GH¢3 each, and these two shares will be expected to rise in value to GH¢3.50, a gain of GH¢0.50 for each new share or GH¢1.00 in total for the five existing shares. We can therefore say that the theoretical value of the rights is. GHg0.50 for each new share issued, or GH¢0.20 (GH¢1.00/5 shares) for each current share held. 3 DECOR LTD (a) Advantages of Payback: Simple and easy to use It gives indication of the liquidity. The earlier the payback period the better the liquidity It broadly measures the risk of the project. The earlier the payback period the better the risk Is faster to compute Disadvantages: Itignores the time value of money Ignores the cash flows after the payback period and may discriminate against projects that have significant cash flows after the payback period It ignores the residual value and total economic life of the project Determination of the payback period upfront could be subjective and discretionary It measures mainly recovery of capital and not profitability of the project 228 ‘The institute of Chartered Accountants (Ghana)“Answers to ICAG past exams 2 SAFOO LTD (2) Calculation of weighted average cost of capital Cost of equity = 23 + (1.2 x 5) = 29%. The company's bonds are trading at par and therefore the before tax cost of debt is the same as the interest rate on the bonds which 25%. After tax cost of debt = 25% x (1 - 0.25) = 18.75%. Market value of equity = 5m x 3.81 = GH¢ 19.05 million Market value of debt is equal to its par value of GH¢ 2 million. ‘Sum of Market value of equity and debt = 19.05 million + 2 million = GH¢ 21.05 million. Weighted Average Cost of Capital (WACC) = (0.29%19.05/21.05)+(0.1875%2/21.05) (0.2900 x 0.905) + (0.1875 x 0.095) = 0.2625+0.178 = 0.2803 or 28.03% (b) (i) Factors to consider when choosing source of debt finance * Cost: both issue cost, interest rate and repayment terms + Maturity. This should be carefully matched with the cash flow structure and also flexibility of short term debt against long term debt * Financial risk. Debt increases gearing and hence financial risk of the company and how investors would view that. + Availability of financing. This depends on size of borrowing relative to the size of the firm, relationship with bankers and other financiers (ji) Factors to consider by providers of finance * Security. Are there available assets to be used to secure exposure? The size of debt or finance depends also on size of collateral available. Additionally, interest rate charge by lenders is a function of whether is a secured exposure or unsecured exposure + Risk and ability to meet financial obligations. + Legal restrictions on borrowing * Management capacity and track record in the past and future ‘expectation of their ability to perform and survive in challenging market environments ‘© Emile Woo! Intemational 27 ~The institute of Chartered Accountants (Ghana)Financial Management (b) A financial market is a broad term describing any marketplace where buyers and sellers participate in the trade of assets such as equities, bonds, currencies and derivatives. Financial markets are typically defined by having transparent pricing, basic regulations on trading, costs and fees, and market forces determining the prices of securities that trade. (©) (i) Equity markets allow investors to buy and sell shares in publicly traded companies. They are one of the most vital areas of a market economy as they provide companies with access to capital and investors with a slice of ownership in the company and the potential of gains based on the company's future performance. Debt market is where an investor loans money to an entity (corporate ‘or governmental), which borrows the funds for a defined period of time at a fixed interest rate. Bonds which are mostly used in debt markets are used by companies, municipalities, states and U.S. and foreign governments to finance a variety of projects and activities. Bonds can be bought and sold by investors on credit markets around the world. This market is alternatively referred to as the credit or fixed-income market. It is much larger in nominal terms that the world's stock markets. (i) The money market is a segment of the financial market in which financial instruments with high liquidity and very short maturities are traded. The money market is used by participants as a means for borrowing and lending in the short term, from several days to just under a year. Money market securities consist of negotiable certificates of deposit (CDs), banker's acceptances, commercial Paper, municipal notes, federal funds and repurchase agreements (repos). Money market investments are also called cash investments because of their short maturities. capital market is one in which individuals and institutions trade financial securities. Organizations and institutions in the public and private sectors also often sell securities on the capital markets in order to raise funds. Any government or corporation requires capital (funds) to finance its operations and to engage in its own long-term investments. To do this, a company raises money through the sale of securities ~ stocks and bonds in the company's name. These are bought and sold in the capital markets (iii) The interbank market is the financial system and trading of currencies among banks and financial institutions, excluding retail investors and smaller trading parties. While some interbank trading is performed by banks on behalf of large customers, most interbank trading takes place from the banks’ own accounts. The forex market is where currencies are traded. The forex market is the largest, most liquid market in the world with an average traded value that exceeds $1.9 trillion per day and includes all of the currencies in the world, The forex is the largest market in the world in terms of the total cash value traded, and any person, firm or country may participate in this market. co “The insute of Chartered Aocountanis (Ghana)Answers to IGAG past exams MAY 2017 1 BHIM (2) Bhim (i) Value for money (3Es/4Es) Value for money (VAM) is the process of ensuring that resources applied to achieve optimal results in the most sustainable way and also for the right target. The key elements of value for money are * Economy + Efficiency + Effectiveness * Equity The three key elements (sometimes referred to as the 4Es) are discussed below; + Economy - this measures the acquisition of inputs at the highest quality, at the lowest cost and within acceptable time for achieving a given output + Efficiency — this measures the amount of resources used to achieve a giving output. It also considers the proficiency and appropriateness of the process used for converting the input into output. + Effectiveness — this measures the extent to which stated objectives are achieved, and to the extent that x x + Equity — ensuring fair distribution that targets the needs of vulnerable groups and most deprived entities. (i) Similarities and differences between VFM and value maximization Similarities + VIM and value maximization are both corporate objectives which can be used to measure performance of managers. + As performance measure benchmark, they ensure resources are utilized efficiently for the acquisition of inputs to yield best results. + Achieving VM and ensuring corporate value maximization all have positive social impact jerences + VIMis an objective for not-for-profit entities whereas value maximization is emphasized in profit making entities, + Whereas VIM considers social welfare at large, value maximization focuses on the interest of the shareholders (few ‘owners of the business) * VIM may sacrifice economic benefit for overall social good, especially for vulnerable groups but value maximization focuses on economic returns to the owners for every resource utilised. © Emile Woolf international 225 ‘The Institute of Chartered Accountants (Ghana)Financial Management (i) Using CAPM Ke = 0.24+ 1.4(0.27 - 0.24) .282 = 28.2% 5 PRAISE LIMITED (a) The EOQ ignoring discounts OQ = |e = eecnnss? = 443.74 units or 444 units GH¢ Purchases (no discount) 10,500 « GH¢ 200 4,200,000 Holding cost (444/2) units * 12% x 400 10,656 Ordering costs (10,500/444) x 450 10,702.27 Total annual costs With a discount of 2% and an order quantity of 700 units costs are as follows: GH¢ Purchases 10,500 x 400 x 0.98 4,116,000 Holding cost (700/2 x 0.12 x 400 x 0.98) 16,464 Ordering costs (10,500/700) x 450 6,750 Total annual costs With a discount of 3% and an order quantity of 750 unit cost are as follows: GH¢ Purchases 10,000 x 400 x 0.97 4,074,000 Holding cost (950/2 x 0.12 x 400 x 0.97) 22,116.00 Ordering costs (10,500/950) x 450 4,973.68 4,101,089.7 The cheapest option is to order 950 units at a time (b) Company's current cost of debenture Kd = 12/94 = 12.8% Kd (after tax) = 12.8 x (1 - 0.3) = 8.96% (©) Cost of discount to the company 265 (soot ~ (o- 3) ™ 268) _ ey) 17 46.59% ‘© Erle Woolf international “22h The itu of Chartered Accountants (Ghana)‘Answors to IGAG past exams + Expertise in production Technical ability should be demonstrated through efficient production and value driven skills and competencies. + Expertise in management Management should demonstrate commitment, skills, and experience in promoting the objectives of the organization. * The market and competition The company's proposal should demonstrate that it has a competitive strategy to maintain and expand its market share + Future profits The prospects of the company in generating future profits are realistically expressed in its business plan and proposal + Board membership The company should have a board of directors who will take decisions and consider the interest of the stakeholders + Risk bome by existing shareholders Significant part of the company’s funding is from its owners who also bear the major part of the company's risk 4 JAIALTD (@) (i) Foreign exchange risk is the risk of changes in the foreign ‘exchange rate or the value of a currency. The level of change or movement cannot be determined with certainty making any counterparty with exposure in that be exposed to the market volatility or uncertainty. (i) Transaction exposure refers to the gains orlesses made on foreign exchange transactions due fo the changes in the exchange rate between-the transaction date and the payment or settlement date if the exposure or transaction is unhedged. Translation risk refers to the movement in values either gains or losses of the balance sheet due to the consolidation of the assets and liabilities into a reporting currency from various currencies, () Economic exposure refers to the long term changes in the value of a foreign firm due to the unexpected changes in the exchange rate movements. (b) Estimated cost of equity () Using Gordon Growth Model Ke = do(1+g)/po + g Where do Po 9g (14+0.2)110 + 0.2 32 = 32% 223 "The Insbute of Chartered Accountants (GhanayFinancial Management 3 ‘SAKYIAMA POULTRY FARMS (a) Sakyiama farms (Investment appraisal Years 0 1 2 3 4 Cost 120,000.00 90,000.00 67,500.00 50,625.00 37,968.75, Capital allowance 30,000.00 22,500.00 16,875.00 12,656.25, Tax gain 4,500.00 3,375.00 2,831.25 1,898.44 ‘Additional gain (37, 968.75-10,000) +15%) a Contribution 12,000 «7243 64,800.00 64,800.00 64,800.00 64,800.00 Fixed cost (20,000.00) (20,000.00) (20,000.00) (20,000.00) Cash flow before tax 44,800.00 44,800.00 44,800.00 44,800.00 Tax (15%) (6,720.00) (6,720.00) (6,720.00) (6,720.00) Tax gain 4,500.00 3,975.00 2,631.25 1,898.44 Additional gain 308.44 Costofincubator (120,000.00) Scrap value 410,000.00 Net cash flow (720,000.00) 42,580.00 47,455.00 40,611.25 60,376.88 Discount factor (12.5%) 1.000__0.889 | 0790 _——-0702_——0.624 Present value (120,000.00) _ 37, 32,754.57 26,522.58 97,460.04 Net present value 6.07 ) IRR Net cash flow (120,000.00) 42,580.00 41,455.00 40,611.25 60,376.88 Discount factor (17%) 4,000 0.855 0.731624 0.534 Present value (120,000.00) 36,393.16 30,283.44 26,356.47 Net Present value = 10,876.07 4,083.31) = Neva) p(y IRR= a+ (Gaia) * 0-8) = fare ey 9 IRR = 125 + (

> = GH¢1,010,286 ‘© Emile Woolf international - ait The Insitute of Chartered Accountants (Ghana)Financial Management GHg0.456m every year. Therefore, management should accept the early settlement discount proposal for implementation. (c) Switch from financing working capital needs with bank overdraft to financing with trade credit If the company continues to finance working capital needs with bank overdraft, the annual financing cost would be 15%. If the company finances working capital needs with suppliers trade credit the annual financing cost would be 12.3% (assuming simple interest). ad 365 Cost of trade credit = 755 —GX—— Discount, d = 1 Effective credit period, t= 40 - 10 = 30 : 1365 Cost of trade credit = 7557 x Gy = 0.123 Conclusion: Since the cost of financing with suppliers’ trade credit is lower than the cost of financing with the overdraft facilities, the company should discard its current working capital financing method and finance with trade credit Note: Full credit should be given to candidates who estimate the cost of trade credit based on compound interest: / 100% Cost of trade credit = | ) =a 100 = d, 365/, costottadecoa= ff 100 ) “|-1}-o1 100 (4) Easing cash shortages ‘Steps management can take to ease cash shortages when the company cannot obtain additional funds from external sources include the following: (1) Postpone capital investments. (2) Postpone dividend payments. (3) Accelerate collection from customers by offering incentives for early payment (e.g. early settlement discount, increase in credit limit). This will reduce funds tied up in working capital (4) Reduce investment in inventory to minimise funds tied up in working capital, (6) _ Reverse past investment decisions by selling assets previously acquired but are surplus to the company’s needs, or producing negative or lower returns. Even assets that are needed can be sold and leased back. (6) Negotiate with creditors for more favourable payment terms. ‘© Emile Woolf Intemational 210(b) Answers Introduction of early settlement discount policy Under current policy: Current credit sales GH¢122 million Current credit period 40 days Receivables turnover days 53 days Trade receivables, 20X7 GH¢24.210 million Trade receivables, 20X6 GH¢11.210 milion Under discount policy: Credit sales = GH¢122 million (assumed to be kept at recent sales level) Credit period 40 days Discount period 10 days Discount rate 1.5% Early payment probability = 60% Other relevant data: Financing cost = 15% Cash discount cost Cash discount cost Credit sales x Discount rate x Early payment probability Hg 122m x 1.5% x 60% = GH¢1.098m If credit policy remains unchanged, average trade receivables would be GH¢17.715m: = xcHet22m = GHe17.715m Current average trade receivables = === or GH¢24.210m+GH¢11.210m 2 If early settlement discount is introduced, average trade receivables would be GH¢7.353m: Current average trade receivables= =GH¢17.71m New average trade receivables = (}+60%GH¢122m) +2 x40%xGH¢122m) New average trade receivables=GH¢2.005m+GH¢5.348m=GH¢7. 353m Funds that would be released every year if the early settlement discount is introduced is GH¢11.365m Funds to be released = GH¢17.715m — GH¢7.353m=GH¢10.362m Interest charges that would be saved every year due to the early settlement discount is GH¢1.554: Interest saved=GH¢ 10.362 « 0.15=GH¢.554m_ Summary: GH¢e'm Benefit of new discount policy: Interest saved every year 1.554 Cost of new discount policy: Cash discount allowed every year __1.098 Net benefit of new discount policy 0.456 Conclusion: If the early settlement discount is introduced and 60% of accounts are settled early to take the discount, the company’s profit will increase by ‘© Emile Woolt Intemational a 209 ‘The institute of Chartered Accountants (Ghana)Financial Management had dropped to 54% of total assets. The decreases in liquidity ratio is due to the significant increase in current liabilities, mainly due to the high increment in bank overdraft financing. The growth in long-term capil due to reinvestment of profits as stated capital stood the same and medium-term loan was being amortised over the period. These suggest that the company is financing most of the rapid growth in sales with short- term funds rather than long-term capital is Sales revenue is increasing rapidly, liquidity ratios are falling, long-term capital ratio is falling, and there is significant increase in bank overdraft. On the face of it, one would concluded that the company is overtrading. However, the ratio of long-term capital is not yet too low to permit the conclusion that the company is trying to do too much too quickly with too little long-term capital. If the current trends in long-term capital ratio, sales growth, and liquidity ratios continue in the future, the company might experience overtrading in the near future. Measure 2x5 | 20x6 | 20x8 Growih in sales 50% | 103% Growth invade ATR 5 100% 625% | 116% Growth in inventory xioon am | 164.5% Growth in assets =A x 100% 165.4% | 158% Grow in overdraft OD: = OD 190% 237% row in equity capital xi00% Bee | TORR Growth in medium-term | _ MTL, = MTLe 7 ~16.7% | -20% foan MTL aoe Inventory tumover days | _ Average IN = 138 | 83 days cos * 365 day days lfeseaeatce tumover erage TR 365 days 55 days | 53 days Payables tumover days | _ Average TP see 34 days | 25 days | eagercos u | Total debt ratio 36.7% | 38.3% | 48.9% Long-term debt to 89% | 54% equity ratio Long-term eapital o73 | 067 | O64 total assets Current ratio” 205 | 178 | 154 ‘Quick ratio 1.03 075 0.75 ‘@ Emile Woolf international “The Intute of Chartered Aocountants (Ghana)Answers (c) Sankofa dividend growth rate Year Earnings (GH¢) Dividend 20X4 100,000 25,000.00 20X5 120,000 30,000.00 20X6 180,000 45,000.00 20X7 220,000 55,000.00 20X8 300,000 78,000.00 7 rate = *|Yalueat end of period of ny. ividend growth rate = SG Dividend growth rate = Dividend growth rate = V3 — 0.31607or 31.61% 106 XYZLTD {a)_ Is XYZ overtrading or not? Overtrading occurs when a company tries to do too much too quickly with {00 little long-term capital. Typically, a company that is overtrading would exhibit the following symptoms: * Rapid growth in sales revenue. + Rapid growth in current assets, particularly inventory and receivables. Inventory turnover days and receivables turnover days might grow longer. * There is only small growth in equity capital, which may be through reinvestment of profit and not new equity issue. Much of the growth in assets is financed by credit, particularly, trade payables and bank overdraft. + Significant increases in debt ratios such as total debt ratio and debt- to-equity ratio. * Significant decreases in liquidity fatios such as current ratio and quick ratio. There might be net current liabilities. There has been significant growth in sales revenue (50% in 20X6 and 103% in 20X7). This is accompanied by significant growth in current assets, Particularly receivables and inventory. However, receivables tumover days and inventory turnover days have both shortened from 55 to 53 days and from 138 to 83 days respectively. What is more, the payables tunover days has shortened significantly from 34 days to 25 days due to the increased use of bank overdraft in financing working capital needs. Bank overdraft increased by a whopping 237% in 20X7. The company’s liquidity ratios kept dropping over the three years under review. The current ratio dropped from 2.05:1 in 20X5 to just 1.54:1 in 20X7 while the quick ratio dropped from 1.03:1 in 20X5 to 0.75:1 in 20X7. Besides, the ratio of long-term capital to total assets kept reducing over the same periods. Long-term capital that stood at 73% of total assets in 20X5 ‘© Emile Woof international 207 ‘The institute of Chartered Accountants (Ghana)Financial Management 105 WAY LTD (a) Forms of working capital policy Restrictive or aggressive approach With a restrictive policy, current assets are financed through short term funds. Firms with restrictive working capital policies demonstrate the following * Keeping low cash balances and making little investment in marketable securities; + Making small investments in inventory; + Allowing few or no credit sales, thereby minimizing accounts receivable. Flexible or conservative approach Firms that adopt a flexible or conservative approach to the management of working capital to have a higher investment in current assets. The objective is to reduce the risk of stock out and to maintain high liquidity. Flexible or ‘conservative approach to working capital management results in the following + Keeping large balances of cash and marketable securities; * Granting liberal credit terms, which results in a high level of accounts receivable; + Making large investments in inventory. Moderate approach This is the middle ground between the conservative and the aggressive approach (b) Working capital needs Current Future Production 20,000.00 40,000.00 Selling Price GH¢ (12/(1 - 0.25)) 16 16 Sales (GH¢) 320,000.00 640,000.00 Purchases GH¢ (12) 240,000.00 480,000.00 Working capital needs Inventory 20,000.00 40,000.00 Receivables 26,301.37 78,904.11 Cash 9,863.01 39,452.05, Current assets 56,164.38 158,356.16 Payables Working capital (39,452.05) Amount required from EDAIF = 118,904.11 - 46,301.37 = 72,602.74 ‘© Emile Wooit intemational 206 ~The Insitute of Chartered Accountants (Ghana)