ICAN SFM Past Questions 2014 - Nov 2023
ICAN SFM Past Questions 2014 - Nov 2023
ICAN SFM Past Questions 2014 - Nov 2023
OF NIGERIA
Suggested Solutions
Plus
Examiners’ Reports
QUESTION 1
The sum of N2 billion will be required. The sum of N500 million will be spent to
acquire an existing factory considered suitable for the project. The balance of N1.5
billion will be applied for the procurement and installation of essential plant and
equipment. Tax allowance can be claimed on plant and equipment at a uniform
amount over 5 years with NIL scrap value.
A total of N20million has been spent on various surveys (market, technical, financial,
etc.) to date out of which N10million has been paid. The balance of N10million is due
for payment at the end of year 1.
Year Bags
1 500,000
2 600,000
3 650,000
4 800,000
5 700,000
A bag of cement sells currently for N2,000 in the open market. This price is expected
to increase at the rate of 5% per annum. Variable cost is now per bag. This will
increase at 4% per annum. Fixed overhead costs will be N50 million at current prices
but will rise by 8% per annum. Apportioned head office charges of N25million at
current prices will rise by 10% per annum. Fifty per cent (50%) of the total initial
outlay of N2billion is to be funded with a loan from a Federal Government
The company uses a current Weighted Average Cost of Capital (WACC) of 11% to
appraise all capital projects. The asset beta of the company is 1.2, equity beta is 1.6,
risk-free rate is 5%, while the market risk premium is 7%.
The Finance Director is of the view that it is not appropriate to use the existing WACC
to appraise the new project. He has identified a listed company which currently
produces cement and packaged fruit drinks. The company has the following financial
statistics:
60% of the market value of the company is attributed to cement production while 40%
of the value is attributed to the fruit drinks division. The fruit drinks division has
equity beta of 0.8.
The new project is expected to move AK Plc to the target Debt/Equity ratio of 30%. Tax
rate is 25% for the two companies and is paid in the year profit is made.
a. Compute the appropriate cost of capital that AK Plc should use to appraise the
cement project and state why you consider this rate more appropriate than the
existing WACC of 11%.
Note: Your final cost of capital should be rounded up to the nearest whole
number. State any assumptions made. (12 Marks)
b. Compute the Net Present Value (NPV) and the Modified Internal Rate of Return
(MIRR) of the project, assuming a cost of capital of 13%.
(Work to the nearest N million). (16 Marks)
c. Recommend whether the project should be accepted or not, using both NPV and
MIRR methods. (2 Marks)
(Total 30 Marks)
QUESTION 2
Chelsy Plc has two manufacturing divisions, Bolts and Nuts. The Bolts division is
profitable whereas the Nuts division is not. The company’s share price has
consequently declined to 50 kobo per share from a price of N2.83 per share three years
ago.
ii. To close the Nuts division and continue Bolts division through a leveraged
management buyout. The new company will continue to manufacture bolts
only but will require an additional investment of N275million in order to grow
the Bolts division’s after tax cash flows by 3.5 per cent in perpetuity. The
proceeds from the sale of Nuts division will be applied to pay the division’s
outstanding liabilities. The finance raised from the management buyout will be
applied in paying any remaining liabilities, fund additional investment and
purchase the current equity shares at a premium of 20 per cent. The Nuts
division is twice the size of the Bolts division in terms of the assets attributable
to it.
Extracts from the most recent financial statements of Chelsy Plc are as follows:
Statement of Financial Position as at 31 December 2013.
N’000
Non-current assets 605,000
Current assets 1,210,000
Share capital (40 kobo per share) 220,000
Reserves 55,000
Liabilities (non-current and current) 1,540,000
N’000
Sales revenue: Bolts division 935,000
Nuts division 1,870,000
Costs prior to depreciation,
interest payments and tax:
Bolts division (660,000)
Nuts division (2,035,000)
Depreciation, interest and tax (187,000)
Loss (77,000)
If the company’s assets are sold, the estimated realisable values are as follows:
N’000
Non-current assets 550,000
Current assets 605,000
i. Redundancy and other costs will be approximately N297 million if the whole
company is closed and pro rata for individual divisions that are closed. These
costs have priority for payment before any other liabilities in case of closure.
The taxation effects relating to this may be ignored.
ii. Company income tax on profits is 30% and it can be assumed that tax is payable
in the year it is liable.
iii. Annual depreciation on non-current assets is 10% and this is the amount of
investment needed to maintain the current level of activity.
Required:
b. Estimate the return the creditors and the shareholders will receive in the event
that Chelsy Plc is closed and all its assets sold. (3 Marks)
c. Estimate the additional amount of finance needed and the value of the new
company, if only the assets of Nuts division are sold and the Bolts division is
divested through a management buyout. (8 Marks)
QUESTION 3
Syntax Plc., a fertilizer company, is concerned about fluctuating sales and earnings.
This caused the management of the company to consider acquisition of another
company in the same line of business.
In order to boost its sales and stabilise its earnings, Syntax Plc’s management has
identified Synapse Chemical Company Plc. as a possible target. Syntax proposed to
acquire Synapse for a consideration of N20 million and this was agreed to by the two
companies.
Synapse’s expected future profits as projected from its past financial records are as
follows:
iii. The net book value of Synapse’s assets of N2 million is intended to be sold for
N1 million in year 2015. The expected loss from the disposal of these assets has
been included in the depreciation for year 2015. These assets currently have a
tax written down value of N3 million. Capital allowances were claimed as at
when due.
v. The interest charges of N1 million of Synapse Plc. have been included in other
expenses.
vii. Company income tax is currently at 30 per cent and the tax delay is one year.
viii. The after tax weighted average cost of capital has been calculated at 22%.
The management of Syntax Plc. has asked you, as a Financial Expert, to appraise the
intended acquisition of Synapse Chemical Company Plc. and advise on the
reasonableness of the acquisition.
Your advice should be in the form of a report to the Board of Directors of Syntax Plc.
(20 Marks)
QUESTION 4
A Pharmaceutical company wholly owned by the family of Chief Adedutan Jolomi has
been in business for many years. The directors have decided to seek quotation on the
Alternative Securities Market (ASEM).
A new drug on Ebola Virus Disease (EVD) was developed by the company. The
production of the new drug will require more funding since short-term finance will not
be sufficient. They believed it was time to introduce the drug into the market.
The directors of the company believed that launching the product would significantly
increase the company’s share of the market because the country was anxiously looking
forward to an effective EVD drug. Production and launch of this product is costly and
the company’s shareholders may not be able to raise such fund. This informed the
directors’ decision to seek additional finance to be sourced partly in corporate bond
and partly by issue of shares.
They plan to issue the corporate bond in the first quarter of 2015 and the shares
through Initial Public Offer (IPO) towards the end of year 2015. To be able to decide
Required:
a. Compare and contrast the methods of issuing bonds through private placement
and by public offer. State their advantages and advise on which method would
be more appropriate in the above situation. (12 Marks)
b. Advise the directors on the steps that need to be taken to improve the chances
and success of its proposed Initial Public Offer (IPO). (4 Marks)
c. Explain the THREE forms of Efficient Market Hypothesis (EMH) indicating which
of them is most likely to apply in practice. (4 Marks)
(Total 20 Marks)
QUESTION 5
a. Assume that you are a Finance Manager in a state owned enterprise which is
about to have its majority ownership transferred to the private sector through
listing on the Nigerian Stock Exchange.
You are required to examine the financial objectives and the changes in
emphasis that are associated with strategic and operational decisions in the
above scenario. (10 Marks)
b. What are the associated risks that the company may be exposed to as a result of
privatisation? (5 Marks)
(Total 15 Marks)
QUESTION 6
You are required to present SIX arguments for and FOUR against centralised
treasury management in a multinational organisation. (10 Marks)
b. Discuss any FIVE reasons why conflict of interest may exist between
shareholders and bond holders. (5 Marks)
(Total 15 Marks)
a. Build Nigeria Plc. (BNP) is a giant construction company with head office in
Kano, Nigeria. It is involved in construction of roads, dams, airfields, etc., in
many parts of the country. Recently, the company won construction contracts
across a number of African countries. One of the contracts is for the
construction of a dam for a country in Central Africa whose currency is Central
African dollar (C$). The dam has now been completed and the retention money
of C$210,000,000 is due for settlement in one year’s time.
The current spot exchange rate is C$40 = N1. Risk free rate is 5% in Nigeria and
25% in the foreign country.
The Chief Finance Officer (CFO) of BNP is worried about the above financial
statistics and concluded that BNP will lose as much as N840,000 due to
exchange rate movements between now and the end of the year when the
retention money is received.
You are required to explain, showing all relevant calculations, how the CFO
arrived at the potential loss of N840,000. (4 Marks)
W$ million
Expected payment 450
Expected receipt 750
You are provided with the following financial data:
Deposit Borrowing
% %
Nigeria 13.25 16.5
The West African country 6.5 10.5
You are required to show how BNP can make use of money market hedge to
mitigate the foreign exchange risk inherent in the above payment and receipt.
Show all workings and the necessary steps. (7 Marks)
(a) The appropriate cost of capital should reflect the business risk of the cement
industry and the financial risk of AK Plc.
Step 1: Determine the equity beta of the cement division of the given proxy
company. The given equity beta of the proxy company is a weighted
average of the equity beta of the cement division (which is unknown)
and that of the fruit drinks division (which is 0.8). If x is the unknown
equity beta, then:
This reflects both the business risk of the cement industry and the financial risk
of the proxy company.
Step 2: Ungear the equity beta of the cement division to eliminate the financial
risk of the proxy company. The following formula is used:
E × VE D × VD 1 t
A
VE VD 1 t VE VD 1 t
V D = value of debt.
t = tax rate
This is the beta that reflects the systematic business risk of the cement industry.
Step 3: Regear the above asset beta using the target D/E ratio of Ak Plc – in
order to incorporate the financial risk of Ak Plc. The relevant formula
to use is:
VD
E = A + A D 1 t
VE
Note:
K D = 8 (1 – 0.25)% = 6%
ii. The financial risk associated with the method of financing the project
The index used to measure business risk is asset beta. For the cement
project, we need the asset beta of the cement industry which is computed
above as 2. This figure is significantly higher than the current asset beta
of Ak Plc – indicating that the cement business is inherently riskier than
the existing operations of Ak Plc. Consequently, the current WACC of 11%,
which is based on asset beta of 1.2 is inappropriate as it will understate
the required return on the cement project.
Year 0 1 2 3 4 5
Nm Nm Nm Nm Nm Nm
Sales revenue (W1) 0 1,050 1,323 1,505 1,945 1,787
Variable cost (W2) 0 (416) (519) (585) (749) (681)
Cash fixed cost (W3) 0 (54) (58) (63) (68) (73)
Operating profit 0 580 746 857 1,128 1,033
Tax on operating profit 0 (145) (187) (214) (282) (258)
Tax savings on tax depreciation (W3) 0 75 75 75 75 75
Initial outlay (2,000)
Working capital (W4) (105) (27) (19) (45) 17 179
NCF (2,105) 483 615 673 938 1,029
PVF at 13% 1 0.885 0.783 0.693 0.613 0.543
PV (2,105) 427 482 466 575 559
NPV = N404,000,000
PV
l/n
MIRR = R × 1 r 1
PVi
Where PVR = PV of return stage, which in this case is the PV of NCF from
Years 1 to 5 = N2,509million
PVi =PV of the investment stage, which in this case is the NCF in
Year 0 = N2,105million
r = WACC
Alternative method
/n
1
1/ 5
4,623
MIRR = -1 = 1 17%
2,105
(c) The NPV of the project is positive and the MIRR is higher than the company’s
WACC. If other factors remain constant the project is viable and should be
accepted.
Working Notes
Total ((Nm) 54 58 63 68 73
N N N N N N
- Incremental (cash flow effect) -105 -27 -19 -45 +17 +179
EXAMINER’S REPORT
The question tests candidates’ ability to identify and calculate appropriate cost of
capital for a project on diversification into a different industry. It also tests
candidates’ ability to identify relevant cash flows for a project and their ability to
calculate and interprete net present value and modified internal rate of return.
Being a compulsory question, virtually all the candidates attempted it. However, the
performance is poor as it appears that the candidates lacked an understanding of
these areas of the syllabus.
Candidates’ are advised to always cover the syllabus adequately, work on past
questions and examination - like questions in textbooks.
SOLUTION 2
Management buy out costs may be less compared with other forms of
disposal such as selling individual assets of the division or selling it to a
third party.
N’000
Sale of all assets 1,155,000
Less: redundancy and other costs (297,000)
Net proceeds from sale of all assets 858,000
Total liabilities 1,540,000
N’000
Value of selling nuts division ( /3 x N1,155million)
2
770,000
Redundancy and other costs (2/3 x N297million) (198,000)
Funds available from sale of division 572,000
Amount of current and non-current liabilities 1,540,000
N’000
Sales revenue 935,000
Costs (660,000)
Profits before depreciation 275,000
Depreciation ( 1/3 x N550m) + N275m x 10% (45,833)
Tax 30% of (N275,000 – N45,833) (68,750)
Cash flows before interest payment 160,417
Estimate of the value based on perpetuity
(ii) Once a potential buyer has been found, access should be given so that
they can conduct their own due diligence. Up to date accounts should be
made available, Chelsy Plc should undertake its own due diligence to
check the ability of the potential purchaser to complete a transaction of
this size. It would be necessary to establish how the purchaser intends to
finance the purchase, the timescale involved in their raising the
necessary finance and any other issues that may impede a clean sale.
Chelsy Plc’s legal team will need to assess any contractual issues on the
sale, the transfer of employment rights, the transfer of intellectual
property and any residual rights and responsibilities to Chelsy Plc.
EXAMINER’S REPORT
About 75% of the candidates attempted the question. Performance of the candidates
was poor.
Candidates’ commonest pitfalls were their inability to decode the question and their
inadequate business knowledge.
SOLUTION 3
Date
Dear Sirs,
The proposed acquisition of Synapse Chemical Plc by your company for N25million has
been evaluated.
From the financial data made available to us the outcome of our evaluation and
appraisal reveals that the proposal is worthwhile.
Our evaluation reveals that the networth of your company will increase by about
N 2,112,090 being the net present value of the Synapse Chemical Plc.
Yours faithfully,
Appendix 2
2015 2016 2017 2018 2019 2020
N’M N’M N’M N’M N’M N’M
Profit before tax 10.00 16.00 20.00 24.00 28.00 -
Add: Depreciation 5.00 4.00 4.00 4.00 4.00 -
Interest 1.00 1.00 1.00 1.00 1.00 -
Cash profit before tax 16.00 21.00 25.00 29.00 33.00 -
Less tax 4.50 3.90 6.00 7.20 8.40 9.60
Capital 11.50 17.10 19.00 21.80 24.60 (9.60)
Less Capital Investment Required 5.00 6.00 8.00 9.00 10.00 -
Free cash flow 6.50 11.10 11.00 12.80 14.60 (9.60)
Appendix 3
The question tests candidates’ ability to determine the value of a business using
discounted cash flow method.
About 40% of the candidates attempted the question. Performance of the candidates
was poor.
Candidates’ commonest pitfall was their inability to correctly interprete the question
and note the specific requirements.
SOLUTION 4
- Cost: Cost of issue under private placing will be lower than under public
offer.
- Speed: The placing may be completed quickly than under a public offer.
-. The advertisement of the issue creates public awareness about the company
The directors of the company should use private placement to issue the bonds
as this is likely to be more successful for an unlisted company than a public
issue. It is also a useful first step in helping to raise the marketing profile of the
company in the run up to the planned IPO.
iii. Careful choice of timing in terms of the new product development cycle
(i.e. to ensure that the new product is developed sufficiently, patents
obtained, market research etc).
i. Weak form
EMH in its weak form asserts that the current share price reflects all the
information that could be gleaned from a study of past share price.
ii. Semi-strong form of EMH asserts that the current share price will not only
reflect all historical information, but will also reflect all other published
information.
This form of EMH asserts that the current share price incorporates all
information including non-published information. This would include
insider information and views held by the Directors of the entity.
Therefore, people with insider knowledge of the company could not make
profits by using this information; however, this is insider trading which is
illegal.
EXAMINER’S REPORT
The question tests candidates’ understanding of methods of raising equity and debt
finance. It also tests their knowledge of efficient market hypothesis.
More than 80% of the candidates attempted the question but performance was poor.
Candidates showed no understanding of the requirement in parts (a) and (b) of the
question. However, part (c) of the question was well attempted.
Candidates are advised to read wide and cover the syllabus adequately for better
result.
SOLUTION 5
(a) The financial objectives of a state owned enterprise are determined by the
government of such state and may be strongly influenced by political and social
factors. State owned enterprises often exist to provide a service and to satisfy a
social need, even though, they may not be operating at a profit.
Finance manager’s targets for state enterprises are normally in the form of a
percentage on some pre-defined capital employed or turnover. They are not
normally profit maximizing, but are often expected to cover their operating
costs and to provide from internally generated fund part or all of their funding
for capital investment.
Upon privatization, the finance manager will face a new set of objectives:
- Other strategic and tactical decision which include sourcing for materials
and components, pricing, marketing, production and staffing.
(b) The likely risks that the company may be exposed to as a result of
privatization include:
EXAMINER’S REPORT
The question tests candidates’ knowledge of the objectives of state owned enterprises
and private enterprises.
Almost all the candidates attempted the question but performance was poor.
Candidates’ commonest pitfall was their failure to answer the question set, as
irrelevant points were raised by many of them.
(ii) Larger volumes of cash are available to invest, giving better short-term
investment opportunities (for example international money markets,
high-interest accounts and Certificate of Deposits).
(iii) Any borrowing can be arranged in bulk at lower interest rates than for
smaller borrowings and on international markets, interest rate hedging
will be facilitated.
(vi) The centralised pool of funds required for precautionary purposes will be
smaller than the sum of separate precautionary balances that would be
held under decentralised treasury arrangements.
(vii) A centralised function acts as a single focus, ensuring the strategy of the
group is fulfilled and group profitability is enhanced by cash funding,
investment and foreign currency management.
(viii) Transfer prices can be set centrally, thus minimising the group’s global
tax burden.
(i) Local departments may find it easier to diversify sources of finance and
match local assets.
(iv) A decentralised operation may find it easier to invest its own balances
quickly on a short-term basis than a centralized function would.
(v) A centralised function may find it difficult to monitor remote sites; it may
therefore be difficult to obtain information from those sites.
(b) There could be conflict of interest between shareholders and bondholders for
the following reasons:
The shareholders may want the company to undertake risky projects with
correspondingly high expected levels of returns while the bondholders
will want the company to embark on projects that guarantee sufficient
returns to pay their interest each year and ultimately to repay their loans.
(ii) Dividends
Bondholders may wish to take the company into liquidation if there are
problems paying their interest to guarantee their investment.
Shareholders, however, may wish the company to continue trading if
they expect to receive nothing should the company go into liquidation.
The shareholders may prefer that the company raised additional finance
by means of loans in order to avoid having to contribute in a rights issue
EXAMINER’S REPORT
More than 80% of the candidates attempted the question but performance was very
poor.
Candidate’s commonest pitfall was their lack of indepth knowledge of this area of the
syllabus.
Candidates are advised to always give consideration to all sections of the syllabus in
their preparations for the Institutes examinations.
SOLUTION 7
Or N0.025 = C$1
1 RD
1, where
1 RF
Thus:
1.05
1 16%
1.25
1 RD
F = S0 x where
1 RF
= 1/40 = 0.025
Thus:
1.05
F = 0.25 x = 0.021
1.25
Since both payment and receipt occur in the same currency and at the same
time, the amount to be hedged is the net (W$750 – W$450)m = W$300m
receipt.
(ii) Determine the amount of W$ to borrow today at 10.5% p.a. that will grow
to become W$300m after 6 months. This is simply the PV of W$300m i.e.
1
W$300m x = W$285.04m
0.105
1
2
1/ 2
1
(Note: W$300 x = W$285.39 should be fully rewarded)
1.105
Convert the borrowed sum into N at the spot rate of 1.4735 – the bank’s
buying rate to give
(iii) Place the N420.01m in deposit in Nigeria at 13.25% p.a. for 6 months.
This will grow to become:
0.1325
N420.01 x 1
2
= N447.84m
(iv) In 6 month’s time, collect the net receivable of W$300m and use it to off-
set the loans plus accumulated interest (totaling W$300m)
What the money market hedge has done is to convert the foreign asset to
domestic asset thereby eliminating the foreign exchange risk.
(v) Ensures market liquidity up to two years into the future in most cases
Disadvantages
(ii) Forward contracts can acquire value and become a liability for one party
and an asset ot another
(iii) Because no money changes hands at the time of making the contract, the
risk of default is even higher, as the seller may not deliver the product at
the agreed price or the buyer may not pay the agreed price.
(iv) Forward contracts involve buying a product, unseen. The problem is that
physical characteristics of the product can vary.
EXAMINER’S REPORT
Less than 20% of the candidates attempted the question and performance was poor.
- inability to make use of the correct formulae when computing forward rate/rate
of depreciation of the foreign currency,
- failure to net expected payment against expected receipt in the same currency
and at the same time.
Question Papers
Suggested Solutions
Plus
Examiners’ Reports
63
a. Prepare the Statement of Financial Position, Income Statement and Cash Flow Analysis
of the company for each of the years 2015 and 2016 and advise the company on the
extent of additional funding requirement in that period.
Notes
(i) All figures in your calculations should be rounded up to the nearest N1m.
(ii) Compliance with accounting standards is not necessary since these are
management reports. (20 Marks)
b. Recommend and comment on actions the company can take to close the funding gap
identified in (a) above (10 Marks)
(Total 30 Marks)
64
QUESTION 2
The Directors of Actuarial Plc., a conglomerate, is targeting Minororia Plc., an engineering
machinery manufacturer, for possible acquisition of its entire share capital. They believe that the
takeover will not affect their business risks. The statement of financial position of Minororia
Plc. as at 31st December, 2014 is expected to be as follows:
Minororia Plc.
N’000 N’000
Non-current asset (net of depreciation) 651,600
Current assets: Inventory and W.I.P. 515,900
Receivables 745,000
Bank balance 158,100 1,419,000
2,070,600
Current liabilities:
Payables 753,600
Bank overdraft 862,900 1,616,500
454,100
Representing:
Capital and Reserves:
Issued ordinary shares of N1 each 50,000
Distributable Reserves 404,100
454,100
The summarised financial records of Minororia Plc. for five years to 31st December 2014 is as
follows:
Minororia Plc.
65
Additional information:
(i) There have been no changes in the issued share capital of Minororia Plc. during the past
five years.
(ii) The estimated values of Minororia Plc’s. non-current assets, inventory and work-in-
progress for the year ended 31st December 2014 will be as follows:
Replacement Realisable
Value Value
N’000 N’000
Non-current assets 725,000 450,000
Inventory and W.I.P 550,000 570,000
(iii) It is expected that 2% of Minororia Plc’s. receivables at 31 December, 2014 will become
uncollectable.
(iv) The Cost of Capital of Actuarial Plc. is 9%. However, the shareholders of the company
expect a minimum return of 12% per annum on their investment in the company.
(v) The current P/E ratio of Actuarial Plc. is 12.
Companies within the industry having similar profit levels with those of Minororia Plc.
have P/E ratio of approximately 10, although these companies tend to be larger than
Minororia plc.
66
QUESTION 3
KING Plc. and QUEEN Plc. both manufacture and sell household equipment. The summarised
Income Statements of the two companies for the year 2012 are as follows:
Each company has earned a constant level of profit for a number of years and both are expected
to continue to do so for the nearest future. The policy of both companies is to distribute all
profits as dividend to ordinary shareholders as they are earned. None of the companies has any
fixed interest capital.
67
Required:
a. As a financial consultant to KING Plc., advise on the maximum price that the company
should be willing to pay for the entire share capital of QUEEN Plc. showing clearly the
basis of your advice. (6 Marks)
b. Show how the entire benefit from the takeover will accrue to the present shareholders of
KING Plc. assuming that the takeover price is agreed at half of the figure you advised,
and that the purchase consideration will be settled by an exchange of ordinary shares in
QUEEN Plc. (4 Marks)
c. Discuss briefly any other factors that the directors and shareholders of both companies
might consider in assessing the acceptability of the proposed takeover.
(5 Marks)
d. List any FIVE defence tactics that could be used by QUEEN Plc. to frustrate the takeover
bid of KINGS Plc. (5 Marks)
(Total 20 Marks)
QUESTION 4
Oseka Bags Limited is a chain of retail outlets, specialising in high quality leather bags and
briefcases. One of the products purchased by Oseka Bags Limited for resale is an executive
briefcase. The Company sells a fixed quantity of 100 briefcases per week and 50 weeks per
year. The estimated holding cost of a briefcase is N100 per annum per briefcase.
Delivery to Oseka Bags Limited by the existing supplier takes two weeks and the purchase price
per briefcase delivered to Oseka Bags Limited is N1,000. The current supplier charges a fixed
N900 order processing charge for each order regardless of the order size.
Oseka Bags Limited has recently been approached by an alternative supplier of leather briefcase
which are very similar to the existing briefcase range. It is expected that this alternative
briefcase can be sold in the same quantity and price as the existing range.
The alternative supplier’s offer is as follows:
68
Required:
a. Assuming Oseka Bags Limited continues to purchase from the existing supplier, calculate
the:
i. Economic Order Quantity (EOQ)
ii. Total cost of stocking the briefcase for one year (6 Marks)
b. Assuming Oseka Bags Limited switches to the new supplier of briefcase, calculate the:
i. Economic Order Quantity;
ii. Total cost of stocking the alternative briefcase for one year and
determine if it is financially viable to change to this new supplier.
(6 Marks)
c. Discuss TWO limitations of the above calculations and describe briefly TWO non-
financial factors to be taken into account before a final decision is made.
(4 Marks)
d. Assuming there is an upfront investment cost for Oseka Bags Limited of N400,000,
payable immediately and that the annual savings from switching to the new supplier arise
at the end of the next three years, calculate the net present value of switching, if the cost
of capital for the company is 10% per annum.
(4 Marks)
(Total 20 Marks)
QUESTION 5
a. Globalisation has created more opportunities for money laundering with its associated
risks, which government and international bodies are trying to combat through
legislations.
Required:
i. Explain the term money laundering and identify TWO major perpetrators.
(3 Marks)
69
b. In recent times, there has been rapid expansion in the use of Islamic finance globally.
You are required to identify FIVE major advantages of Islamic financing.
(5 Marks)
(Total 15 Marks)
QUESTION 6
Your investment firm is a major player in the Nigerian Capital market. Following recent positive
signs in the capital market, your firm has just recruited a number of young graduates. An in-
house training programme is being planned for the young trainees and you are to facilitate on
subject areas such as portfolio concepts, capital asset pricing model, etc.
a. Your Managing Director requires you to explain, without the use of graphs, Capital
Market Line (CML) and the Security Market Line (SML). You are also required to
highlight the difference between the two. (4 Marks)
b. Consider a client having a portfolio of three stocks. The various expectations and the
current market situations are tabulated below (all annualised values). The current risk
free interest rate is 6% per annum.
Stocks Expected Standard Beta
Return Deviation
Stock A 14% 35% 1.36
Stock B 9.4% 20% 0.52
Stock C 10% 18% 0.69
Market Index 12% 23%
i. Calculate the required returns from the three stocks if they are correctly priced in
accordance with the Capital Asset Pricing Model (CAPM).
(5 Marks)
ii. Are there any discrepancies between the return based on the CAPM theory and
your own expectations? If yes, advise on how to reshuffle the portfolio within
these three stocks in order to profit from them. If no, explain why.
(6 Marks)
(Total 15 Marks)
70
= + − (1 − )
Asset Beta
(1 − )
= +
( + (1 − )) ( + (1 − ))
Equity Beta
= +( − ) (1 − )
Growing Annuity
1+
= 1−
− 1+
= 1+ − 1
71
72
Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1
2 1·970 1·942 1·913 1·886 1·859 1·833 1·808 1·783 1·759 1·736 2
3 2·941 2·884 2·829 2·775 2·723 2·673 2·624 2·577 2·531 2.487 3
4 3·902 3·808 3.717 3·630 3.546 3.465 3·387 3·312 3·240 3·170 4
5 4·853 4·713 4·580 4·452 4·329 4·212 4·100 3·993 3.890 3·791 5
6 5·795 5·601 5·417 5·242 5·076 4·917 4·767 4·623 4.486 4·355 6
7 6·728 6.472 6·230 6·002 5·786 5·582 5·389 5·206 5·033 4·868 7
8 7·652 7·325 7·020 6·733 6·463 6·210 5·971 5·747 5·535 5·335 8
9 8·566 8·162 7·786 7.435 7·108 6·802 6·515 6·247 5·995 5·759 9
10 9·471 8·983 8·530 8·111 7·722 7·360 7·024 6·710 6.418 6·145 10
11 10·368 9·787 9·253 8·760 8·306 7·887 7.499 7·139 6·805 6.495 11
12 11·255 10·575 9·954 9·385 8·863 8·384 7·943 7·536 7'161 6·814 12
13 12·134 11·348 10·635 9·986 9·394 8·853 8·358 7·904 7·487 7·103 13
14 13·004 12·106 11·296 10·563 9·899 9·295 8·745 8·244 7·786 7·367 14
15 13·865 12·849 11·938 11·118 10·380 9·712 9·108 8·559 8·061 7·606 15
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1
2 1·713 1·690 1·668 1·647 1·626 1·605 1·585 1·566 1·547 1·528 2
3 2.444 2.402 2·361 2·322 2·283 2·246 2·210 2·174 2·140 2·106 3
4 3·102 3·037 2·974 2·914 2·855 2·798 2·743 2.690 2·639 2.589 4
5 3·696 3·605 3·517 3·433 3·352 3·274 3·199 3·127 3·058 2·991 5
6 4·231 4·111 3·998 3·889 3·784 3·685 3·589 3.498 3.410 3·326 6
7 4·712 4·564 4.423 4·288 4·160 4·039 3·922 3·812 3·706 3·605 7
8 5·146 4·968 4.799 4·639 4.487 4·344 4·207 4·078 3·954 3·837 8
9 5·537 5·328 5·132 4·946 4·772 4·607 4.451 4·303 4·163 4·031 9
10 5·889 5·650 5.426 5·216 5·019 4·833 4·659 4.494 4·339 4·192 10
11 6·207 5·938 5·687 5.453 5·234 5·029 4·836 4·656 4.486 4·327 11
12 6·492 6·194 5·918 5·660 5·421 5·197 4·988 4·793 4·611 4.439 12
13 6·750 6.424 6·122 5·842 5·583 5·342 5·118 4·910 4·715 4·533 13
14 6·982 6·628 6·302 6·002 5·724 5.468 5·229 5·008 4·802 4·611 14
15 7·191 6·811 6.462 6·142 5·847 5·575 5·324 5·092 4·876 4·675 15
73
0·00 0·01 0·02 0·03 0·04 0·05 0·06 0·07 0·08 0·09
0·0 0·0000 0·0040 0·0080 0·0120 0·0160 0·0199 0·0239 0·0279 0·0319 0·0359
0·1 0·0398 0·0438 0·0478 0·0517 0·0557 0·0596 0·0636 0·0675 0·0714 0·0753
0·2 0·0793 0·0832 0·0871 0·0910 0·0948 0·0987 0·1026 0·1064 0·1103 0·1141
0·3 0·1179 0·1217 0·1255 0·1293 0·1331 0·1368 0·1406 0·1443 0·1480 0·1517
0.4 0.1554 0·1591 0·1628 0·1664 0·1700 0·1736 0·1772 0·1808 0·1844 0·1879
0·5 0·1915 0·1950 0·1985 0·2019 0·2054 0·2088 0·2123 0·2157 0·2190 0·2224
0·6 0·2257 0·2291 0·2324 0·2357 0·2389 0·2422 0·2454 0·2486 0·2517 0·2549
0·7 0·2580 0·2611 0·2642 0·2673 0·2704 0·2734 0·2764 0·2794 0·2823 0·2852
0·8 0·2881 0·2910 0·2939 0·2967 0·2995 0·3023 0·3051 0·3078 0·3106 0·3133
0·9 0·3159 0·3186 0·3212 0·3238 0·3264 0·3289 0·3315 0·3340 0·3365 0·3389
1·0 0·3413 0·3438 0·3461 0·3485 0·3508 0·3531 0·3554 0·3577 0·3599 0·3621
1·1 0·3643 0·3665 0·3686 0·3708 0·3729 0·3749 0·3770 0·3790 0·3810 0·3830
1·2 0·3849 0·3869 0·3888 0·3907 0·3925 0·3944 0·3962 0·3980 0·3997 0.4015
1·3 0.4032 0.4049 0.4066 0.4082 0.4099 0.4115 0.4131 0.4147 0.4162 0.4177
1.4 0.4192 0.4207 0.4222 0.4236 0.4251 0.4265 0.4279 0.4292 0.4306 0.4319
1·5 0.4332 0.4345 0.4357 0.4370 0.4382 0.4394 0.4406 0.4418 0.4429 0.4441
1·6 0.4452 0.4463 0.4474 0.4484 0·4495 0.4505 0.4515 0.4525 0.4535 0.4545
1·7 0.4554 0.4564 0.4573 0·4582 0·4591 0.4599 0·4608 0·4616 0.4625 0.4633
1·8 0.4641 0.4649 0.4656 0.4664 0.4671 0.4678 0.4686 0.4693 0.4699 0·4706
1·9 0.4713 0.4719 0.4726 0.4732 0.4738 0.4744 0.4750 0.4756 0.4761 0.4767
2·0 0.4772 0.4778 0.4783 0.4788 0.4793 0.4798 0.4803 0.4808 0·4812 0.4817
2.1 0.4821 0.4826 0.4830 0.4834 0.4838 0.4842 0.4846 0·4850 0.4854 0.4857
2·2 0.4861 0.4864 0.4868 0·4871 0.4875 0.4878 0.4881 0·4884 0.4887 0.4890
2·3 0.4893 0·4896 0.4898 0.4901 0.4904 0.4906 0.4909 0.4911 0.4913 0.4916
2·4 0.4918 0.4920 0.4922 0.4925 0.4927 0.4929 0·4931 0.4932 0.4934 0.4936
2·5 0.4938 0.4940 0.4941 0.4943 0.4945 0.4946 0.4948 0.4949 0.4951 0.4952
2·6 0.4953 0.4955 0·4956 0.4957 0.4959 0.4960 0.4961 0·4962 0.4963 0·4964
2·7 0.4965 0.4966 0.4967 0.4968 0.4969 0.4970 0.4971 0.4972 0.4973 0·4974
2·8 0.4974 0.4975 0.4976 0.4977 0.4977 0·4978 0.4979 0.4979 0.4980 0.4981
2·9 0·4981 0.4982 0.4982 0.4983 0.4984 0.4984 0.4985 0.4985 0.4986 0·4986
3·0 0·4987 0.4987 0·4987 0.4988 0.4988 0.4989 0.4989 0·4989 0.4990 0·4990
SOLUTION1
74
75
Comparing 31 December 2014, 2015 and 2016, the maximum funding requirement in
2015 and 2016 appears to arise on 31 December, 2016:
Nm Nm
Maximum funding requirement:
- Bank loan 160
- Overdraft 84 244
Available facility (160 + 30) 190
Funding gap 54
However, it should be noted that we do not have any information about intra-year cash
flows; these need to be examined to determine whether a greater funding shortfall arises
at some other point during the period.
Working Notes
1. Non-current assets
Nm Nm
Property, etc b/fwd 300 375
Capital expenditure 200 200
Net total 500 575
76
2. Calculation of taxes
Nm Nm
30% of revenue 311 357
Less: Capital allowance (200) (200)
Add: Depreciation 125 144
Interest on bank loan (10) (10)
Interest on overdraft (1) (3)
Taxable profit 225 288
Taxes 30% 68 86
(b) As indicated in (a) above, a funding gap of N54million exists at the end of 2016.
Management may consider the following options in order to close the funding
gap.
NM
EBIT 411 357 x 1.15
Add depreciation 143 25% (431 + 140)
Net cash from operations 554
Interest (15) 6% (160 + 84)
Dividend (232)
Tax paid (86)
Capital expenditure (140)
Estimated net cash flow in 2017 81
77
RECOMMMENDATION
A bank loan would enable dividend and investment strategies to remain unchanged and
hence protect the future expansion plans of the business and meet shareholder payout
expectations. If it is not possible to borrow the whole amount needed, it may be possible
to borrow a substantial proportion of the amount required. Any remaining amount should
be obtained by delaying capital expenditure plans or, if that is not feasible or would
damage business prospects, reduce dividend payouts in 2017.
EXAMINER’S REPORT
The question tests candidates’ ability to prepare projected financial statements, including
projected cash flows.
In view of the fact that the question is compulsory, almost all the candidates, that is, over
90% of them attempted it, but only a very few appear to understand its requirements,
hence performance was poor.
78
Candidates are advised to take time to read, understand and interprete questions
appropriately and note their specific requirements before attempting them. They should
also endeavour to improve their knowledge on the preparation of projected financial
statements by revising other subject linkages such as performance management, financial
reporting, etc.
79
, , , , , ,
b= = = 0.495 0r 50%
, , , , , ,
80
, ( . )
= = N441,667
. .
Note
In answering this part of the question, candidates are likely to come up with different but
acceptable assumptions. Some of these include:
- No growth in dividend- because dividend has been constant for the last two years
and it is also projected at the same level for year 2014. In that case the formula to
use is:
D/r
- The retention rate, b, can be calculated using the 2014 projected results rather
than using average.
ROE = , using results for 2014 or the average for the period
given.
(b) LIMITATIONS
81
ALTERNATIVE SOLUTION
i. Replacement cost N N
Non-current assets 725,000
Inventory and W.I.P 550,000
Add: Book value: Receivables 745,000
82
EXAMINER’S REPORT
The question tests candidates’ knowledge of the various methods of valuing a company’s
equity and the validity of each method.
More than 80% of the candidates attempted the question and performance was average.
Most of the candidates have good understanding of sections (i), (ii) and (iii) of part ‘a’ of
the question, but demonstrated poor understanding of sections (iv) and (v). Part ‘b’ of the
question was fairly attempted.
Candidates’ commonest pitfalls were their inability to calculate dividend growth rate and
their limited knowledge of the limitations of the various valuation methods.
Candidates are advised to always cover the syllabus adequately by giving considerations to
all sections of the syllabus in their preparation for the Institute’s examinations. They
should also improve their knowledge on the valuation of a company’s equity and the
limitations of each of the valuation methods.
SOLUTION 3
(a)
83
N
Present Value (PV) of future earnings (dividends)
24,750,000 = 247,500,000
=
0.10
Therefore, the maximum price payable by the directors of KING Plc. is the increase in
the value arising from the merger i.e. N250,000,000 –
N175,000,000 = 75,000,000
(b) The takeover price agreed is ½ of N75million i.e. N37.5million. Let x represent the
number of new shares to be issued to QUEEN Plc.
For the entire benefit from the acquisition to accrue to the present shareholders of KING
Plc., value of KING Plc.’s shares issued to QUEEN Plc.’s shareholders must equal the
agreed take-over price i.e.
250 = 37.5m
84
= 250,000,000
50,000,000 + 8,823,529
= 250,000,000 = N4.25
58,823,529
Gain to shareholders of KING Plc. (N4.25 – N3.50) x 50m = N37,500,000. Thus, the
entire benefit from the take-over will accrue to the present shareholders of KING Plc.
(c) The shareholders of QUEEN Plc. should negotiate a takeover price higher than the agreed
N37.5million, At a takeover price of N37.5m, the shareholders of Queen Plc will not get
any benefit from the takeover. Therefore, they may not agree to the takeover.
The directors of QUEEN Plc. might believe from the proposal that the increase in profits
after the acquisition and the sale of assets are indications that they are effectively utilising
their assets hence the company may decide to put them (the assets) to better usage rather
than sell them.
The directors of KING Plc. will have to reassess their estimates. How realistic is the
increase in sales revenue of N1,500,000 p.a. and a reduction in expenses of N1,250,000.
Furthermore, will the reduction in expenses involve retrenchment of staff and what effect
will this have on the morale of the remaining staff? Also if staff are to be laid off, what
about the redundancy payment?
What about the transaction costs of the acquisition? If the takeover is resisted by the
directors of QUEEN Plc or other interested buyers, then the cost of the acquisition could
be quite high.
Further, since KING Plc. and QUEEN Plc. both manufacture and sell household items;
the attitude of the government or trade unions to forestall a monopoly situation may not
have been considered.
(d) If the director of QUEEN Plc. considered the takeover bid unfriendly, the following
defence tactics are available:
i. Seek Government injunction i.e. restricting the predator company under anti-
monopoly or anti-trust law where this is in existence.
85
vii. Asset Restructuring: The target firm purchases assets that effectively restructure
its statement of financial position. These assets may simply be ones that are
unattractive to the bidder or may cause anti-trust problems if the merger creates
significant monopoly power.
vii. Green mail: This technique involves an agreement allowing the target company
to repurchase its own shares back from the acquiring company, usually at a
premium to the market price. It is the termination of a hostile take-over through a
payoff to the acquirer.
ix. Share repurchase: Rather than repurchasing only the shares held by the
acquiring company as a greenmail, a target company might initiate a cash tender
offer for its own outstanding shares.
x. Pacman Defense: This is called after the video game in which characters try to
eat each other before they are eaten themselves, that is, the firm under attack from
a hostile bidder turns the table by bidding for the aggressor.
xi. White Squire Defence: This is similar to white knight defence in that the two
parties, target firm and white squire, seek to implement a strategy to preserve the
target firm’s independence. This is done by placing shares in the hands of a
friendly firm or investor who is not interested in acquiring control of the target
firm and will not sell out to the predator.
EXAMINER’S REPORT
The question tests candidates’ understanding of the valuation of a company for a take-over
and their knowledge of the various post takeover defence strategies.
86
Candidates’ commonest pitfalls were their inability to price the given company and
differentiate between post takeover and pre-takeover defensive tactics.
Candidates are advised to study extensively and adequately cover the syllabus when
preparing for the Institute’s examinations.
SOLUTION 4
EXISTING SUPPLIER
(i) Economic Order Quantity will be assessed using the following formula:
2DK
\ EOQ =
H
Where D = Annual demand (units)
K = Cost per order
H = Unit holding cost per annum
87
N
Holding cost = 500 x N100 = 25,000
2
Ordering cost = 5,000 x N2,500 = 25,000
500
88
89
EXAMINER’S REPORT
The question tests candidates’ knowledge of inventory control with emphasis on the
Economic Order Quantity (EOQ) Model.
Over 75% of the candidates attempted the question and the general performance was
average. Some of the candidates understood the question and therefore performed
brilliantly, but others did not understand the import of the question, hence they performed
below average.
Candidates’ commonest pitfalls were their inability to produce the correct EOQ formula,
calculate EOQ and total cost and discuss the limitations of the EOQ model
Candidates’ are advised to take time to read, understand and interprete questions
appropriately and note their specific requirements before attempting them. They should
also pay attention to an understanding of key formulae and their applications in some
aspects of the syllabus.
SOLUTION 5
90
(ii) Steps involved in assessing the risks associated with money laundering:
- Identifying the money laundering risks that are relevant to the business.
- Carrying out a detailed risk assessment on such areas as customer behaviour
and delivery channels.
- Designing and implementing controls to manage and reduce any identified
risks.
- Monitoring the effectiveness of these controls and make improvements where
necessary.
- Maintaining records of actions taken and reasons for these actions.
91
EXAMINER’S REPORT
The question tests candidates’ understanding of money laundering and their knowledge of
Islamic Finance.
Over 90% of the candidates attempted the question and performance was poor. Most of
the candidates lacked an understanding of part ‘a’ of the question, while some
demonstrated a fair knowledge of part ‘b’.
Candidates’ commonest pitfall was their inability to interprete the question correctly.
Candidates’ are advised to study extensively and adequately cover the syllabus when
preparing for the Institute’s examinations. They should also endeavour to take time to
read, understand and interprete questions appropriately and note their specific
requirements before attempting them.
SOLUTION 6
(a) Capital Market Line (CML) is the line that represents the expected returns of the efficient
portfolios as a function of volatilities measured by the standard deviations of their
returns.
Security Market Line (SML) is the line which measures the expected returns of
individual securities as a function of their sensitivity to market fluctuations (i.e. beta
factor).
The difference between the two lies in the fact that while CML represents only efficient
portfolios, SML represents all portfolios as well as individual securities. Thus all
92
(b)
(i) Based on CAPM, the return expected from each stock is computed as follows:
Ri: = Rf + b i (Rm – Rf)
Rf = Risk free rate
b i= Portfolio risk (Beta)
Rm = Market returns
Ri = Expected return
Ri = 6 + b i (12 – 6) = 6 + 6 b
i
Stock A 6 + 6 (1.36) = 14.16%
B 6 + 6 (0.52) = 9.12%
C 6 + 6 (0.69) = 10.14%
(iii) To reshuffle the portfolio within these three stocks, we need to know if the
theoretical returns using the CAPM theory are in accordance with the expected
returns based on our forecasts. The difference between the two is calculated using
alphas. Hence, we first need to calculate the alpha of each of the stocks in order
to find out which stocks are underpriced/overpriced.
EXAMINER’S REPORT
The question tests candidates’ knowledge of Portfolio Concept and Capital Asset Pricing
Model (CAPM),
The level of attempt was low as the number of candidates that attempted the question was
below 50%. It therefore appears that most of the candidates that sat for the examination
93
Candidates’ are advised to cover the syllabus adequately, work on past questions, make use
of the Institute’s Pathfinder and Study Packs in their preparations for the Institute’s
examinations for better results. They should also endeavour to remember key formulae
and their applications in solving problems.
SOLUTION 7
(a) Hedging is risk management strategy used in limiting or off-setting probability of loss
from fluctuations in the prices of commodities, currencies or securities. In the context of
this question, hedging can be defined as seeking protection against unexpected future
changes in exchange rate.
Finance managers do manage exchange rate risks through hedging. This implies that
finance managers would anticipate the risk, recognise it, quantify it and taking
appropriate actions to reduce it, if not, totally eliminate it.
94
If actual rate is 9%
the bank will pay Famak Plc. N
FRA receipt N100million x (9% - 6%) x 6/12 (1,500,000)
Payment on underlying loan at market rate
net 9% x N100million x 6/12 4,500,000
Net payment on loan 3,000,000
Effective Interest rate on loan = 6%
EXAMINER’S REPORT
95
Question Papers
Suggested Solutions
Plus
Marking Guide
Examiners‟ Reports
SECTION A
Kay Plc. has been expanding rapidly through mergers and acquisitions. Currently,
it is considering a bid for Y Plc. a company whose shares are not traded. The latest
Statement of Financial Position of Y Plc. is summarised below:
N‟m N‟m
Non-current assets 378
Current assets:
Inventory 242
Receivables 163
Cash 21 426
Total assets 804
Kay Plc. has an issued share capital of 80,000,000 N1 shares with a current market
value of N32 per share (ex div). Current earnings per share amount to N4 and
current dividend per share is N1.20. The company‟s asset beta is 0.8. Kay Plc. has
no prior charge on capital and no other non-current liability. The risk free rate of
interest is 8% and the return on the market portfolio is 13%. Kay Plc. uses the
Capital Asset Pricing Model (CAPM) to estimate its cost of capital. The bid will be in
the form of a share exchange.
Required:
b. i. Calculate the maximum price Kay Plc. should offer per share in Y Plc.
to
avoid diluting current earnings per share after the takeover.
(3 Marks)
ii. Estimate the price Kay Plc. must offer per share in Y Plc. in order to
maintain dividend levels to shareholders in that company. You must
assume that Kay Plc. does not intend to change its own dividend per
share. (3 Marks)
iii. Suggest two other bases of valuing the shares in Y Plc. and calculate
the price per share on those bases.
(5 Marks)
c. Estimate Kay Plc.‟s share prices after the takeover for each of the offer prices
calculated in (b) above, assuming that Kay Plc. retains its current P/E ratio
after the takeover. (8 Marks)
d. Advise the directors of Kay Plc. on steps that could be taken to minimise the
risk of failing to realise the potential synergistic benefits arising from the
takeover. (5 Marks)
(Total 30 Marks)
QUESTION 2
QUESTION 3
Gazoline Plc., a public limited company with a market value of N7billion, is a major
supplier of gas to both business and domestic customers. The company also
provides maintenance contracts for both gas and central heating customers using
the well-known brand name “Gas For All”.
Customers can call emergency lines for assistance for any gas-related incident, such
as a suspected leakage. Gazoline Plc. employs its own highly trained work force to
deal with all such situations quickly and effectively. The company also operates a
major new credit card scheme, which has been extensively marketed and is
designed to give users concessions such as reductions in their gas bills.
The company has recently bid N1.1billion for Smooth Car, a long established
mutual organisation (i.e. it is owned by its members) that is the country‟s leading
motoring organisation. Smooth Car is financed primarily by an annual subscription
of its 4.4million members. In addition, the organisation obtains income from a
range of other activities such as a high profile car insurance brokerage, a travel
agency and assistance with all types of travel arrangements. Its main service to
members is the provision of a roadside break-down service which is now an
extremely competitive market with many other companies involved. Although
many of its competitors use local garages to deal with break-downs, Smooth Car
uses its own road patrols.
Smooth Car members have to approve the takeover which, once completed, would
provide them each with a windfall of around N300 each.
Gazoline Plc. intends to preserve the Smooth Car name which is well-known by
customers.
a. Examine the possible reasons why Gazoline Plc. is seeking to buy Smooth
Car. (8 Marks)
b. Discuss how the various stakeholders of Smooth Car might react to the
takeover. (6 Marks)
c. Explain the potential problems that Gazoline Plc. may face in running
Smooth
Car now that the takeover has been achieved. (6 Marks)
(Total 20 Marks)
QUESTION 4
Required:
a. Prepare the Statement of Financial Position of the company after the
completion of the reconstruction.
(6 Marks)
QUESTION 5
The working capital cycle of a business is the length of time between payment for
inventory entering into inventory and receipt of the proceeds of sales.
The table below gives information extracted from the Statement of Comprehensive
Income and the Statement of Financial Position of Bright Sum Plc. for the years
2012 to 2014.
2012 2013 2014
Inventory: N‟000 N‟000 N‟000
Raw materials 1,080 1,458 1,800
Work-in-progress 756 972 933
Finished goods 864 1,296 1,428
Purchases 5,184 7,020 7,200
Cost of goods sold 7,560 9,720 10,983
Revenue 8,640 10,800 11,880
Trade receivables 1,728 2,592 2,970
Trade payables 864 1,053 1,260
a. Calculate the working capital cycle for each of the 3 years. (9 Marks)
b. Explain THREE possible actions that might be taken to reduce the length of
the cycle and TWO possible disadvantages of each. (6 Marks)
(Total 15 Marks)
QUESTION 6
Required:
Describe TWO types of foreign exchange exposures which can arise in respect
of transactions involving a foreign currency. (6 Marks)
You are required to calculate how much Owiya Osese Plc. actually gained or
lost as a result of the hedging transaction, if at the end of 6 months, the
Naira in relation to Waka has:
i. Gained 4%
ii. Lost 2%
iii. Remained stable
NOTE: You may assume that the forward rate of exchange simply reflects the
interest rate differential in the two countries (i.e. it reflects the interest rate
parity analysis of forward rates). (9 Marks)
(Total 15 Marks)
QUESTION 7
Assume you are the Finance Director of a large multinational company listed on a
number of international stock markets. The company is reviewing its corporate
plan and also focuses on maximising shareholder wealth as its major goal. The
Managing Director thinks this single goal is inappropriate and therefore asks his
co-directors for their views on giving greater emphasis to the following:
Asset Beta
𝑉𝐸 𝑉𝐷 (1 − 𝑇)
𝛽𝐴 = 𝛽𝐸 + 𝛽
(𝑉𝐸 + 𝑉𝐷 (1 − 𝑇)) (𝑉𝐸 + 𝑉𝐷 (1 − 𝑇)) 𝐷
Equity Beta
𝑉𝐷
𝛽𝐸 = 𝛽𝐴 + (𝛽𝐴 − 𝛽𝐷 ) (1 − 𝑡)
𝑉𝐸
Growing Annuity
𝑛
𝐴1 1+𝑔
𝑃𝑉 = 1−
𝑟−𝑔 1+𝑟
𝑆0
𝐼𝑛 + (𝑟 + 0.5𝜎 2 )𝑇
𝑑1 = 𝐸
𝜎 𝑇
d2 = d1 - 𝜎 𝑇
r
Where r = discount rate
n = number of periods
Discount rate (r)
Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1
2 1·970 1·942 1·913 1·886 1·859 1·833 1·808 1·783 1·759 1·736 2
3 2·941 2·884 2·829 2·775 2·723 2·673 2·624 2·577 2·531 2.487 3
4 3·902 3·808 3.717 3·630 3.546 3.465 3·387 3·312 3·240 3·170 4
5 4·853 4·713 4·580 4·452 4·329 4·212 4·100 3·993 3.890 3·791 5
6 5·795 5·601 5·417 5·242 5·076 4·917 4·767 4·623 4.486 4·355 6
7 6·728 6.472 6·230 6·002 5·786 5·582 5·389 5·206 5·033 4·868 7
8 7·652 7·325 7·020 6·733 6·463 6·210 5·971 5·747 5·535 5·335 8
9 8·566 8·162 7·786 7.435 7·108 6·802 6·515 6·247 5·995 5·759 9
10 9·471 8·983 8·530 8·111 7·722 7·360 7·024 6·710 6.418 6·145 10
11 10·368 9·787 9·253 8·760 8·306 7·887 7.499 7·139 6·805 6.495 11
12 11·255 10·575 9·954 9·385 8·863 8·384 7·943 7·536 7'161 6·814 12
13 12·134 11·348 10·635 9·986 9·394 8·853 8·358 7·904 7·487 7·103 13
14 13·004 12·106 11·296 10·563 9·899 9·295 8·745 8·244 7·786 7·367 14
15 13·865 12·849 11·938 11·118 10·380 9·712 9·108 8·559 8·061 7·606 15
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1
2 1·713 1·690 1·668 1·647 1·626 1·605 1·585 1·566 1·547 1·528 2
3 2.444 2.402 2·361 2·322 2·283 2·246 2·210 2·174 2·140 2·106 3
4 3·102 3·037 2·974 2·914 2·855 2·798 2·743 2.690 2·639 2.589 4
5 3·696 3·605 3·517 3·433 3·352 3·274 3·199 3·127 3·058 2·991 5
6 4·231 4·111 3·998 3·889 3·784 3·685 3·589 3.498 3.410 3·326 6
7 4·712 4·564 4.423 4·288 4·160 4·039 3·922 3·812 3·706 3·605 7
8 5·146 4·968 4.799 4·639 4.487 4·344 4·207 4·078 3·954 3·837 8
9 5·537 5·328 5·132 4·946 4·772 4·607 4.451 4·303 4·163 4·031 9
10 5·889 5·650 5.426 5·216 5·019 4·833 4·659 4.494 4·339 4·192 10
11 6·207 5·938 5·687 5.453 5·234 5·029 4·836 4·656 4.486 4·327 11
12 6·492 6·194 5·918 5·660 5·421 5·197 4·988 4·793 4·611 4.439 12
13 6·750 6.424 6·122 5·842 5·583 5·342 5·118 4·910 4·715 4·533 13
14 6·982 6·628 6·302 6·002 5·724 5.468 5·229 5·008 4·802 4·611 14
15 7·191 6·811 6.462 6·142 5·847 5·575 5·324 5·092 4·876 4·675 15
(a) The criteria that should be used to assess if a target is appropriate will
depend on the motive for the acquisition. The main criteria that are
consistent with the underlying motive include:
Diversification
The target firm should be in a business which is different from the acquiring
firm‟s business and the correlation in earnings should be low.
Operating synergy
The target firm should have the characteristics that create operating
synergy. Thus, the target firm should be in the same business in order to
create cost savings through economies of scale or it should be able to create
a higher growth rate through increased monopoly power.
Tax savings
The target company should have large claims to be set off against taxes and
not sufficient profits. The acquisition of the target firm should provide a tax
benefit to the acquirer.
Increase the debt capacity
This happens when the target firm is unable to borrow money or is forced to
pay high rates. The target firm should have capital structure such that its
acquisition will reduce bankruptcy risk and will result in increasing its debt
capacity.
If the market value of Kay Plc. is N32 per share ex-div, purchase
consideration for Y Plc. will therefore be:
ALTERNATIVE METHOD
N418,550,000
EPS = x
That is N4
N418,550,000
x
Therefore 4x = N 418,550,000
x = 104,637,500 shares
Shares issued to Y Plc. will be (104,637,500 - 80,000,000)
= 24,637,500 Shares
Total value placed on Y Plc. will be 24,637,500 x N32 = N788,400,000
Value per existing share of Y Plc. will therefore be:
= N788,400,000 ÷120,000,000
= N6.57
Thus maximum price payable per share is N6.57
ALTERNATIVE METHOD
Let x represent total shares issued by Y Plc.
Total dividend receivable in Kay Plc by Y Plc. shareholders will be N1.20 x
This should equal total current dividend in Y Plc, N18,000,000.
= 15,000,000 shares
Asset Basis
Value of Y Plc‟s equity as per its statement of financial position is N456 million
Add: Increase in value of property (N136- N80) million = N56 million
Asset value of Y Plc. will therefore be (N456 + N56) million = N512 million
Since the number of shares held by the shareholders of Y Plc is 120 million, then
the purchase consideration for Y Plc. using the assets basis will be:
𝑁512,000,000
= 𝑁4.26667 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
120,000,000
Therefore expected annual cash flows for the next ten years is N98.550,000.
Kay Plc‟s cost of capital using CAPM is
Ke = Rf +β(Rm –Rf)
= 8% + 0.8(13%-8%)
= 12%
Since the number of existing shares held by the shareholders of Y Plc. is 120
million, then the value per share to Y Plc. will be:
𝑁556,807,500
= N4.64006 = N4.64
120,000,000
𝑉𝑃𝑆 𝑁32
𝐸𝑃𝑆
= 𝑁4
=8
Therefore calculations of new value per share of Kay Plc‟s will be as follows:
viii. Kay Plc. should respect the products, markets and customers of Y. Plc.
EXAMINER‟S REPORT
The question tests candidates‟ knowledge of the issues involved in strategic acquisition
and the different methods of valuing companies for takeover.
Being a compulsory question, almost all the candidates attempted it but most of them did
not understand its requirements. They therefore performed poorly.
Candidates‟ commonest pitfall was their failure to answer the question correctly which may
be due to their inadequate knowledge of the different methods of valuing companies for a
takeover.
Candidates are advised to always cover the syllabus adequately by giving consideration to
all sections of the syllabus in their preparation for the Institute‟s examinations. They should
also improve their knowledge on mergers and acquisitions.
iv) Political & Environmental factors: These are factors that impact negatively
or otherwise on the company beyond the control and even sometimes the
cognitive forecast of its management. It has to do with political factors such
as political turmoil and environmental factors such as the Boko Haram
Insurgency.
v) Cost of funds: Companies raise short term funds for working capital from
the banks (money market) while they raise long term funds from the capital
market. Since cost of funds in Nigeria is very high firms find it very difficult
to source funds for their operations from banks and this has been having
negative effect on their operations.
vi) Inflation: This has made the cost of goods to be high and since the incomes
of the consumers are not moving at the same rate the suppliers increase the
price of their products, it has become difficult for consumers to buy the
products. Many companies‟ warehouses are therefore overstocked with
unsold goods thereby affecting their operational performance.
ix) Government Foreign Exchange Policy: This is also an area that contributes
to corporate failure in the country. For example, the recent Central Bank
guidelines on foreign exchange is adversely affecting many industries as
they are now having a shortage of foreign currency to import necessary
inputs.
EXAMINER‟S REPORT
The question tests candidates‟ understanding of the analysis and evaluation of the
symptoms and causes of corporate failure.
About 90 Percent of the candidates attempted the question and performance was average.
Most of the candidates that attempted the question showed some understanding except for
a few that could not differentiate between the symptoms and causes of corporate failure.
Candidates‟ commonest pitfall was their inability to express themselves well. They are
therefore advised to improve their communication skills.
(a) The objective of a takeover should be consistent with the overall objective of
the firm making the takeover, which in most cases should be to increase the
wealth of the shareholders.
However, there are good and bad reasons behind a takeover. Among the
good reasons is the possibility of creating synergy, that is increasing the
wealth of the shareholders. Although Gazoline Plc. and Smooth Car are in
different market sectors, there is a link between the two. It is possible for
Gazoline Plc. to make use of the services of Smooth Car in their travelling
arrangement for the supply of gas to their customers. They may also use the
services of Smooth Car to transport their staff for their maintenance contracts.
This is also applicable for the insurance of their staff, their assets and the
business. It could therefore be said that the services provided by Smooth Car
are complementary to the business of Gazoline Plc.
In this respect, some possible reasons why Gazoline Plc. may seek to buy
Smooth Car include:
i) Members: They are likely to be happy with the takeover in view of the
promised wind fall. However, they will be interested also in the future
direction of the new company, its earning capacity and the financial
benefits that may accrue to them. They will also be interested in the
consideration for the takeover apart from the wind fall. Since Smooth
Car brand name will be retained, members will like to ensure that the
company is well managed and its culture of quality services
maintained so as to preserve the good name for which it is known. It is
also likely that some members may not feel comfortable with the
takeover as the organisation has always been part of them. These are
the people that may not like change. They may therefore likely look
elsewhere for the maintenance of their vehicles.
ii) Directors and Senior Managers:-These are the members that have been
operating the business of the organisation. While they may not be
comfortable with the takeover because of the likelihood of losing their
jobs, they are expected to act in the best interest of the organisation
and ensure that the takeover is in the interest of their members.
However, some of them may be interested in what they will benefit
from the takeover and therefore, will like to know what the
acquirer(Gazoline Plc) has in stock for them with respect to retention
or redundancy. They will also want to know the ex-gratia payment that
will be due to them in case of redundancy.
iii) Creditors : The creditors will be interested in their payments and when
this are likely to be made, by ensuring that adequate arrangement is
made for their settlement. This will be done by making sure the
acquirer, that is Gasoline Plc., is financially sound.
c). Gazoline Plc.may face a number of problems after the takeover has been
achieved. These include:
i) Former members of Smooth Car who did not agree with the takeover,
and who may have been actively resisting it, may decide to change
their service provider to another organisation. The parent company
(Gazoline Plc.) will have to be pro-active in giving confidence to all its
Smooth Car Customers;
EXAMINER‟S REPORT
Workings
1. Non-current assets:
Freehold property (N15 million – N 5 million) = N10 million
Plant and machinery (N13.5-N5) million + N12.5 million) = N20.5 million
2. Current assets
Inventory & Work in progress (N17.5 –N4) million = N13.5 million
Receivables (N9 - N0.5 million) = N 8.5 million
4. Unsecured payables
N20 million x 0.75 = N15 million
3/12/2015
Sir,
i. Ordinary Shareholders
ii. Secured Debenture Holders and
iii. The Bank
Realisable Value
N
Plant and machinery 5,000,000
Inventories 8,500,000
Receivables 8,500,000
22,000,000
Less: Liquidation Expenses 3,850,000
Amount available to Creditors 18,150,000
10% Secured Debenture N15,000,000
This is secured with the freehold property whose book value of N15 million could
only realise N10 million.
(N)
Unsecured payables 20,000,000
Bank overdraft (Unsecured) 8,000,000
Balance payable to secured debenture holders 5,000,000
33,000,000
These Creditors will have to share the sum of N18,150,000 which is the amount
available to creditors as earlier calculated
Therefore, the proportional amount available to the creditors per naira will be
N18,150,000 = 0.55 or 55k
N33,000,000
The sharing of the available fund will be as follows:
ii) The 10% secured debenture holders will receive N10,000,000 that is from
the realised asset and 0.55 x N5,000,000 = N2,750,000 from the
proceeds of the other assets. They will therefore receive a total amount of
N10 million + N2.75 million =N12.75 million i.e N12,750,000
They will therefore lose (N15- N12.75) million i.e N2.25 million.
The Earnings Per Share (EPS) will therefore be N7,000,000 = 0.28 or 28k
25,000,000
ii. The secured debenture holders will receive N10 million being the proceeds
of the security. They will also receive N910,000 interest per annum on the
unsecured loan stock for 5 years and at the end of the fifth year, they will
receive N6.5 million being the proceeds of the insured loan. They will in
addition receive N0.28 on the 7.5 million ordinary shares allotted to them
and N0.28 on the rights issue. In effect they will earn N2.1 million + N2.1
million =N4.2 million on the shares held.
Their annual earnings will therefore be:
Interest on the 14% unsecured Loan Stock N 910,000
Earnings per share on their shareholdings N 4,200,000
Total yearly earnings N 5,110,000
iii. The bank – The bank will receive a yearly interest of N840,000 for 5 years
after which they will receive the sum of N6 million being the principal value
of the 14% unsecured loan stock. However, the bank will lose N2 million
immediately.
In conclusion, it is clear from the two cases that the secured debenture
holders benefit most whether on liquidation or on reconstruction.
However, the restructuring is the best option for the company and should
therefore be pursued.
Thanks
Yours faithfully
Signed
For:Omo Financial Services Ltd
Unsecured payables ½
EXAMINER‟S REPORT
The question tests candidates‟ knowledge of the principles of reconstruction.
About 50% of the candidates attempted the question but performance was poor. Candidates
are expected to prepare the Statement of Financial Position after the reconstruction and
also evaluate the scheme of reconstruction but they showed lack of understanding of the
requirements of the question hence the poor performance.
Candidates‟ commonest pitfall was their lack of understanding of the requirements of the
question.
Candidates are advised to read wide and cover the syllabus adequately for better result.
They should endeavour to remember the laws guiding liquidation and also improve their
knowledge of corporate restructuring.
(b) Possible actions that might be taken to reduce the length of the working
capital cycle and their disadvantages include:
Disadvantages include:
- Probability of stock outs;
- Increased order cost; and
- Probable delay in manufacturing
Disadvantages include:
- Loss of goodwill,
- Loss of suppliers; and
- Loss of cash discounts.
Disadvantages include:
- Cost of capital investment as a result of the need for injection of
new capital;
- Need to hire experienced and innovative staff hence an increase in
salary cost may occur;
- Increased capital may be required; and
- Possible increase in cost of research and development
Disadvantages include:
- Possibility of stock out;
- Loss of sales; and
- Customers‟ loss of interest in the goods and possible search for
alternatives.
Disadvantages include:
- Cost of discounts;
- Possibility of customers taking the discount and not making early
payment;
- Cost of collection in case of debt collectors or Factors;
- Reduction of customers goodwill; and
- Loss of sales
EXAMINER‟S REPORT
The question tests candidates‟ knowledge of management of working capital.
Candidates are expected to calculate the working capital cycle and to explain the possible
policies required to reduce it. About 90% of the candidates attempted the question and
performance was good. However, a few of the candidates confused working capital with
working capital cycle and therefore performed poorly.
Candidates are advised to always cover the syllabus adequately for better results. They are
also advised to take time to read, understand and interpret questions appropriately and
note their specific requirements before attempting them.
1.09 F
1.075 1.09 2.5
1.075 2.5
2.725
F 2.5349
1.075
Direct Quote
S= 1
2.5 = 0.4000 (N/Waka)
RF= 0.09
RD= 0.075
1.09 0.40
1.075 F
F = 0.3945 (N/Waka)
Evaluation
i) Naira gained 4% N/Waka
1 0.3846
Actual rate = =
2.50 1.04
N
Hedged receipt (500,000 x 0.3945) 197,250
Unhedged receipt (500,00 x 0.3846) (191,300)
Gain from hedging 4,950
EXAMINER‟S REPORT
The question tests candidates understanding of management of financial risk with
emphasis on the different foreign exchange risks and the use of currency forward contract,
to hedge foreign exchange risk.
Candidates are expected to give two types of foreign exchange risk and calculate the
opportunity cost / gain of hedging. About 15% of the candidates attempted the question
and performance was poor
Candidates‟ commonest pitfalls were their inability to understand foreign exchange risk
and the various hedging instruments. They also failed to remember the interest rate parity
formula needed to calculate the implied forward rate.
Candidates are advised to always cover the syllabus adequately in their preparations for
the Institutes‟ examinations. They should also endeavour to remember key formulae and
improve their knowledge on the management of financial risk section of the syllabus for
better result in future.
(a)
To: The Managing Director
Signed
Finance Director
b.(i) Definition /2
1
(iv) Definition 1
/2
Arguments for and against 1
/2
7
15
PATHFINDER
MAY 2016 PROFESSIONAL EXAMINATION
Question Papers
Suggested Solutions
Plus
Marking Guide
Examiners‟ Reports
YOU ARE REQUIRED TO ANSWER FIVE OUT OF SEVEN QUESTIONS IN THIS PAPER SECTION
QUESTION 1
Katam Pie has adopted a strategy of diversification into many different industries in order
to reduce risk for the company’s shareholders. This has resulted in frequent changes in
the company’s gearing level and widely fluctuating risks of individual investments.
Presently, the company has a target debt-to-asset ratio i.e. D/(E + D) of 255, an equity
beta of 2.25 and a pre-tax cost of debt of 5%.
On January 1, 2016, Katam Plc with a year end of December 31, is considering the
purchase of a new machine costing N750million, which would enable it to diversify into a
new line of business. The new business will generate sales of N522.50million in the first
year, growing at 4.5% p.a. A constant contribution margin ratio of 40% cab be expected
throughout the 15-year life of the project. Incremental fixed cash costs will be
N84.32million into the first year growing by 5.4%p.a.
A regional development bank has offered a 10-year loan of 3% interest to finance 40% of
the cost of the machine. The balance of 60% will be financed equally by a 10-year
commercial loan (with annual interest of 5%) and a fresh round of equity.
The issue cost on the commercial loan will be 1% and the new equity will incur issue cost
of 3%. All issue costs are on the gross amount raised for the respective capital. Issue costs
on debt are allowed to tax purposes.
A firm that is already in the business of the new project has a gearing ratio of 20% (debt to
asset) and cost of equity of 18.1%. Its corporate debt is risk-free.
Tax rate if 30% payable in the year the profit is made. Tax depreciation of 20% on cost is
available on the new machine. Katam Pie has weighted average cost of capital of 14%
and cost of equity of 17.5%. The risk-free rate is 4% and the market risk-premium is 7%.
79
a. Estimate the Adjusted Present Value (APV) and advise whether the project should
be accepted? (21 Marks)
b. Explain:
i. The circumstances under which the use of APV is appropriate.
ii. The major advantages and limitations of the use of APV method.
(9 Marks)
(Total 30 Marks)
QUESTION 2
N’000 N’000
Current assets:
Inventory 2,000
Receivables 1,500
Current liabilities:
Equity:
80
Other information:
Required:
a. Ignoring issue costs and any use that may be made of the funds raised by the rights
issue, calculate:
b. Calculate the current earnings per share and the revised earnings per share if the
proceeds of the rights issue are used to redeem some of the existing debentures.
(4 Marks)
c. Evaluate whether the proposal to redeem some of the debentures would increase
the wealth of the shareholders of BeeJay Plc. Assume that the price/earnings ratio
of BeeJay Plc remains constants. (2 Marks)
d. Discuss the reason why a right issue could be an attractive source of finance for
BeeJay Plc. Your discussion should include an evaluation of the effect of the rights
issue on the debt/equity ratio and interest cover.
(11 Marks)
(Total 20 Marks)
81
Skylet Limited is a major player in the aviation industry with a credit rating of AA. The
company plans to raise N5billion from the bond market. The features of the bond are:
• Maturity 4 years
• Coupon payment Annual
• Coupon rate 5%
• Redemption value par
The current annual spot yield curve for government bonds is as follows:
One-year 3.3%
Two-year 3.8%
Three-year 4.5%
Four-year 5.3%
The following table of spreads (in basis points) is given for the aviation industry.
b. Discuss why conflicts of interest might exist between shareholders and bond
holders. (5 Marks)
(Total 20 Marks)
QUESTION 4
Eko Product Plc (EP Plc) is a producer of a variety of vegetable oil and other household
products in Lagos. The company presently faces a significant competition in the market of
one of its major raw materials – palm oil. To secure regular flow of the raw material, the
Directors of EP Plc are now considering making an offer for the entire share capital of
Benin Oil Plc (BO Plc) a palm oil producing company in Benin.
82
EP Plc BO Plc
It is thought that combining the two companies will result in several benefits. It is
estimated that combining the two companies will generate free cash flow to the firm
(FCFF) of N1,080 million in current value terms, but these will increase by an annual
growth rate of 5% for the next four years, before reverting to an annual growth rate of
2.25% in perpetuity. In addition to this, combining the companies will result in cash
synergy benefits of N100million per year, for the next four years. These synergy benefits
are not subject to any inflationary increase and no synergy benefits will occur after the
fourth year. The debt-to-equity ratio of the combined company will be 40:60 in market
value terms and it is expected that the combined company’s cost of debt will be 4.55%
before tax.
The income tax rate is 20%, the current risk free rate of return is 2% and the market risk
premium is 7%. It can be assumed that the combined company’s asset beta is the
weighted average of EP Plc’s and BO Plc’s asset betas weighted by their current market
values. EP Plc has offered to acquire BO Plc through a mixed offer of one of its shares for
two BO Plc shares plus a cash payment, such that a 30% premium is paid for the
acquisition. Shareholders of BO Plc feel that a 50% premium would be more acceptable.
EP Plc has sufficient cash reserves if the premium if 30%, but not, if it is 50%.
a. Estimate the additional equity value created by combining EP Plc and BO Plc based
on the free cash flow to firm method. Comment on the results obtained and discuss
briefly the assumptions made; (11 Marks)
b. Estimate the impact of EP Plc’s equity holders if premium paid is increased to 50%
from 30% (5 Marks)
83
QUESTION 5
Required:
Prepare a draft report to the board of directors which identifies and briefly explains:
a. The main factors to be considered when deciding on the appropriate mix of short,
medium or long term finance for BADEJO Limited. (8 Marks)
b. The practical considerations which could be factors in restricting the amount of the
debt which BADEJO Limited could raise. (7 Marks)
(Total 15 Marks)
QUESTION 6
a. You work in the corporate finance department of a major bank. The bank has
invested in 20,000.000 shares of Ode Oil Plc. You are concerned about the recent
volatility in Ode Oil Plc’s share price due to the recent instability in the global oil
market. You plan to protect the bank’s investment from a possible fall in Ode Oil
Plc’s share price for the next three months and you do not plan to sell the shares at
present.
84
Required:
How many call options do you need to buy or sell in order to delta-hedge the
bank’s position. Please be specific.
b. The expected return on the market portfolio (estimated from past data) is 12% p.a.
with a standard deviation of 15% and the risk-free rate of 4%p.a. The actual prices,
last year dividends and the covariances from three securities (A, B, C) with the
market are given in the table below:
Required:
i. Calculate the betas and the required rates of return of securities A, B and C.
(3 Marks)
ii. In the table below you have market consensus forecast of 12-month price
targets, ex-div, and the expected divided growth rate of the securities.
85
A 122.50 12
B 740.00 10
C 1,500.00 11
Assuming the dividends are paid in 12 months exactly, compute the required
stock price for the 3 stocks and state your conclusion.
(4 Marks)
iii. Considering the results in (ii) above, explain briefly what will be your
strategy? (1 Mark)
(Total 15 Marks)
QUESTION 7
MK Plc is considering the best way to finance the replacement for a particular high
specification piece of equipment that has become too costly to main. The replacement
equipment is estimated to have a useful life of 4 years with no residual value after that
time.
Other information
• MK Plc has cost of equity of 20% and WACC of 16%
• MK Plc is liable to company tax at a marginal rate of 30% which is settled at the
end of the year in which it arises
86
87
𝑉𝑉𝐷𝐷
𝐾𝐾𝐸𝐸𝐸𝐸 = 𝐾𝐾𝐸𝐸𝐸𝐸 + (𝐾𝐾𝐸𝐸𝐸𝐸 − 𝐾𝐾𝐷𝐷 ) (1 − 𝑡𝑡)
𝑉𝑉𝐸𝐸𝐸𝐸
Asset Beta
Equity Beta
𝑉𝑉𝐷𝐷
𝛽𝛽𝐸𝐸 = 𝛽𝛽𝐴𝐴 + (𝛽𝛽𝐴𝐴 − 𝛽𝛽𝐷𝐷 ) � � (1 − 𝑡𝑡)
𝑉𝑉𝐸𝐸
Growing Annuity
𝐴𝐴1 1 + 𝑔𝑔 𝑛𝑛
𝑃𝑃𝑃𝑃 = �1 − � � �
𝑟𝑟 − 𝑔𝑔 1 + 𝑟𝑟
𝑆𝑆
𝐼𝐼𝐼𝐼 � 0� + (𝑟𝑟 + 0.5𝜎𝜎 2 )𝑇𝑇
𝐸𝐸
𝑑𝑑1 =
𝜎𝜎 √𝑇𝑇
d2 = d1 - 𝜎𝜎 √𝑇𝑇
C + Ee-rt = S + P
𝑢𝑢 = 𝑒𝑒 𝜎𝜎×√𝑇𝑇/𝑛𝑛
d = 1/u
𝑎𝑎 = 𝑒𝑒 𝑟𝑟𝑟𝑟/𝑛𝑛
𝑎𝑎 − 𝑑𝑑
𝜋𝜋 =
𝑢𝑢 − 𝑑𝑑
88
r
Where r = discount
n = number of periods
Discount rate (r)
Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1
2 1·970 1·942 1·913 1·886 1·859 1·833 1·808 1·783 1·759 1·736 2
3 2·941 2·884 2·829 2·775 2·723 2·673 2·624 2·577 2·531 2.487 3
4 3·902 3·808 3.717 3·630 3.546 3.465 3·387 3·312 3·240 3·170 4
5 4·853 4·713 4·580 4·452 4·329 4·212 4·100 3·993 3.890 3·791 5
6 5·795 5·601 5·417 5·242 5·076 4·917 4·767 4·623 4.486 4·355 6
7 6·728 6.472 6·230 6·002 5·786 5·582 5·389 5·206 5·033 4·868 7
8 7·652 7·325 7·020 6·733 6·463 6·210 5·971 5·747 5·535 5·335 8
9 8·566 8·162 7·786 7.435 7·108 6·802 6·515 6·247 5·995 5·759 9
10 9·471 8·983 8·530 8·111 7·722 7·360 7·024 6·710 6.418 6·145 10
11 10·368 9·787 9·253 8·760 8·306 7·887 7.499 7·139 6·805 6.495 11
12 11·255 10·575 9·954 9·385 8·863 8·384 7·943 7·536 7'161 6·814 12
13 12·134 11·348 10·635 9·986 9·394 8·853 8·358 7·904 7·487 7·103 13
14 13·004 12·106 11·296 10·563 9·899 9·295 8·745 8·244 7·786 7·367 14
15 13·865 12·849 11·938 11·118 10·380 9·712 9·108 8·559 8·061 7·606 15
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1
2 1·713 1·690 1·668 1·647 1·626 1·605 1·585 1·566 1·547 1·528 2
3 2.444 2.402 2·361 2·322 2·283 2·246 2·210 2·174 2·140 2·106 3
4 3·102 3·037 2·974 2·914 2·855 2·798 2·743 2.690 2·639 2.589 4
5 3·696 3·605 3·517 3·433 3·352 3·274 3·199 3·127 3·058 2·991 5
6 4·231 4·111 3·998 3·889 3·784 3·685 3·589 3.498 3.410 3·326 6
7 4·712 4·564 4.423 4·288 4·160 4·039 3·922 3·812 3·706 3·605 7
8 5·146 4·968 4.799 4·639 4.487 4·344 4·207 4·078 3·954 3·837 8
9 5·537 5·328 5·132 4·946 4·772 4·607 4.451 4·303 4·163 4·031 9
10 5·889 5·650 5.426 5·216 5·019 4·833 4·659 4.494 4·339 4·192 10
11 6·207 5·938 5·687 5.453 5·234 5·029 4·836 4·656 4.486 4·327 11
12 6·492 6·194 5·918 5·660 5·421 5·197 4·988 4·793 4·611 4.439 12
13 6·750 6.424 6·122 5·842 5·583 5·342 5·118 4·910 4·715 4·533 13
14 6·982 6·628 6·302 6·002 5·724 5.468 5·229 5·008 4·802 4·611 14
15 7·191 6·811 6.462 6·142 5·847 5·575 5·324 5·092 4·876 4·675 15
89
This table can be used to calculate N(d) the cumulative normal distribution
90
a)
i) Ungeared cost of Equity (KEU)
The base-case NPV is computed using ungeared cost of equity. We need to
estimate this from the information about the proxy company. A number of
methods can be used:
Substituting 15.04% for WACCgin the above formula, the position will be:
15.04 = 𝑥𝑥[1 − (0.20)(0.30)]
15.04 = 𝑥𝑥(1 − 0.06)
15.04 = 0.94𝑥𝑥
𝑥𝑥 = 16%
91
ALTERNATIVE METHOD
Growing annuity can be used to calculate the present value of each of the items
involving growth (inflation). As given in the formula sheet, the present value of
growing annuity is given by:
A1 1 + g n
1 −
r−g 1 + r
* Contribution
Contribution, net of tax, in Year 1 is
N(522.50 x 0.4) x (1 – 0.30) = N146.30m
146.30 1.045 15
PV = N 1 − = N1,006.46
0.16 − 0.045 1.16
92
Summary
₦m
PV of contribution 1,006.74
PV of fixed costs (425.94)
PV of tax savings on depreciation 147.33
Outlay (750.00)
Base-case NPV (21.87)
Issue costs
Commercial Equity
loan
₦m ₦m
Net amount needed 225.00 225.00
Issue costs �1�99 × 225� 2.27 �3�97 × 225� 6.96
Gross amount 227.27 231.96
93
Note: In calculating the present values of the financing cash flows, the
discount factor used is 5% to reflect the normal borrowing/default risk
of the company.
Alternatively, the risk-free rate of 4% could be used depending on the
assumption made. Credit will be given where these are used to
estimate the discount factor.
Calculation of APV ₦m
Base – case NPV (21.88)
Financing side – effect 71.03
APV 49.15
94
b)
i) The APV method is most appropriate in the following circumstances:
• When it permanently changes the level of gearing of a company.
• When the project involves unusual financing costs such as a subsidised loan.
• It significantly changes the company’s debt capacity.
• If a number of project-specific financing options are to be considered.
Limitations of APV
• The equation for asset betas in a taxed world assumes that cash
flows are perpetuities. The cash flows for this investment are not
perpetuities.
• APV requires the identification of all financing side effects and their discount
at a rate reflecting their risk. In a complex investment situation, especially
an overseas investment, it might be difficult to identify relevant financing
side effects, and their appropriate discount rates.
• Since the regearing process is based on M&M Model, it ignores bankruptcy
costs, tax exhaustion and agency costs.
MARKING GUIDE
Marks Marks
95
EXAMINER’S REPORT
The question tests candidates understanding of the application of capital project appraisal
techniques using Adjusted Present Value (APV) method.
Over 90 percent of the candidates attempted the question. They are expected to compute the
ungeared cost of equity, the base-case NPV, using growing annuity formula provided in the paper,
and the various issue costs. Virtually all the candidates did not show good understanding of the
requirements of the question as they demonstrated lack of proper understanding of adjusted
present value, hence, their failure to provide correct solution to the problem resulting in their poor
performance.
Candidates commonest pitfalls were their
i. Inability to calculate the required cost of capital;
ii. Use of money cash flows rather than real cash flows to save time
iii. Lack of proper understanding of APV;
iv. Failure to include net interest savings on subsidised finance;
v. Lack of understanding of application of annuity factor in solving problems with
constant cash flows; and
vi. Inability to make use of growing annuity formula in dealing with the question in order
to save time.
Candidates are advised to cover the syllabus adequately, make use of the Institute’s Study Text
and Pathfinders and improve their knowledge on the application of appraisal techniques section
of the syllabus, paying particular attention to the appropriateness of adjusted present value (APV),
in arriving at investment decisions. Candidates’ are strongly advised to practice several
comprehensive examination questions when preparing for the Institute’s examinations
96
₦
5 existing shares @ ₦4 = 20.00
1 new share @ ₦3.40 = 3.40
6 23.40
i) Theoretical ex-rights price = ₦23.40 ÷ 6 = ₦3.90
ii) Value of rights in total = ₦3.90 –N3.40 = ₦0.50
Value of rights per existing share = ₦0.50 ÷ 5 = ₦0.10
b) Calculation of EPS
i) Existing EPS
c) As the price/earnings ratio is constant, the share price expected after redeeming part
of the debentures will remain unchanged at ₦4 per share (N0.2625 x 15.24). Since
this is greater than the theoretical ex-rights share price of ₦3.90, using the funds
raised by the rights issue to redeem part of the debentures results in a capital gain of
97
d) Notes: In the analysis below, alternative assumptions are used. Full credit is given for
any of the assumptions used by the candidates.
i) Gearing Ratio
The calculation is based on book value
• Current Position
₦’000
Debt 4,500
Equity 3,500
4,500
:. D/E ratio - N × 100 = 129%
3,500
₦’000
Comments: Both values are above the sector average of 100%. Issuing new equity
will therefore be attractive in this situation.
Excluding Including
Overdraft Overdraft
₦’000 ₦’000
98
If the rights issue is not used to redeem the debenture issue, the decrease in
gearing, is less dramatic.
- Excluding overdraft:
4,500
× 100 = 75%
6,000
Including overdraft:
5,750
× 100 = 96%
6,000
Comments: In both cases, the debt/equity ratio falls to less than the sector average,
signaling a decrease in financial risk. The debt/equity ratio would fall further if
increased retained profits were included in the calculation, but the absence of
information on the company’s dividend policy makes retained profits uncertain.
First, we need to establish the level of EBIT (Earning Before Interest and Tax)
99
Comments: There will be an improvement in interest cover from 3.4 times (which is
below the sector average of 6 times) to 6.5 times (which is marginally better than
the sector average)
A rights issue will also be attractive to BeeJay Plc. since it will make it more likely
that the company can raise further debt finance in the future, possibly at a lower
interest rate due to its lower financial risk.
It should be noted that a decrease in gearing is likely to increase the average cost
of the finance used by BeeJay Plc., since a greater proportion of relatively more
expensive equity finance will be used compared to relatively cheaper debt. This will
increase the discount rate used by the company and decrease the net present value
of any expected future cash flows.
MARKING GUIDE
Marks Marks
b. Existing earnings 1
Revised EPS 3
4
100
EXAMINER’S REPORT
The question tests candidates’ knowledge of the various computations associated with rights issue
and its effects on leverage and interest cover.
Over 80 percent of the candidates attempted the question but most of them showed inadequate
knowledge of its requirements. However, Part a (i and ii) of the question were well attempted by
many of the candidates while the other parts of the question were poorly attempted by almost all
the candidates that attempted it, hence the overall performance was poor.
Candidates’ commonest pitfalls were their failure to evaluate and interpret data correctly and lack
of in-depth knowledge of the requirements of the question particularly in the Part (d) where they
failed to make relevant computations that were expected to assist them in correctly evaluating the
effect of the rights issue on leverage and interest cover.
Candidates’ are advised to cover the syllabus adequately, read, understand and interpret
questions appropriately before attempting them for better result. They should also endeavor to
make use of the Institute’s Study Text when preparing for the Institute’s examinations.
101
a)
i) Issue Price
The spot yield curve should be used to calculate a likely issue price. The
government bond yield curve needs to be adjusted by the credit spread for an AA
rated company.
1 year 2 years 3 years 4
year
Govt’s bond spot-yield curve 3.30 3.80 4.50
5.30
Add AA spread 0.27 0.40 0.51 0.60
3.57 4.20 5.01 5.90
To price the bond, the cash flows associated with it are discounted using the above
spot rates.
5 5 5 105
Price = + (1.042)2 + (1.0501)3 + (1.059)4 = ₦97.24
1.0357
iii) Duration
Year CF DFat PV PV x n
(n) N‘000m 5.80% N‘000m N‘000m
1 5 0.945 4.725 4.725
2 5 0.893 4.465 8.930
3 5 0.844 4.220 12.660
4 105 0.798 83.790 335.160
97.200 361.475
102
ii) Dividends - Large dividends may be preferred by shareholders, but may concern
bondholders, because the payments leave low cash balances in the company
and hence put at risk the company’s ability to meet its commitments to the
bondholders.
iii) Priority in insolvency - Bondholders may wish to take the company into
liquidation if there are problems paying their interest, to guarantee their
investment. Shareholders however may wish the company to continue trading if
they expect to receive nothing should the company go into liquidation.
iv) Attitudes to further finance - Shareholders may prefer the company to raise
additional finance by means of loans, in order to avoid having to participate in
a rights issue, or the risk of dilution of their shareholding and control if an open
stock market issue is made. Bondholders may not wish the company to take on
the burden of additional debt finance, of payment of interest and repayment to
avoid additional financial risk.
vi) Bankruptcy costs - If the costs of bankruptcy, such as receivers and lawyers’ fee,
are likely to be significant, bondholders may be much less willing than
shareholders for the company to bear any risk. Significant bankruptcy costs may
mean that there is insufficient money left to repay loans.
103
Marks Marks
EXAMINER’S REPORT
The question tests candidates’ knowledge of the application and evaluation of bonds based on
business scenarios and their understanding of yield, yields to maturity duration and bond pricing
using government yield curves. It also tests agency problems in finance.
About 90% of the candidates attempted the question and performance was generally poor. The
Part (a) of the question which carried 75% of the mark was not well understood while Part (b) was
fairly attempted.
i. Inability to use the government’s yield curve to generate the spot rate while those who
were able to do so could not successfully use them; and
ii. Lack of sufficient details on conflict of interest between shareholders and bondholders.
Candidates are advised to take time to read, understand and interpret questions appropriately and
note their specific requirements before attempting them. They should also endeavor to cover the
syllabus in their preparation for the Institute’s examinations and make use of the Institute’s Study
Text and other relevant materials.
104
• Asset beta
6,090 2,400
� × 0.9� + � × 1.2� = 0.985
8,490 8,490
• Equity beta
𝑉𝑉𝐷𝐷
𝛽𝛽𝐸𝐸 = 𝛽𝛽𝐴𝐴 + (𝛽𝛽𝐴𝐴 − 𝛽𝛽𝐷𝐷 ) � � (1 − 𝑡𝑡)
𝑉𝑉𝐸𝐸
40
= 0.985 + (0.985 – 0)� �(1 – 0.20) = 1.51
60
• Cost of equity
𝐾𝐾𝐸𝐸 = 𝑅𝑅𝐹𝐹 + 𝛽𝛽𝐸𝐸 (𝑅𝑅𝑀𝑀 − 𝑅𝑅𝐹𝐹 )
= 2 + 1.51(7) = 12.57%
• WACC
105
* The PV of FCFF for the first 4 years can be calculated using the growing
annuity formula provided in the formula sheet:
𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹1 1+𝑔𝑔 𝑛𝑛
PV = �1 − � � �
𝑟𝑟−𝑔𝑔 1+𝑟𝑟
1,080×1.05 1.05 4
= �1 − � � � = 3,937.95
0.09−0.05 1.09
Comments
Although the equity beta and the risk of the combined company is more than that of
EP Plc. on its own, probably due to BO Plc’s higher business risk (reflected by the
higher asset beta), overall the benefits from growth in excess of the risk free rate and
additional synergies have led to an increase in the value of the combined company.
• whether the calculation of the combined company’s asset when based on the
weighted average of the market values is based on good evidence or not; and
• the given figures such as growth rates, tax rates, free cash flows, market risk
premium, etc. are realistic or not.
106
₦million
30% premium = 1.30 × ₦2,400m = 3,120
50% premium = 1.50 × ₦2,400m = 3,600
New number of shares:
210m + (½ × 200m) = 310m
Loss in value per share of combined company, if 50% of premium is paid instead of
30%.
(N3,600 – N3,120)/310 shares = ₦1.55/share
This represents a drop in value of approx 5.3% on original value of EP Plc. share
(1.55/29)
c) The amount of additional cash is about ₦480 million, if EP Plc. agrees to the demand
made by BO Plc.’s shareholders and pays the 50% premium. EP Plc. has a number of
options to raise the ₦480 million:
i) The company could take on additional loan. But this will increase financial
leverage and the WACC, which in turn will reduce the value of the company.
ii) EP Plc. could raise the amount by issuing additional equity capital, but the existing
shareholders may not see this as a positive development.
iii) EP Plc. could offer a higher proportion of its shares in the share-for-share exchange
instead of paying cash for the additional premium – but this will lead to further
dilution of the equity holding of the existing shareholders of EP Plc.
MARKING GUIDE
Marks Marks
107
Total 20
EXAMINER’S REPORT
The question tests candidates’ knowledge of modern business valuation techniques under mergers
and acquisition with emphasis on candidates understanding of the analysis of merger and
acquisition premium.
The level of attempt was low as only about 20 percent of the candidates attempted the question
and performance was poor.
Candidates’ commonest pitfalls were their inability to correctly compute the value of the company
using free cash flow to the firm (FCFF), failure to analyse the synergies and failure to compute the
acquisition premium as demanded in the question.
Candidates are advised to always cover the syllabus adequately and make use of the Institute’s
Study Text when preparing for the Institute’s examination for better result. They should also pay
attention to learning some key formulae and their applications.
108
From: Accountant
SUBJECT:
i. The term of finance - The term should be appropriate to the asset being
acquired. As a general rule, long term finance should be financed from
long-term sources. Cheaper short-term funds should be used to finance
short-term funds requirements such as fluctuations in the level of
working capital.
iii. Repayment terms - The company must have sufficient funds to be able to
meet repayment schedules contained in the loan agreement. Since
short-term funds are usually repayable on demand or at short notice, it
is therefore risky to finance long-term capital investments with short-
term funds.
109
iii. Restriction on current borrowing - If the terms of any current loan to the
company contain restriction on borrowing rights, it may be difficult for
the company to obtain further loan.
Signed
ACCOUNTANT
110
Marks Marks
Format 1½
Total 15
EXAMINER’S REPORT
The question tests candidates’ knowledge of the evaluation and application of financing options
for a business and emphasizes short, medium and long term alternative financing.
Over 90 percent of the candidates attempted the question and performance was poor. Most of the
candidates could not differentiate between sources of finance and factors to be considered in
capital mix hence, performance was poor.
Candidates’ commonest pitfalls were their inability to differentiate between sources of finance and
the factors that determine the capital mix. In addition, they could not identify the limiting factors
to debt financing.
Candidates are advised to adequately cover the syllabus and make use of the Study Text in their
preparation for the Institute’s examinations. They should also ensure to read, understanding and
interpret questions appropriately and note their specific requirements before making an attempt.
111
• N(d1) = N(-0.0753)
= 1 – N(0.0753)
= 0.470
b)
covariance with market
i) Beta =
variance with market
βA = 0.025650�0.152 = 1.14
βB = 0.018675�0.152 = 0.83
βC = 0.029025�0.152 = 1.29
112
ii)
• Expected dividends in 1 year:
Summary
iii) If you believe that the market consensus forecast is correct, sell stock B (over-valued)
and buy stock C (under-valued)
MARKING GUIDE
Marks Marks
a. Calculation of d1 2½
Calculation of d2 2
Calculation of number of calls 1½
Correct interpretation (i.e. sell) 1
7
b. Calculation of covariances 1½
Calculation of required return 1½
Calculation of expected dividends 1½
Calculation of expected price 1½
Summary 1
Conclusion 1
8
113
EXAMINER’S REPORT
Part (a) of the question tests candidates’ knowledge of delta hedging using Black-Scholes option
pricing model while Part (b) tests candidates’ application of Capital Asset Pricing Model (CAPM).
The level of attempt was very low as not more than 20 percent of the candidates attempted the
questions and performance was very poor. Candidates are expected to compute d1 and N(d1) and
apply the result in their recommendations. They are also expected to analyse the securities stated
in the question using capital assets pricing model.
Candidates’ commonest pitfalls were their inability to apply the Black Scholes formula for d1 and
make use of the normal distribution table.
Candidates are advised not to be selective in their choice of study for the examination of the
Institute. They should ensure that they cover the syllabus and not leave out any part in their
preparations.
Candidates are expected to be guided by the Study Text and should not limit themselves to the
Study Text alone but should take advantage of other textbooks for more details.
114
Scheme A. The relevant cost is simply the cost of the equipment i.e. ₦200million
₦’000
Alternative method
115
₦000
Year 1 16,945 x 0.3 = 5,084
2 11,924 x 0.3 = 3,577
3 6,291 x 0.3 = 1,887
iv) Discount rate. The discount rate to use is the cost of borrowing, net of tax
= 13 (1 – 0.30) = 9.1%
0 1 2 3
Year
₦000 ₦000 ₦000 ₦000
Lease rentals (58,790) (58,790) (58,790) (58,790)
Tax relief interest 0 5,084 3,577 1,887
NCF (58,790) 53,706) (55,213) (56,903)
PVF at 9.1% 1 0.917 0.840 0.770
PV (58,790) (49,248) (46,379) (43,815)
Total PV (₦198,232,000)
Note: The above calculations are based on differential cash flows. We have
therefore ignored tax savings on tax depreciation. Whether the company
buys the equipment by borrowing or adopts a finance lease, it is entitled to
tax depreciation on the equipment. If the relevant tax savings are
incorporated into the analysis, the result will be as follows:
116
It is clear that the relative position of the two alternatives remains the same.
The decision to invest in the equipment being financed will have already been
evaluated taking project specific risk into account. The evaluation in (a) is
being used to support the financing decision rather than the investment
decision. Cash flows should be discounted at either WACC or project specific
discount rate when evaluating the investment decision since the project is
financed using the company’s debt and equity resources. However, the
financing decision is a separate decision and the discount rate should be
tailored appropriately.
In financing decision, we can use debt as the ‘base line’ and compare other
forms of finance to the cost of debt by using the cost of debt as the discount
rate. The post-tax cost of debt is the opportunity cost of leasing and can be
used to discount the incremental cash flows arising from leasing as compared
to buying outright using the discount rate. Note that it would have been
equally acceptable to use leasing as the ‘base’ instead of debt and hence
discount cash flows at the post tax implied cost of leasing. However, it is
generally simpler to discount at the post tax cost of debt.
117
Marks Marks
a. Scheme A 1
Scheme B:
• Implied interest rate 2
• Interest calculations 4
• Tax savings on interest 1
• Discount rate to use ½
• NPV of lease option 4½
13
b. Discussion 2
Total 15
EXAMINER’S REPORT
More than 80 percent of the candidates attempted the question and performance was very poor.
Candidates are expected to compute implied interest rate in the lease and also analyse the tax
saving on interest but they showed very limited understanding of the question.
Candidates’ are advised to prepare adequately for the Institute’s examinations and make use of
the Study Text and Pathfinders in their preparations.
GENERAL OBSERVATIONS
This particular examination has demonstrated a number of disturbing trends in the attitude of the
candidates towards the examination. Some of these include:
i. Limited coverage of the syllabus – It would appear that candidates have declared some
parts of the syllabus as unexaminable! How wrong they are!!
118
ii. Key Financial Management Formulae – There are evidences that candidates do not learn
the use and the application of the formulae annexed to the question paper. In this
examination, only very few candidates made use of growing annuity formula in solving
question number one. Candidates wasted time (and hence marks!) in compounding and
discounting over a period of 15 years when the desired result could have been achieved
with one or two lines, using growing annuity.
Future examination questions will continue to test the use and the applications of these
formulae.
119
PATHFINDER
NOVEMBER 2016 DIET
PROFESSIONAL LEVEL EXAMINATIONS
Question Papers
Suggested Solutions
Marking Guides
Plus
Examiner’s Reports
INSTRUCTION: YOU ARE REQUIRED TO ANSWER FIVE OUT OF SEVEN QUESTIONS IN THIS PAPER
QUESTION 1
Tinko Plc (TP) repairs and maintains heavy duty trucks, with workshops all over Nigeria and a
number of countries in Africa.
Below are extracts from the most recent Statement of Financial Position of TP:
₦’million
Share capital (50kobo/share) 200
Reserves 320
Non-current liabilities 760
Current liabilities 60
1,340
TP’s Free Cash Flows to Equity (FCFE) is currently estimated at ₦153million and this is
expected to grow at 2.5% per annum to infinity. The equity shareholders require a return of
11%.
The company’s non-current liabilities consist entirely of ₦1,000 nominal value of bonds which
are redeemable in four years at par, with a coupon rate of interest of 5.4%. The debt is rated
BB and the credit spread on BB rated debt is 80 basis points above the risk-free rate of return.
The government recently launched its “Graduates Back To Land (GBTL)” programme in which
graduates are being encouraged to take on highly mechanised farming. The programme will
involve massive importation of heavy duty agricultural machines like tractors, harvesters,
driers, etc. for distribution to “Graduate Agric Clubs” all over the country. However, there is a
growing concern, within the country about the possibility of effective maintenance of these
machines. TP is therefore considering entering this market through a four-year project. The
project will cease after four years because of increasing competition.
The initial cost of the project is expected to be ₦84million and it is expected to generate the
following after-tax cash flows over its four-year life:
The above figures are based on the GBTL programme growing as expected. However, it is
estimated that there is 25% probability that the GBTL programme will not grow as expected in
the first year. If this happens, then the present value of the project’s cash flows will be 50% of
the original estimates over its four-year life.
It is also estimated that if the GBTL programme grows as expected in the first year, there is still
a 20% probability that the expected rate of growth will slow down in the second and
subsequent years, and the present value of the project’s cash flows would then be 40% of the
original estimates in each of these years.
Feedwell Limited (FL) has offered ₦100million to buy the project from TP at the start of the
second year. TP is considering whether having this choice would add to the value of the
project.
Although, there is no beta for companies offering maintenance services for only agricultural
machines and equipment in the country, Abako Plc (AP), a listed company, offers maintenance
and related services for construction, minning, and agricultural equipment. About 15% of its
business is in the equipment maintenance services in the agricultural sector. AP has an equity
beta of 1.6. It is estimated that the asset beta of non-agricultural maintenance sectors is 0.80.
AP’s shares are currently trading at ₦4.50 per share and its debt is currently trading at ₦1,050
per ₦1,000. It has 80 million shares in issue and the book value of its debt is ₦340million. The
debt beta is estimated to be zero.
The income tax rate applicable to all companies is 20%. The risk-free rate is estimated to be 4%
and the market risk premium is estimated to be 6%.
Required:
a. Calculate the current total market value of TP’s:
i. Equity (3 Marks)
ii. Bonds (4 Marks)
b. Calculate the risk-adjusted cost of capital required for the new project.
(Round your final answer to the nearest %). (10 Marks)
c. Estimate the value of the project with and without the offer from FL
(10 Marks)
d. State the assumptions made in your calculations. (3 Marks)
(Total 30 Marks)
QUESTION 2
Honey Comb Plc, has issued 10% convertible loan stock which is due for redemption in
10 years’ time i.e. December 31, 2025. The option to convert is open only for another
two years. If conversion does not take place by December 31, 2017, the option will
lapse. The issue was sold to the public at a price of N920 for N1000 of convertible loan
stock. The conversion rate at January 1, 2016 was 250 equity shares for N1000 of
stock. Non-convertible loan stock in a similar risk class is presently yielding 12%. The
market price of Honey Comb Plc. equity shares has been increasing steadily over time
reflecting the performance of the company. The shares currently pay a dividend of
N0.30 per share. The current price of the convertible security is N960 and each share is
currently valued at N3.00. A holder of the convertible loan stock is considering
whether to sell his holdings or continue to hold the stock. Ignore taxation, while
answering the questions.
Required:
a. What is the value of the security as simple unconvertible loan stock?
(5 Marks)
b. What is the expected minimum annual rate of growth in the equity share price
that is required to justify the holder of convertible loan stock holding on to the
security before the option expires? (12 Marks)
c. What recommendation would you make to the holder of the security and why?
(3 Marks)
(Total 20 Marks)
QUESTION 3
Jack Limited is a family-owned business which has grown strongly in the last 50 years.
The key objective of the company is to maximise the family’s wealth through their
shareholdings.
Recently, the directors introduced value-based management, using Economic Value Added
(EVA) as the index for measuring performance.
₦’million
Operating profit 340.0
Finance charges (115.0)
Profit before tax 225.0
Tax at 25% (56.3)
Profit after tax 168.7
b. Irrespective of your answer in (a) above, assume the company’s current EVA is
₦120million and that this will decline annually by 2% for the next ten years and then
increase by 4% per annum in perpetuity. Assume the following for this part only:
Cost of equity 14%
WACC 10%
Calculate the market value added (MVA) by the company.
Show all workings (5 Marks)
(Total 20 Marks)
QUESTION 4
Gugi Plc. is now considering whether to establish a factory in the foreign country and stop
export from Nigeria to the country. The project is expected to cost F$1 billion, including
F$200million for working capital.
A suitable existing factory has been located and production could commence immediately. A
payment of F$950million would be required immediately with the remainder payable at the
end of year one. The following additional information is available:
Assume that the above cash items will remain constant throughout the expected life of
the project of 4 years. At the end of year 4, it is estimated that the net realisable value
of the non-current assets will be F$1.40billion.
It is the policy of the company to remit the maximum funds possible to the parent (i.e. Gugi
Plc.) at the end of each year. Assume that there are no legal complications to prevent this.
Production in Nigeria is at full capacity and there are no plans for further capacity expansion.
Tax on the company’s profits is at a rate of 40% in both countries, payable one year in arrears.
A double taxation agreement exists between Nigeria and the foreign country and no double
taxation is expected to arise. No withholding tax is levied on royalties payable from the foreign
country to Nigeria.
Tax allowable “depreciation” is at a rate of 25% on a straight line basis on all non-current
assets.
The Directors of Gugi Plc. believe that the appropriate risk-adjusted cost of capital of the
project is 13%.
Annual inflation rates in Nigeria and the foreign country are currently 5.6% and 10%
respectively. These rates are expected to remain constant in the foreseeable future. The current
spot exchange rate is F$1.60 = N1. You may assume that exchange rate reflects the
purchasing power parity theorem.
Required:
a. Evaluate the proposed investment from the view point of Gugi Plc.
Notes
i. Show all workings and all calculations to the nearest million.
ii. State all reasonable assumptions. (18 Marks)
b. State TWO further information and analysis that might be useful in the
evaluation of this project? (2 Marks)
(Total 20 Marks)
SECTION C: YOU ARE REQUIRED TO ANSWER ANY TWO OUT OF THREE QUESTIONS IN
THIS SECTION (30 MARKS)
QUESTION 5
You are required to show which of the companies is/are overvalued. (9 Marks)
(Total 15 Marks)
QUESTION 6
Osamco Limited, manufacturer of wire and cables, was bought from its conglomerate
parent company in a management buyout deal in August, 2010. Six years after, the
managers are considering the possibility of listing the company’s shares on the
Nigerian Stock Exchange.
The following information is made available:
OSAMCO LIMITED
INCOME STATEMENT FOR THE YEAR ENDED JUNE 30, 2016
N’million
Turnover 91.25
Cost of sales (79.00)
Profit before interest and taxation 12.25
Interest (3.25)
Profit before taxation 9.00
Taxation (1.25)
Profit attributable to ordinary shareholders 7.75
Dividend (0.75)
Retained profit 7.00
One of the means by which companies expand is through mergers and acquisition.
However, there are other means of expansion aside these methods.
Inkline Plc. is one of your client companies intending to expand its business by means
of merger or acquisition.
Your firm of management consultants has been asked to advise the management of
the company on what steps to take, while considering the merger and acquisition
methods, and whether it should go ahead with the expansion programme or
otherwise.
Required:
Asset Beta
(1 − )
= +
( + (1 − )) ( + (1 − ))
Equity Beta
= +( − ) (1 − )
Growing Annuity
1+
= 1−
− 1+
= (1 + ) − 1
r
Where r = discount rate
n = number of periods
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1
2 1·713 1·690 1·668 1·647 1·626 1·605 1·585 1·566 1·547 1·528 2
3 2.444 2.402 2·361 2·322 2·283 2·246 2·210 2·174 2·140 2·106 3
4 3·102 3·037 2·974 2·914 2·855 2·798 2·743 2.690 2·639 2.589 4
5 3·696 3·605 3·517 3·433 3·352 3·274 3·199 3·127 3·058 2·991 5
6 4·231 4·111 3·998 3·889 3·784 3·685 3·589 3.498 3.410 3·326 6
7 4·712 4·564 4.423 4·288 4·160 4·039 3·922 3·812 3·706 3·605 7
8 5·146 4·968 4.799 4·639 4.487 4·344 4·207 4·078 3·954 3·837 8
9 5·537 5·328 5·132 4·946 4·772 4·607 4.451 4·303 4·163 4·031 9
10 5·889 5·650 5.426 5·216 5·019 4·833 4·659 4.494 4·339 4·192 10
11 6·207 5·938 5·687 5.453 5·234 5·029 4·836 4·656 4.486 4·327 11
12 6·492 6·194 5·918 5·660 5·421 5·197 4·988 4·793 4·611 4.439 12
13 6·750 6.424 6·122 5·842 5·583 5·342 5·118 4·910 4·715 4·533 13
14 6·982 6·628 6·302 6·002 5·724 5.468 5·229 5·008 4·802 4·611 14
15 7·191 6·811 6.462 6·142 5·847 5·575 5·324 5·092 4·876 4·675 15
This table can be used to calculate N(d) the cumulative normal distribution
0 (1 ) 153(1.025) 156.825
= = = = ₦1,845million
0.11 0.025 0.085
ii) ● Cost of the bond = Risk-free rate of return plus the credit spread
= 4% + 0.80% = 4.80%
= 54 + 54 + 54 + 1054 = ₦1,021.37
. . . .
The cost of capital should reflect the systematic business risk of the project. This should be
calculated from the information given about AP.
1.6 × 360
= = 0.89
360 (357×0.8)
= 1.4
i) Value of the project without the offer from Feedwell Limited (FL)
Year 1 2 3 4
Cash flow (₦’000) 6,555.20 32,268.6 73,009.4 71,367.20
Present value at 12% 5,852.90 25,724.3 51,966.6 45,355.10
ii) Expected value of the project with the offer from Feedwell Limited (FL)
If the Graduate Back To Land (GBTL) does not grow as expected in the first year, then
it is more beneficial for Tinko Plc. to exercise the offer made by FL, given that FL’s
offer of ₦89.27 million (PV of ₦100 million) is greater than the PV of years two to four
cash flows, that is, 50% × ₦(25.72m + 51.97m + 45.36m) = ₦61.53m for that
possible outcome.
This figure is then incorporated into the expected net present value calculations. Thus,
for possible outcome B:
₦
Year 1: 50% × ₦5,852,900 2,926,000
2: PV of ₦100million 89,286,000
92,212,000
Year 1 Year 2 - 4
d) Key assumptions
It is assumed that the capital structure of the company will not change substantially
when the new project is taken on. Since the initial cost of the project is significantly
smaller than the value of TP itself, it is not an unreasonable assumption.
There may be more possible outcomes in practice than the ones given and financial
impact of the outcomes may not be known with such certainty. The Black-Scholes
Option Pricing Model may provide an alternative and more accurate way of assessing
the value of the project.
It is assumed that TP can rely on FL paying the ₦100m at the beginning of year two
with certainty.
It is assumed that all the figures relating to the beta, growth rates, risk adjusted cost of
capital and probabilities are accurate.
EXAMINER’S REPORT
The question tests candidates’ knowledge of valuation of equity and bond, calculation of risk-
adjusted cost of capital and evaluation of capital project involving risk and uncertainty.
Being a compulsory question, almost all the candidates attempted the question. However, it is
highly disappointing that most of them did not understand the concepts being tested as they
could not generate the required solutions to parts ‘b’ and ‘c’ of the question, hence
performance was poor.
Candidates’ commonest pitfalls were their inability to calculate the equity beta needed for the
project and their failure to sort out its cash flows.
Candidates are advised to cover the syllabus adequately, work on past questions in the
Institute’s Study Texts, Pathfinders and other relevant text books for better results in future
examination.
(a) The value of the security as a simple unconvertible loan stock is the present value of
the future interest (years 1 – 10) and the present value of the face value due in year 10.
(b) For the holder to convert, the current market value of the convertible must at
least equal the present value of interest for the next two years and the present
value of the conversion value. The conversion value:
= Po (1 + g)n x R,
Where:
Po = current VPS = N3
g = growth rate in share price to be determined
n = years to expiration of the option to convert = 2 years
R = conversion ratio = 250 shares
Thus:
Correct Market Value = The Present Value Interest for the next two years + Present
Value of the conversion value.
3(1 g)2 X 250
i.e 960 = 100
(1.12)
100
+ (1.12)2 + (1.12)2
750(1 g)2
960 = 169 +
(1.12)2
MARKING GUIDE
MARKS MARKS
(a) Calculation of value as an unconvertible bond 5
EXAMINER’S REPORT
The question tests candidates’ knowledge of convertible bonds, Part ‘a’ of the question tests
candidates’ knowledge of bond valuation, while part ‘b’ tests analysis of convertibles.
About 40 percent of the candidates attempted the question and performance was generally
poor. A few of the candidates that attempted the question displayed good understanding
while some had problems in providing appropriate solutions hence poor performance.
Candidates’ commonest pitfalls were their inability to recognize the requirements of the
question in part ‘a’ which was simply the valuation of bonds and their failure to work out the
growth rate in part ‘b’.
Candidates are advised to read, understand and interpret questions appropriately and note
their specific requirements before attempting them.
a)
₦m ₦m
Operating profit 340.00
Add back:
Non-cash items 35.00
Accounting depreciation 295.00
Doubtful debts 10.00
Research and development 60.00
Marketing expenses 50.00 450.00
Less
Economic depreciation 415.00
Tax cash paid (45 – 2.5) 42.50
Loss tax relief on interest 28.75 (486.25)
(25% of N115m)
NOPAT 303.75
₦m ₦m
Per 2014 Statement of Financial Position 6,185.00
Add back:
Provision for doubtful debt at the end of 2014
(22.50 – 10) 12.50
Other non-cash expenses (2014) 30.00
Marketing expenses (2014) 45.00 87.50
Adjusted opening capital employed (AOCE) 6,272.50
The company is currently destroying value as it is failing to meet the economic cost of
its own capital. This is an unsustainable position in the long term and will lead to
shareholders’ dissatisfaction.
First 10 years when g= –2%. It is faster to work with growing annuity in this
case.
1 1
PV = 1−
1
1 0.02 10
120(1 0.02) 1
1.10
= = ₦671.28m
0.10 0.02
Years 11 to infinity
101.97 10
PV = × (1.10) = ₦655.23m
0.10 0.04
MARKING GUIDE
MARKS MARKS
(a)i. Adjusted NOPAT 5
ii. Adjusted opening capital employed 5
iii. Calculation of WACC 1
iv. Calculation of EVA 1
v. Comments and recommendations 3
15
(b) Calculation of MVA 5
TOTAL 20
About 50% of the candidates attempted the question but most of them did not have a clear
and accurate understanding of both parts of the question hence their performance was poor.
Candidates’ commonest pitfalls were their inability to carry out the accounting adjustments
required to determine the Net Operating Profit After Tax (NOPAT) and the Opening Capital
Employed (OCE).
Candidates are advised to make use of the Institute’s Study Texts in their preparation for the
Institute’s examinations.
Year 0 1 2 3 4 5
Receipts from foreign project (W4) (594) 99 118 112 957 (289)
Royalty received in Nigeria - 33 33 33 33 -
Related tax in Nigeria (at 40%) - (13) (13) (13) (13)
Net cash flow (594) 132 138 132 977 (302)
PVF at 13% 1 0.885 0.783 0.693 0.613 0.543
PV (594) 117 108 91 599 (164)
Note: The loss of exports to the foreign country is not a relevant cash flow since it will be
replaced by equivalent exports to North Africa.
Working Notes
1. Exchange rate
The rate of change of the value of the foreign currency is given as:
− 1, here
MARKING GUIDE
HEADING MARKS MARKS
(a)i Calculation of exchange rates 3
ii. Conversion of royalty to F$ 1
iii. Computation of profit after tax F$ 4
iv. Projects’ cash flows in N 5
v. Computation of NPV and conclusion 5
18
(b) 1 mark per point, max 2 2
TOTAL 20
EXAMINER’S REPORT
The question tests candidates’ knowledge of the analysis of foreign projects under International
Investment decisions aspect of the syllabus.
About 80 percent of the candidates attempted the question. They however demonstrated
insufficient knowledge of this area of the syllabus hence performance was very poor.
Candidates’ commonest pitfalls include their inability to:
(a) calculate the appropriate exchange rates to use;
(b) sort out the appropriate cash flows;
(c) remove working capital from the initial investment before computing tax depreciation;
(d) convert the royalty paid in Naira to the F$ for the purpose of computing the foreign tax;
(e) account for tax on the resale value of the investment even when the asset has been fully
depreciated for tax purposes;
(f) account for Nigerian tax on royalty collected in Nigeria.
Candidates are advised to always cover the syllabus adequately and make use of the Institute’s
Pathfinders, Study Texts and other relevant text books in their preparations for the Institute’s future
examinations. They should also endeavour to pay attention to and improve their knowledge on
International Investment decisions aspect of the syllabus. However, it is extremely important for
candidates to note that future examination questions will continue to be set to cover all areas of the
syllabus.
(a). Assumptions of Capital Asset Pricing Model (CAPM) include the following:
i. Investors only need to know the expected returns, the variances, and the co-
variances of returns to determine which portfolios are optimal for them;
ii. Investors have identical views about risky assets’ mean returns,
variances of returns, and correlations;
iii. Investors can buy and sell assets in any quantity without affecting price; all
assets are marketable (can be traded);
iv. Investors can borrow and lend at the risk-free rate without limit, and they can
sell short any asset in any quantity;
v. Investors pay no taxes on return;
vi. Investors pay no transaction costs on trades;
vii. All investors’ decisions are based on a single time period.
( . )( )
Akira (A) = = 1.30
( . )( . )
Bombadia (B) = = 0.80
( . )( )
Courage (C) = = 1.11
.
Divine (D) = = 1.70
= + i
( - )
Conclusion
Securities with positive alpha are undervalued and securities with negative
alpha are overvalued and should be sold.
MARKING GUIDE
MARKS MARKS
(a) Any 6 points at 1 mark each 6
EXAMINER’S REPORT
The question tests candidates’ knowledge on Capital Asset Pricing Model (CAPM).
About 25 percent of the candidates attempted the question. The few that attempted it showed
a good understanding of ‘part b’ of the question but others had problems in providing
appropriate solutions hence performance was average.
Candidates’ commonest pitfalls were their mix up of the assumptions of Capital Asset Pricing
Model (CAPM) with those of capital market generally in part ‘a’ of the question and their
failure to apply the appropriate formula to calculate beta factor in part ‘b’.
Candidates are advised to read, understand and interpret questions appropriately and note
their specific requirements before attempting them.
(a). The performance and financial health of Osamco Limited in relation to that of
the industry sector as a whole can be evaluated by comparing its financial
ratios with the industry averages, as follows:
Returns On Equity
Profit attributable to ordinary shareholders: Equity
₦7.75m : ₦31m 25% 16%
Current Ratio
Current assets : Current Liabilities
₦25.25m : ₦22.5m 1.12:1 1.6:1
Gearing Ratio
Debt : Equity
(₦5m + ₦5.5): ₦31m 33.9% 24%
Dividend Cover
Profit attributable to equity: Dividend
₦7.75m : ₦0.75 10.3 times 4.0 times
Interest Cover
Profit before interest and tax (PBIT): Interest
₦12.25m : ₦3.25 3.77 times 4.5 times
Osamco Limited’s return on capital employed, return on equity and operating profit
margin are all significantly above the industry averages. Although, the first two
measures could be inflated due to asset being shown at book values, the profit margin
indicates that OSAMCO LTD is managing to make good profit which could be due to
successful marketing, a low cost base or to its occupation of a particularly profitable
niche in the market.
Liquidity
Both the current and the quick (acid test) ratios are well below the industry averages.
This suggests that Osamco Limited is either short of liquid resources or is managing its
working capital poorly.
However, the three key working capital ratios modify this impression as follows:
.
Receivable days : = 47 days
.
.
Inventory Turnover days: = 51 days
.
.
Payment Period days = 81 days
.
Although, the industry averages are not given, these ratios appear to be good by
general standards.
Financial Stability
Gearing ratio is high in comparison with the rest of the industry and 48% of the debt is
in the form of overdraft which is generally repayable on demand. This is therefore a
risky form of debt to use in large amounts. The debenture is repayable in two years
and will need to be refinanced since Osamco Limited cannot redeem it out of existing
resources. Interest cover is also poor, and this together with the poor liquidity
probably account for the low payment ratio (the inverse of the dividend cover).
In summary, profit performance is strong, but there are significant weaknesses in both
the liquidity and financial stability. These problems need to be addressed if Osamco
Limited is to be able to maintain its record of strong and consistent growth.
MARKING GUIDE
MARKS MARKS
(a)i. Calculation of the given ratios 6
ii. Interpretation 4
10
(b) 1¼ per point (for any four points) 5
TOTAL 15
EXAMINER’S REPORT
The question tests candidates’ ability to calculate and interpret basic financial ratios.
About 90% of the candidates attempted the question and performance was average. Some of
the candidates displayed good understanding of the question while some had problems in
providing appropriate solutions.
Candidates’ commonest pitfalls were their failure to calculate some of the ratios correctly and
their inability to provide appropriate interpretations of the computed ratios.
Candidates are advised to ensure adequate coverage of all sections of the syllabus.
The Directors
Inkline Plc
34, Ojodu Street
Ikeja, Lagos
Dear Sirs,
We have gone through your request asking us to offer advice on your proposed
expansion via merger and acquisition, we advise as follows:
a. (i) The benefits derivable from the proposed method of expansion include:
Your company will experience faster growth than when the internal
development is pursued.
If your company’s expansion is made through acquisition of another
company, there is greater likelihood that your company may inherit new
products, new markets and new/additional customers from the acquired
company which may be difficult to obtain through internal development.
Your mode of expansion will enable your company enter a new market
and set up a new business which would have been difficult because of
high entry barriers.
Your acquisition of a competitor will prevent it from acquiring yours.
Your company may save cost and earn higher profits from synergy effects
EXAMINER’S REPORT
The question tests candidates’ knowledge of Mergers and Acquisitions with specific emphasis
on candidates’ ability to identify advantages and disadvantages of growth by mergers and
acquisition and its alternative means of growth.
About 90% of the candidates attempted the question and performance was good. However,
some of the candidates lost some marks for their failure to present their solution in a report
format.
Candidates are advised to always ensure that they read, understand, interpret questions
correctly and note their specific requirements before attempting them to avoid loss of marks.
PATHFINDER
MAY 2017 DIET
PROFESSIONAL LEVEL EXAMINATIONS
Question Papers
Suggested Solutions
Marking Guides
Plus
Examiner‟s Reports
QUESTION 1
K Plc., a listed company based in Warri, Delta state, has been involved in producing boats
(but excluding the engines). The company is now considering diversifying into the
production of a major component of outboard engine. For this purpose, the company has
recently purchased the patent rights for ₦15million to produce the component.
K Plc. has spent ₦20million developing prototypes of the component and undertaking
market studies. The research studies came to the conclusion that the component will
have a significant commercial potential for a period of five years, after which, newer
components would come into the market and the sales revenue from the component
would virtually fall to zero. The research studies have also found that in the first two
years (the development phase), there will be considerable training and development
costs and fewer components will be produced and sold. However, sales revenue is
expected to grow rapidly in the following three years (the commercial phase).
It is estimated that in the first year, the selling price would be ₦2,000 per component, the
variable costs would be ₦800 per component and the total direct fixed costs would be
₦6,000,000. Thereafter, while the selling price is expected to increase by 8% per year, the
variable and fixed costs are expected to increase by 5% per year for the next four years.
Training and development costs are expected to be 120% of variable costs in the first year,
40% in the second year, and 10% in each of the following three years.
The estimated average number of outboard engine components produced and sold per
year is given below:
Year 1 2 3 4 5
69
Although this would be a major undertaking for the company, it is confident that it can
raise the finance required for the machinery and the first year‟s working capital. The
financing will be through a mixture of a rights issue and a bank loan, in the same
proportion as the market values of current equity and debt capital. Any annual increase in
working capital after the first year, will be financed by internally generated funds.
Marine Engineers (ME) Plc. is a listed company involved in the manufacture of outboard
engine components for many years.
Additional data
Extracts from Statement of Financial Position:
K Plc. ME Plc.
₦’m ₦’m
Non-current assets 1,344 1,668
Working capital 296 628
6% Bank loan 624 -
5% Loan notes (2020 – 2022) - 368
Share capital - ₦0.50 per share 208 -
- ₦1.00 per share - 500
Reserves 808 1,428
Current market value per share (₦) 3.50 3.00
Quoted beta 1.3 1.8
Other data
Tax rate applicable to K Plc. and ME Plc.: 20%
It can be assumed that tax is payable in the same year as the profits on which it is
charged.
Estimated risk-free rate of return : 3%
Historic equity market risk premium : 6%
Required:
a. Given the information on ME Plc. and the project financing mix, including any other
relevant information, calculate the project specific cost of capital. (5 Marks)
70
QUESTION 2
LL Plc. is a large engineering company. Its ordinary shares are quoted on the Stock
Exchange.
LL Plc.‟s Board is concerned that the company‟s gearing level is too high and that
this is having a detrimental impact on its market capitalisation. As a result, the
Board is considering a restructuring of LL Plc. long term funds, details of which are
shown here as at 28 February, 2017:
Total par value Market value
Nm
Ordinary share capital (50k) 67.5 N2.65/share ex-div
7% Preference share capital (N1) 60.0 N1.44/share ex div
4% Redeemable debentures (N100) 45.0 N90% ex-int
The debentures are redeemable in 2022. LL Plc.‟s earnings for the year to 28
February, 2017 were N32.4 million and are expected to remain at this level for the
foreseeable future. Retained earnings, as at 28 February, 2017 was N73.2 million.
The Board is considering a 1 for 9 rights issue of ordinary shares and this additional
funding would be used to redeem 60% of LL Plc.‟s redeemable debentures at par.
However, some of LL Plc.‟s directors are concerned that this issue of extra ordinary
shares will cause the company‟s ordinary share price and its earnings per share
(EPS) to fall by an excessive amount, to the detriment of LL Plc.‟s shareholders.
Accordingly, they are arguing that the rights issue should be designed so that the
EPS is not diluted by more than 5%.
The Directors wish to assume that the income tax rate will be 21% for the
foreseeable future and the tax will be payable in the same year as the cash flows to
which it relates.
Required:
a. i. Calculate LL Plc.‟s gearing ratio using both book and market values
(5 Marks)
ii. Discuss, with reference to relevant theories, why LL Plc.‟s Board might
have concerns over the level of gearing and its impact on LL Plc.‟s
market capitalisation. (6 Marks)
b. Assuming that a 1 for 9 rights issue goes ahead, calculate the theoretical ex-
rights price of LL Plc.‟s ordinary share and the value of a right. (3 Marks)
c. Discuss the Directors‟ view that the rights issue will cause the share price and
the EPS to fall by an excessive amount, to the detriment of LL Plc.‟s ordinary
shareholders. Your discussion should be supported by relevant calculations.
(6 Marks)
(Total 20 Marks)
71
LA Ltd., a food packaging company, has operated as a private company for the past 10
years. The company has been growing rapidly over the last few years. The Directors are
now considering listing the company on the stock market. Preparatory to this, the Directors
are interested in determining a fair price per share for the company. Assume today is
November 1, 2016.
The following information has been extracted from the most recent audited financial
statements of LA Ltd:
72
Required:
a. Calculate the free cash flow available to equity for the year ended October 31,
2016. (7 Marks)
b. Use Free Cash Flow to Equity model to calculate the current value per share.
(5 Marks)
c. What are the key advantages and disadvantages of stock exchange listing?
(8 Marks)
(Total 20 Marks)
QUESTION 4
You are a financial consultant to a major company based in Kano. The company
plans to build a major warehouse in Abuja. You plan to convince the company‟s
manager to raise the needed funds through a convertible bond issue. Based on the
company‟s current bond rating of BBB, you have projected the following offer
terms:
Maturity: 6 years
Annual coupon: 1%
Conversion ratio: 50 shares
Par value per bond: N1,000
Issue price: 98% of par value
Current stock price: N16
Risk-free rate: 0.5%
Coupon on straight bonds: 2% (trading at par)
73
Required:
a. i. Determine the value of the convertible bond offer (5 Marks)
ii. Discuss why the convertible bond cannot generally be considered as
„cheap debt‟ despite its low coupon, given its financing advantage
quantified in economic terms. (3 Marks)
b. i. Compute the company‟s current interest coverage ratio. (1 Mark)
ii. How much money should be raised with the convertible bond issue (in
thousands of naira in order to avoid the threat of a rating downgrade,
based on the quoted rating guidelines? (4 Marks)
c. Advise the company on the advantages of convertible bond for companies on
one hand and for investors on the other hand. (7 Marks)
(Total 20 Marks)
SECTION C: YOU ARE REQUIRED TO ANSWER ANY TWO OUT OF THE THREE
QUESTIONS IN THIS SECTION (30 MARKS)
QUESTION 5
In each of the following situations, identify the stakeholders that could be involved
in potential conflicts:
a. A large conglomerate 'spinning off' its divisions by selling them or setting
them up as separate companies. (5 Marks)
b. A private company converting into a public company. (5 Marks)
c. Japanese car manufacturer building new plants in other countries. (5 Marks)
(Total 15 Marks)
QUESTION 6
Large Plc. (LP) wishes to borrow N200 million for five years to finance the purchase
of new non-current assets. The preference of the company‟s Directors is that these
funds are borrowed at a fixed rate of interest. The company‟s long-term debt is
currently rated BBB, meaning LP would have to pay 6.5% p.a. for fixed rate
borrowing. Alternatively, LP could borrow at a floating rate, i.e. the prime lending
rate (PLR) + 2.25% at the present time.
74
Required:
a. State FIVE reasons that a company might have for entering into an interest
rate swap. (5 Marks)
b. Show how an interest rate swap could be used to the equal benefit of both
companies, assuming that the terms of the swap agreement are such that LP‟s
swap payment to TK Plc. is to be 5.5% fixed per annum. (7 Marks)
c. Identify, with a supporting brief explanation, which of the two companies
would be disadvantaged, if PLR were to fall consistently within the five-year
term of the interest rate swap. (1 Mark)
d. Identify TWO risks that both companies will face, should they decide to enter
into the interest rate swap agreement. (2 Marks)
(Total 15 Marks)
QUESTION 7
You were recently appointed by a major manufacturing company as the senior
accountant at one of the divisions of the company, which is located in Makurdi. You
have received the following memorandum from the divisional manager:
“I tried to see you today, but you were busy with the auditors.
I have to go to a meeting at the head office on Friday about the new project. We
sent to the head office its projected cash flow figures before you arrived.
Apparently one of the head office finance people has discounted our figures, using
a rate which was calculated from the Capital Asset Pricing Model. I do not know
why they are discounting the figures, because inflation is predicted to be negligible
over the next few years. I think that this is all a ploy to stop us from going ahead
with the project and let another division have the cash.
I looked up Capital Asset Pricing Model in a finance book which was lying in your
office, but I could not make a head or tail of it, and anyway it all seemed to be
about buying shares and nothing about our project.
We always use payback for the smaller projects which we do not have to refer to
head office. I am going to argue for it now because the project has a payback of
less than five years, which is our normal yardstick.
I am very keen to go ahead with the project because I feel that it will secure the
medium-term future of our division.
75
I want to know how the Capital Asset Pricing Model is supposed to work, plus any
other things which you feel I ought to know for the meeting. I do not want to look
like a fool or lose the project because they blind me with science.
As you have probably discovered, I do not know much about finance, so please do
not use any technical jargon or complicated maths”.
Required:
Prepare notes for the divisional manager which provide helpful background for the
meeting. (Total 15 Marks)
76
Equity Beta
𝑉𝐷
𝛽𝐸 = 𝛽𝐴 + (𝛽𝐴 − 𝛽𝐷 ) (1 − 𝑡)
𝑉𝐸
Growing Annuity
𝑛
𝐴1 1+𝑔
𝑃𝑉 = 1−
𝑟−𝑔 1+𝑟
Modified Internal Rate of Return
1
𝑃𝑉𝑅 𝑛
𝑀𝐼𝑅𝑅 = 1 + 𝑟𝑒 − 1
𝑃𝑉𝐼
The Black-Scholes Option Pricing Model
C0 = S0N(d1) – Ee-rt N(d2)
𝑆
𝐼𝑛 𝐸0 + (𝑟 + 0.5𝜎 2 )𝑇
𝑑1 =
𝜎 𝑇
d2= d1 - 𝜎 𝑇
The Put Call Parity
C + Ee-rt = S + P
77
1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1
2 1·970 1·942 1·913 1·886 1·859 1·833 1·808 1·783 1·759 1·736 2
3 2·941 2·884 2·829 2·775 2·723 2·673 2·624 2·577 2·531 2.487 3
4 3·902 3·808 3.717 3·630 3.546 3.465 3·387 3·312 3·240 3·170 4
5 4·853 4·713 4·580 4·452 4·329 4·212 4·100 3·993 3.890 3·791 5
6 5·795 5·601 5·417 5·242 5·076 4·917 4·767 4·623 4.486 4·355 6
7 6·728 6.472 6·230 6·002 5·786 5·582 5·389 5·206 5·033 4·868 7
8 7·652 7·325 7·020 6·733 6·463 6·210 5·971 5·747 5·535 5·335 8
9 8·566 8·162 7·786 7.435 7·108 6·802 6·515 6·247 5·995 5·759 9
10 9·471 8·983 8·530 8·111 7·722 7·360 7·024 6·710 6.418 6·145 10
11 10·368 9·787 9·253 8·760 8·306 7·887 7.499 7·139 6·805 6.495 11
12 11·255 10·575 9·954 9·385 8·863 8·384 7·943 7·536 7'161 6·814 12
13 12·134 11·348 10·635 9·986 9·394 8·853 8·358 7·904 7·487 7·103 13
14 13·004 12·106 11·296 10·563 9·899 9·295 8·745 8·244 7·786 7·367 14
15 13·865 12·849 11·938 11·118 10·380 9·712 9·108 8·559 8·061 7·606 15
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1
2 1·713 1·690 1·668 1·647 1·626 1·605 1·585 1·566 1·547 1·528 2
3 2.444 2.402 2·361 2·322 2·283 2·246 2·210 2·174 2·140 2·106 3
4 3·102 3·037 2·974 2·914 2·855 2·798 2·743 2.690 2·639 2.589 4
5 3·696 3·605 3·517 3·433 3·352 3·274 3·199 3·127 3·058 2·991 5
6 4·231 4·111 3·998 3·889 3·784 3·685 3·589 3.498 3.410 3·326 6
7 4·712 4·564 4.423 4·288 4·160 4·039 3·922 3·812 3·706 3·605 7
8 5·146 4·968 4.799 4·639 4.487 4·344 4·207 4·078 3·954 3·837 8
9 5·537 5·328 5·132 4·946 4·772 4·607 4.451 4·303 4·163 4·031 9
10 5·889 5·650 5.426 5·216 5·019 4·833 4·659 4.494 4·339 4·192 10
11 6·207 5·938 5·687 5.453 5·234 5·029 4·836 4·656 4.486 4·327 11
12 6·492 6·194 5·918 5·660 5·421 5·197 4·988 4·793 4·611 4.439 12
13 6·750 6.424 6·122 5·842 5·583 5·342 5·118 4·910 4·715 4·533 13
14 6·982 6·628 6·302 6·002 5·724 5.468 5·229 5·008 4·802 4·611 14
15 7·191 6·811 6.462 6·142 5·847 5·575 5·324 5·092 4·876 4·675 15
A.1
78
(a) For K Plc. the new project is a diversification from boat making into outboard
engine components making. We must make use of the asset beta of ME Plc. which is
currently producing outboard engine components.
𝛽𝐸 ∙ 𝑉𝐸 𝛽𝐷 𝑉𝐷(1 − 𝑡 )
𝛽𝐴 = +
𝑉𝐸 + 𝑉𝐷(1 − 𝑡 ) 𝑉𝐸 + 𝑉𝐷(1 − 𝑡 )
VE = 500m × ₦3 = ₦1,500m
208
𝑉𝐸 = 0.5
× ₦3.50 = ₦1,456m
80
Year 0 1 2 3 4 5
₦’000 ₦’000 ₦’000 ₦’000 ₦’000 ₦’000
Sales revenue 30,000 86,400 233,300 302,280 516,990
Variable costs (12,000) (33,600) (88,200) (111,120) (184,680)
Fixed costs (6,000) (6,300) (6,615) (6,946) (7,293)
Training & development (14,400) (13,440) (8,820) (11,112) (18,468)
Cash operating profit (2,400) 33,060 129,665 173,102 306,549
Tax at 20% 480 (6,612) (25,933) (34,620) (61,310)
Tax savings on depr. (W2) 9,600 9,600 9,600 9,600 25,600
Working capital (W1) (6,000) (5,640) (14,690) (6,898) (21,471) 54,699
Machinery (480,000) 160,000
NCF (486,000) 2,040 21,358 106,434 126,611 485,538
PVF at 12% 1 0.893 0.797 0.712 0.636 0.567
Present value (486,000) 1,822 17,022 75,781 80,525 275,300
NPV = (₦35,550,000)
RECOMMENDATION
The project is not viable because the NPV is negative. Therefore, it should be rejected.
Working Notes
W1: Incremental WC
Year 1 2 3 4 5
Incremental revenue (₦‟000) - 56,400 146,900 68,980 214,710
Incremental WC (10%) (₦‟000) - 5,640 14,690 6,898 21,471
Year due - 1 2 3 4
(c) Assumptions
(i) In computing both the asset beta and the equity beta, it is assumed that
debt is risk-free with beta of 0 (zero).
(ii) Unless where stated otherwise, it is assumed that cash flows occur at the
end of the year.
81
(vi) The book value of the bank loan is approximately its market value.
EXAMINER‟S REPORT
This question tests candidates‟ knowledge of the computation of cost of capital and
appraisal of capital project.
Being a compulsory question, almost all the candidates attempted it. Generally, the
performance in the question was disappointing. This is difficult to understand because the
scenario is straightforward and well defined in the question.
In part (a), many candidates could not properly differentiate between the given equity
beta and the computed asset beta.
In part (b) most of the candidates could not calculate the incremental working capital and
the tax savings associated with tax allowable depreciation.
MARKING GUIDE
SOLUTION 1 MARKS MARKS
(a) Asset beta 1.5
Equity beta 1.5
Cost of equity 0.5
After tax cost of debt 0.5
WACC 1.0 5.0
82
a)
i.
Gearing level Book Market value
value
Nm Nm
Ordinary share capital (50k) 67.50 (135m x N2.65) 357.75
Retained earnings 73.20
7% Preference share capital
(N1) 60.00 (60m x N1.44) 86.40
4% Redeemable debentures
(2022) 45.00 (45m x 0.9) 40.50
Total funds 245.70 484.65
Total geared funds (Nm) 105.00 126.90
Gearing % 1 (Gearing/Total
Funds) 42.7% 26.2%
Or
Gearing % 2 (Gearing/Equity) 74.6% 35.5%
Ignoring taxes, the cost of „cheap‟ loan finance is precisely offset by the
increasing cost of equity, so WACC remains constant at all levels of gearing.
There is no optimal level – managers should not concern themselves with
gearing questions. M&M position in 1958 states that
Vg = Vu (where Vg is value of geared company and Vu is value of
ungeared company).
83
Modern view
M&M are probably right that gearing is only beneficial because of tax relief.
At high levels of gearing, an investor worries about the costs of the business
going into enforced liquidation („bankruptcy‟). This becomes significant as
required returns (both equity and debt) would increase at high levels of
gearing.
Conclusion–a business should gear up to a point where the benefits of tax
relief are balanced by potential costs of bankruptcy and interest rate
increases – here WACC will be at a minimum and value of the business at a
maximum.
Presumably, the directors feel that the current level of gearing is beyond the
optimum i.e. where the WACC is minimised and the company‟s value is
maximised (perhaps because as an engineering company, its operational
risk is very high and gearing adds additional financial risk). Alternatively,
they are incorrectly looking at the book value gearing ratio, as the market
value ratio doesn‟t look particularly bad.
Nm
b) Value of current ordinary shareholding 135m x N2.65 = 357.750
Rights issue (135m/9) 15m x N1.80 = 27.000
Theoretical ex-rights values 150m 384.750
The earnings per share figure will fall by 7.5% (from N0.240 to N0.222).
The proposed rights issue will, as the Board suggests, cause a dilution of the
EPS figure as the additional shares issued have a greater negative impact
than the interest saved from the debenture redemption. Whilst in theory,
(TERP) the market price of LL Plc‟s ordinary shares will fall, at least initially,
84
EXAMINER‟S REPORT
The question tests candidates‟ knowledge of financial gearing, capital structure theories
and basic calculations in rights issue.
More than 50% of the candidates attempted the question, but the level of performance was
very low.
It is important that students should always prepare adequately for the Institute‟s future
examinations.
MARKING GUIDE
SOLUTION 2 MARKS MARKS
(a) i. Calculation of gearing level using per value 2.0
Calculation of gearing level using market value 3.0 5.0
ii. Traditional view 2.0
Modigliani & Miller‟s (M & M) view 2.0
Modern view 1.0
Conclusion 1.0 6.0
85
₦’m
EBIT 1,836
Less tax at 30% 551
1,285
Add depreciation 440
1,725
Less interest, net of tax = N330 (1– 0.30)
million (231)
1,494
Change in working capital (W1) (264)
Purchase of non-current assets (W2) (722)
Additional borrowings (W3) 404
FCFE 912
Alternative method
₦’m
Profit after tax 1,054
Add depreciation 440
Change in working capital (264)
Purchase of non-current assets (722)
Additional borrowings 404
FCFE 912
Working Notes
1) Changes in working capital*
₦’m
Inventory ₦(2,078 – 2,542) = (464)
Receivables ₦(980 – 1,072) = (92)
Payables ₦(3,084 – 2,792) = 292
Changes in working capital (264)
* This calculation must exclude cash and bank balances. In addition, short-term loans
are excluded because they represent financing items.
86
b. The total market value of equity is given by the present value of FCFE. The
appropriate discount rate to use is the cost of equity and not the WACC (since we
are pricing equity rather than the company as a whole).
₦‟m
1
Year 1 N912m × 1.18 × = 936
1.15
1 2
2 N912m × (1.18)2 × = 960
1.15
1 3
3 N912m × (1.18)3 × = 985
1.15
1 4
4 N912m × (1.18)4 × = 1,011
1.15
1 5
5 N912m × (1.18)5 × = 1,037
1.15
4,929
6 – infinity:
5
N912𝑚 × (1.18)5 × 1.05 1
0.15 − 0.05
×
1.15 = 10,892
Note: The present value of FCFE for the first 5 years when the growth rate is 18%
per annum could have been calculated using growing annuity as follows:
𝑛
FCFE1 1+𝑔
PV = × 1−
𝑟−𝑔 1+𝑟
5
N912𝑚(1.18) 1.18
= 0.15 − 0.18 × 1 − 1.15 = N4,930million
87
ii. Cost of capital: Shares in listed companies are perceived by investors as being
less risky than shares in equivalent unlisted companies because of their
marketability. As the risks associated with listed shares are lower, the returns
required by investors will also be lower. Hence, the cost of capital for listed
companies will be lower.
iii. Share price: Shares that are traded on a stock exchange are closely
scrutinized by investors, who will take account of all available information
when assessing their worth. This results in shares that are efficiently priced,
which should give investors confidence when buying or selling shares.
iv. Company Profile: Companies listed on a stock exchange have a higher profile
among investors, and the wider business community than unlisted companies.
This higher profile may help in establishing new contacts or in developing
business opportunities.
vi. Business combinations: A stock exchange listing can facilitate takeovers and
mergers. A listed company can use its shares, as a form of bid consideration
when proposing a takeover of another company.
ii. Regulatory costs: Once the company is floated, the cost of maintaining a stock
exchange listing can be high. An important reason for this is the cost of
additional regulatory requirements surrounding listed companies. The
regulations of modern stock exchanges require greater transparency between
management and owners and this causes some of the additional costs.
88
v. Public scrutiny: Listed companies attract much attention from investors, the
financial press and the broadcasting media. Being in the public spot light
makes it difficult for a company to engage in controversial activities or to
conduct sensitive negotiations. It also makes it difficult for Directors to
hide poor decisions.
vi. Takeover target: The existence of a ready market for shares in a listed
company means that listed company is much more vulnerable to a takeover
than an unlisted company. A listed company may be particularly vulnerable
when there is a fall in its share price, perhaps caused by disillusionment with
the level of returns that are being provided.
EXAMINER‟S REPORT
The question tests candidates‟ knowledge of computing the ratio of Free Cash Flow to
Equity (FCFE) and its use in valuation.
About 60% of the candidates attempted the question but the level of performance was
poor.
Candidates are advised to make comprehensive use of the Institute‟s Study Text in their
preparations for the Institute‟s future examinations.
89
MARKS MARKS
(a) EBIT less interest and tax 1.0
Depreciation 1.0
Change in working capital 2.0
Purchase of non-current assets 1.0
Additional borrowings 1.0
Free cash flow to equity (FCFE) 1.0 7.0
90
2,200,000
= N = 2.75
800,000
ii. We solve for the amount (rounded to ₦1,000) by which interest expense can
rise without affecting the current BBB rating, i.e. at which the interest
coverage ratio is 2.39.
2,200,000
2.39 = N
800,000 x
where x = maximum additional interest expenses allowed)
2.39 N (800,000 + x ) = N2,200,000
x = N120,502
𝑁120,502
With an annual coupon of 1% up to N12,050,000 (i.e. can be raised
0.01
without threatening the current rating.
i. Lower interest rate than on a similar debenture: The firm can ask
investors to accept a lower interest rate on convertibles because the
investor values the conversion right.
91
iii. Self Liquidating: When the share price reaches a level at which
conversion is worthwhile, the bonds will (normally) be exchanged for
shares so the company does not have to find cash to pay off the loan
principal – it simply issues more shares. This has obvious cash flow
benefits. However, the disadvantage is that the other equity holders
may experience a reduction in EPS.
iv. Fewer restrictive covenants: The directors have greater operating and
financial flexibility than they would, with a secured debenture.
Investors accept that a convertible bond is a hybrid between debt and
equity finance and do not tend to ask for high-level security, impose
strong operating restrictions on managerial action or insist on strict
financial boundaries.
i. They are able to wait and see how the share price moves before
investing in equity.
ii. In the short term, there is greater security for their principal,
compared with equity investment, and the annual coupon (interest) is
usually higher than the dividend yield.
92
Less than 50% of the candidates attempted the question and performance was poor.
We recommend adequate coverage of the syllabus and judicious use of the Institute‟s
Study Text and other relevant texts.
MARKING GUIDE
MARKS MARKS
(a) i. Calculation of the value of the convertible bond offer 5.0
ii. Discussion 3.0 8.0
93
i. Shareholders
They will see the chance of immediate gains in share price if
subsidiaries are sold.
i. Existing shareholders/managers
They will want to sell some of their shareholding at a price as high as
possible. This may motivate them to overstate their company's
prospects. Those shareholders/managers who wish to retire from the
business may be in conflict with those who wish to stay in control - the
latter may oppose the conversion into a public company.
94
(c) Japanese car manufacturer building new car plants in other countries
iii. The government of the local country, representing the tax payers
The reduction in unemployment will ease the taxpayers' burden and
increase the government's popularity (provided that subsidies offered
by the government do not outweigh the benefits!).
EXAMINER‟S REPORT
This question tests candidates‟ knowledge of the stakeholders‟ groups and possible inter-
group conflict of interest.
More than 75% of the candidates attempted the question and surprisingly the performance
is very disappointing.
Generic solutions were produced thereby ignoring the specific scenario of each part
of the question.
The same sets of stakeholders were repeated in the three different parts of the
question.
95
MARKING GUIDE
96
(a) Reasons why a company might enter into an interest rate swap include:
i. To obtain a lower rate of interest on its preferred type of debt by
exploiting the quality spread differential between two counterparties.
ii. To achieve a better match of assets and liabilities
iii. To access interest rate markets that might otherwise be closed to the
firm (or only accessible at excessive cost)
iv. To hedge interest rate exposure by converting a floating rate
commitment to a fixed rate commitment (or vice versa).
v. To restructure the interest rate profile of existing debts (avoiding new
loans/fees)
vi. To speculate on the future course of interest rates
vii. Availability for longer terms than other methods of hedging interest
rate exposure
LP:
Pay PLR + 2.25% to lenders
Pay TK Plc. 5.5%
Receive from TK Plc. PLR + 1.375%
Net borrowing cost 6.375% (saving 0.125% on its own fixed rate
borrowing).
TK Plc.:
Pay 5.5% fixed to lenders
Pay LP PLR + 1.375% toLP
Receive from LP 5.5%
Net borrowing cost PLR + 1.375% (saving 0.125% on its own floating rate
borrowing cost).
97
iii. Transparency risk, that is, the risk that the impact of swap transaction
will undermine the clarity and transparency of the firm‟s financial
statements.
EXAMINER‟S REPORT
The question tests candidates‟ knowledge of the mechanism involved in the Interest Rate
Swap.
Less than 30% of the candidates attempted the question. There is evidence that most of the
candidates do not have sufficient knowledge of Interest Rate Swap.
Virtually all the candidates who attempted the question could not produce the required
elementary calculations in part (b).
We recommend that students should create more time to cover the syllabus adequately.
MARKING GUIDE
SOLUTION 6 MARKS MARKS
(a) Reasons - 1 mark per valid point (max 5) 5.0
98
Discounting
Discounting of future cash flows is a technique used to place less value on cash
flows which are received further into the future. This reflects the fact that our
investors would rather receive money now than in the future. This preference for
money now, which is known as the time value of money, is increased if there is
inflation in the economy, as investors also need to be compensated for the buying
power of their money being reduced in the future.
Therefore, the discount rate is a combination of both the time value of money and
inflation. Even if inflation is negligible, cash flows still need discounting to reflect
the time value of money.
The use of CAPM considers the returns paid on shares on the stock market,
compared to the risk or variation in returns of those shares. Because investors in
general are risk averse, they will expect a higher average return by way of
dividends and capital gains to compensate for a higher risk.
The logic then follows that if shareholders can earn a given return on the stock
market for a certain level of risk, then any project that may be undertaken must, at
least, satisfy that target return.
Where CAPM is special, is in the way it considers risk. A company or project looked
at on its own may have a very high level of risk. However, if it is added to the
shareholders' portfolio of investments, some of the investment risks will be removed
or diversified away.
This is because two different causes of the total risk of a company can be identified.
Systematic risk – Due to the economy, such as interest rates, exchange rates, etc.
which affect all companies.
Systematic risk cannot be diversified away; however, the unsystematic risk will
cancel out across companies, as bad events in one company are evened out by
good events in another.
99
CAPM measures the systematic risk as a beta. A beta of 1 indicates that the
company has the same level of risk as the average of all shares in the stock market,
called the market portfolio. A beta of 0.5 would indicate that it has only half the
risk of the market portfolio, and therefore does not need to give such a high return.
When using CAPM to derive a discount rate, it is the beta of the project which
should be used, rather than that of the company.
100
Payback is a good technique in that it uses earlier cash flows which are more
certain and useful if a company is short of cash. However, it has the following
drawbacks:
EXAMINER‟S REPORT
The question tests candidates‟ knowledge of some elementary concepts in finance like,
discounting, discount rate, CAPM, payback period.
Most of the candidates attempted the question and the performance level was most
disappointing.
Most of the candidates could not explain the above elementary terms in a non-technical
manner as required by the question.
MARKING GUIDE
SOLUTION 7 MARKS MARKS
Discounting – Discussion 3.0
Discount rate: CAPM discussion 2.0
- Systematic risk discussion 2.0
- Unsystematic risk discussion 2.0
- CAPM formula for calculating required Return 2.0
Payback – the drawbacks – 1 mark per valid point (max 3) 3.0
Conclusion 1.0 15.0
101
PATHFINDER
NOVEMBER 2017 DIET
PROFESSIONAL LEVEL EXAMINATIONS
Question Papers
Suggested Solutions
Marking Guides
Plus
Examiner‟s Reports
QUESTION 1
(vii) The company's annual dividend growth rate will remain at 6% per year.
Annual dividends are declared at the year end and paid in full during the
following financial year;
75
Extracts from the company's most recent financial statements are provided
below:
Income Statement for the year ended March 31, 2017
N'000
Revenue 60,240
Operating costs (49,500)
Operating profit 10,740
Finance costs (800)
Profit before tax 9,940
Tax (2,286)
Profit after tax 7,654
Non-current liabilities
6% Debentures (2025) 8,000
76
Required:
a. Prepare a Forecast Financial Statement (comprising Income Statement,
Statement of Financial Position and Cash Flow Statement) for each of the
years ending March 31, 2018 and March 31, 2019. (24 Marks)
b. Beyond March 31, 2019 the directors are considering a suggestion by the
Finance Director that one of Lekki Plc.‟s smaller subsidiaries be disposed of
because, relative to most of the other company‟s operations, it is performing
poorly. Whilst the directors are broadly supportive of the Finance Director's
suggestion, they are keen to avoid liquidation of the subsidiary as they are
conscious of the industrial relations problems that might arise from the
consequent redundancies.
Required:
Discuss THREE methods, other than liquidation, that the firm might consider to
effect the divestment of this subsidiary company. (6 Marks)
(Total 30 Marks)
SECTION B: YOU ARE REQUIRED TO ANSWER ANY TWO OUT OF THREE QUESTIONS
(40 MARKS)
QUESTION 2
77
Additional information:
(i) If Harold Limited were to remain an independent company, its Directors
estimate that reported Profit After Tax would be ₦15million for 2018 and
then grow by 2% yearly in perpetuity;
(ii) If the acquisition were to go ahead, Raymond Plc.‟s Directors estimate that
Harold Limited‟s profit after tax would be 5% higher for 2018 than if the
company remains an independent company and that profit after tax would
then grow by 3% yearly in perpetuity;
(iii) The average ungeared Cost of Equity for the industry is 8%;
(iv) Both Raymond Plc. and Harold Limited are wholly equity financed; and
(v) Profit after tax can be assumed to be a good approximation of free cash flow
attributable to investors.
The Directors of Raymond Plc. are considering offering to purchase Harold Limited
at a price of ₦7.00 per share. It is estimated that transaction costs of ₦8million
would be payable on the acquisition and that ₦2million would be required in the
first year to cover the costs of integrating the two companies.
Required:
a. Calculate:
i. The value of Raymond Plc. as at December 31, 2017.
ii. The value of Harold Limited as at December 31, 2017 before taking the
possible acquisition of the company by Raymond Plc. into account.
iii. The overall increase in value created by the acquisition of Harold Limited
by Raymond Plc. (8 Marks)
c. Evaluate the proposed offer price of ₦7.00 per share for Harold Limited from the
point of view of:
i. Harold Limited‟s shareholders.
ii. Raymond Plc.‟s shareholders. (8 Marks)
(Total 20 Marks)
78
The Finance Director of Peter Plc. is, however, uncertain about this and at a recent
board meeting where the matters were discussed, she made the following
statement:
„According to the Efficient Market Hypothesis, all share prices are correct at all
times, with prices moving randomly when new information is publicly announced.
The analysts at investment banks are unable to predict future share prices.‟
Required:
a. Calculate the theoretical ex-rights price per share and the value of the rights
per existing share, assuming the company chooses this option. (2 Marks)
b. Discuss the alternative courses of action open to the owner of 500 shares in
Peter Plc. as regards the rights issue, in each case, determining the effect on
the wealth of the investor. (4 Marks)
c. Discuss the factors that will influence the actual ex-rights price per share.
(4 Marks)
d. Discuss the meaning and significance of the three forms of the Efficient
Market Hypothesis and, with specific reference to these, discuss both the
recommendation that the company waits for six months before undertaking a
public issue and the Finance Director‟s statement. (10 Marks)
(Total 20 Marks)
79
You are the Financial Director of Kudi Limited, a Nigerian Company that imports
raw materials mainly from Tiko (with T$ as currency) and exports finished products
to Katuga (with K$ as currency). Kudi is partly financed by loan raised in the
domestic market and usually hedges its foreign currency exposure by using the
forward or money markets. Most customers are allowed 3 months‟ credit. The
company has recently sold some products to a customer in Katuga for K$20 million.
The following information is available:
Exchange rate K$ per N T$ per N
Required:
a. Comment on the Interest Rate Parity and Purchasing Power Parity methods for
estimating exchange rates. (6 Marks)
In answering each of the following questions, include appropriate
calculations, where relevant, to aid your discussion:
i. As interest rates are higher in Nigeria than in Tiko, should T$ be
depreciating against naira, hence trading at a discount? (3 Marks)
ii. What 3-month K$ forward rate of exchange is implied by the
information given, and therefore what naira receipts can the company
expect in 3 months‟ time from the customer in Katuga?
(3 Marks)
iii. Would a sensible policy be: to buy T$ on the spot market now and place
it on deposit until when needed by Kudi? (3 Marks)
80
Private sector companies have multiple stakeholders who are likely to have
divergent interests.
Required:
a. Identify FIVE stakeholder groups and discuss briefly their financial objectives.
(10 Marks)
b. Explain ways in which companies‟ directors can be encouraged to achieve the
objective of maximisation of shareholders‟ wealth. (5 Marks)
(Total 15 Marks)
QUESTION 6
You have recently taken up employment with Large Plc., a Nigerian company with
manufacturing subsidiaries in many countries across Africa. As the Financial
Analyst, you report directly to the Managing Director who currently requires
briefings on the following areas:
(i) Ethical issues and capital investment decisions,
(ii) Options and company valuation
Required:
a. Explain, with examples, ethical issues that might affect capital investment
decisions and discuss the importance of such issues for Strategic Financial
Management. (8 Marks)
QUESTION 7
a. In the context of the selection and holding of investments, discuss each of the
following scenarios:
i. An investor holding only one security needs to be concerned with
unsystematic risk of that security. (3 Marks)
81
b. The equity beta of KT Plc. is 1.2 and the equity alpha is 1.4. Explain the
meaning and significance of these values to the company. (6 Marks)
(Total 15 Marks)
82
Equity Beta
𝑉𝐷
𝛽𝐸 = 𝛽𝐴 + (𝛽𝐴 − 𝛽𝐷 ) (1 − 𝑡)
𝑉𝐸
Growing Annuity
𝑛
𝐴1 1+𝑔
𝑃𝑉 = 1−
𝑟−𝑔 1+𝑟
83
n = number of periods
1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1
2 1·970 1·942 1·913 1·886 1·859 1·833 1·808 1·783 1·759 1·736 2
3 2·941 2·884 2·829 2·775 2·723 2·673 2·624 2·577 2·531 2.487 3
4 3·902 3·808 3.717 3·630 3.546 3.465 3·387 3·312 3·240 3·170 4
5 4·853 4·713 4·580 4·452 4·329 4·212 4·100 3·993 3.890 3·791 5
6 5·795 5·601 5·417 5·242 5·076 4·917 4·767 4·623 4.486 4·355 6
7 6·728 6.472 6·230 6·002 5·786 5·582 5·389 5·206 5·033 4·868 7
8 7·652 7·325 7·020 6·733 6·463 6·210 5·971 5·747 5·535 5·335 8
9 8·566 8·162 7·786 7.435 7·108 6·802 6·515 6·247 5·995 5·759 9
10 9·471 8·983 8·530 8·111 7·722 7·360 7·024 6·710 6.418 6·145 10
11 10·368 9·787 9·253 8·760 8·306 7·887 7.499 7·139 6·805 6.495 11
12 11·255 10·575 9·954 9·385 8·863 8·384 7·943 7·536 7'161 6·814 12
13 12·134 11·348 10·635 9·986 9·394 8·853 8·358 7·904 7·487 7·103 13
14 13·004 12·106 11·296 10·563 9·899 9·295 8·745 8·244 7·786 7·367 14
15 13·865 12·849 11·938 11·118 10·380 9·712 9·108 8·559 8·061 7·606 15
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1
2 1·713 1·690 1·668 1·647 1·626 1·605 1·585 1·566 1·547 1·528 2
3 2.444 2.402 2·361 2·322 2·283 2·246 2·210 2·174 2·140 2·106 3
4 3·102 3·037 2·974 2·914 2·855 2·798 2·743 2.690 2·639 2.589 4
5 3·696 3·605 3·517 3·433 3·352 3·274 3·199 3·127 3·058 2·991 5
6 4·231 4·111 3·998 3·889 3·784 3·685 3·589 3.498 3.410 3·326 6
7 4·712 4·564 4.423 4·288 4·160 4·039 3·922 3·812 3·706 3·605 7
8 5·146 4·968 4.799 4·639 4.487 4·344 4·207 4·078 3·954 3·837 8
9 5·537 5·328 5·132 4·946 4·772 4·607 4.451 4·303 4·163 4·031 9
10 5·889 5·650 5.426 5·216 5·019 4·833 4·659 4.494 4·339 4·192 10
11 6·207 5·938 5·687 5.453 5·234 5·029 4·836 4·656 4.486 4·327 11
12 6·492 6·194 5·918 5·660 5·421 5·197 4·988 4·793 4·611 4.439 12
13 6·750 6.424 6·122 5·842 5·583 5·342 5·118 4·910 4·715 4·533 13
14 6·982 6·628 6·302 6·002 5·724 5.468 5·229 5·008 4·802 4·611 14
84
15
85
WORKINGS (W1)
Tax
Profit before tax 11,504 14,650
Add back depreciation 875 875
Capital allowances (1,440) (1,181)
Taxable profits 10,939 14,344
Tax@ 21% 2,297 3,012
86
b)
(i) Management Buy-out: a new company acquires either the trade and
assets or the shares of the subsidiary to be sold, with the purchase
usually funded by a mix of debt and equity provided by the managers
(equity), venture capital providers (debt and equity) and other financiers
(debt).
(ii) Management Buy-in: as in (i) above, but with purchase by a group of
external managers.
(iii) Spin-off (demerger): shareholders are given shares in the new entity pro-
rata to their shareholdings in the parent company - there is no change in
ownership; with separate legal identities established; used to avoid the
problems of the conglomerate discount; sometimes used as a defence
against takeover of the entire business.
(iv) Sell-off: The business is sold to another company usually for cash.
(v) Carve-out: where shares of the subsidiary are sold to the public through
initial public offer resulting in cash inflow to the holding company.
(vi) Split-off: a means of re-organising an existing corporate structure in
which the share of a business division, subsidiary or newly affiliated
company is transferred to the shareholders of the parent company in
exchange for shares in the latter.
87
Payments:
Operating costs** 51,187 53,233
Additional inventory 902 -
Non-current assets 8,000 -
Finance cost 1,200 1,200
Tax 2,297 3,012
Dividend 2,784 2,951
Total payments (T) 66,370 60,396
EXAMINER‟S REPORT
Part „a‟ of the question tests the ability of the candidates to project financial
statements using a given scenario, while Part „b‟ deals with various methods of
divestment.
Being a compulsory question, virtually all the candidates attempted the question.
Although, we have some exceptionally good scripts, the average level of
performance was very poor.
88
Marking Guide
89
ii) Key challenges in realising the potential added value after the merger are:
Success depends on the extent that Harold's management and staff
accept the transfer of ownership and remain committed to servicing
Harold Limited‟s clients to the best of their ability. To overcome this
challenge, Raymond Plc. should consider introducing an incentive
scheme such as a bonus payment or employee‟s share option scheme;
It also depends on whether Harold's clients are happy with the new
arrangement and are confident of receiving the same level of service as
before; and
The reliability of the forecast improvement in earnings and growth is also
key to successful realisation of the potential added value.
90
Raymond Plc.‟s shareholders‟ perspective: Possibly too high a price for comfort.
The main reasons for this conclusion are as follows:
The reverse of the above: Raymond Plc.‟s shareholders take all the risk and
contribute most value to the combined business and yet only expect to
receive 45% of the increase in value; and
It is likely that Harold Limited has a higher business risk than Raymond Plc.
despite being in the same industry because of the different clients profile. If
one customer were to be lost by Harold Limited, then this could have a
significant impact on cash flow and hence the variability of Harold Limited‟s
cash flows is likely to be higher than for Raymond Plc. Therefore, it is
possible that a higher discount rate should be used to value Harold Limited
which would have the effect of reducing its value.
Conclusion: The price needs to be reduced. The proposed price is not fair to
Raymold Plc‟s shareholders and Harold Limited is potentially over-valued at a
discount rate of 8%.
91
About 40% of the candidates attempted the question and performance was very
poor with some candidates scoring zero.
About 80 percent of the candidates that attempted the question made use of wrong
formulae in discounting the given cash flows and could not carry out the required
analysis of their results.
b) i) Sensible suggestions 2
ii) 1 mark per explained point (max 2) 2 4
c) Share of synergy
- Raymond Plc. 1½
- Harold Limited 1½
Evaluation – Raymond Plc. 2
– Harold Limited 2
Conclusion 1 8
20
SOLUTION 3
92
(b) The value of 625 shares after the rights issue =625 x N4.90 = N3,062.50
The value of 500 shares before the rights issue =500 x N5.00 = N2,500.00
The value of 500 shares after the rights issue =500 x N4.90 = N2,450.00
The amount of cash subscribed for the new shares =125 x N4.50 = N562.50
The amount of cash raised from the sale of rights =500 x N0.10 = N50.00
Options:
The shareholder could either do nothing, take up the rights, sell the rights or
exercise his rights in respect of part of the issue and sell the remaining to pay
or part pay for the issue taken up.
ii) If the shareholder sells his rights, the rights issue will also have a
neutral effect on his wealth. The value of 500 shares after the rights
issue (N2,450.00) plus the cash received from selling the rights
(N50.00) equals the value of 500 shares before the rights issue
(N2,500.00). Again, the make-up of the shareholder‟s wealth will have
changed (more cash, less shares), but not his total wealth;
iii) If the shareholder neither takes up the rights nor sells the rights, a loss of
wealth of N50 will occur, representing the difference between the value
of 500 shares before the rights issue (N2,500.00) and the value of 500
shares after the rights issue (N2,450.00); and
iv) If the shareholder takes up 75 of the rights issue and sells the remaining
50 shares, it will have a neutral effect on his wealth.
(c) Factors that may influence the actual share price following the rights issue
include:
i) The expectations of investors/the stock market regarding the company‟s
future;
ii) The level of take-up of the rights issue – if the issue was not fully taken
up, for example, the share price might fall;
93
(d) The three forms of theoretical stock market efficiency are weak, semi-strong
and strong.
If a stock market has weak form efficiency then only past information is
currently reflected in share prices. Weak form efficiency, therefore, implies
that share prices fully and fairly reflect all past information about the share
and investors cannot, therefore, make abnormal gains by studying and acting
upon any past information.
If a stock market has semi-strong form efficiency then not only all past
information but also all publicly available current information (eg financial
statements, press reports) are currently reflected in share prices. Semi-strong
form efficiency, therefore, implies that share prices fully and fairly reflect all
past and current publicly available information and investors cannot,
therefore, make abnormal gains by studying and acting upon any such
information.
If a stock market has strong form efficiency then not only all past and current
publicly available information but also all relevant private information (eg
board minutes) is currently reflected in share prices. Strong form efficiency,
therefore, implies that share prices fully and fairly reflect all past, current
publicly available and private information and investors cannot, therefore,
make abnormal gains by acting upon information of any sort.
The implication of all these, is that, if the stock market is efficient in all the
three forms, investors cannot beat the market by having superior information
as it does not, by definition, exist. However, if the stock market is not strong
form efficient then abnormal gains can be made from possession of private
(insider) information.
94
Finally, as regards the ability of analysts to predict future share prices, if the
stock market is strong form efficient then analysts will be unable to achieve
consistently superior rates of return. But that does not mean they cannot
predict share prices – by chance they may do so on occasions, but the
implication is that they will be unable to do so consistently. However, if the
market is only semi-strong form efficient, then if the analysts have access to
any private information then they may be able to predict the future share
price and make superior rates of return.
EXAMINER‟S REPORT
The first part of the question tests candidates‟ knowledge of the analysis of right
issue while the second part tests the knowledge of Efficient Market Hypothesis.
More than 80% of the candidates attempted the question but, the level of
performance was disappointing. It is highly troubling that candidates writing the
final examination could not compute ex-right price and for those who did, they
could not analyse the effect of the right issue on shareholders‟ wealth.
In future, candidates are advised to improve their analytical skill. They need to
read widely and practise with past examination questions.
95
SOLUTION 4
a) There are two important theories linking exchange rates, interest rates and
inflation rates which need to be considered when determining strategies in
this area.
Interest Rate Parity
Interest Rate Parity (IRP) is based on the hypothesis that the difference
between interest rates in the two countries should offset the difference
between the spot rates and the forward foreign exchange rates over the same
period. Specifically, if investors can obtain a higher risk-free rate in one
currency than they can in the other, the country offering the higher rate will
have its currency depreciated against the other. For example, if risk-free rate
in Ghana is 10% and it is 6% in Nigeria, the Cedi will depreciate against the
Naira by approximately 4% per year.
The relevant formula is:
1 + 𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝐴 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒
Forward rate currency 𝐴 B = Spot 𝐴 𝐵 ×
1 + 𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝐵 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒
Where A and B are two different countries.
96
= 1.9540
With forward contract, the expected receipt = K$20,000,000 ÷ 1.9540
= N10,235,415
iii) Placing T$ on deposit
The arrangement described is money market hedge, buying the currency,
putting it on deposit and using the principal and interest to make the T$
payment when it falls due.
Money market hedging may be slightly more beneficial than using the
forward exchange markets, but the difference is likely to be small, as the
premium or discount on the forward exchange rates will reflect interest
rate differentials. Money market hedging is currently a strategy that the
company uses.
Therefore, the policy described above is more sensible and should be
adopted.
b) Economic exposure is the risk that the present value of a company's future
cash flows might be reduced by unexpected adverse exchange rate
movements. Economic exposure includes transaction exposure, that is, the risk
of adverse exchange rate movements occurring in the course of normal
international trading transactions.
97
EXAMINER‟S REPORT
This question tests candidates‟ knowledge of the use of interest rate parity theorem
and purchasing power parity theorem to estimate foreign exchange rate.
More than 60% of the candidates attempted the question but majority of them
generated unacceptable solutions hence, performance was very poor.
Failure of the candidates to cover the risk management part of the syllabus;
Inability to identify the difference between direct and indirect quotes;
Use of inappropriate formulae; and
Use of annual interest rates to calculate 3-month forward rate, etc.
Candidates are reminded that questions for each examination are designed to cover
all sections of the syllabus, hence, they are advised to cover all aspects of the
syllabus when preparing for the examinations of the Institute.
98
SOLUTION 5
a) Stakeholders in a company include amongst others: shareholders; directors
/managers; lenders; employees; suppliers; customers; and government. These
groups are likely to share in the wealth and risk generated by a company in
different ways and thus conflicts of interest are likely to exist. Conflicts also
exist not just between groups but within stakeholder groups. This might be
because sub-groups exist, for example preference shareholders and equity
shareholders within the overall category of shareholders.
Shareholders
Shareholders may have other objectives for the company and these can be
identified in terms of the interests of other stakeholder groups. Thus,
shareholders as a group may be interested in profit maximisation. They may
also be interested in the welfare of their employees, or the environmental
impact of the company's operations.
Management
While executive directors and managers should attempt to promote and
balance the interests of shareholders and other stakeholder groups, it has
99
This problem arises from the divorce between ownership and control. The
behaviour of managers cannot be fully observed by the shareholders, giving
them the capacity to take decisions which are consistent with their own
reward structures and risk preferences. Directors may therefore be interested
in their own remuneration package.
They may also be interested in building empires, exercising greater control, or
positioning themselves for their next promotion. Non-financial objectives of
managers are sometimes inconsistent with what the financial objectives of the
company ought to be.
Lenders
Lenders are concerned to receive payment of interest and eventually re-
payment of the capital at maturity. Unlike the ordinary shareholders, they do
not share in the upside (profitability) of successful organisational strategies.
They are therefore likely to be more risk averse than shareholders, with an
emphasis on financial objectives that promote liquidity and solvency with low
risk (e.g. low gearing, high interest cover, security, strong cash flow).
Employees
The primary interests of employees are their salary/wage and the security of
their employment. To an extent there is a direct conflict between employees
and shareholders as wages are a cost to the company and income to
employees.
100
Share option schemes bring the goals of shareholders and directors closer
together to the extent that directors become shareholders themselves. Share
options allow directors to purchase shares at a specified price on a specified
future date, encouraging them to make decisions which exert an upward
pressure on share prices. Unfortunately, a general increase in share prices can
lead to directors being rewarded for poor performance, while a general
decrease in share prices can lead to managers not being rewarded for good
performance. However, share option schemes can lead to a culture of
performance improvement and so can bring continuing benefit to
stakeholders.
Corporate Governance codes of best practice seek to reduce corporate risk and
increase corporate accountability. Responsibility is placed on directors to
identify, access and manage risk within an organisation. An independent
perspective is brought to directors‟ decisions by appointing non-executive
directors to create a balanced board of directors, and by appointing non-
executive directors to remuneration committees and audit committees.
101
Almost all the candidates attempted the question and performance was good with
some candidates scoring all the marks. Surprisingly though, we also have some
few candidates scoring zero.
Candidates are advised to cover all aspect of the syllabus in their preparation for
future examinations.
SOLUTION 6
(i) Health and safety - Employees and the public should be protected
from danger, which includes working conditions, following
employment laws and product safety;
(ii) Environmental issues – Environmental issues such as, controlling
pollution, protecting wildlife and the countryside. Fully satisfying
these issues might be an expensive element in a capital investment;
(iii) Bribes and other payments - Investment might proceed more quickly
and efficiently if bribes, 'incentive payments', 'gifts' etc. are paid to
officials. This is a difficult area, as gifts are part of the business
culture in some countries. Even the ethics of political contributions is
debatable;
(iv) Corporate governance - Many examples exist of companies, e.g.
Enron,
where the results of investments and the true financial position have
been hidden from shareholders and the public;
(v) Taxation - Companies may try to minimise their tax liability. Tax
evasion is illegal, but there is an ethical question over the use of
102
There are five variables which are input into the BSOP model to determine the
value of the option. Proxies need to be established for each variable when using
the BSOP model to value a company. The five variables are: the value of the
underlying asset; the exercise price; the time to expiry; the volatility of the
underlying asset value; and the risk free rate of return.
For the exercise price, the debt of the company is taken. In its simplest form, the
103
The proxy for the value of the underlying asset is the fair value of the company's
assets less current liabilities on the basis that if the company is broken up and
sold, then that is what the assets would be worth to the long-term debt holders
and the equity holders.
The time to expiry is the period of time before the debt is due for redemption.
The owners of the company have that time before the option needs to be
exercised, that is when the debt holders need to be repaid.
The proxy for the volatility of the underlying asset is the volatility of the
business' assets.
The risk-free rate is usually the rate on a riskless investment such as a short-
term government bond.
EXAMINER‟S REPORT
Less than 20% of the candidates attempted the question and performance was very
poor.
In part „a‟ of the question, candidates could not offer any meaningful ethical issues.
In part „b‟, the very few candidates that were able to identify the key variables in
Black-Scholes model failed to identify the relevant proxy for each variable within
the context of company valuation.
We recommend that candidates should make effort to cover the entire syllabus
when preparing for future examinations.
104
b) Circumstances of use 2
1 mark per each valid variable identified 5 7
15
SOLUTION 7
a. i) Unsystematic Risk
The total risk to the investor under such circumstances is only the systematic
risk of the market itself. The total risk to an investor in a number of securities
may therefore be made up of only systematic risk, or systematic plus
unsystematic risk, depending on the extent to which the portfolio is
diversified.
105
b) The equity beta measures the systematic risk of a company‟s shares, the risk
that cannot be eliminated by diversification. It is a measure of a share‟s
volatility in terms of the market‟s risk, and may be estimated by relating the
covariance between the returns on the share and the returns on the market to
market variance. An equity beta of 1.2 suggests that KT. Plc‟s shares are more
risky than the market as a whole, which has a beta of 1. If average market
returns change, for example, increase by 5%, the return of KT. Plc‟s shares
would be expected to increase to 1.2 × 5% = 6%.
The alpha value measures the abnormal return on a share. An alpha value of
1.4% means that the returns on KT plc‟s shares are currently 1.4% more than
would be expected given the share‟s systematic risk. Alpha values are only
temporary and may be positive or negative; in theory the alpha for an
individual share should tend to zero. An alpha value of 1.4% should cause
investors to buy the share to benefit from the abnormal return, which would
increase share price and cause the return to fall until the alpha value falls to
zero. In a well-diversified portfolio the alpha value is expected to be zero.
EXAMINER‟S REPORT
About 90% of the candidates attempted the question and performance was average.
Part „b‟ of the question was however poorly answered with some candidates
describing alpha value as a risk measurement.
Alpha value is well discussed and illustrated in the ICAN Study Text. Candidates are
therefore advised to make use of the ICAN Study Text and other relevant materials
when preparing for the Institute‟s future examinations.
106
107
QUESTION 1
Bode, Ugo, Musa and Company is a firm of Chartered Accountants that has existed
for over 20 years and achieved a strong reputation for quality audit work. The firm
has expanded significantly over the past ten years - doubling its client base across
the different sectors of the Nigerian economy. The firm currently audits two banks,
five listed entities and over seventy other companies. It has also increased its audit
staff base and grown the number of its partners from two to seven over the same
period.
However in the last two years, the firm has series of regulatory reviews due to a
number of instances of errors noted in some financial statements audited by the
firm. One of the clients, the shareholders of NigerKap Plc, petitioned the regulator
over a misstatement in the value of their investment property. This resulted in
overstatement of profit and overpayment of taxes by the company based on the
financial statements for the year ended December 31, 2015. The shareholders also
threatened to take legal action against the firm.
The Managing Partner (MP) of the firm is apparently very concerned about this
situation and has commenced internal procedures to evaluate the quality of audits
performed by the firm especially for the NigerKap audit of 2015. A committee set
up by him has conducted a review of a number of audit files and has noted among
others, that very poor audit work was performed by the NigerKap engagement
team of 2015 led by Amy Smith, one of the partners who is supposed to retire in
2018. The MP has therefore instructed that Oluwatoyin Bede-Nwokoye, a new
partner of the firm, should perform the 2016 audit of NigerKap Plc. The Statement
of Financial Position of NigerKap Plc as at December 31, 2016 has been provided to
the firm and some of the balances therein are shown below:
108
*The deferred tax relates to unused tax losses that have accumulated during the
past three years. Management is confident that there will be sufficient future
operating profits to claim the benefit of the tax losses in full in future years.
Required:
a. Discuss FOUR consequences of the poor audit work on the firm of Bode, Ugo,
Musa and Company (Chartered Accountants). (5 Marks)
b. Recommend SIX actions that the new partner should implement to ensure that
a high overall quality of the audit of 2016 financial statements of NigerKap plc
is achieved. (9 Marks)
c. What are the FOUR key audit procedures that should be carried out by the
engagement team to determine whether the recognition of the deferred tax
asset of the company in 2016 is appropriate? (8 Marks)
d. What specific audit procedures should be carried out by the audit team in
respect of the following balances in the financial statements of the company
(other than casting and agreement of amounts per schedule to the general
ledger/trial balance)?
109
QUESTION 2
All employees, apart from a few in the marketing, accounts and administration
departments were rendered redundant, and were given one month‟s notice with
effect from March 31, 2016.
Zaka would now operate under the new name, Chuks Zaka Limited (CZL) from its
former head office in Johannesburg as a marketing company selling CRP‟s drones
in the South African Region. To this effect, CRP will take up 55 percent of CZL, for
which payment was due by February 1, 2017.
Your firm of Chartered Accountants has been the external auditors to CRP and the
company has now engaged your firm to also audit its subsidiary, CZL.
a. Analyse and evaluate the business risks that would be assessed by the
management of CZL. (6 Marks)
b. Analyse and evaluate the business risks that would be assessed by the directors
of CRP. (6 Marks)
110
Tophem Bank Nigeria Plc has been operating for 20 years and your firm took over
the audit 5 years ago.
Your partner has reviewed the audit file for the year ended December 31, 2016 and
has approved the issuance of a modified opinion. He drew a titular sketch of the
audit report and has asked you to fill up some gaps.
QUESTION 4
The management of Pony Bank Plc. and its fully owned subsidiary Ponte Micro
Finance Bank Limited arranged and invented bogus loans that totalled N5.5 billion
worthless assets which the former auditors did not detect.
The former auditors claimed that a clique of highly clever and organised swindlers
among the staff of Pony Bank deceived the auditors and devoted themselves to
defeating the audit and covering up their nefarious acts.
111
a. Advise the engagement partner on the risks involved in taking up the audit.
(4 Marks)
SECTION C: YOU ARE REQUIRED TO ANSWER ANY TWO OUT OF THREE QUESTIONS
IN THIS SECTION (30 MARKS)
QUESTION 5
You are the audit manager for XYZ Bank Limited for the year ended December 31,
2016.
From your review of the Bank‟s Board of Directors minutes of meetings, you noted
that during the year, the Board was concerned about a litigation issue involving the
Bank and another company named BBB Limited, in which the Bank is the
defendant.
BBB Limited had sued the Bank for converting a cheque worth N2.1billion and the
high court has declared the Bank guilty and imposed a penalty in the sum of N2.1
billion (i.e. the value of the cheque) on the Bank.
From the available information, it was noted that the claimant (i.e. BBB Limited)
had commenced the process to claim the judgment amount from the Bank.
The Bank was not satisfied with the case and had immediately filed for objection at
the Court of Appeal. The Directors of the Bank, based on the professional legal
counsel obtained, are of the opinion that the judgment issued by the Federal High
Court is baseless and unjustifiable, and that a favourable judgment would be
obtained at the Court of Appeal.
112
a. Discuss FOUR of ISA 501 Audit evidence - specific consideration for selected
items requirements on the procedures the auditors can perform to obtain
sufficient and appropriate audit evidence on the litigation provision.
(5 Marks)
b. Comment on the adequacy or otherwise of the amount recognised as
provision for litigation in the financial statements as at December 31, 2016.
(5 Marks)
c. Prepare a summary disclosure of the entity‟s litigation status for inclusion in
the notes to the financial statements as at December 31, 2016. (5 Marks)
(Total 15 Marks)
QUESTION 6
During the course of your audit of fixed assets of Next Engineering Plc at December
31, 2016 two problems arose:
(i) The calculations of the cost of direct labour incurred on assets in the course
of construction by the company‟s employees have been accidentally
destroyed for the early part of the year. The direct labour cost involved is
₦20,000,000.00; and
Required:
a. Discuss the general forms of modifications available to the auditors in
drafting their report in accordance with appropriate standards and state the
circumstance in which each form is appropriate. (6 Marks)
b. On the assumption that you decide that a modified audit report would be
necessary with respect to the treatment of government grant, prepare a draft
of the section that deals with the matter (whole report not required).
(5 Marks)
113
YET has not been satisfied with the work of the previous auditors and has
approached your firm to be appointed as the new auditors. Appropriate
professional clearance has been resolved for the work to commence. You are the
audit manager responsible for the engagement. You have also been assigned on
the job with some new trainees who are not conversant with controls in on-line
businesses.
Required:
a. Discuss FIVE of the controls an auditor should focus on to assess the
effectiveness of controls in an on-line system such as YET. (5 Marks)
b. Evaluate FOUR risks associated with the business of YET in the application of
electronic data interchange in an on-line business and FOUR effective controls
that may be put in place to minimise the risks. (10 Marks)
(Total 15 Marks)
114
(i) ethical standards are complied with and appropriate action taken
if there is evidence to the contrary;
(ii) independence requirements are met, including:
- identifying circumstances and relationships that might give
rise to threats to independence;
- assessing the impact of breaches of the firm‟s independence
policies and procedures and whether such breaches create a
threat to
- independence; and
- taking suitable action to eliminate identified threats or to
withdraw from the engagement if appropriate.
(iii) the audit is carried out by an audit team with the appropriate
competence and capabilities;
(iv) appropriate management of the engagement is in place, including
the direction and supervision of staff and the review of audit
work;
(v) on or before the date of the audit report, the engagement partner
must, through a review of audit documentation and discussion
with the audit team, be satisfied that sufficient and appropriate
evidence has been obtained to support the conclusions reached.
(vi) adequate consultations have taken place on difficult or
contentious matters and the conclusions from such consultations
implemented;
115
(i) Obtain a copy of the client‟s tax computations and agree the figures in
the calculation to the accounting records. Also consider recalculating
the amount to check it‟s accuracy;
(ii) Review any correspondence about tax that may exist with a view to
verifying the propriety of the tax losses used in the calculation;
(iii) Make an assessment about whether the tax losses will be recoverable,
by obtaining forecasts from the client of future profitability. The
assumptions used in the forecast should be assessed for
reasonableness in the context of the auditor‟s understanding of the
client‟s business;
(iv) If the forecasts of future profitability are reasonable, the auditor should
assess how long it will be before the losses are recovered in full. This
116
(v) Determine from the tests above, whether the deferred tax asset should be
recognised in full or whether some amounts should not be fully
recognised; and
(vi) Check that relevant disclosures required in respect of deferred taxes have
been made in the financial statements.
di Inventories
Important specific audit procedures for Intangible assets include the following:
117
Almost all the candidates attempted the question and performance was average.
SOLUTION 2
i. The parent company operates in another country with different laws and
regulations;
iii. CZL is now a new company selling items different from its erstwhile
products. New customers would be sought and new marketing efforts
would be employed, yet only skeletal staff were retained;
iv. Staff of Zaka may sue for redundancy costs. Redundancy payments have
not been made. There may be need to make provisions;
vi. The change in line of business will affect after-sales service for customers
of the old company and they may sue for damages;
vii. Receiving products for sale only from its parent company is a limitation
to going concern of the company; and
118
EXAMINER‟S REPORT
About 95% of the candidates attempted the question but performance was poor.
119
Total 20
SOLUTION 3
120
121
d. Qualified opinion
In our opinion, except for the possible effects of the matter described in the
basis for Qualified Opinion paragraph, the accompanying financial
statements give a true and fair view of the financial position of Tophem Bank
Plc as at 31 December 2016 and the financial performance and cash flows
for the year then ended in accordance with the International Financial
Reporting Standards, the Companies and Allied Matters Act Cap C20 LFN
2004, the Banks and other Financial Institutions Act CAP B3 LFN 2004, the
Financial Reporting Council of Nigeria Act, 2011, and other relevant Central
Bank of Nigeria guidelines and circulars.
EXAMINER‟S REPORT
About 56% of the candidates attempted the question and performance was poor.
Candidates are advised to prepare adequately for the examination by reading the
Institute‟s study text in detail.
MARKING GUIDE
122
123
a. The engagement partner should take cognisance of the following risks that the
firm could be exposed to, if it takes up the audit:
i. The client‟s working environment has been corrupted with lack of integrity
among staff leading to the creation of non-existent loans;
ii. Internal evidence therefore cannot be relied upon, as they have no weight;
and
iii. The opening balances cannot be relied upon because the financial
statements of prior years have been misstated.
Granted that the business risks are high and that these will create financial
statements risks, the partner must take appropriate actions to reduce their
effects on the financial statements.
The firm must be cautious in dealings with client‟s staff. External evidence
should be used to corroborate whatever internal evidence that would be
presented. Management representation should be obtained, covering
significant matters in the financial statements.
c MANAGEMENT LETTER
124
The Directors
Dear Sir
MANAGEMENT LETTER
We have completed the audit of your Bank‟s financial statements for the year ended
31 December 2016 and we made some observations during the course of the audit.
The observations are presented below.
Observation
The staff of your bank and the subsidiary Micro Finance Bank colluded and created
bogus loans totalling N5.5 billion over a period of seven years.
Implication
Recommendation
There is an urgent need to write off this fictitious asset from the books.
Response
Observation
The staff of your bank colluded to cover up fraud and gross misstatement.
Implication
This means that the backbone of the internal control system has been broken and it
is difficult to rely on the system for the preparation of the financial statements.
Recommendation
There is an urgent need to overhaul the human resource of the bank. There is need
for thorough investigation and those found culpable should be relieved of their
positions.
125
Conclusion
Please provide a response and action plan for each weakness identified in the
report. This should be inserted in the space provided. Additional sheets could be
attached for further explanation that could help us to serve you better. The contents
of this letter and your response thereupon will be followed up in future audits.
Thank you.
Truly yours,
Engagement Partner.
EXAMINER‟S REPORT
The question tests candidates understanding of audit risks associated with financial
statements.
About 90% of the candidates attempted the question and performance was poor.
Candidates displayed inadequate preparation, and lack in-depth knowledge of audit risks.
Candidates are advised to read the Institute‟s study text thoroughly before attempting the
examination.
MARKING GUIDE
126
SOLUTION 5
(a) ISA 501 states that the auditor shall design and perform audit procedures in
order to identify litigation and claims involving the entity which may give
rise to a risk of material misstatements, including:
127
There is a past event - the relevant past event for the litigation
provision is the event that gives rise to the claim, i.e. the high court
judgment.
EXAMINER‟S REPORT
About 65% of the candidates‟ attempted the question but performance was poor.
The commonest pitfall of the candidates was that they applied general knowledge
rather than being specific. They were not familiar with ISA 501 requirement.
The extensive use of the Institute‟s study text is recommended for improved
performance.
128
SUB TOTAL 5
TOTAL 15
129
Qualified Opinion
This is issued when financial statements are materially misstated, but in the
auditor‟s judgment, the effect of the misstatement is not considered
pervasive.
OR
Adverse opinion
Issued when financial statements are materially misstated, and in the
auditor‟s judgment, the effect of the misstatement is pervasive on these
financial statements.
Disclaimer of opinion
Issued when the auditor is unable to obtain sufficient appropriate audit
evidence and the possible effect of the misstatement is material and
pervasive on the financial statements.
c The directors are solely responsible for the Directors‟ report and the auditors
have no general responsibility for it.
However, they are required to consider whether the information in the
Directors‟ report is consistent with the information in the financial
statements and information they are aware of in the course of their audit.
130
This is unlikely, but any information at all in the Directors‟ report which
seems to the auditor as dubious would put the auditor on enquiry.
EXAMINER‟S REPORT
About 45% of the candidates attempted the question, but performance was poor.
MARKING GUIDE
131
a) Although on-line systems are usually efficient and effective for the users,
they create additional problems for the auditor who needs to assess the
effectiveness of the system‟s controls. There are two categories of system
controls in an on-line system. These are general and application controls.
ii. Software Control -There should be controls written into the system
software to prevent or detect unauthorised changes to programs;
iv. Internet Access Control - Firewalls should be used for systems that
have access to the internet.
132
Auditors should expect to find effective controls in place to minimise the risk
inherent in EDI systems. Typically, controls will cover such matters as:
EXAMINER‟S REPORT
The commonest pitfall of the candidates was that their solutions tend towards
controls in a Non-Electronic Data Processing.
Candidates are enjoined to read the question and interpret it correctly before
attempting it. Also, the Institute‟s study text should be used by the candidates in
preparing for future examinations.
Marking Guide
133
CASE STUDY
Time Allowed: 4 hours (including reading time)
INSTRUCTION: YOU ARE TO USE THE CASE STUDY ANSWER BOOKLET FOR THIS
PAPER
Requirement
You are Dave Chukwurah, a recently qualified Chartered Accountant and a Junior
Consultant in the firm of Dauda, Eporum, Bala & Co, a firm of consulting accountants
and tax practitioners. One of your Senior Partners, Jaja Eporum, has sent you an email
(Exhibit 1) requiring you to prepare a report to be submitted to Joel Ramsey, Chief
Executive Officer (CEO) of Tostol Drinks Nigeria Limited, one of your clients. Tostol
Drinks Nigeria Limited (TDNL) has requested from your firm an advice in respect of the
company‟s proposed strategic plan aimed at increasing the company‟s shareholders‟
value while at the same time satisfy the company‟s other stakeholders.
The following time allocation is suggested:
Reading 1 hour
4 hours
134
EXHIBIT DESCRIPTION
2. Email from Joel Ramsey, CEO of Tostol Drinks Nigeria Limited, one
of your clients, to Jaja Eporum.
135
Further to my discussions with you this morning in my office in respect of our above named
client, I will like you to go through the attachments to this email (Exhibit 2 – 7) and
prepare a report as requested by Joel Ramsey, the Chief Executive Officer (CEO) of Tostol
Drinks Nigeria Limited (TDNL) for my review.
As I made it clear to you, the board of TDNL is concluding the company‟s strategic plan for
the next five years with a central focus on “increase in shareholders‟ value”. The board has
decided to carry out a backward integration by acquiring all the shares of Brilliant Bottles
Nigeria Limited (BBNL). Therefore, the board has asked our firm to carry out a financial
due diligence on the financial statements of BBNL together with additional notes provided.
We are also required to recommend a range of prices that TDNL can offer for the
acquisition.
Further, as part of the input to the strategic plan, TDNL‟s board will want us to review the
company‟s last five years financial statements with a focus on shareholders‟ value analysis
using Economic Value Added (EVA) approach to determine how the company‟s
shareholders‟ value has grown over the years to enable the board set target for the
strategic plan period. The CEO of TDNL has asked us to assume a weighted average cost of
capital of 15% and has availed us with the company‟s financial statements for the last five
years with some additional information.
Required:
Using the attached exhibits, prepare a draft report to Jaja Eporum, your Senior Partner, for
his review before forwarding same to TDNL‟s board. Your report should include:
1. Appraisal of TDNL‟s performance in the past five years based on the company‟s
business model and this should include the additional value added to the
shareholders of TDNL using EVA approach; and
2. A report on the financial due diligence of BBNL to determine its future financial
performance, and whether its acquisition will result in increase in TDNL‟s
shareholders value. You are also to recommend a range of prices that TDNL should
offer to the shareholders of BBNL, based on the share valuation models agreed with
the board of BBNL.
136
Dear Jaja,
Further to my telephone conversation with you this morning, I write to confirm our Board‟s
approval for your firm to assist us in carrying out a financial due diligence for the
acquisition of BBNL which we hope to conclude before the last quarter of the year and also
appraise TDNL performance.
Your firm is required to make input into our strategic plan as follows:
1. Carry out an appraisal of our financial performance in the last five years, taking into
consideration our business model. We need to know how we are faring in respect of
each component of our business model. You are also to determine the value that has
been added to our shareholders in each of the past five years to enable us set targets
for the strategic plan period. You are to use economic value added (EVA) model to
determine value added in those years. I attach herewith our summarised financial
statements for 2012 to 2016 together with some additional information. I also attach
a summary of our business model which is at the heart of our business and also
determines our key performance indicators (KPIs); and
2. In respect of our plan to acquire all the shares of Brilliant Bottles Nigeria Limited, as
a step towards backward integration during the plan period, recommend whether the
acquisition will result in net value added to our present performance. Enclosed
herewith are the company‟s summarised five years financial statements with some
additional information to enable you carry out a financial due diligence on the
company. Your recommendation should also include the range of prices we can offer
to the shareholders of the company.
I hope I can count on you, as usual, to get the report out on time.
Joel Ramsey
CEO, Tostol Drinks Nigeria Limited
137
Our business model is developed along this vision. Our business model therefore, is
to manage our business responsibly, sustainably and delivering superior value to
our shareholders by satisfying our other stakeholders. We believe this will bring
opportunity for superior business growth through our presence in emerging
markets coupled with expanding margins to those achieved in the previous years.
To maintain our consumers in the face of increasing campaign for healthy living,
we have decided to focus on healthy, active lifestyles, while still maintaining our
old range of products, thus significantly broadened our product portfolio by
offering consumers a choice of soft drinks that contains zero sugar and with low
calories. We are also providing more information on our products‟ labels to help
consumers make informed choices between our wide range of product offerings.
Our business model is at the heart of everything we do. It defines the activities we
engage in, the relationships we depend on and the outputs and outcomes we aim
to achieve in order to create value for all our stakeholders in the short, medium and
long term. This is being achieved through constant value creation.
138
We create value for our stakeholders and our business by carefully managing the
use of and return on all capitals or inputs. Also, additional values created are
being shared among the various stakeholders regularly.
VALUE SHARING
Shareholders: Through the process of managing all inputs to our business well, we
create value for our shareholders through dividend payments and increase in our
share value.
139
Income Statements
Equity
Share capital 4.0 4.0 4.0 4.0 4.0
Retained earnings 227.0 278.4 325.4 389.8 489.1
Total equity 231.0 282.4 329.4 393.8 493.1
Liabilities:
Long term loans 258.7 235.6 264.7 183.9 125.3
Employee benefit 7.2 10.8 18.2 18.3 23.8
30.7 49.6 60.9 52.7 65.6
140
141
2. Personnel Information:
No of staff 2,168 2,179 2,182 2,245 2,356
Retirements/resignations in the year 20 19 28 32 35
Least paid staff N1.4m N1.6m N1.7m N1.8m N2.0m
4. Dividend declared:
During the year (per share) N20.0 N24.0 N26.0 N27.5 N28.0
5. Authorised and issued share capital:
Ordinary share capital of 50 Kobo each 8m 8m 8m 8m 8m
6. Inventories:
Inventories comprise:
N‟m N‟m N‟m N‟m N‟m
Finished goods 10.2 9.4 9.2 8.5 8.6
Raw materials:
Concentrates 30.0 25.2 25.0 32.0 31.0
Sugar 16.0 8.5 14.1 15.5 15.0
Components:
Bottles 40.5 42.3 48.1 50.4 50.5
Crown cocks 2.3 2.4 2.1 3.2 3.0
142
143
Income Statements
144
1. Retained earnings:
Retained earnings are stated as follows:
Years 2011 2012 2013 2014 2015 2016
N‟000 N‟000 N‟000 N‟000 N‟000 N‟000
Profit after tax - 14.3 9.0 7.0 9.0 14.2
Dividend paid during the year - 12.1 8.0 4.7 8.5 10.0
Transfer to retained earnings - 2.2 1.0 2.3 0.5 4.2
Retained earnings B/F - 5.6 7.8 8.8 11.1 11.6
Retained earnings C/F 5.6 7.8 8.8 11.1 11.6 15.8
2. Tax expense:
Tax expense as calculated is settled on preceding year basis. The company
has no outstanding tax liability other than the current year tax liability which
is payable the following year. However, the Federal Inland Revenue Service
(FIRS) carried out an audit of the company‟s income tax liabilities from 2011
to 2015 and came up with an additional tax liability of N10.5m. The company
has objected to this tax liability within the stipulated time but the issue has
not been resolved. No provision has been made in the financial statement of
2016 for this liability. It is projected that the final liability will be N8.5m.
3. Personal income tax liability:
The state government carried out tax audit on the company for 2015 and 2016
personal income tax liabilities. Additional liabilities of N1.45m and N1.02m
have been raised. The company has objected to these liabilities but
reconciliation meeting has not been held with the tax authority. Based on the
company‟s tax consultant‟s assessment, the final liabilities are expected to be
N0.8m and
N0.65m for the two years respectively.
4. Contingent liability:
Apart from the specific potential liabilities mentioned, the company has no
other contingent liability.
145
1. Purchase consideration:
The acquisition will be done through payment of cash. TDNL is not under any
obligation whatsoever to absorb any of the existing directors of BBNL.
2. Valuations:
From the preliminary discussions with the board of BBNL, the company will
accept a valuation of the average of the net assets per share and 5 years profit
after tax with a growth rate of 10 percent per annum. The average profit for
the last five years is to be taken as the annual maintainable profit.
a. It is estimated that the current BBNL‟s plant and machinery will meet
TDNL‟s bottle requirements for the next five years. However, TDNL will
make additional investment in plant and machinery of N15m to acquire
a recycling plant to recycle used bottles in line with TDNL‟s business
model of environmental responsible business practice; and
b. It is projected that the acquisition will reduce the cost of bottles of TDNL
by 25 per cent. The cost of bottles in TDNL‟s cost of sales is currently 20
per cent.
146
a. The savings from the cost of bottles should be based on the average cost
of bottles for the last five years with a growth rate of 12 per cent per
annum in the next five years which is the estimated life of BBNL‟s
production plant; and
147
First Marking
SUPERVISOR CHECKER
SIGNATURE SIGNATURE
Change made?
148
Uses information provided in Exhibit 2 Identifies that TDNL's market share is not provided.
V NC BC CA SA V NC BC CA SA
USES PROFESSIONAL TOOLS AND KNOWLEDGE APPLIES PROFESSIONAL SCEPTICISM AND ETHICS
Prepares common size analysis to show trends Recognises that we do not have the indication on the
in the components of the financial statements. movement in TDNL's share value.
-
V NC BC CA SA V NC BC CA SA
Determines the rate of growth in TDNL's operating Recognises that TDNL's performance is increasing
performance. yearly.
Understand the concept of economic value Recognises that TDNL has a high dividend pay out
added (EVA). ratio.
V NC BC CA SA V NC BC CA SA
149
V NC BC CA SA
V NC BC CA SA
SA
CA
BC
150
151
Uses information in email provided in Exhibit 1 Need to consider trade unions issues.
V NC BC CA SA V
NC BC CA SA
USES PROFESSIONAL TOOLS AND KNOWLEDGE (written APPLYING PROFESSIONAL SCEPTICISM AND
into report) ETHICS
Performs appropriate calculation to determine BBNL's Considers whether the summarised financial
net assets statement is from the audited accounts of BBNL
Performs appropriate calculation to determine the value Considers the correctness of the estimated tax
of BBNL based on five years maintainable earnings. payable on the two tax audits.
Recognises the treatment of potential liabilities of the Ensures that other analysis & evaluation are
tax audits. considered
Calculates the savings expected from the cost of bottles on Considers whether all the shareholders of BBNL
TDNL's operations. will agree to the acquisition.
Prepares trends analysis of BBNL's financials. Considers use of other appraisal methods
Calculates the net present value of cash flows to determine Considers likely savings in BBNL's operating costs
whether the acquisition is worthwhile. because of the acquisition.
152
CONCLUSIONS
(Draws distinct conclusions under a heading)
Concludes on net assets value of BBNL.
V NC BC CA SA
V NC BC CA SA
SA
CA
BC
NC
V
Total 8
153
V NC BC CA SA V NC BC CA SA
V NC BC CA SA V NC BC CA SA
CC
SC
IC
ID
NA
Total
155
Marketing & Distribution expenses - 145.3 - 188.7 43.4 - 29.9 -209.3 (20.6) 10.9 -216.9 -7.6 3.6 -259 -42.1 19.4
Administrative expenses - 45.5 - 53.1 7.6 - 16.7 -60.2 (7.1) 13.4 -73.4 -13.2 21.9 -76.9 -42.1 57.4
Finance expenses - 3.3 - 9.4 6.1 - 184.8 -21.5 (12.1) 128.7 -47.5 -26.0 120.9 -44.3 -84.2 177.3
-
Profit before income tax 211.8 250.5 - 38.7 18.3 276.9 26.4 10.5 294.5 17.6 6.4 375.2 -126.3 -42.9
Income tax expenses - 17.0 - 39.1 22.1 - 130.0 -37.9 1.2 -3.1 -22.1 15.8 -41.7 -55.9 -33.8 152.9
Profit after income tax expenses 194.8 211.4 - 16.6 - 8.5 239.0 27.6 13.1 272.4 33.4 14.0 319.3 46.9 17.2
Property, plant and equipment 550.2 622 71 13.0 658.8 37 6.0 675.1 16.3 2.5 691.5 16.4 2.4
Current assets:
Inventories 99 87.8 - 11 (11.3) 98.5 11 12.2 109.6 11.1 11.3 108.1 -1.5 -1.4
Trade receivables 109.8 134.6 25 22.6 178.8 44 32.8 223.3 44.5 24.9 244.5 21.2 9.5
Cash and cash equivalents 10.7 38.1 27 256.1 66.5 28 74.5 37 -29.5 -44.4 129.3 92.3 249.5
Total current assets 222.1 263.5 41 18.6 346.8 83 31.6 373.9 27.1 7.8 487.2 113.3 30.3
Total assets 772.3 885.1 113 14.6 1005.6 121 13.6 1049 43.4 4.3 1178.7 129.7 12.4
Equity:
Share capital 4 4 0 - 4 0 - 4 0 - 4 0 -
Retained earnings 227 278.4 51.4 22.6 325.4 47 16.9 389.8 64.4 19.8 489.1 99.3 25.5
Long term loans 258.7 235.6 -23.1 - 8.9 264.7 29.1 12.4 183.9 -80.8 - 30.5 125.3 -58.6 - 31.9
Employee benefir 7.2 10.8 3.6 50.0 18.2 7.4 68.5 18.3 0.1 0.5 23.8 5.5 30.1
Deferred tax liabilities 30.7 49.6 18.9 61.6 60.9 11.3 22.8 52.7 -8.2 - 13.5 65.6 12.9 24.5
- -
Total non - current liabilities 296.6 296 -0.6 0.2 343.8 47.8 16.1 254.9 -88.9 - 25.9 214.7 -40.2 15.8
Bank overdraft 0 49.5 49.5 0 -49.5 - 100.0 12.4 12.4 3.1 -9.3 -75.0
Short term loans 23.8 23.5 -0.3 - 1.3 28 4.5 19.1 34.8 6.8 24.3 50.4 15.6 44.8
-
Trade and other payables 26.6 34.6 8 30.1 9.5 -25.1 72.5 127.3 117.8 1,240.0 171.1 43.8 34.4
Provisions 191.3 195.4 4.1 2.1 290.7 95.3 48.8 220.5 -70.2 - 24.1 240.1 19.6 8.9
Total current liabilities 3 3.7 0.7 23.3 4.2 0.5 13.5 5.3 1.1 26.2 6.2 0.9 17.0
Total equity and liabilities 244.7 306.7 62 25.3 332.4 25.7 8.4 400.3 67.9 20.4 470.9 70.6 17.6
772.3 885.1 112.8 14.6 1005.6 120.5 13.6 1049 43.4 4.3 1178.7 129.7 12.4
158
Equity:
Share capital 0.5 0.5 0.4 0.4 0.3
Retained earnings 29.4 31.5 32.4 37.2 41.5
Total equity 29.9 31.9 32.8 37.5 41.8
Liabilities:
Long term loans 33.5 26.6 26.3 17.5 10.6
Employee benefir 0.9 1.2 1.8 1.7 2.0
Deferred tax liabilities 4.0 5.6 6.1 5.0 5.6
Total non - current liabilities 38.4 33.4 34.2 24.3 18.2
159
160
Social responsibility report( % of pre tax profit) 6/211.8% 8/250.5% 8/276.9% 7.5/294.5% 7.6/375.2%
2.83% 3.19% 2.90% 2.55% 2.03%
NOTE:
Usually, the opening capital is used to calculate cost of capital, but because we were not given the opening
capital for 2012, we have used the closing capital for 2012 caculation while for other years we used opening capital.
161
Revenue 78.4 82.5 4.1 5.2 80.6 - 1.9 - 2.3 90.5 9.9 12.3 11.8
- - -
Cost of sales 36.8 - 41.2 4.4 12.0 39.6 1.6 - 3.9 - 40.6 - 1.0 2.5 13.8
- -
Gross Profit 41.6 41.3 0.3 0.7 41.0 - 0.3 - 0.7 47.9 6.9 16.8 14.8
- - -
Marketing & Distribution expenses 10.3 - 11.5 1.2 11.7 12.8 - 1.3 11.3 - 13.9 - 1.1 8.6 9.4
- - -
Administrative expenses 11.2 - 14.8 3.6 32.1 15.1 - 0.3 2.0 - 16.2 - 1.1 7.3 4.9
- - -
Finance expenses 2.0 - 3.1 1.1 55.0 2.5 0.6 - 19.4 - 2.1 0.4 - 16.0 - 14.3
- -
Profit before income tax 18.1 11.9 6.2 34.3 10.6 - 1.3 - 10.9 15.7 5.1 48.1 33.8
- - -
Income tax expenses 3.8 - 2.9 0.9 23.7 3.6 - 0.7 24.1 - 5.8 - 2.2 61.1 17.2
- -
Profit after income tax expenses 14.3 9.0 5.3 37.1 7.0 - 2.0 - 22.2 9.9 2.9 41.4 43.4
Inventories 5.0 6.2 1.2 24.0 6.1 - 0.1 - 1.6 8.9 2.8 45.9 - 1.1
- -
Trade receivables 3.0 2.8 0.2 6.7 3.2 0.4 14.3 5.1 1.9 59.4 - 9.8
Cash and cash equivalents 1.5 1.8 0.3 20.0 1.6 - 0.2 - 11.1 1.2 - 0.4 - 25.0 41.7
Total current assets 10.0 11.4 1.4 14.0 16.8 5.4 47.4 21.0 4.2 25.0 35.7
- -
Total assets 25.0 24.9 0.1 0.4 28.8 3.9 15.7 31.5 2.7 9.4 19.0
162
Retained earnings 7.8 8.8 1.0 12.8 11.1 2.3 26.1 11.6 0.5 4.5 36.2
Total equity 17.8 18.8 1.0 5.6 21.1 2.3 12.2 21.6 0.5 2.4 19.4
Liabilities:
- -
Trade and other payables 3.2 2.8 0.4 12.5 3.5 0.7 25.0 3.6 0.1 2.9 13.9
- -
Tax liabilities 3.8 2.9 0.9 23.7 3.6 0.7 24.1 5.8 2.2 61.1
Other payables and acrued
expenses 0.2 0.4 0.2 100.0 0.6 0.2 50.0 0.5 - 0.1 - 16.7 60.0
- -
Total current liabilities 7.2 6.1 1.1 15.3 7.7 1.6 26.2 9.9 2.2 28.6 18.2
- -
Total equity and liabilities 25.0 24.9 0.1 0.4 28.8 3.9 15.7 31.5 2.7 9.4 19.0
163
164
165
166
167
There are two requirements the candidates are expected to address in their report
on the case. The requirements are:
To be able to write a good report and perform very well in the paper, candidates
are expected to prepare the following appendices:
(a) Relevant financial ratios for Tostol Drinks Nigeria Limited, including trend
analysis, taking into consideration the company‟s business model;
(b) Calculation of economic value added for Tostol Drinks Nigeria Limited, from
2012 to 2016;
(c) Relevant financial ratios for Brilliant Bottles Nigeria Limited, including trend
analysis for 2012 to 2016;
(d) Valuation of Brilliant Bottles Nigeria Limited based on net assets basis and
average maintainable earnings; and
(e) Net present value calculation to show the effect of the acquisition on the
performance of Tostol Drinks Nigeria Limited.
Candidates‟ performance was poor as only few candidates scored 50% or above.
(b) Inability to correctly calculate economic value added of Tostol Drinks Nigeria
Limited;
(c) Inability to calculate correctly the appropriate performance ratios for Tostol
Drinks Nigeria Limited based on its business model;
(d) Inability to carry out correct valuation of Brilliant Bottles Nigeria Limited
based on the two indicated valuation models;
174
(f) Inability to understand how to generate figures required to calculate the net
present value from the financial data provided; and
(g) Inability to write a good report with appropriate headings and subheadings.
175
PATHFINDER
MAY 2018 DIET
PROFESSIONAL LEVEL EXAMINATIONS
Question Papers
Suggested Solutions
Examiner‟s Reports
Plus
Marking Guides
QUESTION 1
Plateau Plc. (PT) is a Nigerian company that manufactures and sells innovative
products. Following favourable market research that cost N4,000,000, PT has
developed a new product. It plans to set up a production facility in Kano, although
its board had contemplated setting up the facility in an overseas country. The
project will have a life of four years.
The selling price of the new product will be N5,900 per unit and sales in the first
year to December 31, 2019 are expected to be 120,000 units, increasing by 5% p.a.
thereafter. Relevant direct labour and material costs are expected to be N3,400 per
unit and incremental fixed production costs are expected to be N60million p.a. The
selling price and costs are stated in December 31, 2018 prices and are expected to
increase at the rate of 3% p.a. Research and development costs to December 31, will
amount to N25 million.
Investment in working capital will be N30million on December 31, 2018 and this
will increase in line with sales volumes and inflation. Working capital will be fully
recoverable on December 31, 2022.
The company will need to rent a factory during the life of the project. Annual rent
of N20million will be payable in advance on December 31 each year and will not
increase over the life of the project.
Plant and machinery will cost N1billion on December 31, 2018. The plant and
machinery is expected to have a resale value of N300million (at December 31, 2022
prices) at the end of the project. The plant and machinery will attract 20%
(reducing balance) capital allowances in the year of expenditure and in every
subsequent year of ownership by the company, except in the final year when there
will be a balancing allowance or charge.
68
Required:
a. Calculate, using money cash flows, the NPV of the project on December 31,
2018 and advise the company whether to proceed with the project or not.
(15 Marks)
b. Calculate and interpret the sensitivity of the project to a change in:
(i) The annual rent of the factory (2 Marks)
QUESTION 2
Kazaure Limited has a cash surplus of N20m which the financial manager is keen
to invest in corporate bonds. He has identified two potential investment
opportunities in two different companies which are both rated A by the major credit
rating agencies.
Bond A
The issuer plans to raise N500m 2-year bond with a coupon rate of 10%. The bond is
redeemable at a premium of 8% to nominal value.
69
AAA 6 16 28
AA 15 25 40
A 20 30 50
Required:
a. For a nominal value of N1,000, calculate the theoretical issue prices of the
two bonds and indicate how many of each of the bonds Kazaure Limited can
buy assuming it invests in only one of them. (5 Marks)
Note: Calculate issue prices to the nearest N.
QUESTION 3
Kehinde is a wholesaler who buys and sells a wide range of products, one of which
is electrical component TK. Kehinde sells 24,000 units of TK each year at a unit
price of N2,000. Sales of TK normally follow an even pattern throughout the year
but to protect the business against possible stock-out, Kehinde keeps a minimum
inventory of 1,000 units. Further supplies of TK are ordered whenever the inventory
falls to this minimum level and the time lag between ordering and delivery is small
and can be ignored.
70
Kehinde stores TK in a warehouse which he rents on a long lease for N500 per
square metre per annum. Warehouse space available exceeds current requirements
and, as the lease cannot be cancelled, spare capacity is sublet on annual contracts
at N400 per square metre per annum. Each unit of TK in inventory requires 2
square metres of space.
Kehinde estimates that other holding costs amount to N1,000 per TK per annum.
Kehinde has recently learnt that another supplier of TK, Ema Limited offers
discounts on large orders. Ema Limited sells TK at the following prices:
Required:
a. Calculate the relevant
i. cost per order
b. Irrespective of your answers in (a) above and assuming cost per order of
N150,000 and holding cost per unit per annum of N1,800, calculate the
optimal re-order quantity for TK and the associated annual profit Kehinde
can expect from their purchase and sale, assuming that he continues to buy
from Ajoke Limited. (6 Marks)
71
QUESTION 4
Sunmola Funds (SF) Plc. has a portfolio of short-term investments in the shares of
four quoted companies.
Company Holding
Tomiwa (T) 100,000 shares
Pascal (P) 155,000 shares
Binta (B) 260,000 shares
Yetunde (Y) 420,000 shares
The market risk premium is 10% per year and the risk free rate is 6% per year.
Required:
a. Estimate the Beta of SF Plc.‟s short-term investment portfolio. (4 Marks)
(Hint: Consider the alpha values of the shares and the propriety of investing
short-term funds in equity).
c. Explain THREE factors that a financial manager should take into account
when investing in marketable securities. (6 Marks)
(Total 20 Marks)
72
QUESTION 5
Katangwa Limited will need to borrow ₦50 million in three months‟ time for a
period of six months. The company is concerned that interest rates are expected to
rise over the next few months.
Interest rates and forward rate agreements (FRAs) are currently quoted as follows:
● Spot 5.75 – 5.50
● 3 – 6 FRA 5.82 – 5.59
● 3 – 9 FRA 5.94 – 5.64
Required:
a. Explain how a forward rate agreement (FRA) may be useful to the company.
Illustrate this on the basis that interest rates
i. Rise to 6.50%
ii. Fall to 4.50% (8 Marks)
b. Compare the use of interest rate futures with FRA in this instance (4 Marks)
c. Explain how interest rate guarantees or short-term interest rate cap could be
used. (3 Marks)
(Total 15 Marks)
QUESTION 6
Okpara Plc. is a large publicly quoted company in the eastern part of Nigeria. It
operates in the home appliances industry with significant market share. In a recent
strategy meeting, the directors decided to pursue aggressive growth through
mergers in other parts of the country and along the ECOWAS sub-region.
Required:
Prepare a report to the Board of Directors of Okpara Plc. to address the following
matters:
73
Nkata Plc. is a large publicly quoted company. The directors are currently debating
a number of issues, including the following:
Required:
a. Discuss the role of non-executive directors in the corporate governance of a
listed public company. (4 Marks)
b. Identify and discuss THREE areas where the interests of shareholders and
directors may conflict leading the directors to pursue objectives other than
maximizing shareholders‟ wealth. (6 Marks)
c. Identify FIVE examples of covenant that might be attached to bonds and
discuss briefly the advantages and disadvantages of each to companies.
(5 Marks)
(Total 15 Marks)
74
Equity Beta
𝑉𝐷
𝛽𝐸 = 𝛽𝐴 + (𝛽𝐴 − 𝛽𝐷 ) (1 − 𝑡)
𝑉𝐸
Growing Annuity
𝑛
𝐴1 1+𝑔
𝑃𝑉 = 1−
𝑟−𝑔 1+𝑟
75
n = number of periods
1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1
2 1·970 1·942 1·913 1·886 1·859 1·833 1·808 1·783 1·759 1·736 2
3 2·941 2·884 2·829 2·775 2·723 2·673 2·624 2·577 2·531 2.487 3
4 3·902 3·808 3.717 3·630 3.546 3.465 3·387 3·312 3·240 3·170 4
5 4·853 4·713 4·580 4·452 4·329 4·212 4·100 3·993 3.890 3·791 5
6 5·795 5·601 5·417 5·242 5·076 4·917 4·767 4·623 4.486 4·355 6
7 6·728 6.472 6·230 6·002 5·786 5·582 5·389 5·206 5·033 4·868 7
8 7·652 7·325 7·020 6·733 6·463 6·210 5·971 5·747 5·535 5·335 8
9 8·566 8·162 7·786 7.435 7·108 6·802 6·515 6·247 5·995 5·759 9
10 9·471 8·983 8·530 8·111 7·722 7·360 7·024 6·710 6.418 6·145 10
11 10·368 9·787 9·253 8·760 8·306 7·887 7.499 7·139 6·805 6.495 11
12 11·255 10·575 9·954 9·385 8·863 8·384 7·943 7·536 7'161 6·814 12
13 12·134 11·348 10·635 9·986 9·394 8·853 8·358 7·904 7·487 7·103 13
14 13·004 12·106 11·296 10·563 9·899 9·295 8·745 8·244 7·786 7·367 14
15 13·865 12·849 11·938 11·118 10·380 9·712 9·108 8·559 8·061 7·606 15
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1
2 1·713 1·690 1·668 1·647 1·626 1·605 1·585 1·566 1·547 1·528 2
3 2.444 2.402 2·361 2·322 2·283 2·246 2·210 2·174 2·140 2·106 3
4 3·102 3·037 2·974 2·914 2·855 2·798 2·743 2.690 2·639 2.589 4
5 3·696 3·605 3·517 3·433 3·352 3·274 3·199 3·127 3·058 2·991 5
6 4·231 4·111 3·998 3·889 3·784 3·685 3·589 3.498 3.410 3·326 6
7 4·712 4·564 4.423 4·288 4·160 4·039 3·922 3·812 3·706 3·605 7
8 5·146 4·968 4.799 4·639 4.487 4·344 4·207 4·078 3·954 3·837 8
9 5·537 5·328 5·132 4·946 4·772 4·607 4.451 4·303 4·163 4·031 9
10 5·889 5·650 5.426 5·216 5·019 4·833 4·659 4.494 4·339 4·192 10
11 6·207 5·938 5·687 5.453 5·234 5·029 4·836 4·656 4.486 4·327 11
12 6·492 6·194 5·918 5·660 5·421 5·197 4·988 4·793 4·611 4.439 12
13 6·750 6.424 6·122 5·842 5·583 5·342 5·118 4·910 4·715 4·533 13
14 6·982 6·628 6·302 6·002 5·724 5.468 5·229 5·008 4·802 4·611 14
76
NPV = (N29,000,000)
NPV = (N29,000,000)
78
Year 0 1 2 3 4
NPV = 52
52
IRR = 7 + × 10 − 7 = 8.93 approx. 8.9
29 + 52
= 8.9%
The WACC would have to fall by (10 – 8.9)/10 = 0.11 = 11%.
(b) The risk is that political action will reduce the value of the project.
The measures that a foreign government might use include: Quotas;
Tariffs; Non-tariff barriers; Restrictions; Nationalisation; Minimum
shareholding; Blocked funds.
Strategies that can be used to limit the effects of political risk include:
Negotiations with the host government; Insurance; Production
strategies; Management structure.
(d) NPV only considers the cash flows associated with the new project. It
is possible that the project may be worthwhile as a result of the real
options associated with it and these include:
79
Part (b) requires candidates to calculate and comment on the sensitivity of the
project to two of the inputs in the NPV analysis.
Part (c) requires candidates to consider the political risk of setting up the
manufacturing facility overseas and how the company may limit its effects.
In part (a), most candidates did not pay full attention to the timing of cash flows
and when they should be increased for price inflation and growth in quantity sold.
In part (b), most of the candidates had some difficulty, as the project produced a
negative NPV.
In part (c), a large number of the candidates could not identify political risks and
those who did, could not state how to limit its effects.
In part (d), very few candidates were able to identify the real options available to
the company. However, a disappointing number of them did not refer to the
scenario of the question.
80
b) i) PV of factory rent 1
Sensitivity ½
Interpretation ½ 2
ii) IRR 3
Sensitivity ½
Interpretation ½ 4
SOLUTION TWO
(a) The government bond yield curve needs to be adjusted by the credit spread
for an A-rated company.
81
Bond B
1 1 2 1 3
P0 = 𝑁120 + 𝑁120 + 𝑁1,120 = 𝑁1,026
1.097 1.107 1.11
Bond A
Try 10%: NPV = -N1,054 + N1,00(1.736) + N1,080(0.826) = N11.68
Try 11%: NPV = -N1,054 + N1,00(1.713) + N1,080(0.812) = -N5.74
11.68
𝑌𝑇𝑀 = 10 + (11 − 10) = 10.67%
\
11.68 + 5.74
Bond B
Try11%: NPV = -N1,026 + N120(2.444) + N1,000(0.731) = -N1.72
YTM is approximately 11% (actually about 10.94%).
82
(d) If interest rates increase, prices of bonds are expected to fall. Bonds with
relatively higher durations will experience higher percentage drop in price in
response to the same percentage increase in interest rate. Therefore, to
minimise the risk of drop in price, Bond A, with lower duration will be
selected, holding other factors constant.
EXAMINER‟S REPORT
This question tests candidates‟ knowledge of key bond analysis, that is, pricing,
yield and duration.
About 20% of the candidates attempted the question. Only two candidates
produced excellent solutions, but the performance of the other candidates was
disappointing.
Despite the clear instruction that candidates should work with nominal value of
N1,000, about 80% of the candidates who attempted the question elected, at their
own risk, to work with a nominal value of N100.
The key challenges which the candidates faced in the question include the
following:
Inability to deal with the credit spread and thereby incorrectly pricing the
bonds;
Inability to calculate the YTM even when the bond prices were given; and
Lack of understanding of the concept of duration and its meaning.
83
c) Calculation of duration
- Bond A 2
- Bond B 2
Interpretation of duration 2 6
SOLUTION THREE
(a) (i) Cost per order
₦
Fixed shipment charge 100,000
Administration cost 50,000
Total 150,000
Note: The variable delivery charge of ₦50 per unit is not relevant
when computing cost per order because it does not vary with the
number of orders made.
84
85
(i) The model assumes that annual demand can be predicted and
constant usage applies throughout the year.
(ii) The relevant order cost (incremental cost) per unit is extremely
difficult to estimate. In practice most of the order costs are likely to be
semi-fixed.
(iii) The costs of placing an order are assumed to be constant and not to
vary with the size of the order.
EXAMINER‟S REPORT
This question tests the candidates‟ knowledge of Economic Order Quantity (EOQ).
Part (a) tests the ability of the candidates to identify the relevant cost per order and
the holding cost per unit.
Part (b) tests the calculation of basic EOQ and part (c) tests their ability to evaluate
quantity discount.
Though some very few candidates produced very good solutions, large number of
them were found wanting.
EOQ and discount were also tested in a recent examination. Candidates are
advised to make better use of past editions of the Pathfinders in their preparation
for the Institute‟s future examinations.
MARKING GUIDE
Marks Marks
a) i) Shipment charge ¾
Admin cost ¾
Total ½ 2
86
b) EOQ 2
Holding cost 1
Ordering cost 1
Base stock 1
Purchase cost ½
Total revenue ½ 6
SOLUTION FOUR
(a) The risk of Sunmola Funds (SF) plc.‟s short-term investment portfolio may be
measured by the weighted average beta of the four shares. The weighting is
by the market value of the shares.
Market value
N Beta N
T 280,000 1.55 434,000
P 527,000 0.65 342,550
B 390,000 1.26 491,400
Y 39,900 1.14 45,486
1,236,900 1,313,436
Portfolio beta = N1,313,436/N1,236,900 = 1.06
SF Plc.‟s short-term investment portfolio is slightly riskier than what is
obtainable in the capital market.
87
Next, we compute the expected excess return (i.e. the alpha value =
) and make recommendation.
88
(c) The factors that a financial manager should take into account when
investing in marketable securities include:
i) Default risk. The risk that interest and/or principal will not be paid on
schedule on fixed interest investments. Most short-term investments in
marketable securities are confined to investments with negligible risk of
default;
ii) Price risk. The risk of the value of the investment changing, for
example, when interest rates change. Financial managers normally
wish to avoid substantial price risk;
iv) Taxation. Whether there are any special tax effects on the selected
marketable securities;
v) Yield. Managers will usually try to achieve the maximum yield possible
consistent with a satisfactory level of risk and marketability;
89
viii) The period for which the investment is to be made. The type of
investment should be matched with the timing requirements of future
need for funds.
EXAMINER‟S REPORT
The question tests some basic concepts of portfolio theory and CAPM.
About 80% of the candidates attempted the question. 40% of the candidates who
attempted the question, scored 50% or above of the allocated marks.
In part (a), using nominal value of the shares rather than market values;
Wrongly calculating alpha value as required return minus expected return
rather than expected return minus required return;
Wrong interpretation of alpha values; and
Inability of the candidates to apply their knowledge to examination
questions. For example, in the final part of question (b), would any of the
candidate invest money needed to pay rent in six months time in equity?
This is just common sense!
We recommend that students should read widely, making use of the Institute‟s
Study Text, Pathfinder and other examination related text books.
MARKING GUIDE
Marks Marks
a) Computing market value 3
Portfolio beta 1 4
b) Required returns 2
Alpha values 2
Buy/hold/sell decision with Reasons 3
Propriety of the investment 3 10
90
= (₦360,000) = ₦140,000
Interest on ₦50m for 6 months (₦1,125,000) (₦1,625,000)
Net payment (₦1,485,000) (₦1,485,000)
If rates rise, then futures‟ prices‟ fall (futures‟ price = 100 rate), hence, to
gain, we must sell interest rate futures.
91
They represent an interest rate option giving the holder the right, but not the
obligation, to deal at an agreed interest rate at a future maturity date.
This means that if rates rise, the option would be exercised by Katangwa Ltd.
locking the rate. If rates fall, however, Katangwa Ltd. would allow the option
to expire without exercising it, and benefit from the lower interest rate in the
market.
EXAMINER‟S REPORT
The question tests candidates‟ knowledge of interest rate risk management
techniques.
Less than 20% of the candidates attempted it. Candidates demonstrated lack of
knowledge of the risk management section of the syllabus.
Candidates are advised to make better use of the Institute‟s Study Text, past
editions of the Pathfinder and any other relevant text books.
MARKING GUIDE
Marks Marks
a) Explanation of the use of FRA in
hedging interest rate risk 2
92
SOLUTION SIX
The criteria that should be used to assess whether a target is appropriate will
depend on the motive for the acquisition.
The main criteria that are consistent with the underlying motives include:
ii. Diversification
If the objective is risk reduction, the target firm should be in a
business which is different from our own business and the correlation
in earnings should be low;
93
b. Purchase Consideration
The key factors that determine the form of purchase consideration include:
i. Liquidity
Clearly, the use of cash as consideration depends upon having
sufficient liquid resources available. Equity or debt securities, if used,
will not affect the firm‟s cash position;
ii. Control
The use of cash will not transfer control from the existing shareholders
but the use of equity shares and convertible bonds will lead to loss of
control;
iii. Gearing
The use of debt securities leads to increase in financial gearing and
associated financial risk. This may be acceptable if the takeover is
small or if there is previously unused debt capacity;
94
Signed
Name
EXAMINER‟S REPORT
More than 80% of the candidates attempted the question. About 10% of the
candidates that attempted the question scored zero.
Candidates are advised to put in greater effort to ensure their success in the
Institute‟s examinations.
MARKING GUIDE
Marks Marks
a) Report format 1
½ mark per valid factor mentioned, max 3
1 mark for explanation of the valid
points, max 5 9
SOLUTION SEVEN
(a) The Board of Directors of a listed public company will usually consist of
executive directors, who hold specific responsibilities within the business (for
example, personnel director and non-executive directors), who do not have
specific responsibilities. Non-executive directors are usually employed on a
part-time basis and are not involved in day-to-day operational matters.
Nevertheless, executive and non-executive directors have the same legal
obligations towards the shareholders of the company.
95
(b) Takeovers
Directors often devote large amounts of time and money to defend their
companies against takeover. However, research has shown that shareholders
in companies that are successfully taken over often earn large financial
returns. On the other hand, directors of companies that are taken over
frequently lose their jobs. This is a common example of the conflict of
interest between the two groups.
Time horizon
Directors know that their performance is usually judged on their short-term
achievements; shareholders‟ wealth, on the other hand, is affected by the
long-term performance of the firm. Directors can frequently be observed to
be taking a short-term view of the firm which is in their own best interest but
not in that of the shareholders.
Risk
Shareholders appraise risks by looking at the overall risk of their investment
in a wide range of shares. They do not have „all their eggs in one basket‟
unlike directors whose career prospects and short-term financial
remuneration depend on the success of their individual firms.
Moral hazard
This deals with manager‟s interest in receiving all the perquisites of his
office like domestic staff, company cars, use of company‟s airplane; company
sponsored holiday trips with family abroad etc. Such moral hazards which
increase if the manager has no stake in the company tend to drain the
96
Working hours
Ordinarily, managers prefer to work for less hours than the stipulated
working period especially if the reward system does not recognise overtime
and hard work. The implication is that the earnings of the company will
reduce as well as share price and returns to shareholders. This will be more
pronounced with senior management if profit sharing or bonus payment is
not attached to profitability.
Dividend policy
Unfortunately, the remuneration of directors and senior managers is often
related to the size of the company, rather than its profits. For this reason,
executive management may favour a high retention policy which implies
growth in asset and size of the company. On the other hand, the
shareholders may favour a higher dividend payout which implies more
money for them to meet up with their needs
97
Advantages of covenants
i. The main advantage of covenant is that lenders may be prepared to
lend more money to the company if it provides the security of a
covenant; and
ii. Covenants may mean that the costs at which the company can borrow
money are lower.
Disadvantages of covenants
ii. Covenants may require the borrower to bear monitoring costs such as
provision of information, auditors‟ fees or trustee expenses.
EXAMINER‟S REPORT
The question tests candidates‟ knowledge of basic concepts in finance, such as
agency problems, conflict of interest etc.
Over 80% of the candidates attempted the question, but performance was very
poor.
The major pitfall was lack of basic knowledge and understanding of rudimentary
concepts in financial management.
MARKING GUIDE
Marks Marks
a) Reasonable comment on roles
of executive directors 4
b) Identification of 3 areas of conflict
(1/2mark each) 1½
Discussion on the 3 areas identified
(11/2mark each) 41/2 6
c) Identification of any FIVE covenants
mentioned with explanations 5
15
98
PATHFINDER
NOVEMBER 2018 DIET
Suggested Solutions
Marking Guides
Plus
Examiner‟s Reports
151
QUESTION 1
Eko Plc. (Eko) is a listed company in food retailing sector and has large stores in all
major cities in the country. Eko‟s board is considering diversifying by opening
holiday travel shops in all of its stores.
At a recent board meeting, the directors discussed how the holiday travel shops
project (the project) should be appraised. The sales director insisted that Eko‟s
current weighted average cost of capital (WACC) should be used to evaluate the
project as majority of its operations will still be in food retailing. The finance
director disagreed because the existing cost of equity does not take into account the
systematic risk of new projects. He said that the company‟s overall WACC, which
reflects all of the company‟s activities, would change as a result of the project‟s
acceptance. The board was also concerned about the market‟s reaction to its
diversification plans. Another board meeting was scheduled at which Eko‟s advisors
would be asked to make a presentation on the project.
You work for Eko‟s advisors and have been asked to prepare information for the
presentation. You have established the following:
Eko intends to raise the capital required for the project in such a way as to leave its
existing debt to equity ratio (by market value) unchanged following the diversification.
Extracts from Eko‟s most recent management accounts are shown below:
Statement of financial position as at May 31, 2017
N‟M
Ordinary share capital (10 kobo shares) 233
Retained earnings 5,030
5,263
6% Redeemable debentures at nominal value (redeemable 2021) 1,900
Long term bank loans (interest rate 4%) 635
7,798
73
Required:
a. Ignoring the project, calculate the current WACC of Eko using:
i. The Capital Asset Pricing Model (CAPM) (8 Marks)
ii. The Gordon‟s Growth Model (6 Marks)
b. Use the CAPM to calculate the cost of equity that should be included in a
WACC suitable for appraising the project and explain your reason.
(5 Marks)
c. By calculating an overall equity beta and using the CAPM, estimate the
overall WACC of Eko assuming that the project goes ahead and comment on
the implications of a permanent change in the overall WACC. (5 Marks)
d. Advise whether Eko should diversify its operations and how the stock market
might react to the proposed project. (3 Marks)
74
QUESTION 2
Tamilore Limited (TL) is an agro-based firm, specialising in yam and rice
production in Benue State of Nigeria. One of the harvesters is due to be replaced on
November 30, 2018, the last day of TL‟s current financial year. An investment
appraisal exercise has recently been completed which confirmed that it is
financially beneficial to replace the machine at this point. TL is now considering
how best to finance the acquisition of the harvester to be replaced. TL is already
highly geared.
Alternative 1
A loan of N49,200,000 at 6% interest rate to buy the machine on November 30,
2018. If this option is selected, the machine will be depreciated on a straight-line
basis over its estimated useful life of 5 years.
Alternative 2
Enter into a finance lease. This will involve payment of annual rental of N12 million
with first payment due on November 30, 2019. The lease payments will be for the
entire estimated useful life of the machine which is 5 years when the ownership
will pass to TL without further payment.
Other information
(i) Whether leased or purchased outrightly, maintenance would remain the
responsibility of TL and would be N450,000 payable annually in advance.
(ii) TL is liable to tax at a rate of 25%, payable annually at the end of the year in
which the tax charge or tax saving arises.
(iii) TL is able to claim capital allowances on the full capital cost of the machine
in equal installments over the first four years of the machine.
(iv) Assume that TL has sufficient taxable profits to benefit from any savings
arising therefrom.
(v) All workings in N‟000.
Required:
a. Show that the implied interest rate in the lease agreement is 7%. (3 Marks)
75
QUESTION 3
Lagelu Plc. (LP) is a very successful entity. The company has consistently followed a
business strategy of aggressive acquisitions, looking to buy companies that it
believes were poorly managed and hence undervalued. LP can be described as a
modern day conglomerate with business interests stretching far and wide.
Its board of directors has chosen the takeover targets with care. LP has maintained
its price earnings (P/E) ratio on the stock market at 12.2.
LP‟s figures show a profit after tax of ₦4,430 million, and it has 375 million shares.
₦‟Million
Revenue 7,500
Operating profit 2,400
Interest (685)
Profit before tax 1,715
Taxation @ 25% (429)
Profit after tax 1,286
Number of shares in issue 150 million
Earnings Per Share(EPS) ₦8.57
Operating profits are shown after deducting non-cash expenses (including tax
allowable depreciation) of ₦650m. This is expected to increase in line with sales.
However, the company has recently spent ₦1,050m on purchase of non-current
76
The company has a cost of equity of 17% and weighted average cost of capital of
12%.
Some of LT‟s major shareholders are not so confident about the future and would
like to sell the business as a going concern. The minimum price they would
consider would be the fair value of the shares, plus 10% premium. LT‟s Chief
Financial Officer believes the best way to find the fair value of the shares is to
discount the forecast Free Cash Flows to the firm, assuming that beyond year 2021
these will grow at a rate of 3% per annum indefinitely.
Required:
a. Prepare a schedule of forecast Free Cash Flows to the firm for each of the
years from December 31, 2018 to 2021. (5 Marks)
b. Estimate the fair value of LT‟s equity on per share basis. (6 Marks)
QUESTION 4
Yemi John Plc. (YJ) is planning to raise N30 million new finance for a major
expansion of existing business and is considering a rights issue, a placing or an
issue of bonds. The corporate objectives of YJ, as stated in its annual report, are to
maximise the wealth of its shareholders and to achieve continuous growth in
earnings per share. Recent financial information on YJ is as follows:
2017 2016 2015 2014
Turnover (Nm) 28.0 24.0 19.1 16.8
Earnings before interest and tax (EBIT) (Nm) 9.8 8.5 7.5 6.8
Profit after tax (PAT) (Nm) 5.5 4.7 4.1 3.6
Dividends (Nm) 2.2 1.9 1.6 1.6
Ordinary shares (Nm) 5.5 5.5 5.5 5.5
77
Required:
a. Evaluate the financial performance of YJ, analyse and discuss the extent to
which the company has achieved its stated objectives of:
b. Analyse and discuss the relative merits of a rights issue, a placing and an
issue of bonds as ways of raising finance for the expansion. (7 Marks)
(Total 20 Marks)
QUESTION 5
Kuku Plc. had a need for a machine. After four years of purchase, the machine will
no more be capable of efficient working at the level of use by the company.
Meanwhile, it has been the company‟s practice to replace machines every four
years. The production manager has pointed out that in the fourth year, the
machine will need additional maintenance to keep it working at normal efficiency.
The question has therefore arisen as to whether the machine should be replaced
after three years instead of four years, in line with the company‟s practice.
78
(i) A new machine will cost N240,000. If the machine is retained for four years,
it will have a zero scrap value at the end of the period. If it is retained for
three years, it will have an estimated disposal value of N30,000. The
machine will attract capital allowance of 20% (reducing balance tax
allowance) in the years of being owned by the company except the last year.
In the last year, the difference between the machine‟s written-down value
for tax purposes and its disposal proceeds will be allowed to the company as
an additional tax relief if the disposal proceeds are less than the tax written-
down value.
It is assumed that the machine will be bought and disposed of on the last
day of the company‟s accounting year.
(ii) The company tax rate is 30% and tax is payable on the last day of the
accounting year concerned.
(iii) During the first year of ownership, the supplier takes responsibility for any
necessary maintenance work. In the second and third years, maintenance
costs average N30,000 a year. During the fourth year, these will rise to
N60,000. Maintenance charges are payable on the first day of the company‟s
accounting year and are allowable for tax.
Required:
b. Discuss two other issues that could influence the company‟s replacement
decision. This should include any weakness. (3 Marks)
(Total 15 Marks)
QUESTION 6
Alpha Plc. is a Nigerian manufacturer of plastic containers, which it sells in many
West African and other African countries. In three months‟ time, Alpha Plc. is due
to receive 70 million Kudi from a country in Central Africa whose currency is Kudi.
At a board meeting slated for today, the directors will be discussing whether or not
there is a need to hedge the foreign exchange exposure associated with this
transaction and if so, how best this might be achieved. At the board meeting, three
possible alternatives will be considered:
(i) Not to hedge this transaction;
79
Required:
a. State four reasons why a firm might reasonably choose not to hedge its
exposure to exchange rate risk. (4 Marks)
b. Show the effect of each of the three alternatives being considered, assuming
that the spot-exchange rate in three months‟ time is:
i. 1.1850 – 1.1880 Kudi/N
ii. 1.1295 – 1.1320 Kudi/N (7 Marks)
c. State four methods available to firms to reduce their exposure to foreign
exchange risks which do not involve the use of financial contracts.
(4 Marks)
(Total 15 Marks)
QUESTION 7
Agency theory was developed by Jenson & Meckling (1976) who defined the
agency relationship as a form of contract between a company‟s owners and its
managers, that is, where the owners appoint agents (managers) to manage the
company on their behalf. As part of this arrangement, the owners must delegate
decision-making authority to the management.
In this respect, the owners expect the agents to act in their best interest.
Required:
a. Agency conflicts may arise in various ways. Discuss four of these conflicts.
(9 Marks)
b. State four methods by which problems arising from the conflicts could be
reduced. (6 Marks)
(Total 15 Marks)
80
Equity Beta
𝑉𝐷
𝛽𝐸 = 𝛽𝐴 + (𝛽𝐴 − 𝛽𝐷 ) (1 − 𝑡)
𝑉𝐸
Growing Annuity
𝑛
𝐴1 1+𝑔
𝑃𝑉 = 1−
𝑟−𝑔 1+𝑟
81
n = number of periods
1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1
2 1·970 1·942 1·913 1·886 1·859 1·833 1·808 1·783 1·759 1·736 2
3 2·941 2·884 2·829 2·775 2·723 2·673 2·624 2·577 2·531 2.487 3
4 3·902 3·808 3.717 3·630 3.546 3.465 3·387 3·312 3·240 3·170 4
5 4·853 4·713 4·580 4·452 4·329 4·212 4·100 3·993 3.890 3·791 5
6 5·795 5·601 5·417 5·242 5·076 4·917 4·767 4·623 4.486 4·355 6
7 6·728 6.472 6·230 6·002 5·786 5·582 5·389 5·206 5·033 4·868 7
8 7·652 7·325 7·020 6·733 6·463 6·210 5·971 5·747 5·535 5·335 8
9 8·566 8·162 7·786 7.435 7·108 6·802 6·515 6·247 5·995 5·759 9
10 9·471 8·983 8·530 8·111 7·722 7·360 7·024 6·710 6.418 6·145 10
11 10·368 9·787 9·253 8·760 8·306 7·887 7.499 7·139 6·805 6.495 11
12 11·255 10·575 9·954 9·385 8·863 8·384 7·943 7·536 7'161 6·814 12
13 12·134 11·348 10·635 9·986 9·394 8·853 8·358 7·904 7·487 7·103 13
14 13·004 12·106 11·296 10·563 9·899 9·295 8·745 8·244 7·786 7·367 14
15 13·865 12·849 11·938 11·118 10·380 9·712 9·108 8·559 8·061 7·606 15
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1
2 1·713 1·690 1·668 1·647 1·626 1·605 1·585 1·566 1·547 1·528 2
3 2.444 2.402 2·361 2·322 2·283 2·246 2·210 2·174 2·140 2·106 3
4 3·102 3·037 2·974 2·914 2·855 2·798 2·743 2.690 2·639 2.589 4
5 3·696 3·605 3·517 3·433 3·352 3·274 3·199 3·127 3·058 2·991 5
6 4·231 4·111 3·998 3·889 3·784 3·685 3·589 3.498 3.410 3·326 6
7 4·712 4·564 4.423 4·288 4·160 4·039 3·922 3·812 3·706 3·605 7
8 5·146 4·968 4.799 4·639 4.487 4·344 4·207 4·078 3·954 3·837 8
9 5·537 5·328 5·132 4·946 4·772 4·607 4.451 4·303 4·163 4·031 9
10 5·889 5·650 5.426 5·216 5·019 4·833 4·659 4.494 4·339 4·192 10
11 6·207 5·938 5·687 5.453 5·234 5·029 4·836 4·656 4.486 4·327 11
12 6·492 6·194 5·918 5·660 5·421 5·197 4·988 4·793 4·611 4.439 12
13 6·750 6.424 6·122 5·842 5·583 5·342 5·118 4·910 4·715 4·533 13
14 6·982 6·628 6·302 6·002 5·724 5.468 5·229 5·008 4·802 4·611 14
15 7·191 6·811 6.462 6·142 5·847 5·575 5·324 5·092 4·876 4·675 15
82
83
(𝑁0.25 × 2,330)
= = 11.77%
N5,263 − N(2,330 × 0.134)
(Note: In the above calculation, opening shareholders‟ fund has been used as the
preferred method. If average shareholders fund is used, it will be fully rewarded
but for future examinations, the former is preferred)
84
b) The cost of equity should be adjusted to reflect the systematic risk of the new
project. The equity beta for the holiday travel industry should be adjusted for
gearing. It is assumed that debt is risk free, since we are not given beta of
debt.
Asset beta (βA) of the holiday travel industry will be:
1.40 ×5
β𝐴 = = 0.95 while
5+3(1−0.2)
The WACC to be used for the project should reflect the business risk of the
project and the financial risk of the company.
c) If the diversification goes ahead, cost of equity will reflect the systematic risk
of both divisions.
85
The discount rate will be that of an all equity company using the βA of 0.95 to
reflect the systematic risk. Therefore, the discount rate will be:
2 + 0.95(8 - 2) = 0.077 or 7.7%.
This will be used to calculate the base case NPV. The NPV will then be
adjusted for the financing side effects.
EXAMINER‟S REPORT
About 95% of the candidates attempted the question. Candidates were expected to
calculate weighted average cost of capital (WACC) under varying scenarios and to
comment on the results. Generally, the performance of the candidates was poor.
86
87
SOLUTION TWO
a) Implied interest rate in the lease
Cost of machine/annual lease rental = N49,200/N12,000 = 4.100
From the annuity table under „5 years‟, this gives an implied rate of 7%.
Candidates can also use IRR to determine the implicit interest rate using the
following figures.
Year 0 (49,200)
1-5 12,000
b) Notes
In the following evaluation of the financing options, the following items are
ignored because they are common to the two alternatives:
88
Recommendation
An outright purchase of the machine at a cost of N49,200,000 is relatively
cheaper and therefore recommended.
The intention is to avoid injustice, asymmetric risk and moral hazard and
unfair enrichment at the expense of another party.
89
Parts „a‟ and „b‟ of the question test candidates‟ understanding of the analysis of
lease or buy decision, while part „c‟ tests candidates‟ knowledge of the basic
principles of Islamic finance.
About 80% of the candidates attempted the question. Candidates are expected to
calculate implicit interest rate on a lease and assess the desirability of lease or buy.
Despite the fact that a similar question was tested in a recent examination, the
level of performance was below average.
Candidates are advised to make effective use of the Institute‟s Study Text and the
Pathfinder.
MARKING GUIDE
Mark Mark
(a) Confirmation of the 7% implied interest rate with relevant
computation 3
90
Note: It is also possible to calculate forecast free cash flow to the firm (FCFF)
starting from profit after tax. In this question however, it is faster starting from
operating profit (EBIT).
=2,400/7,500 = 32%
₦m
2018 1,442 (1.12) –1
= 1,288
2021 – Infinity:
1,555 × 1.03
× (1.12) – 4 = 11,310
0.12 − 0.03
91
LP expects to maintain its P/E ratio after acquiring LT. Therefore, the post-
acquisition value of the two entities combined can be ascertained by
applying LP‟s P/E ratio to the sum of the latest earnings of each company (as
the P/E ratio of LP (12.2), exceeds that of LT, (7.4), this is known as
“bootstrapping”).
LP 4,430
LT 1,286
5,716
Currently in LP 375
Shareholders in LP
154.97 − 144.12
= × 100 = 7.53%
144.12
Shareholders in LT
77.49 − 63.39
= × 100 = 22.24%
63.39
92
EXAMINER‟S REPORT
The question tests candidates‟ knowledge of valuation of equity using free cash
flow to the firm. It also tests candidates‟ understanding of various discounting
techniques (growing annuity, delayed growth etc).
About 40% of the candidates attempted the question. Candidates were expected to
calculate free cash flow to the firm, market value of equity and analysis of gain of
the various stakeholders. However, candidates‟ failure to understand the basic
requirements of the question led to their poor performance.
Candidates are advised to use the Institute‟s Study Text, the Pathfinder and cover
the syllabus comprehensively when preparing for the Institute‟s examinations in
future.
MARKING GUIDE
Mark Mark
(a) Calculations of:
- Revenue 1
- Operating profit 1
- Tax 1
Non cash expenses 1
Capital expenditure 1 5
93
SOLUTION FOUR
a) Financial Analysis
2017 2016 2015 2014
Turnover growth 17% 26% 14% -
Geometric average growth: 19%
EBIT growth 15% 18% 10% -
Geometric average growth 13%
EPS (kobo) 100 85 75 66
EPS growth 18% 13% 14% -
Geometric average growth 15%
Dividend per share (kobo) 40 35 29 29
DPS growth 14% 21% - -
Geometric average growth 11%
94
The current debt/equity ratio of the company is 42% (20/47.5). Although, this is less
than the sector average value of 50%, it is more useful from a financial risk
perspective to look at the extent to which interest payments are covered by profits.
2017 2016 2015 2014
EBIT (Nm) 9.8 8.5 7.5 6.8
Bond interest (Nm) 1.6 1.6 1.6 1.6
Interest coverage ratio (times) 6.1 5.3 4.7 4.3
The interest coverage ratio is not only below the sector average, it is also low
enough to be a cause for concern. While the ratio shows an upward trend
over the period under consideration, it still indicates that an issue of further
debt would be unwise.
95
(b) A placing will dilute ownership and control, provided a new equity issue is
taken up by new institutional investors, while a rights issue will not dilute
ownership and control, provided existing shareholders take up their rights.
A bond issue does not have ownership and control implications, although
restrictive or negative covenants in bond issue document can limit the
actions of a company and its managers.
All the three financing choices are long-term sources of finance and so are
appropriate for a long-term investment such as the proposed expansion of
existing business.
Equity issues such as a placing and a rights issue do not require security. No
information is provided on the non-current assets of the company, but it is
likely that the existing bond issue is secured. If a new bond issue was being
considered, the company would need to consider whether it has sufficient
non-current assets to offer as security, although it is likely that new non-
current assets would be bought as part of the business expansion.
EXAMINER‟S REPORT
The question tests candidates‟ knowledge of key accounting ratios and their use in
performance evaluation. It also tests candidates‟ understanding of the relative
merits of placing, rights and bonds issues.
About 85% of the candidates attempted the question and performance was poor.
Candidates were expected to calculate and interprete, from the given data, some
key accounting ratios. They were also expected to discuss relative merits of
placing, rights and bonds issues.
Candidates‟ commonest pitfalls were their inability to make use of the calculated
accounting ratios to assess the performance of the given company and their failure
to understand the concept of placing as they wrote completely irrelevant things.
96
SECTION C
SOLUTION FIVE
(a)
3-Year Life
Year 0 1 2 3
N N N N
Outlay (240,000)
Tax savings on capital allowances 14,400 11,520 9,216 27,864
Maintenance cost (30,000) (30,000)
Tax savings on Maintenance cost 9,000 9,000
Scrap value _________ ________ ________ 30,000
Net Cash Flows (225,600) (18,480) (11,784) 66,864
DCF @15% 1 0.897 0.756 0.658
PV (225,600) (16,577) (8,909) 43,997
NPV = (N207,089)
97
WORKINGS
Time/ Year
Tax @ 30%
N N
0 Cost 240,000
Capital allowance (20%) (48,000) 14,400
1 Tax written down value 192,000
Capital allowance (20%) (38,400) 11,520
2 Tax written down value 153,600
Capital allowance (20%) (30,720) 9,216
Tax written down value 122,880*
Proceeds (30,000)
Balancing allowance if sold in year 3 92,880 27,864
3 Tax written down value 122,880*
Capital allowance (20%) (24,576) 7,373
Balancing allowance if sold in year 4 98,304 29,491
*Represents tax written down value if machine is not sold at the end of the
3rd year.
98
(ii) The approach taken assumes that replacement will take place with an
identical machine. The machine may be technologically superseded.
The company may conclude that it no longer has a need for such a
machine. In practice, it seems unlikely that many such assets are
replaced with identical models on a continuing basis; and
(iii) The timing of the cash outflows on new machines could be an issue in
practice, i.e making payments every fourth year may cause less of a
cash flow problem than every third year.
EXAMINER‟S REPORT
This question tests candidates‟ ability to analyse and explain capital asset
replacement.
About 85% of the candidates attempted the question and performance was very
poor.
MARKING GUIDE
Mark Mark
(a) Computation and recognition of capital allowances and tax
saving thereon for the two years (3 & 4 years respectively)
2 marks for each year 4
Recognition of maintenance cost and the tax savings
thereon for the two years – 1 mark for each year 2
Recognition of the scrap value for the third year /4
1
99
(a) Reasons why a firm might reasonably choose not to hedge its exposure to
exchange rate risk include:
Note that the company is selling Kudi and the bank is buying. The relevant
buying rate should be used, i.e 1.1880 and 1.1320.
As the company is hedging a foreign asset, a put option (the right to sell) is
needed. A premium of N1.25 per 100 Kudi will be paid, i.e
(70,000,000 Kudi/100) x N1.25 = N875,000.
100
(c) Methods available to firms to reduce their exposure to foreign exchange risk
which do not involve the use of financial contracts include:
(i) Appropriate choice of invoice currency;
(ii) Matching payments and receipts (e.g creating payables and receivables
in same currency);
(iii) Matching assets and liabilities (e.g creating overdraft borrowing in
respect of a receivable);
(iv) Leading and lagging payments; and
(v) Maintaining currency accounts.
EXAMINER‟S REPORT
The question tests candidates‟ ability to analyse various foreign currency hedging
techniques. In particular, they are to analyse the use of forward contract and over
the counter (OTC) option.
101
SOLUTION SEVEN
(a) Agency conflicts are differences in the interests of a company‟s owners and
the managers.
These conflicts arise in several ways which include:
102
(b) Several methods of reducing the agency problems have been suggested.
These include:
i. Assessing the relative importance of stakeholders‟ interests. Apart from
the problem of taking different stakeholders‟ interests into account, an
organisation also faces the problem of weighing stakeholders‟ interests
when considering future strategy;
ii. Agency theory resolution strategy. This relates to analysing the problem
that can arise when ownership and control are separated and how they
might be mitigated by negotiating contracts that allow the principal to
control the agent in such a way that the agent will operate in the
interests of the principal;
iii. Firm induced strategies. Agency theory sees employers of businesses,
including managers, as individuals, each with his or her own objectives.
Also, within a department of a business, there are departmental
objectives. If achieving these various objectives also leads to the
achievement of the objective of the organisation as a whole, there is said
to be goal congruence. Examples are: profit-related/economic value
added pay, share awards, share options and so on;
iv. Separation of roles. Too much power should not accrue to a single
individual within an organisation. For example the role of the Chairman
and the Chief Executive should be separated;
v. Accounting standards. Adequate information should be given in the
financial statements of a company;
103
viii. Exposure to take-over bid: This could deter managers from taking actions
that will be at variance with share price maximisation. If the company‟s
earnings potentials are being knowingly or unknowingly suppressed
through bad policies and the share is consequently undervalued in
relation to its true value, it may be exposed to hostile take-over bid. The
result is that some top managers might lose their job.
EXAMINER‟S REPORT
About 95% of the candidates attempted the question. The performance was
generally satisfactory with some candidates producing excellent solutions.
Candidates are expected to discuss the various possible conflicts of interest
between managers and shareholders. They are also required to identify mitigating
factors.
Candidates‟ commonest pitfalls were their inability to explain correctly the major
conflict areas identified by them and their lack of knowledge of the mitigating
factors.
Candidates are advised to study the Institute‟s Study Text, Pathfinders and other
materials relating to agency conflicts and costs to be able to perform better in
future examinations.
104
105
PATHFINDER
MAY 2019 DIET
PROFESSIONAL LEVEL EXAMINATIONS
Question Papers
Suggested Solutions
Examiner‟s Reports
Plus
Marking Guides
QUESTION 1
Pako Plc. will soon announce a take-over bid for Ronke Tina (RT) Plc., a company in
the same industry. The initial bid will be an all-share bid of four Pako shares for
every five RT Plc. shares. The most recent annual data relating to the two
companies are shown below:
N000 N000
Pako RT
Sales revenue 13,333 9,400
Operating costs ( 8,683) (5,450)
Tax-allowable depreciation ( 1,450) (1,100)
Earnings before interest and tax 3,200 2,850
Net interest ( 715) (1,660)
Taxable income 2,485 1,190
Taxation (30%) ( 746) ( 357)
After-tax income 1,739 833
Dividend 870 458
Other information
Annual replacement capital expenditure (N000) 1,600 1,240
Expected annual growth rate in sales, operating costs
(including depreciation), replacement investment and
dividends for the next four years 5% 6.5%
Expected annual growth rate in sales, operating costs
(including depreciation), replacement investment and
dividends after four years 4% 5%
Gearing (long-term debt/long-term debt plus equity
by market value) 30% 55%
Market price per share (kobo) 298 192
Number of issued shares (million) 7 8
Current market cost, before tax, of fixed-interest debt 6% 7.5%
Equity beta 1.18 1.38
Risk-free rate 4%
Market return 11%
77
Sales and costs relevant to the decision may be assumed to be in cash terms.
Required:
QUESTION 2
The following financial information is available for PH Plc:
78
b. Explain why the changes that occurred in the figures calculated in (a) above
over the past four years might have happened. (6 Marks)
(Total 20 Marks)
QUESTION 3
Able bank, on April 24, 2019 received the following statement of financial position
prepared for its customers, Pinko Limited (PL):
PL is a long established company which traded profitably until a few years ago.
Following the expiration of exclusive patent rights on a particularly profitable
product line, results declined dramatically. Over the last twelve months, the
company‟s cash flow problems have steadily increased. The overdraft facility at
79
A meeting has been arranged to consider the company‟s future. The above
statement of financial position will be presented at the meeting and the following
proposals will be discussed:
(b) Tayo Limited (TL) has made an offer to take over the entire business
activities of PL: Under the terms of the offer, Able Bank would receive 80%
of the balance due, but repayment would not be made until exactly one
year from the date of the creditors‟ meeting. No further interest would be
considered to accrue on the balance due to Able Bank (AB) during the
twelve month period.
Notes: Assume that the Bank earns 15% per annum on all its lending
and that the amounts in the statement of financial position include
interest that accrued to date. Assume, for convenience, that any adopted
proposal would be implemented immediately with payments received
immediately unless otherwise stated.
80
Required:
a. Calculate the amounts which Able Bank would receive under each of
the three proposals. (10 Marks)
QUESTION 4
The managers of a pension fund follow an active portfolio management strategy.
They try to purchase shares and bonds that show a positive abnormal return
(positive alpha factor in the case of shares). The pension fund is required by law to
hold at least 40% of its investments in bonds. N100million is currently available for
investment.
Three shares and three bonds are being considered for purchase.
The required return on bonds may be measured using a model similar to the capital
asset pricing model, where beta is replaced by the relative duration of the
individual bond (Di) and the bond market portfolio (Dm) i.e. Di/Dm.
Expected return Standard deviation Correlation coefficient of
Shares (%) of returns returns with the markets
Equity
market 10.5 15 1
A Plc 11.0 25 0.76
B Plc 9.5 18 0.54
C Plc 13.5 35 0.63
Redemption yield
Bonds Duration (years) Coupons (%) (%)
Bond market 7.5 - 5.8
Federal Govt. 1.5 8 4.5
D Plc 8.6 6 5.3
E Plc 14.2 9 7.2
81
Required:
a. Evaluate whether or not any of the shares or bonds is expected to offer a
positive abnormal return. (10 Marks)
b. The pension fund currently has the maximum permitted investment in shares
and wishes to continue this strategy. It has a market value of N1,000 million
and a beta of 0.62.
Required:
Calculate the required return from the pension fund if any shares and bond with
positive abnormal returns are purchased.
QUESTION 5
You are the portfolio manager of an asset management company based in Kano.
Your company has in its portfolio 27,750,000 shares of Yaro Plc., a company listed
on the Nigerian Stock Exchange. The shares are currently trading at N3.60 per
share.
Your company plans to sell the shares in six months‟ time to pay dividend and you
plan to hedge the risk of Yaro‟s shares falling by more than 5% from their current
market value. A decision has therefore been taken to buy an over the counter
option to protect the shares. A merchant bank has offered to sell an appropriate six
month option to your company for N1,250,000.
Yaro‟s share price has annual standard deviation of 13% and the risk-free rate of 4%
per year.
Required:
a. Evaluate whether or not the price at which the merchant bank is willing to sell
the option is a fair price. (11 Marks)
82
QUESTION 6
You are the head of the treasury group of Top Flight Aviation (TFA), a Nigerian
company. The company operates chartered international flights for the elites in the
country.
It is now December 31 and TFA needs to borrow £60 million from a UK bank to
finance a new air jet. The borrowing and the purchase will be in three months‟ time
and the borrowing will be for a period of six months.
You have decided to hedge the relevant interest rate risk using interest rate futures.
Your expectation is that interest rates will increase from 13% by 2% over the next
three months.
In the month of March, the current price of Sterling 3-month futures is 87.25. The
standard contract size is £500,000.
Required:
a. Set out calculations of the effect of using the futures market to hedge against
movements in the interest rate if:
(i) Interest rates increase from 13% by 2% and the futures market price
moves by 2%;
(ii) Interest rates increase from 13% by 2% and the futures market price
moves by 1.75%; and
(iii) Interest rates fall from 13% by 1.5% and the futures market price moves
by 1.25%.
83
The time value of money, taxation and margin requirements are to be ignored.
(4 Marks)
(Total 15 Marks)
QUESTION 7
V Plc. manufactures engineering equipment. The company has received an order
from a new customer for five machines at N5,000,000 each. V Plc.‟s terms of sale
are 10 percent of the sales value payable with the order. The deposit has been
received from the new customer. The balance is payable 12 months after
acceptance of the order by V Plc.
V Plc.'s past experience has been that only 60 percent of similar customers pay
within 12 months.
Customers who do not pay within 12 months are referred to a debt collection
agency to pursue the debt. The agency has in the past, had a 50 percent success
rate of obtaining immediate payment once they became involved. When they are
unsuccessful, the debt is written off by V Plc. The agency‟s fee is N500,000 per
order, payable by V Plc. with the request for service. This fee is not refundable if the
debt is not recovered.
Incremental costs associated with the new customer's order are expected to be
N3,600,000 per machine, 70 percent of these costs are for materials and are
incurred shortly after the order has been accepted. The remaining 30 percent is for
all other costs which you can assume are paid shortly before delivery, that is in 12
months‟ time. The company is not at present operating at full production capacity.
A credit bureau has offered to provide an error-free credit information about the
new customer if the price is right.
84
a. Evaluates, from a purely financial point of view, if V Plc. should accept the
order from the new customer on the basis of the above information; and
(12 Marks)
85
Equity Beta
𝑉𝐷
𝛽𝐸 = 𝛽𝐴 + (𝛽𝐴 − 𝛽𝐷 ) (1 − 𝑡)
𝑉𝐸
Growing Annuity
𝑛
𝐴1 1+𝑔
𝑃𝑉 = 1−
𝑟−𝑔 1+𝑟
86
n = number of periods
1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1
2 1·970 1·942 1·913 1·886 1·859 1·833 1·808 1·783 1·759 1·736 2
3 2·941 2·884 2·829 2·775 2·723 2·673 2·624 2·577 2·531 2.487 3
4 3·902 3·808 3.717 3·630 3.546 3.465 3·387 3·312 3·240 3·170 4
5 4·853 4·713 4·580 4·452 4·329 4·212 4·100 3·993 3.890 3·791 5
6 5·795 5·601 5·417 5·242 5·076 4·917 4·767 4·623 4.486 4·355 6
7 6·728 6.472 6·230 6·002 5·786 5·582 5·389 5·206 5·033 4·868 7
8 7·652 7·325 7·020 6·733 6·463 6·210 5·971 5·747 5·535 5·335 8
9 8·566 8·162 7·786 7.435 7·108 6·802 6·515 6·247 5·995 5·759 9
10 9·471 8·983 8·530 8·111 7·722 7·360 7·024 6·710 6.418 6·145 10
11 10·368 9·787 9·253 8·760 8·306 7·887 7.499 7·139 6·805 6.495 11
12 11·255 10·575 9·954 9·385 8·863 8·384 7·943 7·536 7'161 6·814 12
13 12·134 11·348 10·635 9·986 9·394 8·853 8·358 7·904 7·487 7·103 13
14 13·004 12·106 11·296 10·563 9·899 9·295 8·745 8·244 7·786 7·367 14
15 13·865 12·849 11·938 11·118 10·380 9·712 9·108 8·559 8·061 7·606 15
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1
2 1·713 1·690 1·668 1·647 1·626 1·605 1·585 1·566 1·547 1·528 2
3 2.444 2.402 2·361 2·322 2·283 2·246 2·210 2·174 2·140 2·106 3
4 3·102 3·037 2·974 2·914 2·855 2·798 2·743 2.690 2·639 2.589 4
5 3·696 3·605 3·517 3·433 3·352 3·274 3·199 3·127 3·058 2·991 5
6 4·231 4·111 3·998 3·889 3·784 3·685 3·589 3.498 3.410 3·326 6
7 4·712 4·564 4.423 4·288 4·160 4·039 3·922 3·812 3·706 3·605 7
8 5·146 4·968 4.799 4·639 4.487 4·344 4·207 4·078 3·954 3·837 8
9 5·537 5·328 5·132 4·946 4·772 4·607 4.451 4·303 4·163 4·031 9
10 5·889 5·650 5.426 5·216 5·019 4·833 4·659 4.494 4·339 4·192 10
11 6·207 5·938 5·687 5.453 5·234 5·029 4·836 4·656 4.486 4·327 11
12 6·492 6·194 5·918 5·660 5·421 5·197 4·988 4·793 4·611 4.439 12
13 6·750 6.424 6·122 5·842 5·583 5·342 5·118 4·910 4·715 4·533 13
14 6·982 6·628 6·302 6·002 5·724 5.468 5·229 5·008 4·802 4·611 14
15 7·191 6·811 6.462 6·142 5·847 5·575 5·324 5·092 4·876 4·675 15
87
Pako Plc.
Cost of equity using CAPM:
Ke = 4% + 1.18 (11 % - 4%) = 12.26%
Weighted average cost of capital:
Note: Rounded discount rates, for example 10%, are also acceptable in the
solution.
Free cash flow to the firm (FCFF)
Year 1 2 3 4
Sales revenue N‟000 N‟000 N‟000 N‟000
14,000 14,700 15,435 16,206
Operating costs (10,640) (11,172) (11,730) ( 12,317)
EBIT 3,360 3,528 3,705 3,889
Tax (30%) (1,008) (1,058) ( 1,112) ( 1,167)
Add back depreciation 1,523 1,599 1,679 1,762
Replacement investment (1,680) (1,764) (1,852) (1,945)
FCFF 2,195 2,305 2,420 2,539
Discount factors (9.84%) 0.910 0.829 0.755 0.687
Present values 1,997 1,911 1,827 1,744
Note: Interest is ignored as financing costs and their associated tax effects are
included in the company's discount rate.
RT Plc.
Cost of equity using CAPM:
88
RT
Year 1 2 3 4
Sales revenue N‟000 N‟000 N‟000 N‟000
10,011 10,662 11,355 12,093
Operating costs (6,976) (7,429) (7,912) (8,426)
EBIT 3,035 3,233 3,443 3,667
Tax (30%) (911) (970) (1,033) (1,100)
Add back depreciation 1,172 1,248 1,329 1,415
Replacement investment (1,321) (1,406) (1,498) (1,595)
FCFF 1,975 2,105 2,241 2,387
Discount factors (9.3%) 0.917 0.841 0.772 0.708
Present values 1,811 1,770 1,730 1,690
2,387(1.05)
Value beyond year 4 is estimated = x 0.708 44,032
0.0903 0.05
Total estimated value of RT = ₦51,033,000 (₦7,001,000 + N44,032,000)
Combined company
Year 1 2 3 4
N‟000 N‟000 N‟000 N‟000
Sales revenue 24,097 25,543 27,075 28,700
Operating costs (70%) (16,868) (17,880) (18,953) (20,090)
EBIT 7,229 7,663 8,122 8,610
Tax (30%) 2,169) (2,299) (2,437) (2,583)
Add back depreciation 2,703 2,865 3,037 3,219
Replacement investment (3,010) (3,191) (3,382) (3,585)
FCFF 4,753 5,038 5,340 5,661
Discount factors (9%) 0.917 0.842 0.772 0.708
Present values 4,359 4,242 4,122 4,008
5.661(1.05)
Value beyond year 4 is estimated to be = 0.708 105,210
0.0900 0.05
89
90
Check:
Year 2 = 2,195 x 1.05
3 = 2,195 x 1.052, etc
Calculate the FCFF for Year 1 and then apply the growing annuity formula.
1.05 4
PV of FCFF Years 1 – 4 = 1 7,480
2,195
1.0984
0.0984 −0.05
*
= 44,008
2,505 𝑋 0.708
Years 5 – infinity =
0.0903 −0.05
*
5,944 𝑋 0.708
Years 5 – infinity = = 105,209
0.09−0.05
121,944
(* FCFF5 = 4,753 x (1.06) x 1.05 = 5,944)
3
91
i) Speed
The acquisition of another company is a quicker way of implementing a
business plan, as the company acquires another organisation that is
already in operation. An acquisition also allows a company to reach a
certain optimal level of production much quicker than through organic
growth. Acquisition, as a strategy for expansion, is particularly suitable
for management with rather short time horizons.
92
93
v) Integration problems
Most acquisitions are beset with problems of integration, as each
company has its own culture, history and ways of operation.
EXAMINER‟S REPORT
In par (c) candidates‟ were asked to discuss the key advantages and disadvantages
of merger and acquisition rather than organic growth.
Being a compulsory question, visually all the candidates attempted it, more than
75% of the candidates did not attempt part (a) of the question and those who did,
showed a real lack of understanding of free cash flow model despite the fact that
the topic has been tested severally in recent examination, hence performance was
poor.
Candidates are advised to practise examination type questions using the Institutes‟
pathfinder.
Marking Guide
Question 1 Marks Marks
Calculation of Pako‟s cost of equity using CAPM – Pako 1
Calculation of Pako‟s weighted cost of capital (WACC) 1
Calculating the changes in Pako‟s statement of profit or loss:
- Sales revenue ½
94
95
Solution 2
(a) Data 2014 2015 2016 2017
1 Equity earnings (Nm) 200 225 205 230
2 Number of shares (m) 2,000 2,100 2,100 1,900
3 Price per share (kobo) 220 305 290 260
4 Dividend per share (kobo) 5 7 8 8
5 Earnings per share (= 1 ÷ 2) (kobo) 10.0 10.7 9.8 12.1
Dividend yield (= 4 ÷ 3) 2.3% 2.3% 2.8% 3.1%
Dividend cover (= 5 ÷ 4) 2.0 1.5 1.2 1.5
Price/earnings ratio (= 3 ÷ 5) 22.0 28.5 29.6 21.5
Dividend cover
The dividend cover shows how many times EPS is bigger than the dividend per
share. A high dividend cover shows that a large proportion of equity earnings is
being reinvested for growth.
Price/earnings ratio
The price/earnings ratio (P/E ratio) shows how many times the share price is
bigger than the EPS. In general, the bigger the EPS, the more the share is in
demand, though care must be taken when making comparisons because
whereas EPS is a historical result, the share price is based on future
expectations and is affected by both risk and growth factors. Consequently,
abnormal results can often arise from a crude use of P/E ratios.
96
Trends in 2016
The company‟s earnings and EPS fell in 2016, either because of normal cyclical
business risks or possibly because the high 2015 dividend left insufficient cash
for reinvestment. However, the company gave a „bullish‟ signal to the market by
increasing its dividend per share, indicating future prospects of a swift recovery
and increased growth. As a result, the dividend yield increased and, although
the share price fell in line with earnings, there was no disproportionate drop in
demand for the company‟s shares, as shown by the stability of the P/E ratio.
Trends in 2017
There was 12% earnings growth in 2017. The company used some of its cash to
buy back ordinary shares. This is possibly because it offered shareholders the
choice between a cash and a scrip dividend. Share capital reduced by about
10%, resulting in a big increase in earnings per share. Although 2017 was a
successful year for earnings, demand for the company's shares fell, as shown by
the drop in share price and P/E ratio. It is possible that the market has become
uncertain of the company's future plans, as a result of the share issue and share
buy-back in quick succession.
EXAMINER‟S REPORT
The question test candidates‟ knowledge of some basic stock market financial
ratios. Candidates were expected to calculate, interpret and assess the trend in the
given ratios over a number of years.
Almost all the candidates attempted the question, but performance was average.
Whereas most of the candidates were able to calculate the ratios, large number of
them could neither interpret nor assess the given trend.
97
Solution 3
a) (i) In a liquidation: the assets would realise the following amounts:
₦’000 ₦’000
Freehold property 65,000
Plant 21,000
Inventory 40,000
Receivables 26,000 87,000
152,000
The proceeds from the freehold property would be used to repay the 10% loan
notes of ₦50,000,000 (which has a first charge on the property) and the
remaining ₦15,000,000 would be used to repay some of the overdraft (which
has a second charge). This leaves ₦(45,000,000 – 15,000,000) = ₦30,000,000 of
the overdraft as an unsecured creditor.
Liquidation expenses are ignored, as indicated in the note to the question.
Priority for payment ₦’000 ₦’000
Secured creditors:
10% loan notes 50,000
Bank overdraft (balance of property value) 15,000
65,000
Preferential creditors 27,000
92,000
Realisable sales value of assets 152,000
98
Able Bank will hold one-sixth of the equity. Able Bank‟s share of the dividend
will be
1 2
× × ₦40,500,000 = ₦4,500,000
6 3
The first dividend will be received after one year but further dividends should
be expected in subsequent years.
In addition, Able Bank will be repaid one-half of the debt at once, i.e. 50% of
₦45,000,000 = ₦22,500,000
99
b) The return from the three proposals may be compared by calculating their
present value using the given interest rate of 15%.
Proposal (a) ₦’000
Overdraft due now 30,000
Proposal (b) ₦’000
PV of payment from Tayo Ltd: N36,000,000/1.15 31,304
Proposal (c) ₦’000
Overdraft received now: 50% × N45,000,000 22,500
Dividends: ₦4,500,000 from Year 1 to infinity:
₦4,500,000/0.15 30,000
Total present value 52,500
Proposal (c) offers, by far, the highest return, but it is perhaps the most risky
option. If the reconstructed company fails to make the expected profits, the
bank might receive only ₦22,500,000. On the other hand. If the reconstruction
ends in success, the bank will make a „profit‟ on its current overdraft
investments in Pinko Ltd. (which is only ₦45 million).
Liquidation (proposal (a) is the least risky option, but it offers the lowest return.
The choice between the three proposals will depend on the judgement of the
management of Able Bank, and in particular, on an assessment of the degree of
risk with each option.
EXAMINER‟S REPORT
The question tests candidates‟ knowledge of financial reconstruction, etc.
Candidates were expected to identify how to distribute available assets in
liquidation, among other things.
100
Candidates for future examinations are advised to cover the entire syllabus
comprehensively.
Marking Guide
a Recognising priority payment to secured creditors:
- 10% loan notes ½
- Bank Overdraft (Able Bank) ½
- Payment to preferential creditors 1
Calculating balance due to Able bank and other creditors 1
Calculation of dividend due to the unsecured creditors 1
Calculation of payment due to Able bank as an unsecured creditor 1
Calculation of payment due to Able bank under proposal (b) 2
Calculation of payment due to Able bank under proposal (c) 3 10
b Comparative analysis of the relative financial merits of the 3 proposals
to Able bank applying the given 15% interest rate:
- Proposal (a) 1
- Proposal (b) 1
- Proposal (c) 2
Comments on the result of the comparative figures arrived at under
the 3 proposals, 2 marks each 6 10
20
Solution 4
a) A positive abnormal return will exist if the expected return from a security is
higher than the required return. This may be established by using the Capital
Asset Pricing Model (CAPM).
101
0.54 × 18
βB= = 0.65
15
0.63 × 35
βC= = 1.47
15
If these data are accurate, the shares of B Plc. and the Federal Government
bond offers a positive abnormal return.
102
c) The company‟s strategy relies upon the pension fund managers being able to
regularly and correctly identify underpriced securities. The implication is that
the securities‟ markets are not continuously efficient, and that excess returns
can be earned by trading in mispriced securities. Markets are certainly not
perfectly efficient, but whether or not mispriced securities can be regularly
found that will lead to an abnormal return, after any administrative and
transactions costs, is debatable.
A policy of selecting only mispriced securities might mean that the portfolio risk
and return are not consistent with the objectives of the portfolio or desire of the
investment clients.
The strategy is based on using the capital asset pricing model, and presumes
that the model presents an accurate measure of the required returns from
securities. The CAPM, however, is based on a number of unrealistic
assumptions, such as existence of a perfect capital market, borrowing and
lending can take place at the risk free rate, investors have the same
expectations about risk and return, investors are well diversified, and all
investors consider only the same single time period. It also states that
systematic risk is the only relevant measure of risk. It is likely that multifactor
models such as the arbitrage pricing theory offer better explanations of the
relation between risk and return. Accurate data input for elements of the CAPM
such as the market return and relevant betas are difficult to estimate, and the
CAPM has empirical anomalies, for example, it appears to overstate the
required return on high beta securities and understate the required return on
low beta securities.
103
The question tests candidates‟ knowledge of capital asset pricing model (CAPM).
They were expected to calculate, for each security, beta factor, required return and
alpha value (abnormal return).
Success in the Institute‟s examinations can only be earned through diligent study
and adequate use of various study support materials provided by the Institute.
Marking Guide
a Calculations of the beta of the individual share – A, B & C Plc‟s 1½
3
Calculations of Alpha i.e R i - Ri of A, B & C Plc
Calculations of the relative durations for the bonds: Federal Govt., D Plc &
E Plc 1½
Calculations of Alpha i.e R i - Ri for the bonds: Federal Govt., D Plc & E Plc
3
1 10
Comment on the result of the Alpha ( R i-Ri) calculations
b Calculation of the beta for the revised portfolio 3
Calculation of the required return 1 4
c Discussion on the possible problems with the pension funds – Para. 1 (2
marks), Para. 2 (1 mark) and Para. 3 (3 marks) 6
20
Solution 5
a) Put options are required to hedge the price of the shares.
Step 1: Determine d1and d2
In S/E + (r + σ2 /2)T
d1 =
σ T
104
Step 4: Using Put Call Parity (PCP), determine the value of put option
2,876 + 342e-0.04(0.5)= P + 360
P = 3.99 kobo
On the assumption that one put option is bought per share:
Total value of Option = 27.75 million × 3.99kobo = ₦1,107,225
Overcharge by bank: ₦1,250,000 - ₦1,107,225 = ₦142,775
b) • Volatility of the stock price: A decrease in volatility will mean that a call option
becomes less valuable. A decrease in volatility will decrease the chance that the
stock price will be above the exercise price when the option expires.
• Risk free rate of return: A decrease in the risk free rate will mean that a call
option becomes less valuable. The purchase of an option rather than the
underlying will mean that the option holder has spare cash available which
can be invested at the risk free rate of return. A decrease in that rate will
mean that it becomes less worthwhile to have spare cash available, and hence
to have an option rather than having to buy the underlying security.
105
Part (a) of the question tests candidates‟ ability to make use of the Black-Scholes
option pricing model to price a put option. Candidates were expected to identify
the appropriate option required for the hedge and to price the option accordingly.
In part (b), candidates were required to discuss some option „greeks‟.
Less than 5% of the candidates attempted the question and performance was very
poor. There is a clear evidence that candidates lack knowledge of this important
topic in finance.
Granted the poor level of performance, candidates should note that the examiners
are motivated to revisit this topic area in future examination. The study test
contains good illustrations for students‟ practice.
Marking Guide
a Stating the purpose of the put option 1
Calculation of:
- The exercise price (E) ½
- di 2
- d2 1
- N (di) 1
- N (d2) 1
Determination of the value of call option 1½
Determination of the value of put option 1
Calculation of the total value of options 1
Overcharge by bank 1 11
b Comment on the volatility of the stock price 2
Comment on the risk free rate of return 2 4
15
106
a) Note:
For each of the scenarios of interest rate movements given in the question, we
need to identify the appropriate market price of the futures contracts. Generally,
the movements in interest rates and futures prices should be in the same
direction but not necessarily „one-on-one‟.
107
The guarantee would be used in cases (i) and (ii) because the actual rate (15%)
is greater than the target rate (13%).
Then, total cost limiting interest rates to 13% is actual interest of £3,900,000
plus premium £150,000, that is, £4,050,000.
This costs more than the futures contracts hedge in cases (i) and (ii). In case
(iii), the guarantee is not used because the prevailing interest rate of 11.5% is
less than the guarantee rate of 13%.
Interest costs at 11.5% are:
This costs less than the futures hedge, reflecting the fact that declining to take
up the interest rate option in the case of the guarantee, has allowed the
company to take advantage of the lower interest rates in the cash market.
EXAMINER‟S REPORT
Less than 10% of the candidates attempted the question and performance was poor.
108
Solution 7
As required, I have looked into the above subject matter. There are three
possible outcomes. These are:
i) If all things go as expected, we will receive the balance due from the
customer (probability 60%);
ii) we have to pay a ₦500,000 collection fee, as a result of which the
balance is received (probability 20%); and
iii) we pay the ₦500,000, but the balance is not forthcoming (probability
20%).
These can be evaluated, and a statistically expected figure calculated, as
follows:
Outcome
(i) (ii) (iii)
₦000 ₦000 ₦000
Now Receive 10% of ₦25m 2,500 2,500 2,500
(Pay)70% of ₦18m (12,600) (12,600) (12,600)
Net (K) (10,100) (10,100) ( 10,100)
109
Please let me know if you want me to elaborate on any of the above or take
any aspect further.
EXAMINER‟S REPORT
110
Candidates need to prepare adequately for the Institute‟s examinations and avail
themselves of the study materials made available by the Institute.
Marking Guide
a Report format; From, To, Date and Signature ¼ each, subject matter ½ 1½
Stating the three possible outcomes 1½
Calculating the three outcomes (now) – K 2
Calculating the three outcomes (in Year 1) – T 4
Calculation of the net present value(K + T) 1
Calculation of the expected value 1
Comment on the result 1 12
b 1 mark for each reasonable factor stated, max. 3 marks 3
15
111
PATHFINDER
NOVEMBRT 2019 DIET
PROFESSIONAL LEVEL EXAMINATIONS
Question Papers
Suggested Solutions
Examiner‟s Reports
Plus
Marking Guides
QUESTION 1
Agbeloba Limited (AL) is an unlisted company based in Akure, Nigeria. Over the
years, the company has been producing and selling agricultural support tools. AL is
now considering the production and sale of yam pounders.
Although this is a completely new venture for AL, it will be in addition to the
company‟s core business. AL‟s directors plan to develop the project for a period of
four years and then sell it for N24million to a group of young investors.
The government is excited about the project and has offered AL a subsidised loan of
up to 80% of the investment funds needed at the beginning of the project, at a rate
of 200 basis points below AL‟s borrowing rate. Currently AL can borrow at 300 basis
points above the five-year government debt yield rate.
A feasibility study commissioned by the directors, at a cost of N5,000,000, has
produced the following information:
The company can buy an existing suitable factory at a cost of N16.5m payable
now;
N4.5m is required now to buy and install the necessary plant and machinery;
The company will produce and sell 1,300 units in the first year. Unit sales will
grow by 40% in each of the next two years before falling to an annual growth
rate of 5% for the final year;
Unit selling price for the first year will be N3,750 but this will increase by 3%
per year thereafter;
In the first year, total variable cost per unit will be N1,800 but this will increase
by 8% per year thereafter;
In the first year, the fixed overhead costs will be N3.75m, of which 60% are
centrally allocated overheads. The fixed overheads will increase by 5% per year
after the first year;
85
NOT TO BE SOLD | Compiled by: Babatunde Isaiah | Email: [email protected]
AL will require working capital of 15% of the anticipated sales revenue for the
year, at the beginning of each year. The working capital is expected to be
released at the end of the fourth year when the project is sold;
AL‟s tax rate is 25% per year on taxable profits. Tax is payable in the same year
as when the profits are earned. Tax allowable deprecation is available on the
plant and machinery on a straight-line basis. It is anticipated that the value
attributable to the plant and machinery after four years is N600,000 of the price
at which the project is sold. No tax allowable depreciation is available on the
factory;
AL uses 12% as its discount rate for new projects but feels that this rate may not
be appropriate for this new type of investment. It intends to raise the full
amount of funds through debt finance and take advantage of the government‟s
offer of a subsidised loan;
Issue costs are 4% of the gross finance required. It can be assumed that the debt
capacity available to the company is equivalent to the actual amount of debt
finance to be raised for the project;
The five-year government debt yield is currently estimated at 4.5% and the
market risk premium at 4%.
Required:
a. Evaluate, on financial grounds, whether AL should proceed with the project.
(28 Marks)
b. Discuss the appropriateness of the evaluation method used and explain the
assumptions made in part (a). (5 Marks)
QUESTION 2
86
NOT TO BE SOLD | Compiled by: Babatunde Isaiah | Email: [email protected]
In country A, electricity supplies are provided by a nationalised industry. In
country B, electricity supplies are provided by a number of private sector
companies.
Required:
(i) Explain how the objectives of the nationalised industry might differ
from those of the private sector companies. (6 Marks)
(ii) Briefly discuss, whether investment planning and appraisal
techniques are likely to differ in the nationalised industry and private
sector companies. (6 Marks)
b. Explain, the circumstances in which the Black- Scholes option pricing (BSOP)
model could be used to assess the value of a company and the data
required for the variables used in the model. (8 Marks)
(Total 20 Marks)
QUESTION 3
R Plc. is a successful IT services company formed ten years ago. It was listed on the
stock exchange three years ago. The company has a broad customer base mainly
consisting of small and medium sized companies. R Plc. has achieved rapid growth
in recent years by obtaining repeat business from satisfied customers and also by
acquiring other IT services companies.
Forecast financial data for R Plc. and H Limited as at December 31, 2019 is
summarised below:
R Plc. H Limited
Share capital (ordinary N1 shares) N150m N40m
Market share price N 4.90 N/A
87
NOT TO BE SOLD | Compiled by: Babatunde Isaiah | Email: [email protected]
(iv) Both R Plc. and H Limited are wholly equity financed.
(v) Profit after tax can be assumed to be a good approximation of free cash flow
attributable to investors.
QUESTION 4
You are the portfolio manager of an asset management company. A client has
approached you for the creation of his portfolio. The client is considering three
stocks A, B and C. Your research department has provided you with the
following annualised details concerning the three stocks and the market index.
Risk-free rate is 3 %.
Required:
a. Explain which of the three stocks A, B and C will lie on the capital market
line (CML). (2 Marks)
88
NOT TO BE SOLD | Compiled by: Babatunde Isaiah | Email: [email protected]
b. Using the security market line (SML), which of the three stocks is the most
attractive to buy. Show all relevant calculations. (4 Marks)
c. Using the CAPM theory and the above tabulated data, calculate the
correlation coefficient with the market index for each of the three stocks.
(2 Marks)
d. Your client wants to invest 10% in stock B and the rest in stock A and C as
suggested by you. Also he wants to have a market exposure of 1 (i.e. a
portfolio beta of 1).
Calculate what will be the investments in the other two assets to reach the
client's objective. Also calculate the expected return of the resulting
portfolio.
(Assume you can sell short any quantity of any stock). (4 Marks)
e. Now assume the client wants to invest only in stock B and the risk-free
asset. He wants portfolio‟s standard deviation of 10%. Calculate what the
weight on stock B should be in order to achieve the stated objective.
(3 Marks)
f. The equity beta of Zinta Plc., another client of yours, is 0.95 and the alpha
value is 1.5%. Explain the meaning and significance of these values to the
company. (5 Marks)
(Total 20 Marks)
QUESTION 5
a. You have worked with a major oil servicing company in Nigeria, with
headquarters in the USA, for the past six years. Recently you completed your
ICAN examinations and have been asked to join the international treasury
department in New York City for a two-year attachment.
89
NOT TO BE SOLD | Compiled by: Babatunde Isaiah | Email: [email protected]
Options market (₤31,250 contracts size, premiums are quoted in cents per
₤1)
Call option Put option
Exercise price 2-month 5-month 2-month 5-month
expiry expiry expiry expiry
1.9000 2.88 3.55 0.15 0.28
1.9200 1.59 2.32 1.00 1.85
1.9400 0.96 1.15 2.05 2.95
You are required to advise the company which of the following hedging
strategies should be adopted for the payment due in three months. Show all
workings.
i. Forward contract
ii. Currency futures
iii. Currency options (15 Marks)
b. In your personal investment portfolio, you have gone short (i.e. you have sold)
110,000 units of Big Bank plc. Call and put options exist on the bank‟s shares.
You decide to hedge your position using put options on the bank‟s shares. For
the relevant option you know that;
N (d1) = 0.45
You are required to calculate how many put options you will need to buy or
sell in order to delta-hedge.
Be specific. (5 Marks)
(Total 20 Marks)
QUESTION 6
The directors of Jaleyemi plc. (JP), an Abuja-based entertainment company, are
currently considering the appropriate cost of capital to use in appraising capital
investments. It is the policy of the company to assess the financial viability of all
capital projects using net present value criterion.
You have been provided with the following financial information of the company.
Most recent statement of financial position
Nm Nm
Equity finance
Ordinary shares (N1 nominal value) 200
Reserves 120 320
Non-current liabilities
7% Convertible bonds (N100 nominal value) 160
5% Preference shares (N1 nominal value) 80 240
90
NOT TO BE SOLD | Compiled by: Babatunde Isaiah | Email: [email protected]
Current liabilities
Trade payables 80
Overdraft 120 200
Total liabilities 760
JP has an equity beta of 1.2 and the ex-dividend market value of the company‟s
equity is N1 billion. The ex-interest market value of the convertible bonds is N168
million and the ex-dividend market value of the preference shares is N50 million.
The convertible bonds of JP have a conversion ratio of 19 ordinary shares per bond.
The conversion date and redemption date are both on the same date in five years‟
time. The current ordinary share price of JP is expected to increase by 4% per year
for the foreseeable future.
The equity risk premium is 5% per year and the risk-free rate of return is 4% per
year. JP pays profit tax at an annual rate of 30% per year.
Required:
a. Calculate the market value after-tax weighted average cost of capital of JP,
explaining clearly any assumptions you made. (10 Marks)
c. Discuss how the capital asset pricing model can be used to calculate a
project - specific cost of capital for JP, referring in your discussion to the key
concepts of systematic risk, business risk and financial risk. (6 Marks)
(Total 20 Marks)
91
NOT TO BE SOLD | Compiled by: Babatunde Isaiah | Email: [email protected]
Formulae
Modigliani and Miller Proposition 2 (with tax)
𝑉𝐷
𝐾𝐸𝐺 = 𝐾𝐸𝑈 + 𝐾𝐸𝑈 − 𝐾𝐷 (1 − 𝑡)
𝑉𝐸𝐺
Asset Beta
𝑉𝐸 𝑉𝐷 (1 − 𝑇)
𝛽𝐴 = 𝛽𝐸 + 𝛽
(𝑉𝐸 + 𝑉𝐷 (1 − 𝑇)) (𝑉𝐸 + 𝑉𝐷 (1 − 𝑇)) 𝐷
Equity Beta
𝑉𝐷
𝛽𝐸 = 𝛽𝐴 + (𝛽𝐴 − 𝛽𝐷 ) (1 − 𝑡)
𝑉𝐸
Growing Annuity
𝑛
𝐴1 1+𝑔
𝑃𝑉 = 1−
𝑟−𝑔 1+𝑟
Modified Internal Rate of Return
1
𝑃𝑉𝑅 𝑛
𝑀𝐼𝑅𝑅 = 1 + 𝑟𝑒 − 1
𝑃𝑉𝐼
The Black-Scholes Option Pricing Model
C0 = S0N(d1) – Ee-rt N(d2)
𝑆
𝐼𝑛 0 + (𝑟 + 0.5𝜎 2 )𝑇
𝑑1 = 𝐸
𝜎 𝑇
d2= d1 - 𝜎 𝑇
The Put Call Parity
C + Ee-rt = S + P
Binomial Option Pricing
𝑢 = 𝑒 𝜎× 𝑇/𝑛
d = 1/u
𝑎 = 𝑒 𝑟𝑇 /𝑛
𝑎−𝑑
𝜋=
𝑢−𝑑
The discount factor per step is given by = 𝑒 −𝑟𝑇 /𝑛
92
NOT TO BE SOLD | Compiled by: Babatunde Isaiah | Email: [email protected]
Annuity Table
Present value of an annuity of 1 i.e. 1 - (1 + r) -n
r
Where r = discount rate
n = number of periods
1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1
2 1·970 1·942 1·913 1·886 1·859 1·833 1·808 1·783 1·759 1·736 2
3 2·941 2·884 2·829 2·775 2·723 2·673 2·624 2·577 2·531 2.487 3
4 3·902 3·808 3.717 3·630 3.546 3.465 3·387 3·312 3·240 3·170 4
5 4·853 4·713 4·580 4·452 4·329 4·212 4·100 3·993 3.890 3·791 5
6 5·795 5·601 5·417 5·242 5·076 4·917 4·767 4·623 4.486 4·355 6
7 6·728 6.472 6·230 6·002 5·786 5·582 5·389 5·206 5·033 4·868 7
8 7·652 7·325 7·020 6·733 6·463 6·210 5·971 5·747 5·535 5·335 8
9 8·566 8·162 7·786 7.435 7·108 6·802 6·515 6·247 5·995 5·759 9
10 9·471 8·983 8·530 8·111 7·722 7·360 7·024 6·710 6.418 6·145 10
11 10·368 9·787 9·253 8·760 8·306 7·887 7.499 7·139 6·805 6.495 11
12 11·255 10·575 9·954 9·385 8·863 8·384 7·943 7·536 7'161 6·814 12
13 12·134 11·348 10·635 9·986 9·394 8·853 8·358 7·904 7·487 7·103 13
14 13·004 12·106 11·296 10·563 9·899 9·295 8·745 8·244 7·786 7·367 14
15 13·865 12·849 11·938 11·118 10·380 9·712 9·108 8·559 8·061 7·606 15
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1
2 1·713 1·690 1·668 1·647 1·626 1·605 1·585 1·566 1·547 1·528 2
3 2.444 2.402 2·361 2·322 2·283 2·246 2·210 2·174 2·140 2·106 3
4 3·102 3·037 2·974 2·914 2·855 2·798 2·743 2.690 2·639 2.589 4
5 3·696 3·605 3·517 3·433 3·352 3·274 3·199 3·127 3·058 2·991 5
6 4·231 4·111 3·998 3·889 3·784 3·685 3·589 3.498 3.410 3·326 6
7 4·712 4·564 4.423 4·288 4·160 4·039 3·922 3·812 3·706 3·605 7
8 5·146 4·968 4.799 4·639 4.487 4·344 4·207 4·078 3·954 3·837 8
9 5·537 5·328 5·132 4·946 4·772 4·607 4.451 4·303 4·163 4·031 9
10 5·889 5·650 5.426 5·216 5·019 4·833 4·659 4.494 4·339 4·192 10
11 6·207 5·938 5·687 5.453 5·234 5·029 4·836 4·656 4.486 4·327 11
12 6·492 6·194 5·918 5·660 5·421 5·197 4·988 4·793 4·611 4.439 12
13 6·750 6.424 6·122 5·842 5·583 5·342 5·118 4·910 4·715 4·533 13
14 6·982 6·628 6·302 6·002 5·724 5.468 5·229 5·008 4·802 4·611 14
15 7·191 6·811 6.462 6·142 5·847 5·575 5·324 5·092 4·876 4·675 15
93
NOT TO BE SOLD | Compiled by: Babatunde Isaiah | Email: [email protected]
94
NOT TO BE SOLD | Compiled by: Babatunde Isaiah | Email: [email protected]
SOLUTION 1
a)
Year 0 1 2 3 4
Sales revenue (W1) 4,875 7,031 10,136 10,962
Direct costs (W2) (2,340) (3,538) (5,351) (6,064)
Fixed overheads (1,500) (1,575) (1,654) (1,736)
Cash profit 1,035 1,918 3,131 3,162
Tax on cash profit (259) (480) (783) (791)
Tax savings on tax depr. (W5) 244 244 244 244
Investment/sale (21,000) 24,000
Working capital (W3) (731) (324) (465) (124) 1,644
Net cash flows (21,731) 696 1,217 2,468 28,259
D F@ 10% 1.0 0.909 0.826 0.75 0.683
PV (21,731) 633 1,005 1,853 19,301
Year 1 2 3 4
Qty sold (q) 1,300 1,820 2,548 2,675
Selling price (₦) 3,750 3,863 3,978 4,098
Sales revenue (₦‟000) 4,875 7,031 10,136 10,962
Year 0 1 2 3 4
₦‟000 ₦‟000 ₦‟000 ₦‟000 ₦‟000
Cumulative (15% of sales) 731 1,055 1,520 1,644
Incremental cash flows (731) (324) (465) (124) 1,644
95
NOT TO BE SOLD | Compiled by: Babatunde Isaiah | Email: [email protected]
4. Ungeared cost of equity
E x VE D x V D (1 t )
A =
V E V D (1 t ) V E V D (1 t )
(Since we are not given the beta of debt, we assume it has a beta of 0).
Cost of equity of ungeared is:
37.952
14 = x + ( x – 4.5) (1 0.28)
37.95
14 = x + 0.72 x – 3.24
17.24 = 1.72 x
x = 17.24/1.72 = 10.02% = 10%
5. Tax savings on tax depreciation
4.50m 0.60m
x 25% = ₦243,750
4 years
96
NOT TO BE SOLD | Compiled by: Babatunde Isaiah | Email: [email protected]
ii) Financing side effects
97
NOT TO BE SOLD | Compiled by: Babatunde Isaiah | Email: [email protected]
Recommendation – With positive APV, the project is viable.
b) The adjusted present value can be used where the impact of using debt
financing is significant. Here the impact of each of the financing side
effects from debt is shown separately rather than being imputed into the
weighted average cost of capital. The project is initially evaluated by only
taking into account the business risk element of the new venture. This
shows that, although the project results in a positive net present value, it is
fairly marginal and volatility in the input factors could turn the project to a
negative net present value. However, sensitivity analysis can be used to
examine the sensitivity of the factors. The financing side effects show that
almost 110% value is added when the positive impact of the tax shields and
subsidy benefits are taken into account even after the issue costs.
Assumptions
1. CL ungeared cost of equity is used because it is assumed that this
represents the business risk attributable to the new line of business.
7. It is assumed that all cash flows occur at the end of the year unless
specified otherwise.
8. All amounts are given either in ₦'000 or to the nearest ₦'000. When
calculating the units produced and sold, the nearest approximation
for each year is taken.
98
NOT TO BE SOLD | Compiled by: Babatunde Isaiah | Email: [email protected]
remains high and the management need to assess how to make sufficient
funds available.
Considering assumptions 1 and 2, the adjusted present values methodology
assumes that MM proposition 2 applies and the equivalent ungeared cost of
equity does not take into account the cost of financial distress. This may be
an unreasonable assumption. The ungeared cost of equity is based on
another company which is in a similar line of business to the new project,
but it is not exactly the same. It can be difficult to determine an accurate
ungeared cost of equity in practice. Generally, the discount rate (cost of
funds) tends to be the least sensitive factor in investment appraisal and
therefore some latitude can be allowed.
c. There are many possible answers to this question. The solution suggested
below is indicative only.
• Health and safety. Employees and the public should be protected from
danger, which includes working conditions, effective employment law
and product safety;
99
NOT TO BE SOLD | Compiled by: Babatunde Isaiah | Email: [email protected]
• Individual manager‟s ethics. The ethics of individuals, including
pursuing their own goals and self-interest (such as job security) rather
than those of the organisation might influence the outcome of
investment decisions.
EXAMINER‟S REPORT
This was a three-part question that tested the candidates‟ understanding of capital
investment element of the syllabus. In addition, it tested candidates‟ understanding
of ethical issues in capital investment decisions.
Part (a) of the question implicitly required candidates to appraise a capital project
using adjusted present value (APV).
Part (b) asked candidates to discuss the appropriateness of the evaluation method
used in Part (a).
Being a compulsory question, virtually all the candidates attempted it but the level
of performance was disappointing.
100
NOT TO BE SOLD | Compiled by: Babatunde Isaiah | Email: [email protected]
MARKING GUIDE
MARKS MARKS
(a) i. Base case NPV
Sales revenue 4
Direct costs 4
Fixed overheads 2
Tax on cash profits 1
Tax savings on tax depreciations 1
Investment/sale ½
Working capital calculations 2
Net cash flows 1
Discount factor @ 10% ½
Present values @ 10% 1
Computation of equity beta of CL ½
Calculation of asset beta 2
Calculation of Tax savings on tax depreciation 1
SOLUTION 2
101
NOT TO BE SOLD | Compiled by: Babatunde Isaiah | Email: [email protected]
Service considerations might mean the provision of electrical facilities
to remote areas at far less than full cost price. In order to provide
reasonably priced electricity for all people, a government might be
prepared to subsidise the nationalised industry and set a negative
target return on capital. Alternatively the target return might be set
such that the industry is a substantial contributor to government
finances.
102
NOT TO BE SOLD | Compiled by: Babatunde Isaiah | Email: [email protected]
sector techniques cannot be used in the public sector. Discounted cash
flow for example is often used in nationalised industries.
There are five variables which are input into the BSOP model to
determine the value of the option. Proxies need to be established for
each variable when using the BSOP model to value a company. The
five variables are: the value of the underlying asset, the exercise price,
the time to expiry, the volatility of the underlying asset value and the
risk free rate of return.
For the exercise price, the debt of the company is taken. In its simplest
form, the assumption is that the borrowing is in the form of zero
coupon debt, i.e., a discount bond. In practice such debt is not used as
a primary source of company finance and so we calculate the value of
an equivalent bond with the same yield and term to maturity as the
company‟s existing debt. The exercise price in valuing the business as
a call option is the value of the outstanding debt calculated as the
present value of a zero coupon bond offering the same yield as the
current debt.
The proxy for the value of the underlying asset is the fair value of the
company‟s assets less current liabilities on the basis that if the
company is broken up and sold, then that is what the assets would be
worth to the long-term debt holders and the equity holders.
The time to expiry is the period of the time before the debt is due for
redemption. The owners of the company have that time before the
option needs to be exercised, that is when the debt holders need to
be repaid.
The proxy for the volatility of the underlying asset is the volatility of
the business‟ assets.
The risk-free rate is usually the rate on a riskless investment such as a
short-term government bond.
103
NOT TO BE SOLD | Compiled by: Babatunde Isaiah | Email: [email protected]
EXAMINER‟S REPORT
This was a two-part question. The first part tested the candidates‟ understanding of
the key objectives of nationalised industry vs those of private sector companies. The
second part tested candidates‟ understanding of the circumstances under which the
Black-Scholes option pricing model can be used to value companies.
Large number of the candidates attempted the first part of the question and
performance was average. Less than half of the candidates attempted the second
part with below average level of performance.
In the first part of the question, most of the candidates could not relate their
discussion to “investment planning and appraisal techniques” as required by the
question.
In part (b), most of the candidates could not identify the required variables of the
model despite the fact that the Black-Scholes formula is given in the formula sheet.
Those who identified the variables could not relate them to the special case of
company valuation.
MARKING GUIDE
SOLUTION 3
a)
Pre-acquisition value: ₦’m
R Plc. ₦4.90 × 150m = 735.00
15𝑚
H Ltd. 0.08 − 0.02 = 250.00
985.00
104
NOT TO BE SOLD | Compiled by: Babatunde Isaiah | Email: [email protected]
Post-acquisition value: ₦’m
15𝑚 × 1.05
H Ltd. 0.08 − 0.03 = 315.00
R Plc. 735.00
Transaction costs (8.00)
2𝑚
Integration costs 1.08 = (1.85)
Total value 1,040.15
Pre-acquisition total value (985.00)
Incremental value 55.15
ii) Key challenges in realising the potential added value after the merger
Success depends on the extent that H's management and staff accept the
transfer of ownership and remain committed to servicing H's clients to
the best of their ability. Consider introducing an incentive scheme such as
a bonus payment or employee share option scheme.
It also depends on whether H's clients are happy with the new
arrangement and are confident of receiving the same level of service as
before.
The reliability of the forecast improvement in earnings and growth is also
key to successful realisation of the potential added value.
105
NOT TO BE SOLD | Compiled by: Babatunde Isaiah | Email: [email protected]
c) Consideration paid: ₦7 × 40 million shares = ₦280 million
Comparison of shareholders‟ wealth before and after the acquisition:
R Plc. H Limited Total value
Before the acquisition ₦735 million ₦250 million ₦985 million
After the acquisition ₦760 million ₦280 million ₦1,040 million
It is likely that H Ltd. has a higher business risk than R Plc. despite being in
the same industry because of the different client profile. If one customer
were to be lost by H Ltd. then this could have a significant impact on cash
flow and hence the variability of H Ltd.‟s cash flows is likely to be higher
than for R Plc. Therefore it is possible that a higher discount rate should be
used to value H Ltd. which would have effect of reducing its value.
Conclusion: The price needs to be reduced. The proposed price is not fair to R
Plc.‟s shareholders and H Ltd. is potentially over-valued at a discount rate of 8%.
EXAMINER‟S REPORT
106
NOT TO BE SOLD | Compiled by: Babatunde Isaiah | Email: [email protected]
the combined company in order to determine the appropriate synergy. Candidates
were also expected to identify the problems of realising synergies in practice.
MARKING GUIDE
(a) Calculation of :
Pre-acquisition value 2
- Post acquisition value 4 6
SOLUTION 4
a) None of the stocks lies on the Capital Market Line (CML). The CML describes
the risk-return relationship applicable only to efficient portfolios. It does not
apply to individual assets or non-efficient portfolios.
107
NOT TO BE SOLD | Compiled by: Babatunde Isaiah | Email: [email protected]
α = Expected return – Required return
A 12.8 – 12 = 0.8
B 15.2 – 16.44 = - 1.24
C 5.6 – 5.64 = - 0.04
Stock with positive alpha are undervalued and worth buying and stocks with
negative alpha are overvalued and are not worth buying. Therefore, only stock
A is worth buying.
0.75 X 21.2
A = 0.89
17.8
1.12 × 21.2
B = 0.93
25.4
0.22 × 21.2
C
12.6
= 0.37
d) The client wants a 10% investment in stock B, thus remaining 90% should be
invested in stock A and/or stock C. The client also wants his portfolio beta to be
1.
Let w = weight in stock A
Weight in stock C = 0.9 – w
Portfolio beta is a weighted average of the betas of securities in the portfolio.
Thus:
(0.75w) + (1.12 × 0.1) + 0.22 (0.9 – w) = 1
0.75w + 0.112 + 0.198 – 0.22w = 1
0.53w = 0.69
w = 1.3019 (i.e. 130.19%)
Hence the effective investments to meet the client‟s objective will be:
Stock A = 130.19%
Stock B = 10%
Stock C = 0.90 – 1.3019 = - 0.4019 = - 40.19%
The client will therefore have to short sell stock C to meet his objective.
Check:
(0.75 × 1.3019) + (1.12 × 0.1) – (0.22 × 0.4019) = 1
With beta of 1, the portfolio return should be the same as the market return.
108
NOT TO BE SOLD | Compiled by: Babatunde Isaiah | Email: [email protected]
Check:
E(Rp) = (12 × 1.3019) + (16.4 × 0.10) – (5.6 × 0.4019) = 15%
Check
f) The equity beta measures the systematic risk of a company‟s shares, the risk
that cannot be eliminated by diversification. It is a measure of a share‟s
volatility in terms of the market‟s risk, and may be estimated by relating the
covariance between the returns on the share and the returns on the market to
market variance. An equity beta of 0.95 suggests that Zinta Plc shares are less
risky than the market as a whole which has a beta of 1. If average market
returns change, for example increase by 4% the return of Zinta Plc shares would
be expected to increase to 0.95 × 4% = 3.8%.
The alpha value measures the abnormal return on a share. An alpha value of
1.5% means that the returns on Zinta Plc shares are currently 1.5% more than
would be expected given the shares systematic risk. Alpha values are only
temporary and may be positive or negative; in theory the alpha for an
individual share should tend to zero. An alpha value of 1.5% should cause
investors to buy the share to benefit from the abnormal return, which would
increase share price and cause the return to fall until the alpha value falls to
zero. In a well-diversified portfolio the alpha value is expected to be zero.
EXAMINER‟S REPORT
This multi-part question tested the candidates‟ knowledge of some elementary
calculations in portfolio theory and capital asset pricing model (CAPM). Candidates
were expected to show an understanding of capital market line (CML) and security
market line (SML).
109
NOT TO BE SOLD | Compiled by: Babatunde Isaiah | Email: [email protected]
About 50% of the candidates attempted the question with the level of performance
being below average.
The most common pitfall in parts (a) and (b) was the inability of the candidates to
differentiate between CML and SML.
MARKING GUIDE
4. (a) 2 marks for a well explained point 2
110
NOT TO BE SOLD | Compiled by: Babatunde Isaiah | Email: [email protected]
SOLUTION 5
a)
i. Forward Contract
Since the payment is due in three months, the three-month forward contract
should be used. The company is to buy pounds and the currency dealer is
selling. We therefore make use of the selling rate of $1.9339.
The cost = ₤5 million × $1.9339 = $9,669,500
ii. Currency Futures
Buy or sell futures?
You need to sell dollars in other to buy pounds, so we need to buy
futures.
Which expiry date?
The first futures to mature after the expected payment date
(transaction date) are choosen. We therefore select the 5-month expiry
date.
How many contracts?
₤5,000,000 ÷ ₤62,500 = 80 contracts
So we buy 80 contracts at $1.9170/₤
Predicted futures rate
Current basis = spot price – futures price = $(1.9339 – 1.9170)=
$0.0169
Unexpired basis on the transaction date =1/2 x 0.0169 =
0.0067
Lock-in exchange rate = opening futures price + unexpired basis
= $1.9170 + $0.0067 = $1.9237
Expected total cost = ₤5,000,000 × $1.9237 = ₤9,618,500
Put or Call?
We are required to buy pounds so we must buy a call option on
pounds.
How many contracts?
₤5,000,000 ÷ ₤31,250 = 160 contracts
111
NOT TO BE SOLD | Compiled by: Babatunde Isaiah | Email: [email protected]
Which exercise price?
We should choose the cheapest one that includes the exercise price
and the premium. Since we are buying pounds we add the premium
to the exercise price:
Exercise price + Premium = Net cost
$ $ $
1.9000 + 0.0355 = 1.9355
1.9200 + 0.0232 = 1.9432
1.9400 + 0.115 = 1.9515
EXAMINER‟S REPORT
The question tested candidates‟ understanding of key derivative instruments used
to hedge foreign exchange risk. They were expected to make use of forward
contract, futures and options.
112
NOT TO BE SOLD | Compiled by: Babatunde Isaiah | Email: [email protected]
Less than 20% of the candidates attempted the question and performance was
simply woeful! It would appear that the candidates have made up their minds not
to study the risk management section of the syllabus.
MARKING GUIDE
(a) i. Forward contract:
- Determining the rate and cost to adopt for the
payment due in 3 months 3
ii. Currency futures:
Determining the rate and calculation of the
expected total cost 3½
iii. Currency options
Determining the rate and calculation of the
expected cost 7½
Comment/recommendation 1 15
SOLUTION 6
a)
Cost of equity (KE), using CAPM
KE = 4 + (1.2 × 5) = 10%
Cost of convertible bonds
After-tax interest payment = 0.07 × 100 × (1- 0.3) =N4.90 per bond
113
NOT TO BE SOLD | Compiled by: Babatunde Isaiah | Email: [email protected]
Year cash flow N Discount at 6% PV (N)
0 Market price (105.00) 1.000 (105.00)
1-5 Interest 4.90 4.212 20.64
5 Conversion value 115.52 0.747 86.29
1.93
After-tax KD = 6 + ((7-6) × 1.93)/(1.93 + 2.54)) = 6 + 0.43 = 6.43%
If book values are used as weights, the WACC will be lower than if market
values were used, due to the understatement of the contribution of the cost
of equity, which is higher than the cost of capital of other sources of finance.
This can be seen in the case of JP, where the market value after-tax WACC
was found to be 9.4% and the book value after-tax WACC is 8.7% (10% × 320
+ 8% × 80 + 6.43% × 160/560).
If book value WACC were used as the discount rate in investment appraisal,
investment projects would be accepted that would be rejected if market
value WACC were used. Using book value WACC as the discount rate will
therefore lead to sub-optimal investment decisions.
114
NOT TO BE SOLD | Compiled by: Babatunde Isaiah | Email: [email protected]
As far as the cost of debt is concerned, using book values rather than market
values for weights may make little difference to the WACC, since bonds often
trade on the capital market at or close to their nominal (par) value. In
addition, the cost of debt is lower than the cost of equity and will therefore
make a smaller contribution to the WACC. It is still possible, however, that
using book values as weights may under – or over-estimate the contribution
of the cost of debt to the WACC.
c) The capital asset pricing model (CAPM) assumes that investors hold
diversified portfolios, so that unsystematic risk has been diversified away.
Companies using the CAPM to calculate a project-specific discount rate are
therefore concerned only with determining the minimum return that must be
generated by an investment project as compensation for its systematic risk.
Since the investing companies is only interested in the business risk of the
proxy company, the proxy company‟s equity beta is „ungeared‟ to remove the
effect of its capital structure. „ungearing‟ converts the proxy company‟s
equity beta into an asset beta, which represents business risk alone. The
asset betas of several proxy companies can be averaged in order to remove
any small differences in business operations.
The asset beta can then be „regeared‟, giving an equity beta whose
systematic risk takes account of the financial risk of the investing company
as well as the business risk of an investment project. Both ungearing and
regearing use the weighted average beta formula, which equates the asset
beta with the weighted average of the equity beta and the debt beta.
The project-specific equity beta resulting from the regearing process can
then be used to calculate a project-specific cost of equity using the CAPM.
This can be used as the discount rate when evaluating the investment
project with a discounted cash (DCF) flow investment appraisal method such
as net present value or internal rate of return. Alternatively, the project-
specific cost of equity can be used in calculating a project-specific weighted
average cost of capital, which can also be used in a DCF evaluation.
115
NOT TO BE SOLD | Compiled by: Babatunde Isaiah | Email: [email protected]
EXAMINER‟S REPORT
The question tested the candidates‟ understanding of cost of capital. In part (a),
they were expected to calculate:
• Cost of equity;
• Cost of preference shares; and
• Cost of convertible bond, and WACC.
Part (b) asked candidates to explain the preference of market value over book
value when computing WACC.
In part (c), candidates were asked to explain how CAPM can be used to estimate
project-specific cost of capital.
About 60% of the candidates attempted the question and the level of performance
was just about average.
In part (a), some of the candidates were able to calculate cost of equity and cost of
preference shares. However, majority of them struggled with the calculation of cost
of convertible bond.
In parts (b) and (c), most of the answers submitted were completely meaningless.
MARKING GUIDE
116
NOT TO BE SOLD | Compiled by: Babatunde Isaiah | Email: [email protected]
(c) 1½ marks per points, max 4 points - essential
to discuss business risk, systematic risk and
financial risk 6
20
117
NOT TO BE SOLD | Compiled by: Babatunde Isaiah | Email: [email protected]
THE INSTITUTE OF CHARTERED
ACCOUNTANTS OF NIGERIA
PATHFINDER
MARCH/JULY 2020 DIET
PROFESSIONAL LEVEL EXAMINATIONS
Question Papers
Suggested Solutions
Marking Guides
and
Examiner‟s Reports
PAGE
FOREWARD
QUESTION 1
Division A
This division manufactures household appliances for sale in Nigeria and ECOWAS
sub-region. The division is considering the development of a new product with a
planned selling price of ₦10,000.
It is expected that the selling price will be held constant over the initial planning
period of five years.
The company is uncertain about the scale of demand (at the selling price of
₦10,000). It is estimated that two states of demand are equally likely: State A and
State B. Once the state has been identified, there remains some uncertainty about
the actual level of demand as a result of general economic conditions.
State A State B
Volume per annum Probability Volume per annum Probability
(units) (%) (units) (%)
8,000 20 12,000 20
11,000 60 15,000 60
15,000 20 19,000 20
69
The division has cost of equity of 20% and cost of debt, net of tax of 10%. The target
debt/equity ratio is 1. Ignore taxation and inflation.
Division B
This division runs staff canteens for a number of major corporate organisations in
Abuja. The meals are prepared at a central location.
Yaro is offering a dishwasher that will cost ₦9,000,000 and has an expected life of
ten years, after which it is expected to have a ₦200,000 scrap value. A warranty is
included for the first year, however after that, continuing maintenance is available
at ₦5,400,000 for a single payment to cover the remaining nine-year period; or
alternatively by an annual charge of ₦750,000, payable in advance of the year of
cover.
The purchase of the new dishwasher is essential to comply with the new hygiene
regulations introduced by central government to reduce food poisoning outbreaks.
Required:
a. For division A, assess and recommend which of the two models of the Machine
should be purchased, if any. In this part, ignore the market research.
(18 Marks)
b. If the market research is undertaken, recommend the maximum sum division A
should be prepared to pay for the market research survey, assuming the
decision would be based on a calculation of expected net present value.
(2 Marks)
70
e. Provide a justification why it is not appropriate to use the same cost of capital
to appraise the two projects under consideration. (4 Marks)
(Total 40 Marks)
QUESTION 2
Mr. Big Heart is a Nigerian highly successful business man with interest in
manufacturing, transportation, telecommunication and aviation. He has recently
shown interest in acquiring one of the La liga league football clubs in Spain.
Negotiation with the current owners of the club is now completed and price
agreed.
Mr. Big Heart‟s group of companies have been able to raise a significant portion
of the total amount needed for the purchase consideration of the club but there
is a shortfall of $150 million today September 16, 2020 and the total payment for
the acquisition must be made by December 16, 2020. A two-month loan of $150
million, commencing from December 16, 2020 is therefore being considered.
The group finance director (GFD) has spoken to the bankers in Madrid who have
agreed to provide the $150 million needed. Given Mr. Big Heart‟s credit rating,
the short-term loan will be at a rate of 90 basis points above LIBOR. Currently,
LIBOR is at 6%. The bank has also suggested that, due to the current economic
uncertainty, LIBOR may rise by 1% or even fall by 0.5% over the coming months.
With this in mind, the group treasury department has been mandated to manage
this risk in a manner it thinks will best minimise the inherent interest risk. The
department has obtained the following data from the money and traded
derivatives markets.
Derivative contracts may be assumed to mature at the end of the month.
Three months sterling future ($500,000 contract size, $12.50 tick size)
Sept. 93.870
Dec. 93.790
March 93.680
Options on three months sterling futures
($500,000 contract size, premium cost in annual %)
71
FRA prices:
3 v 6 7.01 – 6.91
3 v 5 7.08 – 7.00
3 v 8 7.28 – 7.20
Required:
Demonstrate and explain the possible ways in which the interest rate risk may be
managed in relation to the purchase of the club, using the information provided.
Based on your analysis, advise on an appropriate course of action.
Note: Your analysis should be based on the three derivatives identified in the
scenario, that is:
FRA
Financial futures
Traded options (Total 20 Marks)
QUESTION 3
At the request of the Finance Director, the Board of Directors has convened a
special board meeting to consider the appropriate discount rate, or rates, to use to
evaluate the two investments. Each of the two investments being considered is in a
non-listed company and will be financed by 60% equity and 40% debt.
In the past, TL has used an estimated post-tax weighted average cost of capital of
12% to calculate the net present value (NPV) of all investments. The Managing
Director thinks this rate should continue to be used, adjusted if necessary by plus or
minus 1% or 2% to reflect greater or lesser risk than the “average” investment.
The Finance Director disagrees and suggests using the capital asset pricing model
(CAPM) to determine a discount rate that reflects the unsystematic risk of each of
the proposed investments based on proxy companies that operate in similar
businesses. The Finance Director has obtained the betas and debt ratio of two listed
companies (Company A and Company B) that could be used as proxies. These are:
72
Other information
- The expected annual post-tax return on the market is 8% and the risk-free rate
is 3%.
- Assume the debt that TL raises to finance the investment is risk-free.
- All three companies (TL, Company A and Company B) pay corporate tax at 25%.
- TL has one financial objective, which is to increase earnings each year to enable
its dividend payment to increase by 4% per annum.
The Managing Director and the other Board members are confused about the
terminology being used in the CAPM calculation and do not understand why they
are being asked to consider a different method of calculating discount rates for use
in evaluating the proposed investments.
Required:
a. Discuss the meaning of the term “systematic” and “unsystematic” risk and
their relationship to a company‟s equity beta. (6 Marks)
b. Using CAPM and the information given in the scenario about TL and
companies A and B, calculate for each of TL‟s proposed investments:
73
You are the portfolio manager of Aka Asset Management Limited. You have
collected the following data for three possible investments.
Price
Stock Price Forecast Dividend Beta
Today Price*
X 25 31 2 1.6
Y 105 110 1 1.2
Z 10 10.80 0 0.5
Required:
a. Using the security market line (SML), identify in which of the three stocks you
will invest. Show all relevant calculations. (6 Marks)
Security „A' has an expected rate of return of 12%, with a standard deviation of
32.65%.
The expected rate of return is derived from three equal possibilities
(i) that the actual rate of return will be the same as the expected rate of return;
(ii) that the actual rate of return will be higher than the expected rate of return by
x%;
(iii) that the actual rate of return will be lower than the expected rate of return by
x%.
b. You are required to calculate the two probable actual rates of return under
(ii) and (iii) above (6 Marks)
e. Given that the correlation coefficient of the return on security' A' with the
return on the market portfolio is 0.25 and that the standard deviation for the
market portfolio is 13.5%, you are required to calculate the Beta factor for
security „A' and to interpret the result you obtain. (2 Marks)
(Total 20 Marks)
74
₦million
Long term borrowings 9,500
Share capital (₦1 shares) 5,000
Retained reserves 4,000
Last year PT paid a dividend of 16kobo per share, representing a dividend pay-out
ratio of 40%. Earnings have grown by 8% a year on average over the last 5years and
dividend pay-out ratio has been between 30% and 50% over the period.
Company K has a current market capitalisation of A$20,000 million and the current
A$/₦ spot exchange rate is 9.20. K has a P/E ratio of 10 and earnings are expected
to grow at 6% a year in future years.
Required:
a. The extent to which the company meets its financial objectives both before and
after the proposed acquisition of Company K. (17 marks)
b. The appropriateness of the stated financial objectives of PT and how they could
be improved. (3 marks)
(Total 20 marks)
75
76
Equity Beta
𝑉𝐷
𝛽𝐸 = 𝛽𝐴 + (𝛽𝐴 − 𝛽𝐷 ) (1 − 𝑡)
𝑉𝐸
Growing Annuity
𝑛
𝐴1 1+𝑔
𝑃𝑉 = 1−
𝑟−𝑔 1+𝑟
d = 1/u
𝑎 = 𝑒 𝑟𝑇 /𝑛
𝑎−𝑑
𝜋=
𝑢−𝑑
The discount factor per step is given by = 𝑒 −𝑟𝑇 /𝑛
77
n = number of periods
1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1
2 1·970 1·942 1·913 1·886 1·859 1·833 1·808 1·783 1·759 1·736 2
3 2·941 2·884 2·829 2·775 2·723 2·673 2·624 2·577 2·531 2.487 3
4 3·902 3·808 3.717 3·630 3.546 3.465 3·387 3·312 3·240 3·170 4
5 4·853 4·713 4·580 4·452 4·329 4·212 4·100 3·993 3.890 3·791 5
6 5·795 5·601 5·417 5·242 5·076 4·917 4·767 4·623 4.486 4·355 6
7 6·728 6.472 6·230 6·002 5·786 5·582 5·389 5·206 5·033 4·868 7
8 7·652 7·325 7·020 6·733 6·463 6·210 5·971 5·747 5·535 5·335 8
9 8·566 8·162 7·786 7.435 7·108 6·802 6·515 6·247 5·995 5·759 9
10 9·471 8·983 8·530 8·111 7·722 7·360 7·024 6·710 6.418 6·145 10
11 10·368 9·787 9·253 8·760 8·306 7·887 7.499 7·139 6·805 6.495 11
12 11·255 10·575 9·954 9·385 8·863 8·384 7·943 7·536 7'161 6·814 12
13 12·134 11·348 10·635 9·986 9·394 8·853 8·358 7·904 7·487 7·103 13
14 13·004 12·106 11·296 10·563 9·899 9·295 8·745 8·244 7·786 7·367 14
15 13·865 12·849 11·938 11·118 10·380 9·712 9·108 8·559 8·061 7·606 15
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1
2 1·713 1·690 1·668 1·647 1·626 1·605 1·585 1·566 1·547 1·528 2
3 2.444 2.402 2·361 2·322 2·283 2·246 2·210 2·174 2·140 2·106 3
4 3·102 3·037 2·974 2·914 2·855 2·798 2·743 2.690 2·639 2.589 4
5 3·696 3·605 3·517 3·433 3·352 3·274 3·199 3·127 3·058 2·991 5
6 4·231 4·111 3·998 3·889 3·784 3·685 3·589 3.498 3.410 3·326 6
7 4·712 4·564 4.423 4·288 4·160 4·039 3·922 3·812 3·706 3·605 7
8 5·146 4·968 4.799 4·639 4.487 4·344 4·207 4·078 3·954 3·837 8
9 5·537 5·328 5·132 4·946 4·772 4·607 4.451 4·303 4·163 4·031 9
10 5·889 5·650 5.426 5·216 5·019 4·833 4·659 4.494 4·339 4·192 10
11 6·207 5·938 5·687 5.453 5·234 5·029 4·836 4·656 4.486 4·327 11
12 6·492 6·194 5·918 5·660 5·421 5·197 4·988 4·793 4·611 4.439 12
13 6·750 6.424 6·122 5·842 5·583 5·342 5·118 4·910 4·715 4·533 13
14 6·982 6·628 6·302 6·002 5·724 5.468 5·229 5·008 4·802 4·611 14
15 7·191 6·811 6.462 6·142 5·847 5·575 5·324 5·092 4·876 4·675 15
78
80
State A State B
Contribution (₦000) 56,000 76,000
Fixed costs (₦000) (20,000) (20,000)
Net Cash flow (₦000) 36,000 56,000
Cumulative Discount Factor at 15% 3.352 3.352
Present Value (₦000) 120,672 187,712
Outlay (₦000) (120,000) (120,000)
NPV (₦000) 672 67,712
Probability 0.5 0.5
336 33,856
81
After computing the expected sales in units for each state and for each model, some
candidates could proceed as follows:
Model 1 Model 2
Expected sales (q) 11,300* 13,200*
Annual NCF (N‟000) =5000q – 20m 36,500 46,000
CDF at 15% 3.352 3.352
PV (N‟000) 122,348 154,192
Outlay (N‟000) (80,000) (120,000)
ENPV (N‟000) 42,348 34,192
Recommendation
In the absence of the market research, the company should buy the small
machine, with ENPV of ₦42,348,000.
82
ii. The expected value may not correspond to any of the possible expected
outcomes;
iii. Unless the same decision has to be made many times, the expected value
will not be achieved. It is therefore not a valid way of making a decision
in 'one-off' situations unless the firm has a number of independent projects
and there is a portfolio effect; and
iv. The average gives no indication of the spread of possible results, i.e. it
ignores risk.
d) Yaro:- The first decision to make is the choice between a single maintenance
payment of ₦5,400,000 or a series of annual payment of ₦750,000 from year
1 to year 9. The present value of ₦750,000 from year 1 to year 9 at 6% is
₦750,000 × 6.80 = ₦5,100,000. This is less than the single payment of
₦5,400,000. Therefore the annual payment of ₦750,000 is recommended. We
can now determine the net present value of Yaro‟s offer.
Tony
Item Year NCF PVF PV
Outlay 0 (7,350,000) 1 (7,350,000)
Maintenance 1-4 (720,000) 3.47 (2,498,400)
Scrap value 10 1,100,000 0.75 825,000
(9,023,400)
83
Assumptions
i. The two suppliers offer the same terms of payment.
ii. The two suppliers will offer the same after sales service
iii. The use of AEC assumes that there will be perpetual replacement at the
same costs and terms of the dishwasher.
e) The cost of capital used to appraise a capital project should reflect both the
business risk associated with the project (not necessarily the company) and the
financial risk associated with the method of financing the project.
Business risk: It is not likely that the two projects have the same business risk as
they belong to two different business sectors. Division A, operating in the
manufacturing sector, will be expected to have higher asset beta (higher
business risk) than Division B that operates in food sub-sector.
The higher business risk of Division A will demand higher rate of return.
Financial risk: We know the target debt/equity ratio of Division A but that of
Division B is not given. If the funding of the two projects results in the two
Divisions having different financial leverage, their financial risk will not be the
same. This will result in different equity beta and different required return.
84
Marking guide
Marks Marks
a. Calculation of expected sales (units):
Small machine - State A 1
- State B 1
Calculation of WACC 1
Computation of ENPV – Small machine – State A 3
Small machine – State B 3
Calculations of expected sales (units)
Big machine - State A 1
- State B 1
Computation of ENPV – Big machine – State A 3
Big machine – State B 3
Recommendation 1 18
85
Solution 2
The treasury department could take the following two strategies to manage the
short-term interest rate risk:
Lock or fix the rate today. This will remove both upside and downside
movement in LIBOR. This can be achieved by using a FRA or an interest rate
future; and
Create a cap or ceiling rate. The department will then know what the
maximum interest rate on the loan will be. They will use an appropriate
interest rate option to create the ceiling rate.
86
Today (16/09/2020)
Big Heart will obtain a $150 million FRA 3 v 5 at a rate of 7.08% p.a. from OTC
market. This will lock the LIBOR at that annual rate.
September 15, 2019
Irrespective of whether LIBOR rises or falls, the effective annual cost of the short-
term finance will be 7.08 + 0.9 = 7.98%
Financial Future
September 16, 2020:
Sell December contracts at 93.79%.
Number of contracts:
$150m 2
× = 200 contracts
$0.50m 3
*Basis
Today June 15
LIBOR (cash market) 6.00%
Less futures (100 – 93.790) (6.21)
Current basis –0.21
Basis will reduce to zero by the expiry date of the contract (December 31).
Assuming basis reduces in a linear manner, the basis at December 16, when the
hedge is lifted is:
0.5
× −0.21 = −0.03
3.5
Lock-in rate %
Current futures implied as above 6.21
Outstanding basis – 0.03
Spread over LIBOR 0.90
Lock-in rate 7.08
The lock-in rate is the same irrespective of the actual LIBOR rate at the point of
borrowing.
87
(Note: Either of the approaches could be used but the former is preferred
because it saves time)
Traded Options
There are various ways in which the company can choose a rate at which to cap the
interest rate. One method is to choose an option, which caps the value at the
current LIBOR of 6%.
Evaluation
LIBOR 5.500% 7.00%
Expected future price as per
futures above 94.470 92.970
Implied interest rate (100 - 94.47) 5.530% (100 – 92.970) 7.030%
Exercise price 6.000% 6.000%
Exercise? No Yes
Gain – (7.030–6.000) 1.030
88
The facility is needed for a short period of time. Locking the rate will provide the
company with certainty. The treasury department will know what the cash cost of
the loan will be and can plan accordingly. The FRA is more expensive in this case
compared to futures.
However, the options will provide an element of flexibility should rates fall.
Examiner’s report
The question tests the candidates‟ knowledge of the risk management aspect of the
syllabus. Specifically, candidates were required to analyse the following derivative
interest rate risk hedging techniques:
FRA
Financial futures; and
Traded options.
Like in the previous examinations, less than 5% of the candidates attempted the
question and the performance was extremely disappointing.
For the three derivatives, the candidates lost marks due to the following reasons:
Failure to identify the appropriate „maturing‟ date to use;
Inability to analyse the selected derivatives;
Providing unnecessary and time-wasting calculations; and
In the case of traded options, inability to identify whether to make use of „put‟
option or „call‟ option.
Due to very high volatility in the global financial market, it should be very
apparent to discerning candidates, that the risk management aspect of the syllabus
has come to stay in the Institute‟s examination! Future candidates are therefore
expected to pay greater attention to this part of the syllabus.
89
Solution 3
a) Systematic and unsystematic risk
Risk that cannot be diversified away is called systematic risk. This risk is due to
economic factors which affect the economy as a whole (such as interest rates,
recession etc.).
Total risk is the combination of systematic and non-systematic risk. The total
risk of a share can be measured by its standard deviation. Systematic risk of a
share is measured by its equity beta.
90
VE VD (1 − t)
βA = βE + βD
VE + VD (1 − t) VD 1 − t + VE
Company A
Company B
0.9×6
βA = 6+ 1(1−0.25) + 0 = 0.8
Step 2: To reflect the financial risk of the method of financing; the above asset
betas must now be “regeared”.
VD
βE = βA + (βA − βD ) (1 − t)
VE
91
Next, we compute the WACC for each investment. We are not given cost of debt.
We therefore make use of the post-tax risk-free rate of 3%.
Investment 1: WACC = (0.6 × 11.25) + (0.4 × 3) = 7.95%
Investment 2: WACC = (0.6 × 9) + (0.4 × 3) = 6.6%
An asset beta is more useful than an equity beta in Proxy companies A and B
because it incorporates the total business risk inherent in those companies, but
tripping out the impact of the financing structures of the individual companies.
Companies A and B have been selected as proxy companies primarily because
they have the same business risk characteristics as Investments 1 and 2.
However, the asset beta does not take into account the financing structure of
the investments, therefore the asset beta needs to be adjusted. This is achieved
by regearing the asset (that is, the ungeared) beta and inserting it in the CAPM
formula to obtain a geared cost of equity which reflects both
• The business risk of the investment (based on the business risk of the
proxy company); and
• The long-term financing structure.
Using CAPM-derived rates could help determine if TL‟s current use of 12% for all
investments is appropriate. For example, the CAPM-derived rates calculated in
part (b) suggest that for the investments under consideration lower rates, i.e.
less than 12% would be more appropriate. TL would have rejected investment
opportunities that would have been profitable and therefore contributed to the
achievement of its objective.
On the other hand if the CAPM had suggested rates above 12% then TL would
not be fully compensating shareholders for the risks inherent in its investments,
which in the long term might threaten the viability of its business and not just
its dividends.
92
For the candidates that attempted the question, the common mistakes include:
Marking guide
a. Discussion of systematic risk 2
Discussion of unsystematic risk 2
Discussion of the relationship of both systematic risk and
unsystematic to a company‟s equity beta 2 6
93
Solution 4
a) In the context of the SML, a security is underpriced if the required return is less
than the holding period (or expected) return, it is overpriced if the required
return is greater than the holding period (or expected) return, and it is correctly
priced if the required return equals the holding period (or expected) return.
The holding period returns and the required returns are computed as follows:
Holding period (expected) return
closing price +dividend
= −1
opening price
31+2
Stock X = − 1 = 32%
25
110+1
Y= − 1 = 5.7%
105
10.80+0
Z= − 1 = 8%
10
Required return
Ri = Rf + βi(Rm - Rf)
X 4 + 1.6(12 - 4) = 16.8%
Y 4 + 1.2(12 - 4) = 13.6%
Z 4 + 0.5 (12 - 4) = 8%
94
2
𝑥 2 must also equal the variance so:
3
2 2
𝑥 = 1,066.0225
3
X2 = 1,600
X =40 or -40
The two probable actual returns therefore are
12 +40 =52%
12 – 40 = -28%
However, under portfolio theory the investor would not choose between the two
investments by simply comparing their relative risks and returns. The objective
is to reduce the risk of the investor's overall portfolio, and his investment taken
together. The risk of the whole portfolio does not depend on the standard
deviation or risk of the individual security but on the effect that those securities
will have on the risk of the portfolio as a whole.
95
It may be that, although security' A' has a higher standard deviation or risk, in
combination with the existing portfolio the overall standard deviation or risk is
reduced. This would be because the returns from security' A' move in the
opposite direction to the portfolio returns i.e. they are negatively correlated to
the portfolio returns, and therefore, will reduce the overall risk.
e)
(𝑟 𝐴 ,𝑚 )(𝜎𝐴 ) (0.25)(0.3265 )
𝛽= = = 0.6
𝜎𝑀 0.135
Beta factor of 0.60 means that if the market return moves up or down by say
4% then the return from security „A‟ will move by 0.6 × 4% = 2.40%
Examiner’s report
The question tests a number of key principles in CAPM and portfolio theory. About
70% of the candidates attempted the question but the performance was
disappointing.
In part (a), the candidates could not calculate the expected return of the stocks and
therefore, could not estimate the alpha value of each of the stocks.
Part (b) offered the greatest challenge to the candidates as they could not decode
the question.
In part (d), it is surprising that candidates could not make reference to the use of
correlation in portfolio selection.
96
Solution 5
a) Financial objective 1: To increase dividends by 10% a year
Before the acquisition, PT‟s earnings have grown by 8% per annum on
average. The target growth in dividends of 10% is therefore not sustainable
over the long term without significant growth in earnings in the future.
Company K‟s long term earnings growth prospects are lower at 6% per year
and so the acquisition risks reducing long term earnings growth.
97
₦’m
Current earnings of PT 2,000
Current earnings of K 217
Interest on loan on purchase
consideration converted to naira
= 5% × 23,000/9.2 (125)
2,092
EPS = 2,092/5,000 shares 41.84kobo
Percentage increase in:
earnings (2,092/2,000) – 1 4.6%
EPS (41.84/40) – 1 4.6%
98
Post-acquisition
₦’m
Debt funding
** Using market value
Existing debt 9,500
New debt to pay for acquisition
(A$23,000/9.2) 2,500
Total value of debt 12,000
Total value of equity (5,000 + ₦2.90) 14,500
₦’m
Equity funding:
** Using market value
Existing equity 14,500
New issue (A$23,000/9.2) 2,500
Total value of equity 17,000
Debt (no change) 9,500
99
The general growth target does not have any number attached. An earnings
growth target or a growth in market capitalisation target could be added in
order to enable this target to be quantified and success measured in financial
terms.
Examiner’s report
The question tests the candidates‟ ability to appraise a set of corporate objectives,
assess the success of an acquisition, manipulate foreign currency conversion, etc.
About 80% of the candidates attempted the question but performance was very
poor.
In analysing the first objective, candidates were expected to calculate the EPS,
before and after acquisition, and determine the growth rate in EPS. More than 90%
of the candidates attempted the question with very low level of performance.
In part (b), candidates were expected to assess the impact of acquisition on
financial leverage. Candidates performed poorly because they could not logically
analyse the impact of the method of financing the acquisition on the value of debt
and value of equity.
100
Marking guide
Marks Marks
Mentioning financial objective 1 – To increase dividend by
10% a year 2.0
101
Solution 6
a) Report Format
The risk/return trade-off
There is a trade-off between risk and return. Investors in riskier assets expect
to be compensated for the risk. In the case of ordinary shares, investors hope
to achieve their return in the form of an increase in the share price (a capital
gain) as well as from dividends.
An investor has the choice between different forms of investment. The
investor may earn interest by depositing funds with a financial intermediary
who will lend on to, say, a company, or it may invest in loan notes of a
company. Alternatively, the investor may invest directly in a company by
purchasing shares in it.
The current market price of a security is found by discounting the future
expected earnings stream at a rate suitably adjusted for risk. This means that
investments carrying a higher degree of risk will demand a higher rate of
return. This rate of return or yield has two components:
i. Annual income (dividend or interest); and
ii. Expected capital gain
In general, the higher the risk of the security, the more important is the
capital gain component of the expected yield.
102
i. Commercial banks;
ii. Merchant banks;
iii. Finance houses; and
iv. Insurance companies.
Maturity transformation
An example of this is the mortgage banks, which allows depositors to
have immediate access to their savings while lending to mortgage
holders for 25 years. The intermediary takes advantage of the
continual turnover of cash between borrowers and investors to
achieve this.
Convenience
They provide a simple way for the lender to invest, without him
having personally to find a suitable borrower directly. All the investor
has to decide is for how long the money is to be deposited and what
sort of return is required; all he then has to do is to choose an
appropriate intermediary and form of deposit.
Regulation
There is a comprehensive system of regulation in place in the
financial markets that is aimed at protecting the investor against
negligence or malpractice.
Information
Intermediaries can offer a wide range of specialist expert advice on
the various investment opportunities that is not directly available to
the private investor.
103
iii) A further effect of high interest rates may be to depress share prices,
thereby reducing the ability of businesses to raise new capital for
investment.
iv) The additional level of demand in the economy may boost inflationary
pressures. Expectations of higher inflation will generally cause a fall
in the level of optimism about the economy and place pressure on
private sector investment.
(v) High domestic interest rates are likely to strengthen the exchange rate
making it harder for businesses to export. At the same time imports
will become cheaper thus increasing competitive pressures in the
home market.
Examiner’s Report
The question tests candidates‟ knowledge of:
Risk/return trade-off;
Role of financial intermediaries; and
The effects on private sector businesses of public sector budget deficit.
Being a theoretical question, almost all the candidates attempted it. However, only
few candidates were able to score average marks in the question. Common
problems indentified include:
Lack of understanding of the concept of risk/return trade-off;
Not answering the question asked;
Complete lack of knowledge of government budget deficit and
Poor use of English!
It is recommended that candidates should always cover the Institute‟s syllabus and
practise past examination questions.
104
105
PATHFINDER
NOVEMBER 2020 DIET
PROFESSIONAL LEVEL EXAMINATIONS
Question Papers
Suggested Solutions
Marking Guides
and
Examiner‘s Reports
162
NOT TO BE SOLD | Compiled by: Babatunde Isaiah | Email: [email protected]
THE INSTITUTE OF CHARTERED ACCOUNTANTS OF NIGERIA
PROFESSIONAL LEVEL EXAMINATION – NOVEMBER 2020
STRATEGIC FINANCIAL MANAGEMENT
Time Allowed: 31/4 hours (including 15 minutes reading time)
QUESTION 1
Assume today is November 20, 2019. In 2018, the Oyin Division of Aba plc
successfully launched a new premium wine- ‗Aladun‘, in Nigeria. The Divisional
Board of Oyin Division is now considering plans put forward by the Divisional
Marketing Manager to launch the full range of Aladun in another country ‗‘Linder‘‘.
Linder has Linderian dollar (L$) as currency and the launch is planned for January
1, 2020.
It is well known within the industry that it can be very difficult for a foreign
company to break into the Linderian market for fruit wine because there is
significant loyalty towards local Linderian brands and imported South African
brands. Initial market research based on free tasting sessions has met an
encouraging response but there is still some uncertainty over the success of the
launch. However, the greatest danger to the success of Aladun in Linder is
considered to be the risk that a Nigerian competitor might launch a similar range
of products in the same market.
73
It can be assumed that if Scenario A occurs in 2020, it will also occur in all
subsequent years. The same is true for Scenario B. It is estimated that there is a
70% probability of occurrence of Scenario A and a 30% probability of Scenario B.
Other relevant financial information:
Required:
a. Ignoring the abandonment option:
i. Calculate the NPV for the project as at January 1, 2020 for Scenarios A
and B individually as well as the overall total expected NPV.
(17 Marks)
ii. Calculate the payback period for the project for each of Scenarios A and B.
(4 Marks)
74
c. Advise how real options and other strategic financial issues might influence
the initial investment decision. (8 Marks)
(Total 40 Marks)
QUESTION 2
Peter John plc (PJP) is considering a takeover bid for Yekin plc (YP).
PJP's board of directors has issued the following statement:
'Our superior P/E ratio and synergistic effects of the acquisition will lead to a post-
acquisition increase in earnings per share and in the combined market value of the
companies'.
75
QUESTION 3
a. What are the main responsibilities faced by companies when developing an
ethical framework, and in what ways can these responsibilities be
addressed? (10 Marks)
b. Discuss how ethical considerations impact on each of the main functional
areas of a firm. (10 Marks)
(Total 20 Marks)
QUESTION 4
b. A plc wants to borrow N200 million for five years with interest payable at
six-monthly intervals. It can borrow from a bank at a floating rate of NIBOR
plus 1% but wants to obtain a fixed rate for the full five-year period. A swap
bank has indicated that it will be willing to receive a fixed rate of 8.5% in
exchange for payments of six-month NIBOR.
76
Calculate the fixed interest six-monthly payment with the swap in place.
(4 Marks)
c. Calculate:
QUESTION 5
Yinko plc operates in the hospitality and leisure industry. The board of directors
met recently to discuss a number of financial proposals.
Proposal 1
To increase the company‘s level of debt by borrowing a further N100 million and
use the funds raised to buy back its shares.
Proposal 2
To increase the company‘s level of debt by borrowing a further N100 million and
use these funds to invest in additional non-current assets in the form of expansion
in available rooms in one of their hotels.
Proposal 3
To sell excess non-current assets in another hotel. The net book value of the assets
is ₦100 million and they will be sold for N135 million. This will enable the
company to focus on the other high-performing hotel units. These other hotel units
will require no additional investment in non-current assets. All the funds raised
from the sale of the non-current assets will be used to reduce the company‘s debt.
Extracts from the Forecast Financial Position for the coming Year
Nmillion
Non-current assets 1,410
Current assets 330
Total assets 1,740
Equity and liability:
Share capital (40 kobo per share par value) 240
Retained earnings 615
Total equity 855
Non-current liabilities 700
Current liabilities 185
Total liabilities 885
Total liabilities and capital 1,740
77
Yinko‘s effective tax rate is 20%. The company‘s estimated after tax rate of return on
investment is expected to be 15% on any new investment. It is expected that any
reduction in investment would suffer the same rate of return.
Required:
a. Estimate the impact of each of the three proposals on the forecast statement
of financial position, the earnings per share, and the financial gearing (Total
Debt/Total Assets) of Yinko Plc.
QUESTION 6
Binko Industrial Services plc is an all equity financed and a Stock Exchange listed
company. Over recent years the company's management has adopted a fairly
cautious and conservative policy of not seeking expansion, but has been contented
to earn a steady level of profits, most of which have been distributed as dividends.
Recently there have been some personnel changes at board level with the result
that the company has more actively been seeking new investment opportunities. In
the financial year which has just ended the company reported profits of ₦50
million, a similar figure to that of recent years.
It has been estimated that the company's cost of equity is 15% per annum.
Four investment projects have been identified, all of which could commence
immediately. The estimated cash flows and timings of these projects are as follows.
78
Each of these projects is in the same risk class as the company's existing projects.
You have been asked by the board to give your advice on dividend policy at next
week's board meeting.
Required:
a. Calculate how much Binko Industrial Services plc should pay to shareholders
as dividend in respect of the company's financial year which has just ended,
assuming that Modigliani and Miller were correct in their original 1961
proposition on dividend policy.
b. Prepare notes on which you will base your contribution to the board
meeting. These should include a brief explanation of the Modigliani and
Miller proposition on dividend policy and reasons why the company's board
may decide not to pay the level of dividend which you indicated in (a). You
should bear in mind the fact that most members of the board have little or
no accounting or financial knowledge. Your comments must relate to the
particular circumstances of Binko Industrial Services plc
Ignore inflation.
Work to the nearest ₦1,000 (15 Marks)
(Total 20 Marks)
79
Equity Beta
𝑉𝐷
𝛽𝐸 = 𝛽𝐴 + (𝛽𝐴 − 𝛽𝐷 ) (1 − 𝑡)
𝑉𝐸
Growing Annuity
𝑛
𝐴1 1+𝑔
𝑃𝑉 = 1−
𝑟−𝑔 1+𝑟
80
r
Where r = discount rate
n = number of periods
1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1
2 1·970 1·942 1·913 1·886 1·859 1·833 1·808 1·783 1·759 1·736 2
3 2·941 2·884 2·829 2·775 2·723 2·673 2·624 2·577 2·531 2.487 3
4 3·902 3·808 3.717 3·630 3.546 3.465 3·387 3·312 3·240 3·170 4
5 4·853 4·713 4·580 4·452 4·329 4·212 4·100 3·993 3.890 3·791 5
6 5·795 5·601 5·417 5·242 5·076 4·917 4·767 4·623 4.486 4·355 6
7 6·728 6.472 6·230 6·002 5·786 5·582 5·389 5·206 5·033 4·868 7
8 7·652 7·325 7·020 6·733 6·463 6·210 5·971 5·747 5·535 5·335 8
9 8·566 8·162 7·786 7.435 7·108 6·802 6·515 6·247 5·995 5·759 9
10 9·471 8·983 8·530 8·111 7·722 7·360 7·024 6·710 6.418 6·145 10
11 10·368 9·787 9·253 8·760 8·306 7·887 7.499 7·139 6·805 6.495 11
12 11·255 10·575 9·954 9·385 8·863 8·384 7·943 7·536 7'161 6·814 12
13 12·134 11·348 10·635 9·986 9·394 8·853 8·358 7·904 7·487 7·103 13
14 13·004 12·106 11·296 10·563 9·899 9·295 8·745 8·244 7·786 7·367 14
15 13·865 12·849 11·938 11·118 10·380 9·712 9·108 8·559 8·061 7·606 15
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1
2 1·713 1·690 1·668 1·647 1·626 1·605 1·585 1·566 1·547 1·528 2
3 2.444 2.402 2·361 2·322 2·283 2·246 2·210 2·174 2·140 2·106 3
4 3·102 3·037 2·974 2·914 2·855 2·798 2·743 2.690 2·639 2.589 4
5 3·696 3·605 3·517 3·433 3·352 3·274 3·199 3·127 3·058 2·991 5
6 4·231 4·111 3·998 3·889 3·784 3·685 3·589 3.498 3.410 3·326 6
7 4·712 4·564 4.423 4·288 4·160 4·039 3·922 3·812 3·706 3·605 7
8 5·146 4·968 4.799 4·639 4.487 4·344 4·207 4·078 3·954 3·837 8
9 5·537 5·328 5·132 4·946 4·772 4·607 4.451 4·303 4·163 4·031 9
10 5·889 5·650 5.426 5·216 5·019 4·833 4·659 4.494 4·339 4·192 10
11 6·207 5·938 5·687 5.453 5·234 5·029 4·836 4·656 4.486 4·327 11
12 6·492 6·194 5·918 5·660 5·421 5·197 4·988 4·793 4·611 4.439 12
13 6·750 6.424 6·122 5·842 5·583 5·342 5·118 4·910 4·715 4·533 13
14 6·982 6·628 6·302 6·002 5·724 5.468 5·229 5·008 4·802 4·611 14
15 7·191 6·811 6.462 6·142 5·847 5·575 5·324 5·092 4·876 4·675 15
81
a.(i). Scenario A
Year 0 1 2 3 4
Distribution centre (L$
million) (84) 52
Net L$ cash flows growing at
5% (L$ million) 0 90 94.50 99.23 104.19
Exchange rate 1.200 1.2240 1.2485 1.2734 1.2989
Naira equivalent cash flows
(₦million) (70) 73.53 75.69 77.93 120.25
Market research/launch (30)
Naira cash outflows, growing
at 5% (₦million) _ 0__ _(20) (21)_ (22.05) (23.15)
Net (100) 53.53 54.69 55.88 97.10
Tax relief on distribution
centre (₦m) (w1) 0 24.02 (14.01)
Tax relief on market
research/launch(₦m) 0 10.50
Tax payable on NCF
excluding residual (₦m) 0___ (18.74) (19.14) (19.56) (19.97)
NCF (100) 69.31 35.55 36.32 63.12
PVF at 15% 1.000 0.870 0.756 0.658 0.572
PV (₦m) (100) 60.30 26.88 23.90 36.10
Total NPV=₦47.18 million.
Scenario B
Year 0 1 2 3 4
Distribution centre (L$
million) (84) 52
Net L$ CF growing at 5% (L$
million) 45 47.25 49.61 52.09
Exchange rate 1.2000 1.2240 1.2485 1.2734 1.2989
Naira equivalent CF
(₦million) (70) 36.76 37.85 38.96 80.14
Market research/launch (₦
million) (30)
Naira cash outflows
growing at 5% (₦million) ____ (15) (15.75) (16.54) (17.36)
NCF (₦m) (100) 21.76 22.10 22.42 62.78
83
Working Notes
Tax relief on distribution centre
- On cost = 84m/1.2240 × 35% = ₦24.02m
(Tax savings due in year 1)
- On scrap value:
52m/1.2989 × 35% = ₦14.01m
(Tax liability due in year 4)
ii) Payback
Scenario A
Scenario B
Year NCF Cumulative NCF
(₦m) (₦m)
0 (100) (100.00)
1 48.66 (51.34)
2 14.36 (36.98)
3 14.57 (22.41)
4 40.81 18.40
Payback = 3 + 22.41/40.81 = 3.55years
84
The expected NPV of the project is ₦28.8 million and therefore we might
conclude that the project should go ahead on basis of a positive NPV.
The payback results also reinforce the conclusion that the project is risky under
Scenario B. Payback is not achieved until mid-way through year 4 (toward the
end of the project) under Scenario B, indicating that the project struggles to pay
back the funds invested at all, let alone show a profit.
In this case, it is important to consider the results for each of the two Scenarios
separately. Under Scenario A, there are strong positive results for both NPV and
Payback. However, the results are poor under Scenario B, with a negative NPV
for the project. This is telling us therefore that there is a chance that the
Linderian launch will not be successful (and we have estimated this chance at
30%). Whether the project will be accepted or not will therefore depend on the
risk attitude of the Board and whether it is willing to accept the possibility of
such losses.
85
Examiner‘s Note: Valid alternative approaches will be given full credit. For
example, recalculating Scenario B assuming that the project is abandoned early.
Evaluation:
The PV of the remaining cash flows is greater if the project is not abandoned at
this point (NPV of ₦50 million versus ₦40 million if the project were to be
abandoned)
The ultimate decision will also depend on the sensitivity of the cash flows – is it
possible that cash flows could be low in early years but increase in later years
once the product has gained acceptance in the market?
It will also depend on other factors such as the possible loss of reputation as a
consequence of early withdrawal from the market or loss of market share to a
competitor.
The development of this new market may be a key element required to meet the
company‘s strategic aim of increased market share in both domestic and
overseas markets.
86
c) Advise how real options and other strategic financial issues might
influence the initial investment decision.
Even under the ‗worst case‘ scenario, Scenario B, it is unlikely that the
project would be abandoned and therefore the abandonment option has
little influence on the investment decision and little value on 1 January
2020. The abandonment option is ‗out-of-the-money‘, on that date. However,
it does not follow that the option has no value on 1 January 2020 because
there is always a possibility that out-turn results are even worse than
predicted by Scenario B and the option would then be exercised. The
‗insurance‘ provided by the abandonment option has some value, linked to
the extent of loss that would be avoided and the probability that the option
would move to being ‘in-the-money‘ by the end of the year. Depending on
the risk appetite of the company, this insurance against an even larger loss
may be sufficient to influence the investment decision in favour of
proceeding with the investment.
Other real options include ‗wait‘ and ‗follow on‘.
A ‗follow on‘ would seem to be the most likely to apply in this instance. If,
for example, ‗Aladun‘ were to be successful in Linder, it might open up the
possibility of the launch of further product lines in Linder. This option could
therefore have significant value and should be evaluated and built into the
investment appraisal of this project.
A ‗wait‘ option could be dangerous in this case as it could give competitors
time to break into the market ahead of us and establish a market lead.
Other strategic financial issues that might be raised in discussion include:
Availability of finance. What is the company‘s credit worthiness and
credit rating? Is there a refinancing risk? Are sufficient funds available to
fund this expansion?
Do some areas of the business need to be sold in order to release capital
for expansion?
Impact on shareholder returns such as earnings per share. Under
Scenario A the project returns more than 15% on the investment on an
NPV basis, but under Scenario B the project would damage earnings per
share due to its loss making position.
Impact on gearing. The impact of the project on gearing is likely to be
immaterial due to the relatively small size of the project in relation to the
group as a whole. However, group gearing is quite high and this could
87
Marking Guide
Mark Mark
a (i) Scenario A
- Recognition of the amount spent on distribution centre
and the residual value in years 0 and 4 0.5
- Calculation of the growing cash flows-years 1 to 4 1.0
Calculation of the exchange rate-years 1 to 4 1.0
Conversion of the foreign currency to Naira 0.5
Recognition of the cost of market research/launch in year 0 0.5
Calculation of the Naira cash out/flows for years 1 to 4 1.0
Computation of the tax relief on distribution centre 0.5
Computation of the tax relief on market research/launch 0.5
Computation of tax payable on net cash flow 1.0
Determination of the present value factor for years 0 to 4 0.5
Calculation of the present value for years 0 to 4 0.5
Computation of the net present value 0.5
Scenario B
- Recognition of the amount spent on distribution centre and the
residual values in years 0 and 4 0.5
- Calculation of the growing cash flows for years 1 to 4 1.0
- Calculation of the exchange rate for years 1 to 4 1.0
- Conversion of the foreign currency to Naira=years 1 to 4 0.5
- Recognition of the cost of market research /launch in year O 0.5
- Calculations of the Naira cash outflows for years 1 to 4 1.0
- Computation of the tax relief on: Distribution centre 0.5
: Market Research/launch 0.5
- Computation of tax payable on net cash flow 1.0
- Determination of the present value factor for years 0 to 4 0.5
- Calculations of the present value for years 0 to 4 0.5
- Computation of the net present value 0.5
- Computations of the expected values for scenarios A & B 1.0 17
ii) Computation of payback period-Scenario A 2
Computation of payback period-Scenario B 2 4
iii) Summary of the result of calculations of the NPV and payback
investment appraisal exercise 0.5
Comment on the result of the calculated NPV 1.5
Conclusion on the pay back results of Scenarios A and B 0.5
Comment on the result of the payback years 1.5 4
88
Examiner’s Report
The question tests candidates‘ knowledge of foreign capital project. They were
expected to calculate expected net present value and payback period. They were
also expected to evaluate an option to abandon the project after the first year.
Being a compulsory question, almost all the candidates attempted the question but
the level of performance was very poor.
Common mistakes include:
Computing capital allowances on advertising costs, cost of market research, etc;
Adding together figures given in foreign currency and in naira;
Inability to calculate the appropriate exchange rates;
Applying the Black-Schole option pricing model to part (b) despite the fact that
the key variables needed for model are not available in the question; and
Producing generic comments in parts (a)(iii) and (c).
We recommend that candidates should supplement their reading with examination-
type of questions from time to time.
SOLUTION 2
a) PJP currently has 400 million ordinary shares, and Fader 300 million.
Earnings per share:
PJP YP
N44.10 N28.70
= 11.025 kobo = 9.57 kobo
400m 300m
P/E ratios
PJP YP
2,900 1,800
= 263.04 = 188.09
N11.025 N9.57
89
Increasing earnings per share alone is not enough. The effect on the market
value is the crucial factor. When a relatively high P/E company acquires a
company with a lower P/E, the expected earnings per share will increase, but
not necessarily the total market value of the companies.
However, this ignores the impact of the redundancy costs, ₦7,000,000 after
tax.
When this is included the combined value of the companies is still expected to
substantially increase.
ii) Changes in expected cash flows as a result of the takeover are as follows:
₦7,500,000
PV of operating savings (to infinity) = = ₦62,500,000
0.12
90
d) Both estimates are likely to be inaccurate. Many other factors are likely to affect
the post-acquisition share price. For example:
91
Marking Guide
a) Calculations of earning per share (EPS) for PJP & YP 1.0
Calculations of price earnings ratios P/E ratios – PJP & YP 1.0 2
b) Calculation of number of shares after merger 1.0
Calculation of total earnings after merger 1.0
Computation of the earnings per share after merger 1.0
Comment on the importance of increasing EPS 1.0 4
i) Computation of the current combined value of PJP&YP 1.0
Computation of the post- acquisition P/E ratio 0.5
Calculation of the post acquisition market value 1.0
ii) Calculation of PV of operating savings (to infinity) 1.5
Adjustment of redundancy cost, after tax relief, to determine
net effect on PV 0.5
Comment on the net effect on NPV 0.5 5
c) ½ mark per valid listed limitation factor, max 6 points 3
d) 1 mark per valid point on hostile bid, max 4 points 4
1 mark per valid point on organic growth, max 2 points 2 6
20
Examiner’s Report
The question tests candidates‘ knowledge of take over and some related basic
calculations like EPS, pre-and-post-takeover P/E ratios, capitalization of synergies,
etc.
Most candidates attempted the question and once again, the level of performance
was very poor.
92
We recommend that candidates should cover the entire syllabus when preparing for
the Institute‘s examinations and solve past examination questions.
SOLUTION 3
Economic
i) Management should always be acting in the best interests of the company's
shareholders, and should therefore always be actively making decisions that
will increase shareholders' wealth.
ii) Projects that have positive NPVs should be pursued as far as funds will
allow, as such projects will increase the value of the company and thus
shareholders' wealth.
iii) While management may have a different attitude towards risk than do the
shareholders, they should always manage risk according to shareholders'
requirements.
iv) Financing - the optimal financing mix between debt and equity should be
chosen as far as possible.
v) Dividends - there is no legal obligation to pay dividends to ordinary
shareholders, but the reasons for withholding dividends must be in the
interests of the company as a whole (for example, maintaining funds within
the company in order to finance future investment projects).
Legal
i) Companies must ensure that they are abiding by the rules and regulations
that govern how they operate. Company law, health and safety, accounting
standards and environmental standards are examples of these boundaries.
93
Ethical
i) Ethical responsibilities arise from a moral requirement for companies to act
in an ethical manner.
ii) Pursuit of ethical behaviour can be governed by such elements as:
Mission statements
Ethics managers
Reporting channels to allow employees to expose unethical behaviour
Ethics training and education (including ethics manuals)
Philanthropic
i) Anything that improves the welfare of employees, the local community or the
wider environment.
ii) Examples: provision of an employees' gym; sponsorship of sporting events;
charitable donations.
Human resources
i) Provision of minimum wage. In recent years, much has been made of 'cheap
labour' and 'sweat shops'. The introduction of the minimum wage is designed
to show that companies have an ethical approach to how they treat their
employees and are prepared to pay them an acceptable amount for the work
they do.
ii) Discrimination - whether by age, gender, race or religion. It is no longer
acceptable for employers to discriminate against employees for any reason -
all employees are deemed to be equal and should not be prevented from
progressing within the company for any discriminatory reason.
Marketing
i) Marketing campaigns should be truthful and should not claim that products
or services to something that they in fact cannot.
ii) Campaigns should avoid creating artificial wants. This is particularly true
with children's toys, as children are very receptive to aggressive advertising.
94
Market behaviour
i) Companies should not exploit their dominant market position by charging
vastly inflated prices.
ii) Large companies should also avoid exploiting suppliers if these suppliers
rely on large company business for survival. Unethical behaviour could
include refusing to pay a fair price for the goods and forcing suppliers to
provide goods and services at uneconomical prices.
Product development
i) Companies should strive to use ethical means to develop new products - for
example, more and more cosmetics companies are not testing on animals, an
idea pioneered by such companies as The Body Shop.
ii) Companies should be sympathetic to the potential beliefs of shareholders -
for example, there may be large blocks of shareholders who are strongly
opposed to animal testing. Managers could of course argue that if potential
investors were aware that the company tested their products on animals
then they should not have purchased shares.
iii) When developing products, be sympathetic to the public mood on certain
issues - the use of real fur is now frowned upon in many countries; dolphin-
friendly tuna is now commonplace.
iv) Use of Fairtrade products and services - for example, Green and Blacks
Fairtrade chocolate; Marks &.Spencer using Fairtrade cotton in clothing and
selling Fairtrade coffee.
95
This question tests the candidates‘ knowledge of ethical issues in finance. Most of
the candidates attempted the question but performance was below average.
It is required that they should make efforts to read widely and apply their work
experiences in examination situations.
SOLUTION 4
The effect of this on the business could be dramatic, reducing cashflow and
profit and perhaps, if the rise in rates is a large one and the company is
highly geared (with a high proportion of debt), bringing the risk of
liquidation. Alternatively, a business with a large amount of fixed rate
borrowing (for example a fixed rate loan or fixed interest preference shares
or bonds) is exposed to a fall in interest rates. If the company has borrowed
large sums at 10% fixed, and a short time later rates fall to 8%, it will be
paying more for its debt than it needs to. Cashflow and profits could be
better if only the debt were not a fixed rate.
Companies thinking about borrowing in the near future also face risk. Should
they borrow at a fixed rate now because they are worried about a rise in
interest rates or should they wait in the hope that rates may fall shortly? A
wrong decision could be costly.
Finally, there are companies with debt capital maturing that will need to be
replaced. A company may have issued N5million of bonds due to mature
between 2024 and 2026. The company itself will have the choice as to
exactly when they will repay the holders of the debt. If they think that
96
b) A Plc borrows N200million with interest rate at 6-month NIBOR plus 1%. This
transaction is in the cash market. In the swap market, it receives 6-month
NIBOR and pays fixed interest at 8.5%. The net effect is to acquire a fixed
rate obligation at 9.5% for the full term of the swap.
(In the following analysis, N stands for NIBOR)
%
Cash market: borrow at N + 1% (N+1)
Swap market: receive (floating) N
pay (fixed) (8.5)
Net payment (fixed) (9.5%)
A Plc will therefore fix its payments at N9.50m – (N200m × 9.5% × 6/12) every
six months for the five year.
At each six-monthly fixing (re-setting) date for the swap, the payment due
from A to the swaps bank or from the bank to A will depend on the market
rate for six-month NIBOR at that date.
c) i) NIBOR 10%
Suppose that on the first re-set date for the swap, at the end of month 6
in the first year, 6-month NIBOR is 10%. The payment due to each party to
the swap will be as follows:
Nm
Due from A-8.5% (N200m × 8.5% × /12)6
= (8.5)
Due to A-10%(N200m × 10% × 6/12) = 10
Net amount due to A Plc 1.5
A Plc will receive this amount six months later at the end of 12 months of
the first year- rates are fixed in advance and payments made in arrears. A
plc will pay interest on its cash market loan at NIBOR + 1% which for this
six-month period is 11% (10% + 1%). Taken with the amount received
under the swap agreement, the net cost to A Plc is equivalent to interest
payable at 9.5%.
Nm
Interest on loan = (N200m × 11% × /12) =
6
(11)
Net receipt from swap 1.5_
Net interest payment (for 6 months) (9.50)
Effective annual rate = /200 × /6
9.5 12
= 9.5%
97
Examiner’s Report
This question tests candidates‘ knowledge of interest rate risk generally and
hedging using interest rate swap in particular. Less than 20% of the candidates
attempted the question but performance was very poor.
Candidates were expected to discuss how changes in interest rates affect both
lenders and borrowers. They were also expected to illustrate the effect of pre-
designed swap arrangement. Most of the candidates that attempted the question
demonstrated lack of knowledge of this area of the syllabus.
Candidates are advised to cover every section of the Institute‘s syllabus when
preparing for the examinations
98
Working Notes
Proposal 1
Debt is increased by ₦100million and shareholders fund reduced by the same
amount as follows:
₦000
Share capital-par value*:
40𝑘𝑜𝑏𝑜
₦100m × 12,500
320𝑘𝑜𝑏𝑜
Retained earnings:
320−40
₦100m × 87,500
320
100,000
(* Only the par value can be removed from share capital. This is very important
please)
99
Proposal 2
Retained Current
earnings assets
₦000 ₦000
Additional interest as above (6,400) (6,400)
Return on additional non-current assets
= ₦100m × 15% 15,000 15,000*
Net change 8,600 8,600
(* If cash sales, it will be part of cash or bank and if credit sales, it will be in
receivables)
Adjusted PAT = ₦130m + ₦8.60m = ₦138.60m
Proposal 3
Non-current assets are reduced by ₦100m (the net book value of the assets
sold). The profit on disposal of ₦100m increases retained earnings (through
profit and loss account). The net change in retained earnings and current assets
are as follows:
Retained Current
earnings assets
₦000 ₦000
Profit on disposal 35,000
Interest savings on loan paid:
₦135,000,000 × 0.06 × (1 – 0.2) 6,480 6,480
Reduction of interest on remaining loan
= ₦565,000,000 × 0.0015 × (1 – 0.2) 678 678
Return lost due to reduction in investment
100
b) Discussion
Proposals 1 appears to produce opposite results to others. Proposal 1 would lead
to a small increase in the earnings per share (EPS) due to reduction in the
number of shares. However, the level of gearing would reduce substantially (by
about 12%)
With proposal 3, although the overall profits would increase. because of the
profit from sale of assets with interest savings is larger than the lost earnings
due to downsizing. It has the lowest gearing.
Proposal 2 would give a significant boost in the EPS from 21.67kobo to
23.10kobo. This is mainly due to increase in earnings through extra investment.
However, the amount of gearing would increase by more than 4.7%.
Overall proposal 1 appears to be the least attractive option. The choice between
proposals 2 and 3 would be between sustainability of earning and less gearing
Proposal 3, may not be sustainable because profit from sales of asset is a one-
off transaction.
Other factors to consider are the capital structure of the competitors, the
reaction of the equity market to the proposal, the implications of the change in
the risk profile of the company and the resultant impact on the cost of capital.
(Note: Credit will be given for alternative relevant comments and suggestions)
101
Proposal 3
Computation of the new balance on non-current assets 1.0
Adjustment of current assets 0.5
Calculation of new balance on non-current liabilities 1.0
Adjustment of retained earnings 0.5
Adjustment of profit after tax 1.0
Calculation of the new EPS 1.0
Calculation of the new financial leverage 1.0 6
b)
1 mark per acceptable discussion, max 4 points 4 20
Examiner' Report
The question tests candidates‘ knowledge of financial projection, using given
scenarios. Only about 50% of the candidates attempted the question and again the
level of performance was poor.
102
As there is sufficient capital to undertake all positive NPV projects, the company
should invest in Band D and use ₦30m.
The dividend under the Modigliani and Miller policy is the residue,
i.e. ₦50m – ₦30m = ₦20m. It could also be argued that under M&M's
assumptions any dividend would do, as shortfalls of cash could be replaced by
new equity issues.
The current dividend should be whatever was not needed for investing in
Positive NPV projects (residual dividend policy).
M&M suggested that any shareholders who require income (i.e. dividends)
and who are unhappy with the level of dividend paid can sell some of their
shares. These shares will have increased in value as a result of the company
accepting positive NPV projects.
103
• Transaction costs
The buying and selling of shares is not costless in the real world.
Therefore, the 'manufacture' of home-made dividends would cause a loss
in the wealth of shareholders, leading to a preference for payouts
(dividends) rather than retentions.
• Clientele theory
It follows that Binko Industrial Services Plc. should discover whether its
shareholders prefer dividends or capital gains.
However, as the company has been following a policy of paying out most
of its profits as dividends for a number of years, it is likely to have
attracted those investors (or the clientele) who prefer this policy.
A change to one of retaining profits in order to give a capital gain may
well be unpopular with these current investors, and may prompt a wide
trading of the shares as they are replaced by investors who prefer a
policy of retention.
104
• Project estimates
The calculation of the dividend depended upon the net present value of
the projects, which in turn depended upon estimates of the cash flows
and the company's cost of capital.
Reassessment of any of these estimates may lead to a different dividend,
and the company may want to undertake some sensitivity analysis on
these net present values.
Marking Guide
a)
Calculation of NPV of project A 1.0
Calculation of NPV of project B 1.0
Calculation of NPV of project C 1.0
Calculation of NPV of project D 1.0
Comment on the result of the calculations of net interest values
of A, B, C, & D 1.0 5
105
Examiner’s Report
The question tests candidates‘ knowledge of dividend policy, especially the residual
theory of dividend.
Candidates were expected to calculate the net present values of a given set of
capital projects. This is needed to determine how much is required to finance
profitable projects and how much fund is left for the payment of dividend. They
were also required to explain other factors that influence payment of dividend.
Almost 90% of the candidates attempted the question but only the (a) part was
properly answered.
106
PATHFINDER
MAY 2021 DIET
PROFESSIONAL LEVEL EXAMINATIONS
Question Papers
Suggested Solutions
Marking Guides
and
Examiner‟s Reports
QUESTION 1
Palemo Temidayo (PT) is a large engineering company listed on the stock market.
The company is considering the purchase of Zinco, an unlisted company that
produces a number of engineering components.
The board of directors is concerned about the appropriate price to pay for Zinco. As
a starting point, it has been decided to provide a range of valuations based on
different industry recognised techniques.
Summarised financial statements of Zinco Limited for the last two years are shown
below:
Current asset
Inventory 17,000 13,900
79
Required:
a. Prepare a report that gives an estimate of Zinco using:
(i) Asset based valuation (8 Marks)
(ii) P/E ratios (6 Marks)
(iii) Dividend based valuation (6 Marks)
(iv) The present value of expected future cash flows (5 Marks)
(v) Discuss the potential accuracy of each of the methods used and
recommend, with reasons, a value or range of values that PT might bid
for Zinco. State clearly any assumptions that you make.
(10 Marks)
80
QUESTION 2
You should assume that the current date is 31 December 2019
You work for Eko Corporate Finance (ECF). One of the clients for whom you are
responsible is Gap Plc (GP).
Gap Plc is a listed company and is seeking to raise ₦560 million to invest in new
projects during 2020. Currently Gap Plc is financed by equity. However, at recent
board meeting, the finance director stated that, since other companies in Gap‟s Plc
industry have average gearing ratios (measured by debt/equity by market value) of
30% (with a maximum of 40%) and an average interest cover of 6 times (with a
minimum of 5 times), perhaps the company should access the debt markets. The
finance director presented to the board two alternative sources of finance to raise
the ₦560 million.
Equity issue: The ₦560 million would be raised by a 1 for 2 rights issue, priced at a
discount on the current market value of GP‟s shares.
Debt issue: The ₦560 million would be raised by an issue of 7% coupon bonds,
redeemable on 31 December 2029. The yield to maturity (YTM) of the bonds would
be equal to the YTM of the bonds of Eko Ventures (EV), another listed company in
Gap‟s Plc market sector. Eko Ventures has a similar risk profile to Gap Plc and has
recently issued its bonds. Eko Ventures‟ bonds have a coupon of 7%, will be
redeemed in four years at par and their current market price is ₦110 per ₦100
nominal value.
There were concerns expressed by a number of board members regarding the debt
issue since it has been the long-standing policy of the company not to borrow. Their
concerns were how Gap‟s Plc shareholders and the stock market would react. The
81
An extract from Gap’s Plc most recent management accounts is shown below:
₦m
Operating profit 200
Taxations at 20% (40)
Profit after tax 160
Additional information:
(i.) Gap Plc has an equity beta of 1.1
(ii.) The risk free rate is expected to be 3% p.a.
(iii.) The market return is expected to be 8% p.a.
(iv.) Gap‟s Plc current share price is ₦5 per share ex-div
(v.) Gap Plc has 320 million shares ordinary shares in issue.
Required:
a. Calculate, using the CAPM, Gap‟s Plc cost of capital on 31 December 2019
(1 Mark)
b. Assuming a 1 for 2 rights issue is made on 1 January 2020:
i. Calculate the discount, the rights issue represents on Gap‟s Plc
current share price (1 Mark)
ii. Calculate the theoretical ex-rights price per share (1 Mark)
iii. Discuss whether the actual share price is likely to be equal to
the theoretical ex-rights price. (4 Marks)
d. Outline the advantages and disadvantages of the two alternative sources for
raising the ₦560 million, discuss the concerns of the board regarding the bond
issue (using the gearing and interest cover information provided by the
finance director) and advise Gap‟s Plc board on which source of finance should
be used. (5 Marks)
(Total 20 Marks)
82
Required:
a. Discuss and provide examples of the types of non-financial, ethical and
environmental issues that might influence the objectives of companies. Consider
the impact of these non-financial, ethical and environmental issues on the
achievement of primary financial objectives such as the maximisation of
shareholder wealth. (12 Marks)
b. Discuss generally, the nature of the financial objectives that may be set in a
not-for-profit organisation such as a charity or a hospital. (8 Marks)
(Total 20 Marks)
QUESTION 4
83
QUESTION 5
Ponk Plc is a market research company. It has seen significant growth in recent
years and obtained a stock market listing 5 years ago. Due to current economic and
political turmoil in the country, there has been a significant drop in revenue and
profit.
Ponk Plc is planning a takeover bid for XY, a rival market research company
specialising in the telecommunication industry – an industry that has been very
resistant to the current economic turbulence in the country. XY has an advanced
information technology and information system which was developed in-house and
which Ponk Plc would acquire the rights to use. Ponk Plc plans to adopt XY‟s
information technology and information system following the acquisition and this is
expected to be a major contributor to the overall estimated synergistic benefits of
the acquisition. These benefits are believed to worth ₦8million (in cash flow) at the
end of the first year of acquisition and growing annually at 5%.
Ponk Plc has 30 million shares in issue and a current share price of ₦69 before any
public announcement of the planned takeover.
Required:
a. Assuming synergistic benefits are realised, evaluate bid offer 1 and bid offer 2
from the viewpoint of:
(i) Ponk‟s existing shareholders
(ii) XY‟s shareholders. (10 Marks)
84
QUESTION 6
Tico Plc is comprised of only four major investment projects, details of which are as
follows:
Project % of Annual % return Risk Correlation
company during the last 5 % standard with the
market years deviation market
value
1 28 10 15 0.55
2 17 18 20 0.75
3 31 15 14 0.84
4 24 13 18 0.62
The risk free rate is expected to be 5% per year, the market return 14% per year, and
the standard deviation of market returns 13%.
Required:
a. Assume that Tico Plc‟s shares are currently priced based upon the assumption
that the last five years‟ experience of returns will continue for the foreseeable
future. Evaluate whether or not the share price of Tico Plc. is undervalued or
overvalued. (8 Marks)
b. Discuss why your results in (a) above might not correctly identify whether or
not the share price of Tico Plc. is undervalued or overvalued. (6 Marks)
c. Briefly discuss the key limitations of portfolio theory in the analysis of physical
investment decisions in practice. (6 Marks)
(Total 20 Marks)
85
Equity Beta
𝑉𝐷
𝛽𝐸 = 𝛽𝐴 + (𝛽𝐴 − 𝛽𝐷 ) (1 − 𝑡)
𝑉𝐸
Growing Annuity
𝑛
𝐴1 1+𝑔
𝑃𝑉 = 1−
𝑟−𝑔 1+𝑟
86
r
Where r = discount rate
n = number of periods
1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1
2 1·970 1·942 1·913 1·886 1·859 1·833 1·808 1·783 1·759 1·736 2
3 2·941 2·884 2·829 2·775 2·723 2·673 2·624 2·577 2·531 2.487 3
4 3·902 3·808 3.717 3·630 3.546 3.465 3·387 3·312 3·240 3·170 4
5 4·853 4·713 4·580 4·452 4·329 4·212 4·100 3·993 3.890 3·791 5
6 5·795 5·601 5·417 5·242 5·076 4·917 4·767 4·623 4.486 4·355 6
7 6·728 6.472 6·230 6·002 5·786 5·582 5·389 5·206 5·033 4·868 7
8 7·652 7·325 7·020 6·733 6·463 6·210 5·971 5·747 5·535 5·335 8
9 8·566 8·162 7·786 7.435 7·108 6·802 6·515 6·247 5·995 5·759 9
10 9·471 8·983 8·530 8·111 7·722 7·360 7·024 6·710 6.418 6·145 10
11 10·368 9·787 9·253 8·760 8·306 7·887 7.499 7·139 6·805 6.495 11
12 11·255 10·575 9·954 9·385 8·863 8·384 7·943 7·536 7'161 6·814 12
13 12·134 11·348 10·635 9·986 9·394 8·853 8·358 7·904 7·487 7·103 13
14 13·004 12·106 11·296 10·563 9·899 9·295 8·745 8·244 7·786 7·367 14
15 13·865 12·849 11·938 11·118 10·380 9·712 9·108 8·559 8·061 7·606 15
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1
2 1·713 1·690 1·668 1·647 1·626 1·605 1·585 1·566 1·547 1·528 2
3 2.444 2.402 2·361 2·322 2·283 2·246 2·210 2·174 2·140 2·106 3
4 3·102 3·037 2·974 2·914 2·855 2·798 2·743 2.690 2·639 2.589 4
5 3·696 3·605 3·517 3·433 3·352 3·274 3·199 3·127 3·058 2·991 5
6 4·231 4·111 3·998 3·889 3·784 3·685 3·589 3.498 3.410 3·326 6
7 4·712 4·564 4.423 4·288 4·160 4·039 3·922 3·812 3·706 3·605 7
8 5·146 4·968 4.799 4·639 4.487 4·344 4·207 4·078 3·954 3·837 8
9 5·537 5·328 5·132 4·946 4·772 4·607 4.451 4·303 4·163 4·031 9
10 5·889 5·650 5.426 5·216 5·019 4·833 4·659 4.494 4·339 4·192 10
11 6·207 5·938 5·687 5.453 5·234 5·029 4·836 4·656 4.486 4·327 11
12 6·492 6·194 5·918 5·660 5·421 5·197 4·988 4·793 4·611 4.439 12
13 6·750 6.424 6·122 5·842 5·583 5·342 5·118 4·910 4·715 4·533 13
14 6·982 6·628 6·302 6·002 5·724 5.468 5·229 5·008 4·802 4·611 14
15 7·191 6·811 6.462 6·142 5·847 5·575 5·324 5·092 4·876 4·675 15
87
SOLUTION 1
a) Report
The valuation of private companies involves considerable subjectivity. Many
alternative solutions to one presented below are possible and equally valid.
As PT is considering the purchase of Zinco, this will involve gaining ownership
through the purchase of Zinco‟s shares, hence an equity valuation is required.
Before undertaking any valuations it is advisable to recalculate the earnings for
2020 without the exceptional item. It is assumed that this is a one-off expense,
which was not fully tax allowable.
The revised profit or loss is:
2020
₦‟000
Sales revenue 112,400
Operating profit before exceptional items 6,510
Interest paid (net) (1,400)
Profit before tax 5,110
Taxation (30%) (1,533)
Profit after tax 3,577
Dividend 1,000
Change in equity 2,577
i) Asset-based valuation
An asset valuation might be regarded as the absolute minimum value of the
company. Asset-based valuations are most useful when the company is being
liquidated and the assets disposed of. In an acquisition, where the company is a
going concern, asset-based values do not fully value future cash flows, or items
such as the value of human capital, market position, etc.
Asset values may be estimated using book values, which are of little use,
replacement cost values, or disposal values. The information provided does not
permit a full disposal value, although some adjustments to book value are
possible. In this case, an asset valuation might be:
₦000
Net assets 31,430
Patent 50,000
Inventory adjustment (5,100)
76,330
89
There is also a question of whether or not the P/E ratio should be adjusted
downwards for an unlisted company, and how different expected growth rates
should be allowed for.
Expected earnings growth for Zinco is much higher than the average for the
industry, especially during the next three years. In view of this, it might be
reasonable to apply a P/E ratio of at least the industry average when attempting to
value Zinco.
The after-tax earnings of Zinco, based upon the revised statement of profit or loss,
are ₦3,577,000.
Using P/E ratio of 30, this gives an estimated value of ₦3,577,000 × 30 =
₦107,310,000.
It could be argued that the value should be based upon the anticipated earnings
rather than the past earnings months ago.
This is estimated to be:
2021
₦000
Sales revenue 140,500
Operating profit before exceptional items 11,240
Interest paid (net) (1,750)
Profit before taxation 9,490
Taxation at 30% (2,847)
Profit after tax 6,643
Estimated value = ₦6,643,000 × 30 = 199,290
90
= 76,461
91
4 – infinity:
= 285,036
Total = 299,021
Recommended valuation
It is impossible to produce an accurate valuation. The valuation using the
dividend growth model is out of line with all others and will be ignored.
On the basis of this data, the minimum value should be the adjusted asset value,
a little over ₦76,880,000, and the maximum approximately ₦299,021,000.
Examiner’s Report
Asset basis
P/E ratios
Dividend basis
Free cash flow to equity
They were also to comment on the accuracy of each of the methods:
92
Being a compulsory question, almost all the candidates attempted it. It is highly
troubling that majority of the candidates could not provide any meaningful
analysis.
Among the major challenges candidates faced in answering the question include:
Marking guide
Marks Marks
(a) (i) Asset based valuation adjusting for inventory. 8
(ii) P/E ratio based valuation adjusting for exceptional items
thereby increasing the tax charge. 6
(iii) Dividend based valuation using the expected present
value of future dividends 6
(iv) Present value of expected future cash flows based valuation
using the adjusted figures and ignoring exceptional items 5
(v) Discussing the potential accuracy of each of the valuation
methods above (i-iv) and making recommendations giving
reasons for a value or range of value that PT might bid for
the purchase of Zinco 10 35
(b) Calculation of coupon rate 5
40
93
b) i) A 1 for 2 rights issue will require 320/2 = 160 million new shares to be
issued.
The price per share = ₦560 million/160 million = ₦3.50
A discount on the current market price of (₦5 – 3.50)/5 = 30% (or
₦1.50).
If we were told the net present value of the projects, this could be
incorporated in the theoretical ex-rights price of ₦4.50, giving a more
realistic estimate of the actual share price post rights issue.
94
ii) EV has similar risk to GP so it may be reasonable to assume that bond holders
would require the same yield to maturity (YTM) in return for investing with
either company. But how similar is similar? Eg, how comparable is EV to GP
in terms of gearing?.
However the EV bonds have only four years until redemption, whilst the GP
bonds mature in ten years. It is likely that bond holders would require a
higher yield to redemption for investing in the GP bonds to compensate them
for the risk of investing for a further six years.
d) The gearing and interest cover ratios of GP immediately after the bond issue
will be as follows:
Gearing by market values assuming the current market price per share:
Market capitalisation 320 × 5 = ₦1,600 million. Gearing (D/E) 560/1,600 =
35% In time, both interest cover (more operating profits) and gearing
(greater equity value) are likely to improve with the acceptance of positive
NPV projects and any favourable market reaction to the issuance of debt and
its tax shield.
95
Note: Candidates might also comment on EPS and produce the following
figures:
Current EPS = ₦160m/320 = 50k
EPS with rights issue = ₦160m/480 = 33k
EPS with a bond issue: ((₦200m – 31.52) × 0.80)/320 = 42k
Addressing the concerns of the board:
The company will have a gearing ratio of 35% and an interest cover of 6.35
times. Gearing is between the industry maximum and average of 40% and
30% respectively. The interest cover is slightly above the industry average of
6. Since this is the first time that GP has borrowed, both shareholders and the
stock market might be concerned and prefer these ratios to be around the
averages or better.
Borrowing should reduce the current 8.5% cost of capital of the company
since debt is generally less expensive than equity because it is less risky than
equity for the debt holders. Also the company receives tax relief on the
interest that it pays. Because there is increased financial risk when a
company borrows the shareholders may require a higher return but this is
unlikely to offset the cheaper proportion of debt finance. The company value
should increase as a result of the cost of capital reducing and new funds
being invested in positive NPV projects.
Advice: It would be prudent for the company to restrict its borrowing to the
industry average gearing level especially since its interest cover is slightly
above the industry average. I would advise the company not to borrow the
full ₦560 million, perhaps this could be achieved by revising its plans for
raising the finance. For example an issue of both debt and equity to ensure
that gearing and interest cover ratios are more favourable. Or selling surplus
assets.
Examiner’s Report
More than 60% of the candidates attempted the question and again the level of
performance was very poor.
96
Marking guide
Marks Marks
(a) Calculation of cost of capital – using CAPM 1
(b) (i) Calculation of the discount on the current market
price 1
(ii) Calculation of the theoretical ex-rights price 1
(iii) Discussion on the actual share price viz-a-viz its likely
equality with the theoretical ex-rights price 4 6
(c) (i) Calculations of the issue price and the total nominal
Value of the shares of Eko Ventures bonds 5
(ii) Discussion of the validity of the use of YTM of Eko Ventures
bonds in the calculations 3 8
SOLUTION 3
a) Non-financial issues, ethical and environmental issues in many cases overlap,
and have become of increasing significance to the achievement of primary
financial objectives such as the maximisation of shareholder wealth. Most
companies have a series of secondary objectives that encompass many of these
issues.
97
iii) Provision of, or fulfilment of, a service. Many organizations, both in the
public sector and private sector provide a service, for example to remote
communities, which would not be provided on purely economic grounds.
iv) Growth of an organization, which might bring more power, prestige, and a
larger market share, but might adversely affect shareholder wealth.
v) Quality, many engineering companies have been accused of focusing upon
quality rather than cost effective solutions.
vi) Survival, Although to some extent linked to financial objectives, managers
might place corporate survival (and hence retaining their jobs) ahead of
wealth maximisation. An obvious effect might be to avoid undertaking risky
investments.
Ethical issues of companies were brought into sharp focus by the actions of
Enron and others. There is a trade-off between applying a high standard of
ethics and increasing cash flow or maximisation of shareholder wealth. A
company might face ethical dilemmas with respect to the amount and accuracy
of information it provides to its stakeholders. An ethical issue attracting much
attention is the possible payment of excessive remuneration to senior directors,
including very large bonuses and „golden parachutes‟.
All of these issues have received considerable publicity and attention in recent
years. Environmental pressure groups are prominent in many countries;
companies are now producing social and environmental accounting reports,
and/or corporate social responsibility reports. Companies increasingly have
multiple objectives that address some or all of these three issues. In the short-
term non-financial, ethical and environmental issues might result in a reduction
in shareholder wealth; in the longer term, it is argued that only companies that
address these issues will succeed.
98
Since the amount of funding available is limited, NFP organisations will seek to
generate the maximum benefit from available funds. They will obtain resources
for use by the organisation as economically as possible: they will employ these
resources efficiently, minimising waste and cutting back on any activities that
do not assist in achieving the organization‟s non-financial objectives; and they
will ensure that their operations are directed as effectively as possible towards
meeting their objectives. The goals of economy, efficiency and effectiveness are
collectively referred to as value for money (VFM). Economy is concerned with
minimising the input costs for a given level of output. Efficiency is concerned
with maximising the outputs obtained from a given level of input resources, i.e
with the process of transforming economic resources into desires services.
Effectiveness is concerned with the extent to which non-financial organizational
goals are achieved. Measuring the achievement of the financial objective of VFM
is difficult because the non-financial goals of NFP organisations are not
quantifiable and so not directly measurable. However, current performance can
be compared to historic performance to ascertain the extent to which positive
change has occurred. The availability of the healthcare provided by a hospital,
for example, can be measured by the time that the patients have to wait for
treatment or for an operation, and waiting times can be compared year on year
to determine the extent to which improvements have been achieved or
publicised targets have been met.
Lacking a profit motive, NFP organizations will have financial objectives that
relate to the effective use of resources, such as achieving a target return on
capital employed. In an organization funded by the government from finance
raised through taxation or public sector borrowing, this financial objective will
be centrally imposed.
99
In part (a), candidates were expected to discuss the types of non-financial, ethical
and environmental factors that shape company‟s financial objectives.
In part (b), they were expected to discuss the nature of financial objectives in a not-
for-profit organisations.
Large number of the candidates attempted the question and surprisingly, the level
of performance was below average.
In both parts of the question, candidates could not provide meaningful response to
the requirements.
It is our view that the only insurance against poor performance is wide reading.
Marking guide
Marks Marks
(a) Discussing and providing examples of non-financial issues and
considering its impacts on the achievement of primary financial
objectives – 1 mark per valid point max 5 points 5
Discussing and providing examples of ethical issues and
considering the impact on the achievement of primary financial
objectives. 1 mark per valid point Max 3 points 3
Discussing and providing examples of environmental issue and
considerations of its impact on the achievement of company‟s
corporate financial objectives – 1 mark per point, max 4 points 4 12
(b) General discussion on the nature of the financial objectives that
may be set in a not-for-profit organizations – 2 max per valid
point, max 4 points 8
Total 20
SOLUTION 4
a) Economic exposure
Economic exposure is the risk that the present value of a company's future cash
flows might be reduced by unexpected adverse exchange rate movements.
Economic exposure includes transaction exposure, the risk of adverse exchange
rate movements occurring in the course of normal international trading
transactions.
100
b) The law of one price suggests that identical goods selling in different countries
should sell at the same price, and that exchange rates relate these identical
values.
This leads on to purchasing power parity theory, which suggests that changes in
exchange rates over time must reflect relative changes in inflation between two
countries. If purchasing power parity holds true, the expected forward exchange
rate (F) can be forecast from the current spot rate (S) using the following
formula:
1 + iF S
= (DC/FC) where:
1 + iD F
This relationship has been found to hold in the longer-term rather than the
shorter-term and so tends to be used for forecasting exchange rates several
years in the future, rather than for periods of less than one year. For shorter
periods, forward rate can be calculated using interest rate parity, which
suggests that changes in exchange rates reflect differences between interest
rates between countries.
101
d) Money market
Expected receipt after 3 months = C$6,000,000
C$ 3 – month borrowing interest rate = 15/4 = 3.75%
C$ to borrow now to have C$ 6,000,000 liability after 3 months =
C$ 6,000,000/1.0375 = C$5,783,133 spot rate for selling = N0.5611/C$
Amount of naira to deposit now = 5,783,133 × 0.5611 = ₦3,244,916
Naira deposit rate over 3 months = 9/4 = 2.25%
Value of deposit in after 3 months = ₦3,244,916 × 1.0225 = ₦3,317,927
Based on the above calculations, the forward market rate provides higher net
receipt.
102
Examiner’s report
The questions tests candidates‟ knowledge of management of foreign currency risk.
Less than 10% of the candidates attempted the question and performance was very
poor.
Furthermore, in answering parts (c) and (d), most of the candidates failed to
recognise the need to net off the payment and against receipt in month one. In
addition, candidates could not identify the appropriate exchange rates to use.
103
SOLUTION 5
a) The present value of the synergistic benefits is:
₦8million/(0.15 – 0.05) = ₦80 million
Current values
₦million
PK 30 million × ₦69 = 2,070
XY 5 million × ₦128.40 = 642
2,712
i) Share offer
Total market value after take over:
₦million
Existing total value 2,712
Synergies 80
2,792
Total number of shares:
Currently in PK 30 million
104
Comments
The above calculations indicate that the bid offer is advantageous to both PK
and XY shareholders assuming that the synergistic benefits are realised.
PK shareholders can expect to make a higher financial gain under the cash
offer than under the share offer. Under the cash offer, the share price is
expected to increase from ₦69 to ₦70.57, a gain of ₦1.57 per share and
₦47.10 million in total. Under the share offer, a lower rise in the share price
is expected, from ₦69 to ₦69.80 per share, a total gain of ₦24million.
However, the share offer carries greater risk for the shareholders of XY
because they are exposed to the risk of a fall in the share price of PK if the
market fails to respond to the merger favourably and/or the potential
synergistic benefits are not realised.
PK has to consider how to raise ₦675 million cash required under the cash
offer. The impact of such a payment on gearing.
The share offer also has cash flow implications in paying future dividends on
a large number of shares. This could have an even greater call on over time
but has a delayed impact on cash flow.
105
Share offer
The new VPS is = 2,712𝑚 40𝑚 = ₦67.80
Cash offer
₦’million
Comments
PK‟s shareholders can expect to see a fall in share price under both the
share offer and the cash offer (in the order of ₦36 million for the share
offer and ₦33 million for the cash bid). The acquisition will therefore only
be attractive to PK‟s shareholders if additional benefits can be realised
such as the synergistic benefits arising from improved IT/IS systems to
enhance future growth through the business.
ii) The realisation of synergistic benefits will depend upon a smooth and
efficient integration process, Key issues to discuss:
106
Examiner’s report
The question tests candidates‟ knowledge of various aspects of merger and
acquisition. Candidates were expected to quantify the possible financial gains of
the merger to shareholders of both companies.
About 60% of the candidates attempted the question and once again, performance
was below average. This is despite the fact that the question was in the
examination in the year 2019!
Candidates could not logically analyse the financial impact of the merger on the
shareholders. They also failed to apply the appropriate valuation models in their
solutions. For example, in part (a), they could not recognise the need to apply
perpetual growth model to value the synergy arising from the merger.
The fact that the question was tested in a recent examination underscores the need
for candidates to revise with the Institute‟s pathfinder when preparing for the
examination.
Marking guide
Marks Marks
(a) Calculation of the present value of the synergistic benefit 0.5
Computation of the current values of PK and XY shares 1.0
Calculating the total market value after take over 1.0
Determining the total number of shares after the take over 1.0
Computing the post take over value per shares 1.0
Determining the value of existing shares in PK after the cash offer 1.0
Value of PK shares after the take over 0.5
Comments based on the calculations 4.0 10
(b)(i) Calculation of the new value per share based on share offer 1.0
Determining the revised total value of PK and XY shares based on
share offer 1.0
Calculation of the wealth of the current shareholders in PK
based on cash offer 1.0
Determining the new value per share in PK based on cash offer 1.0
Comments based on the calculations 2.0 6
(ii) Discussing the steps to take in minimizing the risk of failing to
realize the potential synergistic benefits
1 mark per point, max 4 points 4
Total 20
107
The overall company beta is the weighted average of the project betas, the
weighting being by their proportion of total market value. The beta of TK is
estimated to be:
Using the capital asset pricing model, the return that might be expected from TK
may be estimated to be:
5% + (14% - 5%) 0.860 = 12.74%
Assuming these historic returns are expected to continue, the share price of TK
is likely to be undervalued, as the company is yielding a higher return than
expected for its systematic risk.
b) Reasons why the results may not correctly identify whether the share price is
overvalued or undervalued include:
i) The data relating to returns, risk and correlation with the market is
historic and is unlikely to repeat itself in the future. Betas may change
108
Examiner’s report
The question tests candidates‟ knowledge of securities‟ valuation using CAPM.
Candidates were expected to:
Calculate the historical beta factor of each of the company‟s projects;
Calculate the average beta factor of the company;
109
They were also required to assess the validity of CAPM conclusion. Almost all the
candidates attempted the question and performance was very poor.
In part (a), most of the candidates were assessing the individual projects rather
than the company as a whole! Besides, some of them made use of wrong formulae
when calculating beta factor. In parts (b) and (c), most of the candidates could not
produce any meaningful answer.
Marking guide
Marks Marks
(a) Calculating the „beta‟ for each project. 1 mark for each
calculation 4 projects 4.0
Calculating the overall beta of the projects using WACC 1.5
Calculating the expected return from TK using CAPM 0.5
Computing the historic return on TK shares 1.5
Comment on the result of the historical return 0.5 8
(b)(i) Discussions on why the results of the calculation above may not
correctly identify whether the share price is over-valued or
undervalued. 2 marks per valid point discussed.
Max 3 points 6
(ii) Discussing the steps to take in minimizing the risk of failing to
realize the potential synergistic benefits
11/2 mark per point, max 4 points 6
Total 20
110
PATHFINDER
NOVEMBER 2021 DIET
PROFESSIONAL LEVEL EXAMINATIONS
Question Papers
Suggested Solutions
Marking Guides
and
Examiners‘ Reports
QUESTION 1
Femi Appliances Limited (FAL) is a Nigerian – based manufacturer of household
appliances with many distribution centres across various locations in Nigeria and
along the ECOWAS sub-region. FAL is now considering the development of a new
motor vehicle vacuum cleaner – VC4.
The product can be introduced quickly, and has an expected life of four years
change with a more efficient model. Costs associated with the product are
estimated to be:
Materials:
6 kilos of material Z at ₦146 per kilo
Three units of component P at ₦480 per unit
One unit of component Q at ₦640
Other variable costs: ₦210 per unit.
Indirect costs
Apportionment of management salaries: ₦10,500,000 per year
Tax allowable depreciation of machinery: ₦21,000,000 per year
Selling expenses (not including any salaries): ₦16,600,000 per year
Apportionment of head office costs: ₦5,000,000 per year
Rental of buildings: ₦10,000,000 per year
Annual interest charges: ₦10,400,000
Other annual overheads: ₦7,000,000 (including apportionment of building rates
₦2,000,000. N.B. rates are a local tax on property).
80
The new product will require two additional managers to be recruited at an annual
gross cost of ₦2,500,000 each, and one manager currently costing ₦2,000,000 will
be moved from another factory where he will be replaced by a deputy manager at a
cost of ₦1,700,000 per year. 70,000 kilos of material Z are already in inventory and
are not required for other production. The realisable value of the material is
₦9,900,000.
FAL will use the existing advertising campaigns for its distribution centres to also
advertise the new product. This will save approximately ₦5,000,000 per year in
advertising expenses.
The price per unit of the product in the first year will be ₦11,000, and demand is
projected at 12,000, 17,500, 18,000 and 18,500 units in years 1 to 4 respectively.
The inflation rate is expected to be 5% per year, and prices will be increased in line
with inflation. Wage and salary costs are expected to increase by 7% per year, and
all other costs (including rent) by 5% per year. No price or cost increases are
expected in the first year of production.
Income tax is at the rate of 35% payable in the year the profit occurs. Assume that
all sales and cost are on cash basis and occur at the end of the year, except for the
initial purchase of machinery which would take place immediately. No inventory
will be held at the end of any year.
Required:
a. Calculate the expected internal rate of return (IRR) associated with the
manufacture of VC4. Show all workings to the nearest ₦million.
(19 Marks)
b. i. What is meant by an asset beta and how it is different from an equity
beta? (2 Marks)
ii. If you are told the company‘s equity beta is 1.2, the market return is
15% and the risk free rate is 8%, discuss whether you would recommend
introducing the product. (4 Marks)
81
QUESTION 2
You run a financial consultancy firm and you have been approached by a new client
for advice on a potential acquisition. Kola Plc (KP) is a large engineering company
that was listed on the stock market ten years ago with the founders retaining a 20%
stake in the business. Whilst KP had previously experienced rapid growth in
earnings before tax, problems arose soon after the listing as competition
intensified. Although the company remains profitable, annual growth has declined
significantly and is currently 4%. The board is concerned by the lack of future
growth opportunities. The current share price reflects these concerns, trading well
below the offer price of ten years ago. In response, the directors have decided to
invest in a market development strategy for future growth, utilising significant cash
reserves to acquire companies in other areas of the country where competition is
less intense. The board has identified a potential target, Temidayo Engineering
(TE).
Temidayo Engineering (TE)
TE is a private engineering company, established eight years ago. Accumulated
unrelieved losses were incurred in the early years of development, although the
company is now profitable and achieving growth in earnings before tax of 8% per
annum. However, cash reserves are low. Access to capital has been a serious
constraint to TE‘s investment potential throughout this period. The founders and
their families own 70% of the shares with the balance held by a venture capitalist
who acquired its equity stake around five years ago.
Acquisition information
KP‘s board is keen to ensure that TE‘s founders remain as directors after the
acquisition and the company has sufficient cash reserves to purchase TE outrightly.
It is believed that a cash offer of ₦13.10 per share is likely to encourage TE‘s
shareholders to approve the acquisition. As an alternative, the board is considering
a share-for-share exchange to fund the acquisition in order to preserve cash for
future acquisitions and dividend payments. Recent mergers have attracted an
acquisition premium of around 25% - 30% and TE‘s directors indicated that their
shareholders would be expecting a premium towards the higher end of this scale
82
TE upgraded its main manufacturing facility during the previous year and expects
to make annual pre-tax cost savings of ₦50 million from the start of the current
financial year. The company has ₦0.25 ordinary shares of ₦700 million. Based on
an analysis of companies of comparable size and cost structure, it is estimated that
TE‘s P/E ratio is 20% higher than KP‘s current P/E ratio.
KP‘s chief executive officer estimates annual pre-tax revenue and cost synergies of
₦304 million to arise as a result of the acquisition. Furthermore, the finance
director anticipates annual pre-tax financial synergies of ₦106 million although she
insists this is a cautious estimate after reading an article on recent merger and
acquisition activity where post-acquisition synergies have either been
overestimated or failed to materialise. Assume tax rate of 20%.
Required:
a. Discuss possible sources of financial synergy arising from KP‘s acquisition of
TE. (6 Marks)
b. Advise the directors on a suitable share-for-share exchange offer which meets
the criteria specified by TE‘s shareholders and calculate the effect of the cash
and share-for-share offers on the post-acquisition wealth of both KP‘s and TE‘s
shareholders (14 Marks)
(Total 20 Marks)
83
The company has just finalised a long-term contract to supply a large chain of
restaurants with a variety of food products. The contract requires investment in a
new machinery costing ₦24 million. This machinery would become operational on
1 January 2022, and payment would be made on the same date. Sales would
commence immediately thereafter.
The company policy is to pay out all profits as dividends and, if ZY Plc continues to
be all- equity financed, there will be an annual dividend of ₦9 million in perpetuity
commencing 31 December 2022.
There are two alternatives being considered to finance the required investment of
₦24 million:
1. A 2-for-5 rights issue, in which case the annual dividend would be ₦9
million. The cum rights price per share would be ₦6.60; and
For either alternative, the directors expect the cost of equity to remain at its present
annual level of 10%.
Required:
a. Calculate the issue and ex-rights share prices of ZY Plc., assuming a 2-for-5
rights issue is used to finance the new project at 1 January 2022. Ignore
taxation. (4 Marks)
b. Calculate the value per ordinary share in ZY Plc at 1 January 2022 if 7.5%
irredeemable bonds are issued to finance the new project. Assume that the
cost of equity remains at 10% each year. Ignore taxation. (4 Marks)
c. Write a report to the directors of ZY Plc which
i. Compare and contrast the rights issue and the bond issue methods
of raising finance – you may refer to the calculations in your answer
to requirements (a) and (b) and to any assumptions made. (6 Marks)
ii. Discuss the appropriateness of the following alternative methods of
issuing equity finance in the specific circumstances of ZY Plc:
a placing
an offer for sale
a public offer for subscription. (6 Marks)
(Total 20 Marks)
84
The entity has a long history of sound and spectacular profitability. The directors
and shareholders are reasonably happy with this situation and are averse to
adopting strategies that they think involve a substantial increase in risk, for
example, acquisition or setting up manufacturing capability overseas. As a
consequence, LL accepts its growth rate will be relatively low, compared with some
of its competitors.
The entity is financed 70% equity and 30% debt (based on book values). The debt is
a mixture of secured and unsecured bonds carrying interest rates of between 7%
and 8.5% and repayable in 5 to 10 years‘ time. Assume for this purpose that
inflation is near zero and interest rates are low and possibly falling. The Company
Treasurer is investigating the opportunities for, and consequences of refinancing.
LL‘s main financial objective is simply to increase dividends each year. It has one
non-financial objective, which is to treat all stakeholders in the organisation with
‗‘fairness and equality‘‘. The Board has decided to review these objectives. The new
Finance Director believes maximisation of shareholder wealth should be the sole
objective, but the other directors do not agree and think a range of objectives
should be considered, for example profits after tax and return on investment and
performance improvement across a number of operational areas.
Required:
a. Evaluate the appropriateness of LL‘s current objectives and the Finance
Director‘s suggestion, and discuss the issues that the LL Board should
consider when determining the new corporate objectives. Conclude with a
recommendation. (10 Marks)
b. Discuss the factors that the treasury department should consider when
determining financing, or re-financing strategies in the context of the
economic environment described in the scenario and explain how these
might impact on the determination of corporate objectives. (10 Marks)
(Total 20 Marks)
85
Layo has total net assets of ₦1.5 billion and a gearing ratio of 45% (debt to debt
plus equity), which is typical for its industry. It is currently considering raising a
substantial amount of capital to finance an acquisition.
Required:
Discuss the criteria that the two entities described above have to consider when
setting objectives, recognising the needs of each of their main stakeholder
groups.
Make some reference in your answer to the consequences of each of them failing
to meet its declared objectives. (Total 15 Marks)
86
Details of the portfolio, which consists of shares in four Nigerian listed companies
are as follows:
Company Holding Market price
The yield on Treasury Bills is 11% a year and the market return is 19% a year.
Required:
a. On the basis of the data given, calculate the risk (i.e. Beta) of Bettaluck‘s short-
term investment portfolio relative to the market. (4 Marks)
b. Recommend, giving your reasons, whether the composition of the company‘s
short-term investment portfolio should be changed. (Relevant calculations must
be shown). (6 Marks)
c. Discuss the factors that a financial manager should take into account when
investing in marketable securities. (5 Marks)
(Total 15 Marks)
87
Required:
a. Ignoring issue costs and any use that may be made of the funds raised by
the rights issue, calculate:
i. the theoretical ex rights price per share;
ii. the value of rights per existing share. (4 Marks)
b. What alternative actions are open to the owner of 1,500 shares in James Obasi
plc as regards the rights issue? Determine the effect of each of these actions
on the wealth of the investor. (6 Marks)
88
Formulae
Modigliani and Miller Proposition 2 (with tax)
𝑉𝐷
𝐾𝐸𝐺 = 𝐾𝐸𝑈 + 𝐾𝐸𝑈 − 𝐾𝐷 (1 − 𝑡)
𝑉𝐸𝐺
Asset Beta
𝑉𝐸 𝑉𝐷 (1 − 𝑇)
𝛽𝐴 = 𝛽 + 𝛽
(𝑉𝐸 + 𝑉𝐷 (1 − 𝑇)) 𝐸 (𝑉𝐸 + 𝑉𝐷 (1 − 𝑇)) 𝐷
Equity Beta
𝑉𝐷
𝛽𝐸 = 𝛽𝐴 + (𝛽𝐴 − 𝛽𝐷 ) (1 − 𝑡)
𝑉𝐸
Growing Annuity
𝑛
𝐴1 1+𝑔
𝑃𝑉 = 1−
𝑟−𝑔 1+𝑟
89
n = number of periods
1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1
2 1·970 1·942 1·913 1·886 1·859 1·833 1·808 1·783 1·759 1·736 2
3 2·941 2·884 2·829 2·775 2·723 2·673 2·624 2·577 2·531 2.487 3
4 3·902 3·808 3.717 3·630 3.546 3.465 3·387 3·312 3·240 3·170 4
5 4·853 4·713 4·580 4·452 4·329 4·212 4·100 3·993 3.890 3·791 5
6 5·795 5·601 5·417 5·242 5·076 4·917 4·767 4·623 4.486 4·355 6
7 6·728 6.472 6·230 6·002 5·786 5·582 5·389 5·206 5·033 4·868 7
8 7·652 7·325 7·020 6·733 6·463 6·210 5·971 5·747 5·535 5·335 8
9 8·566 8·162 7·786 7.435 7·108 6·802 6·515 6·247 5·995 5·759 9
10 9·471 8·983 8·530 8·111 7·722 7·360 7·024 6·710 6.418 6·145 10
11 10·368 9·787 9·253 8·760 8·306 7·887 7.499 7·139 6·805 6.495 11
12 11·255 10·575 9·954 9·385 8·863 8·384 7·943 7·536 7'161 6·814 12
13 12·134 11·348 10·635 9·986 9·394 8·853 8·358 7·904 7·487 7·103 13
14 13·004 12·106 11·296 10·563 9·899 9·295 8·745 8·244 7·786 7·367 14
15 13·865 12·849 11·938 11·118 10·380 9·712 9·108 8·559 8·061 7·606 15
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1
2 1·713 1·690 1·668 1·647 1·626 1·605 1·585 1·566 1·547 1·528 2
3 2.444 2.402 2·361 2·322 2·283 2·246 2·210 2·174 2·140 2·106 3
4 3·102 3·037 2·974 2·914 2·855 2·798 2·743 2.690 2·639 2.589 4
5 3·696 3·605 3·517 3·433 3·352 3·274 3·199 3·127 3·058 2·991 5
6 4·231 4·111 3·998 3·889 3·784 3·685 3·589 3.498 3.410 3·326 6
7 4·712 4·564 4.423 4·288 4·160 4·039 3·922 3·812 3·706 3·605 7
8 5·146 4·968 4.799 4·639 4.487 4·344 4·207 4·078 3·954 3·837 8
9 5·537 5·328 5·132 4·946 4·772 4·607 4.451 4·303 4·163 4·031 9
10 5·889 5·650 5.426 5·216 5·019 4·833 4·659 4.494 4·339 4·192 10
11 6·207 5·938 5·687 5.453 5·234 5·029 4·836 4·656 4.486 4·327 11
12 6·492 6·194 5·918 5·660 5·421 5·197 4·988 4·793 4·611 4.439 12
13 6·750 6.424 6·122 5·842 5·583 5·342 5·118 4·910 4·715 4·533 13
14 6·982 6·628 6·302 6·002 5·724 5.468 5·229 5·008 4·802 4·611 14
15 7·191 6·811 6.462 6·142 5·847 5·575 5·324 5·092 4·876 4·675 15
90
Year 0 1 2 3 4
Costs:
Direct labour (W2) 35 55 61 67
Material Z (W3) 10 16 17 19
Component P (W3) 17 26 29 31
Component Q (W3) 8 12 13 14
Other variable costs (W4) 3 4 4 5
Management salaries (W5) 7 7 8 8
Rental (W6) 12 13 13 14
Other fixed overheads (W7) 5 5 6 6
Selling expenses (W8) 17 17 18 19
Total operating costs 117 155 169 183
Sales (W1) 132 202 218 236
Cash profit 18 47 49 53
Tax (W12) 1 (9) (10) (11)
Machinery (86) 2
NCF (86) 19 38 39 44
Calculation of IRR
Year CF PV at PV at
18% 20%
₦m ₦m ₦m
0 (86) (86) (86)
1 17 14.407 14.167
2 38 27.291 26.389
3 39 23.737 22.569
4 44 22.695 21.219
NPV = 3,825 0.01
At 20%, the NPV is zero and therefore the IRR is approximately 20%.
92
1. Sales
Year 1 2 3 4
Qty sold (q) 12,000 17,500 18,000 18,500
Selling price (₦) 11,000 11,550 12,128 12,734
Sales (₦m) 132 202 218 236
2. Direct labour
Cost per unit (₦) = (L) = 2,950 3,157 3,377 3,614
Total cost (₦m) = (q × L) = 35 55 61 67
3. Materials
- Material Ƶ
₦m
Year 1:
Total needed= 6 × 12,000 = 72,000
Available in inventory = 70,000
To be bought 2,000
- Component P
Year 1 2 3 4
Cost per unit of VC4 (k) ₦1,440 ₦1,512 ₦1588 ₦1667
Total cost (₦m) = (q × k) 17 26 29 31
- Component Q
Year 1 2 3 4
Cost per unit of VC4 (T) ₦640 ₦672 706 741
Total cost (₦m) = (q × T) 8 12 13 14
93
6. Rental
The opportunity rental of ₦12 million is the relevant cost in year 1,
increasing by 5% per year subsequently.
8. Selling expenses
These will be ₦16.60 million (rounded to ₦17 million in year 1 and then
rising by 5% per year subsequently.
9. Interest cost
This is ignored as the cost of finance is encompassed within the discount
rate.
10. Apportioned head office costs do not involve cash flow and therefore
irrelevant.
12. Tax
Year 1_ 2_ 3_ 4_
Cash profit 18 47 49 53
Tax allowable depreciation 21 21 21 21
Taxable (6) 26 28 32
Tax at 35% (2) 9 10 11
bi. An asset beta reflects a company‘s systematic business risk and is the
weighted average of the beta of equity and the beta of debt (including any
relevant tax effects). On the other hand, equity beta reflects both systematic
business risk and financial risk. Only systematic risk, the risk that cannot be
diversified away, is considered in an asset beta and equity beta.
94
If 16.4% is the appropriate cost of capital it would appear that the project is
acceptable because the IRR of 19% is higher than the required rate of return
of 16.4%. However, there are several other reasons to consider in arriving at
the appropriate decision.
Level of diversification
If the company is not well diversified, management may not consider
systematic risk to be an appropriate measure as some unsystematic risk
is present.
Non-financial factors
Non-financial factors might have an important influence on this
investment decision.
c) Step 1: Compute the NPV of the project, using discount rate of 17%.
Year 0 1 2 3 4
NCF (86) 19 38 39 44
PVF at 17% 1 0.855 0.731 0.624 0.534
PV (86) 16.25 28 24 23
NPV = ₦5.25 million
95
Year 1 2 3 4
Tax cash flows (1) 9 10 11
PVF at 17% 0.855 0.731 0.624 0.534
PV (0.86) 6.6 6.2 5.9
Total = N17.84million
NPV 5.25
SM 100 19.4%
PV of tax liability 17.84
This means that the project can absorb increase in tax rate of 23.53%. Thus,
the maximum tax rate allowed for the project to breakeven is 35 × (1.2353)
= 43.24%.
Examiner’s report
This is a standard investment appraisal question and it is in three parts. Part (a)
tests the candidates‘ understanding of:
Relevant costs:
Investment appraisal and inflation and taxation; and
Calculation of IRR
Part (b) requires the candidates to distinguish between asset beta and equity beta.
It also tests a number of practical issues concerning the appropriate cost of capital
required for the appraisal of a project.
Part (c) of the question deals with sensitivity of the tax rate.
Being a compulsory question, almost all the candidates attempted it.
In part (b), most of the candidates could not explain clearly the difference between
asset beta and equity beta.
96
Marking guide
Marks Marks
1a. Computation of direct labour 1
Computation of cost of material Z 2
Computation of cost of component P 1
Computation of cost of component Q 1
Computation of other variable cost 1
Computation of management salaries 2
Computation of rental cost 1
Computation of other fixed overhead 1
Computation of selling expenses 1
Computation of sales 1
Tax computation 2
Cost of machinery and salvage value ½
Determination of net cash flow (NCF) 1
Determination of IRR 2
Ignoring interest cost ½
Ignoring apportioned head office cost ½
Ignoring savings from advert ½ 19
97
a) Tutorial notes
It is very important to note that the question asks for FINANCIAL SYNERGY. Any
discussions of revenue synergy or cost synergy will not be rewarded.
Furthermore, the discussion must be within the context of the given scenario
rather than being generic.
Financial synergies
Many acquisitions are justified on the basis that the combined organisation will
be more profitable or grow at a faster rate than the companies operating
independently. The expectation is that the acquisition will generate higher
expected cash flows or a lower cost of capital, creating value for shareholders.
The additional value created is known as synergy, the sources of which can be
categorised into three types: revenue, cost and financial synergies.
Assuming both companies‘ cash flows are less than perfectly correlated, those of
the combined company will be less volatile than the individual companies
operating independently. This reduction in volatility will enable the combined
company to borrow more and possibly cheaper financing than would otherwise
have been possible. This increase in debt capacity, and therefore, the present
value of the tax shield, increases the value of the combined company in the form
of a lower cost of capital.
Further benefits may arise if KP is able to utilise TE‘s unrelieved tax losses.
Whilst TE is no longer loss making and could offset these tax losses
independently, the combined company may be able to obtain tax relief earlier
since the acquisition increases the availability of profits against which carried
forward tax losses can be offset. The present value of the tax saved will therefore
be greater in the combined company.
98
Share-for-share offer
KP TE
₦m ₦m
Pre-acquisition value 79,200 29,557.44
Add 30% premium 8,867,24
-
Balance of excess value due to KP (₦10,162.77 – 8,856) 1,293
Post-acquisition value 80,493 38,424.68
Relative value 2.1 1
99
Cash offer
Cash paid to TE = 2,800m × ₦13.10 36,680
KP post-acquisition value
= ₦118,882.77m – 36,680m = 82,237
% increase in wealth 3.83% 24.01%
Share-for-share offer
Post-acquisition value:
₦118,882.77 × 67.74% 80,554.38
₦118,882.77 × 32.26% 38,362.62
% increase in wealth 1.71% 29.79%
Thus, the terms of the share-for-share offer meet the criteria specified by the
directors of TE.
Examiner’s report
This is a question on business valuation and merger. In part (a), candidates are
expected to identify, from the given scenario, possible financial synergy. In part (b),
candidates were expected to value a company for takeover, using P/E ratio and to
design a share-for-share payment scheme.
Only very few candidates attempted the question and the performance was poor.
In part (a), common errors include:
Discussion of revenue and cost synergies rather than financial synergy; and
Failure to relate discussion to the given scenario. Generic discussion earned
very little or no credit.
In part (b), it is apparent that majority of the candidates were ill-equipped in
business valuation. They could not sort out the appropriate earnings to use with
the given P/E ratio – thereby losing significant marks.
100
Marks Marks
2a. Explanation of Synergy 1
Discussion of possible sources of financial
Synergy in line with the question 5 6
SOLUTION 3
a) Rights issue
5 × ₦6.60 + 2 × ₦6
Ex − rights price = = ₦6.43
7
b) Irredeemable bonds
Dividends per annum = ₦9m – (7.5% × ₦24m) = ₦7.2m
Dividend per share = ₦0.72 pa
0.72
Share price = PV of dividends = 0.1 = ₦7.20
c) REPORT
To: Directors of ZY Plc
From: Accountant
Date: xx of 20xx
101
However, the issue costs associated with the bonds are likely to be
lower than those incurred on a rights issue. In addition, the fixed
income and asset security will lead to a cheaper cost than the equity
which is enhanced by the tax relief available on debt interest.
The calculations in (b) have assumed the cost of equity (and hence the
total market value) would stay the same under a bond issue. However,
the risk to the shareholders would increase (as the financial risk of the
interest being paid out of profits increases the fluctuation in returns)
and so the return required would increase. It therefore may not be as
beneficial to shareholders as it appears, as the share value may drop
from the price calculated.
An offer for sale is when an issuing house buys the shares and then
offers them to the public, at a fixed price or via a tender, by
circulating a prospectus. The costs are likely to be higher as the fees
effectively incorporate underwriting of the issue.
102
Examiner’s report
This is a question on sources of long-term finance. Part (a) deals with the
calculation of issue price and ex-right price. Part (b) requires candidates to
compute value of equity after the issue of an irredeemable bonds. Part (c)(i) asks
the candidates to compare right issues and bond issues. In part (c)(ii), candidates
are expected to discuss the appropriateness of three methods of raising equity
finance: placing, offer for sale and public offer.
Almost all the candidates attempted the question and performance was fair.
Some of the candidates were able to make the required calculations in parts (a) and
(b).
Part (c) of the question proved to be a major discriminator between stronger and
weaker candidates, with some picking up fairly good marks, while many others
showed complete lack of understanding. Between these two extremes, the most
common error was failure to relate their answers to the circumstances of the
company.
Marking guide
Marks Marks
3a. Computation of offer price 2
Computation of ex-right price 2 4
103
Disadvantages are:
Accounting ratios are historic and backward-looking;
They are subject to manipulation;
A variety of accounting policies are available – even within
Accounting Standards; and
Tax can be affected by factors outside the control of managers.
Recommendation
Maximisation of shareholder wealth, using the theoretical definition, is
difficult to apply in the circumstances of LL. As a minimum it would be worth
introducing an objective that incorporates earnings growth as well as
dividend growth.
A range of objectives could be considered, such as risk-related returns to
investors, but again this is more difficult with a private entity than one with a
share listing.
The entity needs to consult its shareholders and possibly, consider using a
balanced scorecard approach to determine a range of objectives appropriate
for an entity such as LL.
104
(i) Finance theory suggests that entities should use a judicious amount of
debt in their capital structure to lower cost of capital. Debt is cheaper
than equity because interest payments attract tax relief and are
(generally) cheaper than equity. This is because interest is (usually)
secured and providers of debt do not participate in profits. Here we have
a mixture of secured and unsecured debt, but the entity appears sound
and of high credit worthiness so should be able to borrow at
comparatively favourable rates.
(ii) This might even be an argument in favour of increasing gearing which
will provide the ability to pay a special dividend or undertaken a share
buyback, as seems to be the desire of the major shareholders.
(iii) The opposite argument is that in a period of low and falling interest
rates, fixed rate debt becomes a burden. Some of the reasons are as
follows:
The real value of debt is not being eroded when there is low or no
inflation, so one of the benefits of debt disappears;
The return on assets funded by debt will fall and lower taxable profits,
meaning the tax benefit of debt is reduced;
If the growth is low, debt interest may have to be paid out of static
(or even falling) profits, lowering return to shareholders;
Although interest rates may fall, they never become negative, so the
real cost of borrowing increases;
The equity risk premium will tend to be less in inflationary times, so
equity is relatively less expensive; and
Raising equity is safer if profits really dive; dividends do not have to
be paid and the shareholders do not get their money back in a
liquidation. However, raising new equity in a private entity is more
difficult than in a public entity, where shares are listed so there is a
ready benchmark for the price of new shares.
(iv) Floating rate debt overcomes some of these concerns, but if markets are
efficient then the interest rate obtainable should reflect expectations.
(v) In theory (according to MM), the mix of debt and equity does not
affect the value of profits to three groups of stakeholders: lenders,
government (taxers) and owners (shareholders).
(vi) The main question is therefore what combination of dividend policy
and capital structure is likely to maximise the present value of cash
flows to shareholders. This is where the financing strategies adopted
contribute to the achievement of the objectives of the entity.
105
Examiner’s report
This is a question of two parts. Part (a) deals with appropriate corporate objective
for a large private company and part (b) deals with the factors treasury department
should consider in financing strategies. Almost all the candidates attempted the
question.
Part (a) was reasonably well answered. However it was disappointing to note that
most candidates did not relate their answers to the circumstances of the company.
For example, the fact that the company is not quoted means that an ‗appropriate‘
value does not exist.
In part (b), either through a lack of attention to the precise question being asked or,
more probably, an inability to answer that precise question, a good number of the
candidates simply reproduced all that they know about sources of finance.
At this level of the Institute‘s examinations, students are advised to pay critical
attention to questions‘ requirements and avoid generic answers.
106
Marks Marks
4a. Evaluation of the current objectives and finance directors 5
suggestion
Disadvantages/issues to be considered 2
Recommendation 3 10
SOLUTION 5
The main issues to consider when determining objectives are:
In the case of Layo, the main stakeholders are the shareholders who provide the risk
capital of the business. The entity needs to recognise the needs of this group, in
respect of the risk/return relationship and the attitude to dividends versus capital
growth.
Both entities have other groups of stakeholders, such as employees and suppliers,
but nowadays there is likely to be little difference in how the two entities recognise
these groups when setting objectives. An interesting fact about Layo is that it
chooses to maintain its HQ in a relatively small town. This suggests the company
takes seriously its responsibilities to ―minor‖ stakeholders, such as employees and
the local community and makes it even more comparable with Ibile than many
large listed companies. There could also be implications of this decision for
shareholders, although whether it is favourable (lower costs of an HQ) or otherwise
(distance from City and major shareholders perhaps) is hard to say.
107
Examiner’s report
This question which is closely related to the preceding question, tests candidates‘
understanding of corporate objective setting in the public sector - a local
government. A large number of the candidates attempted the question but
performance was very disappointing.
Candidates made it clear that most of them are lacking in the elementary
knowledge of business and finance by writing ‗maximisation of shareholders
wealth‘, ‗maximisation of profit, etc., in a local government! Those candidates
therefore lost easy marks.
Once again, it is very important that students prepare adequately for this
examination, making use of all the study supports made available by the Institute.
Marking guide
Marks
5. Detailing the criteria of ibile 5
Detailing the criteria of Layo 5
Explanation of the consequences 5
Total 15
108
a) The beta of the portfolio is the weighted average of the beta of each of the
companies. The weighting is by the market value of shares.
109
If the above data are accurate, the shares in companies D and F are not
expected to give a satisfactory return relative to their systematic risk and
should be sold. Further shares in company E should be bought because they
offer a return higher than what is required by the level of systematic risk.
Shares in company G should be held because alpha value is zero.
This analysis considers only systematic risk. If Bettaluck does not have other
investments and is not well diversified, systematic risk is likely to under
estimate the risk to Bettaluck of these investments.
c) The factors that a financial manager should take into account when investing
in marketable securities include:
i. Default risk: The risk that interest and/or principal will not be paid on
schedule on fixed interest investments. Most short-term investment in
marketable securities is confined to investments with negligible risk of
default;
ii. Price risk: The risk of the value of the investment changing for example
when interest rates change. Financial managers normally wish to avoid
substantial price risk;
110
Examiner’s report
This is a three – part question. Part (a) deals with calculation of portfolio beta. In
part (b), candidates are expected to calculate, using CAPM, securities‘ required
returns and the relevant alpha values. Part (c) requires candidates to identify
factors to consider when investing in marketable securities.
Almost all the candidates attempted the question. Part (a) was reasonably well
answered by a number of the candidates. Major errors include:
Calculation of market values of the given companies using par values of
shares rather than market values; and
Calculation of portfolio beta using quantity of shares rather than total
market values.
Part (b) was poorly answered virtually by all the candidates because they
could not figure out the appropriate expected return. They failed to realise
that return to shareholders is a combination of dividend yield and capital
gain.
Some good answers were given to part (c) and a number of candidates
cleared all the allocated 5 marks.
111
SOLUTION 7
112
c) Calculation of EPS
i) Existing EPS
EPS = VPS/PER = ₦4/15.24 = 26.25K
4𝑚 6
= × = 9.6𝑚 𝑠ℎ𝑎𝑟𝑒𝑠
0.50 5
Gross funds raised = 1.6m × ₦3.40 = ₦5.44m
Less issue costs ₦2.00m
Net proceeds = ₦3.44m
Current profit after tax = 26.25k × 8m shares = ₦2.10m
Add bond interest saved, net of tax = 12% × ₦3.44m × (1 – 0.30) = 0.289m
Revised profit after tax = 2.389m
Revised EPS = ₦2.389m/9.6m shares = 24.88k.
113
Parts (a) and (b) were reasonably well answered but candidates struggled with
part(c). Avoidable errors were found in candidates solutions. For example,
candidates ignored interest saved on bond repaid when calculating revised profit.
Furthermore, the additional shares arising from the rights issue were ignored when
computing the revised EPS.
Marking guide
7 Marks Marks
a. Computation of right issue price 1
Computation of ex-right price 2
Computation of value of right 1 4
114
PATHFINDER
MAY 2022 DIET
PROFESSIONAL LEVEL EXAMINATIONS
Question Papers
Suggested Solutions
Marking Guides
and
Examiner’s Reports
QUESTION 1
Vico Tony (VT) is a software design company established six years ago. The company
is owned by five directors. Since establishment, the company has developed rapidly.
VT finds it difficult to obtain bank finance and relies on a long-term strategy of using
internally generated funds to finance expansion. The directors are therefore giving
consideration to the possibility of floating the company on the stock market. As a first
step, you have been appointed by the directors to advise on the current value of the
business under their ownership.
The company’s most recent statement of profit or loss and the extracted balances
from the latest statement of financial position are as follows:
Statement of Profit or loss
N’Million
Sales 10,000
Cost of sales (6,000)
Gross profit 4,000
Other operating costs (3,754)
Operating profits 246
Interest on loan (148)
Profit before tax 98
Statement of Financial Position
N’Million
Opening non-current assets 2,400
Additions 132
Non-current assets (at cost) 2,532
Accumulated depreciation (734)
Net book value 1,798
Current assets
Cash and bank 100
Receivables 520
Inventory 280
900
Total assets 2,698
81
(i) Depreciation is charged at 10% per annum on the year end non-current assets
balance before accumulated depreciation, and is included in other operating
costs in the statement of profit or loss.
(ii) The investment in net working capital is expected to increase in line with the
growth in gross profit.
(iv) Sales and variable costs are projected to grow at 9% per annum and fixed costs
are projected to grow at 6% per annum.
(v) The company pays interest on its outstanding loan of 7.5% per annum and
incurs tax on its profits at 30%, payable in the following year. The company
does not currently pay dividends.
One of your first tasks is to prepare for the directors a forward cash flow projection
for three years and to value the firm on the basis of its expected free cash flow to
equity. In discussion with them, you note the following:
• The company will not dispose of any of its non-current assets but will increase
its investment in new non-current assets by 20% per annum. The company’s
depreciation policy matches the currently available tax allowable depreciation.
This straight-line write off policy is not likely to change;
• The directors will not take a dividend for the next three years but will then review
the position taking into account the company’s sustainable cash flow at that
time;
• The level of loan will be maintained at ₦1.98 billion and interest rates are not
expected to change;
82
Required:
a. Provide an estimate of the appropriate rate of return to be used for the valuation
of VT. Round your answer to the nearest whole number. (7 Marks)
b. Prepare a three-year cash flow forecast for the business on the basis described
above highlighting the free cash flow to equity in each year. (14 Marks)
c. Estimate the value of the business based on the expected free cash flow to equity
and a terminal value based on a sustainable growth rate of 4% per annum
thereafter. (Note: Irrespective of your answer in (a), assume required return of
17%). (5 Marks)
d. Advise the directors on the assumptions and the uncertainties within your
valuation. (4 Marks)
(Total 30 Marks)
83
INSTRUCTION: YOU ARE REQUIRED TO ATTEMPT ANY TWO OUT OF THE THREE
QUESTIONS IN THIS SECTION
QUESTION 2
Required:
a. Write a response to the queries raised by the three directors and advise on the
most appropriate financing instrument for Effe. In your answer, include
calculations of appropriate yield for each instrument.
Ignore tax. (15 Marks)
b. Advise a prospective investor in the five-year unsecured bond issued by Effe
on what information he should expect to be provided with and what further
84
QUESTION 3
Opeyemi operates in an economy that has almost zero inflation. Management ignores
inflation when evaluating investment projects because it is very low and considered
insignificant. Opeyemi is evaluating a number of similar, alternative investments.
The company uses an after tax cost of capital of 6% and has already completed the
evaluation of two investments. The third investment is a new product that would be
produced on a just-in-time basis and is expected to have a life of three years. This
investment requires an immediate cash outflow of N200,000, which does not qualify
for tax depreciation. The expected residual value at the end of the project’s life is
N50,000. A draft financial statement showing the values that are specific to this
investment for the three years is as follows:
Year 1 Year 2 Year 3
N N N
Sales 230,000 350,000 270,000
Production costs:
Materials 54,000 102,000 66,000
Labour 60,000 80,000 70,000
Other* 80,000 90,000 80,000
Profit 36,000 78,000 54,000
Closing receivables 20,000 30,000 25,000
Closing payables 6,000 9,000 8,000
*Other production costs shown above include depreciation calculated using the
straight line method.
The company is liable to pay corporate tax at a rate of 30% of its profits. One half of
this is payable in the same year as the profit is earned, the remainder is payable in
the following year.
Required:
a. Calculate the net present value of the above investment proposal.
(14 Marks)
b. Explain how the above investment project would be appraised if there were
to be a change in the rate of inflation, so that it became too significant to be
ignored. (3 Marks)
85
The company only has N400,000 of funds available. All of the investment
proposals are non-divisible. None of the investments may be repeated.
Required:
Recommend, with supporting calculations, which of the three investment
proposals should be accepted. (3 Marks)
(Total 20 Marks)
QUESTION 4
The finance director of Keyman Plc. has recently reorganised the finance department
following a number of years of growth within the business, which now includes a
number of overseas operations. The company has created separate treasury and
financial control departments.
Required:
a. Describe the main responsibilities of a treasury department, and comment on
the advantages to Keyman Plc. of having separate treasury and financial
control departments. (14 Marks)
INSTRUCTION: YOU ARE REQUIRED TO ATTEMPT ANY TWO OUT OF THE THREE
QUESTIONS IN THIS SECTION
QUESTION 5
86
JP has an equity beta of 1.2 and the ex-dividend market value of the company’s
equity is N1 billion. The ex-interest market value of the convertible bonds is N168
million and the ex-dividend market value of the preference shares is N50 million.
The convertible bonds of JP have a conversion ratio of 19 ordinary shares per bond.
The conversion date and redemption date are both on the same date in five years’
time. The current ordinary share price of JP is expected to increase by 4% per year for
the foreseeable future.
The equity risk premium is 5% per year and the risk-free rate of return is 4% per year.
JP pays profit tax at an annual rate of 30% per year.
Required:
a. Calculate the market value after-tax weighted average cost of capital of JP,
explaining clearly any assumptions you make. (10 Marks)
QUESTION 6
a. You have worked with a major oil servicing company in Nigeria, with
headquarters in the USA, for the past six years. Recently you completed your
ICAN examinations and you have been asked to join the international treasury
department in New York City for a two-year attachment.
The company is due to pay a UK supplier the sum of ₤5million in three months
time. Your team is considering alternative methods of hedging the expected
payment against adverse movements in exchange rate.
87
You are required to advise the company which of the following hedging strategies
should be adopted for the payment due to be made in three months. Show all
workings.
i. Forward contract (2 Marks)
ii. Currency futures (5 Marks)
iii. Currency options (5 Marks)
b. In your personal investment portfolio, you have gone short (i.e. you have sold)
110,000 units of Big Bank plc. Call and put options exist on the bank’s shares.
You decide to hedge your position using put options on the bank’s shares. For the
relevant option you know that;
N(d1) = 0.45
You are required to calculate how many put options you will need to buy or sell
in order to delta-hedge. Be specific. (3 Marks)
(Total 15 Marks)
QUESTION 7
88
Equity Beta
𝑉𝐷
𝛽𝐸 = 𝛽𝐴 + (𝛽𝐴 − 𝛽𝐷 ) ( ) (1 − 𝑡)
𝑉𝐸
Growing Annuity
𝐴1 1+𝑔 𝑛
𝑃𝑉 = (1 − ( ) )
𝑟−𝑔 1+𝑟
89
r
Where r = discount rate
n = number of periods
1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1
2 1·970 1·942 1·913 1·886 1·859 1·833 1·808 1·783 1·759 1·736 2
3 2·941 2·884 2·829 2·775 2·723 2·673 2·624 2·577 2·531 2.487 3
4 3·902 3·808 3.717 3·630 3.546 3.465 3·387 3·312 3·240 3·170 4
5 4·853 4·713 4·580 4·452 4·329 4·212 4·100 3·993 3.890 3·791 5
6 5·795 5·601 5·417 5·242 5·076 4·917 4·767 4·623 4.486 4·355 6
7 6·728 6.472 6·230 6·002 5·786 5·582 5·389 5·206 5·033 4·868 7
8 7·652 7·325 7·020 6·733 6·463 6·210 5·971 5·747 5·535 5·335 8
9 8·566 8·162 7·786 7.435 7·108 6·802 6·515 6·247 5·995 5·759 9
10 9·471 8·983 8·530 8·111 7·722 7·360 7·024 6·710 6.418 6·145 10
11 10·368 9·787 9·253 8·760 8·306 7·887 7.499 7·139 6·805 6.495 11
12 11·255 10·575 9·954 9·385 8·863 8·384 7·943 7·536 7'161 6·814 12
13 12·134 11·348 10·635 9·986 9·394 8·853 8·358 7·904 7·487 7·103 13
14 13·004 12·106 11·296 10·563 9·899 9·295 8·745 8·244 7·786 7·367 14
15 13·865 12·849 11·938 11·118 10·380 9·712 9·108 8·559 8·061 7·606 15
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1
2 1·713 1·690 1·668 1·647 1·626 1·605 1·585 1·566 1·547 1·528 2
3 2.444 2.402 2·361 2·322 2·283 2·246 2·210 2·174 2·140 2·106 3
4 3·102 3·037 2·974 2·914 2·855 2·798 2·743 2.690 2·639 2.589 4
5 3·696 3·605 3·517 3·433 3·352 3·274 3·199 3·127 3·058 2·991 5
6 4·231 4·111 3·998 3·889 3·784 3·685 3·589 3.498 3.410 3·326 6
7 4·712 4·564 4.423 4·288 4·160 4·039 3·922 3·812 3·706 3·605 7
8 5·146 4·968 4.799 4·639 4.487 4·344 4·207 4·078 3·954 3·837 8
9 5·537 5·328 5·132 4·946 4·772 4·607 4.451 4·303 4·163 4·031 9
10 5·889 5·650 5.426 5·216 5·019 4·833 4·659 4.494 4·339 4·192 10
11 6·207 5·938 5·687 5.453 5·234 5·029 4·836 4·656 4.486 4·327 11
12 6·492 6·194 5·918 5·660 5·421 5·197 4·988 4·793 4·611 4.439 12
13 6·750 6.424 6·122 5·842 5·583 5·342 5·118 4·910 4·715 4·533 13
14 6·982 6·628 6·302 6·002 5·724 5.468 5·229 5·008 4·802 4·611 14
15 7·191 6·811 6.462 6·142 5·847 5·575 5·324 5·092 4·876 4·675 15
90
Step 3:Regear the above asset beta to incorporate the financial risk of VT. This
means converting the above asset beta to equity beta.
VD
βE = βA + (βA − βD ) ( ) (1 − t)
VE
Where
βA = asset beta of the industry (computed above) = 1.43
βD = beta of debt of VT = 0. Not given and we assume the debt is risk-free.
t = effective tax rate of VT = 0.30
VD = value of debt of VT = 20*
VE = value of equity of VT = 80*
(*D/D+E of 20% means 20% of total asset is funded by debt and 80% by equity. Same
as D/E of 20/80 = 0.25)
92
Working notes
1. Operating Costs (₦million)
Year 1 Year 2 Year 3
Variable operating costs (9% growth) 1,635 1,782 1,943
Fixed costs (6% growth) 2,120 2,247 2,382
Depreciation (W2) 269 288 311
Total operating costs 4,024 4,317 4,636
93
345(1.04)
= × (1.17)−3 = 1,723
0.17 − 0.04
Total value 2,345
On the basis of the above projection, the total value of the company shares is
₦2,345,000,000.
d) This valuation is based upon a number of assumptions which you should consider
when reviewing this analysis:
• The required rate of return has been calculated using capital asset pricing
model. A number of problems are associated with the model in this instance.
• It assumes the company is well diversified and therefore no unsystematic risk.
There is no evidence in the scenario that the company is properly diversified.
• Since the company is not quoted, an appropriate beta factor does not exist.
We have made use of the beta factor of a proxy company, with adjustments.
These adjustments are not error-free. In fact, no two companies are completely
identical.
94
Examiner’s report
This is a standard question on valuation of business, using free cash flow to equity
(FCFE) model.
Part (a) tests candidates’ understanding of the calculation of specific cost of capital,
using given information of proxy company.
Part (b) requires candidates to project a 3 – year FCFE, using the relevant information
provided.
Part (c) requires candidates to provide a valuation of the company.
Finally, part (c) requires the candidates identify the relevant assumptions and
uncertainties in their calculations.
Being a compulsory question almost all the candidates attempted it.
Generally the performance on the question was very poor.
In part (a), candidates lost marks due to the following errors:
• Failure to recognise that the relevant asset beta is that of the software division.
• The use of wrong leverage ratio.
• Making use of the tax rate of VT (30%) even when the tax rate of the proxy
company was clearly given as 20%.
In part (b), marks were lost due to the following errors:
• Including cash in the calculation of FCFE
• Wrong calculations of purchase of Non – current assets
• Wrong calculation of depreciation
• Failure to adjust for tax
In part (c), the candidates could not calculate the terminal value of the company
at the end of year 3.
It is recommended that students preparing for the institute’s examination
should cover the syllabus comprehensively.
95
Marks Marks
a. Determination of the equity beta of the software 2
division
Ungearing of the equity beta of the software division to
get asset beta 2
Regearing of the above asset beta 2
Computation of the required rate of return using CAPM 1 7
SOLUTION 2
96
97
Year Cashflow PV at 6% PV at 7%
₦m ₦m ₦m
0 (300) (300) (300)
1–5 15.958 67.221 65.431
5 319.149* 238.487 227.549
NPV 5.708 (7.020)
5.708
𝑌𝑇𝑀 = 6 + (7 − 6) = 6.45%
5.708 + 7.020
(* Note that cash of ₦300m is needed. With a discount of 6%, the face value of the
bond must be: ₦300m × 100/94 = ₦319.149. Interest is calculated on face value.
Thus, the annual total interest is 5% of ₦319.149)
98
Year Cashflow PV at 8% PV at 9%
₦ ₦ ₦
0 (100) (100) (100)
1–5 4.5 17.967 17.503
5 120.788 82.206 78.504
NPV 0.173 (3.993)
0.173
IRR = 8 + (9 − 8) = 8.04%
0.173 + 3.993
Examiner’s report
This question tests candidates’ knowledge of the cost of various sources of debt
financing.
Candidates were expected to calculate the relevant yield for each type of debt
finance.
Only very few candidates attempted the question with very poor level of
performance.
There was a very strong evidence that candidates could not carry out the required
level of analysis. The relevant cash flows needed for the yield calculations could not
be isolated.
Candidates are advised to practise standard examination questions when preparing
for the examinations.
99
Marks Marks
a. Identification of yield of bank loan 1
Computation of yield to maturity of the bond 3
More discussion about the queries of director A 2
Computation of conversion value 1½
Computation of yield of the convertible bond 2½
More discussion about the queries of director B 2
Discussion about the concerns of director C 2
Recommendation 1 15
SOLUTION 3
a) Depreciation has been included in “other costs” but since it is not a cash flow it
must be removed. Annual depreciation using the straight line method is ₦50,000
(₦200,000 – ₦50,000) /3 years).
Revenues and costs need to be further adjusted using the values of receivables
and payables to convert them into cash flows.
Calculations follow below:
Year 0 1 2 3 4
₦ ₦ ₦ ₦ ₦
Investment (200,000) 50,000
100
NPV = ₦39,449
101
Examiner’s report
This question tests candidates’ knowledge of standard investment appraisal.
Part (a) demands the calculation of NPV.
Part (b) asks candidates to explain the treatment of inflation in investment appraisal.
Part (c) deals with elementary single - period capital rationing.
Almost all the candidates attempted the question but surprisingly the level of
performance was very poor.
Candidates lost marks due to the following factors:
• Failure to adjust the cash flows for receivables and payables.
• Failure to base tax calculations on incremental cash profits.
• Failure to comply with the timing of tax payment.
In part (b), most of the candidates who attempted the question could not explain the
treatment of inflation in investment appraisal.
To hedge against failure in future examinations, candidates are advised to read
widely and practise past examination questions.
Marking guide
Marks Marks
a. Computation of depreciation 1
Computation of investment and scrap value ½
Computation of sales ½
Computation of closing receivables 1
Computation of opening receivables 1
Computation of product cost 1
Computation of closing payables & closing payables 2
Computation of pre-tax net cash flow ½
Computation of taxation 1½
Computation of net tax due 2
Computation of post-tax net cash flow ½
Computation of discount factor 1
Computation of PV ½
Computation of NPV 1 14
102
SOLUTION 4
a) The treasury function represents one of the two main aspects of financial
management, the other being financial control.
Treasury is concerned with the relationship between the entity and its
financial stakeholders, which include shareholders, funds lenders and
taxation authorities, while financial control provides the relationship with
other stakeholders such as customers, suppliers, and employees.
In larger entities, treasury will usually be centralised at head office, providing
a service to the various units of the entity and thereby achieving economies of
scale. Financial control will frequently be delegated to individual business
units, where it can more closely impact on customers and suppliers and relate
more specifically to the competition which those units have to face. As a result,
treasury and financial control may often be separated by location as well as
by responsibilities.
The key tasks of the treasury can be categorised according to the three levels
of management as follows:
• Strategic – e.g. matters concerning the capital structure of the business
and distribution/retention policies, raising capital, including share issues,
assessment of the likely return from each source and the appropriate
proportions of funds from each source, the decision as to the level of
dividends, and consideration of alternative forms of finance;
• Tactical – e.g. the management of cash/investments and decisions as to the
hedging of currency or interest rate risk;
• Operational – e.g. the transmission of cash, placing of surplus cash and
other dealings with banks.
Treasurers require specialist skills to be able to handle effectively an ever-
growing range of capital instruments. They also need a knowledge of taxation
in all areas in which the group operates, and the ability to advise on policies
that have taxation implications.
Both the treasurer and the financial controller will usually be responsible to
the finance director. An example of how their roles may differ would be: the
103
104
This is a question of two parts, both dealing with treasury department. Part (a) tests
candidates’ knowledge of the functions of treasury department. In part (b)
candidates were expected to discuss the advantages and disadvantages of operating
the treasury department as a profit centre rather than cost centre.
Almost all the candidates attempted the question with average level of performance.
It is apparent that majority of the candidates were ill-equipped in this important area
of finance. They therefore failed to pick up easy marks expected in this type of
question.
To increase the chance of success in the examination, students need to practise
standard examination questions.
Marking guide
Marks Marks
a. Explanation of treasury function 3½
Describing the main responsibility of treasury
department 3
Discussion the advantages of a separate treasury
function 7½ 14
105
a)
KE = 4 + (1.2 × 5) = 10%
Since the conversion value is higher than the redemption value, it is assumed
that the bondholders will likely convert.
After-tax interest payment = 0.07 × 100 × (1- 0.3) =N4.90 per bond
(2.54)
106
b) Market values of different sources of finance are preferred to their book values
when calculating weighted average cost of capital (WACC) because market
values reflect the current conditions in the capital market. The relative
proportions of the different sources of finance in the capital structure reflect
more appropriately their relative importance to a company if market values
are used as weights. For example, the market value of equity is usually much
greater than its book value, so using book values for weights would seriously
underestimate the relative importance of the cost of equity in the weighted
average cost of capital.
If book values are used as weights, the WACC will be lower than if market
values were used, due to the understatement of the contribution of the cost of
equity, which is higher than the cost of capital of other sources of finance. This
can be seen in the case of JP, where the market value after-tax WACC was
found to be 9.4% and the book value after-tax WACC is 8.7% (10% × 320 + 8%
× 80 + 6.43% × 160/560).
If book value WACC were used as the discount rate in investment appraisal,
investment projects would be accepted that would be rejected if market value
WACC were used. Using book value WACC as the discount rate will therefore
lead to sub-optimal investment decisions.
As far as the cost of debt is concerned, using book values rather than market
values for weights may make little difference to the WACC, since bonds often
trade on the capital market at or close to their nominal (par) value. In
addition, the cost of debt is lower than the cost of equity and will therefore
make a smaller contribution to the WACC. It is still possible, however, that
using book values as weights may under – or over-estimate the contribution
of the cost of debt to the WACC.
107
Marking Guide
108
You need to sell dollars in other to buy pounds, so we need to buy futures.
Which expiry date?
The first futures to mature after the expected payment date (transaction date) are
choosen. We therefore select the 5-month expiry date.
How many contracts?
₤5,000,000 ÷ ₤62,500 = 80 contracts
So we buy 80 contracts at $1.9170/₤
Predicted futures rate
Current basis = spot price – futures price = 1.9410 – 1.9170 = 0.0240
2
Unexpired basis on the transaction date = 5 × 0.0240 = 0.0096
Lock-in exchange rate = opening futures price + unexpired basis
= 1.9170 + 0.0096 = 1.9266
Expected total cost = 5,000,000 × $1.9266 = $9,633,000
109
Examiner’s report
The question tests the candidates’ knowledge of foreign exchange risk hedging
techniques of forward contracts, currency futures contracts, and currency options.
Only about 5% of the candidates attempted the question. It is highly disappointing
that despite the fact that the question was a verbatim reproduction of a very recent
past question, candidates’ performance was unacceptably low. This simply means
that students are not making use of the institute’s pathfinder.
It is recommended that students should make effective use of study materials
provided by the institute.
Marking guide
Marks Marks
a. Identification of the appropriate selling rate 1
Computing the cost of the forward contract 1
Decision to buy or sale futures ½
Selecting the 5 months expiry date ½
Computation of contract size ½
Computation of current basis 1
110
SOLUTION 7
a) Residual theory of dividends. Dividends are only paid out if the capital needs of
the enterprise (i.e. project with positive NPVs) are fully met and there are funds
left over. Corporate profits are cyclical, but capital investment plans involve long-
term commitments, then dividends take up the slack, as it were.
Financial managers cannot follow both a policy of stable dividends and a policy
of long-term commitment to capital investment, unless they are willing to borrow
in times of need to achieve both. With an objective of shareholder wealth
maximisation, if the enterprise can invest in profitable projects (i.e. in excess of
the cost of capital) and earn a higher return than the shareholders can in their
alternative investment opportunities, then it should follow such a policy. Issues
arise to strengthen and weaken the approach with market imperfections.
The argument runs like this. Enterprises establish a track record for giving or not
giving dividends. Shareholders recognise this and because of their preferences -
receiving income now instead of the future because they need it for consumption,
111
i) The required rate of return, KE, rises as dividend pay-out is reduced. Risk-
averse investors are not indifferent to the division of earnings into
dividends and capital gains in the share price;
iii) With volatile stock markets, the maintenance of the increase in share price
is not guaranteed. Shareholders may prefer to have the cash and invest it
or spend it, particularly with the presence of agency costs.
112
Marking guide
Marks Marks
Discussion on residual theory of dividend 3
Discussion on clientele effect 3
Discussion on asymmetric information 2
Discussion on signally properties of dividends 3
Discussion on the bird-in-the hand argument 4
Total 15
113
PATHFINDER
NOVEMBER 2022 DIET
PROFESSIONAL LEVEL EXAMINATIONS
Question Papers
Suggested Solutions
Examiner‟s Reports
and
Marking Guides
QUESTION 1
Abayomi Plc (AP) is a major electrical company in Nigeria. The directors have
recently identified Togo as a priority location for business expansion. Togo uses
currency T$. Assume today is 30 August 2021.
Company K3, located in Togo, has been identified as a potential acquisition target.
AP already manages two business units in Togo, named K1 and K2, and these have
shown strong performance under AP‟s ownership.
K3 is a private company and 100% of its shares are owned by the family that
founded it. Many shareholders are keen to realise their investment by selling the
company to AP.
Both companies are working towards an effective date for the sale of K3 to AP on 1
January 2022.
80
Forecast financial data for K3 for year 2022 onwards, following acquisition by AP
Following consultation with the directors of K3, AP‟s Finance Director has prepared
the following forecast data for K3 assuming it is acquired on 1 January 2022.
Forecast data for K3:
• Free cash flow to the firm, ignoring synergistic benefits, of T$54.6 million in
2022, growing by 4% a year in perpetuity.
• One-off synergistic cash flow benefit of T$8.0 million after tax in 2022.
• After tax annual synergistic cash flow benefit, starting with T$5.0 million in
2023 and then increasing by 4% a year in perpetuity.
In any discounted cash flow analysis, cash flows should be assumed to arise at the
end of the year to which they relate.
A proxy company has been identified which is also located in Togo and has a
similar business model to K3.
81
Assume that Nigeria has the same risk free rate and market risk premium as Togo.
Required:
Assume you are the Finance Director of AP.
a. Advise on:
i. The types of synergistic benefit that might arise from the acquisition
of K3. (8 Marks)
ii. Possible reasons why both one-off and ongoing synergistic benefits
might not be achieved to the extent expected. (4 Marks)
82
The board of directors has recently agreed to support a proposal by the new chief
executive that the company purchase new manufacturing equipment to enable it to
expand its range of dairy products. The new equipment will cost N50 million and
the company is seeking to raise new finance to fund the expenditure in full.
However, the board of directors is undecided as to how the new finance is to be
raised. The directors are considering either a 1 for 5 rights issue at a price of N2.50
per share with a theoretical ex-rights‟ price of N2.92 or a convertible loan of N50
million.
The loan will be secured against the company‟s freehold land and buildings. The
company‟s share is presently quoted at a price of N3.00 per share.
Required:
a. Explain the terms „rights issue‟ and „convertible loans.‟ (3 Marks)
b. Explain how „theoretical ex-rights‟ price of N2.92 is calculated and why the
actual price might be different.
Show your workings. (4 Marks)
c. Prepare a report for the board of directors that fully evaluates the two
potential methods of financing the company‟s expansion plans. (13 Marks)
(Total 20 Marks)
QUESTION 3
Zakai (ZK) Plc is a listed company that owns and operates a large number of farms
throughout the country. A variety of crops are grown.
Financing structure
The following is an extract from the statement of financial position of ZK Plc at 30
September 2021.
₦‟million
Ordinary shares of ₦1 each 200
Reserves 100
9% irredeemable ₦1 preference shares 50
8% loan stock 2022 250
600
83
The market price per preference share was ₦0.90 ex div on 30 September 2021.
Loan stock interest is paid annually in arrears and is allowable for tax at 30%. The
loan stock was priced at ₦100.57 ex interest per ₦100 nominal on 30 September
2021. Loan stock is redeemable on 30 September 2022.
Assume that taxation is payable at the end of the year in which taxable profits
arise.
A new project
Difficult trading conditions have caused ZK Plc to decide to convert a number of its
farms into camping sites with effect from the 2022 holiday season. Providing the
necessary facilities for campers will require major investment, and this will be
financed by a new issue of loan stock. The returns on the new campsite business
are likely to have a very low correlation with those of the existing farming business.
Required:
a. Using the capital asset pricing model, calculate the required rate of return
on equity of ZK Plc at 30 September 2021. Ignore any impact from the new
campsite project. (3 Marks)
b. Briefly explain the implications of a beta of less than 1, such as that for ZK
Plc. (2 Marks)
c. Calculate the weighted average cost of capital of ZK Plc at 30 September
2021 (use your calculation in answer to requirement (a) above for the cost of
equity). Ignore any impact from the new campsite project. (10 Marks)
d. Without further calculations, identify and explain the factors that may
change ZK Plc‟s equity beta during the year ending 30 September 2022.
(5 Marks)
(Total 20 Marks)
QUESTION 4
Tayo Kayode (TK) is a highly successful beverage company listed on the Nigerian
stock market. Its products are particularly attractive to the younger generation.
84
₦‟million
Net present value -250
Present value of future cash flows 4,500
The current long-term government bond yield is 5%. The expected standard
deviation of future cash flows is estimated to be 35%.
Required:
a. Comment on the views of the Marketing and Finance Directors. (5 Marks)
b. Using the Black-Scholes option pricing model for an European call option,
estimate the value of the option to commercially develop and market the
Younky. Provide a recommendation as to whether or not TK should
manufacture the Younky. (10 Marks)
c. Comment on modeling the possibility of delay as a European call option.
(5 Marks)
(Total 20 Marks)
85
QUESTION 5
ADERUPOKO PLC
Aderupoko Plc (ADP), a large listed media group, has been the holding company of
Adamu Publishers Limited. (APL) since 2015. The publishing company (APL) is 100%
owned by ADP since inception.
Recently the directors of APL informed ADP‟s board of their readiness to make a
management buy-out (MBO) of APL. Accordingly, ADP‟s board decided to value APL
using the shareholder value analysis method (SVA). ADP‟s board estimates that APL
has a four-year competitive advantage over its competitors (to 30 September, 2024)
and the following data regarding APL‟s value drivers and additional financial
information has been collected.
Required:
a. Calculate the value of APL‟s equity using SVA (12 Marks)
b. Outline THREE methods by which APL‟s directors might raise the funds
necessary for the proposed MBO of the company (3 Marks)
(Total 15 Marks)
86
Required:
a. Illustrating your answer by use of data from the table above, define and
explain the term P/E ratio, and comment on the way it may be used by an
investor to appraise a possible share purchase. (8 Marks)
b. Using data in the above table, calculate the dividend cover for C and B, and
explain the meaning and significance of the measure from the point of view
of equity investors. (7 Marks)
(Total 15 Marks)
QUESTION 7
'Looking to the year ahead, there are a number of measures which I propose to
increase the company's earnings per share (EPS).
Payments to trade creditors should be made as late as possible, even if this means
extending our credit beyond the terms allowed by our suppliers. The company
currently runs a substantial overdraft and this measure will cut the level of bank
interest and charges.
Staff pay should be frozen at this year's level for the forthcoming year. The
company's sponsorship of the local charity events run by the Staff Social Club
should also, regrettably be ended.
87
Required:
a. Prepare a response to the Chairman's proposals which examines the possible
consequences of the proposals for the price of the company's shares and for
the company's stakeholders. (9 Marks)
88
Equity Beta
𝑉𝐷
𝛽𝐸 = 𝛽𝐴 + (𝛽𝐴 − 𝛽𝐷 ) (1 − 𝑡)
𝑉𝐸
Growing Annuity
𝑛
𝐴1 1+𝑔
𝑃𝑉 = 1−
𝑟−𝑔 1+𝑟
89
r
Where r = discount rate
n = number of periods
1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1
2 1·970 1·942 1·913 1·886 1·859 1·833 1·808 1·783 1·759 1·736 2
3 2·941 2·884 2·829 2·775 2·723 2·673 2·624 2·577 2·531 2.487 3
4 3·902 3·808 3.717 3·630 3.546 3.465 3·387 3·312 3·240 3·170 4
5 4·853 4·713 4·580 4·452 4·329 4·212 4·100 3·993 3.890 3·791 5
6 5·795 5·601 5·417 5·242 5·076 4·917 4·767 4·623 4.486 4·355 6
7 6·728 6.472 6·230 6·002 5·786 5·582 5·389 5·206 5·033 4·868 7
8 7·652 7·325 7·020 6·733 6·463 6·210 5·971 5·747 5·535 5·335 8
9 8·566 8·162 7·786 7.435 7·108 6·802 6·515 6·247 5·995 5·759 9
10 9·471 8·983 8·530 8·111 7·722 7·360 7·024 6·710 6.418 6·145 10
11 10·368 9·787 9·253 8·760 8·306 7·887 7.499 7·139 6·805 6.495 11
12 11·255 10·575 9·954 9·385 8·863 8·384 7·943 7·536 7'161 6·814 12
13 12·134 11·348 10·635 9·986 9·394 8·853 8·358 7·904 7·487 7·103 13
14 13·004 12·106 11·296 10·563 9·899 9·295 8·745 8·244 7·786 7·367 14
15 13·865 12·849 11·938 11·118 10·380 9·712 9·108 8·559 8·061 7·606 15
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1
2 1·713 1·690 1·668 1·647 1·626 1·605 1·585 1·566 1·547 1·528 2
3 2.444 2.402 2·361 2·322 2·283 2·246 2·210 2·174 2·140 2·106 3
4 3·102 3·037 2·974 2·914 2·855 2·798 2·743 2.690 2·639 2.589 4
5 3·696 3·605 3·517 3·433 3·352 3·274 3·199 3·127 3·058 2·991 5
6 4·231 4·111 3·998 3·889 3·784 3·685 3·589 3.498 3.410 3·326 6
7 4·712 4·564 4.423 4·288 4·160 4·039 3·922 3·812 3·706 3·605 7
8 5·146 4·968 4.799 4·639 4.487 4·344 4·207 4·078 3·954 3·837 8
9 5·537 5·328 5·132 4·946 4·772 4·607 4.451 4·303 4·163 4·031 9
10 5·889 5·650 5.426 5·216 5·019 4·833 4·659 4.494 4·339 4·192 10
11 6·207 5·938 5·687 5.453 5·234 5·029 4·836 4·656 4.486 4·327 11
12 6·492 6·194 5·918 5·660 5·421 5·197 4·988 4·793 4·611 4.439 12
13 6·750 6.424 6·122 5·842 5·583 5·342 5·118 4·910 4·715 4·533 13
14 6·982 6·628 6·302 6·002 5·724 5.468 5·229 5·008 4·802 4·611 14
15 7·191 6·811 6.462 6·142 5·847 5·575 5·324 5·092 4·876 4·675 15
90
92
93
VD t
WACCg = K EU 1 −
Vg
25 × 0.3
= 10.376 1 − = 9.60%
75 + 25
(Notes: KEU = WACCU, Vg = VEG + VD, using the given D:E ratio of AP)
94
Value of K3 in T$ million
At the proxy company‟s P/E of 12: 408 (= 12 x 34 m)
At AP‟s P/E of 14 (bootstrapping): 476 (= 14 x 34 m)
DCF approach
- Excluding synergy (T$ million)
PV of free cash flow to the firm (FCFF) = FCFF1/(WACC - g)
= 54.60/(0.096 – 0.04) = 975
Less borrowings 375
Total value of equity 600
- Including synergy (T$ million)
Total as above 600
- One-off synergy = 8/1.096 = 7.3
- Perpetual synergy = (5/(0.096 – 0.04))/1.096 = 81.5 88.80
688.80
Or (say) 689
Summary of results
Examiner’s report
The question tests many aspects of acquisition and related business valuation. In
part (a) (i), candidates are expected to identify the types of synergistic benefits
expected from the given acquisition. In part (a) (ii), candidates are expected to
explain why it might be difficult to achieve synergistic benefits in practice.
In question (b) (i), candidates are expected to calculate risk-adjusted WACC needed
for the valuation. In question (b) (ii), candidates are expected to value the equity
of the company using different valuation methods.
Being a compulsory question, large number of the candidates attempted it but the
level of performance was disappointingly low.
95
In question (b) (i), candidates lost easy marks due to the following factors:
Use of wrong formulae in the process of „ungearing‟ (computing asset beta)
and „regearing‟ (computing equity beta); and
Poor understanding of the various financial gearing formulae:
D/E ratio, D/(E + D) ratio, etc. and when to use each one of them.
Candidates are advised to practise past questions, using the pathfinder and cover
the syllabus comprehensively, when preparing for future examinations.
Marking guide
Marks Marks
a. (i) Explanation on types of Synergistic benefits 8 8
(ii) Discussion on possible reasons for failure to
achieve expected benefits 4 4
96
a) Rights issue
Convertible loans
A convertible loan (or bond) is a loan stock that can be converted, at the
option (but not the obligation), of the holder (i.e. the lender) into ordinary
shares of issue (i.e. the borrower) on or before the maturity of the loan.
6 17.50
The actual market value of the shares may be different from the theoretical
price for the following reasons:
c) REPORT
97
For an established listed company, rights issues are much more popular for
the following reasons:
Rights issues are relatively cheap to make, perhaps less than half as
expensive as a public issue;
The issue price is relatively unimportant. Since all existing shareholders
benefit from the cheap price in proportion to their shareholding, there is
no disproportionate gain. The company needs to make the rights price
significantly cheaper than the market price. This puts pressure on
shareholders to take up the shares or to sell them to an investor who will.
Thus, rights issue tend not to fail, i.e. the shares tend to be issued and
the required cash raised;
Control tends to stay with the existing shareholders;
The need to discount the offer price to ensure that the issue is fully
subscribed and to cover the possibility that the market price of shares
might fall between the announcement of the rights issue and its
conclusion; and
The use of rights issue leaves the credit line free to finance further
expansion and enables the non-current assets to be used to secure other
lines of finance, if required.
It seems as if a rights issue would provide a cheaper and more practical way
for the company to raise the funds for the expansion.
Convertibles are a mixture of loan and equity financing. They are issued as
loan stocks with the right to convert them into equity shares of the same
company at some pre-determined rate and date.
From the investors‟ point of view they are relatively safe, in that there is a
close-to guaranteed interest payment periodically and a right to convert to
equity, if it is beneficial to do so.
98
Raising finance, unless it is from a mixture of debt and equity, will affect the
level of gearing, with probable implications for the risk/return profile and
the cost of capital.
Examiner’s report
The question tests the candidates‟ knowledge of rights issues and convertible loans.
The candidates are expected to compare rights issues and convertible loans as
sources of finance.
Most of the candidates did fairly well in parts (a) and (b) of the question but
performance in part (c) was far below expectation.
Candidates failed to gain good marks because they were discussing equity finance
(rather than rights issue) and debt finance (rather than convertible loans).
At this level of the examination, candidates must understand that they are required
to answer the question asked and not the question they wanted.
Marking guide
Marks Marks
a. Explanation of Right Issues 1½
Explanation of Convertible loans 1½ 3
b. Computation of the theoretical ex-rights 2
Discussion on why the actual price might be different 2 4
c. Report address 1
Evaluation of the right issues financing method 6
Evaluation of the convertible loan financing method 6 13
Total 20
99
b) The beta is a measure of the extent to which historic movements in ZK‟s share
price have correlated with average market returns. A beta of less than 1 means
that the share price is less volatile than the market. Thus, at 0.8, it means that if
the market index rises by 10% then on average the share price of ZK would be
expected to increase by 8%.
This argument does not however mean that the required rate of return on ZK‟s
shares also moves in direct proportion to the required return on the market as
this is also affected by the risk free rate.
9
c) Cost of preference shares = = 10%
90
Total value = ₦50m × 0.9 = ₦45m
Cost of debt
Working with face value of ₦100 nominal
With 1 year to redemption, the following formula can be used to calculate the
cost of debt:
EV
KD = − 1, where:
BV
Calculation of WACC
Capital Total value Cost Hash total
₦m % ₦m
Equity 600.00 13 78.00
Pref shares 45.00 10 4.50
Loan stock 251.43 5 12.57
896.42 95.07
WACC = 95.07/896.43 = 10.61%
d) There are three major factors occurring during 2021 which may impact upon the
beta of ZK Plc. These are:
• The opening of a new business venture in campsites;
• The financing of the new venture with a new issue of bonds; and
• The refinancing of the existing debt which is redeemable in 2021.
100
101
Marking guide
Marks Marks
a. Computation of required return on equity 3 3
b. Explanation of the implication of beta less than 1 2 2
c. Computation of cost of preference share 1
Computation of total value of preference share 1
Computation of the total cash flow expected in year 1 loan 1
stock
Computation of cost of debt 2
Computation of the total value of loan stock 1
Calculation of WACC 4 10
d. Identification and explanation of factors that may change 5 5
equity beta
Total 20
102
a) Both Directors are correct to a point but are failing to see the whole picture.
The Marketing Director is correct in her interpretation of the calculated NPV. The
NPV can normally be interpreted as showing the impact of a project on
shareholder wealth, so a negative NPV would indicate that the investment
would erode shareholder value and should thus be rejected.
The Finance Director (FD) is correct to point out a weakness of conventional NPV
analysis. High uncertainty is usually reflected in a higher discount rate and
hence a lower NPV. However, greater uncertainty will usually result in higher
option values, so the FD is correct to suggest that option values must be
incorporated and that TK has an option to delay investment, giving a call
option.
The FD is wrong to suggest that ignoring options is the only weakness of NPV. A
more complete analysis would also try to incorporate non-financial factors such
as the possible implications for TK‟s image with alcoholic research laboratories
(targeting the younger generation). Some investors and customers may object to
this link and hence future sales would be compromised.
103
c) The Black - Scholes model was developed for European options. As production
could commence at any time during the 1 year period the option is an
American option rather than a European option.
It can be argued that, where there is no dividend payable and where time
value still exists, it is worthwhile holding an American option to expiry and
thus the valuation as a European call is valid.
In this case, however, it is likely that investment would be commenced (i.e.
the call option exercised) as soon as the forecast NPV became positive due to
revised forecasts. The valuation as a European call would thus give a lower
limit on the value of the option to delay.
Examiner’s report
The entire question 4 tests candidates‟ knowledge of real options.
In part (a), candidates are expected to explain the impact of real option on net
present value of a capital project. In part (b), candidates are expected to value a
call option on a capital project – using Black-Scholes Option Pricing Model.
Part (c), tests the candidates‟ knowledge on the practical limitations of the above
model.
Less than 5% of the candidates attempted the question. Their performance indicates
lack of knowledge of this area of the syllabus.
104
SOLUTION 5
a)
Year 1 2 3 4 5 – Infinity
₦m ₦m ₦m ₦m ₦m
Sales (see workings) 84.00 87.40 90.00 91.80 91.80
Operating profit 6.72 7.87 9.00 9.18 9.18
Tax at 20% (1.34) (1.57) (1.80) (1.84) (1.84)
Depreciation 2.00 2.00 2.00 2.00 2.00
Operating cash flow 7.38 8.30 9.20 9.34 9.34
Replacement non-current assets (2.00) (2.00) (2.00) (2.00) (2.00)
Capital expenditures (0.20) (0.20) (0.08) (0.04) (0.00)
Working capital (0.24) (0.17) (0.10) (0.07) (0.00)
Free cash flow 4.94 5.93 7.02 7.23 7.34
PVF at 10% 0.909 0.826 0.751 0.683 6.830*
PV 4.49 4.89 5.27 4.94 50.10
₦m
Total PV 69.69
Add short-term investment 0.80
Less market value of debentures = ₦10m × 95/100 = (9.50)
Total value of equity 60.99
(* Annuity factors at 10% years 5 – infinity)
105
Year 0 1 2 3 4 5 - Infinity
₦m ₦m ₦m ₦m ₦m ₦m
Sales* 80.0 84.0 87.4 90.0 91.8 91.8
Sales increase - 4.0 3.4 2.6 1.8 0
Capital expenditure* - 0.20 0.20 0.08 0.04 0
Additional working capital* - 0.24 0.17 0.10 0.07 0
v) Mezzanine finance
A hybrid of debt and equity financing that gives the lender the right
to convert to an equity interest in the company in case of default,
generally, after venture capital companies and other senior lenders
are paid.
106
Examiner’s report
This question tests candidates‟ knowledge of the computational aspect of
shareholder value analysis (SVA). Candidates are expected to calculate the freecash
flow using SVA and value the company.
Only very few candidates attempted the question. Based on the candidates
performance level, it is clear that candidates do not have any knowledge of the
subject matter. Performance in the question was therefore extremely poor.
Marking guide
Marks Marks
Computation of sales 1
Computation of operation profit 1
Computation of tax 1
Computation of depreciation 1
Computing replacement of non-current assets 1
Computation of capital expenditure 1
Computation of working capital 1
Computation of free cashflow 1
Computation of PVF 1
Computation of PV 1
Computation of value equity 2 12
Discussion on methods of raising funds for the
proposed MBO of the company 3 3
Total 15
107
a) Price-earnings ratio
The price earnings (P/E) ratio is regarded by many as the most important
yardstick for assessing the relative worth of a share. It is calculated as:
Market price of share Total market value of equity
=
EPS Total earnings
The P/E ratio is a measure of the relationship between the market value of a
company's shares and the earnings from those shares. It is an important ratio
because it relates two key variables for investors, the market price of a share
and its earnings capacity.
Comparisons
Earnings potential is strongly related to the sector in which the business
operates, and therefore P/E comparisons are only valid in respect of companies
in the same market sectors. They can be used in this case since all the
companies are publicly quoted food retailers.
A has a current share price of 63 kobo and a P/E ratio of 14.2. Earnings for last
year were therefore 4.437 kobo per share (63/14.2). At its high point for the year
when the share price was 112, the P/E ratio was 25.2, while at its low point, the
108
b) Dividend cover
The dividend cover is the number of times that the actual dividend could be
paid out of current profits. It indicates the proportion of distributable profits for
the year that is being retained by the company and the level of risk that the
company will not be able to maintain the same dividend payments in future
years, should earnings fall.
Dividend paid
Div yield =
Market share price
Dividend paid
P/E × Div yield = since the market share price cancels out
Earnings
Comparisons
As, with the P/E ratio, comparisons with other companies in the same sector are
a lot more valuable than comparisons with companies in different sectors, as
the 'typical rate' for different business sectors will vary widely.
109
Examiner’s report
This question tests candidates‟ knowledge of key capital market financial ratios.
Part (a) of the question asks the candidates to explain and illustrate P/E ratio. Part
(b) asks candidates to calculate and explain dividend cover.
More than 80% of the candidates attempted the question and surprisingly the level
of performance was very poor.
Almost all the candidates who attempted the question could not correctly calculate
dividend cover. More disappointly however, very large proportion of the candidates
could not give meaningful interpretation of the two ratios.
It is recommended that candidates should always practise with past questions and,
in addition, read financial papers when preparing for future examination.
Marking guide
Marks Marks
a. Definition and explanation of P/E ratio 2
Comment on the way P/E ratio may be used by investor to
appraise a possible share purchase 6 8
b. Meaning of dividend cover 1
Calculation of dividend cover for C and B 4
Significance of the measure of dividend cover for C and B
for investment purpose 2 7
Total 15
110
a) To: Chairman
From: Finance Director
Date: 15 June 2021
Subject: Proposals aimed at maximisation of the share price
Further to our recent discussions, I agree fully with your desire to seek the
maximisation of the company's share price and therefore its market
capitalisation.
However, although I agree that a relationship does exist between reported
profits, earnings per share and the share price, short-term are not in themselves
the principal driver of the share price.
I believe that some of the current proposals could damage the position of some
of the groups of stakeholders in the firm and could even have a negative impact
on the share price.
111
Signed
Finance Director
Performance-related pay
Part of the remuneration of managers can be made conditional upon their
achieving specified performance targets, so that achieving these performance
targets assists in achieving stakeholder objectives. Achieving a specified
increase in earnings per share, for example, could be consistent with the
112
Monitoring
One theoretical way of encouraging managers to achieve stakeholder objectives
is to reduce information asymmetry by monitoring the decisions and
performance of managers. One form of monitoring is auditing the financial
statements of a company to confirm the quality and validity of the information
provided to stakeholders.
Note: Only four ways to encourage the achievement of stakeholder objectives
were required to be discussed.
113
Almost all the candidates attempted the question and the level of performance was
above average.
Effective revision, using past questions and the pathfinder will always enhance
candidates‟ performance in the examination.
Marking guide
Marks Marks
a. Report on the possible consequences of the proposal 9 9
b. Discussion on ways that encourage managers to achieve
stakeholders objectives 6 6
Total 15
114
1. Check your pockets, purse, mathematical set, etc. to ensure that you do not
have prohibited items such as telephone handset, electronic storage device,
programmable devices, wristwatches or any form of written material on you
in the examination hall. You will be stopped from continuing with the
examination and liable to further disciplinary actions including cancellation
of examination result if caught.
6. Do NOT answer more than the number of questions required in each section,
otherwise, you will be penalised.
7. All solutions should be written in BLUE or BLACK INK. Any solution written
in PENCIL or RED INK will not be marked.
8. A formula sheet and discount tables are provided with this examination
paper.
87
QUESTION 1
KK, a company quoted on the Stock Exchange, has cash balance of ₦230 million
which are currently invested in short-term money market deposits. The cash is
intended to be used primarily for strategic acquisitions, and the company has
formed an acquisition committee with a remit to identify possible acquisition
targets. The committee has suggested the purchase of ZL, a company in a different
industry that is quoted on the AIM (Alternative Investment Market). Although ZL is
quoted, approximately 50% of its shares are still owned by three directors. These
directors have stated that they might be prepared to recommend the sale of ZL, but
they consider that its shares are worth ₦220 million in total.
Summarised financial data
KK ZL
₦’000 ₦’000
Revenue 4,800,000 380,000
Pre tax operating cash flow 510,000 53,000
Taxation (33%) (168,300) (17,490)
Post tax operating cash flow 341,700 35,510
KK ZL
Long-term finance
Ordinary shares (25 kobo par) 100,000 (ZL 10 kobo par) 5,000
Reserves 1,583,200 52,000
12% Bond 200,000 -
10% Bank term loan 150,000 Recent 11% bank loan 35,000
2,033,200 92,000
88
The risk free rate of return is 6% per annum and the market return is 14% per
annum.
The rate of inflation is 2.4% per annum and is expected to remain at approximately
this level.
Expected effects of the acquisition:
(i) 50 employees of ZL would immediately be made redundant at an after tax cost
of ₦12 million. Pre-tax annual wage savings are expected to be ₦7.50 million (at
current prices) for the foreseeable future.
(ii) Some land and buildings of ZL would be sold for ₦8 million (after tax).
(iii) Pre-tax advertising and distribution savings of ₦1.50 million per year (at current
prices) would be possible.
(iv) The three existing directors of ZL would each be paid ₦1 million per year for
three years for consultancy services. This amount would not increase with
inflation.
Required:
a. Calculate the value of ZL based upon:
i. The use of comparative P/E ratios (3 Marks)
ii. The dividend valuation model (4 Marks)
iii. The present value of relevant operating cash flows over a 10 year period
(10 Marks)
iv. Provide an evaluation of each of the three valuation methods in (i) to (iii)
above. (7 Marks)
v. Recommend whether KK should go ahead with the offer for ZL. (2 Marks)
89
90
Required:
a. Stock market analysts sometimes use fundamental analysis and sometimes
technical analysis to forecast future share prices.
What are fundamental analysis and technical analysis? (4 Marks)
b. Using the dividend valuation model, estimate what a fundamental analyst
might consider to be the intrinsic (or realistic) value of the company‟s shares.
Comment upon the significance of your estimate for the fundamental analyst.
(12 Marks)
c. Explain whether your answer to (b) above is consistent with the semi-strong
and strong forms of the efficient markets hypothesis (EMH), and comment upon
whether financial analysts serve any useful purpose in an efficient market.
(4 Marks)
(Total 20 Marks)
QUESTION 3
Tinco Limited (TL) is considering an expansion project. The project will involve the
acquisition of an automated production machine costing ₦11,000,000 and payable
now. The machine is expected to have a disposal value at the end of 5 years, which
is equal to 10% of the initial expenditure.
The following schedule reflects a recent market survey regarding the estimated
annual sales revenue from the expansion project over the Project‟s five-year life:
Level of demand ₦’000 Probability
High 16,000 0.25
Medium 12,000 0.50
Low 8,000 0.25
It is expected that the contribution to sales ratio will be 50%. Additional
expenditure on fixed overheads is expected to be ₦1,800,000 per annum.
91
Required:
a. i Evaluate the proposed expansion from a financial perspective. (10 Marks)
ii Calculate and interpret the sensitivity of the project to changes in:
the expected annual contribution (3 Marks)
the tax rate (2 Marks)
b. You have now been advised that the capital cost of the expansion will qualify for
written down allowances at the rate of 25% per annum on a reducing balance
basis. Also, at the end of the project‟s life, a balancing charge or allowance will
arise equal to the difference between the scrap proceeds and the tax written
down value.
You are required to calculate the financial impact of these allowances. (5 Marks)
(Total 20 Marks)
QUESTION 4
The directors of Kenny plc wish to make an equity issue to finance an ₦800 million
expansion scheme, with an expected net present value of ₦110 million. It is also to
re-finance an existing 15% term loan of N500m and pay off penalty of N35m for
early redemption of the loan. Kenny has obtained approval from its shareholders to
suspend their pre-emptive rights and for the company to make a ₦1,500 million
placement of shares which will be at the price of 185 kobo per share. Issue costs
are estimated to be 4 per cent of gross proceeds. Any surplus funds from the issue
will be invested in commercial paper, which is currently yielding 9 per cent per
year.
92
QUESTION 5
a. The following financial information relates to TAXIM Plc, a listed company:
Year 2021 2020 2019
Profit before interest and tax (₦m) 18.3 17.7 17.1
Profit after tax (₦m) 12.8 12.4 12.0
Dividends (₦m) 5.1 5.1 4.8
Equity market value (₦m) 56.4 55.2 54.0
TAXIM Plc has 12 million ordinary shares in issue and has not issued any new
shares in the period under review. The company is financed entirely by equity.
The annual report of TAXIM Plc states that the company has three financial
objectives:
Objective 1: To achieve growth in profit before interest and tax of 4% per
year
Objective 2: To achieve growth in earnings per share of 3.5% per year
Objective 3: To achieve total shareholder return of 5% per year
TAXIM Plc has a cost of equity of 12% per year.
93
QUESTION 7
Obong plc recently received a takeover bid from Abdul plc. If the bid for Obong plc
is successful, it will provide Abdul plc the needed competitive edge in research and
development to expand its laboratories into the production of the covid-19 vaccine.
The shareholders of Obong plc will only accept an offer that meets a required
return of 14% on their current shareholdings.
Obong plc recently paid a dividend of N20 and this is expected to grow at a rate of
7% for the foreseeable future.
Required:
a. Estimate the share price of Obong plc today. (2 Marks)
b. If Obong plc accepts the bid from Abdul plc, it is estimated that the new
growth rate will rise to 12% for the first 3 years and thereafter stabilise at 7%.
Calculate the new share price to the shareholders of Obong plc. (2 Marks)
c. As a financial advisor, recommend to the shareholders of Obong Plc whether
the offer from Abdul plc should be accepted. (2 Marks)
d. According to Efficient Market Hypothesis (EMH), it is believed that the
market would react instantly and accurately to the merger announcement
between Obong plc and Abdul plc.
Define briefly the THREE forms of EMH and their implications to the market.
(9 Marks)
(Total 15 Marks)
94
Equity Beta
𝑉𝐷
𝛽𝐸 = 𝛽𝐴 + (𝛽𝐴 − 𝛽𝐷 ) (1 − 𝑡)
𝑉𝐸
Growing Annuity
𝑛
𝐴1 1+𝑔
𝑃𝑉 = 1−
𝑟−𝑔 1+𝑟
95
r
Where r = discount rate
n = number of periods
1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1
2 1·970 1·942 1·913 1·886 1·859 1·833 1·808 1·783 1·759 1·736 2
3 2·941 2·884 2·829 2·775 2·723 2·673 2·624 2·577 2·531 2.487 3
4 3·902 3·808 3.717 3·630 3.546 3.465 3·387 3·312 3·240 3·170 4
5 4·853 4·713 4·580 4·452 4·329 4·212 4·100 3·993 3.890 3·791 5
6 5·795 5·601 5·417 5·242 5·076 4·917 4·767 4·623 4.486 4·355 6
7 6·728 6.472 6·230 6·002 5·786 5·582 5·389 5·206 5·033 4·868 7
8 7·652 7·325 7·020 6·733 6·463 6·210 5·971 5·747 5·535 5·335 8
9 8·566 8·162 7·786 7.435 7·108 6·802 6·515 6·247 5·995 5·759 9
10 9·471 8·983 8·530 8·111 7·722 7·360 7·024 6·710 6.418 6·145 10
11 10·368 9·787 9·253 8·760 8·306 7·887 7.499 7·139 6·805 6.495 11
12 11·255 10·575 9·954 9·385 8·863 8·384 7·943 7·536 7'161 6·814 12
13 12·134 11·348 10·635 9·986 9·394 8·853 8·358 7·904 7·487 7·103 13
14 13·004 12·106 11·296 10·563 9·899 9·295 8·745 8·244 7·786 7·367 14
15 13·865 12·849 11·938 11·118 10·380 9·712 9·108 8·559 8·061 7·606 15
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1
2 1·713 1·690 1·668 1·647 1·626 1·605 1·585 1·566 1·547 1·528 2
3 2.444 2.402 2·361 2·322 2·283 2·246 2·210 2·174 2·140 2·106 3
4 3·102 3·037 2·974 2·914 2·855 2·798 2·743 2.690 2·639 2.589 4
5 3·696 3·605 3·517 3·433 3·352 3·274 3·199 3·127 3·058 2·991 5
6 4·231 4·111 3·998 3·889 3·784 3·685 3·589 3.498 3.410 3·326 6
7 4·712 4·564 4.423 4·288 4·160 4·039 3·922 3·812 3·706 3·605 7
8 5·146 4·968 4.799 4·639 4.487 4·344 4·207 4·078 3·954 3·837 8
9 5·537 5·328 5·132 4·946 4·772 4·607 4.451 4·303 4·163 4·031 9
10 5·889 5·650 5.426 5·216 5·019 4·833 4·659 4.494 4·339 4·192 10
11 6·207 5·938 5·687 5.453 5·234 5·029 4·836 4·656 4.486 4·327 11
12 6·492 6·194 5·918 5·660 5·421 5·197 4·988 4·793 4·611 4.439 12
13 6·750 6.424 6·122 5·842 5·583 5·342 5·118 4·910 4·715 4·533 13
14 6·982 6·628 6·302 6·002 5·724 5.468 5·229 5·008 4·802 4·611 14
15 7·191 6·811 6.462 6·142 5·847 5·575 5·324 5·092 4·876 4·675 15
96
a) i) P/E ratio
Since ZL operates in a different industry, the comparative P/E ratio valuation
must be based upon the average P/E ratios in that industry. The P/E ratio of
7:1 will therefore be used.
Current share price 370 kobo
Earnings yield 19.2%
Earnings per share 71.04 kobo (370 × 19.2%)
Price per share 497.28 kobo (71.04 × 7)
Value of ZL ₦248.64m (₦4.9728 × 50m shares)
d0 (1 + g)
P0 =
Ke − g
₦8,420,000 (1 + 0.08)
P= = ₦206.67m
(0.124 − 0.08)
98
The first stage is to estimate what the operating cash flows will be following
the acquisition.
₦‘000
Current pre-tax operating cash flow 53,000
Post-acquisition adjustments:
Annual wage savings 7,500
Advertising/distribution savings 1,500
62,000
Taxation (33%) 20,460
Annual post tax cash flow 41,540
99
The discount rate used will be the existing weighted average cost of capital
(WACC) for ZL, although it must be recognised that this could be different
after the acquisition since KK is a much larger company and its shares are
quoted on the main market rather than the AIM. The cost of equity has
already been calculated above as 12.4%, and the cost of debt is 11% as per
the statement of financial position. The following expression will be used.
VE VD
WACC = K eg = + Kd 1 − T
VE + VD VE + VD
185 35
WACC = 12.4% + 11% (1 − 0.33)
(185 + 35) 185 + 35
WACC = 11.60%
This discount rate has been calculated on the basis of market values, and
therefore, will incorporate inflation. The cash flows (with the exception of the
consultancy fees) all exclude inflation and therefore, either the nominal
discount rate that has been calculated must be adjusted to the real rate, or
the cash flows must be adjusted to include inflation.
If we adjust the discount rate to exclude the expected 2.4% rate of inflation:
1.116 ÷ 1.024 = 1.0898, i.e. the real discount rate to be used is 8.98%, say
9.0%.
PV of cash flow
The present value of the cash flows can now be found.
100
101
In part (a), candidates are expected to value the given company using three
different methods.
Part (b) of the question tests the candidates‟ knowledge of regulation of take overs.
In part (a) of the question, candidates lost marks due to the following factors:
Use of wrong P/E ratio
Inability to derive the EPS from the given earnings yield
Failure to identify the relevant cash flows when using the operating cash
flows method
Using the wrong WACC.
In part (b), most of the candidates could not provide any meaningful
response.
Candidates need to practise past questions using the Pathfinder and cover the
syllabus comprehensively.
Marking guide
Marks Marks
(a) i. Computation of the value of ZL based on the use
of the comparative P/E ratios:
Selecting the average P/E of companies recently
taken over, based upon the offer price for ZL ½
Stating the current share price ½
Stating the earnings yield ½
Computation of the EPS ½
Computation of price per share ½
Computation of the value of ZL ½ 3
SOLUTION 2
The most important form of technical analysis is Chartism. Chartism involves the
study of historic share price and volume information to see if any patterns or
relationships exist. Chartists believe that historic share price behaviour, as
revealed by such patterns, will repeat itself and they analyse charts of current
share price movements to identify whether established historic patterns are
currently occurring. If such patterns are identified the chartists believe that the
historic patterns will reveal future share price movements. Knowledge of
company earnings or other economic data is not required. Technical analysis is
often said to have no underlying economic logic.
b) Cost of equity
• The asset beta of EHP (= 0.763) given in Table 1 reflects the systematic
business risk of the hotel industry. This will be used to calculate the equity
beta of AHP. Note that the other data given in the table are irrelevant since
we are already given the asset beta of the proxy.
103
Kobo
1
1
Year 1 7 1.25 = 7.54
1.16
1 2
2
2 7 1.25 = 8.13
1.16
7 1.25 2 (1.095) 1 2
3 − infinity × = 136.93
0.16−0.095 1.16
Intrinsic value per share 152.60
c) The semi-strong form of the EMH suggests that share prices quickly and without
bias, fully reflect all relevant publicly available information.
The strong form of the EMH goes one sta ge further in suggesting that share
prices fully reflect all information, including insider information.
If the EMH is correct, in either the semi-strong or strong form, the current
market price will already correctly value AHP‟s shares and there is nothing to be
104
Analysts still serve a useful purpose although their forecasts of future share
prices are of little value in an efficient market.
Examiner’s report
This is a 3-part question. In part (a), candidates are expected to explain
fundamental analysis and technical analysis.
In part (b), they are expected to determine, using dividend valuation model, the
intrinsic value of a company‟s shares. They are also expected to comment on the
relevance of intrinsic to the fundamental analyst.
In part (c), candidates are expected to demonstrate their knowledge of the efficient
market hypothesis.
Only about 20% of the candidates attempted the question. It is absolutely clear that
the candidates lacked any knowledge of this aspect of the syllabus.
Once again it is important that students preparing for this examination should
cover the syllabus comprehensively.
Marking guide
Mark Marks
s
(a) Explaining what fundamental analysis and technical
analysis are 4
105
SOLUTION 3
a) i)
Expected annual sales (₦000) = (16,000 × 0.25) + (12,000 × 0.5) +
(8,000 × 0.25) = ₦12,000
Expected annual contribution = ₦12,000 × 0.5 = ₦6,000
Expected annual cash profit = ₦6,000 – 1,800 = ₦4,200
All the above figures are in real terms. Due to the one-year delay in the
payment of tax, the cash profits will be converted to money cash flows and
tax calculated on the money cash profits. The money cash profits are
expected to grow annually by the rate of inflation of 5%.
Total PV ₦13,854
Initial outlay (11,000)
NPV 2,854_
106
Tax payment in real terms. Due to the one year delay in payment of tax, the
real tax liability each year, from year 2 - 5 = (₦4,200 × 0.2) × (1.05)-1
= ₦800
Calculation of NPV (₦000)
Item Year NCF PVF at 10% PV
Outlay 0 (11,000) 1 (11,000)
Cash profit 1-5 4,200 3.791 15,922
Tax 2-6 (800) 3.446* (2,757)
Scrap value 5 1,100 0.621 683__
NPV 2,848_
(* Annuity factor at 10%, years 2 - 6)
The small difference in NPV is due to rounding errors
Recommendation
The project has a positive NPV and if other factors are held constant, it should
be accepted.
107
b) Note:
The annual written down allowances are fixed and do not increase with
inflation. They are already in money terms. Consequently, they decline in
real terms over the years. If real cash flows approach is adopted, the
annual written down allowances (or better still, the related tax savings)
must be converted to real cash flows by dividing by:
108
Examiner’s report
This question tests candidates‟ knowledge of capital budgeting involving taxation,
inflation, and risk and uncertainty.
Candidates are expected to compute the relevant cash flows and eventually the NPV
of the project.
A very high proportion of the candidates attempted the question but performance
was only average.
Many of the candidates that attempted the question failed to achieve any
reasonable marks due to the following reasons:
Marking guide
Marks Marks
(a) i. Evaluation of the proposed expansion:
Computation of expected annual sales 1
Computation of expected annual contribution ½
Computation of annual cash profit ½
Calculation of NPV 7½
Recommendation ½ 10
ii. Computation and interpretation of sensitivity of
the project to changes in expected annual 3
contribution
Computation and interpretation of sensitivity of
the project to changes in the tax rate 2 5
109
SOLUTION 4
i) Cost. If the market is efficient then the cost paid for any individual financing
source will be the appropriate cost for that source, taking into account the
relative risks of alternative sources. The fact that debt finance is normally
cheaper than equity finance does not necessarily mean that debt finance
should be chosen. Cost is important as it affects the company's overall cost of
capital and therefore, its market value per share. Assuming that financial
structure influences the market value of a company, the company should
attempt to select the financing combination that minimises its overall cost of
capital;
ii) Risk. The effect of financing upon risk can be measured in several ways,
including financial gearing, interest cover, cash-flow cover, and the
company's beta coefficient (systematic risk);
iii) Control. The ownership structure of the company's shares, and hence the
control of the company, will differ according to the financing method
selected;
iv) Market conditions. If share prices are falling, an equity issue might not
succeed or, if interest rates are expected to fall, a fixed-rate debt issue might
be unwise. Market conditions can, therefore, influence the financing choice;
v) Speed of raising finance. Some forms of finance can be raised more
quickly and easily than others. If the need for funds is urgent, speed of
raising finance might outweigh some other considerations; and
vi) Flexibility. Can the finance be redeemed easily and cheaply, or swapped
into another form of commitment (e.g. an interest rate swap)?
(Note: Reasonable alternative factors will be rewarded)
110
c. In a semi-strong market the share price should accurately reflect new relevant
information when it becomes publicly available. This would include the effect
on Kenny of the expansion scheme and the redemption of the term loan.
₦m ₦m
Existing value of equity = ₦1.90 × 3,200m shares 6,080
NPV of new project 110
Proceeds of the new issue 1,500
Issue cost (4%) (60)
Future cash flows avoided at present value:
- interest ₦500m × 15% × 3.791* 284.325
- redemption value ₦500m × 0.621** 310.500 594.825
Redemption cost now (500)
Penalty cost now (35) (535.000)
Expected total market value 7,689.825
d. i) Changes in factors affecting the value of the company‟s shares between the
setting of the terms of issue and the issue date;
ii) existing shareholder reaction to the issue;
iii) the effect of the extra volume of shares on their marketability;
111
Examiner’s report
The question tests various aspects of sources of finance. Candidates are expected to
discuss factors that determine the sources of finance to use in a given scenario.
They are expected to discuss pre-emptive rights and the advantages and
disadvantages.
Almost all the candidates attempted the question. It is however, surprising that
students‟ performance was very disappointing. It is very worrisome that candidates
at this level of the examination do not understand „pre-emptive rights‟.
Once again we advise that students preparing for this examination should cover the
entire syllabus in their revision.
Marking guide
Marks Marks
(a) Discussion on the four factors to be considered
before deciding which form of financing to use 6
112
a) Objective 1
TAXIM Plc has stated an objective to achieve growth in profit before interest and
tax of 4% per year. Analysis shows that profit before interest and tax growth was
3.4% in 2021 (18.3m/17.7m) and 3.5% in 2020 (17.7m/17.1m). TAXIM Plc has
therefore, not achieved this objective in either year.
Objective 2
Year 2021 2020 2019
Profit after tax ₦12.8m ₦12.4m ₦12.0m
Number of shares 12m 12m 12m
Earnings per share (kobo) 106.67 103.33 100.00
Annual growth 3.2% 3.3%
TAXIM Plc has stated an objective to achieve growth in earnings per share of
3.5% per year. Analysis shows that growth in earnings per share was 3.2% in
2021 (106.67kobo/103.33kobo) and 3.3% in 2020 (103.33kobo/100.00kobo).
TAXIM Plc has therefore, not achieved this objective in either year.
Objective 3
TAXIM Plc has stated an objective to achieve growth in total shareholder return
(TSR) of 5% per year. Analysis shows that growth in TSR was 11.4% in 2021 and
11.7% in 2020. TAXIM Plc has therefore, achieved this objective in both 2021
and 2020.
113
However, PRP performance objectives need very careful consideration if they are
to be effective in encouraging managers to achieve stakeholder targets. In recent
times, long-term incentive plans (LTIPs) have been accepted as more effective
than PRP, especially where a company‟s performance is benchmarked against
that of its competitors.
Corporate governance codes of best practice
Codes of best practice have developed over time into recognised methods of
encouraging managers to achieve stakeholder objectives, applying best practice
to many key areas of corporate governance relating to executive remuneration,
risk assessment and risk management, auditing, internal control, executive
responsibility and board accountability. Codes of best practice have emphasised
and supported the key role played by non-executive directors in supporting
independent judgement and in following the spirit of corporate governance
regulations.
114
Monitoring
One theoretical way of encouraging managers to achieve stakeholder objectives
is to reduce information asymmetry by monitoring the decisions and
performance of managers. One form of monitoring is auditing the financial
statements of a company to confirm the quality and validity of the information
provided to stakeholders.
Note: Only four ways to encourage the achievement of stakeholder objectives
were required to be discussed.
Examiner’s report
Part (a) of the question tests candidates‟ knowledge of basic corporate financial
objectives. Part (b) tests candidates‟ knowledge of how to align managers‟ and
shareholders‟ objectives. Almost all the candidates attempted the question and
performance was average.
In part (a), candidates lost valuable marks because they could not calculate the
basic metrics needed to measure the identified objectives such as growth rates and
total shareholders returns etc.
It is recommended that students should not neglect any section of the syllabus.
Marking guide
Marks Marks
(a) Analysis and discussion on whether objective 1 was
achieved 2
Analysis and discussion on whether objective 2 was
achieved 3
Analysis & discussion on whether objective 3 was
achieved 4 9
115
ii) Adopting strategies that will increase the company‟s share price
Maximising share price is not the same as maximising shareholder
wealth. In addition Gordon‟s growth rate model suggests that the
growth of dividends, and hence share price, is dependent on the
proportion of funds retained; the higher the proportion retained, the
more can be invested in projects that generate surpluses and hence
higher long-term dividends.
iii) Satisfying our shareholders will ensure our success
Other stakeholders, as well as shareholders, are affected by Neko Plc
activities and they will impact on Neko Plc success to varying degrees.
Loss of key employees because of poor working conditions may
impact adversely, also suppliers stopping credit because Neko Plc has
been a slow payer. Neko Plc will also have to fulfil legal and
regulatory requirements imposed by the government and
regulators; failure to do may lead to heavy costs and ultimately
threaten its existence. Neko Plc may also be more attractive to
consumers if it follows what is regarded as ethical and environmental
best practice.
iv) Reducing costs by manufacturing overseas
Manufacturing overseas may reduce the costs of factors of production.
However Neko Plc will have to bear costs of investment, and also
perhaps increased selling and distribution costs. There may also be
increased costs arising from controlling the quality of overseas output
and managing the overseas operations. Neko Plc directors should also
consider the risk implications; perhaps political instability might
116
b) Dividend capacity
The free cash flow is the amount of money that is available for distribution
to the capital contributors. If the project is financed by equity only, then
these funds could be potentially distributed to the shareholders of the
company.
However, if the company is financing the projects by issuing debt, then the
shareholders are entitled to the residual cash flow left over after meeting
interest and principal payments. This residual cash flow (free cash flow to
equity) represents dividends that could potentially be paid to shareholders.
This is usually not the same as actual dividends in a given year because
normally the management of a company deliberately smoothes dividend
payments across time.
The free cash flow to equity is a measure of what is available to the
shareholders after providing for capital expenditures to maintain existing
assets and to create new assets for future growth. Thus, if a firm has
substantial working and capital expenditure requirements then the free
cash flow can be negative even if the earnings are positive.
Accurate financial forecasts covering timing and size of all cash flows are
essential in order to determine the dividend capacity of a company.
117
Part (b) on the other hand asks candidates to explain how dividend capacity can be
estimated.
Part (a) of the question was barely properly attempted by a good number of the
candidates.
In part (b), performance was extremely poor thereby indicating that candidates had
no idea of the subject matter. This is despite the fact that „Free Cash Flow to Equity‟
(FCFE) is a regular topic in this examination.
Effective revision, using past questions and the pathfinder will always enhance
candidates‟ performance in the examination.
Marking guide
Marks
(a) Discussion on the validity and implications of each 10
strategy
SOLUTION 7
a) Current share price:
P0 = D1 /(r − g)
= 20(1.07)/(0.14 – 0.07)
= ₦305.71
118
1) Weak-Form EMH
The weak-form EMH asserts that current stock price fully reflects all
security market information, including the historical sequence of
prices, rates of return, trading volumedata, and other market
generated information, such as block trades, and transactions by
exchange specialists. Because it assumes that current market prices
already reflect all past returns and any other securities market
information. This hypothesis implies that past rates of return and
other historical market data should have no relationship with future
rates of return (that is rates of return should be independent). A
primary implication of the weak form of the EMH is that an investor
cannot consistently earn excess returns using technical analysis
trading rules.
2) Semistrong-Form EMH
The semistrong form of the EMH states that current market prices
reflect all publicly available information. The semistrong hypothesis
encompasses the weak-form hypothesis, because all the market
information considered by the weak-form hypothesis, such as stock
prices, rates of return, and trading volume, is public. Public
information also include all non-market information such as earnings
and dividend announcements, P/E ratios, dividend yield ratios, stock
splits, news about the economy, and political news. The hypothesis
implies that investors who base their decisions on any important
information after it is public should not derive above-average risk-
adjusted profits from their transactions, considering the cost of
trading because the security price already reflects all such new public
information.
119
Examiner’s report
The question tests candidates‟ knowledge of share valuation using dividend
valuation model and the Efficient Market Efficiency (EMH). Almost all the
candidates attempted the question.
Part (a) of the question was well answered with most of the candidates scoring the
allocated 2marks. However, in parts (b) most of the candidates could not handle 2 –
stage growth and thereby losing valuable marks.
In part (b) a good number of the candidates provided the required solution and
scored decent marks.
Marking guide
Marks
(a) Estimation of current share price 2
120
1. Check your pockets, purse, mathematical set, etc. to ensure that you do not
have prohibited items such as telephone handset, electronic storage device,
programmable devices, wristwatches or any form of written material on you
in the examination hall. You will be stopped from continuing with the
examination and liable to further disciplinary actions including cancellation
of examination result if caught.
6. Do NOT answer more than the number of questions required in each section,
otherwise, you will be penalised.
7. All solutions should be written in BLUE or BLACK INK. Any solution written
in PENCIL or RED INK will not be marked.
8. A formula sheet and discount tables are provided with this examination
paper.
79
QUESTION 1
Finkex Plc (FP) is a listed company which operates in the pharmaceutical sector,
manufacturing a broad range of drugs under licence in a number of countries along
the ECOWAS sub-region. For a number of years the company has grown organically.
Three years ago, the company acquired 20% of the issued share capital of Toba Plc
(TP) for N110 million, as a route to both expansion and diversification. The
acquisition was by private negotiation in exchange for an issue of its own shares.
Toba Plc is involved in a different area of the pharmaceutical sector from FP as it is
primarily a research-driven company involved in the development of new drugs.
To fasten the realisation of its diversification strategy, the directors of FP have now
decided to acquire the remaining 80% of Toba is share capital.
Extracts from the financial statements of Finkex Plc are given below:
Finkex Plc
Extracts from financial statements for last two years
Year 2023 2022
N’m N’m
Non-current assets (including investment in Toba plc) 602.8 499.4
Current assets 265.0 180.4
867.8 679.8
Current liabilities 199.2 136.8
668.6 543.0
Non-current liabilities 149.5 159.4
Net assets 519.1 383.6
Issued share capital
(ordinary shares of ₦1 each) 100.0 73.6
Share premium 84.0 12.4
Profit or loss account 335.1 297.6
519.1 383.6
80
All that you know about Toba plc is that it has 114 million shares in issue; total
share capital and reserves are N684 million; earnings after tax in the most recent
year were ₦85.2 million on sales of N1,252.0 million, which were double those of
the previous year; and that it has an investment valued at N80 million (book and
market) in a type of enterprise which might not be of interest to Finkex Plc.
The current stock market prices per share are: Finkex Plc 300k; Toba plc 341k. Both
companies pay tax at 50%.
Required:
a. At the above market prices, how many shares of Finkex Plc would have to be
issued to buy the rest of Toba plc on a share-for-share offer? (4 Marks)
b. With regard to earnings and also the book value of assets per share, how
would the above share-for-share offer affect the position of:
ii. the 80% shareholders in Toba Plc whose shares were to be acquired?
(4 Marks)
c. Assuming that the 80% shareholders in Toba Plc were prepared to accept ₦80
million 10% Loan Stock as part of the consideration:
d. If the board of Toba Plc decided to advise its shareholders not to accept an
offer from Finkex Plc, what arguments might they use - including any derived
from the financial information available about Finkex Plc? (8 Marks)
(Total 30 Marks)
81
QUESTION 2
About one year ago, you were employed by Tesco, an American company based in
New York. You work on-line from home in Nigeria and you are a member of the
international treasury of Tesco.
Tesco supplies medical equipment to the USA and Europe. It also buys some basic
raw materials from Europe.
It is currently 30 November 2024.
On 31, May 2025 Tesco is due to receive CHF16.3 million from a Swiss customer and
also to pay CHF4.0 million to a Swiss supplier.
Future price
December 1.0306
March 1.0336
June 1.0369
Currency options (contract size CHF125,000; exercise price quotation US$ per CHF1,
premium: US cents per CHF1).
82
Required:
Advise Tesco, showing relevant calculations, which of the under listed hedging
strategies the company should adopt for its CHF cash flows on 31 May 2025:
i. Forward contracts (3 Marks)
ii. The money market (5 Marks)
iii. Traded futures (6 Marks)
iv. Traded options (6 Marks)
In the case of options, assume the options are exercised.
Note: Any amount not hedged by a future or option contract will be hedged on the
forward market. (Total 20 Marks)
QUESTION 3
Niko Plc is a large company operating across the country. It is purely equity
financed and has year-end of 31 December.
Currently the company has to fulfill a particular contract in Abuja, and it can do this
in one of two ways.
Under the first (proposal A), it can purchase plant and machinery; while under the
second (proposal B), it can use a machine already owned by the company.
The end-year operating net cash inflows in nominal (i.e. money) terms and before
corporate tax are as follows:
Proposal A
Under this proposal the company will incur an outlay of N312,500,000 on 31
December 2023 for the purchase of plant and machinery.
83
Proposal B
The second proposal covers a two year period from 31 December 2023. It will
require the company to use a machine which was purchased for ₦750 million a
number of years ago and has been fully written down for tax purposes. The
company has no current use for the machine, and its net realisable value at 31
December 2023 is N250 million.
However, if retained unused there would be no incremental costs of keeping it, and
it would be sold on 1 January 2025 for an estimated N300 million in nominal
money terms. If used under the second proposal, the expected residual value of the
machine would be zero at the end of the two year period.
The labour force required under the second proposal would be recruited from
elsewhere within the company, and in end-year nominal cash flow terms would be
paid ₦100 million and N108 million respectively for 2024 and 2025. However, the
staff that would have to be taken on in other departments to replace those switched
over to the new project would in corresponding end-year nominal cash flow terms
cost N110 million for 2024 and N118.80 million for 2025.
The end-year nominal net cash inflows of N350 million for both 2024 and 2025
which are associated with the second proposal are after deducting the
remuneration of the work force actually employed on the scheme.
Working Capital
Working capital requirements in nominal money terms at the beginning of each
year are estimated at 10% of the end-year operating net cash inflows referred to in
the table above. The working capital funds will be released when a proposal is
completed.
Other information
Expected annual inflation rates over the next four calendar years are:
84
Income tax is expected to be 40% over the planning period, tax being payable
twelve months after the accounting year end to which it relates.
Capital allowances are available on plant and machinery at 20% reducing balance.
You can assume that the company generates sufficient taxable profits to relieve all
capital allowances at the earliest opportunity.
Required:
a. Calculate the net present value at 31 December 2023 of each of the two
mutually exclusive projects; (17 Marks)
Notes
i. Calculate to the nearest N000
ii. Show all calculations clearly
iii. Repetition of a project is not possible (Total 20 Marks)
QUESTION 4
Xeco is looking to spend N15m to expand its existing business. This expansion is
expected to increase profit before interest and tax by 20%. Recent financial
information relating to Xeco can be summarised as follows:
N’000
Profit before interest and taxation 13,040
Finance charges (interest) (240)
Profit before taxation 12,800
Taxation (3,840)
Profit for the year (earnings) 8,960
Xeco is not sure whether to finance the expansion with debt or with equity. If debt
is chosen, the company will issue N15m of 8% loan notes at their nominal value of
N100 per loan note. If equity is chosen, the company will have a 1 for 4 rights issue
at a 20% discount to the current market price of N6.25 per share. Xeco has 12
million shares in issue. The company pays corporate tax at 30%.
85
QUESTION 5
Ope plc has N10m 5 percent convertible bonds in issue. The option to convert into
40 N1 ordinary shares is open only for one more year; they must be either converted
in one years‟ time or left as ordinary bonds until nine years‟ time when they will be
redeemed at par. The current share price is ₦1.60 and annual growth rate in share
price is 15 percent per annum. The current required return on Ope‟s equity is 25
percent, its business being relatively risky.
Ife plc has 100,000 warrants outstanding, each entitling the holder to subscribe for
one N1 ordinary share at 90 kobo any time during the next 3 years. The current
share price is 57 kobo and the capital growth is expected to be constant at 12
percent p.a. in the future. The current price of the warrant is 10 kobo.
Required:
a. Calculate the current value of Ope‟s convertibles as straight debt, i.e. ignoring
the option to convert and the value if conversion were to take place today.
Would you expect the market value of the convertible to be above or below
each of these amounts and why? (5 Marks)
b. By how much should the share price of Ope Plc rise before holders would be
induced to convert, on the last possible date for conversion? (4 Marks)
86
QUESTION 6
a. State and explain examples of conflicts of interest that may exist between
shareholders and managers. (9 Marks)
b. Explain the likely implications for a typical company of lower interest rates.
(6 Marks)
(Total 15 Marks)
QUESTION 7
Kayode John just completed his ICAN examinations, picking up prices at every level
of the examinations. John is starting a job as a junior financial analyst for Eko
Assets Management. John is convinced that an in-depth understanding of the
forward P/E ratio is one of the most useful tools for investment decisions. He plans
to use the forward P/E ratio to help his firm identify undervalued stocks.
John is concerned about FP‟s new management team. In a recent news conference,
the new Chief Financial Officer (CFO) of FP stated that FP should have increased
their dividend payout ratio to 60% last year. The CFO stated that a higher dividend
payout ratio would have increased the stock price.
John is evaluating the validity of the CFO‟s statement. John expects that FP‟s Return
on Equity (ROE) and required return would have remained the same if the company
changed their dividend payout ratio to 60%. He is uncertain about the impact on
the price of the stock. (Round all earnings, dividends and prices to the nearest kobo
and round all other figures to four decimal places.)
For further information see Table 1” Statement of Financial Position for FP” and
Table 2 “Income Statement for FP” and “Additional Information”.
87
a. Provide an estimate of FP‟s ROE in 2023 and use the DuPont identity to
decompose into three factors. (2 Marks)
Notes
Due to missing information for 2022, use the statement of financial position
values as of December 31, 2023, for your ROE calculation.
The DuPont identity is given by:
ROE = Profit margin × Total asset turnover × Equity multiplier
ROE = (Net income/Sales) × (Sales/ Total assets) × (Total assets/ Equity)
c. Using the CAPM, calculate the required return for FP. (1 Mark)
d. Calculate, at the start of 2024, the forward P/E ratio and the stock price under
two scenarios. The first scenario is based on the FP‟s actual dividend payout
ratio in 2023. The second scenario is based on the assumption that the new CFO
changed the dividend payout ratio to 60% in 2023. (Note: Base your
computations on the constant growth dividend model). (6 Marks)
Note: Forward P/E ratio is also called leading P/E ratio = P0 /E1
e. Should FP have changed the dividend payout ratio to 60% in 2023? Explain the
reasons why increasing the dividend payout ratio would have been a good or
bad idea for FP. What is the critical question that the CFO should consider when
making this decision? Explain your answer. (4 Marks)
(Total 15 Marks)
88
N’000
Current Assets
Cash 20,000
Accounts receivable 60,000
Inventories 80,000
Total current assets 160,000
Other Assets
Property, plant and equipment 375,000
Accumulated depreciation -75,000
Net property, plant and equipment 300,000
Intangible assets 215,000
Other non-current assets 50,000
Total non-current assets 565,000
Total assets 725,000
Current liabilities
Short-term notes payable 25,000
Accounts payable 35,000
Total current liabilities 60,000
Long-term liabilities
Long-term liabilities 225,000
Other non-current liabilities 35,000
260,000
Total liabilities 320,000
Total long-term liabilities
Shareholder equity
Ordinary shares 50,000
Retained earnings 355,000
Total equity 405,000
Total equity and liabilities 725,000
89
Additional information
90
Asset Beta
Equity Beta
Growing Annuity
d2= d1 -
The Put Call Parity
C + Ee-rt = S + P
d = 1/u
91
n = number of periods
1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1
2 1·970 1·942 1·913 1·886 1·859 1·833 1·808 1·783 1·759 1·736 2
3 2·941 2·884 2·829 2·775 2·723 2·673 2·624 2·577 2·531 2.487 3
4 3·902 3·808 3.717 3·630 3.546 3.465 3·387 3·312 3·240 3·170 4
5 4·853 4·713 4·580 4·452 4·329 4·212 4·100 3·993 3.890 3·791 5
6 5·795 5·601 5·417 5·242 5·076 4·917 4·767 4·623 4.486 4·355 6
7 6·728 6.472 6·230 6·002 5·786 5·582 5·389 5·206 5·033 4·868 7
8 7·652 7·325 7·020 6·733 6·463 6·210 5·971 5·747 5·535 5·335 8
9 8·566 8·162 7·786 7.435 7·108 6·802 6·515 6·247 5·995 5·759 9
10 9·471 8·983 8·530 8·111 7·722 7·360 7·024 6·710 6.418 6·145 10
11 10·368 9·787 9·253 8·760 8·306 7·887 7.499 7·139 6·805 6.495 11
12 11·255 10·575 9·954 9·385 8·863 8·384 7·943 7·536 7'161 6·814 12
13 12·134 11·348 10·635 9·986 9·394 8·853 8·358 7·904 7·487 7·103 13
14 13·004 12·106 11·296 10·563 9·899 9·295 8·745 8·244 7·786 7·367 14
15 13·865 12·849 11·938 11·118 10·380 9·712 9·108 8·559 8·061 7·606 15
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1
2 1·713 1·690 1·668 1·647 1·626 1·605 1·585 1·566 1·547 1·528 2
3 2.444 2.402 2·361 2·322 2·283 2·246 2·210 2·174 2·140 2·106 3
4 3·102 3·037 2·974 2·914 2·855 2·798 2·743 2.690 2·639 2.589 4
5 3·696 3·605 3·517 3·433 3·352 3·274 3·199 3·127 3·058 2·991 5
6 4·231 4·111 3·998 3·889 3·784 3·685 3·589 3.498 3.410 3·326 6
7 4·712 4·564 4.423 4·288 4·160 4·039 3·922 3·812 3·706 3·605 7
8 5·146 4·968 4.799 4·639 4.487 4·344 4·207 4·078 3·954 3·837 8
9 5·537 5·328 5·132 4·946 4·772 4·607 4.451 4·303 4·163 4·031 9
10 5·889 5·650 5.426 5·216 5·019 4·833 4·659 4.494 4·339 4·192 10
11 6·207 5·938 5·687 5.453 5·234 5·029 4·836 4·656 4.486 4·327 11
12 6·492 6·194 5·918 5·660 5·421 5·197 4·988 4·793 4·611 4.439 12
13 6·750 6.424 6·122 5·842 5·583 5·342 5·118 4·910 4·715 4·533 13
14 6·982 6·628 6·302 6·002 5·724 5.468 5·229 5·008 4·802 4·611 14
15 7·191 6·811 6.462 6·142 5·847 5·575 5·324 5·092 4·876 4·675 15
92
The EPS will therefore increase to 58.75 kobo from a previous average of
about 51 kobo.
Assets
Existing:
Net Asset ₦519.10
No. of shares 100.00
Assets per share ₦5.19
Expected
Existing Net Asset of FP 519.10
Toba‟s net asset 684.0
Investment in associated company (110.0)
1,093.10
No of shares 203.66
Asset per share ₦5.37
94
Every unit of share in Toba plc that currently earns 74.74, will after acquisition
by FP earn = 58.75 × 341/300 = 66.78k.
Asset
Existing asset per share (APS) in Toba plc = ₦684/114 = ₦6
Expected APS in FP is ₦5.37 × ₦341/300 = ₦6.10.
This means that the existing 80% shareholders in Toba plc will have a
marginal increase in APS.
ii)
₦’m
PAT, as calculated in (b) (i) 119.66
Add back tax 119.66
Current post-takeover EBIT 239.32
Less interest = 10% × ₦80m (8.00)
EBT 231.32
New PAT 115.66
95
d. If the board of Toba plc decided to advise its shareholders not to accept an
offer from FP the following arguments might be used:
The earnings per share for the existing shareholders of Toba plc will fall
unless there is a dramatic improvement in the performance of the
combined company compared to the two individual companies.
Toba plc has doubled its turnover from the previous year and presumably
has improved its earnings after tax.
Following from point 3 above, the prospects of Toba plc may be very
good and the existing shareholders in Toba plc will not reap the full
future benefits because the benefits will be shared with the shareholders
of FP.
96
Examiner’s report
This is a four-part question testing candidates‟ knowledge of various aspects of
acquisition.
In part (a), candidates were expected to calculate share exchange ratio.
In part (b), candidates were expected to use their results in (a) to evaluate the
impact of the acquisition on earnings per share and asset per share of the
respective shareholders.
In part (c), candidates were expected to evaluate the key advantages of paying for
the acquisition using loan stock rather than cash. In addition, they were expected to
estimate the offer price that will not dilute the earnings per share of the existing
shareholders.
Finally in part (d), candidates were expected to provide arguments that might be
used to persuade shareholders in Toba Plc against accepting the offer.
Being a compulsory question, most of the candidates attempted the question but
the level of performance was very poor. Major error committed by most of the
candidates was their inability to recognise the treatment of the initial acquisition of
20% by Finkex Plc as an associated company. Furthermore, candidates that
attempted part (d) of the question merely produced generic solutions rather than
relating their answers to the scenario painted in the question.
Candidates are reminded that success at this level of the examination requires
critical thinking, demonstration of knowledge, and adequate preparation for the
examination.
97
SOLUTION 2
98
Alternatively, the futures price can be calculated from spot rate and June
futures rate. 31 May is 6/7 of time between 30 November and 30 June, so use
6/7 of the difference between spot rate of 1.0292 and Junes rate of 1.0369.
Predicted futures rate at the end of May = 1.0292 + ((1.0369 – 1.0292) × 6/7)
=1.0358
Summary of outcomes
CHF
Futures 12,688,550
Remainder on forward market 51,780
12,740,330
iv. Options
Call/put options? Buy CHF put options to hedge against sale of CHF when
money is received from Swiss customer.
Buy June options – the only date after May
Number of contracts – 98, same as futures
Total amount hedged, CHF12,250,000 – same as futures
Remainder to be hedged on the forward contract: CHF50,000 – same as
futures.
99
Net receipt
Receipt from option US$
CHF125,000 × 98 × 1.0375 12,709,375
Forward contract (as for futures) 51,780
Premium (105,350)
12,655,805
Summary
Hedging Method Net receipt ($)
Forward contract 12,737,880
Money market 12,671,547
Futures 12,740,330
Options 12,655,805
Futures provide a better outcome
Examiner’s Report
The question tests candidate‟s knowledge of foreign exchange risk management.
They were expected to use four different hedging techniques of forward contract,
money market, futures contracts and option contracts.
Only a very few candidates attempted the question and unsurprisingly the level of
performance was very poor. The major problems encountered by the candidates
who attempted it include:
Failure to recognise the need to match the expected receipt and payment
occurring at the same date and in the same currency;
Failure of candidates to identify the relevant exchange rates to use;
Inability to appropriately manipulate the various exchange rates, for
example, dividing instead of multiplying and vice versar, etc.
100
SOLUTION 3
a. Proposal A
Time 0 1 2 3 4
(31.12.23) (31.12.24) (31.12.25) (31.12.26) (31.12.27)
N’000 N’000 N’000 N’000 N’000
(Outlay)/Scrap value (312,500) - - 25,000 -
Net inflows - 200,000 275,000 350,000 -
Tax on inflows at 40% - - (80,000) (110,000) (140,000)
Tax savings on cap.
allowances (W1) - 25,000 20,000 16,000 54,000
Working capital (W2) (20,000) (7,500) (7,500) 35,000
NCF (332,500) 217,500 207,500 316,000 (86,000)
PVF (W3) 1 0.826 0.696 0.597 0.517
Present values (332,500) 179,655 144,420 188,652 (44,462)
Proposal B
Time 0 1 2 3
(31.12.23) (31.12.24) (31.12.25) (31.12.26)
N’000 N’000 N’000 N’000
Net inflow as given - 350,000 350,000 -
Adjustment for labour (W5) - (10,000) (10,800) -
Adjusted net inflows - 340,000 339,200 -
Related tax at 40% - - (136,000) (135,680)
Lost disposal proceeds (W4) - (300,000) - -
Balancing charge avoided at - - - 120,000
40%
Working capital (W6) (35,000) - 35,000 -
NCF (35,000) 40,000 238,200 (15,680)
PVF (W3) 1 0.826 0.696 0.597
Present values (35,000) 33,040 165,787 (9,360)
NPV = ₦173,187 i.e. ₦173,187,000.
101
Working Notes
1. Tax savings on capital allowances year ended
Tax savings at 40% Time due
N’000 N’000
31.12.23 Investment 312,500
WDA at 20% (62,500) 25,000 1
250,000
31.12.24 WDA at 20% (50,000) 20,000 2
200,000
31.12.25 WDA at 20% (40,000) 16,000 3
160,000
31.12.26 Scrap proceeds (25,000)
Bal.allowance 135,000 54,000 4
102
Therefore the company should sell the machine at 1 January 2025 if Proposal
B is not undertaken and the latter cash flows therefore represent the relevant
cash flows to be included in the analysis.
103
About sixty percent of the candidates attempted the question but the performance
level was very poor.
Most of the candidates could not identify the relevant cashflows. Furthermore, they
failed to identify the appropriate timing of the tax savings associated capital
allowances.
In addition, almost all the candidates that attempted the question failed to handle
appropriately the yearly changing money cost of capital.
Candidates need to cover the entire syllabus comprehensively and practise past
questions.
Marking guide
Marks Marks
Calculate the NPV of the two projects 17 17
Reservations based on Investment decision 3 3
Total 20
SOLUTION 4
a. Increased EBIT = 13.040m × 1.2 = ₦15,648,000
Financing by debt
Current interest payment = ₦240,000
Increase in interest = 15m × 0.08 = ₦1,200,000
Revised interest payment = 1,200,000 + 240,000 = ₦1,440,000
Revised PBT = 15,648,000 – 1,440,000 = ₦14,208,000
Revised PAT = 14,208,000 × 0.7 = ₦9,945,600
Current EPS = 8,960,000/12,000,000 = ₦0.747 per share
Revised EPS = 9,945,600/12,000,000 = ₦0.829 per share
Current PER = 6.25/0.747 = 8.37 times
Revised share price = 8.37 × 0.829 = ₦6.94 per share
Capital gain = 6.94 – 6.25 = ₦0.69 per share
104
Comment on findings
Financing by debt is recommended as this leads to the larger capital gain for
the shareholders. This recommendation could have been made on the basis of
EPS values alone, as the price/earnings ratio multiplier is the same for both
financing choices. However, it is important to compare the share price arising
from the equity financing option with the theoretical ex rights share price,
rather than with the cum rights share price.
b. With any investment, there is a risk that the actual outcome may be different
from the expected or predicted outcome. This risk can be reduced by holding
several different investments, since different investments are affected to
differing extents by changes in economic variables such as interest rates and
inflation rates. The return from one investment may increase, for example,
when the return from a different investment decreases. Holding a range of
different investments is known as portfolio diversification.
Experience shows that there is a limit to the reduction in total risk that can be
achieved as a result of portfolio diversification. The risk that cannot be
removed by portfolio diversification is called systematic risk. It represents risk
relating to the financial system as a whole that cannot be avoided by any
company in which an investment is made.
Systematic risk contains both business risk and financial risk. A company with
no debt finance faces business risk alone, while a company with both equity
and debt finance faces both business risk and financial risk.
105
Homogenous expectations
All investors have the same expectations, meaning they all have the same
expectations regarding future assets prices, returns and economic conditions.
106
Examiner’s report
This question tests candidates‟ knowledge of capital budgeting. The candidates
were expected to demonstrate their ability to handle taxation, inflation, relevant
cash flows, etc in capital budgeting.
About sixty percent of the candidates attempted the question but the performance
level was very poor.
Most of the candidates could not identify the relevant cashflows. Furthermore, they
failed to identify the appropriate timing of the tax savings associated capital
allowances.
In addition, almost all the candidates that attempted the question failed to handle
appropriately the yearly changing money cost of capital.
Candidates need to cover the entire syllabus comprehensively and practise past
questions.
Marking guide
Marks Marks
Evaluation: whether to finance with debt or equity 10 10
Explain relationship between systematic and unsystematic risk 5 5
CAPM Assumptions 5 5
20
SOLUTION 5
a. The current value of the convertible bonds as simple straight debt is the PV of
future interest and the redemption value.
107
The market value of the convertible is expected be higher than both its value
as debt and value of equity because of the option to convert to equity, the
excess of the market value of the convertible over the straight debt value is
directly the value of the option.
The reason for the market value exceeding the conversion value is that holders
have the debt to fall back on if the share price drops and they do not
necessarily have to convert. The debt value here acts as a floor price for the
security which means an investor faces less risk than by simply investing
directly in shares.
b. The last possible date for conversion is one year‟s time. If they are
unconverted then their value is as a straight bond with 8 years to redemption.
The straight debt value at the end of year 1 (i.e. 8 years to redemption) is the
PV of the remaining interest for 8 years and the redemption value in year 8.
This is the expected value of the bond in one year‟s time. To induce the bond
holders to convert at that point in time, the conversion value must be at least
equal to ₦69.13. Thus:
CV ≥ 69.13
40 × VPS1≥ 69.13
VPS1 ≥ 1.728
The share price must therefore rise by minimum of ₦1.728 – ₦1.60 = ₦0.128
This entails minimum growth rate in share price of 8% ((1.728/1.60)-1).
(Note that the information on equity rate of return of 25% is totally irrelevant).
c. The company‟s dividend policy has a major impact on its share price, and
hence on the perceived value of the convertible bonds.
108
Were the company to distribute all of its profits, on the other hand, the share
price is likely to stagnate. Whereas by definition, dividends and retentions
benefit the shareholders, only retentions benefit the convertible bonds
holders.
Thus, payment of dividend is expected to reduce the market value of
convertible bonds.
d. It will be worthwhile to exercise the warrants if the share price exceeds the
exercise price of ₦0.90. At the projected growth rate of 12% p.a., the expected
share price in 3 years‟ time is = 57k (1.12)3 = 80k. It will therefore not be
worthwhile to exercise the warrants.
The minimum growth rate necessary to induce holders to exercise the warrants
is given by:
57k(1 + g)3 = 90k
(1 + g)3 = 90/57
g = (90/57)1/3 − 1 = 16.45%
Examiner’s report
The question tests candidates‟ knowledge of the valuation of convertable bonds and
warrants. Only about twenty percent of the candidates attempted the question but
the level of performance was far below average.
We emphasise once again the need for students to cover the entire syllabus and
practice examination type of questions when preparing for this examination.
Marking guide
Marks Marks
a. Calculate the current value of Ope‟s convertible at
straight debt 5 5
b. Determine how much should share price of Ope‟s Plc
rise 4 4
c. Explain why market value of a convertible bond is
likely to be affected 4 4
d. Minimum annual growth rte required 2 2
15
109
iv. Mergers and Acquisitions: Managers may pursue acquisitions that benefit
their personal interests, such as increased power or job security, even if
they are not in the best interest of shareholders or the company's overall
performance.
vii. Time Horizon: Managers might prioritise short-term results to boost their
performance metrics, while shareholders might be interested in the
company's long-term growth and sustainability.
110
(ii) The value of the company‟s shares will rise, both because of the higher
level of company profitability and also because of the lower alternative
returns that investors could earn from banks and deposits, if interest
rates are expected to remain low in the longer term.
(iii) The higher share value results in a lower cost of equity capital, and
hence a lower overall cost of capital for the company. Investment
opportunities that were previously rejected may now become viable.
(iv) As interest rates fall, consumers have more disposable income. This may
increase demand for the company‟s products. Falling returns on deposits
may, however, encourage many people to save more, rather than spend.
Examiner’s report
This two-part question. Part (a) of the question tests candidates‟ knowledge of
agency problems. On the other hand, part (b) tests candidates‟ knowledge of the
implications of reduction in interest rate.
Almost all the candidates answer the question. Candidates showed strong level of
understanding in part (a) but performance in part (b) was very disappointing as
majority of them could not provide any meaningful answer.
Candidates are strongly advised to practise past questions and other examination
type of questions when preparing for this examination.
111
SOLUTION 7
112
Scenario 2. Assume the company changed the dividend payout ratio to 60%
in 2023.
Using justified leading P/E ratio.
Justified leading P/E ratio = P0/E1 = D1/E1/(r - g)
= (1 - b)/(r - g) g = (ROE)(b) = (9.07)(0.4) = 3.63%
P/E ratio = P0/E1 = (1 - b)/ (r - g)
= (1 – 0.4)/ (0.0815 – 0.0363) = 13.27
P0= (P / E) × E1
= (P / E) × E0 × (1 + g)
= (13.27)(36,750/20,000)(1.0363)
=₦25.28
e. No, FP should not have increased their dividend payout ratio to 60% in 2023.
Increasing the dividend payout ratio from 40.82% to 60% would have
decreased the price of the stock from ₦28.48 to ₦25.28. The CFO does not
realise that paying out a higher percentage of earnings in dividends means
that the company will retain less funds and forego good investments. This
would result in a lower growth rate. (recall, growth = ROE × retention ratio).
In general increasing the dividend payout ratio impacts the stock price in two
ways. The first is clear: a higher naira dividend will increase stock price. The
second is that a higher payout ratio means lower growth which decreases the
stock price. The factor that dominates depends on the simple question. Is the
company making good investments?
If ROE > required return, then the company is making good investments; since
the investments are earning more than the required return. Recall that FP has
an ROE of 9.07% and a required return of 8.15% thus ROE (9.07%) > Required
113
Examiner’s report
This is a multi-part question testing some basic knowledge of finance. Part (a) tests
candidates‟ knowledge of the major drivers of return on equity (ROE) using DuPont
analysis. In part (b), candidates were expected to estimate sustainable growth rate.
Part (c) tests candidates‟ knowledge of using CAPM to estimate required return. In
the other part of the question, candidates were expected to estimate the forward
P/E ratio and the appropriate stock price. They were also expected to explain the
impact of payout ratio on stock price.
Most of the candidates attempted the question but generally the level of
performance was very poor. Candidates were able to pick up some marks in parts
(a) – (c). They however demonstrated complete lack knowledge in the remainly part
of the question.
As already noted, students need to cover the entire syllabus when preparing for the
institute examination.
Marking guide
Marks Marks
a. Estimate of FP‟s ROE in 2023 2 2
b. Estimate sustainable growth rate in 2023 2 2
c. Calculate the required return for FP 1 1
d. Calculate forward P/E ratio and stock price 6 6
Justify decision on increasing dividend payout ratio 4 4
15
114