UNIVERSITY EXAMINATIONS: 2020/2021
COLLEGE OF BUSINESS
EXAMINATION FOR THE DEGREE OF BACHELOR OF COMMERCE
SEPTEMBER – DECEMBER 2020 TRIMESTER
FIN 3206: ISSUES IN FINANCIAL MANAGEMENT
DATE: DECEMBER, 2020
Instructions:
1. Attempt ALL questions.
2. Show all your workings.
QUESTION ONE
Elimu Co, a listed company, is a major supplier of educational material, selling its products in many countries. It supplies schools
and colleges and also produces learning material for business and professional exams. Elimu Co has exclusive contracts to produce
material for some examining bodies. Elimu Co has a well-defined management structure with formal processes for making major
decisions.
Although Elimu Co produces online learning material, most of its profits are still derived from sales of traditional textbooks. Elimu
Co’s growth in profits over the last few years has been slow and its directors are currently reviewing its long-term strategy. One
area in which they feel that Elimu Co must become much more involved is the production of online testing materials for exams
and to validate course and textbook learning.
Elimu Co has recently made a bid for Mtandao Co, a smaller listed company. Mtandao Co also supplies a range of educational
material, but has been one of the leaders in the development of online testing and has shown strong profit growth over recent years.
All of Mtandao Co’s initial five founders remain on its board and still hold 45% of its issued share capital between them. From the
start, Mtandao Co’s directors have been used to making quick decisions in their areas of responsibility. Although listing has imposed
some formalities, Mtandao Co has remained focused on acting quickly to gain competitive advantage, with the five founders
continuing to give strong leadership.
Elimu Co’s initial bid of Kshs.40.00 per share in Mtandao Co was rejected by Mtandao Co’s board. There has been further
discussion between the two boards since the initial offer was rejected and Elimu Co’s board is now considering a proposal to offer
Mtandao Co’s shareholders Kshs.48.40 per share or one 8% debenture at par value Kshs.1,000 for every 50 ordinary shares of
Mtandao Co. It is expected that Mtandao Co's shareholders will choose one of the following options:
i.
ii.
To accept the one 8% debenture at par value Kshs.1,000 for every 50 ordinary shares offer for all the Mtandao Co shares;
or,
To accept the cash offer for all the Mtandao Co shares.
Extracts from the two companies’ most recent accounts are shown below:
Elimu Co
Annual sales (Shs. Millions)
1,500
Net income (Shs. Millions)
120
Ordinary shares outstanding (Millions)
15
Earnings per share (Shs)
8
Market price per share (Shs)
88
Mtandao Co
180
15
3
5
40
Both companies are in the 40% tax bracket.
Required:
a) Discuss the advantages and disadvantages of the acquisition of Mtandao Co from the viewpoint of Elimu Co.
(4 marks)
b) Calculate, and comment on, the funding required for the acquisition of Mtandao Co and the impact on Elimu Co’s
earnings per share and gearing, for each of the two options given above.
(12 marks)
c) Determine the level of Earnings Before Interest and Tax (EBIT) where Elimu Co would be indifferent between the two
modes of financing.
(4 marks)
(Total: 20 marks)
QUESTION TWO
The following draft appraisal of a proposed investment project has been prepared for the finance director of Egeza Co by a trainee
accountant. The project is consistent with the current business operations of OKM Co.
Year
Sales (units/yr)
Contribution
Fixed costs
Depreciation
Interest payments
Taxable profit
Taxation
Profit after tax
Scrap value
After-tax cash flows
Discount at 10%
Present values
1
250,000
Kshs000
1,330
(530)
(438)
(200)
–––––
162
–––––
162
2
400,000
Kshs000
2,128
(562)
(438)
(200)
–––––
928
(49)
–––––
879
3
500,000
Kshs000
2,660
(596)
(437)
(200)
–––––
1,427
(278)
–––––
1,149
–––––
162
0.909
–––––
147
–––––
–––––
879
0.826
–––––
726
–––––
–––––
1,149
0.751
–––––
863
–––––
4
250,000
Kshs000
1,330
(631)
(437)
(200)
–––––
62
(428)
–––––
(366)
250
–––––
(116)
0.683
–––––
(79)
–––––
5
Kshs000
(19)
–––––
(19)
(19)
0.621
–––––
(12)
–––––
Net present value = 1,645,000 – 2,000,000 = (Kshs355,000) so reject the project.
The following information was included with the draft investment appraisal:
i.
The initial investment is Kshs.2 million
ii.
Selling price: Kshs.12/unit (current price terms), selling price inflation is 5% per year
iii.
Variable cost: Kshs.7/unit (current price terms), variable cost inflation is 4% per year
iv.
Fixed overhead costs: Kshs.500,000/year (current price terms), fixed cost inflation is 6% per year
v.
Kshs.200,000/year of the fixed costs are development costs that have already been incurred and are being recovered by
an annual charge to the project
vi.
Investment financing is by a Kshs.2 million loan at a fixed interest rate of 10% per year
vii.
Egeza Co can claim 25% reducing balance tax allowable depreciation on this investment and pays taxation one
year in arrears at a rate of 30% per year
viii.
The scrap value of machinery at the end of the four-year project is Kshs.250,000
ix.
The real weighted average cost of capital of Egeza Co is 7% per year
x.
The general rate of inflation is expected to be 4.7% per year
Required:
(a) Identify and comment on any errors in the investment appraisal prepared by the trainee accountant.
(5 marks)
(b) Prepare a revised calculation of the net present value of the proposed investment project and comment on the project’s
acceptability.
(10 marks)
(c) Discuss the problems faced when undertaking investment appraisal in the following areas and comment on how these problems
can be overcome:
(i) an investment project has several internal rates of return
(ii) the business risk of an investment project is significantly different from the business risk of current operations.
(5 marks)
(Total: 20 marks)
QUESTION THREE
a)
Many experts see blockchain technology as having serious potential for uses like online voting and crowdfunding, and
major financial institutions see the potential to lower transaction costs by streamlining payment processing. However,
because cryptocurrencies are virtual and are not stored on a central database, a digital cryptocurrency balance can be
wiped out by the loss or destruction of a hard drive if a backup copy of the private key does not exist.
Highlight blockchain as an alternative in the 21st century, in light of the above statement.
(5 marks)
b)
´´Behavioral portfolio theory (BPT), provides an alternative to the assumption that the ultimate motivation for investors
is the maximization of the value of their portfolios´´.
Briefly critique the above statement.
(5 marks)
(Total: 10 marks)