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  • 15 Marks

AAA – May 2022 – L3 – Q7 – Risk Management in Audits

Evaluate key risk areas for auditors in consolidating Nigerian and UK company accounts, considering transfer pricing and related party transactions.

BARCHI International Limited is a company with corporate registrations in both the United Kingdom (U.K.) and Nigeria. The Chairman of the company is based in Nigeria and from time to time travels to the U.K. to oversee the office there and order for the purchase of some of the articles for sale. To ensure steady supply of the products, some of the products are also ordered from China. The purchases from the U.K. are charged to the Nigerian entity in pound sterling, while the purchases from China are charged to the Nigerian company in American dollars.

In September 2020, the Chairman embarked on a trip to Dubai for two weeks where he spent part of his annual holiday. During this period, he hosted a couple of friends with the costs that were paid for by the company as the costs were above his approved annual holiday expenses. He subsequently traveled to the U.K. and was quarantined for two weeks due to COVID-19 before moving to the usual business lodge that he uses. Despite using that period to oversee the U.K. company, all the costs incurred were borne by the Nigerian company.

The products bought in the U.K. and sent to Nigeria were charged at cost plus 25%, while the Nigerian company was responsible for insurance and freight. The goods purchased from China were forwarded to Nigeria at the cost of landing in Nigeria plus 30%. The China-made products are less expensive and therefore give better profits despite the cost of the long-distance freight.

Money was transferred to the Chairman’s account for the company’s purchases in the U.K., the purchases made in China, and the Chairman’s personal expenses. An agent in China bought the goods which were paid for by the Chairman.

The U.K. company staff handled the documentation of all the transactions of the Chairman while there and transferred them to Nigeria subject to the approval of the Chairman.

Separate records were not maintained for the Chairman’s expenses in the U.K. However, his comparison of the results of the two units showed that for the immediate past financial year, the Nigerian company had performed sub-optimally and way below the targeted profit in relation to the U.K. company. The Chairman is very unhappy about this as he expects that his personal visit to the U.K. would reduce the purchasing and associated costs.

It is usual for the Chairman to account for the cost of purchases based on his personal expenses attributable to each purchase together with the actual cost of purchases. The U.K. component is elated about this costing method which favors it and would wish that this arrangement continues.

The two units prepare separate financial statements which are audited by separate accounting firms before the two financial statements are consolidated in Nigeria for the Chairman’s evaluation.

Required:

Evaluate, with appropriate justifications, from the scenario above, the areas of risk which the auditor needs to consider. (15 Marks)

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  • 15 Marks

AAA – May 2022 – L3 – Q6 – Ethical Issues in Auditing

Prepare a manual on external auditor eligibility and discuss auditor objectives under ISA 200.

The accountancy profession earns confidence and public respect partly as a result of its self-regulatory mechanism, application of legal principles, and professional standards.

This issue became a subject of discussion when a group of business owners who just incorporated their companies were deliberating on who should carry out an audit and what are the guiding principles for determining the performance of such responsibility.

Required:

a. Prepare a manual to enable the discussants to understand this professional member’s eligibility to act as an external auditor. (9 Marks)

b. Discuss the objectives of an auditor in accordance with ISA 200: Overall objectives of the independent auditor and the conduct of an auditor in accordance with International Standards on Auditing. (6 Marks)

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  • 15 Marks

AAA – May 2022 – L3 – Q5 – Regulatory Framework and Professional Standards

Discuss arguments for and against audit exemption for small companies and evaluate considerations for auditing small entities.

The Companies and Allied Matters Act, 2020 has classifications and responsibilities for various types of companies incorporated under it. A particular class that has received more attention in recent times and in the Act is small companies.

Your audit team has been approached by a few of these small companies for guidance on the issue and your team has been assigned this responsibility. Part of the concerns of your firm is whether or not those small companies merit the concerns of regulatory authorities and the accounting firms that have to be responsible for their audit.

Your team has a number of young assistants who are yet to understand the differences and therefore need enlightenment on this as part of the training programs.

Required:

a. Discuss the arguments for and against the exemption of small companies from audit. (10 Marks)

b. On the basis that an audit may be conducted for a small entity, evaluate the points the auditors would consider. (5 Marks)

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  • 20 Marks

AAA – May 2022 – L3 – Q4 – Ethical Issues in Auditing

Discuss correspondence with previous auditors, reasons for change in appointments, and client identification under AML regulations.

The idea to incorporate Peters & Shamsudeen Haulages Limited was mooted in London and it was incorporated on the return of Alhaji Shamsudeen to Nigeria. He met Peters during his stay in the UK. They had a good relationship which started in a coffee shop. As they met regularly in this shop, what to do on Alhaji Shamsudeen’s return to Nigeria became the subject of discussion. Based on their experiences, the idea of Peters & Shamsudeen Haulages Limited was birthed. Alhaji Shamsudeen subsequently returned to Nigeria, incorporated the company, obtained the appropriate expatriate quota, and Mr. Peters came in and started running the company.

On commencement, Sejumade Uzoma & Co was appointed the company’s external auditors. Whilst Mr. Peters was around, there was a good working relationship between the company and the audit firm.

After about nine years, Mr. Peters returned to the UK, leaving the company in the hands of Alhaji Shamsudeen. Subsequently, Sejumade Uzoma & Co started receiving complaints from Alhaji Shamsudeen and his key accounting staff. These complaints were rife even before the ninth month of the current year that Sejumade Uzoma & Co. decided not to continue with the engagement. The audit fee for the previous year had about thirty percent outstanding at this stage.

This was the position when Alhaji Shamsudeen approached your partner at Musa, Edewo & Co. (Chartered Accountants). Their discussion was fruitful for your firm, hence it was agreed by the partners that full professional procedures would be applied as normal. Part of the information available on interaction is that the year is almost ending, and there was uncertainty about the firm that will do the audit before the engagement of your firm. You have the responsibility of assisting your partner in ensuring that proper documentations would be done without any compromise.

Required:

a. According to professional requirements, discuss the issues your firm is expected to address in her correspondence with Sejumade Uzoma & Co. (10 Marks)

b. Evaluate the various circumstances that would lead to change in professional appointment. (5 Marks)

c. In consideration of the client, analyze the procedures necessary for proper client identification in accordance with anti-money laundering requirements. (5 Marks)

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  • 20 Marks

AAA – May 2022 – L3 – Q3 – Audit of Prospective Financial Information

Discuss auditor assurance work on prospective financial information, cash flow forecast procedures, and forming an opinion on PFI.

Tijara Nigeria Limited has a credit facility of N6 million with Godiya Bank. The facility was due to expire on December 31, 2021. The overdraft in the recently audited statement of financial position as at September 30, 2021 is N5.5 million. The directors of Tijara have started negotiations with their bankers for a renewal of the facility and to increase the amount to N9 million. To support this request, the bank has asked Tijara to provide a business plan for the coming twelve months consisting of a cash flow forecast supported by a forecast income statement and statement of financial position.

The management of Tijara has produced a cash flow forecast for the period October 1, 2021, to September 30, 2022, and, at the request of the bank, has asked an auditor to examine and report on it.

The Audit Manager, who has recently completed Tijara’s audit, has been asked to make a preliminary examination of the cash flow forecast and supporting materials. The manager has made the following observations:

  1. The cash flows from sales are based on the assumption of an overall increase in sales of 24% compared to the previous financial year. Analysis shows that this is based on an increase in selling price of 5% and an increase in the volume of sales of 18%. Just over a quarter of all Tijara sales are made to foreign customers.
  2. The cost of sales in the recently audited comprehensive income to September 30, 2021, was 80% of sales revenue, giving a gross profit of 20%. In the forecast income statement for the year to September 30, 2022, the cost of sales has fallen to 72%, giving a gross profit of 28%. Manufacturing costs are made up of equal proportions of materials, labor, and production overheads.
  3. The trade receivables collection period used in the cash flow forecast to September 30, 2022, is 61 days. In the year to September 30, 2021, this period averaged 93 days. Management has stated that it is its intention to inform all customers of a new standard 60-day credit period. In addition, an early settlement discount of 1% will apply to customers who settle their accounts within 30 days of the statement. Conversely, the credit period for trade payables has been extended from an average of 45 days in the current year to 90 days in the forecast.
  4. The cash flow forecast showed that the maximum credit required during the period would rise to nearly N9 million in August 2022.

Required:

a. Describe the general approach to the assurance work an auditor should consider before accepting the engagement of a reporting accountant on Prospective Financial Information (PFI) under ISAE 3400: The Examination of Prospective Financial Information. (8 Marks)

b. Detail the procedures applicable to the cash flow forecast of Tijara for the year to September 30, 2022. (7 Marks)

c. Prepare a summarized presentation of what the reporting accountant should consider in forming an opinion on prospective financial information (PFI). (5 Marks)

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  • 20 Marks

AAA – May 2022 – L3 – Q2 – Assurance Engagements

Discuss due diligence processes and provide IFRS 16 guidance on lease recognition, measurement, and disclosure.

Pegrace Nigeria Limited (PNL), your audit client, is a national hotel group with substantial cash resources. Its accounting functions are well managed and the group’s accounting policies are rigorously applied. The company’s financial year-end is December 31.

The company has been seeking to acquire a construction company for some time in order to bring in-house the building and refurbishment of hotels and related leisure facilities, like swimming pools, volleyball courts, and restaurants. The management has recently identified Robin Construction Company Limited (RCCL) as a potential target and has urgently requested that you undertake a limited due diligence review.

Further to the preliminary talks between the management of RCCL and PNL, you were provided with the following brief on Robin Construction Company Limited:

  1. The Chief Executive, Managing Director, and Finance Director are all family members and major shareholders. The company has an established reputation for quality constructions.
  2. Due to a recession in the building business, the company has been operating at its overdraft limit for the last 18 months and has been close to breaching debt obligations on several occasions.
  3. Robin’s accounting policies are generally less prudent than those of Pegrace (assets are depreciated over longer estimated useful lives).
  4. Contract revenue is recognized on the percentage of completion method, measured by reference to costs incurred to date. Provisions are made for loss-making contracts.
  5. The company’s management team includes a qualified and experienced quantity surveyor, whose main responsibilities are:
    • Supervising quarterly physical counts at major construction sites;
    • Comparing costs to date against quarterly rolling budgets; and
    • Determining profits or losses, by contract, at each financial year-end.
  6. Labour force is provided under subcontracts. During construction, the regulatory body visited the site and discovered non-compliance with site health and safety regulations.

In February 2021, Robin received a claim that a site on which it built a housing development in Banana Estate was not properly drained and is now sinking. Residents are demanding rectification and asking for payment or damages. Robin has referred the matter to its legal counsel and denied all liability, as the site preparation was subcontracted to Sahara Services Company Limited. No provisions have been made in respect of the claims, nor has any disclosure been made.

The auditor’s report on Robin’s financial statements for the year ended December 31, 2020, was signed, without modification, in March 2021.

Required:

a. Prepare a document to give the explanatory meaning of the term ‘due diligence’ and subsequently discuss items to investigate in a due diligence exercise. (12 Marks)

b. Advise on how to recognize, measure, present, and disclose leases as required by IFRS 16. (8 Marks)

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  • 30 Marks

AAA – May 2022 – L3 – Q1 – Quality Control in Audit Firms

Discuss ISQC 1 quality control requirements for leadership, ethics, engagements, human resources, monitoring, and documentation.

A firm of Chartered Accountants has 25 partners and 100 audit staff. The firm provides a range of audit, assurance, tax and advisory/consultancy services. The firm has offices around the country and clients ranging from sole traders to limited liability companies.

The quality control partner has recently resigned. He has not yet been replaced as the Board of Partners of the firm has not been able to find a suitable replacement. Before his departure, the quality control partner was in the process of implementing a system of ethical compliance for assurance staff. Based on the foregoing, staff would be required to confirm in writing their compliance with the Code of Ethics, hence, implementation of this system is incomplete.

Oshodi Plc is one of the firm’s largest clients for which the firm provides audit, tax, and other advisory services. A new engagement partner has been assigned to the audit, as the previous partner in charge was the one who resigned. The fee for the audit work and other services has been set at the same level as the previous year in spite of the fact that additional work will need to be performed because Oshodi Plc has introduced a new computerized system. The starting date of the audit has been delayed due to problems with the new system. The management of Oshodi Plc was very insistent that the fee should not be increased as a result of this.

Required:

Discuss the requirements of ISQC 1: International Standard on Quality Control on overall audit firm level, which address each of the following:

a. Leadership responsibilities for quality (3 Marks)
b. Ethical requirements (5 Marks)
c. Acceptance and continuance of engagements (5 Marks)
d. Human resources (5 Marks)
e. Engagement performance (5 Marks)
f. Monitoring (4 Marks)
g. Documentation (3 Marks)

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  • 15 Marks

FM – May 2022 – L3 – Q7 – Dividend Policy

Brief on various dividend concepts, including residual theory, clientele effect, and signaling.

You are required to provide a briefing on the following dividend concepts:
a. Residual theory of dividends (3 Marks)
b. Clientele effect (3 Marks)
c. Asymmetric information (2 Marks)
d. Signaling properties of dividends (3 Marks)
e. The ‘bird-in-the-hand’ argument (4 Marks)

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  • 3 Marks

FM – May 2022 – L3 – Q6b – Financial Risk Management

Calculate the number of put options needed to delta-hedge a short position.

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 to delta-hedge. Be specific.

 

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  • 12 Marks

FM – May 2022 – L3 – Q6a – Foreign Exchange Risk Management

Evaluate hedging methods for a UK supplier payment of £5 million in three months.

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.

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)

 

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  • 8 Marks

AAA – Nov 2021 – L3 – Q3b – Audit of IT Systems and Data Analytics

Discuss audit team activities using CAATs on client premises and analyze two types of audit software.

You have been appointed as the auditor of a company that processes its accounting functions using a computer system. You have decided to use computer-assisted audit techniques (CAATs) to generate necessary audit evidence for this engagement.

Required:

i. Discuss the activities members of the audit team could perform with their computers in the client’s office. (4 Marks)

ii. Analyze TWO types of audit software in use in computer-based information systems. (4 Marks)

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  • 7 Marks

AAA – Nov 2021 – L3 – Q3a – Audit of IT Systems and Data Analytics

Discuss solutions to audit trail loss and evaluate CAATs' merits and demerits in auditing.

The availability of Computer Assisted Audit Techniques (CAATs) should be considered by the Auditor when planning the nature, extent, and timing of tests in an audit. Hence, the auditor must determine their testing strategies, which will depend on their decision of either using a Manual Testing method or CAATs method, to avoid loss of audit trail.

Required:

i. Discuss FIVE solutions to loss of audit trail. (5 Marks)

ii. Evaluate the merits and demerits of the application of CAATs. (7 Marks)

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  • 20 Marks

AAA – Nov 2021 – L3 – Q2 – Advanced Audit Planning and Strategy

Evaluate internal and external business risks and outline pre-engagement activities for Sunsit Manufacturers Ltd.

The auditors of Sunsit Manufacturers Limited had disagreements with the company on various issues. This came to a climax with the withholding of a part of the payment of the last audit fees. The auditors had also been disenchanted with the undue pressures of management and have decided that, as a result of this and the withheld fees, they would disengage from the client.

The company’s chairman, in consideration of past issues, has considered the size of the audit firm as being partly responsible for its inability to manage adequately the pressures from the company’s accounting and management team. He has subsequently approached your firm for a change, and the partners have accepted the engagement despite the predecessor auditor’s declaration of the forfeiture of the firm’s outstanding fees and no further involvement with the client and issues relating to the company.

Required:

a. Following the background to the client and the engagement, evaluate the internal and external business risks that need to be considered with respect to the client. (10 Marks)

b. Discuss the pre-engagement activities to be carried on the client. (10 Marks)

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  • 30 Marks

AAA – Nov 2021 – L3 – Q1 – Overview of Advanced Audit and Assurance

Evaluate auditor's objectives under ISA 250, internal control deficiencies, and communication requirements for audit strategy.

Eat Well Bakeries is a private limited liability company. It bakes bread and other confectioneries, produced from the main bakery and a smaller bakery in another part of town. Products are sold from these two bakeries and five additional outlets in the same town. Distributors purchase products outright and bear the risk of sale.

The main administrative and management functions of the bakeries are conducted from the main bakery, while basic records are kept at the small bakery and sales outlets. These records are transmitted to the main office every morning. Detailed accounting records and performance analysis are handled in the main administrative office.

Despite being a private business, the chairman insists on maintaining proper standards to stay competitive. The chairman transferred the company’s audit to your firm after a discussion with your partner, and professional clearance was obtained. However, limited documentation from the predecessor auditor was available, and no extensive documentation was done at the beginning of the audit.

You have been assigned to continue the audit from where it was left off, ensuring the chairman’s expectations are met.

Required:

a. Evaluate the Auditor’s objective concerning ISA 250 that would be discussed with the chairman. (5 Marks)

b. Prepare an outline of matters that should be communicated. (5 Marks)

c. Your review shows internal control challenges. Based on this, prepare a brief on:

  • i. The meaning of deficiency as per ISA 265 (3 Marks)
  • ii. The components to be included in communication to the chairman regarding deficiencies (5 Marks)

d. Evaluate potential audit strategies, and recommend an appropriate model for application to Eat Well Bakeries. (12 Marks)

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  • 15 Marks

FM – Nov 2021 – L3 – Q7 – Financing Decisions and Capital Markets

Analyze the effects of a 1-for-5 rights issue for James Obasi plc, calculate theoretical ex-rights price, and assess investor options and impacts.

James Obasi plc, a medium-sized drone manufacturing firm, is considering a 1-for-5 rights issue at a 15% discount to the current market price of N4.00 per share. Expected issue costs are N2 million, payable from the funds raised. The proceeds from the rights issue will be used to redeem some of the company’s existing bonds at par.

Financial Information:

Statement of Financial Position (N’000):

Required:

a. Ignoring issue costs and any use 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. Identify the alternative actions available to an owner of 1,500 shares in James Obasi plc concerning the rights issue and determine the effect of each action on the investor’s wealth. (6 Marks)

c. Calculate the current earnings per share and the revised earnings per share if the rights issue funds are used to redeem some of the existing bonds.
(5 Marks)

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  • 15 Marks

FM – Nov 2021 – L3 – Q6 – Portfolio Management

Analyze the risk profile of Bettaluck plc's short-term equity portfolio and assess investment adjustments based on market returns and financial strategy.

Bettaluck plc is experiencing a substantial net cash inflow, which has been temporarily invested in a short-term equity portfolio. This portfolio consists of investments in four Nigerian listed companies. The funds are intended to meet tax obligations, dividend payments, and future capital expenditures in several months.

Portfolio Details:

Required:

a. Based on the data provided, calculate the risk (i.e., Beta) of Bettaluck’s short-term investment portfolio relative to the market. (4 Marks)

b. Recommend whether the composition of Bettaluck’s short-term investment portfolio should be adjusted. Provide reasons for your recommendation, including relevant calculations. (6 Marks)

c. Discuss the factors a financial manager should consider when investing in marketable securities. (5 Marks)

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  • 15 Marks

FM – Nov 2021 – L3 – Q5 – Corporate Governance and Stakeholder Management

Analyze criteria for setting objectives in public and private sectors, addressing stakeholder needs and potential consequences of unmet objectives.

a. Ibile is a local government entity financed approximately equally by central government funding and local taxation. The central government funding allocation is primarily determined on a per capita basis, adjusted for the level of deprivation or special needs within Ibile’s region. A small portion of Ibile’s revenue comes from the private sector, such as renting out City Hall for private events.

Ibile’s Main Objectives:

  • Enhance the region’s economic prosperity and attractiveness as a place to live and work.
  • Provide service excellence in health and education for the local community.

b. Layo is a large, publicly listed entity with extensive commercial and geographical interests. It has historically established its headquarters in Ibile’s region, which is unusual for a company of its size, as such entities typically base their HQ in a capital or major city.

Layo’s Main Objectives:

  • Financial: Achieve an average annual increase of 10% in shareholder wealth.
  • Non-Financial: Maintain favorable treatment of various stakeholders, including local communities where it operates.

Layo’s total net assets are valued at ₦1.5 billion with a gearing ratio of 45% (debt to debt plus equity), consistent with industry norms. The company is currently exploring options to raise significant capital to fund an acquisition.

Required:

Discuss the criteria that each entity (Ibile and Layo) must consider when setting objectives, taking into account the needs of their main stakeholder groups. Reference the consequences each might face if it fails to achieve its stated objectives.

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  • 20 Marks

FM – Nov 2021 – L3 – Q4 – Corporate Governance and Financial Strategy

Assess LL's corporate objectives, the finance director's view, and treasury strategies within a low-interest economic environment.

Leye Limited (LL) is a privately-owned toy manufacturer in Nigeria, operating internationally as both a supplier and a customer. While privately owned, LL’s revenue and asset base are comparable to some publicly listed companies. It has numerous shareholders but has no plans for public listing. Major shareholders have expressed an interest in buying out smaller investors.

LL has a strong history of profitability, which satisfies both directors and shareholders. They avoid strategies that increase risk significantly, such as acquisitions or overseas manufacturing setups, accepting a comparatively lower growth rate than competitors.

The company’s capital structure is composed of 70% equity and 30% debt (based on book values), with debt comprising secured and unsecured bonds carrying interest rates between 7% and 8.5%, maturing in 5 to 10 years. In a low-inflation and potentially declining interest rate environment, the company treasurer is exploring refinancing options.

LL’s primary financial objective is annual dividend growth, with a non-financial objective of treating all stakeholders with fairness and equality. The Board is currently reassessing these objectives. While the new Finance Director advocates for shareholder wealth maximization as the sole objective, other directors favor a balanced approach, including goals such as profit after tax, return on investment, and operational performance improvements.

Required:

a. Evaluate the appropriateness of LL’s current objectives and the Finance Director’s suggestion. Discuss the issues the Board should consider in setting new corporate objectives, concluding with a recommendation. (10 Marks)

b. Discuss factors the treasury department should consider when formulating financing or refinancing strategies in the given economic context. Explain how these factors might influence the determination of corporate objectives. (10 Marks)

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  • 20 Marks

FM – Nov 2021 – L3 – Q3 – Financing Decisions and Capital Markets

Analyze financing alternatives for ZY Plc's new investment and assess rights issue and bond issue implications.

ZY Plc is an all-equity financed, publicly listed company in the food processing industry. The ZY family holds 40% of its ordinary shares, with the remainder owned by large financial institutions. ZY Plc currently has 10 million ₦1 ordinary shares in issue.

Recently, the company secured a long-term contract to supply food products to a large restaurant chain, necessitating an investment in new machinery costing ₦24 million. This machinery will be operational starting January 1, 2022, with payment due the same day, and sales commencing shortly afterward.

The company’s policy is to distribute all profits as dividends. If ZY Plc continues as an all-equity financed company, it will pay an annual dividend of ₦9 million indefinitely, starting December 31, 2022.

To finance the ₦24 million investment, ZY Plc is considering two options:

  1. A 2-for-5 rights issue, where the annual dividend would remain at ₦9 million. The cum-rights price per share is expected to be ₦6.60.
  2. Issuing 7.5% irredeemable bonds at par with interest payable annually in arrears. For this option, interest would be paid out of the ₦9 million otherwise allocated to dividends.

Under either financing method, the cost of equity is anticipated to remain at its current rate of 10% annually, with no tax implications.

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 as of January 1, 2022. Ignore taxation. (4 Marks)

b. Calculate the value per ordinary share in ZY Plc on January 1, 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 that includes: i. A comparison and contrast of the rights issue and bond issue methods for raising finance, referencing calculations from parts (a) and (b) and any assumptions. (6 Marks)
ii. A discussion on the appropriateness of the following alternative methods of issuing equity finance in the specific context of ZY Plc: – A placing – An offer for sale – A public offer for subscription (6 Marks)

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  • 20 Marks

FM – Nov 2021 – L3 – Q2 – Mergers and Acquisitions

Advise on financial synergies from KP's acquisition of TE and evaluate cash vs. share-for-share offers.

You run a financial consultancy firm and 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. KP initially experienced rapid growth in earnings before tax, but soon after listing, competition intensified, leading to a significant decline in growth, which currently stands at 4%. Concerned about limited future growth opportunities, the board has decided to adopt a market development strategy for growth by acquiring companies in less competitive regions using KP’s significant cash reserves. The board has identified Temidayo Engineering (TE) as a potential acquisition target.

Temidayo Engineering (TE):

TE is a private engineering company established eight years ago, with early accumulated losses that have now turned profitable, achieving an 8% annual growth in earnings before tax. Cash reserves remain low, and capital access has been a constraint on TE’s investment potential. The founders and their families own 70% of the shares, while a venture capitalist holds the remaining 30%.

Acquisition Information:

KP’s board prefers that TE’s founders remain as directors post-acquisition and has sufficient cash reserves to purchase TE outright. A cash offer of ₦13.10 per share is considered likely to encourage TE’s shareholders to approve the acquisition. Alternatively, KP’s board is exploring a share-for-share exchange to preserve cash for future acquisitions and dividends. Recent mergers in the industry have attracted a 25-30% acquisition premium, with TE’s shareholders expecting a premium towards the higher end for a share-for-share offer. KP has asked you to design a share-for-share offer scheme with a 30% premium.

Extracts from the Latest Financial Statements:

Additional Financial Information:

  • KP has ₦0.50 ordinary shares totaling ₦7,500 million, with each share trading at ₦5.28. It is expected that KP’s price-to-earnings (P/E) ratio will increase by 10% if the acquisition proceeds.
  • TE upgraded its main manufacturing facility last year, expecting annual pre-tax cost savings of ₦50 million from the current financial year. TE has ₦0.25 ordinary shares totaling ₦700 million. TE’s P/E ratio is estimated to be 20% higher than KP’s current P/E ratio based on comparable company analysis.
  • KP’s CEO estimates annual pre-tax revenue and cost synergies of ₦304 million post-acquisition, while the finance director anticipates additional pre-tax financial synergies of ₦106 million, though cautiously, following reports that many acquisitions overestimate synergies. The tax rate is 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 that meets TE’s shareholders’ criteria and calculate the impact of both cash and share-for-share offers on the post-acquisition wealth of KP’s and TE’s shareholders. (14 Marks)

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