Question Tag: Cost of Capital

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FM – Nov 2024 – L2 – Q5a – Management of Receivables

Evaluate the financial implications of different strategies for managing Abaa LTD's accounts receivable.

Abaa LTD, a company that manufactures and sells electronic appliances, has been facing challenges with its accounts receivable management. Currently, the company allows its customers 60 days of credit. Due to the highly competitive market, Abaa LTD has been experiencing an increasing amount of bad debts and delayed payments, which has adversely affected its cash flow and profitability. To address these issues, the company’s Finance Manager is considering several strategic changes:

  1. Reduction in Credit Period: Reducing the credit period from 60 days to 45 days. It is estimated that this change could reduce sales by 5% due to the stricter credit terms, but it would also decrease the bad debt ratio from 4% to 2% of sales.
  2. Offering Early Payment Discounts: Introducing a 2% discount for customers who pay within 30 days. The company anticipates that 30% of its customers will take advantage of this discount, which would improve cash flow and reduce the average collection period by 15 days.
  3. Engagement of a Factor: The company is also considering engaging a factoring company to manage its receivables. The factor would advance 80% of the invoice value upon the sale of goods at 200 basis points below the company’s cost of capital and charge a 3% fee on all sales. The factor is expected to reduce the bad debt ratio to 1% of sales and further reduce the average collection period by 20 days. Engaging the factor will lead to annual administrative savings of GH¢90,000.

Abaa LTD’s current annual sales are GH¢20 million, and the variable cost of sales is 60% of sales. The company’s cost of capital is 12% per annum.

Required:
Evaluate the financial implications of the following:
i) Reduction in Credit Period
ii) Offering Early Payment Discounts
iii) Engagement of a Factor
iv) Recommend the appropriate method to manage the credit sales

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FM – May 2016 – L3 – Q1 – Investment Appraisal Techniques

Calculation of Adjusted Present Value (APV) for a proposed project and analysis of its application in investment appraisal.

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 25%, 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% can be expected throughout the 15-year life of the project. Incremental fixed cash costs will be N84.32million in 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 an issue cost of 3%. All issue costs are on the gross amount raised for the respective capital. Issue costs on debt are allowed for tax purposes.

A firm that is already in the business of the new project has a gearing ratio of 20% (debt to asset) and a cost of equity of 18.1%. Its corporate debt is risk-free.

The tax rate is 30% payable in the year the profit is made. Tax depreciation of 20% on cost is available on the new machine. Katam Pie has a weighted average cost of capital of 14% and a cost of equity of 17.5%. The risk-free rate is 4%, and the market risk premium is 7%.

You are required to:

  1. Estimate the Adjusted Present Value (APV) and advise whether the project should be accepted? (21 Marks)
  2. Explain:
    i. The circumstances under which the use of APV is appropriate. (5 Marks)
    ii. The major advantages and limitations of the use of the APV method. (4 Marks)

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FM – Nov 2016 – L3 -SB – Q3 – Capital Gains Tax

Calculate EVA for Jack Limited and determine its market value added (MVA) based on provided assumptions.

Jack Limited is a family-owned business that 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.

You are provided with the following financial information:

Statement of Profit or Loss and Other Comprehensive Income for the year ended December 31, 2015:

₦’million 2015
Operating profit 340.0
Finance charges (115.0)
Profit before tax 225.0
Tax at 25% (56.3)
Profit after tax 168.7

Notes

Notes 2015 (₦’m) 2014 (₦’m)
(i) Capital employed – from the Statement of Financial Position 6,285 6,185
(ii) Operating costs:
Depreciation 295 285
Provision for doubtful debts 10 2.5
Research and development 60
Other non-cash expenses 35 30
Marketing expenses 50 45
(iii) Economic depreciation is assessed to be ₦415 in 2015. Economic depreciation includes any appropriate amortisation adjustments. In previous years, it can be assumed that economic and accounting depreciation were the same.
(iv) Tax is the cash paid in the current year (₦45million) and an adjustment of ₦2.5million for deferred tax provisions. There was no deferred tax balance prior to 2015.
(v) The provision for doubtful debts was ₦22.5million on the 2015 Statement of Financial Position.
(vi) Research and development cost is not capitalised in the accounts. It relates to a new project that will be developed over five years and is expected to be of long-term benefit to the company. The first year of this project is 2015.
(vii) The company has been spending heavily on marketing each year to build its brand long term.
(viii) Estimated cost of capital of the company:
Equity 16%
Debt (pre-tax) 5%
(ix) Gearing (Debt/Equity) Ratio 1.5: 1

Required:
a. Calculate, showing all relevant workings, the Economic Value Added (EVA) for the year ended December 31, 2015. Make use of the adjusted opening capital employed. Comment on your result and make appropriate recommendations. (15 Marks)

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)

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FM – Nov 2016 – L3 – SA – Q1 – Cost of Capital

Analyze a potential investment project, including the valuation of the firm’s equity and bonds, calculation of the risk-adjusted cost of capital, and project valuation with and without a buyout offer.

Tinko Plc (TP) repairs and maintains heavy-duty trucks with workshops across Nigeria and parts of Africa. Below are extracts from its financial position:

Item ₦’million
Share capital (50k/share) 200
Reserves 320
Non-current liabilities 760
Current liabilities 60

The company’s Free Cash Flow to Equity (FCFE) is estimated at ₦153 million, with a perpetual growth rate of 2.5% annually. The equity shareholders require an 11% return.

The non-current liabilities consist of ₦1,000 nominal value bonds redeemable in 4 years at par with a 5.4% coupon. The credit spread is 80 basis points above the risk-free rate.

A project related to the “Graduates Back To Land (GBTL)” program is under consideration. The initial investment is ₦84 million, with estimated cash flows for four years. Details about the project include alternative scenarios for the program’s growth and a potential buyout offer of ₦100 million at the end of year one.

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. (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)

 

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FM – Nov 2014 – L3 – SA – Q1 – Investment Appraisal Techniques

Evaluate the financial feasibility of a cement production project using cost of capital, NPV, and MIRR methods.

AK Plc is a company listed on the Nigerian Stock Exchange. It is involved in property development and sales.

The company currently imports more than 60% of its cement requirements. At a recent meeting of the board of directors, a decision was taken to establish a division for the production of cement in Ore, Ondo State. If the division is set up and the cement production goes ahead, output from the division will be sold to AK Plc and external customers at market price. For planning purposes, it has been decided that the financial viability of the project over the next five years should be determined.

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 N20 million has been spent on various surveys (market, technical, financial, etc.) to date out of which N10 million has been paid. The balance of N10 million is due for payment at the end of year 1.

Production of cement for the next five years is projected as follows:

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 N1,000 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 N25 million at current prices will rise by 10% per annum. Fifty per cent (50%) of the total initial outlay of N2 billion is to be funded with a loan from a Federal Government Development Bank at a concessionary fixed interest rate of 8%, payable at the end of each year. Half of the loan will be repaid at the end of year 3 while the balance will be paid at the end of year 5. The project will require a working capital of 10% of annual revenue, and this should be available at the beginning of each year.

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 that currently produces cement and packaged fruit drinks. The company has the following financial statistics:

  • Equity beta: 1.82
  • Debt beta: 0.4
  • Debt/Equity ratio: 40%
  • 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 an 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.

Required:

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 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)

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FM – Nov 2016 – L3 – Q4 – International Financial Management

Evaluate a foreign investment decision for Gugi Plc, including cash flow, tax, and exchange rate considerations.

Gugi Plc. is a highly successful manufacturing company operating in Nigeria. In addition to sales within Nigeria, the company also exports to a foreign country (with currency F$) along the ECOWAS sub-region. The export sales generate annual net cash inflow of ₦50,000,000.

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$200 million for working capital.

A suitable existing factory has been located, and production could commence immediately. A payment of F$950 million would be required immediately, with the remainder payable at the end of year one. The following additional information is available:

Details Figures
Annual production and sales 110,000 units
Unit selling price F$5,000
Unit variable cost F$2,000
Unit royalty payable to Gugi Plc ₦300
Incremental annual cash fixed costs F$50 million

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 realizable value of the non-current assets will be F$1.40 billion.

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.

If the new factory is set up and export to the foreign country is stopped, it is expected that new export markets of a similar worth in North Africa could replace the existing exports. 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 = ₦1. You may assume that the exchange rate reflects the purchasing power parity theorem.

Required:

(a) Evaluate the proposed investment from the viewpoint of Gugi Plc.
Notes:

  • Show all workings and calculations to the nearest million.
  • State all reasonable assumptions. (18 Marks)

(b) State two further information and analysis that might be useful in evaluating this project. (2 Marks)

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FM – Nov 2016 – L3 – Q1 – Investment Appraisal Techniques

Evaluate TP’s project considering current market values and assess the risk-adjusted cost of capital.

Tinko Plc (TP) repairs and maintains heavy-duty trucks, with workshops in Nigeria and several other African countries. TP is considering an expansion project in response to the government’s recent policy aimed at encouraging mechanized farming through the “Graduates Back To Land (GBTL)” program, which will likely increase demand for heavy-duty machinery.

Below are extracts from the most recent Statement of Financial Position of TP:

Item ₦’million
Share capital 200
Reserves 320
Non-current liabilities 760
Current liabilities 60
Total 1,340

TP’s Free Cash Flows to Equity (FCFE) is currently estimated at ₦153 million, and it is expected to grow at 2.5% per annum indefinitely. The equity shareholders require a return of 11%.

The non-current liabilities consist entirely of bonds redeemable in four years at par with a coupon rate 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.

In light of the GBTL program, TP is contemplating entry into the mechanized farming support industry through a four-year project, recognizing that after four years, competition may intensify significantly.

The project requires an initial investment of ₦84 million and is expected to generate the following after-tax cash flows:

Additional Information:

  • Scenario Adjustments:
    • There is a 25% probability that the GBTL program will not grow as expected in the first year. If this occurs, the present value of the project’s cash flows over its four-year life will be 50% of the original estimates.
    • If the GBTL program grows as expected in the first year, there is still a 20% probability that growth will slow in subsequent years, reducing the present value of cash flows to 40% of the original estimates for those years.
  • Sale Option: Feedwell Limited (FL) has offered ₦100 million to buy the project from TP at the start of the second year. TP is evaluating if this option adds strategic value to the project.
  • Abako Plc, a comparable company, operates primarily in non-agricultural services, similar to TP, and has an equity beta of 1.6. Abako derives approximately 80% of its revenues from services outside agriculture, with an asset beta of 0.80. Abako’s capital structure consists of 80 million shares trading at ₦4.50 per share and debt of ₦340 million.
  • The debt is trading at ₦1,050 per ₦1,000 with a zero debt beta.
  • Risk-free rate: 4%; Market risk premium: 6%; Corporate tax rate: 20%.

Requirements: a. Calculate TP’s current total market value of:

  • i. Equity (3 Marks)
  • ii. Bonds (4 Marks) b. Determine the risk-adjusted cost of capital for the new project (to the nearest percent) (10 Marks) c. Estimate the value of the project:
  • i. Without factoring in the potential strategic value or synergy from the project (5 Marks)
  • ii. With FL’s offer, assuming it reflects the market’s view of the project’s value (5 Marks) d. Clearly state the assumptions made in your calculations (3 Marks)

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FM – May 2024 – L3 – SC – Q6 – Financial Distress and Bankruptcy

Discuss economic exposure in currency risk management and calculate impact of USD strengthening on Linko Plc’s market value.

(a) With respect to foreign currency risk management, explain economic exposure and discuss generally how a company can manage economic exposure. (8 Marks)

(b) Linko Plc is a UK-based company supplying medical equipment to the USA and Europe, while importing raw materials from the USA. It has net imports of 8 million dollars from the USA, which is expected to continue for the next six years. The company’s cost of capital is 10% per year. Assume cash flows occur at year-end and ignore taxation.

Required:
Assuming no change in the physical volume or dollar price of imports, estimate the impact on the expected market value of Linko Plc, if the market expects the dollar to strengthen by 4% per year against the pound. The current spot exchange rate (US$ per £1) is 1.9156 – 1.9210. (7 Marks)

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FM – Nov 2018 – L3 – Q5 – Capital Budgeting under Uncertainty

Analyze whether replacing a machine after three or four years is more beneficial based on economic costs and tax implications.

Kuku Plc. had a need for a machine. After four years of purchase, the machine will no longer be capable of efficient working at the level of use by the company. The company typically replaces machines every four years. The production manager has noted that in the fourth year, the machine will require additional maintenance to maintain normal efficiency. This raises the question of whether the machine should be replaced after three years instead of four years, as per company practice.

Relevant information is as follows:

(i) A new machine will cost N240,000. If retained for four years, it will have zero scrap value at the end. If retained for three years, it will have an estimated disposal value of N30,000. The machine qualifies for capital allowance of 20% on a reducing balance basis each year, except in the last year. In the final year, if the disposal proceeds are less than the tax written-down value, the difference will be an additional tax relief.

The machine is assumed to be bought and disposed of on the last day of the company’s accounting year.

(ii) The company tax rate is 30%, payable on the last day of the relevant accounting year.

(iii) Maintenance costs are covered by the supplier in the first year. In the second and third years, maintenance costs average N30,000 annually. In the fourth year, they increase to N60,000. Maintenance costs are tax-allowable and payable on the first day of the accounting year.

(iv) The company’s cost of capital is 15%.

Required:

a. Prepare calculations to determine whether it is economically beneficial to replace the machine after three years or four years. (12 Marks)

b. Discuss two additional factors that could influence the company’s replacement decision, including any potential weaknesses in the decision criteria. (3 Marks)

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FM – Nov 2022 – L3 – Q3 – Financing Decisions and Capital Markets

Evaluate the financing structure and calculate required return, WACC, and factors influencing beta.

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 as at 30 September 2021:

The ordinary shares were quoted at ₦3 per share ex div on 30 September 2021. The beta of ZK Plc’s equity shares is 0.8; the annual yield on treasury bills is 5%, and financial markets expect an average annual return of 15% on the market index.

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 as 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 (WACC) of ZK Plc as 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)

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AFM – Nov 2018 – L3 – Q1a – Discounted cash flow techniques

Evaluating an irrigation project using the Adjusted Present Value (APV) method, incorporating debt financing, government subsidy, and project cash flows.

One-Village Water Resources Ltd (One-Village) is considering a damming and irrigation project that will supply water to tomato farms around the Oti River. One-Village plans to commence the construction and installation phase of the project immediately and complete it in three years. One-Village will invest GH¢3 million in new plants and equipment now. Mobilisation to the project site will cost GH¢0.5 million now. Development costs are expected to be GH¢3 million in the first year, GH¢4 million in the second year, and GH¢2 million in the third year.

The commercial phase of the project will commence in the fourth year and run indefinitely. The project will generate after-tax net cash flows of GH¢6 million in the fourth year and GH¢8 million in the fifth year. Beyond the fifth year, cash flows will grow by 5% every year to perpetuity.

One-Village has 10 million shares outstanding, which are currently trading at GH¢3.5 each. The total value of its debt stock is GH¢20 million. One-Village plans to finance the investment requirements of the construction and installation phase of the project with new debt. Its borrowing cost is 20%, while its cost of equity is 25%. The Government of Ghana is promoting large-scale farming and is willing to give a subsidised loan of up to GH¢10 million at 15% annual interest. One-Village plans to take the maximum subsidised loan from the Government of Ghana and finance the balance with a bank loan. Issue costs, which are tax-deductible, are expected to be GH¢0.6 million. Both loans will be repaid in five years. One-Village falls into the 22% corporate income tax category. The risk-free interest rate is 14%, and the return on the market portfolio is 18%.

Required:
Evaluate the project using the adjusted present value (APV) technique and recommend whether it should be implemented or not. (12 marks)

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AFM – May 2016 – L3 – Q2a – Discounted cash flow techniques, Valuation and use of free cash flows, Theories of capital structure

Compute NPV for two investment projects using WACC and CAPM, and provide recommendations based on risk analysis.

a) Joebel Limited is a diversified company operating in different industries on the African Continent. The shares of the company are widely traded on the stock exchange and currently have a market price of GH¢3.20 per share. The company’s dividend payment over the last five years is as follows:

Year Dividend Per Share (DPS) (GH¢)
2015 0.35
2014 0.32
2013 0.30
2012 0.29
2011 0.28

The Board of Directors of Joebel Limited is considering two main investment opportunities: one in the Oil and Gas sector and the other in the Hotel and Tourism sector. Both projects have short lives and their associated cash flows are as follows:

Year Oil & Gas (GH¢’000) Hotel & Tourism (GH¢’000)
1 85 180
2 175 195
3 160 150

The investment in Oil and Gas would cost GH¢400,000, while the investment in Hotel and Tourism would cost GH¢405,000. The Management of the Company has identified the industry beta for Oil and Gas as 1.2 and for Hotel and Tourism as 1.6. However, Joebel Limited’s company beta is 1.5. The average return on companies listed on the stock exchange is 25%, and the yield on Treasury bills is 20%.

Required:
i) Compute the Net Present Values (NPV) of both projects using the company’s weighted average cost of capital as the discount rate. (5 marks)
ii) Compute the NPV using a discount rate that takes into account the risk associated with the individual projects. (5 marks)
iii) Advise Management regarding the suitability and acceptability of the projects. (1 mark)

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MA – Nov 2020 – L2 – Q4a – Discounted Cash Flow

Calculate the cost of capital to break-even for a van investment over five years and discuss the advantages and disadvantages of the payback method.

a) Jayjay & Co is a medium-sized company that is engaged in delivery services. As a result of the recent increase in the demand for its services, the Managing Director (MD) is planning to acquire a delivery van at the cost of GH¢85,000. The expected net cash flow per year is as follows:

Year Net Cash Flow (GH¢)
1 25,000
2 28,000
3 39,000
4 34,000
5 24,000

The Sales Manager has indicated to the MD that the company will recoup its investment in less than four years, and for that reason, it’s a good investment. The Management Accountant, however, has drawn the MD’s attention to the fact that the Sales Manager has not factored in the time value of money and the cost of capital into his analysis.

Required:

i) Calculate the cost of capital that, when used, will make the investment break-even when the useful life of the van is five years with a residual value of GH¢8,500.
ii) Explain TWO (2) advantages and TWO (2) disadvantages of the payback method of investment appraisal and show how it compares to the discounted cash flow method.

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MA – April 2022 – L2 – Q4a – Discounted cash flow

Evaluate the acceptability of a project using the Net Present Value (NPV) method considering cash flows and cost of capital.

Phil Company is considering replacing its existing machine on the introduction of a new product. The existing machine would be sold for GH¢2 million and replaced with a new machine at the beginning of the year at the cost of GH¢16 million. This new machine would be sold at the end of year 4 for GH¢1 million.

A market research recently carried out at a cost of GH¢1.5 million indicates a unit selling price of GH¢300 in year 1, rising by 10% per annum. Sales volume for the four-year life of the project has been estimated as follows:

Year Units
1 60,000
2 85,000
3 85,000
4 80,000

Possible unit variable costs are as follows:

Probability GH¢
0.4 240
0.6 260

Incremental fixed cost as a result of the project is GH¢15 per unit plus GH¢1,000,000 per annum staff cost.

The introduction of the new product is expected to reduce the market demand for an existing product by 5,000 units per annum. The existing product has a unit contribution of GH¢75.

Other annual fixed costs associated with the new product include the following:

  • Amortization of goodwill: GH¢50,000
  • Depreciation: GH¢250,000

Phil Company’s cost of capital is 12%.

Required:

Evaluate the acceptability of the project.

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MA – Nov 2016 – L2 – Q5a – Discounted cash flow

Calculate the NPV break-even point under different cost of capital scenarios and determine the project's duration based on given cash inflows.

DDB Limited has decided to set up a factory to process groundnuts into oil. The feasibility studies cost them GH¢35,000. The consultants have advised that the initial outlay will be GH¢250,000; however, they were unable to estimate the cash inflow due to the uncertain economic environment.

Required:
Using NPV as an appraisal technique, you are required to calculate:

i) The constant cash inflow needed to break even if the cost of capital is 15% and the project is to last for 10 years.

(4 marks)

ii) By how much should the cash inflow increase to break even if the cost of capital is increased to 20%. (4 marks)

iii) If the cash inflow is GH¢45,000, for how long should the project run to break even if the cost of capital is 15%.

(4 marks)

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FM – May 2020 – L2 – Q3a – Simple interest and compound interest

Calculate the quarterly loan installment and prepare an amortization schedule for a loan with compound interest and equal quarterly payments.

Odapagyan Foods Ltd is borrowing GH¢500,000 to finance a project involving an expansion of its existing factory. It has obtained an offer from Sika Bank. The terms of the loan facility are as follows:

  • Annual interest rate: 22%
  • Duration: 2 years
  • Interest method: compound interest with quarterly compounding
  • Payment plan: equal installments at the end of each quarter

Required:

i) Compute the quarterly installment.
(3 marks)

ii) Prepare a loan amortization schedule to show the periodic interest charges, installment payments, principal payments, and balance of the loan at the end of each quarter.
(7 marks)

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FM – MAY 2016 – L2 – Q4 – Capital structure | Cost of capital

Discuss the reasons for pecking order in financing, factors influencing capital structure, and calculate the appropriate cost of capital for Pusher Mining Ltd’s new project.

a) The Directors of Moore Plastics Ltd have been deliberating on the company’s capital structure with a view to identifying an optimal financing mix. Opening the deliberation, the Board Chair remarked, “For the past 10 years, we have deployed a financing strategy of reinvesting as much profit as available. When profit is inadequate, we go for borrowing. New equity offers have been a last resort.”

Required:
i) Explain with THREE reasons why most managers tend to use financing strategies that follow the pecking order. (6 marks)
ii) Identify and explain TWO factors the directors of Moore Plastics Ltd should consider in redesigning the company’s capital structure. (4 marks)

b) Pusher Mining Ltd, a large listed company, operates five mineral concessions in Ghana and Ivory Coast. The company’s financial performance for the past five years has been impressive. The company’s recently published financial results indicate that it earned after-tax profit of GH¢250 million and paid dividends of GH¢50 million out of that profit.

Reserves at two of the five mineral concessions will be exhausted in two years’ time, and stakeholders fear this will adversely affect the company’s profitability. Nevertheless, the directors are aiming at maintaining the company’s dividend payment record. To achieve this, they want to pursue a new project in the oil industry to provide additional cash flows. Though the new project will be financed with existing equity and long-term debts, the directors are not sure what cost of capital to use in appraising the new project.

A summary of the company’s financial position before the new oil project follows:

Item GH¢m
Noncurrent assets 620
Current assets 425
Total assets 1,045
Equity
Stated capital 180
Income surplus 685
Shareholders’ fund 865
Liabilities
Current liabilities 20
Bank loans 40
Bonds 120
Total liabilities 180
Total equity and liabilities 1,045

Notes:

  1. Stated capital: Pusher has in issue 40 million ordinary shares of no par value, all of which are listed on the stock exchange. The current market value of the ordinary stock is GH¢5.5 per share. It is estimated that the market value of the ordinary stock will increase by 8% per annum. The equity beta is 1.25.
  2. Bank loans: These are fixed-rate loans from banks in Ghana. The after-tax cost of the loans is 14.5%.
  3. Bonds: These are 16% coupon bonds with a face value of GH¢100 each. The bonds are currently trading at GH¢98.1 each. In 10 years’ time, the bonds may be either converted into 10 ordinary shares or redeemed at face value at the choice of bondholders. Bondholders are assumed to be rational investors.

If the new oil project is implemented, Pusher Mining Ltd’s main competitor in the oil industry would be Cargo Oil Ltd. The estimated equity beta of the competitor is 1.80 and the market value of its equity stock is GH¢150 million. The long-term debt stock of the competitor is valued at GH¢100 million. The systematic risk of debt stocks is assumed to be zero. The risk-free return is 14% and the market return is 20%. The corporate tax rate is 25%.

Required:
Estimate the appropriate cost of capital Pusher Mining Ltd should use in appraising the new project in the oil industry. Show all relevant computations. (10 marks)

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FM – March 2023 – L2 – Q5a – Management of receivables and payables | Working Capital Management

Evaluate the net benefit or cost associated with the proposed change in Kanzo Food Stores Plc’s credit terms and recommend whether it should be adopted.

Kanzo Food Stores Plc (Kanzo) sells on credit terms of net 60 days. Kanzo’s new Chief Finance Officer (CFO) thinks that the company’s credit terms are too lengthy considering the industry average credit terms of net 45 days.

Kanzo’s annual credit sales revenue is GH¢500 million, and its receivables turnover days are 55 days. The CFO has proposed that the credit terms be revised to net 45 days. Although the tightening of the credit terms would cause annual sales revenue to drop by an estimated GH¢20 million, the CFO believes that the policy change would lower the receivables turnover days to 40 days, which would bring some savings on investment in accounts receivables.

Kanzo has a variable cost ratio of 65% and a cost of capital of 20%.

Required:
i) Compute the net benefit/cost associated with the proposed change in the credit terms and recommend whether the proposed change in the credit terms should be adopted. (10 marks)
ii) The CFO is considering investing funds that would be released from trade receivables in short-term marketable securities. Explain TWO (2) characteristics of marketable securities. (5 marks)

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FM – April 2022 – L2 – Q5a – Management of receivables and payables

Evaluate the impact of a proposed change in credit policy on Poh-Poh Electronics Ltd’s profitability and recommend whether the policy should be implemented, along with advice on procedures for receivables collection.

Poh-Poh Electronics Ltd is a wholesale distributor of household electrical products of major electronic brands. The company currently sells on credit to all its customers. Although the credit term is net 20 days, the receivables turnover days have been 15 days. The company’s annual credit sales revenue is GH¢80 million, and its contribution margin ratio is 30%. Bad debt is 2% of sales revenue, and credit collection cost is GH¢50,000 per annum.

Management is considering extending the credit period to net 30 days. It is expected that the implementation of this proposal would attract new customers, and the annual revenue would increase by 20%. It is also expected that both the existing and the new customers will probably take the full 30 days credit. To mitigate the probable lengthening in the receivables turnover days, management proposes that the extension in the credit period be combined with the introduction of a cash discount policy of 2% on all payments made within the first 10 days of the credit period. It is expected that 30% of all customers will pay their accounts early to take the discount. Consequently, the receivables turnover days would increase to 24 days. While the bad debt will remain at 2% of sales revenue, the annual credit collection cost will increase to GH¢65,000.

The company’s cost of capital is 24%.

Required:
i) Evaluate the proposed change in the credit policy and recommend whether the proposed change should be implemented. (9 marks)
ii) Advise the management team on THREE (3) procedures for the collection of its receivables. (6 marks)

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FM – April 2022 – L2 – Q1b – Capital structure

Calculate the capital structure of Boom Ltd and determine the earnings required to achieve a 25% return for equity holders.

Boom Ltd is into the provision of online conference call facilities which has become popular due to the rising trend in Covid-19 cases in Ghana. The company has 10 million issued shares currently at GH¢50 each, 3 million preference shares trading at GH¢25 each, and 5,000 bonds also trading at GH¢600 each.

Required:
i) Calculate the Capital Structure of the Company. (4 marks)
ii) How much should the company earn annually to achieve a return of 25% per annum on capital employed for equity holders if the dividend rate on preference shares per annum is 20% and the coupon on the bonds is 18%? In Ghana, interest paid on debt is tax deductible and corporate tax is at 25%. (6 marks)

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