Subject: FINANCIAL MANAGEMENT

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FM – May 2022 – L3 – Q5 – Cost of Capital

Calculate market value WACC for JP and discuss its preference over book value WACC for investment appraisals.

Question

The directors of Jindadi 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 the net present value criterion.

You have been provided with some financial information about the company.

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)

b. Discuss why market value weighted average cost of capital is preferred to book value weighted average cost of capital when making investment decisions. (5 Marks)

Answer

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Tags: Book value, Convertible Bonds, Investment decisions, Market Value, Preference shares, WACC
Level: Level 3

Topic: Cost of capital

FM – May 2022 – L3 – Q4 – Treasury Management

Discuss the roles of a treasury department and analyze its operation as a profit versus cost centre.

Question

he 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)

b. Identify the advantages and disadvantages of operating the treasury department as a profit centre rather than a cost centre. (6 Marks)

Answer

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Tags: Cost Centre, Financial Control, Organizational Structuring, Profit Centre, Treasury Roles
Level: Level 3

Topic: Treasury management

FM – May 2022 – L3 – Q3 – Investment Appraisal Techniques

Calculate NPV of an investment, discuss inflation's impact, and recommend an optimal project under capital constraints.

Question

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	2	3
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, and 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)

c. The evaluation of the other two investments is shown below:

Investment	Initial Investment	Net Present Value
W	300,000	75,000
Y	100,000	27,000

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)

Answer

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Tags: Financial management, Inflation impact, Investment Selection, NPV Calculation
Level: Level 3

Topic: Investment Appraisal Techniques

FM – May 2022 – L3 – Q2 – Financing Decisions and Capital Markets

Evaluate the financing options for Effe's expansion and provide advice on creditworthiness for a bond investment.

Question

Effe is a Nigerian company specialising in the provision of information systems solutions to large corporate organisations. It is going through a period of rapid expansion and requires additional funds to finance the long-term working capital needs of the business.

Effe has issued one hundred million N1 ordinary shares, which are listed on the stock market at a current market price of N15 with typical increases of 10% per annum expected in the next five years. Dividend payout is kept constant at a level of 10% of post-tax profits. Effe also has N1,000 million of bank borrowings.

It is estimated that a further N300 million is required to satisfy the funding requirements of the business for the next five-years beginning July 1, 2021. Two major institutional shareholders have indicated that they are not prepared to invest further in Effe at the present time and so a rights issue is unlikely to succeed. The directors are therefore considering various forms of debt finance. Three alternative structures are under discussion as shown below:

Five-year unsecured bank loan at a fixed interest rate of 7% per annum;
Five-year unsecured bond with a coupon of 5% per annum, redeemable at par and issued at a 6% discount; and
A convertible bond, issued at par, with an annual coupon rate of 4.5% and a conversion option in five years’ time of five shares for each ₦100 nominal of debt.

There have been lengthy boardroom discussions on the relative merits of each instrument. Summarised below are the queries of three different directors concerning the instruments.

Director A: “The bank loan would seem to be more expensive than the unsecured bond. Is this actually the case?”
Director B: “Surely, the convertible bond would be the cheapest form of borrowing with such a low interest rate?”
Director C: “If we want to increase our equity base, why use a convertible bond, rather, than a straight equity issue?”

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 analysis he should undertake in order to assess the credit worthiness of the proposed investment. (5 Marks)

Answer

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Tags: Convertible Bonds, Credit Analysis, Debt Instruments, Equity Financing, Yield Calculations
Level: Level 3

Topic: Financing Decisions and Capital Markets

FM – May 2022 – L3 – Q1 – Business Valuation Techniques

Estimate VT's valuation using FCFE, CAPM, and terminal value assumptions for three-year cash flow forecasts.

Question

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:

During the current year:

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.
The investment in net working capital is expected to increase in line with the growth in gross profit.
Other operating costs consisted of:

Sales and variable costs are projected to grow at 9% per annum and fixed costs are projected to grow at 6% per annum.
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.
For estimating the appropriate required return on equity, it is decided to make use of the capital asset pricing model (CAPM). The challenge, however, is that since the company is not quoted, an appropriate beta factor does not exist. You have found a listed company, Konputer Limited (KL) that is into software development. KL is also into computer hardware retailing. It has the following financial statistics:

About 60% of the market value of KL is attributed to the software development division, while 40% of the value is attributed to computer hardware retailing. The computer hardware retailing division has an equity beta of 0.8.
Risk-free rate is 4% and the market risk premium is 8%.
VT has maintained a long-term debt/(debt+equity) ratio of 20%.

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)

Answer

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Tags: Business Valuation, CAPM, Financial Projections, Free Cash Flow to Equity
Level: Level 3

Topic: Business Valuation Techniques

FM – May 2023 – L3 – Q7 – Mergers and Acquisitions

Evaluate the share price of Obong plc under different growth scenarios and advise on the takeover bid. Explain EMH and its implications for the market.

Question

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 stabilize 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)

Answer

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Tags: Dividend growth model, Market Efficiency, Share Price Estimation, Takeover Analysis
Level: Level 3

Topic: Mergers and acquisitions

FM – May 2023 – L3 – Q6 – Dividend Policy

Evaluate the comments in Neko Plc's annual report regarding dividend policy, share price, cost reduction, and tax minimization strategies.

Question

Neko Plc has issued the following statement as part of its annual report:
“This company aims at all times to serve its shareholders by paying a high level of dividends and adopting strategies that will increase the company’s share price. Satisfying our shareholders will ensure our success. The company will reduce costs by manufacturing overseas wherever possible and will attempt to minimize the company’s global tax bill by using tax haven facilities.”

Required:
a. Discuss the validity and implications of each of the comments and strategies in the above statement. (10 Marks)

b. Produce a short note outlining how the company should estimate its dividend capacity. (5 Marks)

Answer

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Tags: Cost Minimization, Dividend Capacity, Shareholder Value, Tax Haven Strategies
Level: Level 3

Topic: Dividend Policy

FM – May 2023 – L3 – Q5b – Corporate Governance and Financial Strategy

Discuss ways to motivate managers to align with and achieve stakeholder objectives.

Question

b. Discuss FOUR ways to encourage managers to achieve stakeholder objectives. (6 Marks)

Answer

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Tags: Corporate Governance, Managerial Incentives, Performance Measurement, Stakeholder Objectives
Level: Level 3

Topic: Corporate Governance and Financial Strategy

FM – May 2023 – L3 – Q5a – Strategic Performance Measurement

Evaluate TAXIM Plc’s financial performance in achieving profit growth, EPS growth, and shareholder return objectives.

Question

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.

Required:
Analyse and discuss the extent to which TAXIM Plc has achieved each of its stated objectives. (9 Marks)

Answer

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Tags: EPS Growth, Financial objectives, Profit Growth, Shareholder Return
Level: Level 3

Topic: Strategic Performance Measurement

FM – May 2023 – L3 – Q4 – Financing Decisions and Capital Markets

Evaluate the implications of equity financing decisions, analyze pre-emptive rights, estimate share price, and explore factors affecting price movement.

Question

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 ₦500 million and pay off a penalty of ₦35 million 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.

Kenny’s current capital structure is summarised below:

₦ million
Ordinary shares (25 kobo per share)	800
Share premium	1,120
Revenue reserves	2,310
Total Equity	4,230
15% term loan	500
11% bond	900
Total Capital	5,630

The company’s current share price is 190 kobo, and bond price is ₦102. Kenny can raise bond or medium-term bank finance at 10 per cent per year.

The stock market may be assumed to be semi-strong form efficient, and no information about the proposed uses of funds from the issue has been made available to the public.

Taxation may be ignored.

Required:

a. Discuss FOUR factors that Kenny’s directors should have considered before deciding which form of financing to use. (6 Marks)

b. Explain what is meant by pre-emptive rights, and discuss their advantages and disadvantages. (4 Marks)

c. Estimate Kenny’s expected share price once full details of the placement, and the uses to which the finance is to be put, are announced. (8 Marks)

d. Suggest two reasons why the share price might not move to the price that you estimated in (c) above. (2 Marks)

Answer

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Tags: Equity Issue, Market Efficiency, NPV, Pre-emptive rights, Share Valuation
Level: Level 3

Topic: Financing Decisions and Capital Markets

FM – DEC 2023 – L2 – Q5 – Cost of capital | Foreign exchange risk and currency risk management

Calculation of the effective cost of various financing options and explanation of internal strategies to manage foreign currency risk.

Question

a) Markwei Pharmaceuticals Ltd plans to import active ingredients to produce vitamin syrup. The company’s managers are considering three financing options for the cedi equivalent of an invoice value of GH¢2.5 million. The options are detailed below:

Option 1: Use supplier’s credit. The credit term is 1.5/10 net 45.

Option 2: Issue a commercial paper to raise the money from the Ghanaian money market. The commercial paper will pay interest at the rate of 18% per annum. Issue costs totaling GH¢15,000 will be incurred.

Option 3: Obtain a 3-month bank loan. The interest rate on the loan is 22% per annum. Loan arrangement and processing fees are expected to be GH¢5,000.

Required:
i) Compute the effective annual cost of each financing option and recommend the most cost-effective option. (10 marks)
ii) Explain TWO (2) advantages of financing the invoice through the issue of a commercial paper instead of a bank loan. (5 marks)

b) Abongo Shoes Ltd (Abongo) imports leather from Italy. Abongo’s demand for euros to settle its import bills exposes its cash flow to foreign exchange risk. Abongo’s Management is looking for internal strategies they can deploy to hedge the company’s currency risk exposure as external hedging strategies might be too expensive for the company.

Required:
Explain TWO (2) internal strategies for managing foreign currency risk exposures that Abongo’s Management can use. (5 marks)

Answer

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Tags: Bank Loan, Commercial Paper, Cost of Finance, Currency risk, Hedging Strategies, Trade Credit
Level: Level 2

Topic: Cost of capital, Foreign exchange risk and currency risk management
Series: DEC 2022

FM – DEC 2023 – L2 – Q4 – Capital rationing | Introduction to Investment Appraisal | Sources of finance: debt

Explanation of capital rationing concepts, NPV and profitability index calculations, and factors influencing debt finance decisions.

Question

a) In periods of difficult global financial environment, raising of capital is a challenge necessitating the need for prudent and best use of scarce capital for projects.

Required:
i) Explain the term capital rationing. (2 marks)
ii) Distinguish between soft capital rationing and hard capital rationing giving an example each. (3 marks)

b) Akonta Ghana Ltd has excess funds of GH¢200 million and is looking for attractive investment opportunities that will yield a return of 15% per annum or better to deploy the funds. An extract from a Feasibility report submitted by a team of investment and project experts is as follows:

Project	Initial Investment Required (GH¢)	Constant Annual Cash Inflow (GH¢)	Project Life (Years)
A	80,000,000	36,000,000	4
B	40,000,000	23,000,000	3
C	78,000,000	30,000,000	5
D	40,000,000	20,000,000	4
E	40,000,000	22,000,000	3

The cash flows per project are constant for the life span of each project and each project is divisible for the purpose of capital allocation.

Required:
i) Calculate the Net Present Values (NPVs) of each project. (7 marks)
ii) Rank the projects using Profitability Index and allocate the GH¢200 million among the projects. (3 marks)

c) There are many sources of debt finance available to a company which has viable and profitable investment opportunities to utilise the funds. It is, however, very important for the Finance Manager to do a thorough work before deciding the type and source of debt finance to tap into.

Required:
Explain THREE (3) factors a Finance Manager should consider when deciding the type of debt finance to raise. (5 marks)

Answer

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Tags: Capital Rationing, Debt Financing, Investment Decision, NPV Calculation, Profitability Index
Level: Level 2

Topic: Capital rationing, Introduction to Investment Appraisal, Sources of finance: debt
Series: DEC 2022

FM – Nov 2020 – L2 – Q5b – Foreign exchange risk and currency risk management

Identify and explain four internal techniques to hedge exchange rate risk.

Question

Identify and explain FOUR (4) techniques that can be used internally to hedge exchange rate risk.

Answer

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Tags: Currency risk management, Exchange rate risk, Hedging, Internal hedging techniques
Level: Level 2

Topic: Foreign exchange risk and currency risk management
Series: NOV 2020

FM – Nov 2020 – L2 – Q5a – Management of receivables and payables

Compare the costs of factoring vs. bank financing for receivables management and advise on the best option.

Question

Pee Ltd has been factoring its debtors for the past 5 years. The factor charges a fee of 2% and will lend up to 80% of the volume of debtors purchases for an additional ¾% per month. The firm typically has sales of GH¢500,000 per month, 70% of which are on credit. By using the factor, two savings are effected:

GH¢2,000 per month that would be required to support a credit department, and
A bad-debt expense of 1% on credit sales.

Pee Ltd’s bank has recently offered to lend it up to 80% of the face value of the debtors shown on the schedule of accounts. The bank would charge 8% per annum interest plus a 2% processing charge per GH¢1 of debtors lending. The firm extends terms of net 30, and all customers who pay their bills do so by the thirtieth of the month.

Required:

If the firm borrows on the average GH¢100,000 per month on its debtors, advise whether the firm should discontinue its factoring arrangement in favor of the bank’s offer.

Answer

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Tags: Bank financing, Cost comparison, Factoring, Receivables Management
Level: Level 2

Topic: Management of receivables and payables
Series: NOV 2020

FM – Nov 2020 – L2 – Q4c – Dividend Policy

Distinguish between dividend irrelevance theory and traditional dividend relevance theory, and explain dividend relevance theories.

Question

There are two major opposing views of dividend policy: the Modigliani and Miller’s dividend irrelevance theory and the traditional view of dividend policy.

Required:

i) Distinguish between the TWO (2) opposing views of dividend policy. (2 marks)
ii) Explain TWO (2) of the dividend relevance theories. (3 marks)

Answer

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Tags: Dividend irrelevance, Dividend Policy, Dividend relevance, Modigliani and Miller
Level: Level 2

Topic: Dividend Policy
Series: NOV 2020

FM – Nov 2020 – L2 – Q4b – Capital rationing

Distinguish between soft and hard capital rationing and provide practical ways to deal with capital rationing.

Question

In the coming years, the company is likely to face restrictions on financing for capital investments.

Required:

i) Distinguish between soft capital rationing and hard capital rationing. (2 marks)
ii) Advise the managers of the company on THREE (3) practical ways of dealing with capital rationing. (3 marks)

Answer

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Tags: Capital Rationing, Hard capital rationing, Investment decision-making, Soft capital rationing
Level: Level 2

Topic: Capital rationing
Series: NOV 2020

FM – Nov 2020 – L2 – Q4a – DCF: Specific applications

Determine the optimal replacement cycle length for the machine using the equivalent annual cost method at Rock Beverages Ltd (RBL)

Question

a) Rock Beverages Ltd (RBL) is a producer of fresh fruit juice. RBL operates a fruit juice extracting machine, which costs GH¢150,000 to purchase and GH¢10,000 to install. The efficiency of the machine reduces over time. Consequently, the costs associated with its use increase over time. Two costs that are influenced by the level of efficiency of the machine are operational costs and maintenance costs. Operational costs are estimated to be GH¢30,000 during the first year of the machine’s use; GH¢35,000 during its second year; and GH¢40,000 during its third year. Maintenance costs are estimated to be GH¢11,000 during the first year of the machine’s use; GH¢13,000 during its second year; and GH¢15,000 during its third year. The resale value of the machine is GH¢40,000 at the end of the first year of use; GH¢35,000 at the end of the second year of use; and GH¢28,000 at the end of the third year of use. RBL’s cost of capital is 18%.

Required:

Determine the optimal replacement cycle length for the machine using the equivalent annual cost method. (10 marks)

Answer

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Tags: Discounted Cash Flow, Equivalent annual cost, Investment Appraisal, Replacement cycle
Level: Level 2

Topic: DCF: Specific applications
Series: NOV 2020

FM – DEC 2023 – L2 – Q3 – Discounted cash flow | Sources of finance: debt | Working Capital Management

Identification of cash flow patterns, present value calculation for two payment strategies, and explanation of the benefits and factors related to credit rating.

Question

a) TekApps is a small technology company that develops financial technology (FinTech) applications for mobile devices. The company is selling one of its highly rated FinTech apps to a financial institution. The financial institution has proposed the following strategic payment options for TekApps’ consideration:

Strategy 1: An immediate payment of GH¢1.2 million followed by payments of GH¢50,000 at the end of each quarter during the next five years.

Strategy 2: Payment of GH¢55,000 at the beginning of each month for the next five years.

TekApps’ required rate of return is 25% per annum.

Required:
i) Identify the type of cash flow pattern described under each option. (3 marks)
ii) Compute the present value of the cash flows for each strategy and advise TekApps on the best payment option. (7 marks)

b) BKB Entertainment Ltd (BKB) currently borrows at an average rate of 24% per annum. The Treasury Manager of the company believes that BKB can borrow at a lower interest rate if its creditworthiness is assessed and rated by a rating agency. He has therefore recommended to the Board of Directors to consider requesting a credit rating.

Required:
i) Explain TWO (2) benefits of credit rating to BKB. (4 marks)
ii) Advise the directors on THREE (3) factors rating agencies will consider in determining the company’s credit rating. (6 marks)

Answer

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Tags: Annuity, Cash Flow Patterns, Financial Decision-Making, Payment Options, Present Value
Level: Level 2

Topic: Discounted cash flow, Sources of finance: debt, Working Capital Management
Series: DEC 2022

FM – Nov 2020 – L2 – Q3c – Foreign exchange risk and currency risk management

Explain the difference between credit risk and liquidity risk in financial management.

Question

The recent financial sector clean-up in Ghana has created tough economic times for borrowers and investors and has tightened Financial Institutions’ appetite for granting credit and depositors’ appetite for depositing or placing funds with Financial Institutions, thereby creating a tight liquidity situation in the market.

Required:

As an expert in Financial Management, explain the difference between credit risk and liquidity risk. (3 marks)

Answer

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Tags: Credit risk, Liquidity risk, Risk Management
Level: Level 2

Topic: Foreign exchange risk and currency risk management
Series: NOV 2020

FM – Nov 2020 – L2 – Q3b – Futures and hedging with futures | Hedging with options

Explain intrinsic value of an option and calculate the intrinsic value for USD/GH¢ call options over several months.

Question

i) Explain the term intrinsic value of an option. (1 mark)

ii) DUU Ghana Ltd bought USD/GH¢ call options from KASA Ltd. The table below shows the various spot rates and strike prices for the various tenors.

Month	Spot Rate USD/GH¢	Exercise Rate/Price USD/GH¢
1	5.1	4.8
2	5.3	5.0
3	5.5	5.4
4	5.8	5.8
5	5.7	6.0
6	6.0	6.4

Required:

Determine the intrinsic value of the option for each trading month and clearly indicate the months in which the option is in-the-money, at-the-money, or out-of-the-money. (6 marks)

Answer

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Tags: Currency risk, Hedging, Intrinsic value, Options
Level: Level 2

Topic: Futures and hedging with futures, Hedging with options
Series: NOV 2020

Subject: FINANCIAL MANAGEMENT

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FM – May 2022 – L3 – Q5 – Cost of Capital

Calculate market value WACC for JP and discuss its preference over book value WACC for investment appraisals.

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FM – May 2022 – L3 – Q4 – Treasury Management

Discuss the roles of a treasury department and analyze its operation as a profit versus cost centre.

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FM – May 2022 – L3 – Q3 – Investment Appraisal Techniques

Calculate NPV of an investment, discuss inflation's impact, and recommend an optimal project under capital constraints.

Recommend, with supporting calculations, which of the three investment proposals should be accepted. (3 Marks)

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FM – May 2022 – L3 – Q2 – Financing Decisions and Capital Markets

Evaluate the financing options for Effe's expansion and provide advice on creditworthiness for a bond investment.

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FM – May 2022 – L3 – Q1 – Business Valuation Techniques

Estimate VT's valuation using FCFE, CAPM, and terminal value assumptions for three-year cash flow forecasts.

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FM – May 2023 – L3 – Q7 – Mergers and Acquisitions

Evaluate the share price of Obong plc under different growth scenarios and advise on the takeover bid. Explain EMH and its implications for the market.

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FM – May 2023 – L3 – Q6 – Dividend Policy

Evaluate the comments in Neko Plc's annual report regarding dividend policy, share price, cost reduction, and tax minimization strategies.

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FM – May 2023 – L3 – Q5b – Corporate Governance and Financial Strategy

Discuss ways to motivate managers to align with and achieve stakeholder objectives.

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FM – May 2023 – L3 – Q5a – Strategic Performance Measurement

Evaluate TAXIM Plc’s financial performance in achieving profit growth, EPS growth, and shareholder return objectives.

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FM – May 2023 – L3 – Q4 – Financing Decisions and Capital Markets

Evaluate the implications of equity financing decisions, analyze pre-emptive rights, estimate share price, and explore factors affecting price movement.

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FM – DEC 2023 – L2 – Q5 – Cost of capital | Foreign exchange risk and currency risk management

Calculation of the effective cost of various financing options and explanation of internal strategies to manage foreign currency risk.

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FM – DEC 2023 – L2 – Q4 – Capital rationing | Introduction to Investment Appraisal | Sources of finance: debt

Explanation of capital rationing concepts, NPV and profitability index calculations, and factors influencing debt finance decisions.

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FM – Nov 2020 – L2 – Q5b – Foreign exchange risk and currency risk management

Identify and explain four internal techniques to hedge exchange rate risk.

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FM – Nov 2020 – L2 – Q5a – Management of receivables and payables

Compare the costs of factoring vs. bank financing for receivables management and advise on the best option.

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FM – Nov 2020 – L2 – Q4c – Dividend Policy

Distinguish between dividend irrelevance theory and traditional dividend relevance theory, and explain dividend relevance theories.

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FM – Nov 2020 – L2 – Q4b – Capital rationing

Distinguish between soft and hard capital rationing and provide practical ways to deal with capital rationing.

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FM – Nov 2020 – L2 – Q4a – DCF: Specific applications

Determine the optimal replacement cycle length for the machine using the equivalent annual cost method at Rock Beverages Ltd (RBL)

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FM – DEC 2023 – L2 – Q3 – Discounted cash flow | Sources of finance: debt | Working Capital Management

Identification of cash flow patterns, present value calculation for two payment strategies, and explanation of the benefits and factors related to credit rating.

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FM – Nov 2020 – L2 – Q3c – Foreign exchange risk and currency risk management

Explain the difference between credit risk and liquidity risk in financial management.

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FM – Nov 2020 – L2 – Q3b – Futures and hedging with futures | Hedging with options

Explain intrinsic value of an option and calculate the intrinsic value for USD/GH¢ call options over several months.

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