FINANCIAL CONCEPTS B MAY 2012 - SUGGESTED SOLUTIONS

SECTION A

Answer 1

(a)(i) Investment decisions – The financial manager will need to identify investment opportunities, evaluate them and decide on the optimum allocation of scarce funds available between investments. They will therefore advise on the allocation of funds in terms of of total amount of assets, composition of non-current and current assets, and the consequent risk profile of the choices.

(1 mark, naming 1 mark explanation; total 2 marks)

(ii)Financing decisions-Responsible for raising funds, choosing from a wider variety of institutions and markets, with each source of finance having different features as regards currency, cost, availability, maturity and risk. It will include those for both long term (capital structure) and the short term (working capital management).

(1 mark, naming 1 mark explanation; total 2 marks)

(i)Dividend decisions – This decision is really an interaction between the investment decision and the financing decision, as the amount of money paid out as dividends will affect the level of retained earnings available for investment. Most companies follow a target dividend payout policy where a constant proportion of earnings is distributed as dividend each year.

(1 mark, naming 1 mark explanation; total 2 marks)

(b)(i) The Aggressive Policy means that a company chooses to operate with lower levels of inventory, debtors and cash, for a given level of activity or sales. The policy will increase profitability, since less cash will be tied in current assets, but will also increase risk, since possibility of cash shortages or stock-outs is increased. (4 marks)

(ii) Conservative Policy or, alternatively, Moderate Policy (1 mark)

(c) sensible working capital policies will:

  • Reflect corporate decisions (Investment? Financing? Dividend?)
  • Take into account the nature of business (Manufacturing? Retail? Service?)
  • Reflect the credit policies of its competitors (Shoprite vs Metro Shops; Zainvs Telekom Networks Limited; Malawi Institute of Management vs The University of Malawi)

(any two arguments, up to a maximum of 2 = 4 Marks)

Answer 2

(a) Advantage of using cash flow accounting include:

(i) Survival of a company depends on its ability to generate cash.

(ii) Cash is comprehensive or concrete whereas profit can be

manipulated.

(iii) Creditors are interested in a company’s ability to repay them. Cash

is direct.

(iv) Cash flow reporting provides a better means of comparing between

entities.

(v) Cash flow reporting satisfies the needs of all users better.

(vi) Cash flow forecasts are easier to prepare and more useful than profit

forecasts.

(vii) Auditing is easier with cash flow accounts than accrual basis

accounts.

(viii) Accruals concept is confusing while cash flows are easily

understood.

(1mark per valid point, up to a maximum of 4 advantages = 4 marks)

(b) (i)Cash flows from Operating Activities include:

  • Cash receipts from sale of goods and rendering of services
  • Cash receipts from royalties, fees, commissions and other revenue
  • Cash payments to suppliers for goods and services
  • Cash payments to and on behalf of employees
  • Cash payments/refunds of income taxes unless they can be specifically identified with financing or investing activities
  • Cash receipts and payments from contracts held for dealing or trading purposes

(any three examples one mark each, total 3 marks).

(ii) Financing activities are activities that result in changes in the size and composition of the equity capital and borrowings of the entity.

Examples are:

  • Proceeds from issuance of share capital;
  • Proceeds from long-term borrowings;
  • Payment of finance lease liabilities; and
  • Dividends paid*

*This could also be shown as an operating cash flow.

(any three examples one mark each, total 3 marks) (Total = 6 marks).

(b) MK

Profit before tax 250,000 from income statement

Depreciation +350,000 not a cash flow, add back

Increase in inventories (270,000) involves outflow of cash

Increase in receivables (580,000) involves outflow of cash

Increase in payables +440,000 cash inflow

______

Net cash from operating activities 190,000 (1mark each, 5 marks)

[TOTAL : 15 MARKS]

Answer 3

(a) The other two are: i or r which is interest rate per period that is used for discounting or compounding and n or N and this is number of periods over which the compounding or discounting takes place. (1 mark per item, naming and correctly explaining the use of the item = 4 marks)

(b) Net Present Value (NPV)

Year / Cash flow
(MK) / Discount Factor / Present Value
(MK) 1
0
1
2
3
4
5
5 (scrap value) / (60,000,000)
10,000,000
12,000,000
28,000,000
20,000,000
30,000,000
15,000,000 / 1.0000
0.8929
0.7972
0.7118
0.6355
0.5674
0.5674 / 60,000,000 1
8,929,000 1
9,566,000 1
19,930,000 1
12,710,000 1
*17,022,000 1
* 8,511,000 1
______
16,668,000 1

*Alternative : Year 5 K45,000,000 x 0.5674 = K25,533,000

Since the Net Present Value is positive, the machine should be purchased.

(2 marks)

11 marks

[TOTAL : 15 MARKS]

Answer 4

(a) Nominal Interest Rate is the interest rate that makes no allowance for inflation; Real Interest Rate is the interest rate that is adjusted for expected changes in the price level. The difference therefore lies in (not) adjusting for inflation. (1 mark each = 2 marks)

(b) (i) FV with compound interest :

1st year = 166,000 x 1.07 = 177,620

2nd year = 177,620 x 1.07 = 190,053

3rd year = 190,053 x 1.07 = 203,357 (3 marks)

(ii) FV with simple interest:

K166,000 + K11,620 + K11,620 + K11,620 = K200,860 (2 marks)

The extra K2,497 comes from the interest of 0.07 (11,620 + 11,620*2+813), that is 0.07 (35,673), K813 being interest on the K11,620 at 7 percent in addition to that on the first and second interest payments. (2 marks)

(c) Using the HP12C

Inputs 2 5 87,000 -

   

HP12C / Display
FFINCLX / 0 / Clear all financial registers
2ⁿ / 2.00 / Compounding periods in years
5 / 5.00 / Interest Rate expressed in years
87000FV / 87000 / FV = the amount it must have after 2 years
Press FV / 78911 / This is the amount it needs to have K87000 at
5% in interest in 2 years time.

(1 mark per step = 6 marks)

Alternatively, using simple calculator

1 Input 1.05

2 Press x or y

3 Input 2

4 Press =

5 Display

6 Press

7 Multiply by 87000

Solution? (6 marks; 1 mark each for the first 5 items and ½ each for 6th and 7th items)

[TOTAL : 15 MARKS]

SECTION B

Answer 5

(a) (i) A related party transaction is a transfer of resources, services or obligations between related parties, regardless of whether a price is charged.

(2 marks)

(ii) The objective of IAS 24 is given as to ensure that an entity’s financial statements contain the disclosures necessary to draw attention to the possibility that its financial position and profit or loss may have been affected by the existence of related parties and by transactions and outstanding balances with such parties. (3 marks)

(iii) It is a transfer of resources, services, or obligations between related parties, regardless of whether a price is charged. Examples:

  • Purchase or sales of goods;
  • Purchase or sales of property and other assets;
  • Rendering or receiving of services;
  • Leasing arrangements;
  • Transfers of research and development;
  • Transfers under license agreement;
  • Transfers under finance arrangements;
  • Transfers under finance agreements (loans, equity contributions in cash and/or in kind);
  • Provisions of guarantees or collateral;
  • Settlement of liabilities on behalf of an entity.

(1mark per example given, up to 6 examples = 6 marks)

(b)The following parties are deemed not to be related:

  • Two firms simply because they have a director or key manager in common;
  • Two venturers who share joint control over a joint venture;
  • Providers of finance, trade unions, public utilities, governments departments and agencies – in the course of their normal dealings with an enterprise; and
  • A single customer, supplier, franchiser, distributor, or general agent with whom an enterprise transacts a significant volume of business merely by virtue of the resulting economic dependence. (any two, 1.5 marks each for correctly identifying the instances and 1 mark each for naming the correct parties in the given situations = 4 marks)

(a)Related Party Transactions can affect the financial position and operating results of a firm in a number of ways

  • Transactions may be entered into with a related party which may not have occurred if there was no relationship.
  • Transactions may be entered into with a related party on terms different from those with an unrelated party.
  • Transactions with this party may be affected by exercise of the relationship.

(5 marks, depending on the robustness of the statements/arguments).

[TOTAL : 20 MARKS]

Answer 6

(a) The figures can be brought to end of year 2012 price levels by applying the following adjustment factors:

2011 2010 2009 2008

282.0 282.0 282.0 282..0

273.9 268.5 253.3 245.9 1 mark

1.0296 1.0503 1.1133 1.1468

The annual figures can now be adjusted to a common price level, using end of year 2010 prices as follows:

2012 2011 2010 2009 2008

Inflation factor 1.0000 1.0296 1.0503 1.1133 1.1468

MK’mn MK’mn MK’mn MK’mnMK’mn

Turnover 4,360.7 4,376.4 4,374.5 4,591.0 4,455.3

Profit after taxation 53.8 49.4 48.0 51.1 49.1

Earnings per share (t) 8.4 7.8 7.7 8.3 8.0

Equity funds per share 255.5 258.8 261.6 274.8 279

(4 marks for each of the 4 items = 16 marks)

(b) By adjusting for inflation, any significant changes or trends become more easily discernible. The turnover is reduced in real terms but profit after taxation has still increased albeit by only MK4.7 million. Whereas EPS has increased but by low amounts following increases and reductions, equity funds per share have been declining (see also the last comment). Also, the fall in turnover, profits and EPS in year 2010 is clear, and the fall in equity funds per share has been continuous since year 2008 (4 marks, depending on robustness of the arguments given with a maximum of 3 marks) (3 marks)

[TOTAL : 20 MARKS]

Answer 7

(a) The principal-agent problem exists where one person (an agent) acts on behalf of another (the principal). Management/shareholder relationship is an example of an agency relationship. Goal congruence occurs when the objectives of the agents match those of the principals. The agency problem is the conflict that arises from the separation of management and ownership in many companies, leading to a lack of goal congruence. The financial and other rewards of managers (agents) mat not be linked to the shareholders’ (principals’) financial return. In theory, management should not be able to act contrary to the wishes of shareholders because the shareholders can dismiss the managers or sell their shares. Unfortunately this is not the case. The majority of the shareholders are ‘disinterested’ about the running of the company and have little power individually to alter its execution.

Occurrence of goal congruence 3 marks

Existence of agency problem 3 marks

Examples given as appropriate

(throughout the explanation) 4 marks

Note: what has been given here is merely the gist / fabric

(b) (i) The Stock Option Scheme – Gives senior managers the right to buy a certain number of the company of the company’s shares at a fixed price at a specified time in the future. The managers therefore have a financial incentive to act in ways to maximize the share price, which benefits all the shareholders (Naming 1 mark, explanation 3 marks but to be capped to 2½ marks, total 3½ marks).

(ii) Profit-Related Incentives – In which bonuses are based on the annual growth in earnings per share, measured against a pre-set target such as the average performance of companies in the sector (Naming 1 mark, explanation 3 marks but to be capped to 2½ marks, total 3½ marks).

(c) The limitations are that it is possible to manipulate accounting profits and as with any performance measure, EPS can also be affected by external factors (like economic or business cycle or tax regime). They may thus give misleading picture of management performance (3 marks)

[TOTAL : 20 MARKS]

Answer 8

(a) Break-even analysis is a valuable tool to be used in credit risk assessment by the banker. Examples of its application in this sense are:

(i) When a new business venture, an extension of an existing business into a new product range or any similar type of project requires to be financed, the banker will obviously be interested in the viability study to see if it is going to be profitable and economically viable over the long run. (2

marks)

(ii) When a business client receives finance by way of a loan, it will have to pay interest on it. The interest cost is part of fixed costs of a business and the question that the banker needs to answer for himself is whether the business will be capable of generating enough sales to pay the extra costs (2

marks).

(b) Per Unit x Volume = Total %

Sales MK 1,000 12,000 12,000,000

Variable Costs MK 750 12,000 (9,000,000)

______

MK 250 12,000 3,000,000 25.000

======

Fixed Costs (1,500,000)

______

Operating Profit 1,500,000

======

(i) Break-even quantity = Fixed Costs

______

Contribution margin per unit (2 marks)

MK1,500,000

K250 (2 marks)

= 6,000 Units (1marks)

______

Total revenues to break-even = 6,000 x MK1,000 = MK6,000,000

or Fixed Costs MK1,500,000

______= ______= K6,000,000 (3 marks)

Contribution margin ration 25.000 %

(ii) Margin of Safety = Sales units – Break-even sales units (2 marks)

(in terms of units )

= 12,000 – 6,000 (1 marks)

= 6,000 units (1 mark)

______

Margin of Safety = Sales – Break-even sales (2 mark)

(in terms of value)

= MK12,000,000 – MK6,000,000 (1 mark)

= MK6,000,000 (1 mark)

______

A qualification examined by the Institute of Bankers in MalawiPage 1