Institute of Bankers in Malawi



COPORATE FINANCE - MODEL ANSWERS

SECTION A

1.

Five key functions of Corporate Finance are

a) Financing decision – relates to the acquisition of finance required to support a firm’s operations and planned investment programmes. Financing decisions involve raising funds by choosing from a wide variety of institutions and markets, with each source of finance having different features as regards cost, availability, maturity and risk. The financing decision of the company is reflected by the liabilities side of the balance sheet (including equity/shareholder funds).

b) Investment decision – involves selecting the best project in which to invest the firm’s resources taking into account of each project’s perceived risk and expected return. It involves allocation of funds in terms of: the total amount of company assets, composition of non-current and current assets, and the consequent risk profile of the choices. The investment decision will be reflected on the asset side of the statement of financial position (balance sheet).

c) Management of financial resources – concerns monitoring investments to ensure that they continue to be as profitable as planned, and making sure that firm’s internal cash flows and its mix of debt and equity financing both maximize the value of the debt and equity claims on the firm. It iInvolves management of cash/liquidity, inventory control, supplier/procurement management and most importantly ensuring that the company is solvent (a going concern) and liquid (able to meet its payments when they fall due).

d) Corporate governance function – encompasses the development of an ownership and corporate governance structure for a company that ensures managers act ethically and in the best interests of the firm’s stakeholders, and in particular, its shareholders.

e) Risk-management function – covers the management of the firm’s exposures to all types of risk in order to maintain the optimum risk-return trade-off and therefore maximize shareholder value. Involves managing and reducing risk (liquidity risk, exchange rate risk, interest rate risk, inflation risk).

f) Dividend decision – can be explained using some of the content in bullet point number 8.

(3 marks for every correct key function raised and fully discussed)

2.

(a) ARR, also known as Return on Investment (ROI) is one of the methods of capital investment appraisal. This approach expresses the profit after tax arising from an investment as a percentage of total outlay on the investment. Alternatively, the method relates average annual profit to either the amount initially invested or average investment, as a percentage.

Formula: ARR= Average annual accounting profit x 100

Average investment

The result is compared to a predetermined company (or group, or division) target, an investment being accepted if the result meets or exceeds the target.

(1.5 marks for the definition and 1.5 marks for explanation of its use= 3 marks)

(b) Other methods of capital investment appraisal are as follows:

• Payback (the payback period); and/or

• Discounted payback;

• Net Present Value (NPV);

• Internal Rate of Return (IRR);

• Profitability Index (PI) or Cost Benefit Ratio;

• Adjusted Present Value (APV) (Any 4, 1 mark each = 4 marks)

(c) The most suitable technique to use in appraising this project is the Discounted Cash Flow technique or Net Present Value. (1 mark)

The present values of the revenues

Period Net Cash inflows Discount Factor NPV

MK000s MK000s 0 (25,000) 1.0000 (25,000) (1 mark)

1 3,000 0.9174 2,752 (1 mark)

2 4,500 0.8427 3,792 (1 mark)

3 9,000 0.7722 6,950 (1 mark)

4 11,500 0.7084 8,147 (1 mark)

3,000 (3,359) (1 mark)

The project has negative NPV, it should therefore not be accepted. (1 mark)

Total 15 marks

3.

(a) Elements of risk attached to a security

Risk is the possibility that actual future returns will be different from expected return. Risk therefore implies that there is a chance for some unfavorable event to occur. Indeed, there are two elements of risk attached to any security: systematic (market) and unsystematic (specific). The differences between these two elements are now explained. (1 mark)

Systematic Risk (also known as non-diversifiable risk, non-specific, unavoidable or market risk) refers to that portion of risk of individual security’s returns caused by factors affecting market as a whole (macroeconomic variables) such as changes in interest rates, inflation, taxation etc. Indeed, systematic risks have market-wide effects.

(any one of the alternative names 1 mark, definition 1.5 marks, any example of factors 1 mark = 3.5 marks)

Unsystematic Risk (diversifiable risk, specific or avoidable risk) refers to risk unique to a particular firm such as a firm going bankrupt or staff of an institution going on strike. Unsystematic risk accounts for approximately 70% of a firm’s total risk and can be reduced through diversification. Reducing unsystematic risk through holding diversified portfolios of share form the basis of Markowitz’s portfolio theory.

(any one of the alternative names 1 mark, definition 1.5 marks, any example of factors 1 mark = 3.5 marks)

In the diagram that follows, the area labeled ‘unsystematic risk’ is the part that can be eliminated by diversification.

Figure Systematic and Unsystematic Risks

Risk

(Std. dev) Unsystematic risk

Total risk

Systematic risk

20 30 No. of securities in a portfolio

(3 marks)

Up to this point, there are 11 marks available. The maximum to award is however 10 marks)

b) CAPM uses the systematic risk of individual securities to determine the fair price by measuring the risk using beta (ß). Beta measures the amount of systematic risk present in a particular risky asset relative to that in an average asset. In other words, it is a measure of the volatility of security’s return relative to the returns of a broad-based market portfolio. In short, CAPM is concerned with two things; how systematic risk is measured and how systematic risk affects the required returns and share price. (3 marks)

c) Areas of application of CAPM include:

• Portfolio selection: Can be used by investors in selecting their portfolio of shares (this will reflect the individual’s risk preference).

• To compare projects of different risk classes.

• If CAPM is accepted, it might be concluded that, when deciding whether to invest in a particular project, management should be concerned with its systematic risk and not with its overall risk.

• Mispriced shares are confirmed.

• Measuring portfolio performance.

• To calculate the required rate of return on a firm’s investment projects.

(any two valid areas of application = 2 marks)

Total 15 marks

4.

(a) Horizontal merger – takes place between two firms in the same line of business. The merged firms are normally former competitors. This type of a merger may be blocked if they are thought to be anti-competitive or create much market power.

Vertical merger – involves companies at different stages of production. The buyer expands back toward the source of raw materials or forward in the direction of the ultimate consumer.

Conglomerate merger or diversification – involves companies in unrelated lines of business. Foe instance, the Korean conglomerate, Daewoo, had nearly 400 different subsidiaries and 150,000 employees. (2 for each term = 6 marks)

(b) Main reasons for a decision of one organization to merge with another organization

include the following:

Economies of scale – to enable benefits of scale to be achieved.

To reduce competition – to co-opt existing competitor in order to reduce competition

Market power – to increase market share or to achieve control over pricing

Sharing complementary resources – bringing together the relative strength of each firm

New market entry – to facilitate expansion to new markets

To reduce risk – diversification

Managerial motives – to avoid being taken over (job security) or to pursue growth in size, status

(1.5 marks for each correct and explained reason, any six = 9 marks),

Total 15 marks

SECTION B

5.

(a) Capital rationing occurs when funds are not available to finance all wealth-enhancing projects i.e. when an organization has insufficient funds to accept all projects with a positive Net Present Value. A decision therefore must be made as to which projects to choose. (2 marks)

The two types of capital rationing are soft rationing and hard rationing. Soft rationing is internal management-imposed limits on investment expenditure. Such limits may be linked to the firm’s financial control policy, such as those that exist in a family business. Hard rationing relates to capital from external sources. For example, the external market may agree with the company as to the desirability of the investment.

In finance, capital rationing is used to deal with such situations. (3 marks)

(b) First we need to calculate the NPV per MK1 of capital invested, that is the return

achieved per unit of limiting factor, and rank the projects according to the results.

Project Investment Required NPV at 20% NPV/MK1 Invested Ranking

MK MK

W 100,000,000 48,000,000 0.48 3

X 20,000,000 16,000,000 0.80 1

Y 30,000,000 18,000,000 0.60 2

Z 45,000,000 21,000,000 0.47 4

(6 marks) (2 marks)

The MK100,000,000 can now be allocated:

Project Investment NPV

MK MK

X 20,000,000 16,000,000

Y 30,000,000 18,000,000

W (balance use ½) 50,000,000 24,000,000

100,000,000 58,000,000

(3 marks) (3 marks)

Justification: This combination of projects gives the maximum return to the company and should therefore be accepted by the management of Lobina Limited). (1 mark)

Total 20 marks

6.

Using the formula:

Investment A

Return Probability Expected r – ř P(r- ř)2

Value

Best outcome

(Boom) 5% 0.2 1.00 (10) 20

Most likely outcome

(Growth) 15% 0.6 9.00 0 0

Worst outcome

(Slump) 25% 0.2 5.00 10 20

ř =15 Variance = 40

Standard deviation = √40 = 6.3245553 = 6.32

(1 mark for each row, 3 rows = 3 marks plus 1 each for ř, variance and standard deviation = 3 marks, total = 6 marks)

Investment B

Return Probability Expected r – ř P(r- ř)2

Value

Best outcome

(Boom) 7% 0.2 1.40 (7) 9.8

Most likely outcome

(Growth) 14% 0.6 8.40 0 0

Worst outcome

(Slump) 21% 0.2 4.20 7 9.8

ř =14 Variance = 19.6

Standard deviation = √19.6 = 4.4271887 = 4.43

(1 mark for each row, 3 rows = 3 marks plus 1 each for ř, variance and standard deviation = 3 marks, total = 6 marks)

a) Under Perfect Positive Correlation

S = √( 0.4)2 40+(0.6)219.6+2( 0.4)(0.6)(1)(6.32)(4.43)

=√6.4 + 7.06 +13.44

=√26.9

= 5.19%

(1 mark for each line, total 4 lines = 4 marks)

b) Under Perfect Negative Correlation

S = √( 0.4)2 40+(0.6)219.6+2( 0.4)(0.6)(-1)(6.32)(4.43)

=√6.4 + 7.06 -13.44

=√0.02

= 0.14%

(1 mark for each line, total 4 lines = 4 marks)

Total 20 marks

7.

The factors affecting Dividend Policy:

a) Legal constraints

Are actual restrictions on payment of dividends. Dividends cannot be paid from any capital reserve (but from accumulated revenue reserves – past and present earnings); companies that are insolvent cannot legally pay dividends (that is, if their external liabilities exceed their assets); companies with various kinds of debt capital may in fact have agreed to restrictions on dividend payments to protect long-term creditors; a company with a loan requiring redemption may need to retain funds for this purpose. (4 points, maximum 5 marks)

b) Growth prospects

If a firm is in a growth phase, it may need all its funds to finance capital expenditures. Firms exhibiting little or no growth may nevertheless periodically need funds to replace or renew assets. These types of firms are likely to pay only a very small percentage of earnings as dividends. Generally, a large, mature firm has adequate access to new capital. Ability to raise funds, cost thereof and speed which finance can be obtained are therefore important.

(4 points, maximum 5 marks)

c) Market considerations

An awareness of the market’s probable response to certain types of policies is helpful in formulating a suitable dividend policy. When earnings decline, corporate managers are averse to change the monetary value of dividend. Also, shareholders are believed to value a policy of continuous dividend payment, which eliminates uncertainty about the frequency and magnitudes of dividends. Another market consideration is the information content of dividends; see item (e) on signaling. (4 points, maximum 5 marks)

d) The clientele effect

Do companies resort to particular dividend policy because of the type shareholder they have? Example: pension funds and insurance companies would like a steady stream of ready cash inflows to balance their outflows. Since shareholders have different requirements, and prefer not to create their own dividends because of the costs or effort involved then they should have bought shares in particular companies because of the observed dividend policies of those companies. Firms then should maintain their dividend policies or risk antagonizing their existing shareholders – or put off potential shareholders.

(4 points, maximum 5 marks)

e) Signalling

When a dividend is announced, particularly if there is a significant rise in its level, the firm is possibly trying to signal its confidence in its future. If so, and if the stock market reacts favourably to this ‘information’, there is an implication that some information available to management of the company is not already incorporated in the share price. But this can be done as a defensive tactic to a hostile takeover bid! Conversely, a reduction in dividend payment is viewed as a negative signal, resulting in a decrease in share price.

(3 points, maximum 5 marks)

f) Agency considerations

The interests of shareholders, managers, and creditors no not necessarily coincide. If dividends are paid, assets shift from the control of management to that of the individual shareholder. They also move out of reach of creditors.

Sometimes companies repurchase (in an open market) some of their shares with the result that a final ‘cash dividend’ will be provided to those shareholders whose shares are repurchased. The reason of share repurchases are often over-capitalisation. Certainly the funds used to repurchase such shares are no longer available to creditors. (4 points, maximum 5 marks)

g) Dividend payments (interim and final)

The payment of cash dividends to shareholders is decided by the firm’s board of directors (quarterly or semi-annually) based on past period’s financial performance and future outlook, as well as recent dividends paid. The payment date of dividend, if one is declared, must also be established. Once paid, there may be a specified plan for the dividend, Dividend Reinvestment Plan (DRP) –which enable shareholders to use dividends received on the firm’s shares to acquire additional shares at little or no transaction (brokerage) cost. Clearly, the existence of DRP may enhance the appeal of a firm’s shares.

(4 points, maximum 5 marks)

Note: additional factors are Contractual Constraints (restrictive provisions in a loan agreement), Internal Constraints (high earnings vs low level of liquid assets), Owner Considerations (tax position, investment opportunities, potential dilution of ownership), and Market Friction (type of taxation systems, costs of buying/selling shares, and issue costs of capital)

Total 20 marks

8.

Bwanamkubwa Traders Limited

Market Value: MK

|Ordinary shares |4,000,000 x MK2.50/2 | = | 5,000,000 |

|Preference shares |1,000,000 x 1.20/1 | = | 1,200,000 |

|Bank loan |Not traded | = | 500,000 |

|Debentures |1,750,000 x 110/100 | = | 1,925,000 |

|Total | | | 8,625,000 |

Proportions: %

|Ordinary shares |5,000,000 / 8,625,000 | = | 57.97 |

|Preference shares |1,200,000 / 8,625,000 | = | 13.91 |

|Bank loan | 500,000 / 8,625,000 | = | 5.80 |

|Debentures |1,925,000 / 8,625,000 | = | 22.32 |

|Total | | | 100.00 |

Relevant returns: %

|Ordinary shares |20 x 2/2.50 | = | 16.00 |

|Preference shares |12 x 1/1.20 | = | 10.00 |

|Debentures |16 x 100/110 | = | 14.55 |

| | | | |

| | | | |

Weighted average cost of capital: %

|Ordinary shares | 57.97 x 16 | = | 9.28 |

|Preference shares | 13.91 x 10 | = | 1.39 |

|Bank loan | 5.80 x 15 x 67/100 | = | 0.58 |

|Debentures | 22.32x14.55 x 67/100 | = | 2.18 |

|Total | | | 13.43 |

1 mark for each row = 18 marks plus 1 mark each for noting/identifying that Bank loan is not traded (when calculating market value) and 1 for correct/acceptable presentation format.

Total 20 marks

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