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  • 20 Marks

MA – L2 – Q71 – Divisional performance

Assess GSO's financial performance in Years 4 and 5, focusing on Primeland and Seconland contributions.

Trading in Primeland in Year 1, and in Year 3 it opened a similar operation in a neighboring country, Scanland. The divisional managers in Primeland and Scanland have the authority to make most operational decisions, but decisions relating to acquisitions and financing are reserved for the board of directors of GSO.

Financial data is shown below for both divisions, for the years ending 31st December Year 4 and Year 5.

Actual results Year 4 Year 5
Primeland GH₵000 Seconland GH₵000 Total GH₵000 Primeland GH₵000 Seconland GH₵000 Total GH₵000
Revenues 4,300 950 5,250 4,500 1,200 5,700
Salaries and fees 1,400 580 1,980 1,500 600 2,100
Other direct costs 1,450 430 1,880 1,480 430 1,910
2,850 1,010 3,860 2,980 1,030 4,010
Marketing 240 70 310 290 95 385
Depreciation/amortization 330 45 380 330 95 425
Interest cost 110 95
570 115 800 620 190 905
Total costs 3,420 1,125 4,660 3,600 1,220 4,915
Profit/(loss) 880 (175) 590 900 (20) 785

Summary statements of financial position
Year 4

Primeland GH₵000 Scanland GH₵000 Total GH₵000
Non-current assets 2,610 240 2,850
Net current assets 710 140 850
3,320 380 3,700
Loan stock 1,400
2,300
Capital and reserves 2,300

Year 5

Primeland GH₵000 Scanland GH₵000 Total GH₵000
Non-current assets 2,600 480 3,080
Net current assets 1,250 190 1,440
3,850 670 4,520
Loan stock 1,200
3,320
Capital and reserves 3,320

Required:
(a) Assess the financial performance of GSO in Year 4 and Year 5, and the contribution of the operations in Primeland and Scanland to the overall performance.

(b) Suggest, with reasons, four additional items of information that you would require in order to provide a more comprehensive financial analysis of performance.

(c) Suggest, with reasons, four factors that should be taken into consideration when comparing performance in Primeland and Seconland.

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  • 15 Marks

FM – L2 – Q40 – Capital structure

Calculate optimal gearing level and WACC for a company given varying costs of debt, ungeared equity beta, and tax rate.

A company has estimated that its cost of debt capital varies according to the level of gearing, as follows:

Gearing Cost of debt
20 5.0
30 5.4
40 5.8
50 6.5
60 7.2

Gearing is measured as the market value of the company’s debt as a proportion of the total market value of its equity plus debt.
The rate of tax is 30%. The ungeared equity beta factor for the company is 0.90. The risk-free rate of return is 4% and the return on the market portfolio is 9%.

Required:
Identify the optimal gearing level and WACC.

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  • 15 Marks

FM – L2 – Q39 – Cost of capital

Calculate change in EPS for Kwadu Cocoa Plc after introducing a new production process with increased fixed costs and reduced variable costs, financed by debentures.

Kwadu Cocoa Plc produces and sells a single product. The company has issued share capital of 800,000 equity shares of GH₵1 each. For the year ended 31st March Year 4, the company sold 60,000 units of the product at a price of GH₵30 each.

The statement of profit or loss for the year to 31st March Year 4 is as follows:

GH₵’000 GH₵’000
Sales 1,800
Variable costs 720
Fixed costs 360
1,080
Net profit before interest and tax 720
Minus interest payable 190
Net profit before tax 530
Tax at 35% 186
Net profit after tax 344

The company has decided to introduce a new automated production process, in order to improve efficiency. The new process will increase annual fixed costs by GH₵120,000 (including depreciation) but will reduce variable costs by GH₵7 per unit. There will be no increase in annual sales volume.

The new production process will be financed by the issue of GH₵2,000,000 12.5% debentures.

Required:
(a) Calculate the change in earnings per share if the company introduces the new production process.

(b) Assume that the company introduces the new production process immediately on 1st April Year 5. Calculate for the year to 31st March Year 5:

(i) the degree of operating gearing

(ii) the degree of financial gearing

(iii) the combined gearing effect.

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  • 10 Marks

FM – L2 – Q38 – Cost of capital

Calculate cost of equity and WACC for Akomo Plastics Plc's investment in chemicals manufacturing using CAPM and given beta data.

Akomo Plastics Plc is engaged in plastics manufacture. It is now considering a new investment that would involve diversification into chemicals manufacture, where the business risk is very different from the plastics manufacturing industry.
Research has produced the following information about three companies currently engaged in chemicals manufacturing, in the same part of the industry that Akomo Plastics Plc is planning to invest.

Company Equity beta Financed by:
A 2.66 40% equity capital, 60% debt capital
B 1.56 75% equity capital, 25% debt capital
C 1.45 80% equity capital, 20% debt capital

Akomo Plastics Plc is financed by 60% equity capital and 40% debt capital, and would intend to maintain this same capital structure if the new capital investment is undertaken.
The risk-free rate of return is 5% and the return on the market portfolio is 9%. Tax is at the rate of 25%. You should assume that the debt capital of Akomo Plastics Plc and Companies A, B and C is risk-free.

Required
(a) Calculate a suitable cost of equity for the proposed investment by Akomo Plastics Plc in chemicals manufacturing.

(b) Suggest a weighted average cost of capital that should be used to carry out an investment appraisal (NPV calculation) of the proposed project.

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  • 6 Marks

FM – L2 – Q37 – Capital structure

Calculate the total value of a geared company and its equity value using Modigliani and Miller's theory after issuing debt to repurchase shares.

A company has 4,000,000 equity shares in issue. The shares have a current market value of GH¢10 each. The company is considering whether to issue GH¢15,000,000 of debt finance and use the cash to buy back and cancel some equity shares. The tax rate is 30%.

According to Modigliani and Miller, if the company decided to issue the debt capital and repurchase shares, what would be:

(a) the total value of the geared company, and (3 marks)

(b) the value of equity in the company? (3 marks)

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  • 20 Marks

FM – L2 – Q36 – Sources of finance: equity

Prepare profit/loss statements, calculate EPS, and determine gearing for three financing schemes for Brighton Enterprises' expansion.

Brighton Enterprises wishes to expand its production facilities to meet an increase in sales demand for its products. It will need GH₵18 million of new capital to invest in equipment. It is expected that annual profit before interest and taxation will increase by GH₵5 million.
Brighton Enterprises is considering the following three possible methods of financing the expansion programme:
(i) Issuing 9 million GH₵0.50 equity shares at a premium of GH₵1.50 per share.
(ii) Issuing 12 million 12% GH₵1 preference shares at par and GH₵6 million 10% debentures at par.
(iii) Issuing 6 million equity shares at a premium of GH₵1.50 per share and GH₵6 million 10% debentures at par.

Assume that the rate of tax on profits is 25%.

The statement of financial position of Brighton Enterprises as at 31st November Year 6 is as follows:

Statement of financial position as at 30th November Year 6

GH₵m GH₵m
Non-current assets 24.8
Current assets
Inventory 18.5
Trade receivables 21.4
Bank 1.9
41.8
Total assets 66.6
Equity and liabilities
GH₵0.50 ordinary shares 10.0
Accumulated profits 22.4
Total equity 32.4
10% Debentures 15.0
Current liabilities
Trade payables
Taxation
19.2
Total equity and liabilities 66.6

A statement of profit or loss for the year to 30th November Year 6 is as follows:

GH₵m
Sales 115.4
Profit before interest and taxation 17.9
Interest payable 1.5
Profit before taxation 16.4
Tax (25%) 4.1
Profit after taxation 12.3

Required
(a) For each of the financing schemes under consideration:
(i) prepare a projected statement of profit or loss for the year ended 30 November Year 7.
(ii) calculate the expected earnings per share for the year ended 30th November Year 7.
(iii) calculate the expected level of financial gearing as at 30th November Year 7, assuming that dividend payments during the year are GH₵0.30 per share.

(b) Assess each of the three financing schemes under consideration from the viewpoint of an existing equity shareholder in Brighton Enterprises.

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  • 15 Marks

FM – FM – L2 – Q35 – Capital structure

Analyze gearing impact on two companies' EPS and financial risk using provided financial data.

The following information is available about Company A and Company B:

Company A Company B
Capital structure GH¢ GH¢
Equity shares of GH¢1 10,000 10,000
Reserves 20,000 90,000
10% debt capital 30,000 —
60,000 100,000
100,000 100,000

| Annual profit | | | | Sales | 80,000 | 80,000 |

| Variable costs | 40,000 | 40,000 |

| Contribution | 40,000 | 40,000 |

| Fixed operating costs | 10,000 | 10,000 |

| Profit before interest and tax | 30,000 | 30,000 |

| Interest costs | 3,000 | — | | Profit | 27,000 | 30,000 |

| Tax (20%) | 5,400 | 6,000 |

| Profit after tax (= earnings after interest and tax) | 21,600 | 24,000 |

Required:

(a) Calculate the earnings per share for Company A and Company B.

(b) Calculate the level of profit before interest and tax at which the earnings per share for Company A will be equal to the earnings per share for Company B.

(c) Comment on the financial risk in Company A and Company B.

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  • 15 Marks

FM – L2 – Q34 – Dividend policy

Analyze dividend policy of Kumasi Freight Plc from 20X1-20X5 and estimate share price under four dividend options.

Question Tags: Dividend policy, Share valuation, Earnings retention, Shareholder returns, Financial strategy
Question Short Summary: Analyze dividend policy of Kumasi Freight Plc from 20X1-20X5 and estimate share price under four dividend options.

———————————————————–
Question:
The table below shows earnings and dividends for Kumasi Freight Plc over the past five years.

Year Net earnings per share Dividend per share
GH¢ GH¢
20X1 1.40 0.84
20X2 1.35 0.88
20X3 1.35 0.90
20X4 1.30 0.95
20X5 1.25 1.00

There are 10,000,000 shares issued and the majority of these shares are owned by private investors. There is no debt in the capital structure.
It is clear from the table that the company has experienced difficult trading conditions over the past few years. In the current year, net earnings are likely to be GH¢10 million, which will be just sufficient to pay a maintained dividend of GH¢1 per share.
Members of the board are considering a number of strategies for the company, some of which will have an impact on the company’s future dividend policy.
The company’s shareholders require a return of 15% on their investment.
Four options are being considered, as follows:
(1) Pay out all earnings as dividends.
(2) Pay a reduced dividend of 50% of earnings and retain the remaining 50% for future investment.
(3) Pay a reduced dividend of 25% of earnings and retain the remaining 75% for future investment.
(4) Retain all earnings for an aggressive expansion programme and pay no dividend at all.
The directors cannot agree on any of the four options discussed so far. Some of them prefer option (1) because they believe to do anything else would have an adverse impact on the share price. Others favour either option (2) or option (3) because the company has identified some good investment opportunities and they believe one of these options would be in the best long-term interests of shareholders. An adventurous minority favours option (4) and thinks this will allow the company to take over a small competitor.

Required:
(a) Comment on the company’s dividend policy between 20X1 and 20X5 and on its possible consequences for earnings.
(b) Advise the directors of the share price for Kumasi Freight Plc which might be expected immediately following the announcement of their decision if they pursued each of the four options, using an appropriate valuation model. You should also show what percentage of total return is provided by dividend and capital gain in each case. You should ignore taxation for this part of the question. Make (and indicate) any realistic assumptions you think necessary to answer this question.

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  • 20 Marks

MA – L2 – Q70 – Performance analysis

Calculate the impact of three strategies on annual profit for Kumasi Ventures Ltd, each implemented independently.

Kumasi Ventures Ltd manufactures and sells a single product. Its budget for the next financial year is as follows:

Sales (80,000 units at GH₵600 per unit) GH₵000
48,000
Production costs: materials and labour 16,000
Other production costs 8,000
Marketing and distribution costs 12,000
Administration costs 10,000
Total costs 46,000
Profit 2,000

Materials and labour costs in production are 100% variable, and 25% of other production costs are variable. All administration costs are fixed costs and two-thirds of marketing and distribution costs are also fixed.

The directors of Kumasi Ventures Ltd are dissatisfied with the budgeted profit, and believe that annual profits should be at least double the size of the budgeted profit.

Three strategies have been proposed to improve profitability.

(1) Strategy 1. Increase sales by opening a new sales office in a neighbouring country. It is expected that this would increase annual sales by 5,000 units, but would add GH₵1.2 million to annual fixed costs.

(2) Strategy 2. Re-design the product by adding several additional features that should add value for the customer. This would have no effect on annual sales volume in units, but the company would be able to raise the sales price to GH₵625. The additional costs of producing the new product design would be GH₵1.5 million each year (all fixed costs).

(3) Strategy 3. Implement a cost reduction exercise throughout the company. It is expected that the planned exercise would reduce all variable costs by 20%, but would add to annual fixed costs by GH₵3.5 million.

Required:
(a) Calculate the effect of each individual strategy on annual profit, assuming that the strategy is implemented on its own, without the other two strategies.

(b) Show whether the three strategies, if they are all introduced together, will close the profit gap between the budgeted profit and the target profit that the directors would like to achieve.

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  • 10 Marks

FM – L2 – Q33 – Dividend policy

Suggest share price for Kumasi Transport PLC based on 25% dividend payout using dividend growth model.

he directors of an all-equity company are considering the company’s policy on dividends and retentions. The cost of capital is 9% and the company is able to invest in new capital projects that will earn this return. The company’s shares are quoted and traded on a major stock market.

In the year just ended, the earnings per share were GH¢2.00 per share. The company pays a dividend annually, and is about to pay a dividend for the year just ended on the basis of its selected dividend and retentions policy.

Required:

Suggest what the company’s share price might be if the directors select a policy of paying annual dividends that are equal to:

(a) 25% of earnings

(b) 50% of earnings

(c) 70% of earnings

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