Subject (SQ): FINANCIAL MANAGEMENT

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  • 14 Marks

FM – L2 – Q123 – Mergers and acquisitions

Calculate NPV of Kofi Ltd's acquisition of Ama Ltd and advise on proceeding with a cash offer

The Directors of Kofi Ltd (Kofi), a large listed company, are considering an opportunity to acquire all the shares of Ama Ltd (Ama), a small listed company with a highly efficient production technology.

Kofi has 10 million shares of common stock in issue that are currently trading at GH¢6.00 each. Ama Ltd has 5 million shares of common stock in issue, each of which is trading at GH¢4.50.

If Ama is acquired and integrated into the business of Kofi, the production efficiency of the combined entity would increase and save the combined business GH¢600,000 in operating costs each year to perpetuity.

Though Kofi operates in the same industry as Ama, its financial leverage is higher than that of Ama. Kofi’s total debt stock is valued at GH¢40 million, and its after-tax cost of debt is 22%. The beta of Kofi’s common stock is 1.2. The return on the risk-free asset is 20% and the market risk premium is 5%.

Required:

Suppose Kofi offers a cash consideration of GH¢25 million from its existing funds to the shareholders of Ama for all of their shares.

(a) Calculate the NPV of the acquisition, and advise the directors of Kofi on whether to proceed with the acquisition or not.

(b) Calculate the value of the combined entity immediately after the acquisition.

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  • 20 Marks

FM – L2 – Q122 – Business valuations

Calculate pre-acquisition market values of Clearfield Farms and Village Industries using Gordon’s growth model.

Clearfield Farms Limited is considering acquiring Village Industries Limited, extracts of the financial statement of the two companies is as follows:

Statement of Financial Position

Clearfield Farms Ltd GH¢’m Village Industries GH¢’m
Net assets 6,300 1,892
Equity:
Ordinary share capital 2,000 1,000
Retained earnings 4,300 892
6,300 1,892

The two companies retain the same proportion of profits each year and this is expected to continue into the future. Clearfield Farms Limited return on investment is 16%, while that of Village Industries Limited is 21%. One year after the post-acquisition period, Clearfield Farms will retain 60% of its earnings and expects to earn a return of 20% on new investment.
The dividends of both companies have been paid. The required rate of return of ordinary shareholders of Clearfield Farms Limited is 12% and Village Industries Limited 18%. After the acquisition, the required rate of return will become 16%.

Required:
(a) If the acquisition is to proceed immediately, calculate the:
(i) Pre-acquisition market values of both companies.

(ii) Maximum price Clearfield Farms Limited will pay for Village Industries Limited

(b) As a Finance Manager in your company, you have been asked to produce an explanatory memo to Senior Management on the subject Mergers and Acquisition. Your memo should clearly outline what actions a target company might take to prevent a hostile takeover bid.

Drake Limited is a Ghanaian registered multi-national company with FIVE subsidiaries in Europe, Asia and Africa. These subsidiaries have traditionally been allowed a large amount of autonomy, but Drake Limited is proposing to centralize most of the group’s treasury management operations.

Required:
(c) Acting as Group Head of Finance to Drake Limited, prepare a memo suitable for distribution to Senior Management of each of the subsidiaries explaining the potential benefits of treasury centralization.

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  • 14 Marks

FM – L2 – Q121 – Cost of capital

Estimate the required rate of return for Kofi Textiles Ltd's equity stock, considering industry return and marketability risk.

Kofi Textiles Ltd is a Kumasi-based textile company owned and managed by its two founders. The company has been selling to only domestic consumers in Nigeria since inception. The founders think it is time to extend the operations of the company to foreign markets, particularly those in neighbouring West African countries. Moving into foreign markets requires additional financing and capabilities, which the company does not have. The owners have agreed on ceding 40% stake in their company to a strategic investor who would provide the additional financing and capabilities needed to compete successfully in the international business environment. However, they are not sure of what range of prices to accept for the shares they would give up.

Below is a summary of financial data for Kofi Textiles Ltd for the recent financial year:

Item Amount
Issued shares 2 million
After-tax profit GH₦’000 9,600
Total dividends GH₦’000 1,920
Property, plant and equipment GH₦’000 50,500
Current assets GH₦’000 25,300
Long-term borrowings GH₦’000 9,100
Current liabilities GH₦’000 11,100

The following information is relevant to the position and value of Kofi Textiles Ltd:
(1) The assets of Kofi Textiles Ltd were valued just after the recent financial statements were published. Inventories and trade receivables, which are included in current assets, were written down by GH₦80,000 and GH₦95,000 respectively. Property, plant and equipment were valued at GH₦52,400,000.
(2) Kofi Textiles Ltd falls into the textile and apparel industry. The average P/E ratio for listed equity stocks in the industry is 10. The average required return on listed equity stocks in the industry is 16%.
(3) Marketability of shares in Kofi Textiles Ltd is limited as its equity stock is not listed on the stock exchange. Consequently, investors demand a marketability risk premium of 7% above the industry average required return on equity in order to invest in the equity stock of Kofi Textiles Ltd.
(4) Earnings and dividends of Kofi Textiles Ltd are expected to grow by 5% every year to perpetuity.

Required:
(a) Estimate an appropriate required rate of return on the equity stock of Kofi Textiles Ltd.

(b) Estimate a range of suitable considerations for 40% stake in Kofi Textiles Ltd using the net assets method, P/E ratio method, and dividend valuation method.

Answer:

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  • 20 Marks

FM – L2 – Q120 – Corporate Restructuring

Discuss advantages of management buy-outs and features of share repurchases and splits, including their effects on share price vs. dividends.

(a) Briefly discuss the potential advantages of management buy-outs.

(b) Discuss the main features of the following and explain why companies might use them:
(i) corporate share repurchases (buy-backs); and
(ii) share (stock) splits;
Include in your discussion comment on the possible effects on share price of share repurchases and share (stock) splits in comparison to the payment of dividends.

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  • 20 Marks

FM – L2 – Q119 – Business valuations

Calculate offer price for SmallCorp using a forward P/E multiple of 8.0 based on expected earnings

LargeCorp is considering a takeover bid for SmallCorp, another company in the same industry. SmallCorp is expected to have earnings next year of GH₵86,000. If LargeCorp acquires SmallCorp, the expected results from SmallCorp will be as follows:

Year after the acquisition
Year 1 Year 2 Year 3
Sales GH₵200,000 GH₵280,000 GH₵320,000
Cash costs/expenses 120,000 160,000 180,000
Capital allowances 20,000 30,000 40,000
Interest charges 10,000 10,000 10,000
Cash flows to replace assets and finance growth 25,000 30,000 35,000

From Year 4 onwards, it is expected that the annual cash flows from SmallCorp will increase by 4% each year in perpetuity. Tax is payable at the rate of 30%, and the tax is paid in the same year as the profits to which the tax relates. If LargeCorp acquires SmallCorp, it estimates that its gearing after the acquisition will be 35% (measured as the value of its debt capital as a proportion of its total equity plus debt). Its cost of debt is 7.4% before tax. LargeCorp has an equity beta of 1.60. The risk-free rate of return is 6% and the return on the market portfolio is 11%.
Required:

(a) Suggest what the offer price for SmallCorp should be if LargeCorp chooses to value SmallCorp on a forward P/E multiple of 8.0 times.

(b) Calculate a cost of capital for LargeCorp.

(c) Suggest what the offer price for SmallCorp might be using a DCF-based valuation.

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  • 20 Marks

FM – L2 – Q118 – Working Capital Management

Assess if AquaPure Ltd is overtrading using financial data and compute relevant ratios.

AquaPure Ltd is a leading producer of mineral water in Zamora. The company sells all of its output to wholesalers on credit terms net 40. The company’s collection policy is somewhat relax, and so the receivables turnover days is currently 53 days. This fairly liberal credit policy has resulted in significant increases in sales revenue in recent years. However, the company has been facing cash flow problems as a significant number of customers take longer than the credit period to settle their accounts. The company typically falls on overdraft facilities from its bankers when it fails to generate adequate cash flows from operations to meet working capital requirements. The average cost of the overdraft facilities is 15% per annum.

Last week, the management team met and discussed the company’s cash flow and liquidity problems with a view to finding solutions to the problems. In that meeting, two proposals were offered to help solve the problems:
Proposal 1: Introduce early settlement discount of 1.5% on accounts that are settled within 10 days in which invoice is sent while the current credit period is maintained. It is estimated that 60% of accounts will be paid within the discount period.
Proposal 2: Switch from financing working capital requirements using the bank overdraft facilities at 15% interest to financing working capital requirements using supplier’s trade credit. Suppliers are willing to supply on credit terms 1/10, net 40. Proponents of the proposals believe that the implementation of their proposal will improve on the company’s financial situation.

Set out below are the company’s statement of profit or loss and statement of financial position for the past three years:

Statement of profit or loss for the year ended 31st December

20X5 (GH¢’000) 20X6 (GH¢’000) 20X7 (GH¢’000)
Revenue 40,000 60,000 122,000
Cost of sales (15,000) (31,000) (58,000)
Gross profit 25,000 29,000 64,000
Selling and administrative expenses (11,000) (17,500) (24,000)
Operating profit 14,000 11,500 40,000

Statement of financial position as at 31st December

20X5 (GH¢’000) 20X6 (GH¢’000) 20X7 (GH¢’000)
Noncurrent assets:
Property, plant and equipment 13,400 19,000 22,500
Current assets:
Inventory 8,000 15,500 25,500
Trade receivables 6,900 11,210 24,210
Cash 1,110 – –
Total current assets 16,010 26,710 49,710
Total assets 29,410 45,710 72,210
Equity:
Stated capital 100 100 100
Income surplus 18,510 28,110 36,810
Shareholders’ equity 18,610 28,210 36,910
Non-current liabilities:
Medium-term loan 3,000 2,500 2,000
Current liabilities:
Trade payables 2,200 3,500 8,600
Dividend payable 5,600 6,400 7,500
Bank overdraft – 5,100 17,200
Total current liabilities 7,800 15,000 33,300
Total liabilities 10,800 17,500 35,300
Total equity and liabilities 29,410 45,710 72,210

Required:
(a) Considering the background information and financial data provided above, would you conclude that AquaPure Ltd is experiencing overtrading? Explain with relevant computations.

(b) Appraise the proposal for early settlement discount (i.e. Proposal 1) and advise on whether it should be accepted for implementation or not. Your appraisal should focus on how the discount policy will influence the company’s profitability. Show all relevant computations.

(c) Appraise the proposal to switch from financing working capital needs using bank overdraft to using suppliers’ trade credit, and advise management accordingly. Show all relevant computations.

(d) Assuming AquaPure Ltd cannot raise additional funds from external sources such as borrowing and new share offer, suggest to management three steps they can take to ease the cash shortages the company is facing.

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  • 20 Marks

FM – L2 – Q117 – Working Capital Management

Identify three types of working capital policies for an organization.

(A) A good working capital policy should facilitate successful achievement of the key short-term financing objectives of an organisation.

Required:
Identify the three types of working capital policies of an organisation.

(B) Sunyani Farms Ltd is preparing a business plan to apply for a grant from GDAIF for an expansion of its rice production. Current production is 20,000 bags at a variable cost per bag of GH₵12.00 and contribution sales ratio is 25%. Variable cost is for purchases. Current receivable days is 30 days and inventory turnover is 12 times. Suppliers allow 15 days credit and the company maintains absolute cash ratio of 1:1.

The funding support from GDAIF is expected to double the production capacity of the company. Inventory and absolute cash ratios would be maintained but receivables and payables days will increase to 45 days and 30 days respectively. GDAIF policy is to support only the extra working capital needs of applicants.

Required:
Determine the amount that should be applied from GDAIF.

(C) Kumasi Ventures Ltd has a dividend cover of 4 times and recorded the following earnings after tax.

Year Earnings (GH₵)
20X4 100,000
20X5 120,000
20X6 180,000
20X7 220,000
20X8 300,000

Required:
Calculate the average dividend growth rate for Kumasi Ventures Ltd.

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  • 25 Marks

FM – L2 – Q116 – Management of Receivables and Payables

Evaluate the impact of a new discount policy on Atefufu Foods Limited’s annual profit and suggest an alternative receivables management policy.

Atefufu Foods Limited has annual sales revenue of GH¢8 million. It has a contribution to sales ratio of 45% and its annual fixed costs are GH¢2.5 million. These figures exclude bad debts which are currently 1.25% of sales. All sales are on credit and standard credit terms are 30 days, although customers take on average 45 days to pay. Accounts receivable are financed by a bank overdraft on which interest is payable at 8%.
The company’s management are considering whether to offer a discount of 2.5% for all customers who pay within 14 days, and to extend the credit period for other customers to 60 days. It has been estimated that if this policy is introduced, 25% of customers would take the settlement discount and the rest would take the full 60 days credit offered.
The new policy would result in higher administration costs equal to 0.5% of total gross sales. It is expected that total (gross) sales would be boosted, and would increase by 3% per year. It is also expected that bad debts would fall to 1% of gross sales.

Required:
(A) Calculate the effect that the new policy would have on annual profit and recommend whether the new policy should be introduced. Suggest an alternative policy for the management of receivables that might improve profit by a larger amount.

(B) Esuna Processing Limited is a subsidiary of Atefufu Foods Limited. It uses the Miller-Orr model to manage its cash balances and has set a minimum cash balance of GH¢12,500. The average rate received on investments is currently 5.68%. Over the past year, the standard deviation of daily cash flows has been GH¢2,800. The cost to the company of selling investments or making deposits is GH¢20 per transaction.

Required:
Calculate the spread, the upper limit and the return point for cash balances using the Miller-Orr model and explain the meaning and purpose of these amounts for the purpose of cash management.

(C) Suggest with reasons how Esuna Processing Limited might invest its short-term cash surpluses.

(D) Discuss the main factors that should be taken into consideration by a company’s management when deciding on how its working capital should be funded.

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  • 25 Marks

FM – L2 – Q115 – Management of receivables and payables

Evaluate if a new credit policy with early settlement discounts increases profitability for Tamale Transport Ltd.

Tamale Transport Ltd has annual sales revenue of GH¢6 million, and all sales are on 30 days’ credit, although customers on average take ten days more than this to pay. Contribution represents 60% of sales, and the company currently has no bad debts. Accounts receivable are financed by an overdraft at an annual interest rate of 7%.
Tamale Transport Ltd plans to offer an early settlement discount of 1.5% for payment within 15 days and to extend the maximum credit offered to 60 days. The company expects that these changes will increase annual credit sales by 5%, while also leading to additional incremental costs equal to 0.5% of turnover. The discount is expected to be taken by 30% of customers, with the remaining customers taking an average of 60 days to pay.

Required:
(A) Evaluate whether the proposed changes in credit policy will increase the profitability of Tamale Transport Ltd.

(B) Salaga Enterprises, a subsidiary of Tamale Transport Ltd, has set a minimum cash account balance of GH¢7,500. The average cost to the company of making deposits or selling investments is GH¢18 per transaction, and the standard deviation of its cash flows was GH¢1,000 per day during the last year. The average interest rate on investments is 5.11%.

Required:
Determine the spread, the upper limit, and the return point for the cash account of Salaga Enterprises using the Miller-Orr model and explain the relevance of these values for the cash management of the company.

(C) Identify and explain the key areas of accounts receivable management.

(D) Discuss the key factors to be considered when formulating a working capital funding policy.

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  • 15 Marks

FM – L2 – Q113 – Management of receivables and payables

Evaluate the impact of extending credit period on Kofi Oil Mill Limited’s profit, considering sales increase and working capital costs.

The summarised budget of Kofi Oil Mill Limited for the year to 31 December 20X8 is as follows:

GH¢’000 GH¢’000
Budgeted sales 20,000
Budgeted variable costs 18,400
Budgeted fixed costs 800
19,200
Budgeted profit 800

The sales manager has proposed that the period of credit allowed to customers should be increased from one month to two months. It is believed that this would increase sales by 15%. All sales are on credit and the cost of capital is 13%. Assume fixed costs will remain constant.

Required
(a) Briefly outline for management the implications of the sales manager’s proposal.

(b) List FOUR factors which should be taken into consideration in determining a policy for the control of credit extended by a company.

(c) Explain FOUR points which should be taken into consideration when granting credit to a particular customer.

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