Financial Risk – Knowsia

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.

Question

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.

Answer

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Tags: Credit Policy, Customer Credit, Financial Risk, Receivables Management
Level: Level 2

Topic: Management of receivables and payables

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.

Question

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.

Answer

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Tags: Capital structure, CAPM, Cost of Equity, Financial Risk, Gearing, Optimal capital structure, Tax shield, Weighted Average Cost of Capital
Level: Level 2

Topic: Capital structure

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.

Question

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.

Answer

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Tags: Capital structure, Combined gearing, Financial gearing, Financial Risk, Operating gearing
Level: Level 2

Topic: Capital structure

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.

Question

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.

Answer

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Tags: Asset beta, Capital structure, CAPM, Chemical manufacturing, Cost of Equity, Equity beta, Financial Risk, investment appraisal, Tax shield, WACC
Level: Level 2

Topic: Cost of capital

FM – FM – L2 – Q35 – Capital structure

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

Question

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.

Answer

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Tags: Capital structure, Debt, Earnings per share, Equity, Financial Risk, Gearing, Profit after tax
Level: Level 2

Topic: Capital structure

AAA – L3 – Q22 – Planning

Identify circumstances affecting audit planning for a new small recruitment company and explain their relevance.

Question

Your firm has recently been appointed auditor of Zebra Recruitment, a small company set up two years ago by the managing director, Daniel Zebra, who was previously an investment banker. The initial capital was provided equally by Daniel and the bank. The bank loan and the current overdraft facility are secured on the company’s assets. The overdraft is running just under its limit.
The company places highly qualified personnel in management positions. Daniel employs the following staff:

A senior recruitment consultant, Laura Leopard.
Three other recruitment consultants.
An office manager, Jacob Antelope.
A bookkeeper, Sarah Slug.
Laura places clients in employment and supervises and trains the other recruitment consultants.
Jacob is in charge of all office administration. He raises invoices for fees when Daniel instructs him to do so and pays invoices when Daniel tells him to. Daniel is the sole cheque signatory.
Sarah maintains the accounting records on a PC located in the general office. The PC is regularly backed up and copies retained in a drawer under the desk on which the PC stands.
Required
Identify, from the situation outlined above, circumstances that should be taken into account when planning the audit. Explain why these matters should be taken into account.

Answer

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Tags: Audit Planning, Financial Risk, Internal controls, IT Controls, New Audit Client, Risk Assessment, Small Business
Level: Level 3

Topic: Planning an Audit

Tag (SQ): Financial Risk

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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.

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.

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.

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.

FM – FM – L2 – Q35 – Capital structure

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

AAA – L3 – Q22 – Planning

Identify circumstances affecting audit planning for a new small recruitment company and explain their relevance.

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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.

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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.

You're reporting an error for "FM – L2 – Q40 – Capital structure"

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.

You're reporting an error for "FM – L2 – Q39 – Cost of capital"

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.

You're reporting an error for "FM – L2 – Q38 – Cost of capital"

FM – FM – L2 – Q35 – Capital structure

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

You're reporting an error for "FM – FM – L2 – Q35 – Capital structure"

AAA – L3 – Q22 – Planning

Identify circumstances affecting audit planning for a new small recruitment company and explain their relevance.

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