Institute of Chartered Accountant Ghana (ICAG) Paper 2.4 Financial Management

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1 Institute of Chartered Accountant Ghana (ICAG) Paper 2.4 Financial Management Final Mock Exam 1 Question paper Time allowed 3 hours Instructions: All five questions in this exam are compulsory and must be attempted. DO NOT OPEN THIS PAPER UNTIL YOU ARE READY TO START UNDER EXAMINATION CONDITIONS

2 ii Financial Management The Institute of Chartered Accountants Ghana First edition 2015 ISBN All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior written permission of BPP Learning Media Ltd. Published by BPP Learning Media Ltd BPP House, Aldine Place London W12 8AA The Institute of Chartered Accountants Ghana 2015

3 ALL FIVE questions are compulsory and MUST be attempted Question 1 Final Mock Exam 1: Questions 1 BBB Ltd, a house-building company, plans to build 100 houses on a development site over the next four years. The purchase cost of the development site is GHS4m, payable at the start of the first year of construction. Two types of house will be built, with annual sales of each house expected to be as follows: Year Number of small houses sold: Number of large houses sold: Houses are built in the year of sale. Each customer finances the purchase of a home by taking out a longterm personal loan from their bank. Financial information relating to each type of house is as follows: Small house Large house Selling price: GHS200,000 GHS350,000 Variable cost of construction: GHS100,000 GHS200,000 Selling prices and variable cost of construction are in current price terms, before allowing for selling price inflation of 3% per year and variable cost of construction inflation of 4.5% per year. Fixed infrastructure costs of GHS1.5m per year in current price terms would be incurred. These would not relate to any specific house, but would be for the provision of new roads, gardens, drainage and utilities. Infrastructure cost inflation is expected to be 2% per year. BBB Ltd pays profit tax one year in arrears at an annual rate of 30%. The company can claim capital allowances on the purchase cost of the development site on a straight-line basis over the four years of construction. BBB Ltd has a real after-tax cost of capital of 9% per year and a nominal after-tax cost of capital of 12% per year. Required (a) Calculate the net present value of the proposed investment and comment on its financial acceptability. Work to the nearest GHS1,000. (13 marks) (b) Discuss the effect of a substantial rise in interest rates on the financing cost of BBB Ltd and its customers, and on the capital investment appraisal decision-making process of BBB Ltd. (7 marks) (Total = 20 marks)

4 2 Final Mock Exam 1: Questions Question 2 (a) (b) Discuss: (i) The significance of trade payables in a firm's working capital cycle (4 marks) (ii) The dangers of over-reliance on trade credit as a source of finance (4 marks) WW Ltd traditionally follows a highly aggressive working capital policy, with no long-term borrowing. Key details from its recently compiled accounts appear below. GHSm Sales (all on credit) Cost of sales 8.00 Interest payments for the year 0.50 Shareholders' funds (comprising GHS1m issued share capital, nominal value 25Gp, and GHS1m revenue reserves) 2.00 Receivables 0.40 Inventories 0.70 Trade payables 1.50 Bank overdraft 3.00 A major supplier, which accounts for 50% of WW's cost of sales, is highly concerned about WW's policy of taking extended trade credit. The supplier offers WW the opportunity to pay for supplies within 15 days in return for a discount of 5% on the invoiced value. WW holds no cash balances but is able to borrow on overdraft from its bank at 12%. Tax on corporate profit is paid at 30%. Assume gross profit equals profit before interest and tax. Required Determine the costs and benefits to WW of making this arrangement with its supplier, and recommend whether WW should accept the offer. Your answer should include the effects on: The working capital cycle Interest coverage Profits after tax Earnings per share Return on equity Capital gearing (12 marks) (Total = 20 marks)

5 Question 3 Final Mock Exam 1: Questions 3 JKL SA, a French company, has agreed a sale of $2,350,000 to a US company on three months credit. Assume that the date is currently the 14th of April. Currency market rates on 14 April: Per Spot rate $ / Three months forward rate $ / Money market rates p.a. on 14 April: Euro 2.2% US 1.2% Required (a) Recommend the most appropriate method for JKL to use to hedge its foreign exchange risk for the next three months. (6 marks) (b) Comment on the advantages of using derivatives to hedge this risk. (4 marks) (c) Explain the terms transaction risk and translation risk and describe the differences between them. (6 marks) (d) Briefly explain two issues that a company faces when it has overseas trade receivables rather than just domestic trade receivables. (4 marks) (Total = 20 marks)

6 4 Final Mock Exam 1: Questions Question 4 (a) MD Ltd has a paid-up ordinary share capital of GHS1.5m represented by 6 million shares of 25Gp each. It has no loan capital. Earnings after tax in the most recent year were GHS1.2m. The P/E ratio of the company is 12. The company is planning to make a large new investment which will cost GHS5,040,000, and is considering raising the necessary finance through a rights issue at 192Gp per share. Required (i) Calculate the current market price per share of MD Ltd's ordinary shares. (2 marks) (ii) Calculate the theoretical ex-rights price, and state what factors in practice might invalidate your calculation. (6 marks) (b) As an alternative to a rights issue, MD Ltd might raise the GHS5,040,000 required by means of an issue of convertible loan notes at nominal value, with a coupon rate of 6%. The loan notes would be redeemable in seven years' time. Prior to redemption, the loan notes may be converted at a rate of 35 ordinary shares per GHS100 nominal. Required (i) Calculate the conversion premium at the date of issue implicit in the data given. (2 marks) (ii) Identify the advantages to MD Ltd of issuing convertible loan notes instead of the rights issue to raise the necessary finance. (3 marks) (iii) Explain why the market value of convertible loan notes is likely to be affected by the dividend policy of the issuing company. (4 marks) (c) Explain the differences between sukuk and conventional bonds. (3 marks) (Total = 20 marks)

7 Question 5 The statement of financial position of KK Ltd provides the following information: Final Mock Exam 1: Questions 5 GHSm GHSm Equity finance Ordinary shares (GHS1 nominal value) 25 Reserves Non-current liabilities 7% Convertible bonds (GHS100 nominal value) 20 5% Preference shares (GHS1 nominal value) Current liabilities Trade payables 10 Overdraft Total liabilities 95 KK Ltd has an equity beta of 1.2 and the ex-dividend market value of the company's equity is GHS125m. The ex-interest market value of the convertible bonds is GHS21m and the ex-dividend market value of the preference shares is GHS6.25m. The convertible bonds of KK Ltd have a conversion ratio of 19 ordinary shares per bond. The conversion date and redemption date are both on the same date in five years' time. The current ordinary share price of KK Ltd is expected to increase by 4% per year for the foreseeable future. The overdraft has a variable interest rate which is currently 6% per year and KK Ltd expects this to increase in the near future. The overdraft has not changed in size over the last financial year, although one year ago the overdraft interest rate was 4% per year. The company's bank will not allow the overdraft to increase from its current level. The equity risk premium is 5% per year and the risk-free rate of return is 4% per year. KK Ltd pays profit tax at an annual rate of 30% per year. Required (a) Calculate the market value after-tax weighted average cost of capital of KK Ltd, explaining clearly any assumptions you make. (14 marks) (b) Identify and describe the three forms of efficiency that may be found in a capital market. (6 marks) (Total = 20 marks)

8 6 Final Mock Exam 1: Questions Formulae sheet Mathematical tables Present value table Present value of 1 ie (1+r) n where r = discount rate n = number of periods until payment Discount rates (r) Periods (n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% % 12% 13% 14% 15% 16% 17% 18% 19% 20%

9 Final Mock Exam 1: Questions 7 Annuity Table Present value of an annuity of 1 ie where r = discount rate n = number of periods -n 1-(1+r) r Interest rates (r) (n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% % 12% 13% 14% 15% 16% 17% 18% 19% 20%

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