Subject: FINANCIAL MANAGEMENT

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  • 6 Marks

FM – May 2021 – L2 – Q5b – Inventory Management

Evaluate whether the company should continue using a bank loan to finance inventory purchases and take advantage of early payment discounts.

Would you advise the company to continue to take the bank loan to pay for the cost of
inventory purchases within the discount period to enjoy the supplier’s early settlement
discount? Support your answer with relevant computations.

Financing method
The company should continue utilizing the bank loan to finance inventory purchases within the discount period to benefit from the discount. This recommendation is based on the fact that the annualized cost of the bank loan is 30%, which is lower than the implied annualized interest cost of trade credit, calculated at 37.2%. By opting to borrow and pay early, the company can reduce financing costs by approximately 7.2%, compared to forgoing the discount and using the full credit period.

Annualized Cost of the Bank Loan

As a form of short-term borrowing, the annualized cost of the bank loan can be calculated as follows:

Assuming the company continues with its current purchase strategy of buying 100,000 units at a purchase price of GH¢120, it would need to borrow GH¢12,000,000. The annualized cost of the loan, therefore, would be 30%:

Periodic Interest = 24% × ¼ × GH¢12,000,000 = GH¢720,000
Processing fee = 1.5% × GH¢12,000,000 = GH¢180,000

Implied Interest Cost of the Settlement Discount

The cost associated with not taking advantage of the settlement discount, thereby utilizing the full 30-day credit period, is 37.2%:

Discount = 2% × GH¢12,000,000 = GH¢240,000
T = the effective credit period = 30 – 10 = 20

  • 5 Marks

FM – May 2021 – L2 – Q5c – Foreign exchange risk and currency risk management

Explain three advantages of using a forward market hedge compared to a futures market hedge for managing currency risk exposure.

c) Explain TWO (2) advantages to a company dealing with a currency risk exposure using a forward market hedge as against a futures market hedge. (5 marks)

  • Tailor-Made Contracts:
    • Forward contracts can be customized to meet the specific needs of a company in terms of contract amount and maturity. This allows a company to hedge exactly the amount it requires for a specific period, aligning the hedge with the company’s cash flow needs. In contrast, futures contracts are standardized in terms of contract size and maturity dates, which might not align perfectly with the company’s specific exposure, leading to inefficiencies in hedging.
  • Absence of Margin Requirements:
    • Forward contracts do not require margin payments, whereas futures contracts typically require the posting of initial and maintenance margins. This means that with forward contracts, the company does not have to tie up cash or other assets as collateral, which can be particularly beneficial for cash flow management. The absence of margin calls reduces the financial burden on the company, especially in volatile markets where frequent margin adjustments might be needed in futures contracts.
  • Flexibility in Settlement:
    • Forward contracts allow for flexibility in settlement, as they can be settled either by actual delivery of the currency or by a cash settlement, depending on the terms agreed upon. This flexibility can be advantageous to a company that may prefer to settle in cash rather than having to deal with the logistics of currency delivery. On the other hand, futures contracts generally require a cash settlement or physical delivery as per the standardized terms, which might not be as convenient for the company.
  • 9 Marks

FM – May 2021 – L2 – Q5a – Inventory Management

Calculate the Economic Order Quantity (EOQ) and related inventory costs for Adom Furniture Ltd.

a) Adom Furniture Ltd is a reputable producer of office desks. A key material that is used in the production of office desks is processed wood boards. The company produces 200,000 units of office desks annually. The production of one unit of office desk requires three units of the processed wood board. The current production level and requirements will apply going forward.

Currently, the company buys 100,000 units of the processed wood board whenever it runs out of wood. The cost price of a processed wood board is GH¢120. It costs GH¢1,000 to place an order to replenish the inventory of processed wood board. On average, it costs GH¢10 to hold one processed wood board per annum.

The company has been financing each round of inventory purchase with short-term borrowing from a bank. The loan is typically granted for three months at an annual nominal interest rate of 24%. The bank charges a loan processing fee of 1.5% of the principal, which is paid upfront. The local distributor of the processed wood board is now willing to sell the product on credit terms 2/10 net 30.

Required:

i) Compute the optimal quantity of the processed wood board the company should order whenever it places an order. (3 marks)

ii) Compute the optimal number of orders to place. (2 marks)

iii) Compute the average costs associated with the current purchase plan of 100,000 units per order and the cost if the optimal quantity is ordered instead. (4 marks)

i) Computation of the Optimal Quantity (Economic Order Quantity – EOQ):

Where:

  • DD = Annual demand = 200,000 x 3 = 600,000 units
  • C0C_0 = Ordering cost = GH¢1,000
  • CHC_H = Holding cost = GH¢10
  • This means the company should order 10,954 units to minimize costs associated with inventory.(3 marks)

    ii) Computation of the Optimal Number of Orders:

    (2 marks)

    iii) Computation of Average Inventory Costs:

    For the current purchase plan (100,000 units per order):

    For the optimal order quantity (10,954 units per order):

    Thus, the company would save costs by ordering the optimal quantity.

    (4 marks)

  • 5 Marks

FM – May 2021 – L2 – Q4b – Treasury Management

Explain interest rate risk and suggest two ways of managing an entity’s exposure to it.

b) Most large companies maintain a treasury department to handle some specialized functions in finance. One of such functions is the management of financial risk, which includes interest rate risk.

Required:

Explain interest rate risk and suggest two ways of managing an entity’s exposure to interest rate risk. (5 marks)

Interest Rate Risk Explanation:

Interest rate risk is the risk of uncertainty and potential loss that could arise due to movements or changes in interest rates. If interest rates rise, the value of bonds or financial assets drops and vice versa. Borrowers at fixed interest rates tend to suffer or lose when interest rates rise, as they may face higher interest expenses on new borrowing or may find that their existing fixed-rate liabilities are now more costly compared to prevailing market rates.

Ways of Managing Interest Rate Risk:

  1. Interest Rate Matching:
    • This strategy involves matching the interest type on the borrowing with the interest type on the investment to be financed. For example, an investment that will return constant cash flows can be financed with a fixed-rate loan. This ensures that the interest expenses are predictable and aligned with the cash flows generated by the investment.
  2. Interest Rate Smoothing:
    • This method involves balancing the amount of fixed-rate loans with variable-rate loans. By maintaining a balanced proportion of fixed-rate and variable-rate loans, any movement in interest rates will result in both losses and gains of fairly equal amounts, which would net off. This approach reduces the volatility in interest expenses due to fluctuations in interest rates.

External Strategies:

  1. Interest Rate Swap:
    • This involves swapping fixed interest payments for variable interest payments, or vice versa. By engaging in an interest rate swap, the entity can achieve a desired interest rate profile that better matches its exposure, thereby reducing the risk of adverse movements in interest rates.
  2. Forward Rate Agreement (FRA):
    • An FRA involves hedging the interest rate exposure with a forward contract with a bank. This allows the entity to lock in an interest rate for a future period, thereby providing certainty over borrowing costs and mitigating the risk of interest rate fluctuations.

Marks Allocation:

  • Explanation of interest rate risk: 2 marks
  • Each management strategy: 1.5 marks
  • 15 Marks

FM – May 2021 – L2 – Q4a – Introduction to investment appraisal

Evaluate the financial viability of an investment using NPV, IRR, and explain the concept of sensitivity analysis.

CVD Ghana Ltd, which is into the production and sale of COVID-19 vaccine in Ghana and abroad, plans to buy a new machine to expand the scope of its operations due to increased demand in both the local and the international markets.

The cost of the machine is GH¢24,000,000 and has a useful life of five years. The machine will require additional investment in working capital of GH¢2,700,000 at the beginning of the first year of operations. At the end of year five, the machine will be sold for scrap, with the scrap value expected to be 5% of the machine’s initial purchase cost. The company has no intention to replace the machine. Production and sales from the new machine are expected to be 1,000,000 packs per year.

The selling price per pack and variable cost per pack are as follows:

Year Selling Price per Pack (GH¢) Variable Cost per Pack (GH¢)
1 48 33
2 48 33
3 55 38
4 55 38
5 60 42

It is also estimated that incremental fixed costs arising from the machine’s operations will be GH¢4,800,000 per year. CVD Ghana Ltd has an after-tax cost of capital of 20%, which it uses as a discount rate in its investment appraisal. The company pays corporate tax at an annual rate of 25% per year. Capital allowance should be ignored.

Required:

i) Compute the Net Present Value of this project and advise CVD Ghana Ltd whether the investment is financially viable. (8 marks)

ii) Calculate the Internal Rate of Return of investing in the machine and advise whether it is financially viable. (5 marks)

iii) Explain the meaning of the term “sensitivity analysis” in the context of investment. (2 marks)

 

i) Net Present Value (NPV) Calculation (8 marks):

To calculate the NPV, we need to determine the net cash flows for each year, then discount them using the company’s cost of capital, and finally, sum these discounted values.

NPV Calculation:

NPV = ∑ (Present Value of Cash Flows) = (26,700,000) + 6,372,450 + 5,309,100 + 5,298,450 + 4,410,300 + 5,547,600 = 237,900

Since the NPV is positive (GH¢237,900), the investment is financially viable, and CVD Ghana Ltd should proceed with the investment.

ii) Internal Rate of Return (IRR) Calculation (5 marks):

To calculate the IRR, we need to find the discount rate that makes the NPV of the project equal to zero. This can be done using trial and error or financial calculators/software.

Trial and Error Approach:

We know that the NPV is positive at 20%, so we try a higher rate, say 30%.

Step 1: Discount Net Cash Flows at 30%

Year Net Cash Flow (GH¢) Discount Factor @ 30% Present Value (GH¢)
0 (26,700,000) 1.000 (26,700,000)
1 7,650,000 0.769 5,883,850
2 7,650,000 0.592 4,528,800
3 9,150,000 0.455 4,163,250
4 9,150,000 0.350 3,202,500
5 13,800,000 0.207 2,856,600

NPV @ 30% = (26,700,000) + 5,883,850 + 4,528,800 + 4,163,250 + 3,202,500 + 2,856,600 = (6,808,000)

Since the NPV at 30% is negative, the IRR lies between 20% and 30%.

Using interpolation:

Since the IRR (20.34%) is slightly above the cost of capital (20%), the investment is financially viable.

iii) Explanation of Sensitivity Analysis (2 marks):

Sensitivity analysis is a technique used to assess how the uncertainty in the output of a model (in this case, the NPV) can be attributed to different sources of uncertainty in the model’s inputs. It involves varying key assumptions or parameters, such as sales volume, selling price, variable costs, or discount rates, to determine how sensitive the NPV is to changes in these variables. This helps in understanding which assumptions have the most significant impact on the investment’s outcome, allowing management to focus on controlling the most critical risks.

  • 3 Marks

FM – May 2021 – L2 – Q3d – Working Capital Management

Discuss one merit and one demerit of engaging the services of a debt factoring agency.

Discuss ONE (1) merit and ONE (1) demerit of engaging the services of a debt factoring agency. (3 marks)

Merit of Engaging a Debt Factoring Agency:

  • Reduction in Internal Debt Administration Costs: Engaging a debt factoring agency can lead to significant savings in the cost of managing and collecting receivables internally. Since the factoring agency takes over the administration and collection of debts, the company can reduce or eliminate the resources allocated to these functions. As the factoring agency specializes in debt administration, it can perform this function more efficiently and often at a lower cost than the company would incur if it managed the debts internally. Additionally, the company benefits from immediate cash flow, improving liquidity.

Demerit of Engaging a Debt Factoring Agency:

  • Higher Cost and Potential Negative Impact on Customer Relationships: One of the disadvantages of using a factoring agency is the potential higher cost compared to other financing options. The factoring agency may charge a higher interest rate on advances than other lenders, which can increase the overall cost of financing. Furthermore, the use of a factoring agency might negatively affect customer relationships. The agency might not treat the company’s customers with the same level of care or flexibility in debt collection as the company would, potentially leading to a loss of customer goodwill. Additionally, the use of a factoring agency may signal financial distress to stakeholders, potentially damaging the company’s reputation.
  • 2 Marks

FM – May 2021 – L2 – Q3c – Factoring Agency

Define what a factoring agency is and explain its role.

What is a factoring agency?

A factoring agency is a financial institution that specializes in managing and financing a company’s accounts receivable. The agency provides a service where it purchases a company’s invoices (accounts receivable) at a discount, giving the company immediate cash flow. The factoring agency then takes on the responsibility of collecting the receivables from the company’s customers.

The key roles of a factoring agency include:

  • Management of Receivables: The factoring agency takes over the administration of the accounts receivable ledger, including the collection of debts from customers.
  • Provision of Short-Term Finance: By advancing funds to the company against its receivables, the factoring agency provides short-term financing, which helps the company improve its cash flow and working capital management.

This service allows companies to focus on their core operations while ensuring a steady flow of cash, thereby reducing the burden of managing receivables internally.

  • 9 Marks

FM – May 2021 – L2 – Q3b – Cost of Capital

Calculate Gbewaa Ghana Ltd’s Weighted Average Cost of Capital

b) Gbewaa Ghana Ltd has issued 10 million shares with a market value of GH¢5 per share. The equity beta of the company is 1.2. The current yield of short-term government debt is 14% per annum, and the equity risk premium is approximately 5% per annum. The debt finance of Gbewaa Ghana Ltd consists of bonds with a book value of GH¢10,000,000. These bonds pay interest at 18% per annum, and the par value and market value of each bond is GH¢100. The company’s tax rate is 25%.

Required:

Calculate Gbewaa Ghana Ltd’s Weighted Average Cost of Capital. (9 marks)

 

To calculate the Weighted Average Cost of Capital (WACC) for Gbewaa Ghana Ltd, we need to calculate the cost of equity, the after-tax cost of debt, and then combine these costs according to their respective weights in the company’s capital structure.

1. Cost of Equity (Re):

  • The cost of equity can be calculated using the Capital Asset Pricing Model (CAPM):

Re = Rf + βe × (Rm−Rf)

Where:

  • = Risk-free rate (yield on government debt) = 14%
  • βe = Equity beta = 1.2
  • Rm − Rf = Equity risk premium = 5%

Re = 14% + 1.2 × 5% = 14% + 6% = 20

2. After-Tax Cost of Debt (Rd):

  • The cost of debt is the interest rate on the company’s bonds, adjusted for taxes:

Rd = Interest Rate × (1−Tax Rate)

Where:

  • Interest rate = 18%
  • Tax rate = 25%

Rd= 18% × (1−0.25) = 18% × 0.75 = 13.5%

3. Market Value of Equity (E):

  • The market value of equity (E) is calculated as:

E =Number of Shares × Market Price per Share

E = 10,000,000 × GH¢5 = GH¢50,000,000

4. Market Value of Debt (D):

  • The market value of debt (D) is the par value of the bonds, which equals the book value in this case:

D = GH¢10,000,000

5. Calculation of WACC:

Where:

  • EE = Market value of equity = GH¢50,000,000
  • DD = Market value of debt = GH¢10,000,000
  • Re = Cost of equity = 20%
  • Rd = After-tax cost of debt = 13.5%Final Answer:

    Gbewaa Ghana Ltd’s Weighted Average Cost of Capital (WACC) is 18.92%.

 

  • 6 Marks

FM – May 2021 – L2 – Q3a – Capital Structure

Discuss the main difficulties associated with highly geared companies.

a) Shareholders and Management of companies generally agree that it is good to introduce gearing into a company’s financing structure to enhance returns to shareholders. Excessive debt and gearing above a level that a company can comfortably afford is risky.

Required:

State and explain THREE (3) main difficulties associated with highly geared companies. (6 marks)

High gearing introduces several risks or problems to companies, and these include:

  1. High volatility to company or equity returns:
    • The higher the level of debt, the higher the company’s level of interest cost or expense. Volatility in interest rates, especially variable interest rate debts, can cause volatility in the company’s earnings. Drops in earnings resulting from a rising interest rate environment, and vice versa, expose the company and shareholder returns to a high level of volatility and uncertainty.
  2. High debt burden and bankruptcy risk:
    • An over-borrowing environment can lead to significant interest payments that may overwhelm the company’s earnings. If the earnings are insufficient to cover these costs, it can push the company into financial distress, increasing the risk of bankruptcy. In such scenarios, shareholders may lose the value of their investments since they are the last to be compensated in a liquidation.
  3. Loss of market reputation and credibility:
    • High levels of debt are easily noticeable in financial disclosures, which can lead to a loss of confidence among shareholders and analysts. This can trigger a crisis of confidence and negatively impact the company’s market reputation and credibility.
  4. Short-termism in management decisions:
    • Excessive gearing may pressure management to focus on short-term financial goals, such as generating cash flow to service debt, rather than on long-term strategies that enhance shareholder value. This short-term focus can compromise the company’s long-term growth and sustainability.
  5. Lower financial flexibility:
    • High levels of debt limit the company’s ability to take on additional financing when needed, reducing its financial flexibility. This can restrict the company’s ability to invest in new opportunities, respond to market changes, or navigate financial downturns effectively.

(Any three points @ 2 marks each = 6 marks)

 

  • 20 Marks

FM – May 2021 – L2 – Q2 – Business Valuations

This question covers distinctions between price and value, the subjectivity of valuation, and the valuation of a printing segment using DCF and asset-based methods.

Kwaafi and Sons Ltd operates a newspaper business. The business has various segments, namely: traditional media, online news, events, and printing. The company’s new strategy is to concentrate on online news, outsource its printing services, and discontinue the printing segment.

The printing segment is one of the company’s cash cows, generating 30% of its revenue of GH¢28,000,000 annually. The company aims to take advantage of the Continental Free Trade Agreement to serve other African countries.

Before deciding to concentrate on online news, the company undertook an extensive retooling of its printing segment. The Finance Director has produced the following information:

i) A new coloured printer was purchased to replace a 15-year-old printer, which was purchased for GH¢3,000,000 and is now obsolete but can be sold as scrap for GH¢15,000.

ii) The new coloured printer was purchased two years ago at GH¢8,000,000 and has a useful life of six years.

iii) A contract has been signed for the servicing of the equipment at a retainer fee of GH¢755,250 per annum over the life of the equipment.

iv) The stock of toners and rollers for the old printer worth GH¢280,000 is obsolete at no cost.

v) Replacement parts for the new equipment, which are enough for the useful life of the equipment is valued at GH¢300,000.

vi) Special carbonated toners for the old printer costing GH¢230,000 is unusable and has to be disposed of at a residual value of GH¢13,000 as soon as possible.

vii) Eighteen (18) rolls of printing sheets and twenty-five (25) boxes of metal plates are valued at GH¢240,000 and GH¢420,000, respectively. These need replacement every year at similar costs.

viii) Annual rent and rates of GH¢800,000, payable at the end of each year, increase by 10% every 2 years.

ix) Other operating expenses of GH¢3,200,000, payable at the end of the year, increases at 10% annually until year 3.

x) It is estimated that the printing segment will now generate 10% more revenue per annum for the New Printer’s remaining life. Depreciation is based on the straight-line method.

xi) For valuation purposes, an expected rate of return of 30% has been agreed upon among the parties. Ignore taxation and inflation.

Following the announcement to discontinue the printing segment, the senior staff of the segment proposed to raise funds to buy the assets of the segment. They obtained invoices of similar assets and used the prices to make an offer to the Board of Directors.

The Finance Director disagreed and suggested that an expert valuer value the assets of the company and its operations. The senior staff have objected to the valuation proposals arguing that valuations are subjective and may not reflect the accurate value of the assets to be disposed off by the company.

Required:

a) Distinguish between market price and value in the context of business valuation. (3 marks)

b) Explain why a valuation process is described as subjective. (2 marks)

c) Calculate the value of the printing segment using the discounted cash flow method. (12 marks)

d) Calculate the value of the printing segment using the assets-based method. (3 marks)

a) Distinction between Market Price and Value (3 marks):

Price:

  • Price is determined by the market forces and is obtained by the interplay of demand and supply.
  • Price is the amount that a willing buyer is ready to pay, and a willing seller is prepared to accept for the exchange of an item.
  • Price is always expressed in monetary terms except in the case of barter where the price of a commodity is quoted in reference to the quantity of another commodity.
  • The price of an asset can also be determined as the present value of all future cash flows of the stated asset.
  • Price can be higher than the value of an item when a premium is paid or lower when a discount is granted.

Value:

  • Value, on the other hand, is the allocation of monetary worth to an item or a subject of valuation.
  • Unlike price, value can be tangible or intangible.
  • Everything has a value, which may be different from the price; though the price can be used as a measure of the value of an item.
  • Whereas price is agreed upon and fixed between a buyer and a seller for a given item, the value of the item in question may differ among the parties.
  • Processes to establish a common value of an item is often the starting point to determine the price.

b) Why Valuation Process is Described as Subjective (2 marks):

  • Valuation methods apply several assumptions that may vary in the future.
  • Different methods produce different values, which can create disagreement on the appropriate method to apply.
  • Several elements for the valuation are based on estimation (future cash flow), which may vary materially from the actual results.
  • Different perspectives of interested parties influence their choice of valuation method. For instance, valuation for taxation purposes may consider factors for the computation of capital gain, which may be different from valuation for accessing credit facility, which will focus on collateral value.
  • Some methods, such as the discounted cash flow, have been described as subjective.
  • The quality of information and completeness thereof influence the competence of the valuation process.

c) Discounted Cash Flow Valuation (12 marks):

 

d) Assets-Based Valuation (3 marks):

Item Value (GHS)
Equipment (NBV) (8,000,000/6 × 4) 5,333,333
Scrap value of old printer 15,000
Scrap value of tonners 13,000
Stock of replacement parts 300,000
Printing sheets 240,000
Plates 420,000
Total Valuation Amount 6,321,333

 

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