Topic: Economic and regulatory environment

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  • 20 Marks

FM – Nov 2023 – L2 – Q1 – Cost of capital | Economic and regulatory environment

Distinguish between expansionary and contractionary monetary policies, discuss the impact of raising the monetary policy rate, and calculate the cost of equity and WACC for Moli Ltd.

a) Monetary policies are seen either as expansionary or contractionary depending on the level of growth within the economy. The Bank of Ghana, which is responsible for pursuing sound monetary policies, has recently raised the monetary policy rate by 150 basis points.

Required:
i) In reference to the statement above, distinguish between expansionary monetary policy and contractionary monetary policy. (4 marks)
ii) Would you describe the raise in the monetary policy rate as an expansionary or contractionary monetary policy action? Explain. (2 marks)
iii) Explain TWO (2) implications of raising the monetary policy rate for the financial performance of businesses. (4 marks)

b) Moli Ltd is financed by a mixture of equity and debt capital in the ratio of 2:1. The pre-tax cost of debt is 25% whilst the risk-free interest rate is 15%. The available market information puts the average stock market return on equity at 22%. The equity beta value of Moli Ltd has been estimated as 0.9. The corporate tax rate is 30%.

Required:
i) Calculate the cost of equity. (4 marks)
ii) Calculate the weighted average cost of capital. (6 marks)

a)

i) Distinction between Expansionary and Contractionary Monetary Policy:

  • Expansionary Monetary Policy:
    This policy lowers interest rates and expands money supply to stimulate economic activities and encourage spending, which would increase inflation to a desired level in the long term. It is typically employed during periods of slow economic growth or recession to boost the economy.
  • Contractionary Monetary Policy:
    This policy increases interest rates and limits the money supply to slow down economic activities, which would reduce inflation to a desired level in the long term. It is typically employed during periods of high inflation or overheated economic growth to cool down the economy.

(4 marks)

ii) Analysis of the Monetary Policy Rate Increase:

  • The Bank of Ghana’s raise in the monetary policy rate by 150 basis points is a contractionary monetary policy action. The increase in the rate is aimed at reducing inflation by increasing the cost of borrowing, thereby discouraging spending and investment.

(2 marks)

iii) Implications of Raising the Monetary Policy Rate:

  1. Increased Borrowing Costs:
    Higher interest rates result in increased borrowing costs for businesses, leading to higher expenses and reduced profitability.
  2. Reduced Consumer Spending:
    Higher interest rates can discourage consumer borrowing and spending, leading to reduced demand for goods and services, which can negatively impact business revenues.

(4 marks)

b)

i) Calculation of Cost of Equity:
Cost of equity
re = rf + B(rm-rf)
= 15% + 0.9 (22% – 15%)
= 21.3%

ii) Calculation of Weighted Average Cost of Capital (WACC):

  • 20 Marks

FM – July 2023 – L2 – Q1 – Economic and regulatory environment | Sources of finance: debt

Discuss the conflicts between management and shareholders, costs associated with appointing management, and calculate the yield and cost of different debt financing options for Gologo Ghana Ltd.

a) Shareholders of a large company substantially delegate the management of their business to agents (managers). Decision-making authority is also delegated to management. In a perfect condition, Management is expected to give priority to the interest of shareholders rather than their personal interest.

Required:
i) In reference to the above, explain THREE (3) areas of conflict between Management and Shareholders. (6 marks)
ii) Explain TWO (2) aspects of cost to shareholders in appointing an agent (Management). (4 marks)

b) Gologo Ghana Ltd is making a choice between issuing a public bond and placing the debt privately for GH¢600 million.

The public offer will be in GH¢100,000 denominations and carry a coupon or interest payment of 25% per annum. The bond will, however, sell for GH¢96,000 each. The issuing and underwriting cost will be 5% of the market value and is tax deductible.

The private placement will attract an interest rate of 26% per annum, and the company will receive the full face value of the loan. In both cases, the debt will be repaid after 20 years. The tax rate for the company is 30%.

Required:
i) Calculate the annual yield (%) the buyers of the public bond will earn. (3 marks)
ii) Compute the cost of both the bond and the private debt. (7 marks)

a)

i) Areas of Conflict Between Management and Shareholders:

  1. Risk-Taking:
    Management might be interested in taking higher risks, but shareholders might prefer to avoid excessive risks to protect their investment and ensure steady returns.
  2. Short-Term vs. Long-Term Performance:
    Management may focus on short-term decisions to generate quick profits, which might not align with shareholders’ interest in long-term growth and value maximization.
  3. Gearing Level Decisions:
    Management might introduce or increase debt in the capital structure, raising the level of financial risk, which might not be acceptable to shareholders who prefer a more conservative approach.

(Any 3 points explained @ 2 marks each = 6 marks)

ii) Costs to Shareholders for Appointing Management:

  1. Hiring and Reward Costs:
    This includes salaries, benefits, and bonuses paid to management, which represent a cost to shareholders.
  2. Cost of Appointing Independent Non-Executive Directors:
    Shareholders may incur costs in appointing independent non-executive directors to oversee management and ensure accountability, which also adds to the overall cost.

(Any two points @ 2 marks each = 4 marks)

b)

i) Annual Yield Buyers of the Bond Will Earn:

 

ii) Cost of Both Bond and Private Debt:

Cost of Public Bond (Kd):

Cost of Private Debt:


  • 20 Marks

FM – NOV 2021 – L2 – Q1 – Economic and regulatory environment | Sources of finance: equity

Functions of the Securities and Exchange Commission and National Insurance Commission; calculation and analysis of a rights issue by LIGRI Bank Ghana Ltd.

a. The Securities and Exchange Commission and the National Insurance Commission are part of a list of regulators established by an Act of Parliament. They play a very critical role in the regulation of the financial services sector in the country.

Required:
i) Explain THREE (3) main functions played by the Securities and Exchange Commission in Ghana. (6 marks)
ii) Explain TWO (2) functions performed by the National Insurance Commission in Ghana. (4 marks)

b) LIGRI Bank Ghana Ltd generates a profit after tax of 15% on shareholders’ funds. The current capital structure of the bank is as follows:

Item GH¢
Ordinary shares 40,000,000
Reserves 80,000,000
Total 120,000,000

The management, with the board’s approval, wishes to raise GH¢50,000,000 from a rights issue to expand their existing operations in the country. The return on shareholders’ funds will not change. The current ex-dividend market price is GH¢4 per share. The right issue price proposed by the Finance Director is GH¢3.8 per share.

Required:
i) Calculate the total number of shares to be issued by the company. (3 marks)
ii) Determine the theoretical ex-right price per share after the issue. (3 marks)
iii) Calculate the new earnings per share after the rights issue. (3 marks)
iv) Comment on the calculations of the theoretical ex-right price calculated in ii) above. (1 mark)

a)
i) The Securities and Exchange Commission performs the following functions:

  • Guidance to companies and the general public on the interpretation of the provisions of securities law, rules, and regulations on listing.
  • Licensing of market operators such as dealers, brokers, advisors, assets, and fund managers.
  • Overseeing the regulation of the fund management industry in Ghana.

ii) The following are the functions performed by the National Insurance Commission:

  • Licensing of entities in the insurance industry such as insurance companies and brokers.
  • Setting up standards and facilitating the establishment of codes for practitioners.

b)
i) Number of shares to be issued:
No. of new shares = GH¢50,000,000 / GH¢3.8 = 13,157,894 shares

ii) Theoretical ex-right price per share = (GH¢90,000,000 / 23,157,894 shares) = GH¢3.886 per share

iii) New earnings per share = GH¢25,500,000 / 23,157,894 shares = GH¢1.1 per share

iv) It is expected that since the return on shareholder funds has not changed, the theoretical ex-right price will be below the current price. It is expected to be issued at a discount.

  • 10 Marks

FM – Nov 2019 – L2 – Q1a – Economic and regulatory environment

Functions of Ghana's Securities and Exchange Commission and implications for corporate investing and financing activities.

The financial sector is one of the most highly regulated sectors of any country. Notably, each industry under the financial sector has a special regulatory framework consisting of statutes to shape the conduct of participants in the industry and a regulator to foresee compliance and promote fairness and efficiency.

Required: i) Describe THREE (3) functions the Securities and Exchange Commission of Ghana (SEC) is expected to perform towards achieving fairness and efficiency in the securities industry. (6 marks)

ii) Explain TWO (2) implications of the regulatory functions of the SEC for corporate investing and financing activities. (4 marks)

i) Functions of the SEC of Ghana The SEC of Ghana is expected to perform the following functions:

  • to advise the Minister responsible for Finance on all matter relating to the securities industry
  • to maintain surveillance over activities in securities to ensure orderly, fair and equitable dealings in securities;
  • to register, licence, authorise or regulate stock exchanges, investment advisers, unit trust schemes, mutual funds, securities dealers, and their agents and to control and supervise their activities with a view to maintaining proper standards of conduct and acceptable practices in the securities business;
  • to formulate principles for the guidance of the industry;
  • to monitor the solvency of licence holders and take measures to protect the interest of customers where the solvency of any such licence holder is in doubt;
  • to protect the integrity of the securities market against any abuses arising from the practice of insider trading;
  • to adopt measures to minimize and supervise any conflict of interests that may arise for dealers;
  • to review, approve and regulate takeovers, mergers, acquisitions and all forms of business combinations;
  • to examine and approve of the new issue of securities on the stock exchange (i.e., IPO);
  • to create the necessary atmosphere for the orderly growth and development of the capital market;

[3 functions @ 2 marks each = 6 marks]

ii) Implications of the regulatory functions of SEC for corporate financing decisions The regulatory functions of the SEC have the following implications for corporate financing:

  • When making securities offers, companies must ensure that the offer is fair and equitable. For instance, all potential buyers must be treated equally, and communications relating to the offer should be true and fair.
  • The company, its members, and directors cannot trade securities based on insider information.
  • The company cannot engage in any form of business combination without the approval of the SEC.
  • The company will need approval from the SEC when making an IPO.

[Marks allocation: 2 implications @ 2 marks each = 4 marks]

  • 20 Marks

FM – MAY 2018 – L2 – Q1 – Economic and regulatory environment

Discusses the effects of high interest rates on the economy, explores the agency problem, and explains why share price maximization is preferred to sales maximization.

a) Economist has always maintained that to increase inflation, the government ought to implement a policy of high interest rate to dampen demand.

Required:
Identify the effects on the economy of a policy of high interest rate on expenditure and investments.

b) Agency problem is pervasive and exists in practically every organization whether a business, church, club, or government. Organizations try to solve it by instituting measures but no organization can remedy it completely.

Required:
i) What is the agency problem within the context of a limited liability company?

ii) Explain TWO causes of the agency problem.
(2 marks)

iii) Explain FOUR remedies to the agency problem.
(4 marks)

c) For a business, it is not necessary that profit should be the only objective; it may concentrate on various aspects such as maximization of share price, maximization of sales, capturing more market shares, return on capital employed among others, which will take care of profitability.

Required:
Explain why maximization of a company’s share price is preferred as a financial objective to maximization of its sales.
(6 marks)

a) Effects on the economy of a policy of high interest rate:

  1. Reduces borrowing:
    High interest rates make borrowing more expensive for businesses and consumers, leading to a reduction in overall demand for loans.
  2. Decreases investment:
    Businesses are likely to cut back on investment in new projects due to the higher cost of borrowing, which can slow down economic growth.
  3. Encourages savings:
    Higher interest rates incentivize saving as people earn more from their savings, reducing consumer spending.
  4. Reduces disposable income:
    For those with variable-rate loans, higher interest rates mean higher loan payments, reducing the amount of disposable income available for spending.
  5. Discourages inflation:
    By dampening demand, higher interest rates can help control inflationary pressures within the economy.

 

b) i) Agency problem within a limited liability company:

The agency problem refers to a conflict of interest where company management (agents) may act in their own interests rather than in the best interests of the shareholders (principals). This can lead to decisions that do not maximize shareholder value.

ii) Causes of the agency problem:

  1. Divergence of interests:
    Managers may prioritize personal benefits such as job security, higher compensation, or perks over the goal of maximizing shareholder value.
  2. Risk aversion:
    Managers may avoid risky but potentially profitable investments because they fear the consequences of failure, even though shareholders may prefer higher-risk, higher-reward projects.

 

iii) Remedies to the agency problem:

  1. Managerial compensation:
    Aligning managers’ incentives with shareholders’ interests through performance-based compensation, such as bonuses or stock options, can motivate managers to work towards maximizing shareholder value.
  2. Shareholder control:
    Shareholders can exert influence over management decisions through voting rights and active participation in annual general meetings.
  3. Threat of dismissal:
    The possibility of being fired for poor performance can incentivize managers to align their actions with shareholders’ interests.
  4. Threat of takeovers:
    The potential for a takeover, where underperforming managers may be replaced, serves as an external control mechanism ensuring management acts in the best interest of shareholders.

 

c) Why share price maximization is preferred to sales maximization:

  1. Focus on profitability:
    Share price maximization inherently considers profitability, whereas sales maximization may prioritize revenue without considering the costs involved.
  2. Reflects market value:
    Maximizing share price aligns with increasing the overall market value of the firm, benefiting shareholders directly.
  3. Incorporates risk:
    Share price maximization takes into account the risks associated with business decisions, unlike sales maximization, which may overlook potential downsides.
  4. Long-term growth:
    A focus on share price encourages long-term strategic decisions that support sustained growth and stability, rather than short-term sales spikes.

 

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