THE COPPERBELT UNIVERSITY

DIRECTORATE OF DISTANCE EDUCATION AND OPEN LEARNING

(DDEOL)

DECEMBER 2015 – SESSIONAL EXAMINATIONS

DBA 320 – FINANCIAL MANAGEMENT

INSTRUCTION:

a) TIME ALLOWED THREE HOURS

b) MARKS ALLOCATED INDICATE THE LENGTH AND DEPTH OF EXPECTED
ANSWER
Section A: answer both questions
Question one 30 marks

The information from DBA plc.

K’000

10% bank loan 150

20% redeemable debt -2020 200

15% irredeemable loan 100

12% preference shares K1.50 each 300

Ordinary shares K1.00 each 500

The redeemable loan stock will be redeemed in five years’ time at par which is currently
trading at K120 per K100 nominal and K115 for irredeemable debt per K100 nominal.
Ordinary shares are trading at K2.5 while preference at K2.0 respectively. Risk premium
is 8% while return on government bonds is 7%. Corporate tax is 30% and beta 0.9

Required, compute:

a. Market value for all capital elements 10 marks

b. Cost of bank loan 2 marks
c. Cost of Redeemable debt 5 marks
d. Cost of Irredeemable debt 2 marks
e. Cost of Preference share capital 2 marks
f. Cost of Ordinary share capital 2 marks
g. Weighted average cost of capital 6 marks
Question Two 30 marks
Two mutually exclusive capital projects are presented below for MOSKA ltd:

BEE CEE
K'000 K'000
Project's Cost 100 100
ye
ar
Cash inflows 1 40 80
2 50 50
3 30 10
4 20 5
5 20 3

BEE will require a working capital of K10, 000 at the start of the project. The weighted
average cost of capital for MOSKA Ltd is 10% and it’s applicable to both investments.
Depreciation and capital allowances are available on both assets at 25% for BEE
reducing balance method, CEE straight line method with no residue value on both
machines. Tax is paid at 35% on both project’s profits for BEE in the year profits are
made while for CEE one year in arrears. The company does not undertake projects with
pay back above 3 years

Required: for each project:

a. Compute the payback period 8 marks
b. Return on capital employed 8 marks
c. Net present value 10 marks
d. Advise MOSKA’s management on the best project to undertake based on the
appraisal you have made 4 marks
Section B: answer only two questions

Question Three
From the list below, write brief notes on any four:
a. Systematic risks 4 marks
b. Capital asset pricing model 4 marks
c. Financial risks 4 marks
d. Overtrading 4 marks
e. Convertible loans 4 marks

Question Four
Financial management basically has two (2) objectives; the financial and non-financial
objectives, however in practice, Shareholders favor management that maximizes their
wealth hence in all management’s decisions financial objectives should be realized.
a) List and explain three financial management decision you know 9 marks
b) How does a commercial organization realize its financial objective using these
decisions in (i) above 5 marks
c) Explain the following components of foreign exchange risks:
i. Economic risk 2 marks
ii. Translation risk 2 marks
iii. Transaction risk 2 marks

Question five

a. In relation to capital structure theory, differentiate the two theories by drawing and
labelling them appropriately, include brief notes.
i. traditional view 4 marks
ii. MM theory(both including and excluding taxes) 6 marks
b. ‘Dividend policy for a corporation is not necessary’ do you agree with this statement
or not? 6 marks
c. List four factors to consider when setting the dividend policy of the company
4 marks
SUGESTED SOLUTION DBA 3 & MARKING KEY

Question one

Market values
K'000
10% bank loan 150
20% loan (200/100*120) 240
15% irredeemable
loan(100/100*115) 115
12% preference (300/1.5*2) 400
ordinary shares (500/1*2.5) 1,250
total 2,155

(2 marks*5)

10% bank loan

Kd=i(1-T)
kd= 10%(1-0.30)
kd=7%
2 marks

20% redeemable debt 5marks

After tax repayment 14 (20(1-30%)

cash DF DF
Year flows (5%) PV (20%) PV
0 -120 1 -120 1 -120
1-5 14 4.33 60.62 3.79 53.06
5 100 0.784 78.4 0.621 62.1
npv 19.02 npv -4.84

using IRR, cost of debt is:

kd = 9%

15% irredeemable debt

After tax interest is 10.5 (15*70%)
kd =i/po*100
kd=10.5/115*100
kd= 9.1

2 marks
 12% preference share capital
dividend=12%*300/(300/1.50)
=0.18/share
ke=i/po*100
ke=0.18/2.0*100
ke = 9%
2 marks
K1 ordinary share capital
using the CAPM,
ke =7%+0.9(15-7)
ke = 14.2
2 marks

WACC %
10% bank loan(150/2155*7) 0.5
20% loan (240/2155*9) 1.0
15%irredemable loan(115/2155*9.1) 0.5
12% preference (400/2155*9) 1.7
ordinary shares(1250/2155*14.2) 8.2
WACC 11.9
6 marks

a.

PAY BACK PERIOD

year BEE CEE
cumulative cash cumulative cash
cash flow flow cash flow flow
0 -100 -100 -100 -100
1 40 -60 80 -20
2 50 -10 50 30
3 30 20 10 40
4 20 40 5 45
5 20 60 3 48

PBP=2+(10/30) PBP=1+(20/50
PBP = 2.3 years PBP = 1.4 years

4 marks for each project

 b.
RETURN ON CAPITAL EMPLOYED
yea
r BEE CEE
cash flow depreciation profit/loss cash flow depreciation profit/loss
1 40 25 15 80 20 60
2 50 19 31 50 20 30
3 30 14 16 10 20 -10
4 20 11 10 5 20 -15
5 20 31 -11 3 20 -17
total 61 48
average profit/loss 12 9.6
ROCE =profit/capital*100
ROCE 24% 19%

4 marks for each project

c.

NET PRESENT VALUE BEE

year 0 1 2 3 4 5
cash flows cost -100
capital -10 10
inflows 40 50 30 20 20
tax -14 -18 -11 -7 -7
net 26 32 19 13 23
tax savings W1 9 7 5 4 11
-110 35 39 24 17 34
DF (10%) 1 0.909 0.826 0.751 0.683 0.621
PV -110 32 32 18 11 21

NPV 4
5 marks

NET PRESENT VALUE CEE

year 0 1 2 3 4 5 6
cash flows cost -100
inflows 80 50 10 5 3
tax -28 -18 -4 -2 -1
tax savings W1 0 0 7 7 7 7
net 80 22 -1 8 8 6
DF (10%) 1 0.909 0.826 0.751 0.683 0.621 0.564
PV -100 72.72 18.172 -0.751 5.464 4.968 3.384
 NPV 4 5 marks

d. From the analysis done, project BEE is more viable has it gives a higher ROCE, its pay back is with
company’s benchmark and its NPV is positive. CEE’s cash flows after pay back are too little hence
though it has better pay back than BEE, its inferior. Therefore, management should undertake
project BEE.

Question three

f. Systematic risks
This is a risk that is specific to the industry in which one shareholder has invested. Also
known as market risks, these risks are never diversifiable regardless of how well one
has diversified his portfolio of assets. In the capital asset pricing model, this risk is
represented by the beta factor.
4 marks for valid points
g. Capital asset pricing model
This is another method of computing the cost of ordinary share capital. It’s a superior
method compared to dividend growth model because it factors in risk (systematic risk),
risk free and market return.
4 marks for valid points

h. Financial risks
This is the risk that companies face as a result of capital structure that it has. The
capital of a company is debt and equity hence financial risk is risk that arises due to the
composition of these capital instruments. Debt finance is cheaper because its tax
deductible hence companies maximize it but it exposes the entity to risks. Usually when
gearing is too much, the company is exposed to bankruptcy and other operational
challenges
4 marks for valid points

i. Overtrading
This is when the business makes too much sales with little cash. This a dangerous
situation because the business will not be able to sustain itself both in the current and
long run. Over trading is evident when the business drastically increase sales, usually
on credit with poor credit terms, sharp increase in inventory levels, reduced levels of
readily available liquidly resources.
4 marks for valid points
 j. Convertible loans
These are loans that have an option of being converted into other forms of securities, in
particular equity financial instruments. For example a loan issued today that gives the
creditor an option to convert into pre-determined number of shares at a later date, say in
two years’ time. These debt instruments are designed this way in order to give the
creditor chance of becoming an equity holder, hence they are more marketable than
other forms of dent instruments provided there will be a premium on conversion or else
it will be uneconomical to convert them.

4 marks for valid points

Question four

a. The following are three key decisions financial managers have to make in the running of their
corporations:
 Investment decision –this decision involves the selection of most profitable capital
projects for the business to undertake which maximize the wealth of the shareholders.
Capital budgeting is a crucial exercise for the success of the company because a lot of
capital is spent hence if it fails to succeed them the entire business may be closed,
however if it succeeds, then the business will succeed. Also because capital expenditure
projects take a relatively long time and inherently risk, management needs a lot of time
and expertise before huge sums of funds are committed. An investment appraisal
process, using appraisal techniques, is undertaken to arrive at the most viable options.
 Financing decision –when the best investment is identified, the next decision to make by
management is on how to finance the undertaking. Debt or equity is available to the
company, however cheaper and efficient and reliable source of capital will be employed.
The risks associated with financing decision are analyzed and finally the financing option
that minimizes both the cost of capital and risks is undertaken.
 Dividend decision –this is a decision in which management decides on how to
remunerate the providers of risk finance ordinary shareholders. Its management that
has a complete say on the dividend payout ratio bearing in mind all appropriate factors.
Management has to decide on how to reward providers of equity finance bearing in
mind that if no dividend is paid, or little is paid, there will be a signaling effect, if all
profits are paid, there will be no funds for refinancing etc. hence a balance is found

3 marks* 3

b. Commercial organizations exist to make maximum profits so as to maximize the wealth of

shareholders. Therefore, in the three decisions above, profit maximizations must be evident.
Under investment decision, the most viable option is undertaken. Under financing decision,
cheap but reliable finance is employed. The dividend policy that maximizes the wealth of
shareholders is one that will leave enough of distributable profits to be reinvested in any
available viable projects.

5 marks for valid points

c. Foreign exchange risk is risk international traders are exposed to as a result of transacting in
currencies that are foreign apart from local currencies. For example, a Zambian traders involved
in import and export trading is exposed to currency risk due to fluctuations of the currencies
(depreciation of the kwacha against foreign convertibles, as the case is currently). Currency risk
is made up of the following:
 Translation risk –this is the risk that one is exposed to who has to translate the
foreign financial results into local currency. Example a Zambian company that has a
foreign branch in South Africa at the end of the financial year, foreign results in
South African rand has to be translated into Zambian kwacha. Hence the loss
suffered on the translation is called translation risk.
  Transaction risk –this is the risk as a result of transacting at different dates in
different exchange rates for the same deal. Example you buy on credit today to pay
in 30 days’ time; if the exchange rate will increase from the spot rate on transaction
date then the trader is exposed to transaction risk.
 Economic risk –this risk is generally affecting the economy or the area in which the
business is. Weak economies, like Zambia, will cause companies to lose market
value, expect higher return on investments. Negative changes in the tax regime,
inflation rates, interest rates , employment levels etc. has an adverse impact on the
overall net present value of the company’s investments.

2 marks* 3

Solution five

a.

The traditional view

Students to draw the charts for the traditional view that argues that a company can obtain an optimal
capital mixture hence a lowest weighted average cost of capital by increasing cheaper finance which is
debt up too maximum level above which it will start increasing due to ordinary shareholders becoming
too suspicious and expensive due to too much debt finance in the capital structure. Hence the lowest
point when cost of capital is plotted against gearing levels, is the optimal capital structure

4 marks for a well-drawn, labeled graph with appropriate notes

MM theory

Students to draw the MM theory with and without taxes. Without taxes the graph will show constant
cost of capital while with taxes cost of capital will reduce up to debt being 100% due to interest on debt
being tax deductible. However in practice too much gearing or leverage risks the business to liquidation
and there would remain no profits relieve tax saving on debt (tax exhaustion) etc.

6 marks for well dawn, labeled graphs with appropriate notes (am limited to show drawn charts here)

b. There are two competing theories on capital structure, hence there are arguments for or against
the statement:

Irrelevance theory: argument for

 All distributable profits must be reinvested in any available viable projects
 High taxation dividends leaves little after tax income to shareholders for spending
 Most shareholders favor capital gains to reduced after tax dividends

Relevancy theory: arguments against

  Shareholders need cash dividends to spend hence would rather invest in a company with
stable dividend payout ratio
 Dividend policy has a signaling effect, hence management just have to declare dividends to
maintain market share, keep with trends and attract good investor clientele –the
clientele effect.
 Like in Zambia, dividends are taxed at 15% final tax, hence 85% goes to the investor; this is
a good percentage for spending to shareholders who oppose the dividend relevancy
theory.

2 marks for each correct point maximum 6 marks

c. The following factors are considered when setting the dividend policy:
 Profitability –dividends are paid out of distributable profits, therefore, a company can
only pay is its profit levels are good over the period.
 Profitable investments available –if a company has projects that are viable it would
rather use internally generated funds to finance such projects hence dividends
payments will be reduced
 Competitors –companies in the same industry will have similar pay out because
investors favor one that pays better than others. Hence one company may attract or
lose investors.
 Taxation –if the tax rate on dividends is too high, its prudent on management to
reinvest the profits or give them benefits in kind that are tax efficient.

1 mark for each correct point maximum 4 marks