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Financial Management Question Paper

Financial Management

Course:Bachelor Of Commerce

Institution: Strathmore University question papers

Exam Year:2009

STRATHMORE UNIVERSITY
FACULTY OF COMMERCE
Bachelor of Commerce
END OF SEMESTER EXAMINATION
BCM 2206: FINANCIAL MANAGEMENT (EVENING COURSE)
DATE: 19th August 2009 TIME: 2 Hours
INSTRUCTIONS: ANSWER QUESTIONS ONE AND ANY TWO QUESTIONS

Question one
a) The following are the costs and values for the firms A and B according to the traditional
approach:
A (Ksh 000) B (Ksh 000)
Total value of firm, V 50,000 60,000
Market value of debt, D 0 30,000
Market value of equity, S 50,000 30,000
Expected net operating income, X 5,000 5,000
Cost of debt, INT = kd D 0 1,800
Net income, X - kdD 5,000 3,200
Cost of equity, ke = (X- kdD)/S 10.00% 10.70%
Debt-equity ratio, D/S 0 .5
Average cost of capital. ko 10.00% 8.33%
Compute the equilibrium value for Firm A and B in accordance with the M-M thesis. Assume
that taxes do not exist and the equilibrium value of ko is 9.09 per cent. (10 marks)
b) Describe the concept Efficient Market Hypothesis and explain it various forms
(8 marks)
(c) Alima Ltd., a manufacturer of edible oils, is contemplating the purchase of a new
oil processing machine to replace the existing one. The existing machine was acquired
two years ago at a cost of Sh.4, 000,000. The useful life of this machine was originally
expected to be five years with no salvage value, but after a critical analysis, the
financial analyst has now estimated that the machine will have an economic life of ten years.
The new machine is estimated to cost Sh.8,000 000 and Sh.400,000 would be incurred
in installing the machine .The new machine is estimated to have a useful life of ten years .An
expert in asset valuation estimates that the existing machine can be sold at Sh.2,500,000 in
the open market. The new machine will have a value of 3,000,000 at end of its useful
life.
2
The new machine is expected to lead to increased sales. To support the increased sales,
debtors would increase by Sh.320, 000, stock by Sh.140, 000 and creditors by Sh300, 000.
The estimated profit before depreciation and tax over the next ten years for the two machines is
as given below:
Year New machine Old machine
sh sh
1 5,500,000 2,800,000
2 4,000,000 3,000,000
3 4,200,000 3,200,000
4 4,100,000 3,400,000
5 4,100,000 3,400,000
6 3,800,000 3,200,000
7 3,800,000 3,100,000
8 3,500,000 2,800,000
9 3,000,000 2,600,000
10 2,800,000 2,400,000
The company's cost of capital is 10% Corporation tax applicable is 30%. The company uses
the straight line method of depreciation.
Required: An evaluation of whether it is worthwhile for Alima Ltd to undertake the
replacement of the machine. (12 marks) (Total 30 marks)

Question two.
a) A firm has current sales of Ksh 7,200,000. The firm has unutilized capacity; therefore,
with a view to boost its sales, it is considering lengthening its credit period from 30 days
to 45 days. The average collection period will also increase from 30 to 45 days. Bad-debt
losses are estimated to remain constant at 3 per cent of sales. The firm’s sales are
expected to increase by Ksh 360,000. The variable production, administrative and selling
costs are 70 per cent of sales. The firm’s corporate tax rate is 50 per cent, and it requires
an after-tax return of 10 per cent on its investment.
Required: Should the firm change its credit period? (8 marks)
b) A company plans to increase its sales by 50%. The past annual sales of were
ksh1,200,000 and an inventory conversion period ( stock turnover period) of one and a
half months, a debtors conversion period ( debt collection period) of two months, a credit
deferral period ( credit payment period) of one month and input costs ( cost of sales) are
50% of sales value. To generate the extra sales, the inventory conversion period will rise
to two months and debtors conversion period to two and a half months. The after tax net
profit margin is 10%. The required rate of return is 20 %.
3
Required . Determine whether the plan to increase sales is worthwhile ( 8 marks)
c) Discuss the weaknesses of Baumol’s cash management model. (4 marks)
(Total 20 marks)

Question three
Country Wallpapers Limited is considering in investing in one of two mutually exclusive
projects I and J. The firm’s cost of capital is 14% and the risk free rate of return is 8%. The firm’s financial manager has gathered the following information relating to each project.

1 Sh.20,000 0.09 20,000 0.95
2 16,000 0.80 25,000 0.09
3 12,000 0.60 15,000 0.85
4 10,000 0.50 20,000 0.08
5 10,000 0.40 10,000 0.80
Required:
i) Find the NPV (unadjusted for risk) for each project. Which project is preferred? ( 8 marks)
ii) The firm uses the following equation to determine the risk adjusted discount rate for each
project:
Rx = Rf +(K-Rf)RIx
Where Rx is the RADR for project x
K is the firm’s cost of capital
RIx is the risk index for project x.
Using the RADR, method, determine the risk adjusted NPV for each project. Which project is
preferred? (8 marks)
iii) Find the certainty equivalent NPV for each project. Which project is preferred? (4 marks)
(Total 20 marks)
4
Question four
Gardiver Ltd had the following capital structure at the end of its 2000/2001 financial year.
KShs ‘000
8% long term debt 6000
Ordinary share capital (KShs. 20 par) 5000
Retained Profits 8000
During the year, the company reported KShs. 4.00 in earnings per share and had a price-earnings
ratio of 33. Gardiver is now considering raising KShs. 6.6 million in additional capital to finance
a proposed plant expansion. The project is expected to provide a return of 18 percent per annum before tax. The two proposals being considered to raise the capital are floatation of additional 8% debt at par value or floatation of additional shares at the current market price. Assume an income tax rate of 50 percent.
Required:
a) Prepare a statement to show how the company’s capital structure would be immediately after
issue under each of the two financing alternatives. ( 8 marks)
b) Which alternative would you recommend? Why? (Show all your workings)( 12 marks)
(Total 20 marks)

Question Five
a) What factor would influence the dividend decision of a company ( 12 marks)
b) In your opinion, would dividend payout rate affect share price of a company? Discuss.
(8 marks) (Total 20 marks)

Financial Management Question Paper

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