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Liquidity – profitability trade-off a firm may be required to consider:
A firm needs to generate profits on returns to those who have their funds. At the same
time, it needs liquidity in order to meet its day obligations. If the firm maintains a high
level of liquidity, there is an opportunity cost in terms of the returns which are foregone
had the funds invested. On the other hand if liquidity levels are too low, the firm may be
unable to meet its obligations as and when they are due. This may be illustrated as
follows:
marto answered the question on February 11, 2019 at 10:26
- Swaleh Ltd. has been in operation for the last eight years. The company is all equity
financed with 6 million ordinary shares with a par value...(Solved)
Swaleh Ltd. has been in operation for the last eight years. The company is all equity
financed with 6 million ordinary shares with a par value of Sh.5 each. The current
market price per share is Sh.8.40, which is in line with the price/earnings (P/E) ratio in
the industry of 6.00. The company has been consistent in paying a dividend of Sh.1.25
per share during the last five years of its operations, and indications are that the current
level of operating income can be maintained in the foreseeable future. Tax has been at a
rate of 30%.
The management of Swaleh Ltd. is contemplating the implementation of a new project
which requires Sh.10 million. Since no internal sources of funds are available,
management is to decide on two alternative sources of finance, namely:
Alternative A
To raise the Sh.10 million through a rights issue. Management is of the opinion that a
price of Sh.6.25 per share would be fair.
Alternative B
To obtain the Sh.10 million through a loan. Interest is to be paid at a rate of 12% per
annum on the total amount borrowed.
The project is expected to increase annual operating income by Sh.5.6 million in the
foreseeable future.
Irrespective of the alternative selected in financing the new project, corporation tax is
expected to remain at 30%.
Required:
(i) Determine the current level of earnings per share (EPS) and the operating
income of the company.
(ii) If Alternative A is selected, determine the number of shares in the rights issue
and the theoretical ex-rights price.
(iii) Calculate the expected earnings per share (EPS) for each alternative, and advise
Swaleh Ltd. on which alternative to accept.
(iv) 'It is always better for a company to use debt finance since lower cost of debt
results in higher earnings per share'.
Briefly comment on this statement.
Date posted: February 11, 2019. Answers (1)
- Distinguish between financial risk and operating risk.(Solved)
Distinguish between financial risk and operating risk.
Date posted: February 11, 2019. Answers (1)
- Magma Ltd. wishes to make a choice between two mutually exclusive projects. Each of
these projects requires Sh.400,000,000 in initial cash outlay. The details of the...(Solved)
Magma Ltd. wishes to make a choice between two mutually exclusive projects. Each of
these projects requires Sh.400,000,000 in initial cash outlay. The details of the two
projects are as follows:
Project A
This project is made up of two sub-projects. The first sub-project will require an initial
outlay of Sh.100,000,000 and will generate Sh.25,600,000 per annum in perpetuity. The
second sub-project will require an initial outlay of Sh.300,000,000 and will generate
Sh.85,200,000 per annum for the 8 years of its useful life. This sub-project does not
have a residual value at the end of the 8 years. Both sub-projects are to commence
immediately.
Project B
This project will generate Sh.87,000,000 per annum in
perpetuity. The company has a cost of capital of 16%.
Required:
(i) Determine the net present value (NPV) of each project.
(ii) Compute the internal rate of return (IRR) for each project.
(iii) Advise Magma Ltd. on which project to invest in, and justify your choice
Date posted: February 11, 2019. Answers (1)
- Joseph Kimeu is trying to determine the value of Bidii Ltd.'s ordinary shares. The
earnings growth rate over his planned six-year holding period is estimated to...(Solved)
Joseph Kimeu is trying to determine the value of Bidii Ltd.'s ordinary shares. The
earnings growth rate over his planned six-year holding period is estimated to be 10%,
and the dividend payout ratio is 60%. The ending price earnings (P/E) ratio is expected
to be 20 and the current earnings per share are Sh.4. The required rate of return for this
share is 15%.
Required:
Compute the market price of Bidii Ltd's ordinary share
Date posted: February 11, 2019. Answers (1)
- (a) Briefly explain how the 'Dow Theory' views the movement of the market prices of
shares traded on a stock exchange.
(b) Identify and briefly explain the...(Solved)
(a) Briefly explain how the 'Dow Theory' views the movement of the market prices of
shares traded on a stock exchange.
(b) Identify and briefly explain the factors that must be taken into account in the design and
construction of a market index for shares.
Date posted: February 11, 2019. Answers (1)
- (a) Outline the factors which contributed to the popularity of commercial papers over bank
overdrafts among large corporations in the 1990s.
(b) Clearly distinguish between 'factoring'...(Solved)
(a) Outline the factors which contributed to the popularity of commercial papers over bank
overdrafts among large corporations in the 1990s.
(b) Clearly distinguish between 'factoring' and 'invoice discounting' in the context of the
management of debtors.
(c) 'Not all new issues of shares are underwritten, but it is clearly better to arrange that they
should be if there is any chance than the issue may be unsuccessful'. Briefly comment
on this statement.
Date posted: February 11, 2019. Answers (1)
- (a) Briefly explain the difference between a broker and a dealer in the stock market.
(b) What are the advantages of having a dealer in a...(Solved)
(a) Briefly explain the difference between a broker and a dealer in the stock market.
(b) What are the advantages of having a dealer in a stock market? (6 marks)
(c) (i)What are the advantages of a central depository system (CDS) for a stock
market?
(ii) What problems are likely to be experienced in the initial introduction of a
central depository system (CDS) in a stock market? (4 marks)
Date posted: February 11, 2019. Answers (1)
- (a) Ujuzi Limited wishes to raise finance to cater for the purchase of new fixed assets, as its
sales level has greatly increased in the recent...(Solved)
(a) Ujuzi Limited wishes to raise finance to cater for the purchase of new fixed assets, as its
sales level has greatly increased in the recent years, and the demand for its products is
expected to increase for the foreseeable future. The company has 900,000 outstanding
shares which are currently trading in the stock exchange at Sh.130 a share. The finance
manager estimates that the fixed assets will cost Sh.22,500,000 and he has convinced the
board of directors to raise the money through a rights issue. The board has set the
subscription price at Sh.75 per share.
Required:
(i) The number of rights required to purchase a new share.
(ii) The price of one share after the rights issue.
(iii) The theoretical value of the rights if the shares are sold ex-right.
(iv) The effect on a shareholder's wealth if he decides neither to exercise nor sell
the right.
(b) PKG Ltd. maintains a minimum cash balance of Sh.500,000. The deviation of the
company's daily cash changes is Sh.200,000. The annual interest rate is
14%. The transaction cost of buying or selling securities is Sh.150 per transaction.
Required:
Using the Miller-Orr cash management model, determine the following:
(i) Upper cash limit
(ii) Average cash balance
(iii) The return point.
(c) Explain briefly the meaning of the term 'over trading'.
Date posted: February 11, 2019. Answers (1)
- The following information represents the financial position and financial results of
AMETEX Limited for the year ended 31 December 2002.
(Solved)
The following information represents the financial position and financial results of
AMETEX Limited for the year ended 31 December 2002.
Required:
Determine the following financial ratios:
(i) Acid test ratio.
(ii) Operating ratio
(iii) Return on total capital employed
(iv) Price earnings ratio.
(v) Interest coverage ratio
(vi) Total assets turnover
(c) Determine the working capital cycle for the company.
Date posted: February 11, 2019. Answers (1)
- Outline four limitations of the use of ratios as a basis of financial analysis.(Solved)
Outline four limitations of the use of ratios as a basis of financial analysis.
Date posted: February 11, 2019. Answers (1)
- 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...(Solved)
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 with a salvage value of Sh.500,000. 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 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 Sh.300,000. The estimated profit before depreciation and tax over the next ten years for the two machines is as given below.
The company's cost of capital is 10%. Corporation tax applicable is 30%.
The company uses the straight line method of depreciation.
Required:
(i) Initial investment required replacement of the old machine.
(ii) An evaluation of whether it is worthwhile for to undertake the replacement of the machine.
Date posted: February 11, 2019. Answers (1)
- Briefly explain the importance of capital budgeting in a business organization.(Solved)
Briefly explain the importance of capital budgeting in a business organization.
Date posted: February 11, 2019. Answers (1)
- The total of the net working capital and fixed assets of Faida Ltd as at 30 April 2003
was Sh.100,000,000. The company wishes to raise additional...(Solved)
The total of the net working capital and fixed assets of Faida Ltd as at 30 April 2003 was Sh.100,000,000. The company wishes to raise additional funds to finance a project within the next one year in the following manner.
The current market value of the company's ordinary shares is Sh.30. The expected dividend on ordinary shares by 30 April 2004 is forecast at Sh.1.20 per share. The average growth rate in both earnings and dividends has been 10% over the last 10
years and this growth rate is expected to be maintained in the foreseeable future. The debentures of the company have a face value of Sh.150. However, they currently sell for Sh.100. The debentures will mature in 100 years.
The preference shares were issued four years ago and still sell at their face value.
Assume a tax rate of 30%
Required:
(i) The expected rate of return on ordinary shares.
(ii) The effective cost to the company of:
- Debt capital
- Preference share capital
(iii) The company's existing weighted average cost of capital.
(iv) The company's marginal cost of capital if it raised the additional Sh.50,000,000 as intended.
Date posted: February 11, 2019. Answers (1)
- In recent years, there has been a trend towards “cross-border” listing of securities of
quoted companies. This has reduced the over-reliance by companies on domestic capital...(Solved)
In recent years, there has been a trend towards 'cross-border' listing of securities of
quoted companies. This has reduced the over-reliance by companies on domestic capital markets.
Required:
(a) Explain the meaning of 'cross-border' listing.
(b) Identify and explain six reasons why companies in your country may seek 'cross border' listing.
(c) Identify five barriers to “cross-border” listing.
Date posted: February 11, 2019. Answers (1)
- Safaricom and Shelter Afrique are examples of companies that have in the recent past issued
floating rate bonds.
Required:
(a) Briefly explain the meaning of a 'floating rate'...(Solved)
Safaricom and Shelter Afrique are examples of companies that have in the recent past issued
floating rate bonds.
Required:
(a) Briefly explain the meaning of a 'floating rate' bond.
(b) From the point of view of a company's financial manager, outline the merits
and demerits, to the company, of issuing floating rate debt as a means of raising capital.
Date posted: February 11, 2019. Answers (1)
- Madawa Chemicals Ltd. is in the process of forecasting its financial needs for the coming year
ending 31 October 2003. The company attained a turnover of...(Solved)
Madawa Chemicals Ltd. is in the process of forecasting its financial needs for the coming year ending 31 October 2003. The company attained a turnover of Sh.300 million for the current year ended 31 October 2002.
Required:
(a) The amount of external finance that will be needed during the year ending 31 October 2003 if sales are expected to increase by 15% in the year.
(b) The maximum expected sales growth that can be achieved in the year ending 31 October 2003 if only internally generated funds are used.
(c) The maximum growth in sales that can be achieved in the year ending 31 October 2003 if the company wishes to maintain its current level of financial gearing.
(d) Briefly comment upon the weaknesses of the method of forecasting used above.
Date posted: February 11, 2019. Answers (1)
- (a) Explain the term 'agency costs' and give any three examples of such costs.
(b) On 1 November 2002, Malaba Limited was in the process...(Solved)
(a) Explain the term 'agency costs' and give any three examples of such costs.
(b) On 1 November 2002, Malaba Limited was in the process of raising funds to undertake
four investment projects. These projects required a total of Sh.20 million.
Given below are details in respect of the projects:
Required:
(i) The levels of total new financing at which breaks occur in the Weighted
Marginal Cost of Capital (WMCC) curve.
(ii) The weighted marginal cost of capital for each of the 3 ranges of levels of total
financing as determined in (i) above.
(iii) Advise Malaba Limited on the projects to undertake assuming that the projects
are not divisible.
Date posted: February 11, 2019. Answers (1)
- Mwamba Limited is considering replacing a production machinery at its Mtwapa plant.
The existing machinery at the plant was bought 3 years ago at a cost...(Solved)
Mwamba Limited is considering replacing a production machinery at its Mtwapa plant.
The existing machinery at the plant was bought 3 years ago at a cost of Sh.50 million. It
is expected to have a useful life of 5 more years with no scrap value at the end of this
period. The machinery could be disposed of immediately with net proceeds of Sh.35
million after tax.
The new machinery will cost Sh.80 million, with a useful life of 5 years and expected
terminal value of Sh.5 million. With the introduction of the new machinery, sales are
expected to increase by Sh.25 million per annum over the next 5 years. Variable costs
are 60 per cent of sales and the corporate tax rate is at 30 per cent per annum.
The operation of the new machinery will also require an immediate investment of Sh.8
million in working capital which will be recovered at the end of its useful life.
Installation costs of the new machinery will amount to Sh.6 million.
Assume that capital allowances are to be provided for on a straight-line basis and
Mwamba Limited's cost of capital is 12 per cent per annum.
Required:
(i) The initial cash outflow for the replacement decision.
(ii) The annual incremental after tax operating cash flows.
(iii) The NPV of the replacement decision and advise Mwamba Limited on whether
to replace the machinery.
(iv) The minimum after tax annual operating cash flows that will make the
replacement feasible
Date posted: February 11, 2019. Answers (1)
- In evaluating investment decisions, cash flows are considered to be more relevant than
profitability associated with the project.
Explain why this is the case.(Solved)
In evaluating investment decisions, cash flows are considered to be more relevant than
profitability associated with the project.
Explain why this is the case.
Date posted: February 11, 2019. Answers (1)
- The following information relates to the current trading operations of Maji Mazuri Enterprises (MME) Ltd:
(Solved)
The following information relates to the current trading operations of Maji Mazuri Enterprises (MME) Ltd:
The management of the company is in the process of reviewing the
company's credit management system with the objectives of reducing the operating
cycle and improving the firm's liquidity. Two alternative strategies, now being
considered by management are detailed as follows:
Alternative A: change of credit terms:
The proposal requires the introduction of a 2% cash discount which is expected to have
the following effects:
-50 per cent of the credit customers (and all cash customers) will take advantage
of the 2 per cent cash discount.
- There will be no change in the level of annual sales, the percentage of credit
- sales and the contribution of sales ratio.
- There will be savings in collection expenses of Sh.2,750,000 per month.
- Bad debts will remain at 2 per cent of total credit sales.
- The average collection period will be reduced to 32 days.
Alternative B: contracting the services of a factor:
The factor would charge a fee of 2% of total credit sales and advance MME Ltd. 90%
of total credit sales invoiced by the end of each month at an interest rate of 1.5% per
month.
The effects of this alternative are expected to be as follows:
- No change is expected in the level of annual sales, proportion of credit sales
and contributions -
-margin ratio.
- Savings on debt administration expenses of Sh.1,400,000 per month will result
-All bad debt losses will be eliminated
-The average collection period will drop to 20 days.
Required:
i) Evaluate the annual financial benefits and costs of each alternative (Assume 360 –day year)
ii) Advise MME Ltd. management on the alternative to implement.
iii) Explain briefly other factors that should be considered in reaching the decision in (ii) above.
Date posted: February 11, 2019. Answers (1)