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Goal congruence refers to the situations where the goals of different groups coincide. In many
companies there are potential conflicts of objectives between the owners of the company, the
shareholders, agents and the managers of the company. Other interest groups such as creditors, the
government, employees and the local community might also have conflicting objectives to the
company's shareholders.
One way by which managers and sometimes employees in general might be motivated to take
decision/engage in actions which are consistent with the goals of the shareholders is through
ESOP?s. ESOP?s will not however assist in encouraging goal congruence between
other interest groups and shareholders and managers.
ESOP?s allow managers to purchase a company's shares at a fixed price during a
specified period of time in the future usually a period of years. They are aimed at encouraging
managers to take decisions which will result in high NPV projects which will lead to an increase in
share price and shareholders wealth. The managers are believed to seek high NPV investments as
they as shareholders will participate in the benefits as share prices increases.
There is however little evidence of a positive correlation between share option schemes and the
creation of extra share value. There is no guarantee that ESOP?s will achieve goal
congruence. Share options will only be part of the total remuneration package and may not be the
major influence on managerial decisions. If share prices fall managers do not have to purchase the
shares and the value of the option to buy shares becomes worthless or very small. Although ESOPs
may assist in the achievement of goal congruence they are by no means a perfect solution.
Kavungya answered the question on April 17, 2021 at 20:48
- A local supermarket chain wishes to increase the number of its retail outlets in the country. The board of directors of the company have decided...(Solved)
A local supermarket chain wishes to increase the number of its retail outlets in the country. The board of directors of the company have decided to finance the acquisition by raising funds from the existing
shareholders through a one for four rights issue. The recently published income statement of the company
for the year ended 31 October 2002 has the following information:
The share capital of the company consists of 12 million ordinary shares with a par value of Sh.5 per share.
The shares of the company are currently being traded on the Stock Exchange with a price/earnings ratio
of 22 times. The board of directors has decided to issue the shares at a discount of 20 per cent on the
current market value.
Required:
a) The theoretical ex-rights price of an ordinary share of the company.
b) The price at which the rights in the company are likely to be traded.
c) Assuming an investor held 4,000 ordinary shares of the company before the rights issue
announcement, evaluate the following options and identify the best option to the investor.
i) Exercise the rights.
ii) Sell the rights
iii) Do nothing.
Date posted: April 17, 2021. Answers (1)
- Matibabu Pharmacia Ltd. recently carried out clinical trials on a new drug which was developed to reduce the effects of diabetes.
The research and development costs...(Solved)
Matibabu Pharmacia Ltd. recently carried out clinical trials on a new drug which was developed to reduce the effects of diabetes.
The research and development costs incurred on the drug amount to Sh.160 million. In order to evaluate the market potential of the drug, an independent research firm conducted a market research at a cost of Sh.15 million. The independent researchers submitted a report indicating that the drug is likely to have a useful life of 4 years (before new advanced drugs are introduced into the market). It is projected that in the year the drug is launched it could be sold to authorized drug stores (chemists and hospitals) at Sh.20 per 500mg capsule. After the first year, the price is expected to increase by 20% per annum.
For each of the four years of the drug's life, the sales have been estimated stochastically as shown below:
Number of
Capsules sold Probability
11 million 0.3
14 million 0.6
16 million 0.1
If the company decides to launch the new drug, it is possible for production to commence immediately. The equipment required to produce the drug is already owned by the company and originally cost Sh.150 million.
At the end of the drug life, the equipment could be sold for Sh.35 million. If the company decides against the launch of the new drug, the equipment will be sold immediately for Sh.85 million as it will be of no further use to the company.
The new drug requires two hours of direct labour for each 500 mg capsule produced. The cost of labour for the new drug is Sh.4 per hour. New workers will have to be recruited to produce the new drug. At the end of the life, the workers are unlikely to be offered further employment with the company and redundancy costs of Sh.10 million are expected. The cost of ingredients for the new drug is Sh.6 per 500mg capsule.
Additional overheads arising from the production of the drug are expected to be Sh.15 million per annum.
Additional work capital of Sh.2 million will be required during the drug's 4-year life.
The drug has attracted interest of the company's main competitors and if the company decides
not to produce the drug, it could sell the patent right to Welo Kam (K) Ltd., its competitor, at Sh.125
million. The cost of capital is estimated to be 12%.
Required:
a) The expected Net Present Value of the new drug.
b) State with reasons whether the company should launch the new drug.
c) Discuss one strength and weakness of the expected Net Present Value approach for making
investment decisions.
Date posted: April 17, 2021. Answers (1)
- Safariloam Limited issued a Sh.100 million par value, 10-year bond, five years ago. The bond was issued at a 2
per cent discount and issuing costs...(Solved)
Safariloam Limited issued a Sh.100 million par value, 10-year bond, five years ago. The bond was issued at a 2
per cent discount and issuing costs amounted to Sh.2 million. Due to the decline in Treasury bill rates in the
recent past, interest rates in the money market have been falling presenting favourable opportunities for
refinancing. A financial analyst engaged by the company to assess the possibility of refinancing the debt
reports that a new Sh.100 million par value, 12 per cent, 5 -year bond can be issued by the company. Issuing
costs for the new bond will be 5 per cent of the par value and a discount of 3 per cent will have to be given
to attract investors. The old bond can be redeemed at 10 per cent premium and in addition, two months
interest penalty will have to be paid on redemption. All bond issue expenses (including the interest penalty)
are amortised on a straight-line basis over the life of the bond and are allowable for corporate tax purposes.
The applicable corporate tax rate is 40 per cent and the after tax cost of debt to the company is
approximately 7%.
Required:
a) Cash investment required for the refinancing decision.
b) Annual cash benefits (savings) of the refinancing decision.
c) i) Net Present Value (NPV) of the refinancing decision.
ii) Is it worthwhile to issue a new bond to replace the existing bond? Explain.
Date posted: April 17, 2021. Answers (1)
- Tom Donji an investment specialist has been entrusted with Sh.10 million by a unit trust and instructed to invest the money optimally over a two-year...(Solved)
Tom Donji an investment specialist has been entrusted with Sh.10 million by a unit trust and instructed to invest the money optimally over a two-year period. Part of the instructions are that:
The funds be invested in one or more of four specified projects and in the money market
The four projects are not divisible and cannot be postponed.
The unit requires a return of 24% over the two years.
Over the two-year period, the risk free rate is estimated to be 16%, the market portfolio return, 27% and
the variance of the return on the market, 100%.
Required:
By analyzing the two-asset portfolios:
i ) Use the mean-variance dominance rule to evaluate how Tom Donji should invest the Sh.10 million.
ii) Determine the betas and required rates of return for the portfolios and then use the Capital Asset
Pricing Model (CAPM) to evaluate how Tom Donji should invest the Sh.10 million.
Date posted: April 17, 2021. Answers (1)
- What are the limitations of the Capital Asset Pricing Model (CAPM) as an investment appraisal technique?(Solved)
What are the limitations of the Capital Asset Pricing Model (CAPM) as an investment appraisal technique?
Date posted: April 17, 2021. Answers (1)
- On 1 March 2001, a Kenyan importer purchased goods from the United States of America worth USD120,000 to be paid for two months later on...(Solved)
On 1 March 2001, a Kenyan importer purchased goods from the United States of America worth USD 120,000 to be paid for two months later on 30 April 2001.
Kenyan shillings futures were available in the money market and could be bought in blocks of Ksh.100,000 and each future contract cost Ksh.1,000.
Spot exchange rate on 1 March 2001 was Ksh.76.50 = USD 1. The two-month forward exchange rate on
30 April 2001 was Ksh.79.50 = USD 1 and the exchange rate at which futures were closed out was
Ksh.77.50 = USD1.
Required:
The net loss(gain) of using the futures contract.
Date posted: April 17, 2021. Answers (1)
- The following data relate to call options on two shares, A and B
Required:
Using the Black-Scholes Option Pricing Model (OPM).
Calculate the price of call option A....(Solved)
The following data relate to call options on two shares, A and B
Required:
Using the Black-Scholes Option Pricing Model (OPM).
Calculate the price of call option A. Of the two call options, which would you expect to have the higher price? Why? (Do not compute).
Date posted: April 17, 2021. Answers (1)
- Given below is the Option Pricing Model (OPM) derived by Black and Scholes in 1973 for predicting the market price of call options.
Required:
State and briefly...(Solved)
Given below is the Option Pricing Model (OPM) derived by Black and Scholes in 1973 for predicting the market price of call options.
Required:
State and briefly explain the relationship between a call option‟s price and the following determinants:
1) the underlying stock‟s price.
2) the exercise price
3) the time to maturity
4) the risk-free rate.
Date posted: April 17, 2021. Answers (1)
- Quality Products (QP), Ltd a leading manufacturer in its field, is planning an expansion programme. It has
estimated that it will need to raise an additional...(Solved)
Quality Products (QP), Ltd a leading manufacturer in its field, is planning an expansion programme. It has
estimated that it will need to raise an additional Sh.100 million. QP Ltd. is discussing with its investment
banker the alternatives of raising the Sh.100 million through debt financing or through issuing additional
shares of equity. The debt to total asset ratio in its industry is 40%. QP Ltd.‟s balance sheet
and income statements are as follows:
The company expects to increase its total revenue by Sh.200 million and net operating income by Sh.26
million if the expansion is undertaken. The company‟s effective tax rate is 40% and dividend
payout has averaged about 60% of net income. At present, its cost of debt is 10% and its cost of equity
is 15%. If the additional funds are raised through debt, the cost of debt will be 10% and cost equity will be
15.2%. If the funds are raised by equity, the cost of debt will be 10% and the cost of equity will be 14.8%.
The current share price at which new equity can be sold is Sh.100.
Required:
Calculate the effects of the alternative forms of financing on:
a) The total value of equity of the firm.
b) The firm‟s total debt to equity ratio (based on balance sheet figures)
c) Price per ordinary share.
d) Total market-value of the firm.
e) The firm‟s weighted average cost of capital.
Date posted: April 17, 2021. Answers (1)
- City Graphics Limited is evaluating a new technology for its reproduction equipment. The technology will have a
three-year life and would cost Sh.800,000. Its impact on...(Solved)
City Graphics Limited is evaluating a new technology for its reproduction equipment. The technology will have a
three-year life and would cost Sh.800,000. Its impact on the company‟s cash flows is subject to risk.
In the first year, management estimates that there is an equal chance that the technology will either
succeed and save the company Sh.800,000 or fail saving it nothing at all.
If the technology fails in the first year, savings in the last two years will be zero. Even worse, there is a 40%
chance that additional Sh.240,000 may be required in the second year to convert back to the original process.
If the technology succeeds in the first year, the second year cash flows may be Sh.1,440,000, Sh.1,120,000 or
Sh.800,000 with probabilities of 0.20, 0.60 or 0.20 respectively. Third year cash flows are then expected to be
Sh.160,000 greater or Sh.160,000 less than cash flows in the second year, with equal chance of either
occurring.
All the cash flows above are after taxes.
Required:
a) A probability tree depicting the above cash flow possibilities.
b) Net present values for each possibility using a risk-free rate of 5%.
c) The expected net present value of the technology using a risk-free rate of 5%
Date posted: April 17, 2021. Answers (1)
- Agency problems can be resolved by proper corporate governance. Corporate governance lays emphasis on
shareholders rights and enhancement of shareholder value. In many countries including Kenya,...(Solved)
Agency problems can be resolved by proper corporate governance. Corporate governance lays emphasis on
shareholders rights and enhancement of shareholder value. In many countries including Kenya, the concept
of corporate governance has gained increasing prominence in recent times as evidenced by the issue of
corporate governance guidelines by the Capital Markets Authority (CMA).
Required:
a) Explain the reasons motivating the increasing interest in corporate governance.
b) Identify the benefits of good corporate governance to shareholders.
e) Write short notes on any five corporate governance guidelines issued by the Capital Markets
Authority (CMA) or similar authority in your country.
Date posted: April 17, 2021. Answers (1)
- The directors of ABC Electronics Ltd. are considering a takeover bid for XYZ Electronics Ltd. However,
they recognize that there are potential problems with any proposed...(Solved)
The directors of ABC Electronics Ltd. are considering a takeover bid for XYZ Electronics Ltd. However,
they recognize that there are potential problems with any proposed bid. First, the directors of ABC Ltd.
believe that any take-over bid would be resisted by the directors of XYZ Ltd.
Secondly, ABC Ltd. is short of cash and so any offer made to the shareholders of XYZ Ltd. would have to
be either in form of a share-for-share exchange or a loan capital-for-share exchange.
Required:
a) Identify and discuss four reasons why a company seeking to maximize the wealth of its shareholders
may wish to take over another company.
b) Evaluate the share-for-share exchange and loan capital-for-share exchange options as methods of
purchase consideration from the viewpoint of the shareholders of both companies.
c) Identify and discuss six defensive tactics the directors of XYZ Ltd. may employ to resist an
unwelcome bid.
Date posted: April 17, 2021. Answers (1)
- Explain with the aid of a diagram a protective put buying strategy.(Solved)
Explain with the aid of a diagram a protective put buying strategy.
Date posted: April 16, 2021. Answers (1)
- Explain and illustrate graphically the options concepts of being:
i) “at the money”
ii) “in the money”
iii) “out of the money”
for both a call and put option.(Solved)
Explain and illustrate graphically the options concepts of being:
i) “at the money”
ii) “in the money”
iii) “out of the money”
for both a call and put option.
Date posted: April 16, 2021. Answers (1)
- Using a numeric example, illustrate and explain the pay-offs of a futures option and a futures
contract.(Solved)
Using a numeric example, illustrate and explain the pay-offs of a futures option and a futures
contract.
Date posted: April 16, 2021. Answers (1)
- The table below gives the end-of-year levels of the price of an ordinary share in Kamili Ltd. and of
a representative Stock Exchange Index.
Required:
Use the information...(Solved)
The table below gives the end-of-year levels of the price of an ordinary share in Kamili Ltd. and of
a representative Stock Exchange Index.
Required:
Use the information to calculate the beta coefficient of Kamili Ltd.s ordinary shares, ignoring any
dividend payments. (Work to four decimal places only at each stage of calculation).
Using the beta calculated in the question above above, and given a risk-free rate of 5% a year and an expected return from equities generally of 8% a year, calculate the expected rate of return on Kamili
Ltd.‟s ordinary shares.
Date posted: April 16, 2021. Answers (1)
- What assumptions must be made in deriving the Capital Asset Pricing Model (CAPM)?(Solved)
What assumptions must be made in deriving the Capital Asset Pricing Model (CAPM)?
Date posted: April 16, 2021. Answers (1)
- A comparative study of the records of two oil companies, A Ltd. and B Ltd., in terms of their asset composition, capital structure and profitability...(Solved)
A comparative study of the records of two oil companies, A Ltd. and B Ltd., in terms of their asset composition, capital structure and profitability shows that they have been very similar for the past five years. The only significant difference between the two firms is their dividend policy. A Ltd. maintains a constant dividend per share while B Ltd. maintains a constant dividend pay-out ratio. Relevant data is as follows:
Required:
a) For each company, determine the dividend pay-out ratio and the price – earnings ratio for each of
the five years.
b) B Ltd‟s management is surprised that the shares of this company have not performed as well
as A Ltd‟s in the stock exchange. What explanation would you offer for this state of affairs?
c) Comment on the applicability of the Simple Price/Earnings (P/E) ratio to the typical technology
(IT) company with a high valuation and heavy losses.
Date posted: April 16, 2021. Answers (1)
- Corporate bonds have recently started gaining prominence as disintermediation financial instruments in developing countries.
i) Distinguish between financial intermediation and financial facilitation.
ii) Explain the relationship between...(Solved)
Corporate bonds have recently started gaining prominence as disintermediation financial instruments in developing countries.
i) Distinguish between financial intermediation and financial facilitation.
ii) Explain the relationship between the price of bonds and:
1. Interest rates in the market generally.
2. Term to maturity of the bonds.
iii) Explain any three theories that can help explain the term “structure of interest rates”
Date posted: April 16, 2021. Answers (1)
- Gathura Ltd. is evaluating the acquisition of a heady duty forklit. The company can either purchase
the equipment through the use of its normal financing mix...(Solved)
Gathura Ltd. is evaluating the acquisition of a heady duty forklit. The company can either purchase
the equipment through the use of its normal financing mix (30% debt and 70% equity) or lease it.
The following additional information is available:
1. Acquisition price Sh.8,000,000
2. Useful life 4 years
3. Salvage value Sh.1,600,000
Depreciation method – straight line
Annual (before tax and depreciation) cash savings Sh.2,400,000
Rate of interest on a four year period 10%
Marginal tax rate 10%
Annual lease rentals Sh.2,400,000
Annual operating expenses Sh. 400,000
Cost of capital 12%
Required:
i) Evaluate whether acquisition of the forklift through purchase is justified.
ii) Should Gathura Ltd. lease the asset?
Date posted: April 16, 2021. Answers (1)