Financial Management revision questions and answers

This revision questions and answers can be used by students pursuing the following Kasneb courses:

Certified public accounts(CPA)

Certified credit professionals(CCP)

Certified secretaries(CS)

Question 1

a)Define the term “Financial Engineering” and explain 3 main components of financial engineering. (8 marks)

Answer

Financial engineering is the design, development and implementation of innovative financial instruments and processes and the formulation of creative solutions to problems in finance.

Financial engineering is concerned with three critical issues:

  • Securities innovations which would add value to the firm and shareholders e.g issue a security which increases the present value of tax shields available to the issues without increasing the investors tax liability.
  •  Innovative financial processes e.g on-line banking, use of central depositing
    system (CDS) in stock market trading to reduce transaction costs etc.
  • Creative strategies to corporate finance problem.
  •  Involves the use of tax-effective cash management strategies and corporate
    restructuring due to internal and external factors e.g leveraged buyout, sale and
    lease back, outsourcing of financial services, project finance etc.

Question 2

1) Explain the factors responsible for financial innovations. (12 marks)

answer

Factors responsible for financial innovations:

  • High level of transaction costs
  • Need to reduce agency costs
  • Existing opportunities to increase liquidity of assets e.g. factoring of debtors
  • Regulatory and legislative changes hence volatility of interest rate and exchange
    rates
  • Use of interest rate swaps
  1.  Volatility of securities prices hence the use of futures and options
  2. Tax asymmetric that can be exploited to produce tax savings for the investors and
  • Issues of securities
  1. Technological advancement and related factors.
  2. Academic work that results in advance in financial theories or better understanding of  the risk – return characteristics of existing securities.

Case study

c)TNT Ltd has a paid up share capital of 1.2 million shares of Sh.20 each. The current market price per share is Sh.36. The company has no loan capital. Maintainable earnings before tax are forecast at Sh.4.8 million. The company‟s effective tax rate is 40%. The company requires to raise a further Sh.15 million in order to achieve additional earnings of Sh.2.2 million per year and proposes doing this by means of a rights issue. Suggested alternative prices for the rights issue are Sh.32 and Sh.25 per share.

Question 3

Calculate, when the price is Sh.32 per share, the theoretical market price per share of the enlarged capital after the issue (the ex-rights price) and also the market value of a right. (8 marks)

Answer

c) Issue price to adopt

  • A low issue price leads to high number of shares being issued which will lead to dilution in future EPS.
  • A high issue price leads to few shares being issued thus less dilution in future EPS.
  • Therefore the preferable issue price is Sh.32 since few shares are issued(468,750  shares) and thus lesser dilution in future EPS. The EPS is one of the critical variables which investors look for before making investment decisions.

d) The factors which might invalidate the calculation are as follows:

  • If the cum-right MPS was to change
  • If flotation costs associated with the issue are considered
  • If all the shares are not subscribed for during the rights issue.

Question 4

a) Explain the main reasons why multi-national companies (MNC) seek foreign investment.

Answer

Reasons why multi national companies seek foreign investment.

  • To seek new markets for their products
  • To seek growth opportunities outside their home markets
  • To take advantage of tax incentives offered in other countries
  • To avoid regulatory and political bottlenecks in their home country
  • To diversify their operations and reduce their overall risk
  • To seek new technology in form of scientific ideas for design of their products
    and services
  • Increase production efficiency by moving to countries with low production
    costs.

Question 5

Explain the types of political risks that face multi-national firms in foreign countries.

Answer

Political risks that face multi-national firms in foreign countries:

  • Non-discriminatory interference’s e.g no transfer price, non-convertibility of the currency of host nation etc.
  • Discriminatory interference e.g special tax rates, government insisting on a joint venture with MNC etc.
  • Discriminatory sanctions e.g. ending the right to remit or repatriate profits
  • Wealth deprivation i.e takeover of a MNC by the government without any  compensation.
  • Anti-trust policies
  • Fiscal & monetary policies e.g invest a portion of liquid cash in government to  bills and treasury bonds etc.

Question 6

Explain the steps than multi-national firms can take to minimize political risks

Answer

  • Investment insurance e.g from multi-national investment guarantee agency (MIGA)
  • Forecast political interference in capital budgeting process
  • Negotiation with the host government before investing
  • Make prior arrangement on issues relating to transfer pricing, profit repatriation etc.
  • Joint venture with the host government
  • Sale of shares in the host country to raise capital
  • Local supply of goods and control of marketing
  • Pre-planned dis-investments and cease operations due to political interference

 

Case study

Daegu Construction Company Ltd made a Sh.100 million bondage 5 years ago when interest rates were substantially high. The interest rates have now fallen and the firm wishes to retire this old debt and replace it with a new and cheaper one. Given here
below are the details about the two bond issues: Old Bonds: The outstanding bonds have a nominal value of Sh.1,000 and 24%
coupon interest rate. They were issued 5 years ago with a 15-year maturity. They were initially sold a their nominal value of Sh.1,000 and the firm incurred Sh.390,000 in floatation costs. They are callable at Sh.1,120. New Bonds: The new bonds would have a Sh.1,000 nominal value and a 20% coupon interest rate. They would have a 10-year maturity and could be sold at their par value.
The issuance cost of the new bonds would be Sh.525,000. Assume the firm does not expect to have any overlapping interest and is in the 35% tax bracket.

Question 7

Calculate the after-tax cash inflows expected from the an-amortized portion of the old bond’s issuance cost.

Answer

 

Question 8

b) Calculate the annual after-tax cash inflows from the issuance of the new bonds  assuming the 10-year amortization. (2 marks)

Answer

Question 9

Calculate the after-tax cash outflow from the call premium required to retire the old bonds.

Question 10

Determine the incremental initial cash outlay required to issue the new bonds.(10mks)

 

Question 11

Calculate the annual cash-flow savings, if any, expected from the bond refunding. (8 marks)

Question 12

If the firm has a 14% after-tax cost of debt, would you recommend the  proposed refunding and reissue? Explain. (4 marks)

Question 14

Discuss the main features of:

(i) Corporate share repurchases (buy-backs); and

(ii) Share (stock) splits;

and why companies might use them. Include in your discussion comment on the possible effects on share price of share repurchases and share (stock) splits in comparison to the payment of dividends.

Answer

 

Share repurchases are a way for companies to distribute earnings to shareholders other than by a cash dividend. They are also a means of altering a target capital structure; supporting the share price during periods of weakness; and deterring unwelcome take-over bids. Companies typically repurchase shares either by making a tender offer for a block of shares, or by buying the shares in the open market. In the absence of taxation and transactions costs share repurchase and the payment of dividends should have the same effect on share value. However, the different treatment of taxation on dividends and capital gains in many countries may lead to a preference for share repurchases by investors. If the repurchase of shares is by means of a tender offer, this will often be at a price in excess of the current market value, and may have a different effect on overall company value.

An important question for share value is what information a share repurchase conveys to the market about the company and its futures prospects.

Managers should take decisions that maximize the intrinsic value of the firm. This, in theory, involves undertaking the optimum amount of positive NPV investments. The use of share repurchases, and the payment of dividends, will therefore be influenced
by the amount of investment that the company undertakes. When a company does not have sufficient investments to fully utilize available cash flow, the payment of dividends or share repurchases are more likely.

Analysts are believed to normally consider an increase in dividends or share repurchases as good news, as they suggest that the company has more cash, and possibly greater potential, than previously believed. However, if this subsequently proves not to be so, share prices will adjust downwards.

Share repurchases in themselves do not create value for the company, but the market may see the information or signals that they provide as significant new information that will affect the share price.

Share splits are the issue of additional shares at no cost to existing shareholders in proportion to their current holdings, but with lower par value. Share splits have no effect on corporate cash flows and, in theory, should not affect the value of the company. The share price, in theory, should reduce proportionately to the number of new shares that are issued.

Motivates for share splits include:

A company wishes to keep its share price within a given trading range, e.g. below £10 per share. It is sometimes argued that investors might be deterred by a high share price, and that lower share prices would ensure a broader spread of share ownership.
Shareholders could actually lose from lower prices, as the bid-offer spread (the difference between buying and selling prices) is often higher as a percentage of share for lower priced shares.

Companies hope that the market will regard a share split as good news, and that the share price will increase (relative to the expected price) as a result of the announcement. Evidence suggests that even if such reaction occurs it is short-lived unless the company improves cash flows, increases dividends etc. in subsequent periods.

 

Question 15

Discuss how government actions can influence the tasks of the financial manager and explain how these actions can affect the attainment of financial objectives.(20 marks)

Answer

How government actions can influence the tasks of the financial manager:

  • Wage controls.
  • Dividend controls.
  • Profit controls, including price controls.
  • Customs duties, tariffs and other trade barriers.
  • Investment incentives, including grants and accelerated  allowances.
  • Schemes for personal savings, including National Savings.
  • Government borrowing requirements from the capital market – this may restrict the funds available to other borrowers.
  • Direct provision of finance to the nationalized sector and other  companies considered of national importance (eg, for the creation or maintenance of employment).
  • Regional policies, enterprise zones.
  • Use of foreign exchange reserves to influence the value of the  pound.
  •  Provision of information through many government departments and statistical services.
  • Health and Safety Acts, environmental controls.
  • Monopolies legislation.
  • Almost all of the above government activities will directly affect companies and their ability to achieve their chosen financial
    objectives. For example, if maximization of shareholder wealth is desired:
  • Taxation affects corporate income, personal disposable income, savings and investment levels, levels of demand, dividend levels and share prices.
  • Credit controls affect the cost and availability of funds, the value of shares, profit and dividend levels.
  • Exchange rate policies can influence the success of export/import-based firms.

Question 16

Justify and criticize the usual assumption made in financial management literature that the objective of a company is to maximize the wealth of its shareholders.(20 marks)

Answer

Financial management is concerned with making decisions about the provisions and use of a firm’s finances. A rational approach to decision-making necessitates a fairly clear idea of what the objectives of the decision maker are or, more importantly, of what are the objectives of those on behalf of whom the decisions are being made.

There is little agreement in the literature as to what objectives of firms are or even what they ought to be. However, most financial management textbooks make the assumption that the objective of a limited company is to maximize the wealth of its
shareholders. This assumption is normally justified in terms of classical economic theory. In a market economy firms that achieve the highest returns for their investors will be the firms that are providing customers with what they require. In turn these companies, because they provide high returns to investors, will also find it easiest to raise new finance. Hence the so called ‘invisible hand’ theory will ensure optimal resource allocation and this should automatically maximize the overall economic welfare of the nation.

This argument can be criticized on several grounds. Firstly it ignores market imperfections. For example it might not be in the public interest to allow monopolies to maximize profits. Secondly it ignores social needs like health, police, defense etc.

From a more practical point of view directors have a legal duty to run the company on behalf of their shareholders. This however begs the question as to what do shareholders actually require from firms.

Another justification from the individual firm’s point of view is to argue that it is in competition with other firms for further capital and it therefore needs to provide returns at least as good as the competition. If it does not it will lose the support of existing shareholders and will find it difficult to raise funds in the future, as well as being vulnerable to potential take-over bids.

Against the traditional and ‘legal’ view that the firm is run in order to maximize the wealth of ordinary shareholders, there is an alternative view that the firm is a coalition of different groups: equity shareholders, preference shareholders and lenders,

employees, customers and suppliers. Each of these groups must be paid a minimum ‘return’ to encourage them to participate in the firm. Any excess wealth created by the firm should be and is the subject of bargaining between these groups.

At first sight this seems an easy way out of the ‘objectives’ problem. The directors of a company could say ‘Let’s just make the profits first, then we’ll argue about who gets them at a later stage’. In other words, maximizing profits leads to the largest pool of
benefits to be distributed among the participants in the bargaining process. However, it does imply that all such participants must value profits in the same way and that they are all willing to take the same risks.

In fact the real risk position and the attitude to risk of ordinary shareholders, loan creditors and employees are likely to be very different. For instance, a shareholder who has a diversified portfolio is likely not to be so worried by the bankruptcy of one of his companies as will an employee of that company, or a supplier whose main customer is that company. The problem of risk is one major reason why there cannot be a single simple objective which is common to all companies.

Separate from the problem of which goal a company ought to pursue are the questions of which goals companies claim to pursue and which goals they actually pursue.

Many objectives are quoted by large companies. Sometimes these are included in their annual accounts. Examples are:

  • To produce an adequate return for shareholders;
  • To grow and survive autonomously;
  • To improve productivity;
  • To give the highest quality service to customers;
  • To maintain a contented workforce;
  • To be technical leaders in their field;
  • To be market leaders;
  • To acknowledge their social responsibilities.

Some of these stated objectives are probably a form of public relations exercise. At any rate, it is possible to classify most of them into four categories which are related to profitability:

Pure profitability goals eg, adequate return for shareholders.

(ii) ‘Surrogate’ goals of profitability eg, improving productivity, happy workforce. Constraints on profitability eg, acknowledging social responsibilities, no  pollution, etc.
‘Dysfunctional’ goals.

The last category are goals which should not be followed because they do not benefit in the long run. Examples here include the pursuit of market leadership at any cost, even profitability. This may arise because management assumes that high sales equal high profits which is not necessarily so.

In practice the goals which a company actually pursues are affected to a large extent by the management. As a last resort, the directors may always be removed by the shareholders or the shareholders could vote for a take-over bid, but in large companies individual shareholders lack voting power and information. These companies can, therefore, be dominated by the management.

There are two levels of argument here. Firstly, if the management do attempt to maximize profits, then they are in a much more powerful position to decide how the profits are ‘carved up’ than are the shareholders.

Secondly, the management may actually be seeking ‘prestige’ goals rather than profit maximization. Such goals might include growth for its own sake, including empire building or maximizing turnover for its sake, or becoming leaders in the technical field
for no reason other than general prestige. Such goals are usually ‘dysfunctional’.

The dominance of management depends on individual shareholders having no real voting power, and in this respect institutions have usually preferred to sell their shares rather than interfere with the management of companies. There is some evidence, however, that they are now taking a more active role in major company decisions.

From all that has been said above, it appears that each company should have its own unique decision model. For example, it is possible to construct models where the objective is to maximize profit subject to first fulfilling the target levels of other goals.However, it is not possible to develop the general theory of financial management very far without making an initial simplifying assumptions about objectives. The objective of maximizing the wealth of equity shareholders seems the least
objectionable.

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