Financial Management – Paper 8 Solutions

Solution 1

To: Board of Directors of FUL

From: Financial Consultant
Date: Exam date
Subject: Cost of capital and Investment appraisal
I submit this report in compliance with my engagement terms as the financial
consultant of the company. The report consists of; estimation of the company’s
weighted average cost of capital, evaluation of the financial viability of Project A,
and the relevance of financial strategy, costs of capital and environmental
scanning. The details of the report are set out below.
(a) Estimation of weighted average cost of capital (WACC):
Cost of equity (Ke) = Div1 + g
P0
Market price per share (P0) = 5,000 x 1.2 = Shs 6,000
Cost of equity (Ke) = 900 + 5% = 20%
6,000
Cost of Preference share capital (Kp) = Div
P0
Dividends = 12% x 10,000 = Shs 1,200 per share
Share price = 10,000 x 90% = Shs 9,000 per share
Kp = 1,200 = 13.3%
9,000
Cost of redeemable debentures = IRR = a + [(P / P + N) (b – a)]
Coupon = 15% x 1,000 x 0.7 = Shs 105
Current price = 1,000 x 1.05 = Shs 1,050
Redemption value = 1,000 x 1.2 = Shs 1,200

Computation of NPVs
Years Cash flow DCFs at 15% PVs DCFs at 10% PVs
0 (1,050) 1.000 (1,050) 1.000 (1,050)
1-5 105 3.352 352 3.791 398.1
5 1,200 0.497 596 0.621 745.2
NPVs (102) 93.3

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 IRR = 10% + [(93.3 / 93.3 + 102) (15% - 10%)] = 12.4%
Cost of term loan = Kd = interest (1 – tax rate)
= 18% x (1 – 30%) = 12.6%
Determining market values of capital (Shs.000)
Source of capital Computations Market value % Prop
Ordinary share capital = 2,000,000 shares x 6,000 12,000,000 41.3%
Preference share capital = 550,000 shares x 9,000 4,950,000 17.0%
Debentures = 4,750,000 stocks x 1,050 4,987,500 17.2%
Term loan 7,124,500 24.5%
29,062,000 100%
Determining WACC;
Source of capital Specific cost of capital % Prop Av. cost
Ordinary share capital 20% 41.3% 8.3%
Preference share capital 13.3% 17.0% 2.3%
Debentures 12.4% 17.2% 2.1%
Term loan 12.6% 24.5% 3.1%
WACC 15.7%
FUL’s WACC = 15.7% approx. 16%

(b) Evaluation of the financial viability of Project A using (NPV)

technique;
NPV computation (Shs. millions)
Years 0 1 2 3 4
Contribution 2,750 3,025 3,327.5 3,660.3
Tax at 30% (825) (907.5) (998.3) (1,098.1)
PAT 1,925 2,117.5 2,329.2 2,562.2
Initial outlay (6,500)
Opportunity cost (150)
Working capital (w1) (450) (22.5) (23.6) (24.8) 521
Tax savings (w2) 487.5 365.6 274.2 297.6
Scrap proceeds 1,750
Net cash flows (7,100) 2,390 2,460 2,579 5,131
DCFs at 16% 1.000 0.862 0.743 0.641 0.552
PVs (7,100) 2,060 1,827 1,653 2,832
NPV 1,273

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Evaluation;
The proposed investment in project A is financially variable since it results into a
positive NPV of Shs 1,273 million implying that if undertaken, it will add value to
the wealth of the shareholders.
W1 - Working capital (WC) (Shs.000)
Years Computation Cumulative WC Incremental WC
0 450,000 450,000
1 = 450,000 x 1.05 472,500 22,500
2 = 472,500 x 1.05 496,125 23,625
3 = 496,125 x 1.05 520,931 24,806
4 Recovery 520,931

W2 - Tax saved on capital allowances (Shs.000)

Year
s WDV Capital allowance Tax saved at 30%
1 6,500,000 = 6,500,000 x 25% = 1,625,000 487,500
2 4,875,000 = 4,875,000 x 25% = 1,218,750 365,625
3 3,656,250 = 3,656,250 x 25% = 914,062.5 274,219
4 2,742,188 = 2,742,188 x 25% = 685,547 205,664
4 Tax saved on balancing allowance (w3) 91,992.3

W3 - Balancing allowance / charge (Shs.000)

Scrap proceeds 1,750,000
WDV - End of year 4 2,056,641
Balancing allowance 306,641
Tax saved 91,992.3
(c) Relevance of;
(i) Financial strategy to an organisation like FUL.
 Helps in understanding the sources of funds;
 Helps in making decisions whether the proposed investment should
be undertaken or not;
 Helps in dividend decisions;
 Helps in working capital management;
 Helps in hedging decisions;

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 (ii) Cost of capital;
 Designing the capital structure - Cost of capital is the significant factor in
designing a balanced and optimal capital structure of a firm. Through
comparing the various specific costs of capital, the financial manager can select
the best and the most economical source of finance and design an optimal
capital structure.
 Helps in capital budgeting decisions – Acceptance or rejection of any
investment proposal depends upon the cost of capital. A proposal shall not be
accepted till its rate of return is greater than the cost of capital.
 Evaluation of financial performance – Cost of capital can be used to evaluate
the financial performance of the capital projects by comparing actual
profitability of the project undertaken with the actual cost of capital of funds
raise to finance the project.
 Financing and dividend decisions – Cost of capital can be conveniently
employed as a tool in making other important financial decisions. On the basis,
decisions can be taken regarding dividend policy capitalisation of profits and
selection of sources of working capital.
(iii) Environmental scanning in investment appraisal.
o Analysis of internal business environment helps to identify strength of
the firm. After identifying the strength, the firm can consolidate or
maximise its strength by further improvement in its existing plans,
policies and resources.
o Environmental scanning helps to identify the weakness of the firm
that should be corrected to achieve the objectives of investments
undertaken.
o Identification of opportunities – Environmental scanning helps to
identify the opportunities in the market.
o Identification of threats – Business is subject to threat from
competitors and various factors. Environmental scanning helps
business identify threats from the external environment and devise
strategies to manage such threats.
o Optimum use of resources – Proper environmental assessment helps
an organisation to make optimum utilisation of scare human, natural
and capital resources by employing them in an effective manner.
o Proper analysis of the environmental factors helps an organisation to
develop plans and policies that could help in easy accomplishment of
organisational objectives.

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Solution 2
(a) (i) Evaluation of credit periods;

Monthly cash flows (Shs.000)

Credit periods 2 months' 3 months'
Sales revenue 577,500 603,750
Less: Variable costs (65%) (375,375) (392,438)
Profit margin 202,125 211,313
Less: Fixed costs (125,000) (125,000)
Less: Bad debts (w1) (4,950) (8,625)
Monthly profit 72,175 77,688
Net profit margin 12.5% 12.87%
W1 - Bad debt (Shs 000)
Credit periods 2 months' 3 months'
Sales revenue 137,500 143,750
Credit sales (60%) 82,500 86,250
Bad debts 4,950 8,625
Evaluation;
The proposed credit policies result in net profit margins of 12.5% and 12.87% for
the 2 months’ and 3 months’ credit periods that marginally exceeds the minimum
return of 12% required by MUL, hence the revisions are viable.
Of the 2 proposals, the 3 months credit period is more viable since it gives a higher
net profit margin of 12.87%. Hence MUL, is advised to implement a 3 months’
credit policy.
Using factoring of receivables to manage working capital;
 In factoring, an organization sells its receivables or invoices at a discount to a
third party called factor in exchange for immediate cash with which to finance
continued business.
 The factor provides immediate cash rather than organization having to wait for
the settlement date and takes charge of the collection of the receivables.
 Therefore, all payments from the debtors are subsequently made to the factor
company and the organization now concentrates on the other businesses.

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Forms of debtor factoring;
 Recourse factoring – This is an arrangement where factoring companies
provide only early payment of invoices in return for factor fees to the business.
In other words, in recourse factoring, the credit risk remains with original
business and the factor is paid a fee for advancing to the money.
 Non-recourse factoring – This is an arrangement where the business sells
its invoices to the factor and receives cash payment immediately. The factor
takes all the responsibility for analyzing the credit worthiness, collection of
payment on due dates and credit loss arising on account of non-payment by
the customer.
(b) MUL’s projected cash operating cycle;

Operating cycle = Material days + work in progress days + Finished goods

days + Receivables days – Payables days
Raw materials days = x 365
Consumption of raw materials = Opening stock + purchases – closing stock
= 630 million + 2,835 million – 315 million
= 3,150 million
Average stock of raw materials = Opening stock + Closing stock
2
= 630 million + 315 million = 472.5 million
2
Raw material days = 472.5 million x 365 days = 55 days
3,150 million
Work in progress days = Average WIP x 365 days
Production cost
Production cost = Opening WIP + materials consumed – closing WIP
= 563,182,000 + 3,150,000,000 - 378,000,000
= 3,335,182,000
Average WIP = Opening stock + Closing stock
2
= 563,182,000 + 378,000,000 = 470,591,000
2
Work in progress days = 470,591,000 x 365 days = 52 days
3,335,182,000
Finished goods days = Average finished goods x 365 days
Cost of goods sold

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Average finished goods = Opening finished goods + Closing finished goods
2
= 1,260 million + 504 million = 882 million
2
Finished goods days = 882 million x 365 days = 97 days
3,335,182,000
Receivables days = Average receivables x 365 days
Credit sales
= 845 million x 365 days = 61 days
80% x 6,300 million
Payables days = Average payables x 365 days
Credit purchases
= 457 million x 365 days = 59 days
2,835 million
Therefore;
Operating cycle = 55 + 52 + 97 + 61 – 59 = 206days
Solution 3
(a) Differences between Conventional and Islamic banking:
The differences between conventional and Islamic banking can best be
understood by analysing the how banking products, contracts or accounts are
treated under each of the banking modes as below.
1. Current and savings accounts:
 Under conventional banking, the bank can invest the depositors’ money without
any prohibition save for limits provided for in the Financial Institutions Act,
2004.
while
 Islamic banking, the bank can use depositors’ funds on current accounts for
investment and other purposes but in line with requirement of Shariah law.
 Relatedly, for savings accounts, any funds deposited are pooled and any
deposit, or transfer of funds is deemed a purchase of investment share in the
respective investment pool.

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2. Leasing/ Ijarah contracts:
Under conventional banking;
 a lease commences on the day on which the price is paid by the bank whether
the customer has taken the delivery or not.
 leases do not differentiate between wear and tear losses due to negligence of
the customer or caused by natural disaster. Therefore, customers are liable to
losses caused by natural disasters.
 penalties are charged on customers for late payment and taken by the bank as
income.
while
Under Islamic banking;
 lease rental payments start after the delivery of the asset and not from the day
the price was paid by the bank.
 the customer does not pay for wear and tear losses caused by natural disasters.
Therefore, the customer is only liable for misuse or negligence.
 if the customer fails to pay lease rentals on due date, the customer undertakes
to pay charity and the money is credited on charity account.
3. Lending /financing
Under conventional banking;
 Conventional banks are in the business of lending and borrowing money based
on interest.
 All types of industries and business are financed except businesses deemed
illegal by the laws of Uganda.
 Conventional banks do not involve them in trade and business. They simply act
as money lenders and play an intermediate role between the buyer and the
seller.
 Banks treat money as a commodity and lend it against interest as its
compensation.
While
Under Islamic banking;
 Islamic banks are not money lending institutions but work as trading and
investment houses.
 Islamic banks work under socio-religious guidelines that prohibit charging of
interest and avoid all impermissible transactions like gambling, and speculation
businesses.
 Islamic banks do not permit financing industries or products that cause harm
to the society like alcohol and tobacco.

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 Islamic banks recognise loans as non-commercial and exclude them from their
domain of commercial transactions. Any loan given out by an Islamic bank must
interest free.
(b) Advantages of Islamic banking:
 Justice and Fairness – Islamic banking is based on a profit-sharing principle,
whereby the risk is shared by the bank and the customer. This system of
financial intermediation contributes to a more equitable distribution of income
and wealth.
 Banking for All – Although based on Shari'ah principles, Islamic banking is
not restricted to muslims only and is available to non-Muslims as well.
 Transparency – Islamic banking is about conducting business in a fair and
transparent manner. Guiding you through to ensure full understanding of risks
and costs associated with the products and services is the utmost prerogative.
 Ethical and moral dimensions – Islamic banking is associated with strong
ethical and moral dimensions of doing business and selecting business activities
to be financed which plays an important role in promoting socially desirable
investments and better individual or corporate behavior.
 Discouraging speculation – Speculative transactions are sources of
instability and by nature is misallocation of capital. Islamic banking prohibits
financing of such activities and emphasizes deployment of capital to the real
economy, to promote socio economic justice.
 Islamic banking rules encourage all parties in the transaction to take a longer-
term view and focus on creating a successful outcome for the venture, which
should contribute to a more stable financial environment.
 The emphasis of Islamic banking is on mutual interest and co-operation, with
a partnership based on profit creation through ethical and fair activity benefiting
the community as a whole.
(c) Principles of Islamic banking:
Shared Risk;
In economic transactions, risk sharing is promoted by Islamic banking. When
two or more parties share the risk, which is based on the principles of Islamic
banking, the burden of the risk is divided and reduced among the parties
which improves the economic activity of the state.
Prohibition of Riba;
This can be regarded as the prohibition of charging interest. According to the
principles of Islamic banking, taking advantage of the issues that others are
facing is unjust.

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 Gharar;
This is a principle that prohibits participation in ambiguous and uncertain
transactions. The principle requires both parties to the transaction to have
proper control over the business and share complete information about the
business so that the profit and loss will be equally shared.
Gambling;
This principle prohibits the acquisition of wealth through evil means or
participation in gambling. Therefore, the principle advocates for Takaful that
involves mutual responsibility and shared risks.
No Investment in Prohibited Industries;
Industries that are harmful to society or have a threat to social responsibilities
are prohibited in Islam. They include pornography, prostitution, alcohol, pork
and drugs. The principle prohibits investment in such industries, or even
participating in the mutual funds that will help such industries to flourish.
Solution 4
(a) Valuation of ZCL using;
(i) Replacement cost;
(Shs.000)
Non-current assets:
Property, plant and equipment 4,800,000
Current assets:
Inventory 420,000
Receivables (2,200,000 x 95%) 2,090,000
Bank 954,500
Total assets 8,264,500
Less: Liabilities:
Payables (1,250,000)
Bank overdraft (1,820,000)
Net assets 5,194,500

Number of shares = Share capital / par value

No. of shares = 1,500 million / 10,000 = 150,000 shares

Value per share = Net assets / No. of shares

Value per share = 5,194.5 million / 150,000 = Shs 34,630

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(ii) Realisable value;
(Shs 000)
Non-current assets:
Property, plant and equipment 4,650,000
Current assets:
Inventory 415,000
Receivables (2,200,000 x 95%) 2,090,000
Bank 954,500
Total assets 8,109,500
Less: Liabilities:
Payables (1,250,000)
Bank overdraft (1,820,000)
Net assets 5,039,500
Value per share = Net assets / No. of shares
Value per share = 5,039.5 million / 150,000 = Shs 33,597
(iii) Gordon dividend growth model;
( )
Value =
From; Div0 x (1+g)n = Div1
Dividend per share for 2019 = Total dividends / No. of shares
= 561,600,000 / 150,000 shares = Shs 3,744

Dividend per share for 2022 = 636,480,000 / 150,000 shares = Shs 4,243.2

Therefore; 3,744 x (1 + g)4 = 4,243.2

g = 3.17%
Therefore; value per share = 3,744 x (1 + 3.17%)
(18% - 3.17%)
= Shs 26,046.4
(iv) P/E ratio.
From;
P/E ratio = Market price per share
Earnings per share
Earnings per share = Profit after tax = 1,060.8 million
No. of shares 150,000 shares
= Shs 7,072

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 Value per share = 4 times x 7,072 = Shs 28,288
(b) Reasons for valuing businesses
 For listing purposes – If a company is seeking for listing on a stock
exchange market, the shares of the company should be valued to
determine the issue price during the initial public offering.
 If there is a takeover bid – If a company bids to take over another
company the target company must be valued to determine the worth in
order to arrive at the offer price.
 Shares can be valued if they are to be used as collateral in the bank to
acquire a loan.
 Shares of the company can be valued during winding up of the company
either voluntary or through forceful winding up.
 To understand your current business – If shareholders want to know
where their company stands in the marketplace, to know how far the
company has come since its inception and to understand how the
company compares with its peers.
Solution 5
(a) Evaluation of the financial performance and position of PRL for the
year ended 31 December 2022.
Financial performance;
PRL’s financial performance has improved during the period under review with
the entity registering improvement in its Return on Capital Employed (ROCE)
from 30.96% in 2021 to 36.4% in the year 2022. Similarly, PRL’s Return on
Equity (ROE) has also improved from 24.75% registered in 2021 to 29.15%
in 2022. See Appendix for detailed analysis.
Financial position;
PRL’s liquidity position has improved as measured by the current and quick
assets ratios over the year. The company’s current ratio has improved from
2.74 : 1 in 2021 to 3.34 : 1 in 2022. Similarly, PRL’s quick ratio has improved
from 1.35 : 1 in 2021 to 1.65 : 1 in 2022, an indicator of a strong liquidity
position.

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 The company’s gearing levels as measured by debt to total capital ratio have
worsened from 60.78% in 2021 to 72.85% in 2022, resulting in increase
financial risk of the company and associated costs such as bankruptcy.
However, PRL’s interest cover has increased from 4.86 times in 2021 to 6
times in 2022 indicating improved company’s ability of its operating profits to
pay off interest expenses.
PRL’s efficiency levels have worsened with increased receivables collection
inventory holding periods. The company’s receivables collection period has
increased from 25 days in 2021 to 29 days in 2022 while its inventory holding
period has increased from 90 days in 2021 to 112 days in 2022. The
lengthening collection period ties up cash and may result into increased bad
debts while the lengthening inventory holding period may result into stock
obsolescence and other holding costs.
From the investment point of view, the company’s earnings per share (EPS)
has improved from Shs.8,765.1 in 2021 to Shs.13,370 in 2022, which should
give investors more confidence about the profitability of the company.

Appendix:

Current ratio = Current assets / Current liabilities : 1

For 2022: Current ratio = 34,965 million / 10,480 million = 3.34 : 1
For 2021: Current ratio = 25,383.6 million / 9,270.5 million = 2.74 : 1
Quick assets ratio = (Current assets - Inventory) / Current liabilities : 1
For 2022: Quick ratio = 17,325 million / 10,480 million = 1.65 : 1
For 2021: Quick ratio = 12,483.6 million / 9,270.5 million = 1.35 : 1
Receivables collection period (RCP) = Receivables / Credit sales x 365 days
For 2022: RCP = 7,700 million / 95,500 million x 365 days = 29.4 days
For 2021: RCP = 5,640 million / 81,175 million x 365 days = 25.4 days
Payables payment period (PPP) = Payables / Credit purchases x 365 days
For 2022: PPP = 4,750 million / 57,300 million x 365 days = 30.3 days
For 2021: PPP = 4,400 million / 52,400 million x 365 days = 30.6 days
Inventory holding period (IHP) = Inventory / Cost of sales x 365 days
For 2022: IHP = 17,640 million / 57,300 million x 365 days = 112.4 days
For 2021: IHP = 12,900 million / 52,400 million x 365 days = 89.8 days

Return on capital employed (ROCE) = PBIT / Net assets x 100

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 For 2022: ROCE = 22,920 million / 62,947 million x 100 = 36.4%
For 2021: ROCE = 15,787 million / 50,990.5 million x 100 = 30.96%
Return on equity (ROE) = PAT / Total equity x 100
For 2022: ROE = 13,370 million / 45,860 million x 100 = 29.15%
For 2021: ROE = 7,669.5 million / 30,990 million x 100 = 24.75%
Debt to total capital ratio (DCR) = Debt / (Debt + Equity) x 100
For 2022: DCR = 45,860 million / 62,947 million x 100 = 72.85%
For 2021: DCR = 30,990 million / 50,990.5 million x 100 = 60.78%
Earnings per share (EPS) = PAT / No. of shares
No. of shares = Share capital / Par value
For 2022: No. of shares = 10,000 million / 10,000 = 1,000,000 shares
For 2021: No. of shares = 8,750 million / 10,000 = 875,000 shares
For 2022: EPS = 13,370 million / 1,000,000 shares = Shs.13,370
For 2021: EPS = 7,669.5 million / 875,000 shares = Shs.8,765.1
Interest cover (IC) = PBIT / Interest expense
For 2022: IC = 22,920 million / 3,820 million = 6 times
For 2021: IC = 15,787 million / 3,247 million = 4.86 times
(b) Requirements for listing on Main Investment market Segment
(MIMS) of Uganda Securities Exchange.
 The Issuer should be a company limited by shares and incorporated or
registered under the Companies Act, 2012 as a public limited liability
company, or if it is a foreign company, it should be registered under the
relevant provisions of the Companies Act;
 The Issuer should have a minimum authorized, issued and fully paid up
share capital of 50,000 currency points and net assets of 100,000 currency
points before the public offering of shares.
 The Issuer should have published audited financial statements for a period
of at least 5 years complying with International Accounting Standards for an
accounting period ending on a date not more than six (6) months prior to
the proposed date of the offer.
 At the date of application, the Issuer should not be in breach of any of its
loan covenants.
 As at the date of the application and for a period of at least 2 years prior to
the date of the application, no director of the issuer may be or may have
been adjudged bankrupt.

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 The Issuer should have declared positive profits after tax attributable to
shareholders in at least three of the last five completed accounting periods
immediately prior to the date of the offer.
 Immediately following the public shares offering, at least 20% of the shares
should be held by not less than 500 public shareholders excluding the
employees and Directors of the Issuer.
 If an Issuer wishing to be listed is subject by law to the regulations of any
regulatory authority, the Issuer should obtain a letter of no objection from
the relevant regulatory authority.

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