SFM MADE SIMPLE

COMPILED PAST QUESTIONS

(NON-CALCULATION ASPECTS)

SFM PASSING TIPS:

1. Read at least twice a day
2. Solve past questions as many as
possible,particularly the one I,Sanni Olawale
reviewed with some experts (DARAMOLA
TEXTS)
3. Above all, be prayerful. God Bless You All.

1. QUESTION 3 – May 2014

“Ascertaining exactly who owns a company’s shares and what, if any, are their particular preferences and
objectives” is a basic piece of information needed by management, if it is to ensure that, as far as possible, it is
acting in the shareholder’s interest.

Required:
a. Explain why a publicly quoted company might seek to know the detailed composition of its shareholders
and their objectives in investing in the company. (5 Marks)

b. Explain any FIVE the major advantages which may accrue to the corporate finance manager from
obtaining this information. (10 Marks)
(Total 15 Marks)

Solution

(a) A publicly quoted company seeks to know the detailed composition of its shareholders and their objectives in
investing in the company for the following reasons:
(i) To enable it take various decisions in accordance with the preferences of such shareholders.
(ii) To prevent the occurrence of conflict of interest as related to principal and agents.

(b) Advantages that may accrue to the corporate finance manager include the following:
(i) Dividend Policy - The knowledge of shareholders’ preferences with regards to dividends or capital
appreciation and marginal tax rates will assist in the determination of the company’s optimal dividend policy.

(ii) Risky Investment - Shareholders’ preferences may assist corporate management when making decisions
concerning risky capital investments. Depending on their attitude to risk and their specific circumstances, they
may dislike, or prefer the company to undertake risky investments with the possibility of a higher return.

(iii) Financing Decisions – With respect to the level of debt to employ, the risk attitude of shareholders can again
be useful; generally speaking, a risky approach is to employ more and more debt, since in the event of default,
the shareholders are paid last. However, a high level of risk is matched by a high potential return to equity
holders.

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 (iv) Rebuffing a take-over: A company whose shares are held by a few may find an unwanted take-over bid less
easy to rebuff as the bidder needs to convince only a few shareholders for the bid to be successful. However, if
shares are held by a few key shareholders, it may be easier to provide these shareholders with the type of return
they require with a possible reduction in their likely acceptance of any take-over.

(v) Measurement of performance: Ascertaining how shareholders judge performance may enable management
to optimize this measure or measures, when making decisions, although this measure may not be in the prime
interest of the company in terms of value maximization.

(vi) Religious Belief: Knowing the religious belief of the shareholders will assist in deciding the type of business
to be involved in. For example, some religion forbids investment in alcoholic business. Such information will
enable corporate finance managers to tailor their performance to satisfy the expectations of the shareholders.

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 2. QUESTION 4 – May 2014

A number of investigations have been undertaken into the use by shareholders of the Annual Reports and
Financial Statements of Companies in which they have invested. Several of these show that the Annual Reports
and Financial Statements are regarded as important sources of information for making decisions on equity
investment. Other types of studies indicate that the market price of the shares in a company does not react in the
short term to the publication of the Company’s Annual Reports and Financial Statements.

Required:
a. Explain briefly the concept of the Efficient Market Hypothesis (EMH) and each of its forms and the degree to
which existing empirical evidence supports them. (5 Marks)

b. State and explain the implication of each of the Efficient Market Hypotheses for investment policy as it
applies to

(i) Technical analysis in form of charting.

(ii) Fundamental analysis. (5 Marks)

c. Explain any TWO major roles or responsibilities of portfolio managers in an efficient market environment.
(5 Marks)
(Total 15 Marks)

Solution

a. Capital markets are said to be efficient when prices of securities in such markets fully reflect all information
about the company, the industry to which it belongs and the economy as a whole. This means that any new
information about a company coming into the market is immediately reflected in the price of the share of the
company such that no investor can make above average return on an investment. In a supposedly efficient
market, the price of a security is expected to fluctuate randomly around its true or intrinsic value. Efficient simply
means security is price efficient. The price is right and represents the best estimate of the security’s true value
based on the available information.

Forms of efficiency:
The Weak Form: This form of efficiency implies that information about past share price movement is already
reflected in the current market price. Therefore, the ability to forecast future prices cannot be enhanced based on
the use of past information alone.

The Semi-Strong Form: This form states that the current market price of a security, fully and immediately reflects
all publicly available information including information from financial statements, Chairman’s report and news
items. Here, insider information is excluded.

The Strong Form: This form of efficiency implies that all pieces of information both public and private (including
insider information) are fully and immediately reflected in the current market price of the security. Insider
information is said to be information that is known to management but unknown to the public.

b(i) Technical analysis in form of charting: This states that future patterns of share prices are a repetition of the
same pattern of price movements which has occurred in the past, i.e. historical price patterns are repeated in the
future. The proponents of this theory believe that share prices/values can be measured in the following ways:

Primary trends show the upward or downward movement of share prices over a year or more.
- Secondary trends show the fluctuations over a period of one a month
- Tertiary trends show fluctuations over a period of days.

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 ii. Fundamental Analysis
The theory states that, at any point in time, a share has an intrinsic value which is the discounted present value of
the expected future cash receipts from the share.

The expectation of future receipts may relate to:

- Past results of the company.
- Ratio analysis of the latest published accounts.
- Future plans or expectations of the company, possibly as a result of published statements i.e. the company reports.
- Influences affecting the economy or industry as a whole.

As investors’ expectations about future earnings change, the intrinsic value of the shares, and therefore their
market price, moves up or down.

c. Roles or responsibilities of portfolio managers in an efficient market environment include:

i. Portfolio managers should be prepared to always release information about their activities to the market
as any such information, particularly the positive one, will immediately be incorporated into the share
price and result in an upward price movement for the benefit of the shareholders.

ii. Portfolio managers should not waste their time waiting for a recovery of the price of the security in a
depressed market before they come with new issues.

iii. If the market is efficient and security prices emerge in a random fashion, there is no reason to believe that
just because they were high in the past, they will move back to the old levels.

iv. Portfolio managers should not waste their time looking for a security that would provide returns in excess
of the normal or expected returns simply by analysing past information on the direction of share price or
by analysing new economic information about the security or the company.

v. It is only when an investor has access to information which has not come to the knowledge of the
investing public at large that an above average return can be made.

2. QUESTION 5 – May 2014

a. “The major objective of financial management is to maximise the value of the firm.”
Analyse how the achievement of the above objective might be compromised by the conflicts which may arise
between the management and the other stakeholders in an organisation. (9 Marks)

b. “Strategic planning is said to be a creative process such that fresh insight received today could very well alter
the decision made yesterday”.
Outline the steps involved in the process of strategic planning in corporate organizations.
(6 Marks)
(Total 15 Marks)

Solution

a. Achievement of the objective of maximisation of the value of a firm might be compromised by conflicts which
may arise between the managers and the other stakeholders in an organisation. Such conflicts include:

(i) Managers might not work industriously to maximise shareholders’ wealth if they feel that they will not have a
fair share in the benefits of their labour.

(ii) There might be little incentive for managers to undertake significant creative activities, including looking for
profitable new ventures or developing new technology.

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 (iii) Managers might be giving themselves high salaries and perks.

(iv) Managers might be providing themselves with larger empires, through merger and organic growth, thus
increasing their opportunity for promotion and social status.

(v) Reducing risk through diversification which may not necessarily benefit shareholders but may well improve the
managers’ security and status.

(vi) Managers might take a more short-term view of the firm’s performance than the shareholders would wish.

(vii) Management acting on behalf of shareholders, might also reduce the wealth and or increase the risk of creditors
e.g by selling off assets of the company.

b. The following are the steps involved in the process of strategic planning in corporate organizations:
i. Establishing company’s objectives and targets to be achieved within a time horizon
ii. Examining the environment for possible opportunities
iii. Appraising the strengths, weaknesses, opportunities and threats (SWOT)
iv. Formulating strategies, with alternatives
v. Implementing strategies and action plans
vi. Performance Evaluation

4. QUESTION 6 – May 2014

The objective of dividend policy should be to maximise the shareholders’ return so that the value of their
investment is maximised.

a. State and explain any SEVEN factors which determine the dividend policy of a large public company whose
shares are quoted on the Stock Exchange. (7 Marks)

Solution

The factors that determine the dividend policy of a large public company whose shares are quoted on the stock
exchange include:

Factors that Determine the Dividend Policy of a Large Public Company

(i) Legal Constraints: The management of a company must recognise the existence of laws guiding payment of
dividends. For example, a company should not pay dividend out of capital and may only pay dividends according
to Companies and Allied Matters Act (CAMA), 2004, as amended) out of:
- Profits arising from the use of company’s property;
- Revenue reserves, and
- Realised profit on a fixed asset sold
CAMA also specifies that dividends can only be declared on the recommendations of the directors, and any
amount so recommended cannot be increased by the general meeting; although it can be reduced.

(ii) Future Financial Requirement: Once the legal constraints have been cleared, management should focus on
its future financial needs including future investment opportunities. This should be done via budgeted sources and
application of funds statements, budgeted cash flow statements and cash budget.
(
iii) Liquidity: Dividends are usually paid out of cash. Therefore, the amount of dividend paid by the company is
largely influenced by the available cash resources. Cash has alternative uses within the firm; management may,
therefore, want to recognise these important alternatives (and also be protected against the future) and may,
therefore, decide not to have a high target dividend-payment.

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 (iv) Capacity for borrowing: A firm may not be liquid, but may be in a strong position to borrow at short notice.
This ability can be by arranging a line of credit. The ability of a firm to borrow often largely influences its ability to
meet its short-term obligations as and when due, including payment of cash dividends.

(v) Access to the Capital Market: If the company is large enough and has good access to the corporate bond
market, it needs not bother much about its liquidity situation for the purpose of paying cash dividends.

(vi) Existence of Restrictive Covenants: Restrictions on payment of cash dividends may be entrenched in a
loan agreement.

(vii) Dilution of Control: Payment of cash dividends, supported by subsequent rising of external finance may
dilute the controlling interest of the existing shareholders, if they do not partake in the provision of such finance.

(viii) Dividend policy decision of other similar firms

(ix) Stock market reaction
(x) Taxation
(xi) Attitude of company’s board of directors
(xii) Repayment of debt
(xiii) Liquidity preference of the dominant shareholder

(b) A stable dividend policy is expected to lead to a higher market valuation of a company’s share because this
policy usually attracts a premium due to preference for current regular income by certain investors. It gives rise to
positive signalling effects and also facilitates conformity with directives issued by regulatory authorities to certain
institutions like the Pension Fund Administrators.

5. QUESTION 4 – November 2014

A Pharmaceutical company wholly owned by the family of Chief Adedutan Jolomi has been in business for many
years. The directors have decided to seek quotation on the Alternative Securities Market (ASEM).
A new drug on Ebola Virus Disease (EVD) was developed by the company. The production of the new drug will
require more funding since short-term finance will not be sufficient. They believed it was time to introduce the drug
into the market.
The directors of the company believed that launching the product would significantly increase the company’s
share of the market because the country was anxiously looking forward to an effective EVD drug. Production and
launch of this product is costly and the company’s shareholders may not be able to raise such fund. This informed
the directors’ decision to seek additional finance to be sourced partly in corporate bond and partly by issue of
shares. They plan to issue the corporate bond in the first quarter of 2015 and the shares through Initial Public
Offer (IPO) towards the end of year 2015. To be able to decide on the appropriate method for the offer, the
directors of the company are interested in being educated on the issue.

Required:
a. Compare and contrast the methods of issuing bonds through private placement and by public offer. State their
advantages and advise on which method would be more appropriate in the above situation. (12 Marks)
b. Advise the directors on the steps that need to be taken to improve the chances and success of its proposed
Initial Public Offer (IPO). (4 Marks)
c. Explain the THREE forms of Efficient Market Hypothesis (EMH) indicating which of them is most likely to apply
in practice. (4 Marks)
(Total 20 Marks)

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 Solution

(a)(i) Differences between Private Placement and Public Issue

Features of Private Placement

Bond units are not offered to the public
Issuing houses, arrange for the bonds to be placed at an agreed price
Bonds are placed by the issuing house with institutional clients
Private placement is faster and cheaper to arrange than an offer for sale
To some extent, private placing is less risky, since the issuing house will be fairly certain that. Its client will
subscribe to the issue before agreeing to a placement.

Features of Public Issue

Issuing house acquires the bonds and offer them to the public at a fixed price
The offer is announced to the public via abridged prospectus in national newspapers
The main issuing house may involve underwriters if it is unsure of the success of the offer.

Other features of offer for sale/public issue include:

Oversubscribed offers are scaled down on a pre-determined basis.
Investors on public issues usually buy to resell later – this is not common with bonds.

Comparison/similarities of the two methods - Private Placement and Public Issue

They are both means of sourcing for funds
Cost will be incurred in respect of both
Both will create new shareholding in the company concerned
Both will create awareness about the company
Capital mix (equity/debt) will be created by the two methods

Advantages of Private Placement for this company

- Marketability: The company’s issues under private placing is limited or restricted than in public issue where the
company is not yet well known.

- Cost: Cost of issue under private placing will be lower than under public offer.

- Speed: The placing may be completed quickly than under a public offer.

- The number of shareholders is low and efforts required to manage them is also reduced.

- Regulatory involvement and control is minimal

Advantages of Public offer

- Publicity preceeding Initial Public Offer (IPO) helps to create awareness in the public, thereby enabling a
successful IPO whenever it comes up even if late in the year.

-. The advertisement of the issue creates public awareness about the company
. It provides cheap cash or source of financing for the company
- It gives opportunity to a wider range of investors to become bond-holders.

Advice on the method to choose

The directors of the company should use private placement to issue the bonds as this is likely to be more
successful for an unlisted company than a public issue. It is also a useful first step in helping to raise the
marketing profile of the company in the run up to the planned IPO.

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 However, where there is firm underwriting of the public issue, a public issue may be preferred.
(b) The success of the IPO can be improved by:
i. An appropriate choice of issue price. To be attractive, the price should be slightly below the perceived market
value, although there is a risk of underpricing the offer as current shareholders would lose out,
ii. Underwriting the issue (it may be at a significant cost),
iii. Careful choice of timing in terms of the new product development cycle (i.e. to ensure that the new product is
developed sufficiently, patents obtained, market research etc).
iv. Choice of timing in terms of market conditions,
v. Careful/planned communication to prospective investors.

(c) Explanation on the three forms of Efficient Market Hypothesis (EMH)

Forms of Efficient Market Hypothesis

i. Weak form
EMH in its weak form asserts that the current share price reflects all the information that could be gleaned from a
study of past share price. Therefore, no investor can earn above average returns by developing trading rules
based on historical price or return information.

ii. Semi-strong form of EMH

This asserts that the current share price will not only reflect all historical information but will also reflect all other
published information. Therefore, no investor can be expected to earn above-average returns from trading rules
based on any publicly available information

iii. Strong form of EMH

This form of EMH asserts that the current share price incorporates all information including non-published
information. This would include insider information and views held by the Directors of the entity.
Therefore, people with insider knowledge of the company could not make profits by using this information;
however, this is insider trading which is illegal. It is the consensus that weak or semi-strong form is the most likely
to occur in practice.

6. QUESTION 5 – November 2014

a. Assume that you are a Finance Manager in a state-owned enterprise which is about to have its majority
ownership transferred to the private sector through listing on the Nigerian Stock Exchange.
You are required to examine the financial objectives and the changes in emphasis that are associated with
strategic and operational decisions in the above scenario. (10 Marks)

b. What are the associated risks that the company may be exposed to as a result of privatisation? (5 Marks)
(Total 15 Marks)

Solution

(a) The financial objectives of a state-owned enterprise are determined by the government of such state and may
be strongly influenced by political and social factors. State owned enterprises often exist to provide a service and
to satisfy a social need, even though, they may not be operating at a profit.
Finance manager’s targets for state enterprises are normally in the form of a percentage on some pre-defined
capital employed or turnover. They are not normally profit maximizing, but are often expected to cover their
operating costs and to provide from internally generated fund part or all of their funding for capital investment.
Upon privatization, the finance manager will face a new set of objectives:
- Autonomy and freedom of operations
- Maximisation of shareholders’ wealth which now becomes a primary objective than when it was state owned.
After privatization, finance manager’s focus will be on strategic and tactical decisions which include the

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 following:

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 - Decision on the company’s shares and market valuations
- Investment, finance and dividend decisions which are likely to affect share price
- Long term plan, opportunities, strength and weaknesses of the organisation
- Other strategic and tactical decision which include sourcing for materials and components, pricing, marketing,
production and staffing.

(b) The likely risks that the company may be exposed to as a result of privatization include:
- Exposure to future takeover bids
- If the government still retains majority shareholding, the company’s objectives might be subjected to political
factors.
- If the government still retains majority shareholding, the social objectives might still be interfering with private
company’s profit maximization objective.
- Exposure to gearing levels which may expose the company to financial risks
- Government continuous intervention in major decisions even after loss of control.

7. QUESTION 6 – November 2014

a. Nimega Plc. is a Nigeria based multinational company that has subsidiaries in two foreign countries. Both
subsidiaries trade with other group members and with four third party companies.
You are required to present SIX arguments for and FOUR against centralised treasury management in a
multinational organisation. (10 Marks)

b. Discuss any FIVE reasons why conflict of interest may exist between shareholders and bond holders. (5 Marks)
(Total 15 Marks).

Solution

(a) Advantages of Centralised Treasury Management

(i) Centralised management avoids having a mix of cash surpluses and overdrafts in different localised bank
accounts. It facilitates bulk cash flows, so that lower bank charges can be negotiated and the subsidiaries that
need to borrow can borrow from the parent company and hence gain the benefit of lower rates.
(ii) Larger volumes of cash are available to invest, giving better short-term investment opportunities (for example
international money markets, high-interest accounts and Certificate of Deposits).
(iii) Any borrowing can be arranged in bulk at lower interest rates than for smaller borrowings and on international
markets, interest rate hedging will be facilitated.
(iv) Foreign currency risk management is likely to be improved in a multinational group of companies. A central
treasury department can match foreign currency income earned by one subsidiary with expenditure in the same
currency by other subsidiaries.
(v) A specialised treasury department will employ experts with knowledge of dealing in forward contracts, futures,
options, euro-currency markets, swaps and so on. Localised departments would not normally have such
expertise.
(vi) The centralised pool of funds required for precautionary purposes will be smaller than the sum of separate
precautionary balances that would be held under decentralised treasury arrangements.
(vii) A centralised function acts as a single focus, ensuring the strategy of the group is fulfilled and group
profitability is enhanced by cash funding, investment and foreign currency management.
(viii) Transfer prices can be set centrally, thus minimising the group’s global tax burden.

Disadvantages of Centralised Treasury Management

(i) Local departments may find it easier to diversify sources of finance and match local assets.
(ii) Centralised management means that managers in subsidiaries and divisions are not motivated by being given
the autonomy to deal with cash management and it may be difficult to assess their performance if the major
decisions are being made centrally.
(iii) A decentralised treasury function may be more responsive to the needs of individual operating units.

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 (iv) A decentralised operation may find it easier to invest its own balances quickly on a short-term basis than a
centralized function would.
(v) A centralised function may find it difficult to monitor remote sites; it may therefore be difficult to obtain
information from those sites.

(b) There could be conflict of interest between shareholders and bondholders for the following reasons:

(i) Different attitudes to risk and return

The shareholders may want the company to undertake risky projects with correspondingly high expected levels of
returns while the bondholders will want the company to embark on projects that guarantee sufficient returns to
pay their interest each year and ultimately to repay their loans.

(ii) Dividends
Large but legal dividends may be preferred by shareholders, but may affect bondholders as the payments leave
low cash balances in the company and hence put at risk the company’s ability to meet its commitment to the
bondholders.

(iii) Priority in Insolvency

Bondholders may wish to take the company into liquidation if there are problems paying their interest to guarantee
their investment. Shareholders, however, may wish the company to continue trading if they expect to receive
nothing should the company go into liquidation.

(iv) Attitude to further finance

The shareholders may prefer that the company raised additional finance by means of loans in order to avoid
having to contribute in a rights issue or the risk of dilution of their shareholding and hence loss of power, if an
open stock market issue is made. Bondholders may not favour the company taking on the burden of additional
debt finance because it may increase the risk that the interest that are due will not be paid, or the company will
have problems repaying their loans especially if the new loans rank above theirs.

(v) Restrictions imposed by bondholders to protect their loans

Restrictions such as charges preventing the company from selling assets or covenants may limit the company’s
ability to maximize returns for shareholders.

(vi) Bankruptcy costs

If the costs of bankruptcy, such as receivers and lawyers’ fees are likely to be significant, it may cause conflict.

8. QUESTION 5 – May 2015

a. Globalisation has created more opportunities for money laundering with its associated risks, which government
and international bodies are trying to combat through legislations.

Required:
i. Explain the term money laundering and identify TWO major
perpetrators. (3 Marks)

ii. State FOUR steps involved in assessing the risks associated with money laundering. (4 Marks)
iii. State THREE necessary steps in curbing the spread of money
laundering. (3 Marks)

b. In recent times, there has been rapid expansion in the use of Islamic finance globally. You are required to
identify FIVE major advantages of Islamic financing.
(5 Marks)
(Total 15 Marks

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 Solution

(a) (i) Money laundering constitutes any financial transactions whose purpose is to conceal the identity of the
parties to the transaction or to make the tracing of the money difficult.

Money laundering is used by:

- Corrupt officials
- Terrorist organizations
- Tax evaders
- Distorters of accounting information

(ii) Steps involved in assessing the risks associated with money laundering:
- Identifying the money laundering risks that are relevant to the business.
- Carrying out a detailed risk assessment on such areas as customer
behaviour and delivery channels.
- Designing and implementing controls to manage and reduce any
identified risks.
- Monitoring the effectiveness of these controls and make improvements
where necessary.
- Maintaining records of actions taken and reasons for these actions.

(iii) Steps involved in curbing money laundering:

- Legislation
- Information and education
- Identifying the likely businesses such as new customers carrying out
large one-off transactions
- Probing suspicious deals and lodgements
- Prosecution
- On-going monitoring of businesses
- Introduction of Bank Verification Number

(b) Advantages of Islamic Finance:

(i) Following the principles of Islamic finance, it allows access to a source of
worldwide funds. Access to Islamic finance is also not just restricted to
Muslim communities which may make it appealing to companies that are
focused on investing ethically.
(ii) Gharar (uncertainty, risk or speculation) is not allowed, reducing the risk
of losses.
(iii) Excessive profiteering is also not allowed, only reasonable mark-ups are allowed.
(iv) Banks cannot use excessive leverage and are therefore less likely to collapse.
(v) The rules encourage all parties 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.
(vi) The emphasis of Islamic finance is on mutual interest and cooperation, with
a partnership based on profit creation through ethical and fair activity benefiting
the community as a whole.

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 9. QUESTION 7 – May 2015

Finance Managers of Multinational Firms manage foreign exchange risks. In the light of the above statement, you
are required to:
a. Explain what is meant by ‘hedging’. (3 Marks)
b. Identify and explain THREE Internal Hedging techniques. (6 Marks)

Solution

(a) Hedging is risk management strategy used in limiting or off-setting probability of loss from fluctuations in the
prices of commodities, currencies or securities. In the context of this question, hedging can be defined as seeking
protection against unexpected future changes in exchange rate.

Finance managers do manage exchange rate risks through hedging. This implies that finance managers would
anticipate the risk, recognise it, quantify it and taking appropriate actions to reduce it, if not, totally eliminate it.
(b) Internal Hedging Techniques includes the following:

(i) Leading and lagging

Leading involves accelerating payments to avoid potential additional cost due to currency rate movements.
Lagging is the practice of delaying payments if currency rate movements are expected to make the later payment
cheaper.

(ii) Invoicing in local currency

This is where an exporter invoices oversees customers in its own domestic currency or for an importer to arrange
with its overseas supplier to be invoiced in its home currency. Although either the exporter or the importer avoids
transaction risk, the other party to the transaction will bear the full risk.

(iii) Matching receipts with payments

This is where a company that expects to make payments and have receipts in the same foreign currency should
plan to off-set its payments against its receipts in that currency. The process of matching is made simpler by
having foreign currency account with a bank.

(iv) Netting
This is a process in which credit balances are netted off against debit balances so that only the reduced net
amounts remain due to be paid by actual currency flows. Netting has the objective of saving transaction cost not
transaction risk. Netting could be bilateral or multilateral.

(v) Protection clauses

This is a situation where an export or import contract is given a protection clause, whereby sale prices in the
foreign currency or the adjusted exchange rate moves outside a defined range.

(vi) Pricing policy

A company can anticipate adverse exchange rate movements by building an extra ‘profit’ margin into the selling
price to act as a cushion in the event that exchange rates do in fact move adversely.

(vii) Do nothing
This is usually the cause of action of most importers and exporters. They will accept whatever comes their way
whenever conversion is to be made.

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 10. QUESTION 7 – November 2015

Assume you are the Finance Director of a large multinational company listed on a number of international stock
markets. The company is reviewing its corporate plan and also focuses on maximising shareholder wealth as its
major goal. The Managing Director thinks this single goal is inappropriate and therefore asks his co-directors for
their views on giving greater emphasis to the following:
(i) Cash flow generation.
(ii) Profitability as measured by profits after tax and return on investment.
(iii) Risk-adjusted returns to shareholders; and
(iv) Performance improvement in a number of areas such as concern for environment, employees‟ remuneration,
quality of working conditions and customers satisfaction.

Required:
a. Provide the Managing Director a report for presentation at the next board meeting which evaluates the
argument that maximisation of shareholders‟ wealth should be the only true objective of a company.
(8 Marks)
b. Discuss the advantages and disadvantages of the Managing Director’s suggestions about alternative goals. (7
Marks) (Total 15 Marks),

Solution

(a)

To: The Managing Director

From: The Finance Director

ARGUMENT ON SHAREHOLDERS‟ WEALTH MAXIMISATION OBJECTIVE OF A COMPANY

The memorandum is meant to educate you on the debate on shareholders‟ wealth maximization objective as the
only true objective of a company.

What is shareholders’ wealth maximization? Shareholders’ wealth maximization objective concept means
maximizing the return to ordinary shareholders as measured by the sum of dividends and capital appreciation. It
means maximizing the net present value of a course of action to shareholders, that is, the difference between the
present value of its benefits and the present value of its costs. A financial action that has a positive Net Present
Value (NPV) creates wealth for shareholders. It also seeks to maximize the value of a firm or its share price.
Though, the share price is determined by a general consensus among market operators, regarding the value of
companies and mirrors its expectation concerning the current and anticipated future profits of the firms, it reflects
the time value of money to them and the risk attached to those profits.
Shareholders‟ wealth maximization may have some practical difficulties in selecting a suitable measurement for
growth in shareholders‟ wealth, financial targets such as profit maximization and growth in earnings per share
might be used but no financial target on its own is ideal.

Financial performance may be assessed in a variety of ways by the actual or expected increase in the share
price, growth in profits, growth in earnings per share and so on. Companies may also adopt profit maximization
(accounting profit), profitability maximization (Return on Capital Employed (ROCE), Return on Equity(ROE),
Return On Investment (ROI), growth, long-term stability and so on as their objective, but all these objectives
ignore risk and time value of money which are taking care of in the shareholders‟ wealth maximization objective.
In practice, however, companies might have other stated objectives, but these can usually be justified in terms of
the pursuit of wealth maximization. Therefore, the shareholders wealth maximization objective is an appropriate
and operationally feasible criterion to choose among the alternative objectives.

14 | P a g e Accountants Wake-Up
 However, shareholders‟ wealth maximization objective should not be adopted in isolation without considering
other objectives such as, profit maximization and earnings growth, in the expectation that if these objectives are
achieved shareholders‟ wealth maximization will be increased by an optimal amount.

It is therefore recommended that companies should assume and follow this objective in their financial decision
making, but they should balance it with those of other stakeholders in the firm. It is theoretically logical and
operationally feasible normative goal for guiding financial decision-making. It is also all embracing, that is, it takes
care, in the long run, all other company objectives including maximization of profits, sales revenue, market share,
level of employee turnover, satisfaction of management staff and so on.

Signed
Finance Director

(b) i) Cash flow generation

Cash flow generation is one of the main sources of liquidity; it is a short-term objective which should be pursued
only in a period of economic meltdown. During this period, it is the „survival instinct‟ that is critical. Shareholders
are not likely to put their funds in a company whose management lacks the required aggressiveness for long-term
profitability and growth. However, if the aim of the firm‟s management is to maximize the net present value of the
cash flows generated in the medium to long term, then this objective will effectively be the same as maximizing
shareholders‟ wealth.

ii) Profitability as measured by profit after tax and return on investment

This is a better objective than profit maximization (accounting profit) as it takes into account both profits and the
assets utilized in generating such profits.
Measures of profitability include return on capital employed (ROCE) or return on investment (ROI) or return on
equity (ROE) and earnings per share (EPS) and so on. This objective has something short coming namely:
i) Problem of definition, that is, which profits and capital are to be used.
ii) The uncertainty that goes with the earning of the profits (risk) is ignored;
iii) Time value of money is also ignored and
iv) It fails to provide an operational feasible measure for ranking alternative courses of action in terms of their
economic efficiency.
However, companies use it to assess performance and control in their organisations. It is useful for the
comparison of widely differing divisions within a diverse multinational company and can provide something
approaching a „level playing field‟ when setting targets for the different branches of the organisation. It is
important, however, that the measurement techniques to be used in respect of both profits and the asset base are
very clearly defined and that there is a clear and consistent approach to accounting for inflation to be able to solve
the problem of definition. The selection of the time frame is also important in ensuring that the selected objectives
work for the long-term health of the business.

iii) Risk adjusted returns to shareholders

It is assumed that the use of risk adjusted returns in this question relates to the criteria used for investment
appraisal rather than to the performance of the firm. As such, it cannot be pursued solely as an organizational
objective, but used as a tool in achieving it.
It provides a useful input to the goal setting process as it focuses attention on the company‟s policy on making
risky investments. Since investment decisions usually affect the value of the firm if the investments are profitable
and add to shareholders‟ wealth, it is important that they are evaluated on a criteria which is compatible with the
objective of the shareholders‟ wealth maximization.
However, it is fundamental that a company uses the right technique to avoid wrong decisions, bearing in mind the
financial implication such decisions can bring to the company. It should also be noted that an investment must
firstly be properly evaluated before selection. It is the acceptable investments that should be included in the
capital expenditure programme of the company. Thus, investments should be evaluated on the basis of a
criterion, which is compatible with the objective of the shareholders‟ wealth maximization bearing in mind that an
investment will
15 | P a g e Accountants Wake-Up
 add to the shareholders‟ wealth if it yields benefits in excess of the minimum benefits as per the opportunity cost
of capital.

iv) Performance improvement in non-financial areas

Aside from the financial objectives which firms pursue, there are other objectives which are critical to the
achievement of the shareholders‟ wealth maximization and which should also be of concern to corporate
organizations. These are the non-financial objectives. A company as an integral part of the society cannot be
separated from the environment (internal and external) in which it operates. It therefore owes stakeholders, both
within and outside the company, certain social and ethical obligations among which are:

-employees: to provide a conducive work environment, job satisfaction and job security;
- customers: to produce good quality product(s) at affordable prices and devoid of any health hazards; good
service and communication and open and fair commercial practice.
- suppliers: to pay as at and when due and avoid exploitation; and
- local community: protect the environment from pollution of the air or water through industrial wastage and oil
spillages. Give financial aids to charities and support sports development programmes. Set up schools and
colleges to enhance educational opportunities of the children in the community etc.
However, the non-financial objectives stated above may often work indirectly to the financial benefit of the firm in
the long term, but in the short term they do often appear to compromise the primary financial objectives. It should
be noted that a company does not stand alone; it forms part of the society and the environment in which it
operates, hence it owes certain social and ethical obligations to the people in its environment to be able to
survive.

11. QUESTION 2 – November 2015

Corporate failure is never the result of a random set of events. It is normally a reflection of deep-seated corporate
shortcomings.
a. Identify and discuss the financial symptoms of corporate failure in Nigeria.

(6 Marks)
b. Discuss SEVEN general causes of corporate failure in Nigeria. (14 Marks) (Total 20 Marks)

Solution

(a) Financial symptoms of corporate failure

i) Declining profitability: Low, negative and/or an adverse trend in operating profitability figures normally represent
a distress situation;

ii) Declining liquidity: Unless timely stemmed, declining profitability inevitably turns into decreased ability to
generate cash and cash crisis.

iii) Declining solvency: Declining profitability sooner or later leads to declining solvency when liabilities exceed
assets. A solvency crisis triggers action by banks and other lenders concerned about lack of cover for their
exposure; and

iv) Inadequate capital: When a company’s capital is not adequate for the business it is engaged in, the company
is likely to fail. In a similar vein, if a company’s gearing/leverage ratio is high and level of income is not enough to
meet the interest payments on the debts, that is, when the interest cover and the liquidity is low, it may lead to
problem in meeting the payment of interest on loans.

16 | P a g e Accountants Wake-Up
 (b) General Causes of corporate failure in Nigeria

i) Bad management: Management is the process of combining, allocating and utilizing an organizations
input(men, materials and funds) by planning, organizing, directing and controlling for the purpose of producing
output-goods and services- desired by customers in order to accomplish organizational objectives. Towards
achieving this objective, it will be necessary to watch the cost, sales, profit margin etc of the organization;.

The end-result of all these management tasks and processes will show in the financial ratios like cash flow to total
debt ratio, return on assets ratio, stability of the earnings and the interest coverage ratio, the retained earnings to
total assets ratio, the current ratio, and the size of total assets which are some of the ratios that indicate corporate
success or failure. From this, it can be safely concluded that how well managers do their work determines
whether a company will fail or not.

ii) Technology: Although investment in technology is a management decision some companies lack the
resources to acquire the right technology for their industry. This sometimes increases their overhead and their unit
cost when compared with their competitors who are able to acquire such modern technology. Since technology
assists in the price of goods and service delivery time, companies that are not able to move with the new
technological developments are bound to lose out even though acquiring new technology goes a little beyond
management decision. Investment in new technology depends on the resource available to the company.

iii) Frauds: Although many companies invest in internal control to avoid or prevent fraud, it still occurs. Corporate
fraud has assumed an alarming proportion in Nigeria today despite the legal provisions made against it. It has led
to the failure of companies by depleting their resources.

iv) Political & Environmental factors: These are factors that impact negatively or otherwise on the company
beyond the control and even sometimes the cognitive forecast of its management. It has to do with political
factors such as political turmoil and environmental factors such as the Boko Haram Insurgency.

v) Cost of funds: Companies raise short term funds for working capital from the banks (money market) while
they raise long term funds from the capital market. Since cost of funds in Nigeria is very high firms find it very
difficult to source funds for their operations from banks and this has been having negative effect on their
operations.
vi) Inflation: This has made the cost of goods to be high and since the incomes of the consumers are not moving
at the same rate the suppliers increase the price of their products, it has become difficult for consumers to buy the
products. Many companies‟ warehouses are therefore overstocked with unsold goods thereby affecting their
operational performance.

vii) Poor infrastructural facilities: The poor level of infrastructural facilities in the country creates additional costs
for organizations in the form of provision of electricity, water, transportation , security, communication, etc.

viii) Multiple Taxation: Businesses in Nigeria are exposed to multiple taxation from Local Government level to
Federal Government level thereby creating additional cashflow burden. Furthermore, a large number of illegal
charges are imposed on organizations by corrupt government officials at the various ports, all of which add to the
cost of doing business in the country.

ix) Government Foreign Exchange Policy: This is also an area that contributes to corporate failure in the
country. For example, the recent Central Bank guidelines on foreign exchange is adversely affecting many
industries as they are now having a shortage of foreign currency to import necessary inputs.

17 | P a g e Accountants Wake-Up
 12. QUESTION 5 – MAY 2016

BADEJO Limited, a small company, is currently considering a major capital investment project for which
additional finance will be required. It is not currently feasible to raise additional equity finance, consequently debt
finance is being considered. The decision has not yet been finalized whether this debt finance will be short or long
term and it is to be a fixed or variable rates. The financial controller has asked you, as the company’s Accountant
to prepare a report for the forthcoming meeting of the board of directors.

Required:

Prepare a draft report to the board of directors which identifies and briefly explains:
a. The main factors to be considered when deciding on the appropriate mix of short, medium or long term finance
for BADEJO Limited. (8 Marks)

b. The practical considerations which could be factors in restricting the amount of the debt which BADEJO Limited
could raise. (7 Marks)
(Total 15 Marks)

Solution

To: The Board of Directors - Badejo Limited

From: Accountant
Date: May 18, 2016

SUBJECT:
(a) The factors to be considered in deciding the appropriate mix of short, medium or long term finance for the
company.
(b) Factors to be considered in restricting the amount of debt which a company could raise

a. The factors to be considered in deciding the appropriate mix of short, medium or long term finance for
the company include:

i. The term of finance - The term should be appropriate to the asset being acquired. As a general rule, long term
finance should be financed from long-term sources. Cheaper short-term funds should be used to finance short-
term funds requirements such as fluctuations in the level of working capital.

ii. Flexibility - Short-term debt is a more flexible source of finance. It is better than long term debt which
sometimes may require payment of penalties when paid before maturity. Long-term debt also has the
disadvantage of being locked in the interest rate payment when there is a fall in interest rate.

iii. Repayment terms - The company must have sufficient funds to be able to meet repayment schedules
contained in the loan agreement. Since short-term funds are usually repayable on demand or at short notice, it is
therefore risky to finance long-term capital investments with short-term funds.

iv. Availability - In case of a negative change in the company’s position or a change in economic conditions, it
may be difficult to renew short-term finance.

v. Cost - Interest on short-term debt is in most cases usually less than on long-term debt. However, if short-term
debt has to be renewed frequently, issue expenses may raise its cost.

iv. Effect on gearing - Certain types of short-term debt (bank overdraft, increased credit from suppliers) will not
be usually included in gearing calculation. If a company is seen as too highly geared, lenders may be unwilling to
lend it money or decide that the high risk of default must be compensated by higher interest rate or restrictive
covenants.

18 | P a g e Accountants Wake-Up
 b. Factors to be considered in restricting the amount of debt which the company could raise include:

i. Restrictions in the memorandum and articles of association of the company - There will be a need for the
company to examine the legal documents carefully to see if there is any restriction placed on the amount the
company could borrow and for what purpose

ii. Previous records of the company - If the company or its directors or shareholders has a low credit rating,
investors may be unwilling to subscribe for the debentures that may be issued by the company

iii. Restriction on current borrowing - If the terms of any current loan to the company contain restriction on
borrowing rights, it may be difficult for the company to obtain further loan.

iv. Uncertainty over project - The project is a significant one, and presumably the interest and ultimate
repayment that lenders obtain may be very dependent on the success of the project. If the result are uncertain,
lenders may not be willing to take the risk.

v. Security- Inability of the company to provide the security that lenders require particularly when it is faced with
restriction on its assets.

Signed

Accountants

13. QUESTION 5 – MAY 2017

In each of the following situations, identify the stakeholders that could be involved in potential conflicts:
a. A large conglomerate 'spinning off' its divisions by selling them or setting them up as separate companies. (5
Marks)

b. A private company converting into a public company. (5 Marks)

c. Japanese car manufacturer building new plants in other countries. (5

Marks) (Total 15 Marks)

Solution

(a) A large conglomerate spinning off its Divisions

Large conglomerates may sometimes have a market capitalisation which is less than the total realisable value of
the subsidiaries ('conglomerate discount'). This arises because more synergy could occur by the combination of
the group's businesses with competitors than by running a diversified group where there is no obvious benefit
from remaining together.

The stakeholders involved in potential conflicts include.

i. Shareholders

They will see the chance of immediate gains in share price if subsidiaries are sold.
ii. Subsidiary company Directors and employees

They may either gain opportunities (e.g. if their company becomes independent) or suffer the threat of job loss
(e.g. if their company is sold to a competitor).

19 | P a g e Accountants Wake-Up
 (b) A private company converting into a public company

When a private company converts into a public company, some of the existing shareholders/managers will sell
their shares to outside investors. In addition, new shares may be issued. The dilution of ownership might cause
loss of control by the existing management.

Stakeholders involved in potential conflicts include:

i. Existing shareholders/managers

They will want to sell some of their shareholding at a price as high as possible. This may motivate them to
overstate their company's prospects. Those shareholders/managers who wish to retire from the business may be
in conflict with those who wish to stay in control - the latter may oppose the conversion into a public company.
ii. New outside shareholders

Most of these will hold minority stakes in the company and will receive their rewards as dividends only. This may
put them in conflict with the existing shareholders who receive dividends. On conversion to a public company,
there should be clear policies on dividends and Directors' remuneration.
iii. Employees, including managers who are not shareholders

The success of the company depends partly on the efforts put in by employees.

They may feel that they should benefit when the company goes public. One way of organising this is to create
employee share options or other bonus schemes.
iv. Regulatory agencies

(c) Japanese car manufacturer building new car plants in other countries

The stakeholders involved in potential conflicts include:

i. The shareholders and management of the Japanese company

They will be able to gain from the combination of advanced technology with a cheaper workforce.
ii. Local employees and managers engaged by the Japanese company They will gain enhanced skills and better
work prospects.
iii. The government of the local country, representing the tax payers

The reduction in unemployment will ease the taxpayers' burden and increase the government's popularity
(provided that subsidies offered by the government do not outweigh the benefits!).
iv. Shareholders, managers and employees of local car-making firms

These will be in conflict with the other stakeholders above as existing manufacturers lose market share.
v. Employees of car plants based in Japan

These are likely to lose their jobs if car-making is relocated to lower wage areas. They will need to compete on the
basis of higher efficiency.

14. QUESTION 5 – NOVEMBER 2017

Private sector companies have multiple stakeholders who are likely to have divergent interests.
Required:
a. Identify FIVE stakeholder groups and discuss briefly their financial objectives.
(10 Marks)
b. Explain ways in which companies’ directors can be encouraged to achieve the objective of maximisation of
shareholders’ wealth. (5 Marks)
(Total 15 Marks)

20 | P a g e Accountants Wake-Up
 Solution

a) Stakeholders in a company include amongst others: shareholders; directors /managers; lenders; employees;
suppliers; customers; and government. These groups are likely to share in the wealth and risk generated by a
company in different ways and thus conflicts of interest are likely to exist. Conflicts also exist not just between
groups but within stakeholder groups. This might be because sub-groups exist, for example preference
shareholders and equity shareholders within the overall category of shareholders.
Alternatively, individuals within a stakeholder group might have different preferences (e.g. to risk and return, short
term and long term returns). Good corporate governance is partly about the resolution of such conflicts. Financial
and other objectives of stakeholder groups may be identified as follows:

Shareholders
Shareholders are normally assumed to be interested in wealth maximisation. This, however, involves
consideration of potential return and risk. For a listed company, this can be viewed in terms of the changes in the
share price and other market-based ratios using share price (e.g. price/earnings ratio, dividend yield, earnings
yield etc).
Where a company is not listed, financial objectives need to be set in terms of other financial measures, such as
return on capital employed, earnings per share, gearing, growth, profit margin, asset utilisation and market share.
Many other measures also exist which may collectively capture the objectives of return and risk.
Shareholders may have other objectives for the company and these can be identified in terms of the interests of
other stakeholder groups. Thus, shareholders as a group may be interested in profit maximisation. They may also
be interested in the welfare of their employees, or the environmental impact of the company's operations.

Management
While executive directors and managers should attempt to promote and balance the interests of shareholders and
other stakeholder groups, it has been argued that they also promote their own individual interests and should be
seen as a separate stakeholder group.
This problem arises from the divorce between ownership and control. The behaviour of managers cannot be fully
observed by the shareholders, giving them the capacity to take decisions which are consistent with their own
reward structures and risk preferences. Directors may therefore be interested in their own remuneration package.
They may also be interested in building empires, exercising greater control, or positioning themselves for their
next promotion. Non-financial objectives of managers are sometimes inconsistent with what the financial
objectives of the company ought to be.

Lenders
Lenders are concerned to receive payment of interest and eventually re-payment of the capital at maturity. Unlike
the ordinary shareholders, they do not share in the upside (profitability) of successful organisational strategies.
They are therefore likely to be more risk averse than shareholders, with an emphasis on financial objectives that
promote liquidity and solvency with low risk (e.g. low gearing, high interest cover, security, strong cash flow).

Employees
The primary interests of employees are their salary/wage and the security of their employment. To an extent there
is a direct conflict between employees and shareholders as wages are a cost to the company and income to
employees.
Performance-related pay, based on financial or other quantitative objectives may, however, go some way toward
drawing the divergent interests together.

Suppliers and Customers

Suppliers and Customers are external stakeholders with their own set of objectives (profit for the supplier and,
possibly, customer satisfaction with the goods or services) that, within a portfolio of businesses, are only partly
dependent on the company in question. Nevertheless, it is important to consider and measure the relationship in
term of financial objectives relating to quality, lead times, volume of business, price and a range of other variables
in considering any organisational strategy.

Government – Interested in payments of tax for planning purposes and the operating environment.

21 | P a g e Accountants Wake-Up
 b) The directors of companies can be encouraged to achieve the objective of maximising shareholders’ wealth
through managerial reward schemes and through regulatory requirements.

Managerial reward schemes

As agents of the company’s shareholders, the directors may not always act in ways which increase the wealth of
shareholders, a phenomenon called the agency problem. They can be encouraged to increase or maximise
shareholders‟ wealth by managerial reward schemes such as performance-related pay and share option
schemes. Through these methods, the goals of shareholders and directors may increase in congruence.

Performance-related pay, links part of the remuneration of directors to some aspect of corporate performance,
such as levels of profit or earnings per share. One problem here is that it is difficult to choose an aspect of
corporate performance which is not influenced by the actions of the directors, leading to the possibility of
managers influencing corporate affairs for their own benefit rather than the benefit of shareholders, for example,
focusing on short-term performance while neglecting the longer term.

Share option schemes bring the goals of shareholders and directors closer together to the extent that directors
become shareholders themselves. Share options allow directors to purchase shares at a specified price on a
specified future date, encouraging them to make decisions which exert an upward pressure on share prices.
Unfortunately, a general increase in share prices can lead to directors being rewarded for poor performance,
while a general decrease in share prices can lead to managers not being rewarded for good performance.
However, share option schemes can lead to a culture of performance improvement and so can bring continuing
benefit to stakeholders.

Regulatory Requirements/ Corporate Governance

Regulatory Requirements can be imposed through Corporate Governance codes of best practice and stock
market listing regulations.
Corporate Governance codes of best practice seek to reduce corporate risk and increase corporate
accountability. Responsibility is placed on directors to identify, access and manage risk within an organisation. An
independent perspective is brought to directors‟ decisions by appointing non-executive directors to create a
balanced board of directors, and by appointing non-executive directors to remuneration committees and audit
committees

15. QUESTION 6 – NOVEMBER 2017

You have recently taken up employment with Large Plc., a Nigerian company with manufacturing subsidiaries in
many countries across Africa. As the Financial Analyst, you report directly to the Managing Director who currently
requires briefings on the following areas:

(i) Ethical issues and capital investment decisions,

(ii) Options and company valuation

Required:
a. Explain, with examples, ethical issues that might affect capital investment decisions and discuss the
importance of such issues for Strategic Financial Management. (8 Marks)

b. Explain the circumstances in which the Black-Scholes Option Pricing (BSOP) model could be used to assess
the value of a company, including the data required for the variables used in the model (7 Marks)

(Note: A report format is not required) (Total 15 Marks)

22 | P a g e Accountants Wake-Up
 Solution

(a) Ethics impact on many aspects of investment decisions. In theory, companies seek to maximise
shareholders wealth, often subject to constraining secondary objectives. Such secondary objectives include
the welfare of the public. Companies are affected by ethical standards relating to:

(i) Health and safety - Employees and the public should be protected from danger, which includes working
conditions, following employment laws and product safety;
(ii) Environmental issues – Environmental issues such as, controlling pollution, protecting wildlife and the
countryside. Fully satisfying these issues might be an expensive element in a capital investment;
(iii) Bribes and other payments - Investment might proceed more quickly and efficiently if bribes, 'incentive
payments', 'gifts' etc. are paid to officials. This is a difficult area, as gifts are part of the business culture in some
countries. Even the ethics of political contributions is debatable;
(iv) Corporate governance - Many examples exist of companies, e.g. Enron, where the results of investments
and the true financial position have been hidden from shareholders and the public;

(v) Taxation - Companies may try to minimise their tax liability. Tax evasion is illegal, but there is an ethical
question over the use of sophisticated tax avoidance measures, especially in developing countries;
(vi) Wage levels - Should a company pay low wages to maximise shareholders‟ wealth, especially in countries
where the standard of living is very low?

(vii) Individual manager's ethics - The ethics of individuals, including pursuing their own goals and self-interest
(such as job security) rather than those of the organisation might influence the outcome of investment decisions

There is inevitably some subjectivity as to what constitutes ethical behaviour, but there is little doubt that ethical
issues are of increasing importance to companies. Acting in an ethically responsible way often has a direct
detrimental impact upon expected cash flows and net present value (NPV). However, stakeholders, including
shareholders, are increasingly expecting companies to act ethically. If they do not, then their share price might
suffer as a result of adverse publicity and investors withdrawing their support.
The concept of ethical shareholders‟ wealth creation is likely to become increasingly important in strategic
financial management.

b) Using the Black-Scholes Option Pricing (BSOP) model in company valuation rests upon the idea that equity is
a call option, written by the lenders, on the underlying assets of the business. If the value of the company declines
substantially then the shareholders can simply walk away, losing the maximum of their investment. On the other
hand, the upside potential is unlimited once the interest on debt has been paid. The BSOP model can be helpful
in circumstances where the conventional methods of valuation do not reflect the risks fully or where they cannot
be used, for example, if we are trying to value an unlisted company with unpredictable future growth.

There are five variables which are input into the BSOP model to determine the value of the option. Proxies need
to be established for each variable when using the BSOP model to value a company. The five variables are: the
value of the underlying asset; the exercise price; the time to expiry; the volatility of the underlying asset value; and
the risk free rate of return. For the exercise price, the debt of the company is taken. In its simplest form, the
assumption is that the borrowing is in the form of zero coupon debt, that is, a discount bond. In practice such debt
is not used as a primary source of company finance and so we calculate the value of an equivalent bond with the
same yield and term to maturity as the company's existing debt. The exercise price in valuing the business as a
call option is the value of the outstanding debt calculated as the present value of a zero coupon bond offering the
same yield as the current debt.

The proxy for the value of the underlying asset is the fair value of the company's assets less current liabilities on
the basis that if the company is broken up and sold, then that is what the assets would be worth to the long-term
debt holders and the equity holders.

23 | P a g e Accountants Wake-Up
 The time to expiry is the period of time before the debt is due for redemption. The owners of the company have that
time before the option needs to be exercised, that is when the debt holders need to be repaid.
The proxy for the volatility of the underlying asset is the volatility of the business' assets.
The risk-free rate is usually the rate on a riskless investment such as a short-term government bond.

16. QUESTION 7 – NOVEMBER 2017

a. In the context of the selection and holding of investments, discuss each of the following scenarios:
i. An investor holding only one security needs to be concerned with unsystematic risk of that security. (3 Marks)
ii. However, an investor who holds a number of securities should take account of total risk. (3 Marks)
iii. An investor should never add to a portfolio investment that yields a return less than the market rate of return. (3
Marks)
b. The equity beta of KT Plc. is 1.2 and the equity alpha is 1.4. Explain the meaning and significance of these
values to the company. (6 Marks)
(Total 15 Marks)

Solution

a. i) Unsystematic Risk
Unsystematic risk may be defined as the risk attached to a specific investment, in contrast to systematic risk,
which is the overall market risk. As such, it is possible by the combination of a portfolio of investments to eliminate
systematic risk through diversification. The investor who only holds one security will therefore bear a total risk,
made up of the systematic risk of the market and the systematic risk of the investment itself.
Hence, it is incorrect to argue that an investor needs only be concerned with the unsystematic risk of that security.
On the other hand, he may well be concerned about the systematic risk of the security, because of the fact that it
is that portion of the risk which is present simply because he holds only one, rather than a portfolio of
investments.

ii) Total Risk

In holding a portfolio of investments, the rational investor will assemble the portfolio in such a way as to minimise
the risk associated with the portfolio. This means that in a large portfolio it is possible to diversify away the
unsystematic risk completely.
The total risk to the investor under such circumstances is only the systematic risk of the market itself. The total
risk to an investor in a number of securities may therefore be made up of only systematic risk, or systematic plus
unsystematic risk, depending on the extent to which the portfolio is diversified.

iii) Market Rate of Return

In deciding whether to add an investment to a portfolio, the investor should determine the effect of the extra
investment on the overall risk of the portfolio. If the effect is to reduce the overall risk then, assuming that the
investor does seek to minimise risk, the investment should be undertaken.

An investment yielding a rate of return less than that of the market is one which is of relatively low risk or possibly
risk-free. It would therefore be appropriate to add such an investment to a currently high-risk portfolio as a means
of reducing the overall level of risk. It is not relative return but the effect on risk which should determine the
investment decision.

b) The equity beta measures the systematic risk of a company‟s shares, the risk that cannot be eliminated by
diversification. It is a measure of a share‟s volatility in terms of the market‟s risk, and may be estimated by
relating the covariance between the returns on the share and the returns on the market to market variance. An
equity beta of 1.2 suggests that KT. Plc‟s shares are more risky than the market as a whole, which has a beta of
1. If average market returns change, for example, increase by 5%, the return of KT. Plc‟s shares would be
expected to increase to 1.2 × 5% = 6%.
24 | P a g e Accountants Wake-Up
 The alpha value measures the abnormal return on a share. An alpha value of 1.4% means that the returns on KT
plc‟s shares are currently 1.4% more than would be expected given the share‟s systematic risk. Alpha values are
only temporary and may be positive or negative; in theory the alpha for an individual share should tend to zero.
An alpha value of 1.4% should cause investors to buy the share to benefit from the abnormal return, which would
increase share price and cause the return to fall until the alpha value falls to zero. In a well-diversified portfolio the
alpha value is expected to be zero.

17. QUESTION 7 – MAY 2018

Nkata Plc. is a large publicly quoted company. The directors are currently debating a number of issues, including
the following:

(i) The role of non-executive directors in corporate governance.

(ii) Conflict of interest between directors and shareholders.
(iii) Bond covenants usually imposed by lenders.

Required:
a. Discuss the role of non-executive directors in the corporate governance of a listed public company. (4
Marks)

b. Identify and discuss THREE areas where the interests of shareholders and directors may conflict leading
the directors to pursue objectives other than maximizing shareholders‟ wealth. (6 Marks)

c. Identify FIVE examples of covenant that might be attached to bonds and discuss briefly the advantages
and disadvantages of each to companies. (5 Marks)

(Total 15 Marks)

Solution

(a) The Board of Directors of a listed public company will usually consist of executive directors, who hold specific
responsibilities within the business (for example, personnel director and non-executive directors), who do not
have specific responsibilities. Non-executive directors are usually employed on a part-time basis and are not
involved in day-to-day operational matters. Nevertheless, executive and non-executive directors have the same
legal obligations towards the shareholders of the company.

Non-executive directors have a valuable role to play in the development of strategy and in monitoring the actions
of the executive directors. In carrying out this role, non-executive directors are expected to challenge the
decisions of the executive directors and to highlight bad practices or poor performance.
Non-executive directors should add value to the company in some way and their ability to do so may depend, to a
large extent, on the personal qualities that they possess. They should normally bring to the company broad
experience of the commercial world as well as considerable expertise in their particular field. These qualities may
help to add value through identifying new opportunities and developing new performance measures or improving
existing control systems. In addition, non-executive directors may be a valuable source of new contacts for the
company.
Non-executive directors can often provide objective and independent advice to the Board of Directors. This
should be of particular value during periods of change or crisis, when a detached view can help the executive
directors maintain perspective.

25 | P a g e Accountants Wake-Up
 (b) Takeovers
Directors often devote large amounts of time and money to defend their companies against takeover. However,
research has shown that shareholders in companies that are successfully taken over often earn large financial
returns. On the other hand, directors of companies that are taken over frequently lose their jobs. This is a
common example of the conflict of interest between the two groups.

Time horizon
Directors know that their performance is usually judged on their short-term achievements; shareholders‟ wealth,
on the other hand, is affected by the long-term performance of the firm. Directors can frequently be observed to
be taking a short-term view of the firm which is in their own best interest but not in that of the shareholders.

Risk
Shareholders appraise risks by looking at the overall risk of their investment in a wide range of shares. They do
not have „all their eggs in one basket‟ unlike directors whose career prospects and short-term financial
remuneration depend on the success of their individual firms.

Moral hazard
This deals with manager‟s interest in receiving all the perquisites of his office like domestic staff, company cars,
use of company‟s airplane; company sponsored holiday trips with family abroad etc. Such moral hazards which
increase if the manager has no stake in the company tend to drain the company‟s earnings which means
reduction in the value of the company. The shareholders wealth and the value of the company will reduce if these
incentives and demands of executive management is not kept in checks.

Working hours
Ordinarily, managers prefer to work for less hours than the stipulated working period especially if the reward
system does not recognise overtime and hard work. The implication is that the earnings of the company will
reduce as well as share price and returns to shareholders. This will be more pronounced with senior management
if profit sharing or bonus payment is not attached to profitability.

Dividend policy
Unfortunately, the remuneration of directors and senior managers is often related to the size of the company,
rather than its profits. For this reason, executive management may favour a high retention policy which implies
growth in asset and size of the company. On the other hand, the shareholders may favour a higher dividend
payout which implies more money for them to meet up with their needs

(c) Bond Covenants include:

i. Asset Covenant: This would govern the company‟s acquisition, use and disposal of assets. This could be for
specified types of assets or assets in general;

ii. Financing Covenant: This covenant often defines the type and amount of additional debt that the company can
issue, and its ranking and potential claim on assets in case of future defaults;

iii. Dividend Covenant: A dividend covenant restricts the amount of dividend that the company is willing to pay.
Such covenants might also be extended to share repurchases;

iv. Financial Ratio Covenants: Fixing the limit of key ratios such as the gearing level, interest cover, net working
capital or a minimum ratio of tangible assets to total debt;

v. Merger Covenant: Restricting future merger activity of the company;

vi. Investment Covenant: This concerns company‟s future investment policy;

vii. Sinking Fund Covenant: This is a situation whereby the company makes payments, typically to the bond
trustees, who might gradually repurchase bonds in the open market or build a fund to redeem bonds; and

viii. Employees Covenant: This requires the regulation of the employment and dismissal of key employees.

26 | P a g e Accountants Wake-Up
 Advantages of covenants
i. The main advantage of covenant is that lenders may be prepared to lend more money to the company if it
provides the security of a covenant; and

ii. Covenants may mean that the costs at which the company can borrow money are lower.

Disadvantages of covenants
i. The main disadvantage of a covenant is that the company‟s actions may be constrained; it may not be able to
raise further funds beyond the covenanted loans or undertake profitable investments; and

ii. Covenants may require the borrower to bear monitoring costs such as provision of information, auditors‟ fees or
trustee expenses.

18. QUESTION 7 – NOVEMBER 2018

Agency theory was developed by Jenson & Meckling (1976) who defined the agency relationship as a form of
contract between a company‟s owners and its managers, that is, where the owners appoint agents (managers) to
manage the company on their behalf. As part of this arrangement, the owners must delegate decision-making
authority to the management.
In this respect, the owners expect the agents to act in their best interest.

Required:
a. Agency conflicts may arise in various ways. Discuss four of these conflicts.
(9 Marks)
b. State four methods by which problems arising from the conflicts could be reduced. (6 Marks)
(Total 15 Marks).

Solution
(a) Agency conflicts are differences in the interests of a company’s owners and the managers.

These conflicts arise in several ways which include:

i) Moral hazard: A manager has an interest in receiving benefits from his or her position as a manager. These
include all the benefits that come from status, such as a company car, use of company’s airplane,
accommodation, lunches and so on;

ii) Effort level: Managers may work less than they would if they were the owners of the company. The effect of
this lack of effort could be lower profit and a lower share price. The problem may exist in a large company at
middle levels of management as well as at senior level management. However, the interests of middle level
managers and the interest of senior level managers might well be different, especially if senior level management
staff are given pay incentives to achieve higher profits while the middle level management staff are not;

iii) Earnings retention: The remuneration of directors and senior managers is often related to the size of the
company rather than its profits. This gives managers an incentive to grow the company and increase its sales
turnover and assets, rather than to increase the returns to the company’s shareholders. Management is more
likely to want to re-invest profits in order to make the company bigger, rather than pay-out the profits as dividends;

iv) Risk aversion: Executive directors and senior managers usually earn most of their income from the company
they work for. They are therefore interested in the stability of the company because this will protect their job and
their future income. This means that management might be risk averse, and reluctant to invest in higher-risk
projects. In contrast, shareholders might want a company to take bigger risks, if the expected returns are
sufficiently high; and

27 | P a g e Accountants Wake-Up
 v) Time horizon: Shareholders are concerned about the long-term financial prospects of their company because
the value of their shares depends on expectations for the long-term future. In contrast, managers might only be
interested in the short term. This is partly because they might receive annual bonuses based on short-term
performance and partly because they might not expect to be with the company for more than a few years.
Managers might therefore have an incentive to increase accounting returns on capital employed (or return on
investment) whereas shareholders have a greater interest in long-term share value.

(b) Several methods of reducing the agency problems have been suggested. These include:
i. Assessing the relative importance of stakeholders’ interests . Apart from the problem of taking different
stakeholders‟ interests into account, an organisation also faces the problem of weighing stakeholders‟ interests
when considering future strategy;

ii. Agency theory resolution strategy. This relates to analysing the problem that can arise when ownership and
control are separated and how they might be mitigated by negotiating contracts that allow the principal to control
the agent in such a way that the agent will operate in the interests of the principal;

iii. Firm induced strategies. Agency theory sees employers of businesses, including managers, as individuals,
each with his or her own objectives. Also, within a department of a business, there are departmental objectives. If
achieving these various objectives also leads to the achievement of the objective of the organisation as a whole,
there is said to be goal congruence. Examples are: profit-related/economic value added pay, share awards, share
options and so on;

iv. Separation of roles. Too much power should not accrue to a single individual within an organisation. For
example the role of the Chairman and the Chief Executive should be separated;

v. Accounting standards. Adequate information should be given in the financial statements of a company; vi.
Corporate governance. This is the system by which companies are directed and controlled. It deals with
governance problems that result from the separation of ownership and management of a company, such as the
rights of shareholders, the role of stakeholders, disclosure and transparency, responsibilities of the board and so
on;

vii. Threat of Dismissal. This may not be effective as ownership in many big companies (where ownership and
control are highly separated) is widely dispersed and shareholders often find it difficult to speak with one voice.
Few shareholders attend the annual general meetings and in any case, directors usually ensure they get enough
proxies to support them at meetings. It should be noted however, that the presence of institutional investors could
weaken the directors‟ strength; and

viii. Exposure to take-over bid: This could deter managers from taking actions that will be at variance with share
price maximisation. If the company‟s earnings potentials are being knowingly or unknowingly suppressed through
bad policies and the share is consequently undervalued in relation to its true value, it may be exposed to hostile
take-over bid. The result is that some top managers might lose their job.

19. QUESTION 2 – NOVEMBER 2019

a. Two neighbouring countries, A and B have chosen to organise their electricity supply industries in different
ways. In country A, electricity supplies are provided by a nationalised industry. In country B, electricity supplies
are provided by a number of private sector companies.

Required:
(i) Explain how the objectives of the nationalized industry might differ from those of the private sector companies.
(6 Marks)

(ii) Briefly discuss, whether investment planning and appraisal techniques are likely to differ in the nationalised
industry and private sector companies. (6 Marks)

28 | P a g e Accountants Wake-Up
 b. Explain, the circumstances in which the Black- Scholes option pricing (BSOP) model could be used to assess
the value of a company and the data required for the variables used in the model. (8 Marks)
(Total 20 Marks)

Solution

a) i. The objectives of the nationalised electricity supply industry are likely

to be strongly influenced by the government and may not be primarily financial. State owned enterprises exist to
provide a service and to ensure that social needs are satisfied; they are not usually profit maximising. The prime
objective of a nationalised electricity supply industry might be to promote the development of an efficient and co-
ordinated economic system of electrical supply, with subsidiary objectives concerned with earning an acceptable
return on capital employed (acceptable being defined by the government), and achieving efficiency through cost
control.

29 | P a g e Accountants Wake-Up
 Service considerations might mean the provision of electrical facilities to remote areas at far less than full cost
price. In order to provide reasonably priced electricity for all people, a government might be prepared to subsidise
the nationalised industry and set a negative target return on capital. Alternatively, the target return might be set
such that the industry is a substantial contributor to government finances.
The objectives of a private sector electrical supply company will be mainly determined by the senior management
of the company. The prime objective of a company is often stated to be the maximisation of shareholders‟ wealth.
In practice management teams might be content to achieve a 'satisfying' level of shareholders‟ wealth and also be
concerned with a number of non-financial objectives. Such objectives include market share, growth,
environmental factors, provision of community facilities, sponsorship, service to consumers, good working
conditions and facilities for employees, and corporate survival. Some of these 'non-financial' objectives will
strongly affect the financial success of the company and shareholders‟ wealth. A vital industry such as electricity
supply, even if privately owned, might well be subject to strong government influence and constraints, particularly
with respect to the provision of services and pricing policy.

(ii) Strategic investment planning in a nationalised industry is normally subject to government approval. Smaller
scale investments will be planned and approved by the management of the nationalised industry. However, the
amount of investment undertaken is likely to be influenced by the government as much of the funding for
investment will come from government sources, and the use of external financing (from the capital markets) will
often be limited by the government.
Investment planning in the private sector is strongly influenced by market forces, with managers considering the
possible effects of investments (with their associated implications for financing decisions and dividend decisions)
on share price and shareholders‟ wealth, and how investments will affect the achievement of other corporate
objectives.
Private sector investment appraisal techniques usually assume that the company is seeking to maximise
shareholders‟ wealth in an efficient market. As there are no share prices in a nationalised industry and inves tors‟
wealth maximisation is not the assumed objective, some private sector investment appraisal techniques will not
be appropriate. However, this does not mean that all private sector techniques cannot be used in the public
sector. Discounted cash flow for example is often used in nationalised industries.

b) Using the Black-Scholes option pricing model in company valuation rests upon the idea that equity is a call
option, written by the lenders, on the underlying assets of the business. If the value of the company declines
substantially then the shareholders can simply walk away, losing the maximum of their investment. On the other
hand, the upside potential is unlimited once the interest on debt has been paid.

The BSOP model can be helpful in circumstances where the conventional methods of valuation do not reflect the
risks fully or where they cannot be used. For example if we are trying to value an unlisted company with
unpredictable future growth.
There are five variables which are input into the BSOP model to determine the value of the option. Proxies need
to be established for each variable when using the BSOP model to value a company. The five variables are: the
value of the underlying asset, the exercise price, the time to expiry, the volatility of the underlying asset value and
the risk free rate of return.
For the exercise price, the debt of the company is taken. In its simplest form, the assumption is that the borrowing
is in the form of zero coupon debt, i.e., a discount bond. In practice such debt is not used as a primary source of
company finance and so we calculate the value of an equivalent bond with the same yield and term to maturity as
the company‟s existing debt. The exercise price in valuing the business as a call option is the value of the
outstanding debt calculated as the present value of a zero coupon bond offering the same yield as the current
debt. The proxy for the value of the underlying asset is the fair value of the company‟s assets less current
liabilities on the basis that if the company is broken up and sold, then that is what the assets would be worth to the
long-term debt holders and the equity holders.
The time to expiry is the period of the time before the debt is due for redemption. The owners of the company
have that time before the option needs to be exercised, that is when the debt holders need to be repaid.
The proxy for the volatility of the underlying asset is the volatility of the business‟ assets.
The risk-free rate is usually the rate on a riskless investment such as a short-term government bond.

30 | P a g e Accountants Wake-Up
 20. QUESTION 6 – MARCH/JULY 2020

Write a report to a private client covering the topics outlined below.

a. Explanation of the „risk/return trade-off‟. (6 Marks)
b. Explanation of the role of financial intermediaries and their usefulness to the private investor. (8 Marks)
c. Identification of the effects on private sector businesses of a significant public sector budget deficit. (6
Marks) (Total 20 Marks)

Solution

a) Report Format

The risk/return trade-off

There is a trade-off between risk and return. Investors in riskier assets expect to be compensated for the risk. In
the case of ordinary shares, investors hope to achieve their return in the form of an increase in the share price (a
capital gain) as well as from dividends.
An investor has the choice between different forms of investment. The investor may earn interest by depositing
funds with a financial intermediary who will lend on to, say, a company, or it may invest in loan notes of a
company. Alternatively, the investor may invest directly in a company by purchasing shares in it.
The current market price of a security is found by discounting the future expected earnings stream at a rate
suitably adjusted for risk. This means that investments carrying a higher degree of risk will demand a higher rate
of return. Y
This rate of return or yield has two components:
i. Annual income (dividend or interest); and
ii. Expected capital gain
In general, the higher the risk of the security, the more important is the capital gain component of the expected
yield.

b) The role of financial intermediaries

A financial intermediary is an institution that links Ienders with borrowers, by obtaining deposits from lenders and
then re-Iending them to borrowers. In Nigeria, the intermediaries include:
i. Commercial banks;
ii. Merchant banks;
iii. Finance houses; and
iv. Insurance companies.

Benefits of financial intermediation

i. Reduction of risk through pooling

Since financial intermediaries lend to a large number of individuals and organisations, losses suffered through
default by borrowers or through capital losses are effectively pooled and borne as costs by the intermediary.
Provided that the intermediary is itself financially sound, the lender should not run the risk of losing his
investment. Bad debts are borne by the financial intermediary in its re- lending operation.

ii. Maturity transformation

An example of this is the mortgage banks, which allows depositors to have immediate access to their savings
while lending to mortgage holders for 25 years. The intermediary takes advantage of the continual turnover of
cash between borrowers and investors to achieve this.

31 | P a g e Accountants Wake-Up
 iii. Convenience

They provide a simple way for the lender to invest, without him having personally to find a suitable borrower
directly. All the investor has to decide is for how long the money is to be deposited and what sort of return is
required; all he then has to do is to choose an appropriate intermediary and form of deposit.

iv. Regulation

There is a comprehensive system of regulation in place in the financial markets that is aimed at protecting the
investor against negligence or malpractice.

v. Information

Intermediaries can offer a wide range of specialist expert advice on the various investment opportunities that is not
directly available to the private investor.

c) A public sector budget deficit

A public sector budget deficit arises when government expenditure exceeds the revenue. The government will be
forced to raise money to finance the deficit, either through borrowing or issuing securities. The effects of a higher
level of government spending and the need of the government to raise money to finance the deficit will affect
private sector businesses in a number of ways.

i) A proportion of the higher spending is likely to be with private sector businesses. Thus a high level of public
spending can boost demand in the economy and have a positive impact on business either directly or through the
multiplier effect.

ii) If the deficit is financed by government borrowings this will put upward pressure on interest rates and thus
increase the financing costs of private sector business, as well as putting pressure on their cash flow and
restricting the funds available for new investment.

iii) A further effect of high interest rates may be to depress share prices, thereby reducing the ability of businesses
to raise new capital for investment.

iv) The additional level of demand in the economy may boost inflationary pressures. Expectations of higher
inflation will generally cause a fall in the level of optimism about the economy and place pressure on private
sector investment.

(v) High domestic interest rates are likely to strengthen the exchange rate making it harder for businesses to
export. At the same time imports will become cheaper thus increasing competitive pressures in the home market.

21. QUESTION 3 – NOVEMBER 2020

a. What are the main responsibilities faced by companies when developing an ethical framework, and in
what ways can these responsibilities be addressed? (10 Marks)
b. Discuss how ethical considerations impact on each of the main functional areas of a firm. (10 Marks)
(Total 20 Marks)

32 | P a g e Accountants Wake-Up
 Solution

a) The main responsibilities faced by companies when developing an ethical framework are:

i) Economic
ii) Legal
iii) Ethical
iv) Philanthropic

The ways in which these responsibilities can be addressed are:

Economic
i) Management should always be acting in the best interests of the company's shareholders, and should
therefore always be actively making decisions that will increase shareholders' wealth.
ii) Projects that have positive NPVs should be pursued as far as funds will allow, as such projects will increase
the value of the company and thus shareholders' wealth.
iii) While management may have a different attitude towards risk than do the shareholders, they should always
manage risk according to shareholders' requirements.
iv) Financing - the optimal financing mix between debt and equity should be chosen as far as possible.
v) Dividends - there is no legal obligation to pay dividends to ordinary shareholders, but the reasons for
withholding dividends must be in the interests of the company as a whole (for example, maintaining funds
within the company in order to finance future investment projects).

Legal
i) Companies must ensure that they are abiding by the rules and regulations that govern how they operate.
Company law, health and safety, accounting standards and environmental standards are examples of these
boundaries.

Failure to abide by the rules can cost companies dearly. One only has to look at the fate of WorldCom and Enron
bosses, as well as Nick Lesson of Barings Bank, for examples of how failure to operate within the legal
framework can cause companies to collapse, taking with them the jobs (and often pension funds) of thousands of
employees.

Ethical
i) Ethical responsibilities arise from a moral requirement for companies to act in an ethical manner.
ii) Pursuit of ethical behaviour can be governed by such elements as:
Mission statements
Ethics managers
Reporting channels to allow employees to expose unethical behaviour
Ethics training and education (including ethics manuals)

Philanthropic
i) Anything that improves the welfare of employees, the local community or the wider environment.
ii) Examples: provision of an employees' gym; sponsorship of sporting events; charitable donations.
Alternative relevant points should be rewarded accordingly

b) Main functional areas of a firm include:

i) Human resources
ii) Marketing
iii) Market behaviour
iv) Product development

33 | P a g e Accountants Wake-Up
 Human resources
i) Provision of minimum wage. In recent years, much has been made of 'cheap labour' and 'sweat shops'. The
introduction of the minimum wage is designed to show that companies have an ethical approach to how they
treat their employees and are prepared to pay them an acceptable amount for the work they do.
ii) Discrimination - whether by age, gender, race or religion. It is no longer acceptable for employers to
discriminate against employees for any reason - all employees are deemed to be equal and should not
be prevented from progressing within the company for any discriminatory reason.

Marketing
i) Marketing campaigns should be truthful and should not claim that products or services to something that they
in fact cannot.
ii) Campaigns should avoid creating artificial wants. This is particularly true with children's toys, as children
are very receptive to aggressive advertising.

Do not target vulnerable groups (linked with above) or create a feeling of inferiority. Again, this is particularly true
with children and teenagers, who are very easily led by what their peer groups have. The elderly are also
vulnerable, particularly when it comes to such things as electricity and gas charges - making false promises
regarding cheaper heating for example may cause the elderly to change companies when such action is not
necessary and may in fact be detrimental.

Market behaviour
i) Companies should not exploit their dominant market position by charging vastly inflated prices.
ii) Large companies should also avoid exploiting suppliers if these suppliers rely on large company business
for survival. Unethical behaviour could include refusing to pay a fair price for the goods and forcing suppliers to
provide goods and services at uneconomical prices.

Product development
i) Companies should strive to use ethical means to develop new products - for example, more and more
cosmetics companies are not testing on animals, an idea pioneered by such companies as The Body
Shop.
ii) Companies should be sympathetic to the potential beliefs of shareholders - for example, there may be large
blocks of shareholders who are strongly opposed to animal testing. Managers could of course argue that if
potential investors were aware that the company tested their products on animals then they should not have
purchased shares.
iii) When developing products, be sympathetic to the public mood on certain issues - the use of real fur is
now frowned upon in many countries; dolphin-friendly tuna is now commonplace.
iv) Use of Fairtrade products and services - for example, Green and Blacks Fairtrade chocolate; Marks
&.Spencer using Fairtrade cotton in clothing and selling Fairtrade coffee.

21. QUESTION 3 – NOVEMBER 2020

You work with a large private company operating in several sectors of the Nigerian economy. The company is
currently being prepared for listing on the stock market through introduction. You are part of the committee
charged with the responsibility of providing corporate financial and non-financial information required for publicity.
You are preparing an initial briefing to other members of the committee.

Required:
a. Discuss and provide examples of the types of non-financial, ethical and environmental issues that might
influence the objectives of companies. Consider the impact of these non-financial, ethical and environmental
issues on the achievement of primary financial objectives such as the maximisation of shareholder wealth. (12
Marks)

b. Discuss generally, the nature of the financial objectives that may be set in a not-for-profit organisation such as
a charity or a hospital. (8 Marks)
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 (Total 20 Marks)

35 | P a g e Accountants Wake-Up
 Solution

a) Non-financial issues, ethical and environmental issues in many cases overlap, and have become of increasing
significance to the achievement of primary financial objectives such as the maximisation of shareholder wealth.
Most companies have a series of secondary objectives that encompass many of these issues.

Traditional non-financial issues affecting companies include:

i) Measures that increase the welfare of employees such as the provision of housing, good and safe working
conditions, social and recreational facilities. These might also relate to managers and encompass generous
perquisites.
ii) Welfare of the local community and society as a whole. This has become of increasing significance, with
companies accepting that they have some responsibility beyond their normal stakeholders in that their actions
may impact on the environment and the quality of life of third parties.
iii) Provision of, or fulfilment of, a service. Many organizations, both in the public sector and private sector provide
a service, for example to remote communities, which would not be provided on purely economic grounds.
iv) Growth of an organization, which might bring more power, prestige, and a larger market share, but might
adversely affect shareholder wealth.
v) Quality, many engineering companies have been accused of focusing upon quality rather than cost effective
solutions.
vi) Survival, Although to some extent linked to financial objectives, managers might place corporate survival (and
hence retaining their jobs) ahead of wealth maximisation. An obvious effect might be to avoid undertaking risky
investments.

Ethical issues of companies were brought into sharp focus by the actions of Enron and others. There is a trade-
off between applying a high standard of ethics and increasing cash flow or maximisation of shareholder wealth. A
company might face ethical dilemmas with respect to the amount and accuracy of information it provides to its
stakeholders. An ethical issue attracting much attention is the possible payment of excessive remuneration to
senior directors, including very large bonuses and „golden parachutes‟.

Environmental issues might have very direct effects on companies. If natural resources become depleted the
company may not be able to sustain its activities, weather and climate factors can influence the achievement of
corporate objectives through their impact on crops, the availability of water etc. Extreme environmental disasters
such as typhoons, floods, earthquakes, and volcanic eruptions will also impact on companies‟ cash flow, as will
obvious environmental considerations such as the location of mountains, deserts, or communications facilities.
Should companies develop new technologies that will improve the environment, such as cleaner petrol or
alternative fuels? Such developments might not be the cheapest alternative.
Environmental legislations is a major influence in many countries. This includes limitations on where operations
may be located and in what form, and regulations regarding waste products, noise and physical pollutants.
All of these issues have received considerable publicity and attention in recent years. Environmental pressure
groups are prominent in many countries; companies are now producing social and environmental accounting
reports, and/or corporate social responsibility reports. Companies increasingly have multiple objectives that
address some or all of these three issues. In the short-term non-financial, ethical and environmental issues might
result in a reduction in shareholder wealth; in the longer term, it is argued that only companies that address these
issues will succeed.

b) In the case of a not-for-profit (NFP) organization, the limit on the services that can be provided is the amount of
funds that are available in a given period. A key financial objective for an NFP organization such as a charity is
therefore to raise as much funds as possible. The fund-raising efforts of a charity is therefore to raise as much
funds as possible. The fund-raising efforts of a charity may be directed towards the public or to grant-making
bodies. In addition, a charity may have income from investment made from surplus funds from previous periods.
In any period, however, a charity is likely to know from previous experience the amount and timing of the funds
available for use. The same is true for an NFP organization funded by the government, such as a hospital, since
such an organization will operate under budget constraints or cash limits. Whether funded by the government or
not, NFP organisation

36 | P a g e Accountants Wake-Up
 will therefore have the financial objective of keeping spending within budget, and budgets will play an important
role in controlling spending and in specifying the level of services or programmes it is planned to provide.
Since the amount of funding available is limited, NFP organisations will seek to generate the maximum benefit
from available funds. They will obtain resources for use by the organisation as economically as possible: they will
employ these resources efficiently, minimising waste and cutting back on any activities that do not assist in
achieving the organization‟s non-financial objectives; and they will ensure that their operations are directed as
effectively as possible towards meeting their objectives. The goals of economy, efficiency and effectiveness are
collectively referred to as value for money (VFM). Economy is concerned with minimising the input costs for a
given level of output. Efficiency is concerned with maximising the outputs obtained from a given level of input
resources, i.e with the process of transforming economic resources into desires services. Effectiveness is
concerned with the extent to which non-financial organizational goals are achieved. Measuring the achievement of
the financial objective of VFM is difficult because the non-financial goals of NFP organisations are not quantifiable
and so not directly measurable. However, current performance can be compared to historic performance to
ascertain the extent to which positive change has occurred. The availability of the healthcare provided by a
hospital, for example, can be measured by the time that the patients have to wait for treatment or for an operation,
and waiting times can be compared year on year to determine the extent to which improvements have been
achieved or publicised targets have been met.
Lacking a profit motive, NFP organizations will have financial objectives that relate to the effective use of
resources, such as achieving a target return on capital employed. In an organization funded by the government
from finance raised through taxation or public sector borrowing, this financial objective will be centrally imposed.
100

22. QUESTION – MAY 2014 Q4

A number of investigations have been undertaken into the use by shareholders of the Annual Reports and
Financial Statements of Companies in which they have invested. Several of these show that the Annual Reports
and Financial Statements are regarded as important sources of information for making decisions on equity
investment. Other types of studies indicate that the market price of the shares in a company does not react in the
short term to the publication of the Company’s Annual Reports and Financial Statements.

a. Explain briefly the concept of the Efficient Market Hypothesis (EMH) and each of its forms and the
degree to which existing empirical evidence supports them.

b. State and explain the implication of each of the Efficient Market Hypotheses for investment policy as
it applies to:
i. Technical analysis in form of charting
ii. Fundamental analysis

c. Explain any TWO major roles or responsibilities of portfolio managers in an efficient market environment.

SOLUTION

a. Capital markets are said to be efficient when prices of securities in such markets fully reflect all
information about the company, the industry to which it belongs and the economy as a whole.
This means that any new information about a company coming into the market is immediately
reflected in the price of the share of the company such that no investor can make above
average return on an investment.
In a supposedly efficient market, the price of a security is expected to fluctuate randomly
around its true or intrinsic value. Efficient simply means security is price efficient. The price is
right and represents the best estimate of the security’s true value based on the available
information.
37 | P a g e Accountants Wake-Up
 Forms of efficiency:
The Weak Form: This form of efficiency implies that information about past share price
movement is already reflected in the current market price. Therefore, the ability to forecast
future prices cannot be enhanced based on the use of past information alone.

The Semi-Strong Form: This form states that the current market price of a
security, fully and immediately reflects all publicly available information including information
from financial statements, Chairman’s report and news items. Here, insider information is
excluded.

The Strong Form: This form of efficiency implies that all pieces of information both public and
private (including insider information) are fully and immediately reflected in the current
market price of the security. Insider information is said to be information that is known
to management but unknown to the public.

b(i) Technical analysis in form of charting: This states that future patterns of share prices are a
repetition of the same pattern of price movements which has occurred in the past, i.e. historical
price patterns are repeated in the future. The proponents of this theory believe that share
prices/values can be measured in the following ways:
- Primary trends show the upward or downward movement of share prices over a year or
more.
- Secondary trends show the fluctuations over a period of one a month
- Tertiary trends show fluctuations over a period of days.

(ii) Fundamental Analysis

The theory states that, at any point in time, a share has an intrinsic value which is the
discounted present value of the expected future cash receipts from the share.
The expectation of future receipts may relate to
- Past results of the company.
- Ratio analysis of the latest published accounts.
- Future plans or expectations of the company, possibly as a result of published
statements i.e. the company reports.
- Influences affecting the economy or industry as a whole.

As investors’ expectations about future earnings change, the intrinsic value of the shares, and
therefore their market price, moves up or down.

b. Roles or responsibilities of portfolio managers in an efficient market environment

include:

- Portfolio managers should be prepared to always release information about their activities to
the market as any such information, particularly the positive one, will immediately be
incorporated into the share price and result in an upward price movement for the benefit of
the shareholders.
- Portfolio managers should not waste their time waiting for a recovery of

38 | P a g e Accountants Wake-Up
 the price of the security in a depressed market before they come with new issues.
If the market is efficient and security prices emerge in a random fashion, there is no reason
to believe that just because they were high in the past, they will move back to the old levels.
- Portfolio managers should not waste their time looking for a security that
would provide returns in excess of the normal or expected returns simply by analysing past
information on the direction of share price or by analysing new economic information about
the security or the company.
It is only when an investor has access to information which has not come to the knowledge
of the investing public at large that an above average return can be made.

23. QUESTION – MAY 2021 Q3

You work with a large private company operating in several sectors of the Nigerian economy. The company is
currently being prepared for listing on the stock market through introduction. You are part of the committee
charged with the responsibility of providing corporate financial and non-financial information required for publicity.
You are preparing an initial briefing to other members of the committee.
Required:
a. Discuss and provide examples of the types of non-financial, ethical and environmental issues that might
influence the objectives of companies. Consider the impact of these non-financial, ethical and environmental
issues on the achievement of primary financial objectives such as the maximisation of shareholder wealth.
(12 Marks)
b. Discuss generally, the nature of the financial objectives that may be set in a not-for-profit organisation such
as a charity or a hospital. (8 Marks)
(Total 20 Marks)

SOLUTION

a) Non-financial issues, ethical and environmental issues in many cases overlap, and have become of
increasing significance to the achievement of primary financial objectives such as the maximisation of
shareholder wealth. Most companies have a series of secondary objectives that encompass many of these
issues.

Traditional non-financial issues affecting companies include:

i) Measures that increase the welfare of employees such as the provision of housing, good and safe
working conditions, social and recreational facilities. These might also relate to managers and encompass
generous perquisites.
ii) Welfare of the local community and society as a whole. This has become of increasing significance, with
companies accepting that they have some responsibility beyond their normal stakeholders in that their
actions may impact on the environment and the quality of life of third parties.
iii) Provision of, or fulfilment of, a service. Many organizations, both in the public sector and private sector
provide a service, for example to remote communities, which would not be provided on purely economic
grounds.
iv) Growth of an organization, which might bring more power, prestige, and a larger market share, but
might adversely affect shareholder wealth.
v) Quality, many engineering companies have been accused of focusing upon quality rather than cost
effective solutions.
vi) Survival, Although to some extent linked to financial objectives, managers might place corporate survival
(and hence retaining their jobs) ahead of wealth maximisation. An obvious effect might be to avoid undertaking
risky investments.
Ethical issues of companies were brought into sharp focus by the actions of Enron and others. There is a trade-off
between applying a high standard of ethics and increasing cash flow or maximisation of shareholder wealth. A
39 | P a g e Accountants Wake-Up
 company might face ethical dilemmas with respect to the amount and accuracy of information it provides to its

40 | P a g e Accountants Wake-Up
 stakeholders. An ethical issue attracting much attention is the possible payment of excessive remuneration to
senior directors, including very large bonuses and „golden parachutes‟.
Environmental issues might have very direct effects on companies. If natural resources become depleted the
company may not be able to sustain its activities, weather and climate factors can influence the achievement of
corporate objectives through their impact on crops, the availability of water etc. Extreme environmental disasters
such as typhoons, floods, earthquakes, and volcanic eruptions will also impact on companies‟ cash flow, as will
obvious environmental considerations such as the location of mountains, deserts, or communications facilities.
Should companies develop new technologies that will improve the environment, such as cleaner petrol or
alternative fuels? Such developments might not be the cheapest alternative.
Environmental legislations is a major influence in many countries. This includes limitations on where operations
may be located and in what form, and regulations regarding waste products, noise and physical pollutants.
All of these issues have received considerable publicity and attention in recent years. Environmental pressure
groups are prominent in many countries; companies are now producing social and environmental accounting
reports, and/or corporate social responsibility reports. Companies increasingly have multiple objectives that
address some or all of these three issues. In the short-term non-financial, ethical and environmental issues might
result in a reduction in shareholder wealth; in the longer term, it is argued that only companies that address these
issues will succeed.

b) In the case of a not-for-profit (NFP) organization, the limit on the services that can be provided is the amount
of funds that are available in a given period. A key financial objective for an NFP organization such as a charity is
therefore to raise as much funds as possible. The fund-raising efforts of a charity is therefore to raise as much
funds as possible. The fund-raising efforts of a charity may be directed towards the public or to grant-making
bodies. In addition, a charity may have income from investment made from surplus funds from previous periods.
In any period, however, a charity is likely to know from previous experience the amount and timing of the funds
available for use. The same is true for an NFP organization funded by the government, such as a hospital, since
such an organization will operate under budget constraints or cash limits. Whether funded by the government or
not, NFP organisation will therefore have the financial objective of keeping spending within budget, and budgets
will play an important role in controlling spending and in specifying the level of services or programmes it is
planned to provide.
Since the amount of funding available is limited, NFP organisations will seek to generate the maximum benefit
from available funds. They will obtain resources for use by the organisation as economically as possible: they will
employ these resources efficiently, minimising waste and cutting back on any activities that do not assist in
achieving the organization‟s non-financial objectives; and they will ensure that their operations are directed as
effectively as possible towards meeting their objectives. The goals of economy, efficiency and effectiveness are
collectively referred to as value for money (VFM). Economy is concerned with minimising the input costs for a
given level of output. Efficiency is concerned with maximising the outputs obtained from a given level of input
resources, i.e with the process of transforming economic resources into desires services. Effectiveness is
concerned with the extent to which non-financial organizational goals are achieved. Measuring the achievement
of the financial objective of VFM is difficult because the non-financial goals of NFP organisations are not
quantifiable and so not directly measurable. However, current performance can be compared to historic
performance to ascertain the extent to which positive change has occurred. The availability of the healthcare
provided by a hospital, for example, can be measured by the time that the patients have to wait for treatment or
for an operation, and waiting times can be compared year on year to determine the extent to which
improvements have been achieved or publicised targets have been met.
Lacking a profit motive, NFP organizations will have financial objectives that relate to the effective use of
resources, such as achieving a target return on capital employed. In an organization funded by the government
from finance raised through taxation or public sector borrowing, this financial objective will be centrally imposed.

41 | P a g e Accountants Wake-Up
 24. QUESTION – NOVEMBER 2021 Q4
Leye Limited (LL) is a privately-owned toy manufacturer in Nigeria. It trades internationally both as a supplier
and a customer. Although LL is privately owned, it has revenue and assets equivalent in amount to some public
listed companies. It has a large number of shareholders, but has no intention of seeking a listing at the present
time. In fact, the major shareholders have often expressed a wish to buy out some of the smaller investors.
The entity has a long history of sound and spectacular profitability. The directors and shareholders are
reasonably happy with this situation and are averse to adopting strategies that they think involve a substantial
increase in risk, for example, acquisition or setting up manufacturing capability overseas. As a consequence, LL
accepts its growth rate will be relatively low, compared with some of its competitors.
The entity is financed 70% equity and 30% debt (based on book values). The debt is a mixture of secured and
unsecured bonds carrying interest rates of between 7% and 8.5% and repayable in 5 to 10 years‘ time. Assume
for this purpose that inflation is near zero and interest rates are low and possibly falling. The Company
Treasurer is investigating the opportunities for, and consequences of refinancing.
LL‘s main financial objective is simply to increase dividends each year. It has one non-financial objective, which is
to treat all stakeholders in the organisation with ‗‘fairness and equality‘‘. The Board has decided to review these
objectives. The new Finance Director believes maximisation of shareholder wealth should be the sole objective,
but the other directors do not agree and think a range of objectives should be considered, for example profits after
tax and return on investment and performance improvement across a number of operational areas.
Required:
a. Evaluate the appropriateness of LL‘s current objectives and the Finance Director‘s suggestion, and discuss
the issues that the LL Board should consider when determining the new corporate objectives. Conclude with a
recommendation. (10 Marks)
b. Discuss the factors that the treasury department should consider when determining financing, or re-financing
strategies in the context of the economic environment described in the scenario and explain how these might
impact on the determination of corporate objectives. (10 Marks)
(Total 20 Marks)

SOLUTION

a) Evaluation
Theory supports the Finance Director, suggesting that maximisation of shareholder wealth is the only true
objective of the entity – now considered an extreme view – and one which may have contributed to some of the
corporate scandals in recent years that have occasioned the increase in corporate governance requirements.
Many entities now establish objectives that aim to maximise shareholders‘ wealth while recognising constraints,
legally enforceable or voluntary, imposed by society.
A major problem with this objective in the circumstances of LL is that this is a private entity that does not have a
quoted share price. Shareholders‘ wealth, as traditionally valued, is difficult to determine.
Looking only at dividends as an objective has its limitations, for example dividends could increase while
earnings fall. The dividend ratio therefore needs to be considered alongside dividend payout. Alternatives such as
those being considered by other directors, are therefore worth further consideration.
For example: profitability as measured by returns after tax and return on investment. The main advantages are:
Well understood measures and recognised guidelines are available in the form of International Accounting
Standards.
Shareholders expect profitability – and indeed the current objective is to increase earnings.

Disadvantages are:
Accounting ratios are historic and backward-looking;
They are subject to manipulation;
A variety of accounting policies are available – even within Accounting Standards; and
Tax can be affected by factors outside the control of managers.

42 | P a g e Accountants Wake-Up
 Recommendation
Maximisation of shareholder wealth, using the theoretical definition, is difficult to apply in the circumstances of LL.
As a minimum it would be worth introducing an objective that incorporates earnings growth as well as dividend
growth.
A range of objectives could be considered, such as risk-related returns to investors, but again this is more difficult
with a private entity than one with a share listing.
The entity needs to consult its shareholders and possibly, consider using a balanced scorecard approach to
determine a range of objectives appropriate for an entity such as LL.

The scenario in this question concerns a large privately owned entity based in Nigeria. It trades internationally,
both as a supplier and customer. Inflation is zero and interest rates are low and, possibly falling. The treasury
department needs to decide how to deal with the challenges and opportunities the specific set of circumstances
provide and evaluate the impact on the entity‘s capital structure.
(i) Finance theory suggests that entities should use a judicious amount of debt in their capital structure to lower
cost of capital. Debt is cheaper than equity because interest payments attract tax relief and are (generally)
cheaper than equity. This is because interest is (usually) secured and providers of debt do not participate in
profits. Here we have a mixture of secured and unsecured debt, but the entity appears sound and of high
credit worthiness so should be able to borrow at comparatively favourable rates.
(ii) This might even be an argument in favour of increasing gearing which will provide the ability to pay a
special dividend or undertaken a share buyback, as seems to be the desire of the major shareholders.
(iii) The opposite argument is that in a period of low and falling interest rates, fixed rate debt becomes a
burden. Some of the reasons are as follows:
The real value of debt is not being eroded when there is low or no inflation, so one of the benefits of debt
disappears;
The return on assets funded by debt will fall and lower taxable profits, meaning the tax benefit of debt is
reduced;
If the growth is low, debt interest may have to be paid out of static (or even falling) profits, lowering return to
shareholders;
Although interest rates may fall, they never become negative, so the real cost of borrowing increases;
The equity risk premium will tend to be less in inflationary times, so equity is relatively less expensive;
and
Raising equity is safer if profits really dive; dividends do not have to be paid and the shareholders do not get
their money back in a liquidation. However, raising new equity in a private entity is more difficult than in a public
entity, where shares are listed so there is a ready benchmark for the price of new shares.

(iv) Floating rate debt overcomes some of these concerns, but if markets are efficient then the interest
rate obtainable should reflect expectations.

(v) In theory (according to MM), the mix of debt and equity does not affect the value of profits to three groups
of stakeholders: lenders, government (taxers) and owners (shareholders).
(vi) The main question is therefore what combination of dividend policy and capital structure is likely to
maximise the present value of cash flows to shareholders. This is where the financing strategies adopted
contribute to the achievement of the objectives of the entity.

The treasury department needs to specifically look at:

Terms of existing borrowing to see if refinancing at lower rates is feasible, recognising any possible penalties
for early retirement of loans; and
Discuss with the directors and major shareholders the possibility (or even probability) that returns are likely to
be lower. The lower the rate of interest, the lower the cost of capital and therefore, the return that can be
expected

43 | P a g e Accountants Wake-Up
 – not least because the rate sought by competitors will be lower.

44 | P a g e Accountants Wake-Up
 25. QUESTION – NOVEMBER 2021 Q5
a. Ibile is a local government entity. It is financed almost equally by a

combination of central government funding and local taxation. The funding from central government is
determined largely on a per capita (per head of population) basis, adjusted to reflect the scale of deprivation (or
special needs) deemed to exist in Ibile‘s region. A small percentage of its finance comes from the private sector,
for example from renting out City Hall for private functions.
Ibile‘s main objectives are:
To make the region economically prosperous and an attractive place to live and work; and
To provide service excellence in health and education for the local community.

b. Layo is a large, listed entity with widespread commercial and geographical

interests. For historic reasons, its headquarters are in Ibile‘s region. This is an anomaly as most entities of Layo‘s
size would have their HQ in a capital city, or at least a city much larger than Ibile.
Layo has one financial objective: To increase shareholders‘ wealth by an average of 10% per annum. It also has
a series of non-financial objectives that deal with how the entity treats other stakeholders, including the local
communities where it operates.
Layo has total net assets of ₦1.5 billion and a gearing ratio of 45% (debt to debt plus equity), which is typical for
its industry. It is currently considering raising a substantial amount of capital to finance an acquisition.
Required:
Discuss the criteria that the two entities described above have to consider when setting objectives, recognising
the needs of each of their main stakeholder groups.
Make some reference in your answer to the consequences of each of them failing to meet its declared objectives.
(Total 15 Marks)

SOLUTION

The main issues to consider when determining objectives are:

Who are the main stakeholders?

In the case of Ibile, it is the local population who are the main stakeholders, irrespective of whether or not they are
taxpayers. The concept of ―universal service‖ means a local government body must allow all inhabitants equal
access to services. The government is also a major stakeholder as it provides much of the finance.
In the case of Layo, the main stakeholders are the shareholders who provide the risk capital of the business. The
entity needs to recognise the needs of this group, in respect of the risk/return relationship and the attitude to
dividends versus capital growth.
Both entities have other groups of stakeholders, such as employees and suppliers, but nowadays there is likely
to be little difference in how the two entities recognise these groups when setting objectives. An interesting fact
about Layo is that it chooses to maintain its HQ in a relatively small town. This suggests the company takes
seriously its responsibilities to ―minor‖ stakeholders, such as employees and the local community and makes it
even more comparable with Ibile than many large listed companies. There could also be implications of this
decision for shareholders, although whether it is favourable (lower costs of an HQ) or otherwise (distance from
City and major shareholders perhaps) is hard to say.

Where is the financing coming from, and in what proportions?

Ibile is financed almost equally by central government and the local population. As central government‘s funding
comes from taxpayers, then many of Ibile‘s stakeholders and financiers will fall into both categories. Layo is
financed mainly by its shareholders, who are therefore its main stakeholders, as noted.
Are there other, higher level, objectives that will supersede those set by the public sector entity,
for example political aims/goals set by the government?
In the case of Ibile, the government‘s objectives cannot be ignored, although the political persuasion of the
elected council might influence the extent to which the central and local objectives complement each
other. Does the objective need to be measurable?
45 | P a g e Accountants Wake-Up
 The objectives of both entities are difficult to measure, but it is easier to interpret whether Layo has achieved its
objective than Ibile. Setting a financial objective has the main advantage of being measurable. If Ibile were to
have a financial objective it could be benchmarked against the performance of similar entities. Both public sector
and private sector entities should have measurable objectives to aid comparison with other similar entities.

Will information on the two entities' performance be subject to public scrutiny?

In both cases, the entities‘ performance will be public information. Ibile has to provide annual reports, as well as
a substantial amount of other information for its population. Layo has to provide annual reports and accounts, but
it is not legally obliged to provide information beyond what is required by Company Law and International
Financial Reporting Standards. The difference might be that those who scrutinise Layo‘s accounts and publicly
announced information are better able to absorb and analyse it than those who receive Ibile‘s information.

MAY,2022

QUESTION 4

The finance director of Keyman Plc. has recently reorganised the finance department following a number of
years of growth within the business, which now includes a number of overseas operations. The company
has created separate treasury and financial control departments.

Required:
a. Describe the main responsibilities of a treasury department, and comment on the advantages to
Keyman Plc. of having separate treasury and financial control departments. (14 Marks)

b. Identify the advantages and disadvantages of operating the treasury department as a profit
centre rather than a cost centre. (6 Marks)
(Total 20 Marks)

a) The treasury function represents one of the two main aspects of

financial management, the other being financial control.
Treasury is concerned with the relationship between the entity and
its financial stakeholders, which include shareholders, funds lenders
and taxation authorities, while financial control provides the relationship
with other stakeholders such as customers, suppliers, and employees.
In larger entities, treasury will usually be centralised at head office,
providing a service to the various units of the entity and thereby achieving
economies of scale. Financial control will frequently be delegated to
individual business units, where it can more closely impact on customers
and suppliers and relate more specifically to the competition which
those units have to face. As a result, treasury and financial control may
often be separated by location as well as by responsibilities.

The key tasks of the treasury can be categorised according to the three
levels of management as follows:
· Strategic – e.g. matters concerning the capital structure of the
business and distribution/retention policies, raising capital, including
share issues, assessment of the likely return from each source and
the appropriate proportions of funds from each source, the decision
as to the level of dividends, and consideration of alternative forms of
46 | P a g e Accountants Wake-Up
 finance;
· Tactical – e.g. the management of cash/investments and decisions as to
the hedging of currency or interest rate risk;
· Operational – e.g. the transmission of cash, placing of surplus cash
and other dealings with banks.
Treasurers require specialist skills to be able to handle effectively an
ever-growing range of capital instruments. They also need a knowledge of
taxation in all areas in which the group operates, and the ability to advise
on policies that have taxation implications.
Both the treasurer and the financial controller will usually be responsible
to the finance director. An example of how their roles may differ would be:
the

103

treasurer is best able to assess cost of capital and quantify the

entity’s aversion to risk, while the financial controller relates these factors
to group policy.

Advantages to the company of a separate treasury function

1. Control of cash will be recognised as a separate and significant
activity, concentrating on the most efficient use of this vital resource.
2. Cash-reporting packages will be receivable in a suitable form and in
good time to help management in making effective cash decisions.
3. The function will be geared to the short response times required for
cash transactions.
4. As a specialist user, treasury can ensure that information
technology software is made available to meet the specific needs of
cash/ currency management.
5. Corporate planning staff will be aided by expert advice and
quick feedback from specialists in such matters as interest rates and
currency movements.
6. Marketing management will be given a competitive edge by
specialist expertise and speed of response in making important
cash-based decisions, especially with regard to overseas projects and
transactions.
7. Treasury could provide a training ground in finance for future line
management, as its staff will need to be capable of making quick-
but-sound decisions.
8. Treasury could operate as a profit centre.
b) The main advantages of operating treasury as a profit centre rather than
as a cost centre are:

47 | P a g e Accountants Wake-Up
 · Individual business units of the entity can be charged a market rate
for the services provided, thereby making their operating costs
more realistic; and
· The treasurer is motivated to provide services as effectively
and economically as possible to ensure that a profit is made at the
market rate, e.g. in managing hedging activities for a subsidiary,
thereby benefiting the group as a whole.
The main disadvantages are:
· The profit concept is a temptation to speculate, e.g. by swapping
funds from currencies expected to depreciate into ones expected to
appreciate;
· Management time is spent in arguments with business units over
charges for services, even though market rates may have been
impartially checked (say by the internal audit department); and
· Additional administrative costs may be excessive.
MAY,2022

QUESTION 7

You are required to provide a briefing on the following dividend concepts:

a. Residual theory of dividends; (3 Marks) b.
Clientele effect; (3 Marks) c.
Asymmetric information; (2 Marks)
d. Signalling properties of dividends; e. The ‘bird-in-the-hand’ argument.

48 | P a g e Accountants Wake-Up
 (3 Marks) (4 Marks)
(Total 15 Marks)

a) Residual theory of dividends. Dividends are only paid out if the capital needs
of the enterprise (i.e. project with positive NPVs) are fully met and there are
funds left over. Corporate profits are cyclical, but capital investment plans
involve long-term commitments, then dividends take up the slack, as it were.

Financial managers cannot follow both a policy of stable dividends and a

policy of long-term commitment to capital investment, unless they
are willing to borrow in times of need to achieve both. With an objective
of shareholder wealth maximisation, if the enterprise can invest in
profitable projects (i.e. in excess of the cost of capital) and earn a higher
return than the shareholders can in their alternative investment
opportunities, then it should follow such a policy. Issues arise to strengthen
and weaken the approach with market imperfections.

b) Clientele effect. This is an appealing and persuasive argument that

enterprises attract particular types of shareholder by their nature and
actions. In this case, the argument is on dividend clienteles, but the
clientele argument could apply to leverage, growth enterprises.

The argument runs like this. Enterprises establish a track record for giving or
not giving dividends. Shareholders recognise this and because of their
preferences -receiving income now instead of the future because they need it
for consumption,
111
shareholders
or because of uncertainty and managers
(‘bird in the hand’), or the have
tax argument - having incomplete
attracted these clients, and different
companies find it difficult to information.
suddenly change their Managers do
policy. The empirical not know how
evidence on dividend shareholders
clienteles is generally not will react to a
supportive. dividend
change;
c) Asymmetric information. In
likewise
the context of dividends and
shareholders
dividend policy, this applies
are not party
to the fact that
to the
49 | P a g e Accountants Wake-Up
 information that is available are no
to managers. The result of transaction
asymmetry in information is costs,
the information content of dividends can
dividends, where dividends be capitalised
have signalling properties. into the share
This is taken up in (d) below. price as the
enterprise
d) Signalling properties of invests them
dividends. With asymmetry internally at
of information as in (c). NPVs of 0 or
above, dividends can be greater. If
represented as signals from shareholders
the managers of the need the cash
enterprise to the now, they
shareholders and financial engage in a
markets. For the home-made
successful transmission of dividend
the signal, it has to be policy
encoded and decoded. ofselling some
Evidence (from a survey) shares to
points to the perception of create the
investors, that dividends are flow of
a signalling device of future income. With
company prospects. With uncertainty, a
some exceptions, empirical series of other
studies indicate that dividend issues arise:
changes do convey some
unanticipated information to i) The
the market. There is still required
some controversy because rate of
this would deny the EMH. return, KE,
Thus it might be that rises as
dividend announcements do dividend
not signal new information pay-out is
but only confirm already reduced.
known or forecasted events. Risk-
averse
e) The ‘bird-in-the-hand’ investors
argument. This arises from are not
the existence of uncertainty. indifferent
If certainty exists and there
50 | P a g e Accountants Wake-Up
 to the division of Sharehol
earnings into dividends ders may
and capital gains in the prefer to
share price; have the
cash and
ii) It follows that to offset invest it
a 1% reduction in or spend
dividends requires a it,
more than 1% increase particular
(in the Gordon model); ly with
and the
iii) With volatile stock presence
markets, the of agency
maintenance of the costs.
increase in share price
is not guaranteed.

88

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52 | P a g e Accountants Wake-Up