CPA REVISION KIT SAMPLE (FM)

SECTION I

 QUESTION ONE

(a) Highlight four advantages and disadvantages to a company of being listed on a stock exchange. (8 marks) (b) In relation to the stock exchange” (i) Explain the role of the following members:
 Floor brokers (2 marks)
 Market makers (2 marks)
 Underwriters (2 marks)
(ii) Explain the meaning of the following terms:
 Bull and bear markets (2 marks)
 Bid-ask spread (2 marks)
 Short selling (2 marks)
(Total: 20 marks)

 QUESTION TWO

 (a) Multi-Link Ltd., a trading company, currently has negligible cash holdings but expects to make a series of cash payments totaling Sh.150 million over the forthcoming year. These payments will become due at a steady rate. Two alternative ways have been suggested of meeting these obligations. Alternative I The company can make periodic sales from existing holdings of short-term securities. The average percentage rate of return on these securities is 12 over the forthcoming year. Whenever Multi-Link Ltd. sells the securities, it will incur a transaction fee of Sh.15,000. The proceeds from the sale of the securities are placed on short-term deposit at 7% per annum interest until needed. Alternative II The company can arrange for a secured loan amounting to Sh.150 million for one year at an interest rate of 18% per annum based on the initial balance of the loan. The lender also imposes a flat arrangement fee of Sh.50,000 which would be met out of existing balances. The sum borrowed could be placed in a notice deposit at 9% per annum and drawn down at no cost as and when required. Multi-Link Ltd.‟s treasurer believes that cash balances will be run down at an even rate throughout the year.
  Required: (a) (i) Explain the weaknesses of the Baumol model in the management of cash. (3 marks)

(ii) Advise Multi-Link Ltd. as to the better alternative for managing its cash. (7 marks) (b) Lynx Services Ltd., a debt collection agency, has estimated that the standard deviation of its daily net cash flow is Sh.22,750. The company pays Sh.120 in transaction cost every time it transfers funds into and out of the money market. The rate of interest in the money market is 9.465%. The company uses the Miller-Orr Model to set its target cash balance. The minimum cash balance has been set at Sh.87,500.
Required: (i) The company‟s target cash balance. (3 marks) (ii) The lower and upper cash limit. (2 marks) (iii) Lynx Services Ltd.‟s decision rules. (5 marks) (Total: 20 marks)

 QUESTION THREE

 Magharibi Cane Millers Ltd. is a company engaged in the pressing and processing of sugar cane juice into refined sugar. For some time, the company has been considering the replacement of its three existing machines. The production manager has learnt from a professional newsletter on sugar of the availability of a new and larger machine whose capacity is such that it can produce the same level of output per annum currently produced by the three machines. Furthermore, the new machine would cut down on the wastage of juice during processing. If the old machines are not replaced, an extraordinary overhaul would be immediately necessary in order to maintain them in operational condition. This overhaul would at present cost Sh.5,000,000 in total. The following additional information is available: 1. The old machines were purchased 5 years ago and are being depreciated over 15 years on a straight line basis, with an estimated final scrap value of Sh.600,000 each. The current second hand market value of each of the machines is Sh.1,000,000. 2. The annual operating costs for each of the existing machines are:
Sh.
Sh.
Raw sugar cane Labour (one operator) Variable expense Maintenance (excluding overhaul expenditure) Fixed expenses: Depreciation Fixed factory overhead absorbed
75,000 2,700,000
60,000,000 1,350,000 925,000 2,000,000 - 2,775,000
3. The new machine has an estimated life of ten years and its initial cost will comprise:
Sh.
Purchase price (scrap value in 10 years Sh.4,500,000) Freight and installation
87,000,000 13,000,000
100,000,000
Questions – Past Papers 10
4. The estimated annual operating costs, if all the current output is processed on the new machine are:
Sh.
Sh.
Raw sugar cane Labour (one operator) Variable expense Maintenance (excluding overhaul expenditure) Fixed expenses: Depreciation Fixed factory overhead absorbed Maintenance
9,550,000 7,800,000
162,000,000 3,900,000 2,275,000 17,350,000 4,500,000
5. The company‟s cost of capital is 10%. 6. For a project to be implemented, it must pass both the profitability test, as indicated by its internal rate of return and also satisfy a financial viability test, in that it must pay back for itself within a maximum period of five years.

Required: (a) (i) Net present values of the proposed replacement decision using discount rates of 10% and 20%. (8 marks) (ii) The estimated internal rate of return (IRR) of the replacement decision using the values determined in (i) above. (4 marks) (iii) Advice management on the proposal based on your answer in (ii) above. (2 marks) (b) Decision as to whether the project meets the financial viability test. (4 marks) (c) Comment on any other qualitative considerations that could influence this decision. (2 marks) Note: Ignore taxation (Total: 20 marks)

QUESTION FOUR

Three years ago, Mrs. Rehema Waziri was retrenched from the Civil Service. She invested substantially all her terminal benefits in the shares of ABC Ltd., a company quoted on the stock exchange. The dividend payments from this investment makes up a significant position of Mrs Waziri‟s income. She was alarmed when ABC Ltd. dropped its year 2001 dividend to Sh.1.25 per share from Sh.1.75 per share which it had paid in the previous two years. Mrs Waziri has approached you for advice and you have gathered the information given below regarding the financial condition of ABC Ltd. and the finance sector as a whole.
11 Past Paper Questions and Answers
ABC Ltd. Balance Sheets as at 31 October
1999 Sh.‟000‟
2000 Sh.‟000‟
2001 Sh.‟000‟
Cash Accounts receivable Inventory Total current assets Land and buildings Machinery Other fixed assets Total assets Accounts and notes payable Accruals Total current liabilities Long term debt Ordinary share capital Retained earnings
15,250 80,320 98,600 194,170 25,230 33,800 14,920 268,120 34,220 15,700 49,920 60,850 115,000 42,350 268,120
14,400 87,800 158,800 261,000 27,600 36,400 18,200 343,200 73,760 34,000 107,760 60,858 115,000 59,582 343,200
8,000 134,400 254,000 396,400 25,000 30,600 16,400 468,400 135,848 67,000 202,848 81,720 115,000 68,832 468,400
ABC Ltd. Income Statements for the year ending 31 October
1999 Sh.‟000‟
2000 Sh.‟000‟
2001 Sh.‟000‟
Sales (all on credit) Cost of sales Gross profit General administrative and selling expenses Other operating expenses Earnings before interest and tax (EBIT) Interest expense Net income before taxes Taxes Net income
827,000 (661,600) 165,400 (63,600) (25,400) 76,400 (12,800) 63,600 (25,400) 38,200
858,000 (710,000) 148,000 (47,264) (31,800) 68,936 (26,800) 42,136 (16,854) 25,282
890,000 (712,000) 178,000 (51,200) (38,200) 88,600 (63,600) 25,000 (10,000) 15,000
Number of shares issued
4,600,000
4,600,000
4,600,000
Per share data: Earnings per share (EPS) Dividend per share Market price (average)
Sh. 8.30 Sh. 1.75 Sh.48.90
Sh. 5.50 Sh. 1.75 Sh.25.50
Sh. 3.26 Sh. 1.25 Sh.13.25

Industry Financial Ratios (2001)
Quick ratio Current ratio Inventory turnover Average collection period Fixed asset turnover Total assets turnover
1.0 2.7 7 times 32 days 13.0 times 2.6 times
Industry Financial rations
Net income to net worth Net profit margin on sales Price-Earnings (P/E) ratio Debt/Equity ratio
1.8% 3.5% 6 times 50%
Notes: 1. Industry ratios have been roughly constant for the past four years. 2. Inventory turnover, total assets turnover and fixed assets turnover are based on the year-end balance sheet figures.
Required: (a) The financial ratios for ABC Ltd for the past three years corresponding to industry ratios given above. (10 marks) (b) Arrange the ratios calculated in (a) above in columnar form and summarise the strengths and weaknesses revealed by these ratios based on: (i) Trends in the firm‟s ratios (6 marks) (ii) Comparison with industry averages. (6 marks) (The summary should focus on the liquidity, profitability and turnover ratios). (Total: 22 marks)

SECTION II
QUESTION FIVE

(a) List and explain five factors that should be taken into account by a businessman in making the choice between financing by short-term and long-term sources. (10 marks) (b) Enumerate four advantages of convertible bonds from the point of view of the borrower. (8 marks) (Total: 18 marks)

QUESTION SIX

 In a company, an agency problem may exist between management and shareholders on one hand and the debt holders (creditors and lenders) on the other because management and shareholders, who own and control the company have the incentive to enter into transactions that may transfer wealth from debt holders to shareholders. Hence the need for agreements by debt holders in lending contracts.
Required: (a) State and explain any four actions or transactions by management and shareholders that could be harmful to the interests of debt holders (sources of conflict). (8 marks) (b) Write short notes on any four restrictive covenants that debt holders may use to protect their wealth from management and shareholder raids. (10 marks) (Total: 18 marks)