ICAN SFM Past Questions 2014 - Nov 2023

THE INSTITUTE OF CHARTERED ACCOUNTANTS
OF NIGERIA
NOVEMBER 2014 PROFESSIONAL EXAMINATION

Question Papers
Suggested Solutions
Plus
Examiners’ Reports
PROFESSIONAL EXAMINATION – NOVEMBER 2014

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NOT TO BE SOLD | Compiled by: Babatunde Isaiah | Email: [email protected]
THE INSTITUTE OF CHARTERED ACCOUNTANTS OF NIGERIA
PROFESSIONAL LEVEL EXAMINATION - NOVEMBER 2014
STRATEGIC FINANCIAL MANAGEMENT
Time Allowed: 3 hours
SECTION A COMPULSORY QUESTION (30 Marks)
QUESTION 1
AK Plc is a company listed on the Nigerian Stock Exchange. It is involved in property

development and sales. The company currently imports more than 60% of its cement
requirements. At a recent meeting of the board of directors, a decision was taken to
establish a division for the production of cement in Ore, Ondo State. If the division is
set up and the cement production goes ahead, output from the division will be sold to
AK Plc. and external customers at market price. For planning purposes, it has been
decided that the financial viability of the project over the next five years should be
determined.
The sum of N2 billion will be required. The sum of N500 million will be spent to
acquire an existing factory considered suitable for the project. The balance of N1.5
billion will be applied for the procurement and installation of essential plant and
equipment. Tax allowance can be claimed on plant and equipment at a uniform
amount over 5 years with NIL scrap value.
A total of N20million has been spent on various surveys (market, technical, financial,
etc.) to date out of which N10million has been paid. The balance of N10million is due
for payment at the end of year 1.
Production of cement for the next five years is projected as follows:
Year Bags
1 500,000
2 600,000
3 650,000
4 800,000
5 700,000
A bag of cement sells currently for N2,000 in the open market. This price is expected
to increase at the rate of 5% per annum. Variable cost is now per bag. This will
increase at 4% per annum. Fixed overhead costs will be N50 million at current prices
but will rise by 8% per annum. Apportioned head office charges of N25million at
current prices will rise by 10% per annum. Fifty per cent (50%) of the total initial
outlay of N2billion is to be funded with a loan from a Federal Government

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Development Bank at a concessionary fixed interest rate of 8%, payable at the end of
each year. Half of the loan will be repaid at the end of year 3 while the balance will
be paid at the end of year 5. The project will require a working capital of 10% of
annual revenue and this should be available at the beginning of each year.
The company uses a current Weighted Average Cost of Capital (WACC) of 11% to
appraise all capital projects. The asset beta of the company is 1.2, equity beta is 1.6,
risk-free rate is 5%, while the market risk premium is 7%.
The Finance Director is of the view that it is not appropriate to use the existing WACC
to appraise the new project. He has identified a listed company which currently
produces cement and packaged fruit drinks. The company has the following financial
statistics:
Equity beta 1.82

Debt beta 0.4
Debt/Equity ratio 40%
60% of the market value of the company is attributed to cement production while 40%
of the value is attributed to the fruit drinks division. The fruit drinks division has
equity beta of 0.8.
The new project is expected to move AK Plc to the target Debt/Equity ratio of 30%. Tax
rate is 25% for the two companies and is paid in the year profit is made.
You are required to:
a. Compute the appropriate cost of capital that AK Plc should use to appraise the
cement project and state why you consider this rate more appropriate than the
existing WACC of 11%.
Note: Your final cost of capital should be rounded up to the nearest whole
number. State any assumptions made. (12 Marks)
b. Compute the Net Present Value (NPV) and the Modified Internal Rate of Return
(MIRR) of the project, assuming a cost of capital of 13%.
(Work to the nearest N million). (16 Marks)
c. Recommend whether the project should be accepted or not, using both NPV and
MIRR methods. (2 Marks)
(Total 30 Marks)

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SECTION B: ATTEMPT ANY TWO OUT OF THREE QUESTIONS (40 Marks)
QUESTION 2
Chelsy Plc has two manufacturing divisions, Bolts and Nuts. The Bolts division is
profitable whereas the Nuts division is not. The company’s share price has
consequently declined to 50 kobo per share from a price of N2.83 per share three years
ago.
The board of directors is considering two proposals:
i. To cease trading and close down the company.
ii. To close the Nuts division and continue Bolts division through a leveraged
management buyout. The new company will continue to manufacture bolts
only but will require an additional investment of N275million in order to grow
the Bolts division’s after tax cash flows by 3.5 per cent in perpetuity. The
proceeds from the sale of Nuts division will be applied to pay the division’s
outstanding liabilities. The finance raised from the management buyout will be
applied in paying any remaining liabilities, fund additional investment and
purchase the current equity shares at a premium of 20 per cent. The Nuts
division is twice the size of the Bolts division in terms of the assets attributable
to it.
Extracts from the most recent financial statements of Chelsy Plc are as follows:
Statement of Financial Position as at 31 December 2013.
N’000
Non-current assets 605,000
Current assets 1,210,000
Share capital (40 kobo per share) 220,000
Reserves 55,000
Liabilities (non-current and current) 1,540,000

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Comprehensive Income statement for the year ended 31 December 2013
N’000
Sales revenue: Bolts division 935,000
Nuts division 1,870,000
Costs prior to depreciation,
interest payments and tax:
Bolts division (660,000)
Nuts division (2,035,000)
Depreciation, interest and tax (187,000)
Loss (77,000)
If the company’s assets are sold, the estimated realisable values are as follows:
N’000
Current assets 605,000
The following additional information has been provided:
i. Redundancy and other costs will be approximately N297 million if the whole
company is closed and pro rata for individual divisions that are closed. These
costs have priority for payment before any other liabilities in case of closure.
The taxation effects relating to this may be ignored.
ii. Company income tax on profits is 30% and it can be assumed that tax is payable
in the year it is liable.
iii. Annual depreciation on non-current assets is 10% and this is the amount of
investment needed to maintain the current level of activity.
iv. The new company’s cost of capital is expected to be 11%.
Required:
a. Discuss, briefly, the possible benefits of divesting Bolts division through a

management buyout. (4 Marks)
b. Estimate the return the creditors and the shareholders will receive in the event
that Chelsy Plc is closed and all its assets sold. (3 Marks)
c. Estimate the additional amount of finance needed and the value of the new
company, if only the assets of Nuts division are sold and the Bolts division is
divested through a management buyout. (8 Marks)

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d. Discuss the issues that should be taken into consideration in relation to:
i. Seeking potential buyers and negotiating the price
ii. Due diligence

(Assume that the Nuts division is to be sold as a going concern)
(5 Marks)
(Total 20 Marks)
QUESTION 3
Syntax Plc., a fertilizer company, is concerned about fluctuating sales and earnings.
This caused the management of the company to consider acquisition of another
company in the same line of business.
In order to boost its sales and stabilise its earnings, Syntax Plc’s management has
identified Synapse Chemical Company Plc. as a possible target. Syntax proposed to
acquire Synapse for a consideration of N20 million and this was agreed to by the two
companies.
Synapse’s expected future profits as projected from its past financial records are as
follows:
2015 2016 2017 2018 2019

N’m N’m N’m N’m N’m
Revenue 60 70 78 86 94
Cost of sales 30 35 39 43 47
Other expenses 15 15 15 15 15
Depreciation 5 4 4 4 4
Total expenses 50 54 58 62 66
Profit before tax 10 16 20 24 28
The following information are relevant:
i. The forecast profits have been limited to five years.
ii. All sales are for cash.
iii. The net book value of Synapse’s assets of N2 million is intended to be sold for
N1 million in year 2015. The expected loss from the disposal of these assets has
been included in the depreciation for year 2015. These assets currently have a
tax written down value of N3 million. Capital allowances were claimed as at
when due.

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iv. Synapse currently has a tax liability of N4.5 million due for payment in 2015.
v. The interest charges of N1 million of Synapse Plc. have been included in other
expenses.
vi. In order to maintain the future earnings’ forecast of Synapse Chemical

Company, Syntax Plc. needs to invest in capital expenditure as follows:
Years 2015 2016 2017 2018 2019

Amount (N’M) 5 6 8 9 10
vii. Company income tax is currently at 30 per cent and the tax delay is one year.
viii. The after tax weighted average cost of capital has been calculated at 22%.
The management of Syntax Plc. has asked you, as a Financial Expert, to appraise the
intended acquisition of Synapse Chemical Company Plc. and advise on the
reasonableness of the acquisition.
Your advice should be in the form of a report to the Board of Directors of Syntax Plc.
(20 Marks)
QUESTION 4
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

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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)
SECTION C: ATTEMPT ANY TWO OUT OF THREE QUESTIONS (30 Marks)
QUESTION 5
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)
QUESTION 6
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)

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QUESTION 7
a. Build Nigeria Plc. (BNP) is a giant construction company with head office in
Kano, Nigeria. It is involved in construction of roads, dams, airfields, etc., in
many parts of the country. Recently, the company won construction contracts
across a number of African countries. One of the contracts is for the
construction of a dam for a country in Central Africa whose currency is Central
African dollar (C$). The dam has now been completed and the retention money
of C$210,000,000 is due for settlement in one year’s time.
The current spot exchange rate is C$40 = N1. Risk free rate is 5% in Nigeria and
25% in the foreign country.
The Chief Finance Officer (CFO) of BNP is worried about the above financial
statistics and concluded that BNP will lose as much as N840,000 due to
exchange rate movements between now and the end of the year when the
retention money is received.
You are required to explain, showing all relevant calculations, how the CFO
arrived at the potential loss of N840,000. (4 Marks)
b. In another contract in a country in the ECOWAS sub-region (with currency of

W$), BNP expects the following payment and receipt in six months time:
W$ million
Expected payment 450
Expected receipt 750
You are provided with the following financial data:
Spot exchange rate:

N per W$1 = 1.4735 – 1.4755
Money market rates
Deposit Borrowing
% %
Nigeria 13.25 16.5
The West African country 6.5 10.5
You are required to show how BNP can make use of money market hedge to
mitigate the foreign exchange risk inherent in the above payment and receipt.
Show all workings and the necessary steps. (7 Marks)
c. Discuss TWO advantages and TWO disadvantages of forward exchange contract.

(4 Marks)

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SOLUTION 1
(a) The appropriate cost of capital should reflect the business risk of the cement
industry and the financial risk of AK Plc.
Step 1: Determine the equity beta of the cement division of the given proxy
company. The given equity beta of the proxy company is a weighted
average of the equity beta of the cement division (which is unknown)
and that of the fruit drinks division (which is 0.8). If x is the unknown
equity beta, then:
0.6x + 0.4 (0.8) = 1.82
 0.6 x = 1.82 – 0.32
0.6x = 1.5 or x = 2.5
This reflects both the business risk of the cement industry and the financial risk
of the proxy company.
Step 2: Ungear the equity beta of the cement division to eliminate the financial
risk of the proxy company. The following formula is used:
 E × VE  D × VD 1  t 
A  
VE  VD 1  t  VE  VD 1  t 
Where  A = asset beta of the proxy company
 E = equity beta of the proxy company
 D = beta of debt of the proxy company
V E = value of equity of the proxy company,
V D = value of debt.
t = tax rate
Note: We actually do not need to know the absolute value of V E and V D . We

only need the relative values. With D/E ratio of 40%, we simply maintain the
ratio:
D: E = 40: 100 = 4: 10, etc.

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2.5 × 100 0.4 × 40(1  0.25)
A   = 2.02 or say 2
100  401  0.25 100  40(1  0.25)
This is the beta that reflects the systematic business risk of the cement industry.
Step 3: Regear the above asset beta using the target D/E ratio of Ak Plc – in
order to incorporate the financial risk of Ak Plc. The relevant formula
to use is:
 VD 
 E =  A +  A   D  1  t 
 VE 
Note:
V D = value of debt of Ak Plc
V E = value of equity of Ak Plc
 E = 2 + (2 – 0.4) (30/100) (1 – 0.25) = 2.36
Step 4: Determine cost of equity, using CAPM
K E = RF +  E ( RM - RF ) = 5 + 2.36 (7) = 21.52%
Step 5: Determine cost of debt, net of tax.
Assumption: In the absence of additional information, we assume that the

appropriate cost of debt, before tax, is the concessionary interest rate of 8%.
K D = 8 (1 – 0.25)% = 6%
Step 6: Compute the WACC
WACC = (100/130 x 21.52) + (30/130 x 6)
= 16.56 + 1.39 = 17.95 = 18% approx
Why the computed WACC is appropriate
The WACC used to appraise a new project should reflect:
i. The business risk of the project and
ii. The financial risk associated with the method of financing the project

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The existing WACC of 11% reflects the average business risk of the
existing portfolio of projects and the financial risk of the company (i.e.
AK Plc).
The index used to measure business risk is asset beta. For the cement
project, we need the asset beta of the cement industry which is computed
above as 2. This figure is significantly higher than the current asset beta
of Ak Plc – indicating that the cement business is inherently riskier than
the existing operations of Ak Plc. Consequently, the current WACC of 11%,
which is based on asset beta of 1.2 is inappropriate as it will understate
the required return on the cement project.
b)i. Computation of NPV
Year 0 1 2 3 4 5
Nm Nm Nm Nm Nm Nm
Sales revenue (W1) 0 1,050 1,323 1,505 1,945 1,787
Variable cost (W2) 0 (416) (519) (585) (749) (681)
Cash fixed cost (W3) 0 (54) (58) (63) (68) (73)
Operating profit 0 580 746 857 1,128 1,033
Tax on operating profit 0 (145) (187) (214) (282) (258)
Tax savings on tax depreciation (W3) 0 75 75 75 75 75
Initial outlay (2,000)
Working capital (W4) (105) (27) (19) (45) 17 179
NCF (2,105) 483 615 673 938 1,029
PVF at 13% 1 0.885 0.783 0.693 0.613 0.543
PV (2,105) 427 482 466 575 559
NPV = N404,000,000
ii) Computation of MIRR
 PV 
l/n

MIRR =  R  × 1  r   1
 PVi  
Where PVR = PV of return stage, which in this case is the PV of NCF from
Years 1 to 5 = N2,509million
PVi =PV of the investment stage, which in this case is the NCF in
Year 0 = N2,105million
r = WACC
n = life of the project

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 2,509 1 / 5 
MIRR =   × 1.13  1  17%
 2,105  
Alternative method
An alternative is to first compute the terminal value of the return phase:
Year NCF Future value factor Future value

(a) (b) (a x b)
1 483 (1.13)4 788
2 615 (1.13)3 887
3 673 (1.13)2 859
4 938 (1.13)1 1,060
5 1,029 (1.13)0 1,029
4,623
Next, we compute the MIRR using:
/n
1
1/ 5
 4,623 
MIRR = -1 =   1  17%
 2,105 
(c) The NPV of the project is positive and the MIRR is higher than the company’s
WACC. If other factors remain constant the project is viable and should be
accepted.
Working Notes
1. Annual sales revenue

Year 1 2 3 4 5
Quantity sold (Q) 500,000 600,000 650,000 800,000 700,000
Selling price (N) 2,100 2,205 2,315 2,431 2,553
Sales revenue (Nm) 1,050 1,323 1,505 1,945 1,787
2. Annual total variable cost

Year 1 2 3 4 5
Variable Cost/unit (N) = (V) 832 865 900 936 973

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Total Variable Cost (Nm) (V x Q) 416 519 585 749 681
3. Incremental fixed cost (cash)

Year 1 2 3 4 5
Total ((Nm) 54 58 63 68 73
4. Incremental working capital

Year 0 1 2 3 4 5
N N N N N N
Total (10% of revenue) - 105 132 151 196 179
- Incremental (cash flow effect) -105 -27 -19 -45 +17 +179
5. Other cost items

i) Loan repayments: Loan repayments and interest on loan are irrelevant
in DCF calculations. They are financing items.
ii) Apportioned overheads: These are irrelevant because they do not
involve incremental cash flows.
iii) Cost of surveys: These are sunk costs and are therefore irrelevant.
6. Tax savings on tax deprecation

Annual tax depreciation = N1,500m/5 = N300m
Tax savings at 25% = N75m
EXAMINER’S REPORT
The question tests candidates’ ability to identify and calculate appropriate cost of
capital for a project on diversification into a different industry. It also tests
candidates’ ability to identify relevant cash flows for a project and their ability to
calculate and interprete net present value and modified internal rate of return.
Being a compulsory question, virtually all the candidates attempted it. However, the
performance is poor as it appears that the candidates lacked an understanding of
these areas of the syllabus.
Candidates’ commonest pitfalls were their inability to differentiate between

debt/equity ratio and debt/equity plus debt ratio. They were required to carry out the

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‘gearing’ and ‘ungearing’ processes. They failed to recognise that financing items are
irrelevant in Net Present Value and Modified Internal Rate of Return calculations.
Candidates’ are advised to always cover the syllabus adequately, work on past
questions and examination - like questions in textbooks.
SOLUTION 2
(a) Possible benefits of disposing Bolt division through a management buy-out

include:
 Management buy out costs may be less compared with other forms of
disposal such as selling individual assets of the division or selling it to a
third party.
 It may be the quickest method to raise funds compared to other methods.
 There would be less resistance from the managers and employees

thereby making the process smoother and easier to accomplish than if
both divisions were to be closed down.
 It may offer a better price. The current management and employees

possibly have the best knowledge of the division and are able to make it
successful. They may therefore be willing to pay for it.
 There will be continuity in management since existing management will

become owners and continue to avail the business of their knowledge
and expertise.
 There would be improved commitment and achievements by the

management since they are now owners.
(b) Close the company:
N’000
Sale of all assets 1,155,000
Less: redundancy and other costs (297,000)
Net proceeds from sale of all assets 858,000
Total liabilities 1,540,000

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 858,000,000 
The creditors will receive 56 kobo per N1 owed them  i.e. 
 1,540,000,000 
while equity shareholders will not receive anything.
(c) Sell Nuts Division:
N’000
Value of selling nuts division ( /3 x N1,155million)
2
770,000
Redundancy and other costs (2/3 x N297million) (198,000)
Funds available from sale of division 572,000
Amount of current and non-current liabilities 1,540,000
Amount of funds needed to be paid with respect to management buy-out

Current and non-current liabilities (N1,540m – N572m) 968,000
Amount of management buy-out funds needed to pay shareholders 330,000
Investment needed for new venture 275,000
Total funds needed for management buy-out 1,573,000
Estimating the value of the new company after management buy-out
N’000
Sales revenue 935,000
Costs (660,000)
Profits before depreciation 275,000
Depreciation ( 1/3 x N550m) + N275m x 10% (45,833)
Tax 30% of (N275,000 – N45,833) (68,750)
Cash flows before interest payment 160,417
Estimate of the value based on perpetuity
N1660,417,000 (1.035) = N166,031,595

0.11 – 0.035 0.075
= N2,213.754,600
This is about 41% in excess of the funds invested in the new venture and
therefore the buy-out is beneficial. However, the amounts are all estimates and
a small change in some variables like the growth rate or the cost of capital can
have impact on the value. Besides, the assumption of cash flow growth in
perpetuity may not be accurate. It is therefore advisable to undertake
sensitivity analysis.

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(d)
(i) Potential buyers will need to be sought through open tender or through
an intermediary. Depending upon the nature of the business being sold
a single bidder may be sought or arrangements made for an auction of
the business. Chelsy Plc’s suppliers and distributors may be interested,
as competitors in the same industry. High level of discretion is required
in the search process to protect the value of the business from adverse
competitive action. Otherwise, an interested and dominant competitor
may open a price war in order to force down prices and hence the value
of Nuts division prior to a bid.
(ii) Once a potential buyer has been found, access should be given so that
they can conduct their own due diligence. Up to date accounts should be
made available, Chelsy Plc should undertake its own due diligence to
check the ability of the potential purchaser to complete a transaction of
this size. It would be necessary to establish how the purchaser intends to
finance the purchase, the timescale involved in their raising the
necessary finance and any other issues that may impede a clean sale.
Chelsy Plc’s legal team will need to assess any contractual issues on the
sale, the transfer of employment rights, the transfer of intellectual
property and any residual rights and responsibilities to Chelsy Plc.
A sale price will be negotiated which is expected to maximise the return.

The negotiation process should be conducted by professional negotiators
who have been thoroughly briefed on the terms of the sale, the
conditions attached and all legal requirements. The consideration for the
sale, the deeds for the assignment of assets and terms for the transfer of
staff and their accrued pension rights will also be subject to agreement.
EXAMINER’S REPORT
The question tests candidates’ ability to analyse business reconstructions and

restructuring.
About 75% of the candidates attempted the question. Performance of the candidates
was poor.
Candidates’ commonest pitfalls were their inability to decode the question and their
inadequate business knowledge.

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Candidates are advised to practise examination – like questions. They should also
read, understand and interprete questions appropriately noting their specific
requirements before attempting them.
SOLUTION 3
Arikuyeri & Co.

Financial Consultants
XYZ Street, Alegongo
Ibadan, Oyo State
Date
The Board of Directors,

Syntax Fertilizers Plc,
126, Broad Street,
Lagos
Dear Sirs,
RE: ACQUISITION OF SYNAPSE CHEMICAL PLC
The proposed acquisition of Synapse Chemical Plc by your company for N25million has
been evaluated.
From the financial data made available to us the outcome of our evaluation and
appraisal reveals that the proposal is worthwhile.
Our evaluation reveals that the networth of your company will increase by about
N 2,112,090 being the net present value of the Synapse Chemical Plc.
Analysis of this appraisal is contained in the attached appendices.
If you need further clarification, do not hesitate to contact us.
Yours faithfully,
For: ARIKUYERI & CO.

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Computation of Tax Liability
Appendix 1
2015 2016 2017 2018 2019

N’M N’M N’M N’M N’M
Profit before tax 10 16 20 24 28
Add: Depreciation 5 4 4 4 4
Adjusted profit 15 20 24 28 32
Less: Balancing allowances 2 ___ ___ ___ ___
13 20 24 28 32
Tax @ 30% 3.90 6.00 7.20 8.40 9.60
Computation of Cash flows
Appendix 2
2015 2016 2017 2018 2019 2020
N’M N’M N’M N’M N’M N’M
Profit before tax 10.00 16.00 20.00 24.00 28.00 -
Add: Depreciation 5.00 4.00 4.00 4.00 4.00 -
Interest 1.00 1.00 1.00 1.00 1.00 -
Cash profit before tax 16.00 21.00 25.00 29.00 33.00 -
Less tax 4.50 3.90 6.00 7.20 8.40 9.60
Capital 11.50 17.10 19.00 21.80 24.60 (9.60)
Less Capital Investment Required 5.00 6.00 8.00 9.00 10.00 -
Free cash flow 6.50 11.10 11.00 12.80 14.60 (9.60)
Appendix 3
Evaluation of the Acquisition
Years Net Cash DFat 22% Present

flow Value
N’M N’M
2014 (25.00) 1.0000 (25.00000)
2015 6.50 0.8197 5.32805
2016 11.10 0.6719 7.45809
2017 11.00 0.5507 6.05770
2018 12.80 0.4514 5.77792
2019 14.60 0.3700 5.40200
2020 (9.60) 0.3033 (2.91168)
NPV 2.11208

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EXAMINER’S REPORT
The question tests candidates’ ability to determine the value of a business using
discounted cash flow method.
About 40% of the candidates attempted the question. Performance of the candidates
was poor.
Candidates’ commonest pitfall was their inability to correctly interprete the question
and note the specific requirements.
Candidates are to note that there is no alternative to adequate preparation, if success

in the Institute’s examination is desired.
SOLUTION 4
(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.

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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.

86
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)
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 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.

87
It is the consensus that weak or semi-strong form is the most likely to
occur in practice.
EXAMINER’S REPORT
The question tests candidates’ understanding of methods of raising equity and debt
finance. It also tests their knowledge of efficient market hypothesis.
More than 80% of the candidates attempted the question but performance was poor.
Candidates showed no understanding of the requirement in parts (a) and (b) of the
question. However, part (c) of the question was well attempted.
Candidates are advised to read wide and cover the syllabus adequately for better
result.
SOLUTION 5
(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 following:
- Decision on the company’s shares and market valuations

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- 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.
EXAMINER’S REPORT
The question tests candidates’ knowledge of the objectives of state owned enterprises
and private enterprises.
Almost all the candidates attempted the question but performance was poor.
Candidates’ commonest pitfall was their failure to answer the question set, as
irrelevant points were raised by many of them.
Candidates are advised to read, understand and interprete questions appropriately

before attempting them.

89
SOLUTION 6
(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.

90
(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.
(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

91
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, 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.
EXAMINER’S REPORT
The question tests candidates’ knowledge of the advantages and disadvantages of

centralised and decentralised treasury management within multinational companies.
It also tests their understanding of agency theory in finance.
More than 80% of the candidates attempted the question but performance was very
poor.
Candidate’s commonest pitfall was their lack of indepth knowledge of this area of the
syllabus.
Candidates are advised to always give consideration to all sections of the syllabus in
their preparations for the Institutes examinations.
SOLUTION 7
(a) Calculation of potential loss of N840,000
Current spot rate is C$40 = N1
Or N0.025 = C$1
The depreciation rate of the C$ against N is given by
1  RD
 1, where
1  RF

92
RD = domestic interest rate = 0.05
RF = foreign interest rate = 0.25
Thus:
1.05
 1  16%
1.25
The expected exchange rate in one year’s time will be
C$1 = N0.025 x 0.84 = N0.021
Value of the retention money
* Today = N210,000,000 x N0.025 = N5,250,000
* In one year’s time = N210,000,000 x N0.21 = N4,410,000
Exchange rate loss N 840,000
Alternative solution to Q7(a)
Compute the 1 – year forward rate:
 1  RD 
F = S0 x   where
 1  RF 
So = current sport rate in terms of N per C$
= 1/40 = 0.025
RD = domestic risk free = 0.05
RF = foreign risk free = 0.25
Thus:
 1.05 
F = 0.25 x   = 0.021
 1.25 
* Potential loss is:
N210,000,000 x (0.021 – 0.025) = N840,000

93
(b) Money Market Hedge
Since both payment and receipt occur in the same currency and at the same
time, the amount to be hedged is the net (W$750 – W$450)m = W$300m
receipt.
The following steps are required to set up the hedge:
(i) Since a foreign asset (i.e. net receivable) is involved, a corresponding

liability should be created in the foreign country to match the maturity of
the asset.
(ii) Determine the amount of W$ to borrow today at 10.5% p.a. that will grow
to become W$300m after 6 months. This is simply the PV of W$300m i.e.
 
 1 
W$300m x   = W$285.04m
 0.105 
1  
 2 
1/ 2
 1 
(Note: W$300 x   = W$285.39 should be fully rewarded)
 1.105 
The above amount is borrowed today
Convert the borrowed sum into N at the spot rate of 1.4735 – the bank’s
buying rate to give
W$285.04 x 1.4735 = N420.01m
(iii) Place the N420.01m in deposit in Nigeria at 13.25% p.a. for 6 months.
This will grow to become:
 0.1325 
N420.01 x 1  
 2 
= N447.84m
(iv) In 6 month’s time, collect the net receivable of W$300m and use it to off-
set the loans plus accumulated interest (totaling W$300m)
Harvest your N deposit of N447.84m
What the money market hedge has done is to convert the foreign asset to
domestic asset thereby eliminating the foreign exchange risk.

94
(c) Advantages of Forward Exchange Contract
(i) Eliminates currency risk as foreign exchange costs are determined

upfront
(ii) Establishes contracts to match organisations’ cash flows
(iii) Sets up delivery dates to match cash flows
(iv) Secures a contract in any freely convertible currency
(v) Ensures market liquidity up to two years into the future in most cases
Disadvantages
(i) There is no immediate obligation. As time moves forward, the forward

price for delivery on the original date of the contract may change
(ii) Forward contracts can acquire value and become a liability for one party
and an asset ot another
(iii) Because no money changes hands at the time of making the contract, the
risk of default is even higher, as the seller may not deliver the product at
the agreed price or the buyer may not pay the agreed price.
(iv) Forward contracts involve buying a product, unseen. The problem is that
physical characteristics of the product can vary.
EXAMINER’S REPORT
The question tests candidates’ knowledge of foreign exchange risk management
Less than 20% of the candidates attempted the question and performance was poor.
Candidates commonest pitfalls were their
- inability to make use of the correct formulae when computing forward rate/rate
of depreciation of the foreign currency,
- inability to distinguish between direct quote and indirect quote,
- lack of knowledge of bid-offer rates and
- failure to net expected payment against expected receipt in the same currency
and at the same time.

95
Candidates are advised to cover the syllabus adequately, work on past questions,
improve their knowledge of foreign exchange transactions and also endeavour to
remember and interprete formulae appropriately for better result in future.

96
THE INSTITUTE OF CHARTERED
ACCOUNTANTS
OF NIGERIA
MAY 2015 PROFESSIONAL LEVEL EXAMINATIONS
Question Papers
Suggested Solutions
Plus
Examiners’ Reports
PROFESSIONAL LEVEL EXAMINATIONS – MAY 2015

PROFESSIONAL LEVEL EXAMINATION - MAY 2015
ATTEMPT FIVE QUESTIONS IN ALL
SECTION A: COMPULSORY QUESTION (30 Marks)
QUESTION 1
AB Limited is a private company owned by two families who started the business in 2009. The
company produces organic food for distribution in the domestic market using food products from
a number of firms across the country. The company is experiencing a period of rapid growth
with revenue expected to rise by 15% in each of the succeeding five years after take off.
The company is hoping to retain a profit margin (profit before interest and taxes divided by
revenue) of 30% throughout the next five years. The ratio of working capital to revenue is
expected to remain constant (where working capital is inventories plus trade receivables less
trade payables).
Interests paid on the overdraft and bank loan are at 6% per annum and calculated on the balance
outstanding at the beginning of the year. Corporate income tax is paid one year in arrears at a
rate of 30%. For simplicity, assume a 100% tax allowance for capital expenditure in the year in
which it is incurred. In arriving at operating profit, depreciation is charged at 25 % on a reducing
balance basis based on year-end balances.
Extracts from the management accounts of AB Limited on 30 June 2014 are as follows:
STATEMENT OF FINANCIAL POSITION AS AT 30 JUNE, 2014
N’m
Non-current assets 300
Working Capital 180
480
Share Capital (50 kobo ordinary shares) 200
Retained earnings 80
Non-current liability (bank loan) 160
Bank overdraft 20
Current tax payable 20
480
INCOME STATEMENT FOR THE YEAR ENDED 30 JUNE 2014
N’m
Revenue 900
Profit before interest and taxes 270
63

Dividend paid in 2014 (Total) 200
Capital expenditure plans are N200m in 2015, N200m in 2016 and N140m in each of the years
2017 to 2019. No disposals of non-current assets are expected in this period.
Shareholders expect an annual increase in dividend of 5%. Any fund deficit in the year will be
financed by overdraft and any surplus fund will be used to reduce the overdraft. However, with
the increasing demand on the funds of the business to finance growth, the directors are concerned
that the company may exceed the overdraft limit of N30m. They may, therefore, need to
negotiate an increase in the bank loan, although the bank has indicated that it would not accept a
gearing higher than 70% based on the book values where gearing is defined as non-current and
current borrowings (including overdraft) divided by equity. The shareholders have indicated that
they do not wish to inject additional capital into the business.
a. Prepare the Statement of Financial Position, Income Statement and Cash Flow Analysis
of the company for each of the years 2015 and 2016 and advise the company on the
extent of additional funding requirement in that period.
Notes
(i) All figures in your calculations should be rounded up to the nearest N1m.
(ii) Compliance with accounting standards is not necessary since these are
management reports. (20 Marks)
b. Recommend and comment on actions the company can take to close the funding gap
identified in (a) above (10 Marks)
(Total 30 Marks)
64

SECTION B: ATTEMPT ANY TWO OUT OF THREE QUESTIONS IN THIS SECTION (40
Marks)
QUESTION 2
The Directors of Actuarial Plc., a conglomerate, is targeting Minororia Plc., an engineering
machinery manufacturer, for possible acquisition of its entire share capital. They believe that the
takeover will not affect their business risks. The statement of financial position of Minororia
Plc. as at 31st December, 2014 is expected to be as follows:
Minororia Plc.
Projected Statement of Financial Position as at 31st December, 2014.
N’000 N’000
Non-current asset (net of depreciation) 651,600
Current assets: Inventory and W.I.P. 515,900
Receivables 745,000
Bank balance 158,100 1,419,000
2,070,600
Current liabilities:
Payables 753,600
Bank overdraft 862,900 1,616,500
454,100
Representing:
Capital and Reserves:
Issued ordinary shares of N1 each 50,000
Distributable Reserves 404,100
454,100
The summarised financial records of Minororia Plc. for five years to 31st December 2014 is as
follows:
Minororia Plc.
65

Five years financial summary
Year ended 31st December 2010 2011 2012 2013 2014
(Estimated)
N’000 N’000 N’000 N’000 N’000
Profit before extraordinary
items 30,400 69,000 49,400 48,200 53,200
Extraordinary items 2,900 (2,200) (6,100) (9,800) (1,000)
Profit after extraordinary
items 33,300 66,800 43,300 38,400 52,200
Dividend (20,500) (22,600) (25,000) (25,000) (25,000)
12,800 44,200 18,300 13,400 27,200
Additional information:
(i) There have been no changes in the issued share capital of Minororia Plc. during the past
five years.
(ii) The estimated values of Minororia Plc’s. non-current assets, inventory and work-in-
progress for the year ended 31st December 2014 will be as follows:
Replacement Realisable
Value Value
N’000 N’000
Non-current assets 725,000 450,000
Inventory and W.I.P 550,000 570,000
(iii) It is expected that 2% of Minororia Plc’s. receivables at 31 December, 2014 will become
uncollectable.
(iv) The Cost of Capital of Actuarial Plc. is 9%. However, the shareholders of the company
expect a minimum return of 12% per annum on their investment in the company.
(v) The current P/E ratio of Actuarial Plc. is 12.
Companies within the industry having similar profit levels with those of Minororia Plc.
have P/E ratio of approximately 10, although these companies tend to be larger than
Minororia plc.

a. Calculate the value of the total equity of Minororia Plc. using each of the following
methods:
66

i. Statement of Financial Position (net asset basis) (1 Mark)
ii. Replacement Costs (4 Marks)
iii. Realisable Value (5 Marks)
iv. Gordon’s Dividend Growth Model and (4 Marks)
v. P/E Ratio Model (1 Mark)
b. State ONE limitation of each method in (a) above. (5 Marks)
(Total 20 Marks)
QUESTION 3
KING Plc. and QUEEN Plc. both manufacture and sell household equipment. The summarised
Income Statements of the two companies for the year 2012 are as follows:
KING Plc. QUEEN Plc.

N’000 N’000
Revenue 37,500 20,000
Operating expenses (20,000) (15,500)
17,500 4,500
Each company has earned a constant level of profit for a number of years and both are expected
to continue to do so for the nearest future. The policy of both companies is to distribute all
profits as dividend to ordinary shareholders as they are earned. None of the companies has any
fixed interest capital.
Details of the ordinary share capital of the companies are as follows:
KING Plc. QUEEN

Plc.
N’000 N’000
Share Capital:
Ordinary shares of N1 each
Authorised 125,000 50,000
Issued 50,000 25,000
67

The ordinary shares of KING Plc. have a current market value of N3.50 each ex-div, and those of
QUEEN Plc. a current market value of N1.50 each ex-div.
The directors of KING Plc. are considering submitting a bid for the entire share capital of
QUEEN Plc. They believe that if the bid succeeds, the combined sales revenue of the two
companies will increase by N1,500,000 per annum and savings in operating expenses amounting
to N1,250,000 per annum will be possible. Part of the machinery presently owned by KING Plc.
would no longer be required and could be sold for N2,500,000.
Furthermore, the directors of KING Plc. believe that the takeover would result in a reduction of
the returns required by the Ordinary Shareholders to 10%.
Required:
a. As a financial consultant to KING Plc., advise on the maximum price that the company
should be willing to pay for the entire share capital of QUEEN Plc. showing clearly the
basis of your advice. (6 Marks)
b. Show how the entire benefit from the takeover will accrue to the present shareholders of
KING Plc. assuming that the takeover price is agreed at half of the figure you advised,
and that the purchase consideration will be settled by an exchange of ordinary shares in
QUEEN Plc. (4 Marks)
c. Discuss briefly any other factors that the directors and shareholders of both companies
might consider in assessing the acceptability of the proposed takeover.
(5 Marks)
d. List any FIVE defence tactics that could be used by QUEEN Plc. to frustrate the takeover
bid of KINGS Plc. (5 Marks)
(Total 20 Marks)
QUESTION 4
Oseka Bags Limited is a chain of retail outlets, specialising in high quality leather bags and
briefcases. One of the products purchased by Oseka Bags Limited for resale is an executive
briefcase. The Company sells a fixed quantity of 100 briefcases per week and 50 weeks per
year. The estimated holding cost of a briefcase is N100 per annum per briefcase.
Delivery to Oseka Bags Limited by the existing supplier takes two weeks and the purchase price
per briefcase delivered to Oseka Bags Limited is N1,000. The current supplier charges a fixed
N900 order processing charge for each order regardless of the order size.
Oseka Bags Limited has recently been approached by an alternative supplier of leather briefcase
which are very similar to the existing briefcase range. It is expected that this alternative
briefcase can be sold in the same quantity and price as the existing range.
The alternative supplier’s offer is as follows:
68

(i) The cost of each briefcase is N960
(ii) There will be a fixed order processing charge of N2,500, regardless of order size.
(iii) Delivery will take one week.
(iv) The annual holding cost for a briefcase remains N100 per annum.
Required:
a. Assuming Oseka Bags Limited continues to purchase from the existing supplier, calculate
the:
i. Economic Order Quantity (EOQ)
ii. Total cost of stocking the briefcase for one year (6 Marks)
b. Assuming Oseka Bags Limited switches to the new supplier of briefcase, calculate the:
i. Economic Order Quantity;
ii. Total cost of stocking the alternative briefcase for one year and
determine if it is financially viable to change to this new supplier.
(6 Marks)
c. Discuss TWO limitations of the above calculations and describe briefly TWO non-
financial factors to be taken into account before a final decision is made.
(4 Marks)
d. Assuming there is an upfront investment cost for Oseka Bags Limited of N400,000,
payable immediately and that the annual savings from switching to the new supplier arise
at the end of the next three years, calculate the net present value of switching, if the cost
of capital for the company is 10% per annum.
(4 Marks)
(Total 20 Marks)
SECTION C: ATTEMPT ANY TWO OUT OF THREE QUESTIONS IN THIS SECTION

(30 Marks)
QUESTION 5
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)
69

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)
QUESTION 6
Your investment firm is a major player in the Nigerian Capital market. Following recent positive
signs in the capital market, your firm has just recruited a number of young graduates. An in-
house training programme is being planned for the young trainees and you are to facilitate on
subject areas such as portfolio concepts, capital asset pricing model, etc.
a. Your Managing Director requires you to explain, without the use of graphs, Capital
Market Line (CML) and the Security Market Line (SML). You are also required to
highlight the difference between the two. (4 Marks)
b. Consider a client having a portfolio of three stocks. The various expectations and the
current market situations are tabulated below (all annualised values). The current risk
free interest rate is 6% per annum.
Stocks Expected Standard Beta
Return Deviation
Stock A 14% 35% 1.36
Stock B 9.4% 20% 0.52
Stock C 10% 18% 0.69
Market Index 12% 23%
i. Calculate the required returns from the three stocks if they are correctly priced in
accordance with the Capital Asset Pricing Model (CAPM).
(5 Marks)
ii. Are there any discrepancies between the return based on the CAPM theory and
your own expectations? If yes, advise on how to reshuffle the portfolio within
these three stocks in order to profit from them. If no, explain why.
(6 Marks)
(Total 15 Marks)
70

QUESTION 7
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)
c. On 31 December 2014, Famak Plc realised that it needs a N100million fixed rate loan on
1 April 2015, Famak Plc would want to hedge using Forward Rate Agreement (FRA).
The relevant FRA rate will be 6% on 31 December, 2014. Determine the result of the
FRA and the effective loan rate if the 6 month FRA benchmark moves to: (i) 5%; (ii)
9%. (6 Marks)
(Total 15 Marks)
Formulae
Modigliani and Miller Proposition 2 (with tax)
= + − (1 − )
Asset Beta
(1 − )
= +
( + (1 − )) ( + (1 − ))
Equity Beta
= +( − ) (1 − )
Growing Annuity
1+
= 1−
− 1+
Modified Internal Rate of Return
= 1+ − 1
The Black-Scholes Option Pricing Model

C0 = S0N(d1) – Ee-rt N(d2)
+ ( + 0.5 )
=
√
d2= d1 - √
The Put Call Parity

C + Ee-rt = S + P
71

Binomial Option Pricing
×√ /
=
d = 1/u
/
=
−
=
−
72

/
The discount factor per step is given by =
Annuity Table
Present value of an annuity of 1 i.e. 1 - (1+r)-n

r
Where r = discount rate
n = number of periods
Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1
2 1·970 1·942 1·913 1·886 1·859 1·833 1·808 1·783 1·759 1·736 2
3 2·941 2·884 2·829 2·775 2·723 2·673 2·624 2·577 2·531 2.487 3
4 3·902 3·808 3.717 3·630 3.546 3.465 3·387 3·312 3·240 3·170 4
5 4·853 4·713 4·580 4·452 4·329 4·212 4·100 3·993 3.890 3·791 5
6 5·795 5·601 5·417 5·242 5·076 4·917 4·767 4·623 4.486 4·355 6
7 6·728 6.472 6·230 6·002 5·786 5·582 5·389 5·206 5·033 4·868 7
8 7·652 7·325 7·020 6·733 6·463 6·210 5·971 5·747 5·535 5·335 8
9 8·566 8·162 7·786 7.435 7·108 6·802 6·515 6·247 5·995 5·759 9
10 9·471 8·983 8·530 8·111 7·722 7·360 7·024 6·710 6.418 6·145 10
11 10·368 9·787 9·253 8·760 8·306 7·887 7.499 7·139 6·805 6.495 11
12 11·255 10·575 9·954 9·385 8·863 8·384 7·943 7·536 7'161 6·814 12
13 12·134 11·348 10·635 9·986 9·394 8·853 8·358 7·904 7·487 7·103 13
14 13·004 12·106 11·296 10·563 9·899 9·295 8·745 8·244 7·786 7·367 14
15 13·865 12·849 11·938 11·118 10·380 9·712 9·108 8·559 8·061 7·606 15
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1
2 1·713 1·690 1·668 1·647 1·626 1·605 1·585 1·566 1·547 1·528 2
3 2.444 2.402 2·361 2·322 2·283 2·246 2·210 2·174 2·140 2·106 3
4 3·102 3·037 2·974 2·914 2·855 2·798 2·743 2.690 2·639 2.589 4
5 3·696 3·605 3·517 3·433 3·352 3·274 3·199 3·127 3·058 2·991 5
6 4·231 4·111 3·998 3·889 3·784 3·685 3·589 3.498 3.410 3·326 6
7 4·712 4·564 4.423 4·288 4·160 4·039 3·922 3·812 3·706 3·605 7
8 5·146 4·968 4.799 4·639 4.487 4·344 4·207 4·078 3·954 3·837 8
9 5·537 5·328 5·132 4·946 4·772 4·607 4.451 4·303 4·163 4·031 9
10 5·889 5·650 5.426 5·216 5·019 4·833 4·659 4.494 4·339 4·192 10
11 6·207 5·938 5·687 5.453 5·234 5·029 4·836 4·656 4.486 4·327 11
12 6·492 6·194 5·918 5·660 5·421 5·197 4·988 4·793 4·611 4.439 12
13 6·750 6.424 6·122 5·842 5·583 5·342 5·118 4·910 4·715 4·533 13
14 6·982 6·628 6·302 6·002 5·724 5.468 5·229 5·008 4·802 4·611 14
15 7·191 6·811 6.462 6·142 5·847 5·575 5·324 5·092 4·876 4·675 15
73

Standard normal distribution table
0·00 0·01 0·02 0·03 0·04 0·05 0·06 0·07 0·08 0·09
0·0 0·0000 0·0040 0·0080 0·0120 0·0160 0·0199 0·0239 0·0279 0·0319 0·0359
0·1 0·0398 0·0438 0·0478 0·0517 0·0557 0·0596 0·0636 0·0675 0·0714 0·0753
0·2 0·0793 0·0832 0·0871 0·0910 0·0948 0·0987 0·1026 0·1064 0·1103 0·1141
0·3 0·1179 0·1217 0·1255 0·1293 0·1331 0·1368 0·1406 0·1443 0·1480 0·1517
0.4 0.1554 0·1591 0·1628 0·1664 0·1700 0·1736 0·1772 0·1808 0·1844 0·1879
0·5 0·1915 0·1950 0·1985 0·2019 0·2054 0·2088 0·2123 0·2157 0·2190 0·2224
0·6 0·2257 0·2291 0·2324 0·2357 0·2389 0·2422 0·2454 0·2486 0·2517 0·2549
0·7 0·2580 0·2611 0·2642 0·2673 0·2704 0·2734 0·2764 0·2794 0·2823 0·2852
0·8 0·2881 0·2910 0·2939 0·2967 0·2995 0·3023 0·3051 0·3078 0·3106 0·3133
0·9 0·3159 0·3186 0·3212 0·3238 0·3264 0·3289 0·3315 0·3340 0·3365 0·3389
1·0 0·3413 0·3438 0·3461 0·3485 0·3508 0·3531 0·3554 0·3577 0·3599 0·3621
1·1 0·3643 0·3665 0·3686 0·3708 0·3729 0·3749 0·3770 0·3790 0·3810 0·3830
1·2 0·3849 0·3869 0·3888 0·3907 0·3925 0·3944 0·3962 0·3980 0·3997 0.4015
1·3 0.4032 0.4049 0.4066 0.4082 0.4099 0.4115 0.4131 0.4147 0.4162 0.4177
1.4 0.4192 0.4207 0.4222 0.4236 0.4251 0.4265 0.4279 0.4292 0.4306 0.4319
1·5 0.4332 0.4345 0.4357 0.4370 0.4382 0.4394 0.4406 0.4418 0.4429 0.4441
1·6 0.4452 0.4463 0.4474 0.4484 0·4495 0.4505 0.4515 0.4525 0.4535 0.4545
1·7 0.4554 0.4564 0.4573 0·4582 0·4591 0.4599 0·4608 0·4616 0.4625 0.4633
1·8 0.4641 0.4649 0.4656 0.4664 0.4671 0.4678 0.4686 0.4693 0.4699 0·4706
1·9 0.4713 0.4719 0.4726 0.4732 0.4738 0.4744 0.4750 0.4756 0.4761 0.4767
2·0 0.4772 0.4778 0.4783 0.4788 0.4793 0.4798 0.4803 0.4808 0·4812 0.4817
2.1 0.4821 0.4826 0.4830 0.4834 0.4838 0.4842 0.4846 0·4850 0.4854 0.4857
2·2 0.4861 0.4864 0.4868 0·4871 0.4875 0.4878 0.4881 0·4884 0.4887 0.4890
2·3 0.4893 0·4896 0.4898 0.4901 0.4904 0.4906 0.4909 0.4911 0.4913 0.4916
2·4 0.4918 0.4920 0.4922 0.4925 0.4927 0.4929 0·4931 0.4932 0.4934 0.4936
2·5 0.4938 0.4940 0.4941 0.4943 0.4945 0.4946 0.4948 0.4949 0.4951 0.4952
2·6 0.4953 0.4955 0·4956 0.4957 0.4959 0.4960 0.4961 0·4962 0.4963 0·4964
2·7 0.4965 0.4966 0.4967 0.4968 0.4969 0.4970 0.4971 0.4972 0.4973 0·4974
2·8 0.4974 0.4975 0.4976 0.4977 0.4977 0·4978 0.4979 0.4979 0.4980 0.4981
2·9 0·4981 0.4982 0.4982 0.4983 0.4984 0.4984 0.4985 0.4985 0.4986 0·4986
3·0 0·4987 0.4987 0·4987 0.4988 0.4988 0.4989 0.4989 0·4989 0.4990 0·4990
SOLUTION1
74

(a)
(i) INCOME STATEMENT FOR THE YEAR ENDED 30TH JUNE

2015 2016 COMMENTS
Nm Nm
Revenue 1,035 1,190 Increase by 15% p.a
EBIT (earnings before interest & tax) 311 357 30% of revenue
Interest on bank loan (10) (10) 6% of N160m
Interest on overdraft (1) (3) 6% x opening O/Draft
Profit before tax 300 344
Tax (68) (86) See (W2)
Profit after tax 232 258
Dividend 210 221
Retained earnings 22 37
Retained earnings b/f 80 102
Retained earnings c/f 102 139
(ii) STATEMENT OF FINANCIAL POSITION AS AT

2015 2016 Comments
Nm Nm
Non-current Assets
Plant etc 375 431 See (W1)
Working capital 207 238 20% of revenue
582 669
Equity
Share capital 200 200
Retained earnings 102 139
Non-current liabilities
Bank loan 160 160
Current liabilities
Bank overdraft 52 84 See cash flow statement
Tax payable 68 86 See (W2)
582 669
(iii) CASH FLOW ANALYSIS

2015 2016
Nm Nm
EBIT 311 357
75

Add back depreciation 125 144
Increase in working capital (27) (31)
Net cash flow from operations 409 470
Interest paid (11) (13)
Dividends paid (210) (221)
Tax paid (20) (68)
Capital expenditure (200) (200)

Net cash flow (32) (32)
Overdraft b/fwd (20) (52)
Overdraft c/fwd (52) (84)
Note: Alternative presentation in the form of receipts and payments is allowed.
(iv) Funding requirement in 2015 and 2016
Comparing 31 December 2014, 2015 and 2016, the maximum funding requirement in
2015 and 2016 appears to arise on 31 December, 2016:
Nm Nm
Maximum funding requirement:
- Bank loan 160
- Overdraft 84 244
Available facility (160 + 30) 190
Funding gap 54
However, it should be noted that we do not have any information about intra-year cash
flows; these need to be examined to determine whether a greater funding shortfall arises
at some other point during the period.
Working Notes
1. Non-current assets
Nm Nm
Property, etc b/fwd 300 375
Capital expenditure 200 200
Net total 500 575
76

Depreciation at 25% (125) (144)
Property etc c/fwd 375 431
2. Calculation of taxes
Nm Nm
30% of revenue 311 357
Less: Capital allowance (200) (200)
Add: Depreciation 125 144
Interest on bank loan (10) (10)
Interest on overdraft (1) (3)
Taxable profit 225 288
Taxes 30% 68 86
(b) As indicated in (a) above, a funding gap of N54million exists at the end of 2016.
Management may consider the following options in order to close the funding
gap.
(i) INCREASE THE BANK LOAN

The additional funding requirement of N54million would result in gearing level in
excess of the bank’s minimum gearing level of 70%:
244
(84 + 160)/(200 + 139) = = 72%
339
However, the N54million shortfall is only likely to be temporary and
approximately 80% of the loan could be repaid by the end of 2017, so the bank
would be more likely to provide the additional loan if it accepts the company’s
forecasts for 2017 onwards. If the targets for 2017 are achieved, the company can
expect positive cash flows in 2017, as shown below:
NM
EBIT 411 357 x 1.15
Add depreciation 143 25% (431 + 140)
Net cash from operations 554
Interest (15) 6% (160 + 84)
Dividend (232)
Tax paid (86)
Capital expenditure (140)
Estimated net cash flow in 2017 81
77

(ii) REDUCE OR DELAY CAPITAL EXPENDITURE
Reducing or delaying investment and thereby slowing down the growth of the
company could jeopardise the success of the company. A decision would depend
on the nature of the capital expenditure and what impact a delay or reduction
would have on the performance and growth of the business. Alternative ways of
funding the investment such as the use of leasing or sale and leaseback of non-
current assets could also be considered.
(iii) REDUCE OR POSTPONE DEVIDEND

Cutting dividend levels is more easily achieved in a private company such as AB
Ltd. This would create a potential problem if the company were preparing for
floatation and needed to build up a good track record of dividend payments.
However, this may not be acceptable to shareholders who may be dependent on
dividend income.
(iv) EXPLORE INSTALMENTAL PAYMENTS OF TAX

The company may arrange with the tax authorities to pay their assessable tax in
instalments.
(v) OTHER POSSIBLE ACTIONS

- Explore the use of the services of a factor as necessary
- Speed up cash collection from customers
- Delay payments to suppliers taking into consideration the suppliers credit
terms
RECOMMMENDATION
A bank loan would enable dividend and investment strategies to remain unchanged and
hence protect the future expansion plans of the business and meet shareholder payout
expectations. If it is not possible to borrow the whole amount needed, it may be possible
to borrow a substantial proportion of the amount required. Any remaining amount should
be obtained by delaying capital expenditure plans or, if that is not feasible or would
damage business prospects, reduce dividend payouts in 2017.
EXAMINER’S REPORT
The question tests candidates’ ability to prepare projected financial statements, including
projected cash flows.
In view of the fact that the question is compulsory, almost all the candidates, that is, over
90% of them attempted it, but only a very few appear to understand its requirements,
hence performance was poor.
78

Candidates’ commonest pitfall was their lack of indepth knowledge of the requirements of
the question, hence their failure to proffer correct solutions to all the parts, particularly
Part ‘b’, where they failed to identify the funding gap and how the gap can be closed.
Candidates are advised to take time to read, understand and interprete questions
appropriately and note their specific requirements before attempting them. They should
also endeavour to improve their knowledge on the preparation of projected financial
statements by revising other subject linkages such as performance management, financial
reporting, etc.
79

SOLUTION 2
(a) VALUATION OF MINORORIA PLC.
i) Statement of Financial Position (net asset) basis N454,100

N N
ii) Replacement value
Net assets 454,100
Replacement costs 725,000
Less: Book value 651,600 73,400
Inventory and W. I. P
561,600
iii) Realisable value

Net assets 454,100
Realisable value 450,000
Less: Book value 651,600 (201,600)
Inventory and W. I. P
306,600
Less: Uncollectable receivables
2% of N745,000 (14,900)
291,700
iv) Gordon (rb) model

Average proportion of earnings retained =
, , , , , ,
b= = = 0.495 0r 50%
, , , , , ,
r = minimum returns required by Minororia Plc. = 12%
growth rate (g) = rb = 0.5 x 0.12 = 0.6 or 6%

o ( )
Market value of equity = , ℎ
E
KE = Cost of equity capital = 12%
80

Do = dividend as at 31/12/2014 = 25,000
g = growth rate in dividend = 6%
Thus, total value of equity as at 31/12/14 is:
, ( . )
= = N441,667
. .
Note
In answering this part of the question, candidates are likely to come up with different but
acceptable assumptions. Some of these include:
- No growth in dividend- because dividend has been constant for the last two years
and it is also projected at the same level for year 2014. In that case the formula to
use is:
D/r
- The retention rate, b, can be calculated using the 2014 projected results rather
than using average.
- The return on equity (ROE) can be computed as
ROE = , using results for 2014 or the average for the period
given.
P/E ratio model

Since Monororia is not quoted on the stock market, it does not have a P/E ratio.
We make use of the P/E ratio of similar but quoted companies in the industry.
However, since the company is not quoted, it is assumed that it has a higher risk
and lower P/E ratio.
v) A P/E ratio of 8 is assumed.
Therefore total value = 8 x N53,200 = N425,600
(b) LIMITATIONS
(i) Net Asset Basis

· Book values are unlikely to relate closely to economic values of assets.
· The sum of the value of the business component parts may not be the same
as the value of the business as going concern.
81

(ii) Replacement Cost
· An asset that is out of production may not have a replacement cost.
(iii) Net Realisable Value

· The market value may not exist or where it does exist, it might be
unreliable.
(iv) Gordon Dividend Growth Model

· Cannot be used to value non-dividend paying companies.
· Where the growth rate is higher than the cost of equity, the method breaks
down.
· It assumes that dividend will grow at a constant rate to infinity. In
practice, this may not hold.
· For an unquoted company, it could be difficult to identify the relevant cost
of equity to use in the valuation.
(v) P/E Ratio Method

· There are difficulties in finding a quoted company sufficiently similar to
the company being valued.
· Earnings do not necessarily reflect cash generating potential. It is the latter
which is more likely to bear on value than the former.
· The P/E ratio calculation is meaningless when the earnings of a firm are
negative. While using the normalised or average earnings in the recent
past as a proxy for current earnings can reduce this problem, it cannot be
eliminated.
· The volatility of a firm’s earnings can cause wild swings in the P/E ratio
estimates from period to period.
· Earnings per share of a firm depend on the accounting principles used.
Differences in accounting for inventories, depreciation and research and
development may lead to vastly different values for earnings (and
therefore, their P/E ratios) for two firms that may actually be exactly alike.
ALTERNATIVE SOLUTION
i. Replacement cost N N
Inventory and W.I.P 550,000
Add: Book value: Receivables 745,000
82

Bank balances 158,100
2,178,100
Less: Current liabilities 1,616,500
ii. Realisable value

Inventory and W. I. P 570,000
Add: Book value: Receivable 745,000
Less: Uncollectible 14,900 730,100
Bank balances 158,100
1,908,200
Less: Current liabilities 1,616,500
EXAMINER’S REPORT
The question tests candidates’ knowledge of the various methods of valuing a company’s
equity and the validity of each method.
More than 80% of the candidates attempted the question and performance was average.
Most of the candidates have good understanding of sections (i), (ii) and (iii) of part ‘a’ of
the question, but demonstrated poor understanding of sections (iv) and (v). Part ‘b’ of the
question was fairly attempted.
Candidates’ commonest pitfalls were their inability to calculate dividend growth rate and
their limited knowledge of the limitations of the various valuation methods.
Candidates are advised to always cover the syllabus adequately by giving considerations to
all sections of the syllabus in their preparation for the Institute’s examinations. They
should also improve their knowledge on the valuation of a company’s equity and the
limitations of each of the valuation methods.
SOLUTION 3
(a)
83

KING QUEEN Plc.
Plc.
N000 N000
Total market value of equity 175,000 37,500
Value of KING Plc. after the acquisition

Sales (37,500 + 20,000 + 1, 500) 59,000
Opening expenses (20,000 + 15,500 – 1,250) 34,250
Profit (dividends) 24,750
N
Present Value (PV) of future earnings (dividends)
24,750,000 = 247,500,000
=
0.10
Add cash flow from sale of machine 2,500,000

Total value of KING Plc. after merger 250,000,000
Therefore, the maximum price payable by the directors of KING Plc. is the increase in
the value arising from the merger i.e. N250,000,000 –
N175,000,000 = 75,000,000
KING Plc. is advised to pay maximum of N75million for the acquisition.
(b) The takeover price agreed is ½ of N75million i.e. N37.5million. Let x represent the
number of new shares to be issued to QUEEN Plc.
Therefore, total number of shares in issue after takeover becomes

50,000,000 + x shares.
Total value of KING Plc. after acquisition = N250m
For the entire benefit from the acquisition to accrue to the present shareholders of KING
Plc., value of KING Plc.’s shares issued to QUEEN Plc.’s shareholders must equal the
agreed take-over price i.e.
250 = 37.5m
250,000,000 x = 37,500,000 (50,000,000 + x)
84

= 50,000,000 +
.
1,875,000,000 + 37.50x = 250x

x = 8,823,529 Shares
The market value per share after the acquisition or take-over
= 250,000,000
50,000,000 + 8,823,529
= 250,000,000 = N4.25
58,823,529
Gain to shareholders of KING Plc. (N4.25 – N3.50) x 50m = N37,500,000. Thus, the
entire benefit from the take-over will accrue to the present shareholders of KING Plc.
(c) The shareholders of QUEEN Plc. should negotiate a takeover price higher than the agreed
N37.5million, At a takeover price of N37.5m, the shareholders of Queen Plc will not get
any benefit from the takeover. Therefore, they may not agree to the takeover.
The directors of QUEEN Plc. might believe from the proposal that the increase in profits
after the acquisition and the sale of assets are indications that they are effectively utilising
their assets hence the company may decide to put them (the assets) to better usage rather
than sell them.
The directors of KING Plc. will have to reassess their estimates. How realistic is the
increase in sales revenue of N1,500,000 p.a. and a reduction in expenses of N1,250,000.
Furthermore, will the reduction in expenses involve retrenchment of staff and what effect
will this have on the morale of the remaining staff? Also if staff are to be laid off, what
about the redundancy payment?
What about the transaction costs of the acquisition? If the takeover is resisted by the
directors of QUEEN Plc or other interested buyers, then the cost of the acquisition could
be quite high.
Further, since KING Plc. and QUEEN Plc. both manufacture and sell household items;
the attitude of the government or trade unions to forestall a monopoly situation may not
have been considered.
(d) If the director of QUEEN Plc. considered the takeover bid unfriendly, the following
defence tactics are available:
i. Seek Government injunction i.e. restricting the predator company under anti-
monopoly or anti-trust law where this is in existence.
85

ii. Embark on effective public promotion.
iii. Appeal to shareholders not to sell their shares by promising them better prospect
and share appreciation
iv. White knight Defence: The target company may seek for a friendly company
whose offer is more appealing for the takeover bid.
v. ‘Crown Jewel’ Defence: This is a strategy that is employed by the management
of the target company whereby a third party is granted the right to buy the firm’s
assets in order to discourage the predator firm from going ahead with the bid.
The plan is particularly effective when the target company offers for sale its
crown jewel – the target firm most valued asset.
vi. Litigation
vii. Asset Restructuring: The target firm purchases assets that effectively restructure
its statement of financial position. These assets may simply be ones that are
unattractive to the bidder or may cause anti-trust problems if the merger creates
significant monopoly power.
vii. Green mail: This technique involves an agreement allowing the target company
to repurchase its own shares back from the acquiring company, usually at a
premium to the market price. It is the termination of a hostile take-over through a
payoff to the acquirer.
ix. Share repurchase: Rather than repurchasing only the shares held by the
acquiring company as a greenmail, a target company might initiate a cash tender
offer for its own outstanding shares.
x. Pacman Defense: This is called after the video game in which characters try to
eat each other before they are eaten themselves, that is, the firm under attack from
a hostile bidder turns the table by bidding for the aggressor.
xi. White Squire Defence: This is similar to white knight defence in that the two
parties, target firm and white squire, seek to implement a strategy to preserve the
target firm’s independence. This is done by placing shares in the hands of a
friendly firm or investor who is not interested in acquiring control of the target
firm and will not sell out to the predator.
EXAMINER’S REPORT
The question tests candidates’ understanding of the valuation of a company for a take-over
and their knowledge of the various post takeover defence strategies.
86

Over 80% of the candidates attempted the question but most of them did not have a clear
and accurate understanding of parts ‘b’ and ‘c’ while the ‘d’ part was fairly attempted
hence performance was poor.
Candidates’ commonest pitfalls were their inability to price the given company and
differentiate between post takeover and pre-takeover defensive tactics.
Candidates are advised to study extensively and adequately cover the syllabus when
preparing for the Institute’s examinations.
SOLUTION 4
(a) OSEKA BAGS LIMITED
EXISTING SUPPLIER
(i) Economic Order Quantity will be assessed using the following formula:
2DK
\ EOQ =
H
Where D = Annual demand (units)
K = Cost per order
H = Unit holding cost per annum
\ EOQ = = 300 briefcases
The existing optimal order quantity is 300 units
(ii) Total cost

Part (b) of the question involves quantity discount and as a result the total relevant
cost must include purchase cost.
Holding cost = Average stock x unit holding cost

N
= 300 x N100 = 15,000
2
Ordering cost = No of orders x Cost per order
= 100 x 50 x N900 = 15,000
300
Purchase cost = Annual demand x Unit price
87

100 x 50 x N1,000 = 5,000,000
Total annual cost = 5,030,000
(b) NEW SUPPLIER
(i) Economic order quantity

2DK
\ EOQ =
H
, ,
\ EOQ = = 500 briefcases
(ii) Total cost
The total cost of stocking briefcases for the year will be
N
Holding cost = 500 x N100 = 25,000
2
Ordering cost = 5,000 x N2,500 = 25,000
500
Purchase cost = 5,000 x N960 = 4,800,000

Total annual cost 4,850,000
On financial grounds, it would be beneficial by

N180,000 (N5,030,000 - N4,850,000)
Recommendation: The supplier should be changed.
(c) Limitations of the analysis

The above computations dealt with only the financial aspect of the decision and are based
on simplified assumptions which may not be valid in reality.
Over simplified assumptions are:
(i) Constant demand
88

The EOQ model assumes a constant annual demand which may not be the case at
all times. There could be variation in annual demand due to seasonal variations
e.g. sales may be higher in Christmas and other festive periods.
(ii) Reliability of suppliers

It was assumed that both suppliers were totally reliable, particularly in terms of
delivery times. In reality, it is more likely that there may sometimes be
inadvertent delays in lead times.
(iii) Credit terms

It was assumed that both suppliers offered similar credit terms. No allowance was
made, as no information was given for the financial effect of suppliers allowing
different credit periods.
(iv) Storage space

An EOQ of 500 briefcases requires increase in storage space over the current
EOQ of 300 briefcases. Is the extra space available at no extra cost?
Other non-financial factors to consider are:

(i) Quality
It will need to be determined whether the two suppliers can provide the
same consistency of quality. Where there are lapses in quality, Oseka
Limited will need to be reassured of the after sale service consistency of
the two suppliers.
(ii) Reliability and flexibility

Will the two suppliers be consistently reliable and flexible?
(iii) Presentation and packaging

Customers’ perceptions can be significantly influenced by product
presentation and packaging. Information about the leather quality of both
briefcases is required for effective decision.
(iv) Colour range or options

Oseka Limited will need to ensure that both existing briefcases are both
available in the same range of colours and having similar male and female
versions in order that sales volume can be maintained.
89

(d) Net present value
Item Year Cash flow PVF at 10% PV

N
Investment 0 (400,000) 1.000 (400,000)
Cash savings 1-3 180,000 2.487 447,660
NPV 47,660
Based on the above financial analysis, even with a N400,000 immediate

investment cost, it is financially viable to switch to new supplier.
EXAMINER’S REPORT
The question tests candidates’ knowledge of inventory control with emphasis on the
Economic Order Quantity (EOQ) Model.
Over 75% of the candidates attempted the question and the general performance was
average. Some of the candidates understood the question and therefore performed
brilliantly, but others did not understand the import of the question, hence they performed
below average.
Candidates’ commonest pitfalls were their inability to produce the correct EOQ formula,
calculate EOQ and total cost and discuss the limitations of the EOQ model
Candidates’ are advised to take time to read, understand and interprete questions
appropriately and note their specific requirements before attempting them. They should
also pay attention to an understanding of key formulae and their applications in some
aspects of the syllabus.
SOLUTION 5
(a) (i) Money laundering constitutes any financial transactions whose
90

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 organisations
- 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.
91

(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.
EXAMINER’S REPORT
The question tests candidates’ understanding of money laundering and their knowledge of
Islamic Finance.
Over 90% of the candidates attempted the question and performance was poor. Most of
the candidates lacked an understanding of part ‘a’ of the question, while some
demonstrated a fair knowledge of part ‘b’.
Candidates’ commonest pitfall was their inability to interprete the question correctly.
Candidates’ are advised to study extensively and adequately cover the syllabus when
preparing for the Institute’s examinations. They should also endeavour to take time to
read, understand and interprete questions appropriately and note their specific
requirements before attempting them.
SOLUTION 6
(a) Capital Market Line (CML) is the line that represents the expected returns of the efficient
portfolios as a function of volatilities measured by the standard deviations of their
returns.
Security Market Line (SML) is the line which measures the expected returns of
individual securities as a function of their sensitivity to market fluctuations (i.e. beta
factor).
The difference between the two lies in the fact that while CML represents only efficient
portfolios, SML represents all portfolios as well as individual securities. Thus all
92

portfolios lying on the CML are also lying on the SML, but not all portfolios lying on the
SML are efficient and hence need not lie on the CML.
(b)
(i) Based on CAPM, the return expected from each stock is computed as follows:
Ri: = Rf + b i (Rm – Rf)
Rf = Risk free rate
b i= Portfolio risk (Beta)
Rm = Market returns
Ri = Expected return
Ri = 6 + b i (12 – 6) = 6 + 6 b
i
Stock A 6 + 6 (1.36) = 14.16%
B 6 + 6 (0.52) = 9.12%
C 6 + 6 (0.69) = 10.14%
(iii) To reshuffle the portfolio within these three stocks, we need to know if the
theoretical returns using the CAPM theory are in accordance with the expected
returns based on our forecasts. The difference between the two is calculated using
alphas. Hence, we first need to calculate the alpha of each of the stocks in order
to find out which stocks are underpriced/overpriced.
Accordingly, we will decide which stocks need to be bought/sold.
a i = Expected Return - Required Return

Stock A = 14% - 14.16% = -0.16%
B = 9.5% - 9.12% = 0.28%
C = 10.0% - 10.14% = -0.14%
Stocks with negative alphas are over-valued and stocks with positive alphas are
under-valued. Thus, Stocks A and C are over-valued and should be sold. Stock B
with positive alpha is under-priced and more should be bought.
EXAMINER’S REPORT
The question tests candidates’ knowledge of Portfolio Concept and Capital Asset Pricing
Model (CAPM),
The level of attempt was low as the number of candidates that attempted the question was
below 50%. It therefore appears that most of the candidates that sat for the examination
93

did not understand the import of the question. The few candidates that attempted the
question only have just a fair knowledge of it, hence, performance was poor.
Candidates’ commonest problem was their inability to differentiate between Security

Market Line (SML) and Capital Market Line (CML), and correctly apply the Capital
Asset Pricing Model (CAPM) formula. Hence they were unable to calculate the alpha
values.
Candidates’ are advised to cover the syllabus adequately, work on past questions, make use
of the Institute’s Pathfinder and Study Packs in their preparations for the Institute’s
examinations for better results. They should also endeavour to remember key formulae
and their applications in solving problems.
SOLUTION 7
(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
94

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.
(c) If actual rate is 5%

N
6
FRA payment = N10million x (6% - 5%) x /12 500,000
Payment on underlying loan 5% x N100million x 6/12 2,500,000
Net payment on loan 3,000,000
Effective Interest rate on loan = 6%
If actual rate is 9%
the bank will pay Famak Plc. N
FRA receipt N100million x (9% - 6%) x 6/12 (1,500,000)
Payment on underlying loan at market rate
net 9% x N100million x 6/12 4,500,000
Net payment on loan 3,000,000
Effective Interest rate on loan = 6%
EXAMINER’S REPORT
95

NOVEMBER 2015 PROFESSIONAL EXAMINATION
Question Papers
Suggested Solutions
Plus
Marking Guide
Examiners‟ Reports
PROFESSIONAL LEVEL EXAMINATION – NOVEMBER 2015 1

ANSWER FIVE QUESTIONS IN ALL
QUESTION 1 COMPULSORY QUESTION (30 Marks)
SECTION A
Kay Plc. has been expanding rapidly through mergers and acquisitions. Currently,
it is considering a bid for Y Plc. a company whose shares are not traded. The latest
Statement of Financial Position of Y Plc. is summarised below:
N‟m N‟m
Non-current assets 378
Current assets:
Inventory 242
Receivables 163
Cash 21 426
Total assets 804
Current liabilities 242

Non-current liabilities 106 348
Share capital 120
Reserves 336 456
Capital and liabilities 804
Y Plc. has 120million N1 shares issued and fully paid. The non-current assets
shown in the Statement of Financial Position above include a property with a book
value of N80million. The agreed market value of this property is N136million. The
current market values of the remaining assets and liabilities are estimated not to
be substantially different from the figures included in the Statement of Financial
Position above.
Y Plc‟s latest Income Statement is summarised below:
N‟m
Revenue 756
Cost of sales (544)
Gross profit 212
Administrative cost (77)
Operating profit 135
Financing costs (12)
Profit before tax 123
Tax (39)
Profit after tax 84
Dividend (18)
Retained profit 66

No interim dividend has been paid. Kay Plc. believes that if the bid succeeds, it
can reduce financing and operating costs by N14,550,000 per annum (after tax).
Kay Plc. further believes that the annual cash flow it will derive from ownership of
Y Plc. over the next ten years will be approximately equal to that company‟s current
after tax profit plus the forecast cost savings. Kay Plc considers that cash flows
after year ten should be ignored in any valuation of potential acquisitions.
Kay Plc. has an issued share capital of 80,000,000 N1 shares with a current market
value of N32 per share (ex div). Current earnings per share amount to N4 and
current dividend per share is N1.20. The company‟s asset beta is 0.8. Kay Plc. has
no prior charge on capital and no other non-current liability. The risk free rate of
interest is 8% and the return on the market portfolio is 13%. Kay Plc. uses the
Capital Asset Pricing Model (CAPM) to estimate its cost of capital. The bid will be in
the form of a share exchange.
Required:
a. Explain, in general terms, the criteria a company should use in assessing a

potential company for takeover.
(6 Marks)
b. i. Calculate the maximum price Kay Plc. should offer per share in Y Plc.
to
avoid diluting current earnings per share after the takeover.
(3 Marks)
ii. Estimate the price Kay Plc. must offer per share in Y Plc. in order to
maintain dividend levels to shareholders in that company. You must
assume that Kay Plc. does not intend to change its own dividend per
share. (3 Marks)
iii. Suggest two other bases of valuing the shares in Y Plc. and calculate
the price per share on those bases.
(5 Marks)
c. Estimate Kay Plc.‟s share prices after the takeover for each of the offer prices
calculated in (b) above, assuming that Kay Plc. retains its current P/E ratio
after the takeover. (8 Marks)
d. Advise the directors of Kay Plc. on steps that could be taken to minimise the
risk of failing to realise the potential synergistic benefits arising from the
takeover. (5 Marks)
(Total 30 Marks)

SECTION B: ANSWER ANY TWO OUT OF THREE QUESTIONS IN THIS SECTION
(40 MARKS)
QUESTION 2
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)
QUESTION 3
Gazoline Plc., a public limited company with a market value of N7billion, is a major
supplier of gas to both business and domestic customers. The company also
provides maintenance contracts for both gas and central heating customers using
the well-known brand name “Gas For All”.
Customers can call emergency lines for assistance for any gas-related incident, such
as a suspected leakage. Gazoline Plc. employs its own highly trained work force to
deal with all such situations quickly and effectively. The company also operates a
major new credit card scheme, which has been extensively marketed and is
designed to give users concessions such as reductions in their gas bills.
The company has recently bid N1.1billion for Smooth Car, a long established
mutual organisation (i.e. it is owned by its members) that is the country‟s leading
motoring organisation. Smooth Car is financed primarily by an annual subscription
of its 4.4million members. In addition, the organisation obtains income from a
range of other activities such as a high profile car insurance brokerage, a travel
agency and assistance with all types of travel arrangements. Its main service to
members is the provision of a roadside break-down service which is now an
extremely competitive market with many other companies involved. Although
many of its competitors use local garages to deal with break-downs, Smooth Car
uses its own road patrols.
Smooth Car members have to approve the takeover which, once completed, would
provide them each with a windfall of around N300 each.
Gazoline Plc. intends to preserve the Smooth Car name which is well-known by
customers.

Required:
a. Examine the possible reasons why Gazoline Plc. is seeking to buy Smooth
Car. (8 Marks)
b. Discuss how the various stakeholders of Smooth Car might react to the
takeover. (6 Marks)
c. Explain the potential problems that Gazoline Plc. may face in running
Smooth
Car now that the takeover has been achieved. (6 Marks)
(Total 20 Marks)
QUESTION 4
The latest Statement of Financial Position of Kilanko Nigeria Limited is summarised

below:
N‟000 N‟000 N‟000
Non-current assets at net book value 28,500
Current assets:
Inventory and work-in-progress 17,500
Receivables 9,000
26,500
Less: Current liabilities:
Unsecured payables 20,000
Bank overdraft (unsecured) 8,000
28,000
Working capital (1,500)
Total assets less current liabilities 27,000
Liabilities falling due after more than one year
10% Secured Debentures 15,000
Net assets 12,000
Capital and reserves:

Called up share capital 20,000
Statement of profit or loss (8,000)
12,000
Kilanko Nigeria Limited‟s called up capital consists of 20million N1 Ordinary Shares
issued and fully paid. The non-current assets comprise Freehold Property with a
book value of N15,000,000 and Plant and Machinery with a book value of
N13,500,000. The debentures are secured on the Freehold Property.

In recent years, the company suffered series of trading losses which have brought it
to the brink of liquidation. The directors estimate that in a forced sale of the assets,
they will realise the following amounts:
N
Freehold premises 10,000,000
Plant and machinery 5,000,000
Inventory 8,500,000
Receivables 8,500,000
The costs of liquidation are estimated at N3,850,000. However, trading conditions

are now improving and the directors estimate that if new investments in Plant and
Machinery, costing N12,500,000, were undertaken, the company should be able to
generate annual profits before interest of N8,750,000. In order to take advantage
of this, they have put forward the following proposed reconstruction scheme:
(i) Freehold premises should be written down by N5,000,000, plant and
machinery by N5,500,000, inventory and work-in-progress by N4,000,000
and receivables by N500,000.
(ii) The Ordinary Shares should be written down by N15,000,000 and the debit
balance on the Statement of Profit or Loss written off;
(iii) The secured debenture holders would exchange their debentures for
N7,500,000 ordinary shares and N6,500,000 14% unsecured loan stock
repayable five years‟ time.
(iv) The bank overdraft should be written off and the bank should receive
N6,000,000 of the 14% unsecured loan stock repayable in five years time as
compensation.
(v) The unsecured payables should be written down by 25%.
(vi) A rights issue of 1 for 1 at par is to be made on the share capital after the
above adjustments have been made; and
(vii) N12,500,000 will be invested in new plant and machinery.
Required:
a. Prepare the Statement of Financial Position of the company after the
completion of the reconstruction.
(6 Marks)
b. Prepare a report, including appropriate calculations, discussing the

advantages and disadvantages of the proposed reconstruction from the point
of view of:
i. The Ordinary Shareholders.
ii. The Secured Debenture holders
iii. The Bank. (14 Marks)
(Total 20 Marks)

SECTION C: ANSWER ANY TWO OUT OF THREE QUESTIONS IN THIS SECTION
(30 MARKS)
QUESTION 5
The working capital cycle of a business is the length of time between payment for
inventory entering into inventory and receipt of the proceeds of sales.
The table below gives information extracted from the Statement of Comprehensive
Income and the Statement of Financial Position of Bright Sum Plc. for the years
2012 to 2014.
2012 2013 2014
Inventory: N‟000 N‟000 N‟000
Raw materials 1,080 1,458 1,800
Work-in-progress 756 972 933
Finished goods 864 1,296 1,428
Purchases 5,184 7,020 7,200
Cost of goods sold 7,560 9,720 10,983
Revenue 8,640 10,800 11,880
Trade receivables 1,728 2,592 2,970
Trade payables 864 1,053 1,260
a. Calculate the working capital cycle for each of the 3 years. (9 Marks)
b. Explain THREE possible actions that might be taken to reduce the length of
the cycle and TWO possible disadvantages of each. (6 Marks)
(Total 15 Marks)
QUESTION 6
a. In recent years, one of the major problems faced by treasurers of

multinational companies has been the fluctuating value of the Naira against
other currencies and the difficulty of predicting future movements in the rate
of exchange. A treasurer has especially two important functions to perform
in a situation of rapid currency movements. firstly, to be clear as to the
nature of his company‟s exposure in terms of exchange transactions and
secondly, to minimise the risk from such exposure.
Required:
Describe TWO types of foreign exchange exposures which can arise in respect
of transactions involving a foreign currency. (6 Marks)

b. Owiya Osese Plc. a Nigerian Company is due to receive 500,000 Waka, the
currency of an African country, in 6 months time for goods supplied. The
company decided to hedge its currency exposure by using the forward
market.
The short-term interest rate in Nigeria is 15% per annum and the equivalent
rate in the African country is 18%. The spot rate of exchange is 2.50 Waka to
the Naira.
You are required to calculate how much Owiya Osese Plc. actually gained or
lost as a result of the hedging transaction, if at the end of 6 months, the
Naira in relation to Waka has:
i. Gained 4%
ii. Lost 2%
iii. Remained stable
NOTE: You may assume that the forward rate of exchange simply reflects the
interest rate differential in the two countries (i.e. it reflects the interest rate
parity analysis of forward rates). (9 Marks)
(Total 15 Marks)
QUESTION 7
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)

Formulae

𝑉𝐷
𝐾𝐸𝐺 = 𝐾𝐸𝑈 + 𝐾𝐸𝑈 − 𝐾𝐷 (1 − 𝑡)
𝑉𝐸𝐺
Asset Beta
𝑉𝐸 𝑉𝐷 (1 − 𝑇)
𝛽𝐴 = 𝛽𝐸 + 𝛽
(𝑉𝐸 + 𝑉𝐷 (1 − 𝑇)) (𝑉𝐸 + 𝑉𝐷 (1 − 𝑇)) 𝐷
Equity Beta
𝑉𝐷
𝛽𝐸 = 𝛽𝐴 + (𝛽𝐴 − 𝛽𝐷 ) (1 − 𝑡)
𝑉𝐸
Growing Annuity
𝑛
𝐴1 1+𝑔
𝑃𝑉 = 1−
𝑟−𝑔 1+𝑟

1
𝑃𝑉𝑅 𝑛
𝑀𝐼𝑅𝑅 = 1 + 𝑟𝑒 − 1
𝑃𝑉𝐼

C0 = S0N(d1) – Ee-rt N(d2)
𝑆0
𝐼𝑛 + (𝑟 + 0.5𝜎 2 )𝑇
𝑑1 = 𝐸
𝜎 𝑇
d2 = d1 - 𝜎 𝑇
The Put Call Parity

C + Ee-rt = S + P

𝑢 = 𝑒 𝜎× 𝑇/𝑛
d = 1/u
𝑎 = 𝑒 𝑟𝑇/𝑛
𝑎−𝑑
𝜋=
𝑢−𝑑
The discount factor per step is given by = 𝑒 −𝑟𝑇/𝑛

Annuity Table
Present value of an annuity of 1 i.e. 1 - (1 + r)-n
r
Discount rate (r)
Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1
2 1·970 1·942 1·913 1·886 1·859 1·833 1·808 1·783 1·759 1·736 2
3 2·941 2·884 2·829 2·775 2·723 2·673 2·624 2·577 2·531 2.487 3
4 3·902 3·808 3.717 3·630 3.546 3.465 3·387 3·312 3·240 3·170 4
5 4·853 4·713 4·580 4·452 4·329 4·212 4·100 3·993 3.890 3·791 5
6 5·795 5·601 5·417 5·242 5·076 4·917 4·767 4·623 4.486 4·355 6
7 6·728 6.472 6·230 6·002 5·786 5·582 5·389 5·206 5·033 4·868 7
8 7·652 7·325 7·020 6·733 6·463 6·210 5·971 5·747 5·535 5·335 8
9 8·566 8·162 7·786 7.435 7·108 6·802 6·515 6·247 5·995 5·759 9
10 9·471 8·983 8·530 8·111 7·722 7·360 7·024 6·710 6.418 6·145 10
11 10·368 9·787 9·253 8·760 8·306 7·887 7.499 7·139 6·805 6.495 11
12 11·255 10·575 9·954 9·385 8·863 8·384 7·943 7·536 7'161 6·814 12
13 12·134 11·348 10·635 9·986 9·394 8·853 8·358 7·904 7·487 7·103 13
14 13·004 12·106 11·296 10·563 9·899 9·295 8·745 8·244 7·786 7·367 14
15 13·865 12·849 11·938 11·118 10·380 9·712 9·108 8·559 8·061 7·606 15
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1
2 1·713 1·690 1·668 1·647 1·626 1·605 1·585 1·566 1·547 1·528 2
3 2.444 2.402 2·361 2·322 2·283 2·246 2·210 2·174 2·140 2·106 3
4 3·102 3·037 2·974 2·914 2·855 2·798 2·743 2.690 2·639 2.589 4
5 3·696 3·605 3·517 3·433 3·352 3·274 3·199 3·127 3·058 2·991 5
6 4·231 4·111 3·998 3·889 3·784 3·685 3·589 3.498 3.410 3·326 6
7 4·712 4·564 4.423 4·288 4·160 4·039 3·922 3·812 3·706 3·605 7
8 5·146 4·968 4.799 4·639 4.487 4·344 4·207 4·078 3·954 3·837 8
9 5·537 5·328 5·132 4·946 4·772 4·607 4.451 4·303 4·163 4·031 9
10 5·889 5·650 5.426 5·216 5·019 4·833 4·659 4.494 4·339 4·192 10
11 6·207 5·938 5·687 5.453 5·234 5·029 4·836 4·656 4.486 4·327 11
12 6·492 6·194 5·918 5·660 5·421 5·197 4·988 4·793 4·611 4.439 12
13 6·750 6.424 6·122 5·842 5·583 5·342 5·118 4·910 4·715 4·533 13
14 6·982 6·628 6·302 6·002 5·724 5.468 5·229 5·008 4·802 4·611 14
15 7·191 6·811 6.462 6·142 5·847 5·575 5·324 5·092 4·876 4·675 15

This table can be used to calculate N(d) the cumulative normal distribution

SOLUTIONS

SOLUTION 1
(a) The criteria that should be used to assess if a target is appropriate will
depend on the motive for the acquisition. The main criteria that are
consistent with the underlying motive include:
Benefit for acquiring undervalued company

The target firm should trade at a price below the estimated value of the
company when acquired. This is true of companies which have assets that
are not exploited.
Diversification
The target firm should be in a business which is different from the acquiring
firm‟s business and the correlation in earnings should be low.
Operating synergy
The target firm should have the characteristics that create operating
synergy. Thus, the target firm should be in the same business in order to
create cost savings through economies of scale or it should be able to create
a higher growth rate through increased monopoly power.
Tax savings
The target company should have large claims to be set off against taxes and
not sufficient profits. The acquisition of the target firm should provide a tax
benefit to the acquirer.
Increase the debt capacity
This happens when the target firm is unable to borrow money or is forced to
pay high rates. The target firm should have capital structure such that its
acquisition will reduce bankruptcy risk and will result in increasing its debt
capacity.
Disposal of cash slack

This is where a cash rich company seeks a development target. The target
company should have highly profitable projects with positive net present
value but no funds. This happens when for example the target company has
some exclusive right to product or use of asset but no funds to start
activities.
Access to cash resources

A company with a number of cash intensive projects or products in their
pipeline, or heavy investment in R&D might seek a company that has
significant cash resources or highly cash generating product line to support
their own needs.

Control of the Company
In this case the objective is to find a target firm which is badly managed and
whose stock has underperformed the market. The management of an existing
company is not able to fully utilize the potential of the assets of the company
and the bidding company feels that it has greater expertise or better
management methods. The bidding company therefore believes that the
assets of the target company will generate for them a greater return than for
their current owners. The criterion in this case is a market valuation of the
company that is lower than, for example the value of its assets.
Access to key technology

Some companies do not invest significantly in R&D but secure their enabling
technologies by acquisition. Pharmaceutical companies who take over
smaller biotechs in order to get hold of the technology are good examples of
this type of strategy.
b. i) Purchase consideration per share.

If Kay Plc.‟s share capital is 80 million N1 shares and its current
earnings per share is N4 then its total earnings will be:
(80 million x N4) = N320 million
If Y Plc‟s total earnings is N84 million as per income statement and
the additional earnings after takeover is N14.55 million then total
expected earnings after merger will be:
N
Kay Plc. existing earnings 320,000,000
Y Plc.‟s existing earnings 84,000,000
Expected additional earnings 14,550,000
Total expected earnings 418,550,000
Required Earnings Per share = N4
Therefore, total number of post acquisition shares
 418,550,000  = 104,637,500 shares
N 
 4 
Less: Existing share of Kay Plc. = 80,000,000 shares
 No of shares to be issued to
Y Plc.‟s shareholders = 24,637,500 shares
If the market value of Kay Plc. is N32 per share ex-div, purchase
consideration for Y Plc. will therefore be:
24,637,500 shares x N32.00

= N788,400,000

Since the existing number of shares of Y Plc. is 120 million, then the
purchase consideration per existing share in Y Plc. will be:
𝑁788,4000 ,000
= 120,000,000,000 = N6.57
ALTERNATIVE METHOD
Let x represent the post-acquisition number of shares in Kay Plc.
Post –acquisition total earnings:

N
Kay Plc‟s existing earnings 320,000,000
Y Plc‟s existing earnings 84,000,000
Synergy 14,550,000
418,550,000
N418,550,000
EPS = x
That is N4 
N418,550,000
x
Therefore 4x = N 418,550,000
x = 104,637,500 shares
Shares issued to Y Plc. will be (104,637,500 - 80,000,000)
= 24,637,500 Shares
Total value placed on Y Plc. will be 24,637,500 x N32 = N788,400,000
Value per existing share of Y Plc. will therefore be:
= N788,400,000 ÷120,000,000
= N6.57
Thus maximum price payable per share is N6.57
ii) Purchase consideration per share.
Total dividend paid to the Shareholders of Kay Plc. is 80 million x

N1.20=N96million
Existing dividend paid by Y Plc. = N18million

Total dividend paid by Kay Plc. & Y Plc.
to their shareholders before merger = N114million
Required dividend per share after merger = N1.20
Therefore, total number of shares after merger is

𝑁114 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
𝑁1.20
= 95,000,000 𝑠ℎ𝑎𝑟𝑒𝑠

Total number of post - acquisition shares = 95,000,000
Current number of shares – Kay Plc. = (80,000,000)
Number of shares to be issued to shareholders of Y Plc. = 15,000,000
If the market value of Kay Plc‟s share is N32.00

Therefore total purchase consideration for Y Plc.‟s
will be 15 million x N32 = N480,000,000
Since number of shares in Y Plc. is 120 million, then

the purchase consideration for Y Plc. will be
N480 million
= 120 𝑚𝑖𝑖𝑙𝑖𝑜𝑛 𝑠ℎ𝑎𝑟𝑒𝑠
= N4 per share
ALTERNATIVE METHOD
Let x represent total shares issued by Y Plc.
 Total dividend receivable in Kay Plc by Y Plc. shareholders will be N1.20 x
This should equal total current dividend in Y Plc, N18,000,000.
Thus: 𝑁1.20𝑥 = 𝑁18,000,000

𝑁18,000,000
𝑥=
𝑁1.20
= 15,000,000 shares
Total purchase consideration will therefore be:

15,000,000 X N32 = N480,000,000
Thus, amount payable per existing share in Y Plc. will be:
N480,000,000/120,000,000= N4
(iii) Two other possible valuation methods in this question are:
Asset Basis and Discounted Cashflow method.
Asset Basis
Value of Y Plc‟s equity as per its statement of financial position is N456 million
Add: Increase in value of property (N136- N80) million = N56 million
Asset value of Y Plc. will therefore be (N456 + N56) million = N512 million
Since the number of shares held by the shareholders of Y Plc is 120 million, then
the purchase consideration for Y Plc. using the assets basis will be:
𝑁512,000,000
= 𝑁4.26667 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
120,000,000
= N4.27 per share

Discounted Cash Flow (DCF) Method:
N
Annual cash flows from Y Plc. 84,000,000
Expected savings-Financing/Operation Cost 14,550,000
Total Expected annual Cash flows 98,550,000
Therefore expected annual cash flows for the next ten years is N98.550,000.
Kay Plc‟s cost of capital using CAPM is
Ke = Rf +β(Rm –Rf)
= 8% + 0.8(13%-8%)
= 12%
Therefore, purchase consideration for Y Plc. will be:

N98,550,000,000 discounted @ 12 percent for 10 year period
i.e N98,550,000,000 x 5.65 = N556,807,500
Since the number of existing shares held by the shareholders of Y Plc. is 120
million, then the value per share to Y Plc. will be:
𝑁556,807,500
= N4.64006 = N4.64
120,000,000
c) Kay Plc.‟s current P/E ratio is
𝑉𝑃𝑆 𝑁32
𝐸𝑃𝑆
= 𝑁4
=8
If the P/E ratio is maintained, the value will be:

Post- acquisition earnings of Kay Plc x P/E ratio
i.e N418,550,000 x 8 = N3,348,400,000
Therefore calculations of new value per share of Kay Plc‟s will be as follows:
b (i) b(ii) Assets DCF Method

Basis
N‟000 N‟000 N‟000 N‟000
Post acquisition Value of Kay Plc. 3,348,400 3,348,400 3,348,400 3,348,400.0
Purchase consideration for Y Plc. (788,400) (480,000) (512,000) (556,807.5)
New value of Kay Plc 2,560,000 2,868,400 2,836,400 2,791,592.5
Existing number of shares 80,000 80,000 80,000 80,000
Share Price: N32 N35.855 N35.455 N34.895

d) The steps that could be taken to minimize the risk of failing to realize the
potential synergistic benefits from the takeover include:
i. Integration Plan: The acquiring company should prepare a detailed

strategic plan for integration based on its own and the acquired
company‟s strengths and weaknesses. The plan should highlight the
objectives and the process of integration.
ii. Communication: Management should inform employees about their

involvement in making the integration smooth and easy and remove any
ambiguity and fears in the mind of the staff
iii. Authority and responsibility: Management should take the employees

into confidence and decide the authority and responsibility relationships.
The detailed organizational structure can be decided later to avoid
confusion and indecisiveness.
iv. Cultural integration:- Management should focus on cultural integration of

the employees of the merged companies. There is a need for
understanding of the cultures of the two organizations. Clear
communication and training can help to bridge the cultural gaps.
v. Skills and competences upgrading: Management should prepare and

immediately implement a plan for skill and competencies upgrading
through training.
vi. Structural adjustment: Management should be prepared to make

adjustments to accommodate the aspiration of the employees of the
acquired company.
vii. Control systems: Management should ensure that it is in control of all

resources and activities of the merged firm. It must put proper financial
control in place so that resources are optimally utilized and wastage
avoided.
viii. Kay Plc. should respect the products, markets and customers of Y. Plc.
ix. Retention of key personnel (especially of Y.Plc) possibly by offering them

enhanced packages.

Marking Guide Marks
(a) 1 mark for each valid point 6

(b) (i)Post-acquisition total earnings 1
No of shares issued to Y. Plc. 1
Total value placed on Y. Plc. 1
/2_
Maximum price payable per share to Y. Plc. 1
/2_
3
(ii) Post-acquisition dividend 1
No of shares issued to Y. Plc. 1
Total Price payable 1
/2_
Maximum price payable per share to Y. Plc. 1
/2_
3
(iii) Asset Method
Total value of Equity 1
Value per share payable to Y. Plc. 1
DCF Method
Calculation of cost of equity using CAPM method 1
/2
Annual total cashflow expected from takeover 1
Identifying correct discount factor. 1
/2
Total value 1
/2
Value per share 1
/2
5
(c) Calculation of P/E ratio 1
/2
Stating the post-acquisition earnings of Kay Plc. 1
/2
Calculation of the expected total value of Kay Plc. 1
- Post-acquisition
Using the total post acquisition value of Kay Plc. as the
opening figure of the 4 scenarios 1
Amount paid for Y Plc for the 4 scenarios (1/2 mark each) 2
Total value of existing shares in Kay Plc for the 4 scenarios (1/2 1
mark each)
Value per existing share in Kay Plc, for the 4 scenarios
(1/2 mark ech) 2 8
(d) 1 mark for each valid point (max of 5 points) 5
Total marks 30
EXAMINER‟S REPORT
The question tests candidates‟ knowledge of the issues involved in strategic acquisition
and the different methods of valuing companies for takeover.
Being a compulsory question, almost all the candidates attempted it but most of them did
not understand its requirements. They therefore performed poorly.
Candidates‟ commonest pitfall was their failure to answer the question correctly which may
be due to their inadequate knowledge of the different methods of valuing companies for a
takeover.
Candidates are advised to always cover the syllabus adequately by giving consideration to
all sections of the syllabus in their preparation for the Institute‟s examinations. They should
also improve their knowledge on mergers and acquisitions.

SOLUTION 2
(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.
(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.

Marking Guide Marks
(a) 1 mark for each valid point identified(Max 3 points) 3
1 mark for the discussion (3 marks max) of the valid
points identified 3
6
(b) 1 mark for each valid point (max 7 points) 7
1 mark for the discussion of the valid points 7
14
Total 20
EXAMINER‟S REPORT
The question tests candidates‟ understanding of the analysis and evaluation of the
symptoms and causes of corporate failure.
About 90 Percent of the candidates attempted the question and performance was average.
Most of the candidates that attempted the question showed some understanding except for
a few that could not differentiate between the symptoms and causes of corporate failure.
Candidates‟ commonest pitfall was their inability to express themselves well. They are
therefore advised to improve their communication skills.

SOLUTION 3
(a) The objective of a takeover should be consistent with the overall objective of
the firm making the takeover, which in most cases should be to increase the
wealth of the shareholders.
However, there are good and bad reasons behind a takeover. Among the
good reasons is the possibility of creating synergy, that is increasing the
wealth of the shareholders. Although Gazoline Plc. and Smooth Car are in
different market sectors, there is a link between the two. It is possible for
Gazoline Plc. to make use of the services of Smooth Car in their travelling
arrangement for the supply of gas to their customers. They may also use the
services of Smooth Car to transport their staff for their maintenance contracts.
This is also applicable for the insurance of their staff, their assets and the
business. It could therefore be said that the services provided by Smooth Car
are complementary to the business of Gazoline Plc.
In this respect, some possible reasons why Gazoline Plc. may seek to buy
Smooth Car include:
i To create synergy, that is to increase the wealth of its shareholders;

ii. To achieve diversification – spreading its risk. The most obvious being
the marketing systems, the call centre system and local offices and
training facilities for mobile repair/emergency staff;
iii. Elimination of duplicate and competing facilities;
iv. To ensure availability of efficient and reliable transport systems for its
staff on maintenance contracts and the supply of gas;
v. To take advantage of the stable earnings of Smooth Car;
vi. To take advantage of the cash flow profile of Smooth Car, that is, to
reduce the risk of the company‟s (Gazoline Plc.) cashflow profile;
vii. To take the opportunity of the takeover to create a new outlet for its
product by marketing it to the customers on the data base of Smooth
Car (the target company); and
viii. The take over of Smooth Car will abolish its mutual status and will
allow equity funds for expansion to be raised more easily, by share
issues made by the parent company, thus, reducing the cost of capital.

b) The various stakeholders of Smooth Car are its members, who are the
owners, directors and senior managers, other employees, customers and
creditors.
i) Members: They are likely to be happy with the takeover in view of the
promised wind fall. However, they will be interested also in the future
direction of the new company, its earning capacity and the financial
benefits that may accrue to them. They will also be interested in the
consideration for the takeover apart from the wind fall. Since Smooth
Car brand name will be retained, members will like to ensure that the
company is well managed and its culture of quality services
maintained so as to preserve the good name for which it is known. It is
also likely that some members may not feel comfortable with the
takeover as the organisation has always been part of them. These are
the people that may not like change. They may therefore likely look
elsewhere for the maintenance of their vehicles.
ii) Directors and Senior Managers:-These are the members that have been
operating the business of the organisation. While they may not be
comfortable with the takeover because of the likelihood of losing their
jobs, they are expected to act in the best interest of the organisation
and ensure that the takeover is in the interest of their members.
However, some of them may be interested in what they will benefit
from the takeover and therefore, will like to know what the
acquirer(Gazoline Plc) has in stock for them with respect to retention
or redundancy. They will also want to know the ex-gratia payment that
will be due to them in case of redundancy.
iii) Creditors : The creditors will be interested in their payments and when
this are likely to be made, by ensuring that adequate arrangement is
made for their settlement. This will be done by making sure the
acquirer, that is Gasoline Plc., is financially sound.
iv) Government/Regulatory Authorities: Government through the Security

and Exchange Commission, may be interested in the proposed
takeover if it creates monopolistic situation.
c). Gazoline Plc.may face a number of problems after the takeover has been
achieved. These include:
i) Former members of Smooth Car who did not agree with the takeover,
and who may have been actively resisting it, may decide to change
their service provider to another organisation. The parent company
(Gazoline Plc.) will have to be pro-active in giving confidence to all its
Smooth Car Customers;

ii). The two organisations probably had different management styles;
Gazoline Plc. being a stock exchange quoted company with a clear
need for financial results and Smooth Car being more oriented to
serving its customers and acting as a pressure group to represent their
needs, conflicts may arise between directors, managers and
employees of Smooth Car after the takeover as a result of an enforced
change in management style from Gazoline Plc,
iii). Actual and feared redundancy, relocations, changes in work practice,

training methods and other problems may demotivate Smooth Car
employees, causing resistance and a drop in productivity. In this
respect, delays in information provision and decision making can
make the situation worse, and.
iv). Competitors may take advantage of re-organisation at Smooth Car in

order to gain market share.
Marking Guide Marks
a) 2 marks for each valid reason identified

(maximum of 4 reasons) 8
b) 1
/2 mark for various stakeholders identified
(Maximum 4) 2
1 mark each for stating the likely reactions of the
identified 4 stakeholders 4
6
c) 2 marks for each identified potential
problem/discussion(maximum of 3 identified
problems) 6
Total marks 20
EXAMINER‟S REPORT
The question tests candidates understanding of the issues in strategic merger.

These include the benefits of mergers and acquisitions to the acquiring company.
Candidates are expected to give reasons for acquisitions and discuss the integration
challenges that may be faced after acquisition. About 90% of the candidates
attempted the question and performance was good. However, few candidates could
not differentiate between „Shareholders‟ and „Stakeholders‟.
Candidates are advised to read, understand and interprete questions appropriately
and note their specific requirements before attempting them.

SOLUTION 4
(a) KILANKO NIGERIA LIMITED

STATEMENT OF FINANCIAL POSITION
N‟000 N‟000
Non-current assets:
Freehold Property (WI) 10,000
Plant & Machinery (WI) 20,500
30,500
Current assets:
Inventory & work in progress (W2) 13,500
Receivables (W2) 8,500
22,000
Less: Current liabilities
Unsecured payables (W4) 15,000
Working Capital 7,000
Total assets less current liabilities 37,500
Liabilities falling due after 1 year
14% unsecured Loan Stock (Secured Debenture (6,500)
Holders)
14% unsecured Loan Stock (Bank) (6,000)
25,000
Called up share capital (original Shareholder W3) 5,000

Called up share capital (secured debenture holders) 7,500
Rights issues (original Shareholders & Debenture 12,500 25,000

holders)
Workings
1. Non-current assets:
Freehold property (N15 million – N 5 million) = N10 million
Plant and machinery (N13.5-N5) million + N12.5 million) = N20.5 million
2. Current assets
Inventory & Work in progress (N17.5 –N4) million = N13.5 million
Receivables (N9 - N0.5 million) = N 8.5 million
3. Ordinary Share Capital

Called up share capital
(N20 - N 15) million = N5 million (Original Shareholders
N7.5million (Secured Debenture holders)
Total capital before the rights issue = (N5 + N7.5) Million = N12.5 million
Rights issue 1 for 1 = N12.5 million

Therefore Total Capital will be
(N12.5 + N12.5) million =N25 million
4. Unsecured payables
N20 million x 0.75 = N15 million
b) OMO FINANCIAL SERVICES LTD

10 Adedeji Street, Lagos
3/12/2015
The Managing Director

Kilanko Nigeria Limited,
20, Mawamiwa Street,
Odi-Olowo,
Mushin,Lagos.
Sir,
PROPOSED LIQUIDATION/RESTRUCTURING OF KILANKO NIGERIA LTD
In order to be able to make a critical review of the proposed reconstruction of your

company from the point of view of the following stakeholders,
i. Ordinary Shareholders
ii. Secured Debenture Holders and
iii. The Bank
it will be necessary to prepare detailed analysis of the reconstruction under

liquidation and under the suggested restructuring.
In case of liquidation- The position of the company will be as follows:
Realisable Value
N
Plant and machinery 5,000,000
Inventories 8,500,000
Receivables 8,500,000
22,000,000
Less: Liquidation Expenses 3,850,000
Amount available to Creditors 18,150,000
10% Secured Debenture N15,000,000
This is secured with the freehold property whose book value of N15 million could
only realise N10 million.

Therefore the 10% secured debenture holders will realize the security for N10
million and thereafter claim the balance of N5 million along with other creditors.
In this case the total outstanding liability payable will be as follows:
(N)
Unsecured payables 20,000,000
Bank overdraft (Unsecured) 8,000,000
Balance payable to secured debenture holders 5,000,000
33,000,000
These Creditors will have to share the sum of N18,150,000 which is the amount
available to creditors as earlier calculated
Therefore, the proportional amount available to the creditors per naira will be
N18,150,000 = 0.55 or 55k
N33,000,000
The sharing of the available fund will be as follows:
i) Ordinary shareholders-They will receive nothing
ii) The 10% secured debenture holders will receive N10,000,000 that is from
the realised asset and 0.55 x N5,000,000 = N2,750,000 from the
proceeds of the other assets. They will therefore receive a total amount of
N10 million + N2.75 million =N12.75 million i.e N12,750,000
They will therefore lose (N15- N12.75) million i.e N2.25 million.
iii) The bank will receive:

0.55 x N8,000,000 = N4,400,000
Losing (N8 - N4.4) million ie N3.6 million
If the reconstruction succeeds as recommended, the Statement of Financial Position
of the reconstructed company as attached (solution to the part.
However, should the proposed annual profit before interest of N8,750,000 be

achieved, the company‟s Statement of Profit or Loss will be as follows:
N
Profit before tax and interest
8,750,000
Less: Interest on 14% N6.5 million unsecured loan stock
(910,000)
Bank – 14% N6 million unsecured loan stock
(840,000)
7,000,000
The Earnings Per Share (EPS) will therefore be N7,000,000 = 0.28 or 28k
25,000,000

In this case, the position of the stakeholders will be as follows should the
reconstruction succeed.
i. The original shareholders will earn 28k per share after investing an
additional capital of N5 million. In effect they will only own 10 million out of
the 25 million shares of the company making them non-controlling
shareholders. However their share of 28k earning on the old shares will be
N0.28 x 5 million and their share on the rights issue will also be N0.28 x 5
million. These will be N1.4 million + N1.4 million i.e N2.8 million.
ii. The secured debenture holders will receive N10 million being the proceeds
of the security. They will also receive N910,000 interest per annum on the
unsecured loan stock for 5 years and at the end of the fifth year, they will
receive N6.5 million being the proceeds of the insured loan. They will in
addition receive N0.28 on the 7.5 million ordinary shares allotted to them
and N0.28 on the rights issue. In effect they will earn N2.1 million + N2.1
million =N4.2 million on the shares held.
Their annual earnings will therefore be:
Interest on the 14% unsecured Loan Stock N 910,000
Earnings per share on their shareholdings N 4,200,000
Total yearly earnings N 5,110,000
iii. The bank – The bank will receive a yearly interest of N840,000 for 5 years
after which they will receive the sum of N6 million being the principal value
of the 14% unsecured loan stock. However, the bank will lose N2 million
immediately.
In conclusion, it is clear from the two cases that the secured debenture
holders benefit most whether on liquidation or on reconstruction.
However, the restructuring is the best option for the company and should
therefore be pursued.
Thanks
Yours faithfully
Signed
For:Omo Financial Services Ltd

Marking Guide Marks
a) Calculation of Non-current assets–Freehold Property/Machinery 1
b) Current assets – Inventory & work in progress and
Receivables 1/2 mark each 1
Unsecured payables ½
Total assets less current liabilities ½
Unsecured loan – Debenture holders/Bank (½ each) 1

Called-up share capital (original Shareholders /secured
Debenture holders 1/2 each 1
Rights issue (original Shareholders/Secured debenture holders)
1
/2 each 1
6
b. Date, address, subject matter etc 2
Working – liquidation Account 1
Secured Debenture (Stating the fact that the secured
Debentures holders would realize the secured assets and then
claim for the balance along with other creditors)
2
Workings of the dividend available to creditors 1
6
Stating the entitlements of each of the shareholders i.e ordinary
shareholders, the secured debentures and the bank in case of
liquidation. 3
Calculation of the Earnings per share in case of reconstruction

1
Stating the entitlements of each of the Stakeholders i.e

Ordinary Shareholders, the secured debenture holders and the
bank in case of restructuring 3
Conclusion 1
8
Total Marks 20
EXAMINER‟S REPORT
The question tests candidates‟ knowledge of the principles of reconstruction.
About 50% of the candidates attempted the question but performance was poor. Candidates
are expected to prepare the Statement of Financial Position after the reconstruction and
also evaluate the scheme of reconstruction but they showed lack of understanding of the
requirements of the question hence the poor performance.
Candidates‟ commonest pitfall was their lack of understanding of the requirements of the
question.
Candidates are advised to read wide and cover the syllabus adequately for better result.
They should endeavour to remember the laws guiding liquidation and also improve their
knowledge of corporate restructuring.

SOLUTION 5
(a) Working Capital Cycle
2012 2013 2014

i) Raw material R.M .Inventory 365
x
Inventory (R.M Purchases 1 1,458 365 1,800 365
Inventory) = =N 1,080 x 365 =76 N x = 76 N x =91
5,184 1
7,020 1 7,200 1
ii) Trade Payable TP
x
365
(TP) Purchases 1 1,053 365 1,260 365
=N 1,864 x 365 =(61) N x =(55) N x =(64)
5,184 1
7,020 1 7,200 1
iii) Work in WIP
x
365
Progress (WIP) Cost.ofSales 1 972 365 933 365
=N 757 x 365 =37 N x = 37 N x =31
7,560 1
9,720 1 10,983 1
iv) Finished Goods F .G.Inventory 365
x
Inventory (F.G. Cost.ofSales 1 1,296 365 1,428 365
Inventory)
N x =49 N x =47
=N 864 x 365 =42 9,720 1 10,983 1
7,560 1
v) Trade TR
x
365
Receivable Re venue 1
(TR) =N 1,728 x 365 = 73 2,592 365 2,970 365
8,640 1 N x =88 N x =91
10,800 1 11,880 1
Working
Capital
Cycle in days 167 195 196
(b) Possible actions that might be taken to reduce the length of the working
capital cycle and their disadvantages include:
i) Raw Material Inventory

Reducing Raw Materials Inventory: This could be achieved by reducing
safety stock, making orders for small quantity of raw materials, GIT
purchases, etc.
Disadvantages include:
- Probability of stock outs;
- Increased order cost; and
- Probable delay in manufacturing

ii) Trade Payable: This could be done by delaying payment to the
creditors.
- Loss of goodwill,
- Loss of suppliers; and
- Loss of cash discounts.
iii) Work-in-progress: This could be achieved by improved technical know

how and the introduction of new technology that is, introducing
newly developed efficient machines.
- Cost of capital investment as a result of the need for injection of
new capital;
- Need to hire experienced and innovative staff hence an increase in
salary cost may occur;
- Increased capital may be required; and
- Possible increase in cost of research and development
iv) Finished goods: This could be done by reducing the inventory of

finished goods.
- Possibility of stock out;
- Loss of sales; and
- Customers‟ loss of interest in the goods and possible search for
alternatives.
v) Trade Receivable – This could be achieved by offering cash discounts

and improvement in the collection of overdue balance by factoring or
engaging debt collectors.
- Cost of discounts;
- Possibility of customers taking the discount and not making early
payment;
- Cost of collection in case of debt collectors or Factors;
- Reduction of customers goodwill; and
- Loss of sales

Marking Guide Marks
a. ½ mark for each element of the working capital cycle correctly

computed- 15 in all 71/2
½ mark for each working capital cycle for 3 yrs 11/2
9
b. 1 mark for each possible action suggested(Max 3) 3
½ mark for each disadvantage given(2 disadvantages are to be
stated for each possible action suggested 3
6
Total 15
EXAMINER‟S REPORT
The question tests candidates‟ knowledge of management of working capital.
Candidates are expected to calculate the working capital cycle and to explain the possible
policies required to reduce it. About 90% of the candidates attempted the question and
performance was good. However, a few of the candidates confused working capital with
working capital cycle and therefore performed poorly.
Candidates are advised to always cover the syllabus adequately for better results. They are
also advised to take time to read, understand and interpret questions appropriately and
note their specific requirements before attempting them.

SOLUTION 6
(a) Types of foreign exchange exposures which could arise in respect of

transactions involving foreign currency include: Translation Exposure,
Transaction Exposure and Economic Exposure.
(i) Translation exposure

This is the risk of losses or gains arising on the translation of the
Financial Statements of foreign subsidiaries into the currency of the
parent company for the purpose of preparing consolidated accounts.
It arises in international companies with foreign subsidiaries.
Statement of Profit or Loss and Statement of Financial Position will be
denominated in the local currency of the subsidiary and on
consolidation will be translated into the currency of the holding
company. On translation of the Financial Statements from one
currency to another, losses or gains arise due to exchange rate
movements.
(ii) Transaction exposure

This is the foreign exchange risk that arises in transactions between
two parties where the normal transaction currency of each party is
different and when the transaction involves a future receipt/payment
between the two parties. The amount received in domestic currency
might be different from the amount originally expected because of
movements in the exchange rate between the date of the initial
transaction and the date of settlement (payment/receipt).
(iii) Economic exposure

This refers to the long term movement in exchange rates caused by
changes in the competitiveness of a country. It is therefore the risk
that a company might choose to locate its operations in a country
whose currency gains in value over time against the currencies of its
competitors in world markets. The consequence of an increase in the
value of the domestic currency is a loss of competitiveness.
(b) Owiya Osese Plc.

Using Direct Quote
Interest rates in Nigeria over 6 months will be ½ x 15% = 7.5%
Interest rates in the African country over 6 months will be ½ x 18% = 9%
Implied forward rate using Interest Rate parity theory:
i.e I +RF = F
I + RD S
Where: RD = Domestic rate of interest
RF = Foreign rate of interest

S = Spot exchange rate stated in terms of domestic currency
(DC) per unit of foreign currency (FC).
F = Forward exchange rate
Substituting figures for the formula, the position will be:
1.09 F
 1.075  1.09  2.5
1.075 2.5
2.725
F   2.5349
1.075
Gain/Loss from hedging
i) if the Naira has gained 4%:

Waka actual rate will be 2.5 x 1.04 = 2.6
500,000
 the unhedged receipt =  N192,308
2.6
500,000
Whilst the hedged receipt will be =  N197,246
2.5349
 Gain from hedging = N197,246 – N192,308

= N4,938
ii) If the Naira has lost 2%
Waka actual rate will be = 2.5 x 0.98 = 2.45
500,000
Unhedged receipt will be = N204,082
2.45
500,000
Whilst the hedged receipt will be  N197,246
2.5349
 Loss from hedging = N204,082 – N197,246
= N6,836
iii) If the Naira has remained stable

Waka actual rate is still 2.5
500,000
Unhedged receipt = = N200,000
2.5
Whilst the hedged receipt is 500,000 = N197,246
2.5349
 Loss from hedging = N200,000 – N197,246
= N2,754

ALTERNATIVE METHOD
Direct Quote
The interest rates for 6months investment are:

* Naira 15  2 = 7.5%
* Waka 18  2 = 9%
Implied forward rate:
1  RF S

1  RD F
S= 1
2.5 = 0.4000 (N/Waka)
RF= 0.09
RD= 0.075
1.09 0.40

1.075 F
F = 0.3945 (N/Waka)
Evaluation
i) Naira gained 4% N/Waka
1 0.3846
Actual rate = =
2.50  1.04
N
Hedged receipt (500,000 x 0.3945) 197,250
Unhedged receipt (500,00 x 0.3846) (191,300)
Gain from hedging 4,950
ii) Naira lost 2% N/Waka

1 0.4082
Actual rate = =
2.50  0.98
N
Hedged receipt 197,250
Unhedged receipt (500,000 x 0.4082) (204,100)
Loss from hedging 6,850
iii) Naira remains stable N/Waka

Actual rate = (N/Waka) 0.4000
N
Hedged receipt (500,000 x 0.3945) 197,250
Unhedged receipt (500,000 x 0.4) 200,000
Loss from hedging 2,750

Marking Guide Marks
a. 1 mark for each identified exposure(max 2) 2

2 marks for the description/explanation of each identified
exposure 4
b. Calculation of the interest rate for 6 months both ½
domestic and foreign.

Stating the formula applied in the calculations of the ½
implied forward rate.

Calculation of the implied forward rate 2
Calculation of the gain/loss from hedging when the Naira
gained 4% 2
Calculation of the gain/loss from hedging if naira lost 2%
2
Calculation of the gain/loss from hedging if naira remains
stable 2
9
Total 15
EXAMINER‟S REPORT
The question tests candidates understanding of management of financial risk with
emphasis on the different foreign exchange risks and the use of currency forward contract,
to hedge foreign exchange risk.
Candidates are expected to give two types of foreign exchange risk and calculate the
opportunity cost / gain of hedging. About 15% of the candidates attempted the question
and performance was poor
Candidates‟ commonest pitfalls were their inability to understand foreign exchange risk
and the various hedging instruments. They also failed to remember the interest rate parity
formula needed to calculate the implied forward rate.
Candidates are advised to always cover the syllabus adequately in their preparations for
the Institutes‟ examinations. They should also endeavour to remember key formulae and
improve their knowledge on the management of financial risk section of the syllabus for
better result in future.

SOLUTION 7
(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.
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 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.
Marking Guide Marks
a) Title –Date, to whom addressed, from whom etc

1
Subject matter /2
1
Definition of wealth maximisation 1

How is Wealth maximization determined. 1
Comparative analysis vis-a vis profit growth, growth in
earnings per share etc 1
Arguments for wealth maximization objective over other
objectives apart from profitability objective 1
Recognising the fact that wealth maximization objective
should not be pursued in isolation of other objectives 1
Conclusion/Recommendation 1
Signing of the report 1
/2
8
b.(i) Definition /2
1
Arguments for and against 1

(ii) Definition 1
/2
Arguments for and against 11/2
(iii) Definition 1
/2
Arguments for and against 1 /2
1
(iv) Definition 1
/2
Arguments for and against 1
/2
7
15

EXAMINER‟S REPORT
The question tests candidates‟ knowledge of corporate objectives and their impact on
various stakeholders.
About 90% of the candidates attempted the question and performance was poor.
Candidates are expected to assess the shareholders wealth maximization objective but
evaluate the alternative corporate objectives but most of them did not have a clear and
accurate understanding of the question hence the poor performance.
Candidates‟ commonest pitfalls were their misinterpretation of the question and their
failure to present the solution in a report format.
Candidates are advised to read, understand and interprets questions appropriately and
note their specific requirements before attempting them. They should also learn report
writing. The usage of the Institutes‟ Pathfinder and study packs in their preparations for
the examinations of the Institute will assist in this area.

PATHFINDER
MAY 2016 PROFESSIONAL EXAMINATION
Question Papers
Suggested Solutions
Plus
Marking Guide
Examiners‟ Reports

PROFESSIONAL LEVEL EXAMINATION – MAY 2016
YOU ARE REQUIRED TO ANSWER FIVE OUT OF SEVEN QUESTIONS IN THIS PAPER SECTION
A COMPULSORY QUESTION (30 MARKS)
QUESTION 1
Katam Pie has adopted a strategy of diversification into many different industries in order
to reduce risk for the company’s shareholders. This has resulted in frequent changes in
the company’s gearing level and widely fluctuating risks of individual investments.
Presently, the company has a target debt-to-asset ratio i.e. D/(E + D) of 255, an equity
beta of 2.25 and a pre-tax cost of debt of 5%.
On January 1, 2016, Katam Plc with a year end of December 31, is considering the
purchase of a new machine costing N750million, which would enable it to diversify into a
new line of business. The new business will generate sales of N522.50million in the first
year, growing at 4.5% p.a. A constant contribution margin ratio of 40% cab be expected
throughout the 15-year life of the project. Incremental fixed cash costs will be
N84.32million into the first year growing by 5.4%p.a.
A regional development bank has offered a 10-year loan of 3% interest to finance 40% of
the cost of the machine. The balance of 60% will be financed equally by a 10-year
commercial loan (with annual interest of 5%) and a fresh round of equity.
The issue cost on the commercial loan will be 1% and the new equity will incur issue cost
of 3%. All issue costs are on the gross amount raised for the respective capital. Issue costs
on debt are allowed to tax purposes.
A firm that is already in the business of the new project has a gearing ratio of 20% (debt to
asset) and cost of equity of 18.1%. Its corporate debt is risk-free.
Tax rate if 30% payable in the year the profit is made. Tax depreciation of 20% on cost is
available on the new machine. Katam Pie has weighted average cost of capital of 14%
and cost of equity of 17.5%. The risk-free rate is 4% and the market risk-premium is 7%.
79

a. Estimate the Adjusted Present Value (APV) and advise whether the project should
be accepted? (21 Marks)
b. Explain:
i. The circumstances under which the use of APV is appropriate.
ii. The major advantages and limitations of the use of APV method.
(9 Marks)
(Total 30 Marks)
SECTION B: ANSWER ANY TWO OUT OF THREE QUESTIONS IN THIS SECTION

(40 MARKS)
QUESTION 2
BeeJay Plc is a medium-sized manufacturing company which is considered a 1 for 5 rights

issue at a 15% discount to the current market price of N4.00 per share. Issue costs are
expected to be N220,000 and these costs will be paid out of the funds raised. It is
proposed that the funds raised from rights issue will be used to redeem some of the
existing debentures at par. Financial information rating to BeeJay Plc is as follows:
Statement of Financial Position
N’000 N’000
Current assets:
Inventory 2,000
Receivables 1,500
Cash 300 3,800
Total assets 10,350
Current liabilities:
Trade payables 1,100
Overdraft 1,250 2,350
Non-current liabilities: 12% debentures 4,500
Equity:
80

Ordinary shares (50k per value) 2,000
Reserves 1,500 3,500
Total Equity and Liabilities 10,350
Other information:
Price/earnings ratio of Beejay Plc 15.24
Overdraft interest rate 7%
Income Tax rate 30%
Sector average: Debt/equity rate (book value) 100%
Interest cover 6 times
Required:
a. Ignoring issue costs and any use that may be made of the funds raised by the rights
issue, calculate:
i. the theoretical ex-rights price per share
ii. the value of the rights per existing share (3 Marks)
b. Calculate the current earnings per share and the revised earnings per share if the
proceeds of the rights issue are used to redeem some of the existing debentures.
(4 Marks)
c. Evaluate whether the proposal to redeem some of the debentures would increase
the wealth of the shareholders of BeeJay Plc. Assume that the price/earnings ratio
of BeeJay Plc remains constants. (2 Marks)
d. Discuss the reason why a right issue could be an attractive source of finance for
BeeJay Plc. Your discussion should include an evaluation of the effect of the rights
issue on the debt/equity ratio and interest cover.
(11 Marks)
(Total 20 Marks)
81

QUESTION 3
Skylet Limited is a major player in the aviation industry with a credit rating of AA. The
company plans to raise N5billion from the bond market. The features of the bond are:
• Maturity 4 years
• Coupon payment Annual
• Coupon rate 5%
• Redemption value par
The current annual spot yield curve for government bonds is as follows:
One-year 3.3%
Two-year 3.8%
Three-year 4.5%
Four-year 5.3%
The following table of spreads (in basis points) is given for the aviation industry.
Rating 1 Year 2 Year 3 Year 4 Year

AAA 12 23 36 50
AA 27 40 51 60
A 43 55 67 80
You are required to calculate:
a. i. the issue price of the bond; (6 Marks)

ii. the yield to maturity and (3 Marks)
iii. the duration (6 Marks)
b. Discuss why conflicts of interest might exist between shareholders and bond
holders. (5 Marks)
(Total 20 Marks)
QUESTION 4
Eko Product Plc (EP Plc) is a producer of a variety of vegetable oil and other household
products in Lagos. The company presently faces a significant competition in the market of
one of its major raw materials – palm oil. To secure regular flow of the raw material, the
Directors of EP Plc are now considering making an offer for the entire share capital of
Benin Oil Plc (BO Plc) a palm oil producing company in Benin.
82

The following financial information is provided for the two companies:
EP Plc BO Plc
Equity beta 1.2 1.2
Asset beta 0.9 1.2
Number of shares (million) 210 200
Current share price N29 N12
It is thought that combining the two companies will result in several benefits. It is
estimated that combining the two companies will generate free cash flow to the firm
(FCFF) of N1,080 million in current value terms, but these will increase by an annual
growth rate of 5% for the next four years, before reverting to an annual growth rate of
2.25% in perpetuity. In addition to this, combining the companies will result in cash
synergy benefits of N100million per year, for the next four years. These synergy benefits
are not subject to any inflationary increase and no synergy benefits will occur after the
fourth year. The debt-to-equity ratio of the combined company will be 40:60 in market
value terms and it is expected that the combined company’s cost of debt will be 4.55%
before tax.
The income tax rate is 20%, the current risk free rate of return is 2% and the market risk
premium is 7%. It can be assumed that the combined company’s asset beta is the
weighted average of EP Plc’s and BO Plc’s asset betas weighted by their current market
values. EP Plc has offered to acquire BO Plc through a mixed offer of one of its shares for
two BO Plc shares plus a cash payment, such that a 30% premium is paid for the
acquisition. Shareholders of BO Plc feel that a 50% premium would be more acceptable.
EP Plc has sufficient cash reserves if the premium if 30%, but not, if it is 50%.
a. Estimate the additional equity value created by combining EP Plc and BO Plc based
on the free cash flow to firm method. Comment on the results obtained and discuss
briefly the assumptions made; (11 Marks)
b. Estimate the impact of EP Plc’s equity holders if premium paid is increased to 50%
from 30% (5 Marks)
83

c. Estimate the additional funds required if a premium of 50% is paid instead of 30%
and discuss how this premium could be financed. (4 Marks)
(Total 20 Marks)
SECTION C: ANSWER ANY TWO OUT OF THREE QUESTIONS IN THIS SECTION

(30 MARKS)
QUESTION 5
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)
QUESTION 6
a. You work in the corporate finance department of a major bank. The bank has
invested in 20,000.000 shares of Ode Oil Plc. You are concerned about the recent
volatility in Ode Oil Plc’s share price due to the recent instability in the global oil
market. You plan to protect the bank’s investment from a possible fall in Ode Oil
Plc’s share price for the next three months and you do not plan to sell the shares at
present.
You have the following additional information:
84

Ode Oil Plc’s current share price N10
Call option’s current share price N11
Option expiry 3 months
Interest rate (annul) 8%
Ode Oil Plc’s share annual standard deviation 64%
Required:
How many call options do you need to buy or sell in order to delta-hedge the
bank’s position. Please be specific.
Note: Delta may be estimated using N(d1) (7 Marks)
b. The expected return on the market portfolio (estimated from past data) is 12% p.a.
with a standard deviation of 15% and the risk-free rate of 4%p.a. The actual prices,
last year dividends and the covariances from three securities (A, B, C) with the
market are given in the table below:
Security Actual Price Last Year Dividend Covariance with
(N) (N) Market
A 107 1.30 0.025650
B 618 18.00 0.018675
C 1,350 22.00 0.029025
Required:
i. Calculate the betas and the required rates of return of securities A, B and C.
(3 Marks)
ii. In the table below you have market consensus forecast of 12-month price
targets, ex-div, and the expected divided growth rate of the securities.
85

Security 12-month price target Dividend growth rate
(N) (%)
A 122.50 12
B 740.00 10
C 1,500.00 11
Assuming the dividends are paid in 12 months exactly, compute the required
stock price for the 3 stocks and state your conclusion.
(4 Marks)
iii. Considering the results in (ii) above, explain briefly what will be your
strategy? (1 Mark)
(Total 15 Marks)
QUESTION 7
MK Plc is considering the best way to finance the replacement for a particular high
specification piece of equipment that has become too costly to main. The replacement
equipment is estimated to have a useful life of 4 years with no residual value after that
time.
Two alternative financing schemes being evaluated are:
• Scheme A: Buy the equipment outright funded by a bank loan

• Scheme B: Enter into a four year finance lease
Scheme A: Buy outright, funded by a bank loan

MK Plc could purchase the equipment outright at a cost of N200 million on July 1, 2016.
MK Plc can normally borrow at an annual interest rate of 13% a year.
Scheme B: Four year finance lease

The equipment would be delivered on July 1, 2016 and MK Plc would pay a fixed amount
of N58,790.000 each year in advance commencing July 1, 2016, for four years. At the end
of four years, ownership of the equipment will pass to MK Plc without further payment.
Other information
• MK Plc has cost of equity of 20% and WACC of 16%
• MK Plc is liable to company tax at a marginal rate of 30% which is settled at the
end of the year in which it arises
86

• Tax depreciation allowances on the full capital cost are available in equal
instalments over the first four years of operation.
a. Calculate which payment method is expected to be cheaper for MK Plc and

recommend which should be chosen solely on the present value of the two
alternatives as at July 1, 2016. (13 Marks)
b. Discuss the appropriateness of the discount rate used in (a). (2 Marks)

(Total 15 Marks)
87

Formulae
𝑉𝑉𝐷𝐷
𝐾𝐾𝐸𝐸𝐸𝐸 = 𝐾𝐾𝐸𝐸𝐸𝐸 + (𝐾𝐾𝐸𝐸𝐸𝐸 − 𝐾𝐾𝐷𝐷 ) (1 − 𝑡𝑡)
𝑉𝑉𝐸𝐸𝐸𝐸
Asset Beta
𝑉𝑉𝐸𝐸 𝑉𝑉𝐷𝐷 (1 − 𝑇𝑇)

𝛽𝛽𝐴𝐴 = � 𝛽𝛽 � + � 𝛽𝛽 �
(𝑉𝑉𝐸𝐸 + 𝑉𝑉𝐷𝐷 (1 − 𝑇𝑇)) 𝐸𝐸 (𝑉𝑉𝐸𝐸 + 𝑉𝑉𝐷𝐷 (1 − 𝑇𝑇)) 𝐷𝐷
Equity Beta
𝑉𝑉𝐷𝐷
𝛽𝛽𝐸𝐸 = 𝛽𝛽𝐴𝐴 + (𝛽𝛽𝐴𝐴 − 𝛽𝛽𝐷𝐷 ) � � (1 − 𝑡𝑡)
𝑉𝑉𝐸𝐸
Growing Annuity
𝐴𝐴1 1 + 𝑔𝑔 𝑛𝑛
𝑃𝑃𝑃𝑃 = �1 − � � �
𝑟𝑟 − 𝑔𝑔 1 + 𝑟𝑟

1
𝑃𝑃𝑃𝑃𝑅𝑅 𝑛𝑛
𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 = � � (1 + 𝑟𝑟𝑒𝑒 ) − 1
𝑃𝑃𝑃𝑃𝐼𝐼
C0 = S0N(d1) – Ee-rt N(d2)
𝑆𝑆
𝐼𝐼𝐼𝐼 � 0� + (𝑟𝑟 + 0.5𝜎𝜎 2 )𝑇𝑇
𝐸𝐸
𝑑𝑑1 =
𝜎𝜎 √𝑇𝑇
d2 = d1 - 𝜎𝜎 √𝑇𝑇
The Put Call Parity
C + Ee-rt = S + P
𝑢𝑢 = 𝑒𝑒 𝜎𝜎×√𝑇𝑇/𝑛𝑛
d = 1/u
𝑎𝑎 = 𝑒𝑒 𝑟𝑟𝑟𝑟/𝑛𝑛
𝑎𝑎 − 𝑑𝑑
𝜋𝜋 =
𝑢𝑢 − 𝑑𝑑
The discount factor per step is given by = 𝑒𝑒 −𝑟𝑟𝑟𝑟/𝑛𝑛
The Miller – Orr Model

1
3 3
× 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 × 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝑜𝑜𝑜𝑜 𝐶𝐶𝐶𝐶𝐶𝐶ℎ 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 = 3 × �4 �
𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 (𝑎𝑎𝑎𝑎 𝑎𝑎 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝)
88

Annuity Table
r
Where r = discount
Discount rate (r)
Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1
2 1·970 1·942 1·913 1·886 1·859 1·833 1·808 1·783 1·759 1·736 2
3 2·941 2·884 2·829 2·775 2·723 2·673 2·624 2·577 2·531 2.487 3
4 3·902 3·808 3.717 3·630 3.546 3.465 3·387 3·312 3·240 3·170 4
5 4·853 4·713 4·580 4·452 4·329 4·212 4·100 3·993 3.890 3·791 5
6 5·795 5·601 5·417 5·242 5·076 4·917 4·767 4·623 4.486 4·355 6
7 6·728 6.472 6·230 6·002 5·786 5·582 5·389 5·206 5·033 4·868 7
8 7·652 7·325 7·020 6·733 6·463 6·210 5·971 5·747 5·535 5·335 8
9 8·566 8·162 7·786 7.435 7·108 6·802 6·515 6·247 5·995 5·759 9
10 9·471 8·983 8·530 8·111 7·722 7·360 7·024 6·710 6.418 6·145 10
11 10·368 9·787 9·253 8·760 8·306 7·887 7.499 7·139 6·805 6.495 11
12 11·255 10·575 9·954 9·385 8·863 8·384 7·943 7·536 7'161 6·814 12
13 12·134 11·348 10·635 9·986 9·394 8·853 8·358 7·904 7·487 7·103 13
14 13·004 12·106 11·296 10·563 9·899 9·295 8·745 8·244 7·786 7·367 14
15 13·865 12·849 11·938 11·118 10·380 9·712 9·108 8·559 8·061 7·606 15
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1
2 1·713 1·690 1·668 1·647 1·626 1·605 1·585 1·566 1·547 1·528 2
3 2.444 2.402 2·361 2·322 2·283 2·246 2·210 2·174 2·140 2·106 3
4 3·102 3·037 2·974 2·914 2·855 2·798 2·743 2.690 2·639 2.589 4
5 3·696 3·605 3·517 3·433 3·352 3·274 3·199 3·127 3·058 2·991 5
6 4·231 4·111 3·998 3·889 3·784 3·685 3·589 3.498 3.410 3·326 6
7 4·712 4·564 4.423 4·288 4·160 4·039 3·922 3·812 3·706 3·605 7
8 5·146 4·968 4.799 4·639 4.487 4·344 4·207 4·078 3·954 3·837 8
9 5·537 5·328 5·132 4·946 4·772 4·607 4.451 4·303 4·163 4·031 9
10 5·889 5·650 5.426 5·216 5·019 4·833 4·659 4.494 4·339 4·192 10
11 6·207 5·938 5·687 5.453 5·234 5·029 4·836 4·656 4.486 4·327 11
12 6·492 6·194 5·918 5·660 5·421 5·197 4·988 4·793 4·611 4.439 12
13 6·750 6.424 6·122 5·842 5·583 5·342 5·118 4·910 4·715 4·533 13
14 6·982 6·628 6·302 6·002 5·724 5.468 5·229 5·008 4·802 4·611 14
15 7·191 6·811 6.462 6·142 5·847 5·575 5·324 5·092 4·876 4·675 15
89

A.1
90

SOLUTION 1
a)
i) Ungeared cost of Equity (KEU)
The base-case NPV is computed using ungeared cost of equity. We need to
estimate this from the information about the proxy company. A number of
methods can be used:
∗ Using MM cost of Equity Formula

𝑉𝑉
KEG = KEU + (KEU – KD) � 𝐷𝐷�𝑉𝑉 � (1 − 𝑡𝑡), where
𝐸𝐸
KEG = cost of equity of the proxy company = 18.1%
KEU = the ungeared cost of equity, i.e. the cost of equity that reflects only the
business risk of the new project = 𝑥𝑥
𝑉𝑉
� 𝐷𝐷�𝑉𝑉 � = debt/equity ratio of the proxy company = 20/80 = 0.25
𝐸𝐸
KD = cost of debt, before tax, of the proxy company = 4%, since we are told it
is risk-free.
Substituting figures in the formula, the position will be:
18.1 = 𝑥𝑥 + (𝑥𝑥 – 4) (0.25) (1 – 0.30)
18.1 = 𝑥𝑥 + (0.25𝑥𝑥 – 1) 0.70
18.1 = 𝑥𝑥 + 0.175𝑥𝑥 – 0.70
18.1 + 0.70 =1.175 𝑥𝑥

1.175 𝑥𝑥 = 18.8
𝑥𝑥 = 18.8 = 16
1.175
i.e. 16%
∗ Using MM WACC Formula

- Current WACC of the proxy company:
𝑉𝑉E 𝑉𝑉𝐸𝐸
∙ 𝐾𝐾𝐸𝐸 + ∙ 𝐾𝐾𝐷𝐷 ∙ (1 − 𝑡𝑡)
𝑉𝑉𝐸𝐸 + 𝑉𝑉𝐷𝐷 𝑉𝑉𝐸𝐸 + 𝑉𝑉𝐷𝐷
(0.8)(18.1) + (0.2)(4)(1 − 0.3)
i.e. 14.48 + 0.56 = 15.04%
𝑉𝑉𝐸𝐸
WACCg = WACCU�1 − �𝑉𝑉 � (𝑡𝑡)�
𝐸𝐸 +𝑉𝑉𝐷𝐷
Substituting 15.04% for WACCgin the above formula, the position will be:
15.04 = 𝑥𝑥[1 − (0.20)(0.30)]
15.04 = 𝑥𝑥(1 − 0.06)
15.04 = 0.94𝑥𝑥
𝑥𝑥 = 16%
91

ii) Base – Case NPV
Given the life of the project of 15 years and differential growth (inflation)
rates, it is faster to compute the PV of each item separately. Note that the
given WACC of 14% and cost of equity of 17.5% of Katam Plc. are irrelevant.
∗ Contribution, net of tax (₦m)

Contribution at year 0 prices:
(N522.50/1.045) x 0.40 = 200
Less tax at 30% (60)
Net of tax 140
Real cost of capital = (1.16/1.045) – 1 = 0.110048 or say 11%

Annuity factor for 15 years at 11% = 7.191
PV of contribution = N140 x 7.19087 = N1,006.74
∗ Incremental fixed cost, net of tax

Fixed cost at year 0 prices:
(N84.32/1.054) x (1 – 0.3) = N56m
Applicable real cost of capital:

(1.16/1.054) – 1 = 0.10569 or 10%
Annuity factor for 15 years at 10% = 7.606
PV = N56 x 7.606 = N425.94
ALTERNATIVE METHOD
Growing annuity can be used to calculate the present value of each of the items
involving growth (inflation). As given in the formula sheet, the present value of
growing annuity is given by:
A1  1 + g n 
1 −  
r−g   1 + r  
 
* Contribution
Contribution, net of tax, in Year 1 is
N(522.50 x 0.4) x (1 – 0.30) = N146.30m
146.30   1.045  15

PV = N 1 −   = N1,006.46
0.16 − 0.045   1.16  
 
92

* Incremental fixed costs
Amount in year 1, net of tax:
N84.32m x (1 – 0.3) = N59.024m
59.024   1.054 15 
N 1 −   = N424.53m
0.16 − 0.054   1.16  
 
∗ Tax savings on tax depreciation

Annual tax savings = N750 x 0.2 x 0.30 = N45m
These are money cash flows and must be discounted using money cost
of capital of 16%
Annuity factor (years 1 – 5) @ 16% = 3.274
PV = N45 x 3.274 = ₦147.33m
Summary
₦m
PV of contribution 1,006.74
PV of fixed costs (425.94)
PV of tax savings on depreciation 147.33
Outlay (750.00)
Base-case NPV (21.87)
Financing side Effects

The project is financed as follows:
₦m
Development Bank Loan 40% of ₦750m 300
Commercial loan: 60% x 50% x ₦750m 225
Equity 60% x 50% x ₦750m 225
Net amount needed 750
Issue costs
Commercial Equity
loan
₦m ₦m
Net amount needed 225.00 225.00
Issue costs �1�99 × 225� 2.27 �3�97 × 225� 6.96
Gross amount 227.27 231.96
Tax savings on issue cost, due in year 1 = 2.27 x 0.30 = ₦0.68m
Tax savings on interest
93

₦m
Development Bank loan: N300 x 0.03 x 0.30 = 2.70
Commercial loan: N227.27 x 0.05 x 0.30 = 3.41
Total annual tax savings (year 1 -10) 6.11
After tax interest savings on Development Bank’s loan

₦m
Gross savings 300 x (0.05 – 0.03) 6.00
Tax on savings at 30% (1.80)
Net interest savings (years 1 – 10) 4.20
Present value of the financing side effects

The present values of the financing side effects are calculated at the
company’s normal cost of borrowing of 5%, gross of tax.
Items Year NCF PVF PV

₦m @5% ₦m
Issue costs – Equity 0 (6.96) 1.000 (6.96)
- Com. loan 0 (2.27) 1.000 (2.27)
Tax savings on issue cost 1 0.68 0.952 0.65
Tax savings on interest 1 – 10 6.11 7.722 47.18
Interest savings on
Development Bank’s loan 1 – 10 4.20 7.722 32.43
Total PV of financing side
effects 71.03
Note: In calculating the present values of the financing cash flows, the
discount factor used is 5% to reflect the normal borrowing/default risk
of the company.
Alternatively, the risk-free rate of 4% could be used depending on the
assumption made. Credit will be given where these are used to
estimate the discount factor.
Calculation of APV ₦m
Base – case NPV (21.88)
Financing side – effect 71.03
APV 49.15
94

Recommendation
Although the project has a negative NPV if financed purely by equity, it is

worthwhile accepting it because of its proposed financing method. Accepting the
project is expected to increase shareholders’ wealth by ₦49.15 million.
b)
i) The APV method is most appropriate in the following circumstances:
• When it permanently changes the level of gearing of a company.
• When the project involves unusual financing costs such as a subsidised loan.
• It significantly changes the company’s debt capacity.
• If a number of project-specific financing options are to be considered.
ii) The main benefits of this method are that

• It should provide a more accurate assessment of the real worth of the
project to the company.
• It can deal more transparently with the side effects of financing.
• The base case NPV stays the same even if assumptions about capital
structure change, therefore fewer recalculations are required.
Limitations of APV
• The equation for asset betas in a taxed world assumes that cash
flows are perpetuities. The cash flows for this investment are not
perpetuities.
• APV requires the identification of all financing side effects and their discount
at a rate reflecting their risk. In a complex investment situation, especially
an overseas investment, it might be difficult to identify relevant financing
side effects, and their appropriate discount rates.
• Since the regearing process is based on M&M Model, it ignores bankruptcy
costs, tax exhaustion and agency costs.
MARKING GUIDE
Marks Marks
a. Calculation of ungeared cost of equity 3

Calculation of base-case NPV 7
Calculation of financing side effect 9
Calculation of APV 1
Recommendation 1
21
b. Circumstances for use, 1 mark per point, max. 3 points 3
Advantages, ½ mark per point, max 2 points 3
95

Limitations, ½ mark per point, max 2 points 3
9
30
EXAMINER’S REPORT
The question tests candidates understanding of the application of capital project appraisal
techniques using Adjusted Present Value (APV) method.
Over 90 percent of the candidates attempted the question. They are expected to compute the
ungeared cost of equity, the base-case NPV, using growing annuity formula provided in the paper,
and the various issue costs. Virtually all the candidates did not show good understanding of the
requirements of the question as they demonstrated lack of proper understanding of adjusted
present value, hence, their failure to provide correct solution to the problem resulting in their poor
performance.
Candidates commonest pitfalls were their
i. Inability to calculate the required cost of capital;
ii. Use of money cash flows rather than real cash flows to save time
iii. Lack of proper understanding of APV;
iv. Failure to include net interest savings on subsidised finance;
v. Lack of understanding of application of annuity factor in solving problems with
constant cash flows; and
vi. Inability to make use of growing annuity formula in dealing with the question in order
to save time.
Candidates are advised to cover the syllabus adequately, make use of the Institute’s Study Text
and Pathfinders and improve their knowledge on the application of appraisal techniques section
of the syllabus, paying particular attention to the appropriateness of adjusted present value (APV),
in arriving at investment decisions. Candidates’ are strongly advised to practice several
comprehensive examination questions when preparing for the Institute’s examinations
96

SOLUTION 2
a) Rights issue price = ₦4 x 0.85 = ₦3.40
₦
5 existing shares @ ₦4 = 20.00
1 new share @ ₦3.40 = 3.40
6 23.40
i) Theoretical ex-rights price = ₦23.40 ÷ 6 = ₦3.90
ii) Value of rights in total = ₦3.90 –N3.40 = ₦0.50
Value of rights per existing share = ₦0.50 ÷ 5 = ₦0.10
b) Calculation of EPS
i) Existing EPS
Current VPS = ₦4.00

P/E ratio = 15.24
:. EPS = N 4 x 100 kobo = 26.25k
15.24 1
Number of shares = 2m/0.5 = 4m shares

Total earnings = 4m x N0.2625 = ₦1.05m
ii) Post rights EPS
Additional number of shares = 4m ÷ 5 = 800,000

Existing number of shares = 4,000,000
Post-rights number of shares 4,800,000
Gross funds raised = 800,000 x ₦4 x 0.85 = ₦2,720,000
Issue costs (N220,000)
Net funds raised ₦2,500,000
Debenture interest saved, net of tax
= ₦2,500,000 x 0.12 x (1 - 0.30) = N210,000
Revised earnings, after tax
= ₦1,050,000 + N210,000 = ₦1,260,000
Revised EPS = ₦1,260,000 ÷ 4,800,000 = 26.25 kobo
c) As the price/earnings ratio is constant, the share price expected after redeeming part
of the debentures will remain unchanged at ₦4 per share (N0.2625 x 15.24). Since
this is greater than the theoretical ex-rights share price of ₦3.90, using the funds
raised by the rights issue to redeem part of the debentures results in a capital gain of
97

10k per share. The proposal to use the rights issue funds to redeem part of the
debentures therefore results in an increase in shareholders’ wealth.
d) Notes: In the analysis below, alternative assumptions are used. Full credit is given for
any of the assumptions used by the candidates.
i) Gearing Ratio
The calculation is based on book value
• Current Position
Case 1 - Excluding bank overdraft
₦’000
Debt 4,500
Equity 3,500
4,500
:. D/E ratio - N × 100 = 129%
3,500
Case2- Including bank overdraft
₦’000
Debt = N4,500 + N1,250 5750

Equity 3500
5,750
:. D/E ratio = × 100 164%
3,500
Comments: Both values are above the sector average of 100%. Issuing new equity
will therefore be attractive in this situation.
* Expected Position - After rights issue
Excluding Including
Overdraft Overdraft
₦’000 ₦’000
Debt: N4,500 – N2,500 = 2000

(N4,500 – N2,500) + N1,250= 3250
98

Equity N3,500 + N2,500 = 6000 6000
:. D/E ratio 33% 54%
If the rights issue is not used to redeem the debenture issue, the decrease in
gearing, is less dramatic.
- Excluding overdraft:
4,500
× 100 = 75%
6,000
Including overdraft:
5,750
× 100 = 96%
6,000
Comments: In both cases, the debt/equity ratio falls to less than the sector average,
signaling a decrease in financial risk. The debt/equity ratio would fall further if
increased retained profits were included in the calculation, but the absence of
information on the company’s dividend policy makes retained profits uncertain.
ii) Interest Cover
First, we need to establish the level of EBIT (Earning Before Interest and Tax)
Existing earnings, after tax = ₦1,050,000
Tax Rate 30%
Earning before tax:

1,050,000
× 100 = N1,500,000
1−0.30
Add existing interest:
- Debentures ₦4.50m x 0.12 = N540,000
- Overdraft ₦1,250,000 x 0.07 = N87,500
99

EBIT N2,127,500
The EBIT is not affected by any financing decision.
Existing total interest =N540,000 + N87,500 = N627,500

Revised interest payment:
₦627,500 – (0.12 x N2,500,000) = N327,500
Interest cover:
Existing N2, 127,500 / N627,500 = 3.4times

Revised N2,127,500 / N327,500 = 6.5times
Comments: There will be an improvement in interest cover from 3.4 times (which is
below the sector average of 6 times) to 6.5 times (which is marginally better than
the sector average)
A rights issue will also be attractive to BeeJay Plc. since it will make it more likely
that the company can raise further debt finance in the future, possibly at a lower
interest rate due to its lower financial risk.
It should be noted that a decrease in gearing is likely to increase the average cost
of the finance used by BeeJay Plc., since a greater proportion of relatively more
expensive equity finance will be used compared to relatively cheaper debt. This will
increase the discount rate used by the company and decrease the net present value
of any expected future cash flows.
MARKING GUIDE
Marks Marks
a. Ex-right price and value of right 3
b. Existing earnings 1
Revised EPS 3
4
100

c. Analysis of wealth 2
d. Gearing and comments 4

Interest cover and comment 7
11
Total 20
EXAMINER’S REPORT
The question tests candidates’ knowledge of the various computations associated with rights issue
and its effects on leverage and interest cover.
Over 80 percent of the candidates attempted the question but most of them showed inadequate
knowledge of its requirements. However, Part a (i and ii) of the question were well attempted by
many of the candidates while the other parts of the question were poorly attempted by almost all
the candidates that attempted it, hence the overall performance was poor.
Candidates’ commonest pitfalls were their failure to evaluate and interpret data correctly and lack
of in-depth knowledge of the requirements of the question particularly in the Part (d) where they
failed to make relevant computations that were expected to assist them in correctly evaluating the
effect of the rights issue on leverage and interest cover.
Candidates’ are advised to cover the syllabus adequately, read, understand and interpret
questions appropriately before attempting them for better result. They should also endeavor to
make use of the Institute’s Study Text when preparing for the Institute’s examinations.
101

SOLUTION 3
a)
i) Issue Price
The spot yield curve should be used to calculate a likely issue price. The
government bond yield curve needs to be adjusted by the credit spread for an AA
rated company.
1 year 2 years 3 years 4
year
Govt’s bond spot-yield curve 3.30 3.80 4.50
5.30
Add AA spread 0.27 0.40 0.51 0.60
3.57 4.20 5.01 5.90
To price the bond, the cash flows associated with it are discounted using the above
spot rates.
5 5 5 105
Price = + (1.042)2 + (1.0501)3 + (1.059)4 = ₦97.24
1.0357
ii) Yield to Maturity (YTM)
The YTM is computed by trial and error as follows:

Try 6%: NPV = – N97.24 + 5(3.465*) + 100 (0.792) = – N0.71
(* annuity factors at 6% for 4 years)
Try 5%: NPV = – N97.24 + 5(3.546) + 100 (0.823) = N2.79
2.79
YTM = 5 + ��N � × (6 − 5)� = 5.80%
2.79+0.71
iii) Duration
Year CF DFat PV PV x n
(n) N‘000m 5.80% N‘000m N‘000m
1 5 0.945 4.725 4.725
2 5 0.893 4.465 8.930
3 5 0.844 4.220 12.660
4 105 0.798 83.790 335.160
97.200 361.475
Duration = N361.475/ N97.2 = 3.72 years
102

b)
i) Different attitudes to risk and return - Shareholders may want the company to
undertake risky projects with correspondingly high expected levels of returns.
Bondholders will want the company to undertake projects that guarantee
sufficient returns to pay their interest each year, and ultimately to repay their
loans.
ii) Dividends - Large dividends may be preferred by shareholders, but may concern
bondholders, because the payments leave low cash balances in the company
and hence put at risk the company’s ability to meet its commitments 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) Attitudes to further finance - Shareholders may prefer the company to raise
additional finance by means of loans, in order to avoid having to participate in
a rights issue, or the risk of dilution of their shareholding and control if an open
stock market issue is made. Bondholders may not wish the company to take on
the burden of additional debt finance, of payment of interest and repayment to
avoid additional financial risk.
v) Restriction imposed by bondholders - Restriction imposed by bondholders to

protect their loans, 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’ fee,
are likely to be significant, bondholders may be much less willing than
shareholders for the company to bear any risk. Significant bankruptcy costs may
mean that there is insufficient money left to repay loans.
103

MARKING GUIDE
Marks Marks
a.i. Computing spot rates 3

Calculation of bond price 3
6
ii. Computing YTM 3
iii. Computation of duration 6
b. Discussion of agency problems, 1 mark per point, subject to 5

max of 5 points
20
EXAMINER’S REPORT
The question tests candidates’ knowledge of the application and evaluation of bonds based on
business scenarios and their understanding of yield, yields to maturity duration and bond pricing
using government yield curves. It also tests agency problems in finance.
About 90% of the candidates attempted the question and performance was generally poor. The
Part (a) of the question which carried 75% of the mark was not well understood while Part (b) was
fairly attempted.
Candidates commonest pitfalls were their:
i. Inability to use the government’s yield curve to generate the spot rate while those who
were able to do so could not successfully use them; and
ii. Lack of sufficient details on conflict of interest between shareholders and bondholders.
Candidates are advised to take time to read, understand and interpret questions appropriately and
note their specific requirements before attempting them. They should also endeavor to cover the
syllabus in their preparation for the Institute’s examinations and make use of the Institute’s Study
Text and other relevant materials.
104

SOLUTION 4
a) ● Current market value

₦
EP Plc. 210 × ₦29 6,090
BO Plc. 200 × ₦12 2,400
8,490
• Asset beta
6,090 2,400
� × 0.9� + � × 1.2� = 0.985
8,490 8,490
• Equity beta
𝑉𝑉𝐷𝐷
𝛽𝛽𝐸𝐸 = 𝛽𝛽𝐴𝐴 + (𝛽𝛽𝐴𝐴 − 𝛽𝛽𝐷𝐷 ) � � (1 − 𝑡𝑡)
𝑉𝑉𝐸𝐸
40
= 0.985 + (0.985 – 0)� �(1 – 0.20) = 1.51
60
• Cost of equity
𝐾𝐾𝐸𝐸 = 𝑅𝑅𝐹𝐹 + 𝛽𝛽𝐸𝐸 (𝑅𝑅𝑀𝑀 − 𝑅𝑅𝐹𝐹 )
= 2 + 1.51(7) = 12.57%
• WACC
WACC = (0.6 × 12.57) + (0.4 × 4.55)(1 – 0.2) = 9%
• Additional Equity created
Present value of free cash flow:

₦million
1,080×1.05
Yr 1 = 1,040.37
1.09
1,080×1.052
2 = 1,002.19
1.092
1,080×1.053
3 = 965.41
1.093
1,080×1.054
4 = 929.98
1.094
PV of FCFF years 1 – 4* 3,937.95
105

PV of FCFF years 5 – infinity:
1,080×1.054 ×1.0225
(0.09−0.0225)×1.094
= 14,087.52
Total PV of FCFF 18,025.47
Add PV of synergy:
100 × 3.40** 340.00
Total value of the combined
company 18,365.47
Less value of debt (40%) (7,346.18)
Combined value of
equity (60%) 11,019.29
Existing total value of equity (8,490.00)
Additional equity created 2,529.29
* The PV of FCFF for the first 4 years can be calculated using the growing
annuity formula provided in the formula sheet:
𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹1 1+𝑔𝑔 𝑛𝑛
PV = �1 − � � �
𝑟𝑟−𝑔𝑔 1+𝑟𝑟
1,080×1.05 1.05 4
= �1 − � � � = 3,937.95
0.09−0.05 1.09
** Annuity factor at 9% for 4 years.
Comments
Although the equity beta and the risk of the combined company is more than that of
EP Plc. on its own, probably due to BO Plc’s higher business risk (reflected by the
higher asset beta), overall the benefits from growth in excess of the risk free rate and
additional synergies have led to an increase in the value of the combined company.
However, a number of restrictive assumptions have been made in obtaining the

valuation, for example:
• the assumption of growth of cash flows in perpetuity may be unrealistic;
• whether the calculation of the combined company’s asset when based on the
weighted average of the market values is based on good evidence or not; and
• the given figures such as growth rates, tax rates, free cash flows, market risk
premium, etc. are realistic or not.
106

In all, it may be necessary to undertake sensitivity analysis to determine how changes
in the variables would impact on the value of the combined company.
b) Purchase consideration of BO Plc.:
₦million
30% premium = 1.30 × ₦2,400m = 3,120
50% premium = 1.50 × ₦2,400m = 3,600
New number of shares:
210m + (½ × 200m) = 310m
Loss in value per share of combined company, if 50% of premium is paid instead of
30%.
(N3,600 – N3,120)/310 shares = ₦1.55/share
This represents a drop in value of approx 5.3% on original value of EP Plc. share
(1.55/29)
c) The amount of additional cash is about ₦480 million, if EP Plc. agrees to the demand
made by BO Plc.’s shareholders and pays the 50% premium. EP Plc. has a number of
options to raise the ₦480 million:
i) The company could take on additional loan. But this will increase financial
leverage and the WACC, which in turn will reduce the value of the company.
ii) EP Plc. could raise the amount by issuing additional equity capital, but the existing
shareholders may not see this as a positive development.
iii) EP Plc. could offer a higher proportion of its shares in the share-for-share exchange
instead of paying cash for the additional premium – but this will lead to further
dilution of the equity holding of the existing shareholders of EP Plc.
It is however necessary to consider whether the shareholders of BO Plc. would

consider, more of cash or more of equity shares?
MARKING GUIDE
Marks Marks
a. Existing value of equity 1

Asset beta 1
Equity beta 1
107

Cost of equity ½
WACC ½
Total value of the company 3
Extra equity 2
Comments 2
11
b. Premium 2
New number of shares 1
Loss of value 2
5
c. Additional cash required 2

Comments, (1 mark per valid comment – max 2 points) 2 4
Total 20
EXAMINER’S REPORT
The question tests candidates’ knowledge of modern business valuation techniques under mergers
and acquisition with emphasis on candidates understanding of the analysis of merger and
acquisition premium.
The level of attempt was low as only about 20 percent of the candidates attempted the question
and performance was poor.
Candidates’ commonest pitfalls were their inability to correctly compute the value of the company
using free cash flow to the firm (FCFF), failure to analyse the synergies and failure to compute the
acquisition premium as demanded in the question.
Candidates are advised to always cover the syllabus adequately and make use of the Institute’s
Study Text when preparing for the Institute’s examination for better result. They should also pay
attention to learning some key formulae and their applications.
108

SOLUTION 5
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.
109

vi. 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.
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
ACCOUNTANT
110

MARKING GUIDE
Marks Marks
Format 1½
a. 1½ marks per point, max 5 points 7½
b. 1½ marks per point, max 4 points 7
Total 15
EXAMINER’S REPORT
The question tests candidates’ knowledge of the evaluation and application of financing options
for a business and emphasizes short, medium and long term alternative financing.
Over 90 percent of the candidates attempted the question and performance was poor. Most of the
candidates could not differentiate between sources of finance and factors to be considered in
capital mix hence, performance was poor.
Candidates’ commonest pitfalls were their inability to differentiate between sources of finance and
the factors that determine the capital mix. In addition, they could not identify the limiting factors
to debt financing.
Candidates are advised to adequately cover the syllabus and make use of the Study Text in their
preparation for the Institute’s examinations. They should also ensure to read, understanding and
interpret questions appropriately and note their specific requirements before making an attempt.
111

SOLUTION 6
a) The Black – Scholes Option Pricing Model formula given as

𝑆𝑆
𝐼𝐼𝐼𝐼 � 𝐸𝐸0� + (𝑟𝑟 + 0.5𝜎𝜎 2 )𝑇𝑇
𝑑𝑑1 =
𝜎𝜎 √𝑇𝑇
• First, we need to determine d1

10
𝐼𝐼𝐼𝐼 � �+ 0.08+(0.5 ×0.64)×0.25
11
𝑑𝑑1 = = - 0.0753
0.64√0.25
• N(d1) = N(-0.0753)
= 1 – N(0.0753)
=1 – [0.5 + (0.0279 + 0.53(0.0319 – 0.0279)]
= 0.470
• Let 𝑥𝑥 = number of call options needed for delta-hedging

Security Qty Delta/unit Total delta
Shares 20,000,000 1.00 20,000,000
Call 𝑥𝑥 0.47 0.47𝑥𝑥
Total 20,000,000 + 0.47𝑥𝑥
For delta-hedging, this total should be equal to 0. That is:

20,000,000 + 0.47𝑥𝑥= 0
i.e. 0.47𝑥𝑥 = 20,000,000
𝑥𝑥 = – 42,553,191 calls
Thus, the bank needs to sell 42,553,191 calls for delta-hedging.
b)
covariance with market
i) Beta =
variance with market
βA = 0.025650�0.152 = 1.14
βB = 0.018675�0.152 = 0.83
βC = 0.029025�0.152 = 1.29
The required return is given by:

Ri = 𝑅𝑅𝐹𝐹 + 𝛽𝛽𝑖𝑖 (𝑅𝑅𝑀𝑀 − 𝑅𝑅𝐹𝐹 )
RA = 4 + 1.14 (12 – 4) = 13.12%
RB = 4 + 0.83 (12 – 4) = 10.64%
112

RC = 4 + 1.29 (12 – 4) = 14.32%
ii)
• Expected dividends in 1 year:
A 1.3 × 1.12 = ₦1.456

B 18.0 × 1.10 = ₦19.80
C 22.0 × 1.11 = ₦24.42
• Expected stock price (cum-div) in 1 year
A (107 × 1.312) + 1.456 = ₦122.4944

B (618 × 1.1064) + 19.80 = ₦703.5552
C (1,350 × 1.1432) + 24.32 = ₦1,567.64
Summary
Stock Forecast price Required price Conclusion

(₦) (₦)
A 122.50 122.4944 Properly valued
B 740.00 703.5552 Over valued
C 1,500.00 1,567.640 Under valued
iii) If you believe that the market consensus forecast is correct, sell stock B (over-valued)
and buy stock C (under-valued)
MARKING GUIDE
Marks Marks
a. Calculation of d1 2½
Calculation of d2 2
Calculation of number of calls 1½
Correct interpretation (i.e. sell) 1
7
b. Calculation of covariances 1½
Calculation of required return 1½
Calculation of expected dividends 1½
Calculation of expected price 1½
Summary 1
Conclusion 1
8
113

Total 15
EXAMINER’S REPORT
Part (a) of the question tests candidates’ knowledge of delta hedging using Black-Scholes option
pricing model while Part (b) tests candidates’ application of Capital Asset Pricing Model (CAPM).
The level of attempt was very low as not more than 20 percent of the candidates attempted the
questions and performance was very poor. Candidates are expected to compute d1 and N(d1) and
apply the result in their recommendations. They are also expected to analyse the securities stated
in the question using capital assets pricing model.
Candidates’ commonest pitfalls were their inability to apply the Black Scholes formula for d1 and
make use of the normal distribution table.
Candidates are advised not to be selective in their choice of study for the examination of the
Institute. They should ensure that they cover the syllabus and not leave out any part in their
preparations.
Candidates are expected to be guided by the Study Text and should not limit themselves to the
Study Text alone but should take advantage of other textbooks for more details.
114

SOLUTION 7
a) Financial evaluation of the two options.
Scheme A. The relevant cost is simply the cost of the equipment i.e. ₦200million
Scheme B. Finance lease – a number of steps are needed here:
i) Implied interest rate
The implied interest rate on the lease is computed as follows:
₦’000
Cost of equipment ₦200,000

Less advance lease rental (58,790)
Net cost of rental 141,210
This is repaid by ₦58,790,000 p.a. for 3 years.
Annuity factor = 141,210/58,790 = 2.402.
From the annuity tables, a 3-year cumulative present value of 2.402

corresponds to approximately 12%. Therefore the implied interest on the
lease is 12%.
Alternative method
An alternative method is to compute the IRR of the following cash flows

associated with the lease:
₦000
Year 0 Net cost of the asset 141,210
1 – 3 lease rentals (58,790)
IRR = 12% approx.
ii) Interest component of each rental
Opening Rental Closing

Interest
Year balance balance
at 14% ₦’000
₦’000 ₦’000 ₦’000
0 200,000 0 58,790 141,210
1 141,210 16,945 58,790 99,365*
115

2 99,365 11,924 58,790 52,499
3 52,499 6291** 58,790 0
∗ 141,210 – (58,790 – 16,945)
** Rounding error adjusted against interest to ensure closing balance

of zero.
iii) Tax savings on interest
₦000
Year 1 16,945 x 0.3 = 5,084
2 11,924 x 0.3 = 3,577
3 6,291 x 0.3 = 1,887
iv) Discount rate. The discount rate to use is the cost of borrowing, net of tax
= 13 (1 – 0.30) = 9.1%
v) NPV of lease option
0 1 2 3
Year
₦000 ₦000 ₦000 ₦000
Lease rentals (58,790) (58,790) (58,790) (58,790)
Tax relief interest 0 5,084 3,577 1,887
NCF (58,790) 53,706) (55,213) (56,903)
PVF at 9.1% 1 0.917 0.840 0.770
PV (58,790) (49,248) (46,379) (43,815)
Total PV (₦198,232,000)
Note: The above calculations are based on differential cash flows. We have
therefore ignored tax savings on tax depreciation. Whether the company
buys the equipment by borrowing or adopts a finance lease, it is entitled to
tax depreciation on the equipment. If the relevant tax savings are
incorporated into the analysis, the result will be as follows:
Annual tax depreciation: ₦’000

₦200m x ¼ x 0.30 (year 1 – 4) 15,000
Annuity factor at 9.1% (4 years) 3.233
PV = 15,000 x 3.233 = ₦48,495
116

Buy Lease
₦000 ₦000
NPV as previously calculated (200,000) (198,232)
Tax savings on depreciation 48,495 48,495
Net cost (151,505) (149,737)
It is clear that the relative position of the two alternatives remains the same.
Conclusion: The leasing option offers a cost savings of ₦1,768,000 relative

to the purchase option and it is therefore the preferred option.
b) The two main possible discount rates are:
The decision to invest in the equipment being financed will have already been
evaluated taking project specific risk into account. The evaluation in (a) is
being used to support the financing decision rather than the investment
decision. Cash flows should be discounted at either WACC or project specific
discount rate when evaluating the investment decision since the project is
financed using the company’s debt and equity resources. However, the
financing decision is a separate decision and the discount rate should be
tailored appropriately.
In financing decision, we can use debt as the ‘base line’ and compare other
forms of finance to the cost of debt by using the cost of debt as the discount
rate. The post-tax cost of debt is the opportunity cost of leasing and can be
used to discount the incremental cash flows arising from leasing as compared
to buying outright using the discount rate. Note that it would have been
equally acceptable to use leasing as the ‘base’ instead of debt and hence
discount cash flows at the post tax implied cost of leasing. However, it is
generally simpler to discount at the post tax cost of debt.
117

MARKING GUIDE
Marks Marks
a. Scheme A 1
Scheme B:
• Implied interest rate 2
• Interest calculations 4
• Tax savings on interest 1
• Discount rate to use ½
• NPV of lease option 4½
13
b. Discussion 2
Total 15
EXAMINER’S REPORT
The question tests candidates understanding of the analysis of finance lease.
More than 80 percent of the candidates attempted the question and performance was very poor.
Candidates are expected to compute implied interest rate in the lease and also analyse the tax
saving on interest but they showed very limited understanding of the question.
Candidates’ commonest pitfalls were their:
i. Inability to identify the correct discount rate to use;

ii. Improper treatment of the advanced lease rental; and
iii. Inability to calculate implied interest rate and cost.
Candidates’ are advised to prepare adequately for the Institute’s examinations and make use of
the Study Text and Pathfinders in their preparations.
GENERAL OBSERVATIONS
This particular examination has demonstrated a number of disturbing trends in the attitude of the
candidates towards the examination. Some of these include:
i. Limited coverage of the syllabus – It would appear that candidates have declared some
parts of the syllabus as unexaminable! How wrong they are!!
118

In this paper, topics like free cash flow model, bond valuation using spot rates, delta
hedging, etc. were tested at the surface. In future examinations, and based on recent
developments in the Nigerian economy (for example, the decision of the CBN to introduce
currency forwards and futures), candidates should expect these topics to be tested in
greater depth. Candidates should also note that there is “no-go-area” in the entire
syllabus.
ii. Key Financial Management Formulae – There are evidences that candidates do not learn
the use and the application of the formulae annexed to the question paper. In this
examination, only very few candidates made use of growing annuity formula in solving
question number one. Candidates wasted time (and hence marks!) in compounding and
discounting over a period of 15 years when the desired result could have been achieved
with one or two lines, using growing annuity.
Future examination questions will continue to test the use and the applications of these
formulae.
119

ACCOUNTANTS OF NIGERIA
PATHFINDER
NOVEMBER 2016 DIET
PROFESSIONAL LEVEL EXAMINATIONS
Question Papers
Suggested Solutions
Marking Guides
Plus
Examiner’s Reports
PROFESSIONAL LEVEL EXAMINATIONS – NOVEMBER 2016 DIET i

PROFESSIONAL LEVEL EXAMINATION – NOVEMBER 2016

INSTRUCTION: YOU ARE REQUIRED TO ANSWER FIVE OUT OF SEVEN QUESTIONS IN THIS PAPER
SECTION A: COMPULSORY QUESTION (30 MARKS)
QUESTION 1
Tinko Plc (TP) repairs and maintains heavy duty trucks, with workshops all over Nigeria and a
number of countries in Africa.
Below are extracts from the most recent Statement of Financial Position of TP:
₦’million
Share capital (50kobo/share) 200
Reserves 320
Non-current liabilities 760
1,340
TP’s Free Cash Flows to Equity (FCFE) is currently estimated at ₦153million and this is
expected to grow at 2.5% per annum to infinity. The equity shareholders require a return of
11%.
The company’s non-current liabilities consist entirely of ₦1,000 nominal value of bonds which
are redeemable in four years at par, with a coupon rate of interest of 5.4%. The debt is rated
BB and the credit spread on BB rated debt is 80 basis points above the risk-free rate of return.
The government recently launched its “Graduates Back To Land (GBTL)” programme in which
graduates are being encouraged to take on highly mechanised farming. The programme will
involve massive importation of heavy duty agricultural machines like tractors, harvesters,
driers, etc. for distribution to “Graduate Agric Clubs” all over the country. However, there is a
growing concern, within the country about the possibility of effective maintenance of these
machines. TP is therefore considering entering this market through a four-year project. The
project will cease after four years because of increasing competition.
The initial cost of the project is expected to be ₦84million and it is expected to generate the
following after-tax cash flows over its four-year life:
PROFESSIONAL LEVEL EXAMINATIONS – NOVEMBER 2016 DIET 69

Year 1 2 3 4
Cash flows (₦’000) 5.555.20 32,268.60 73,009.40 71,367.20
The above figures are based on the GBTL programme growing as expected. However, it is
estimated that there is 25% probability that the GBTL programme will not grow as expected in
the first year. If this happens, then the present value of the project’s cash flows will be 50% of
the original estimates over its four-year life.
It is also estimated that if the GBTL programme grows as expected in the first year, there is still
a 20% probability that the expected rate of growth will slow down in the second and
subsequent years, and the present value of the project’s cash flows would then be 40% of the
original estimates in each of these years.
Feedwell Limited (FL) has offered ₦100million to buy the project from TP at the start of the
second year. TP is considering whether having this choice would add to the value of the
project.
Although, there is no beta for companies offering maintenance services for only agricultural
machines and equipment in the country, Abako Plc (AP), a listed company, offers maintenance
and related services for construction, minning, and agricultural equipment. About 15% of its
business is in the equipment maintenance services in the agricultural sector. AP has an equity
beta of 1.6. It is estimated that the asset beta of non-agricultural maintenance sectors is 0.80.
AP’s shares are currently trading at ₦4.50 per share and its debt is currently trading at ₦1,050
per ₦1,000. It has 80 million shares in issue and the book value of its debt is ₦340million. The
debt beta is estimated to be zero.
The income tax rate applicable to all companies is 20%. The risk-free rate is estimated to be 4%
and the market risk premium is estimated to be 6%.
Required:
a. Calculate the current total market value of TP’s:
i. Equity (3 Marks)
ii. Bonds (4 Marks)
b. Calculate the risk-adjusted cost of capital required for the new project.
(Round your final answer to the nearest %). (10 Marks)
c. Estimate the value of the project with and without the offer from FL
(10 Marks)
d. State the assumptions made in your calculations. (3 Marks)
(Total 30 Marks)

SECTION B: YOU ARE REQUIRED TO ANSWER ANY TWO OUT OF THREE QUESTIONS IN
THIS SECTION (40 MARKS)
QUESTION 2
Honey Comb Plc, has issued 10% convertible loan stock which is due for redemption in
10 years’ time i.e. December 31, 2025. The option to convert is open only for another
two years. If conversion does not take place by December 31, 2017, the option will
lapse. The issue was sold to the public at a price of N920 for N1000 of convertible loan
stock. The conversion rate at January 1, 2016 was 250 equity shares for N1000 of
stock. Non-convertible loan stock in a similar risk class is presently yielding 12%. The
market price of Honey Comb Plc. equity shares has been increasing steadily over time
reflecting the performance of the company. The shares currently pay a dividend of
N0.30 per share. The current price of the convertible security is N960 and each share is
currently valued at N3.00. A holder of the convertible loan stock is considering
whether to sell his holdings or continue to hold the stock. Ignore taxation, while
answering the questions.
Required:
a. What is the value of the security as simple unconvertible loan stock?
(5 Marks)
b. What is the expected minimum annual rate of growth in the equity share price
that is required to justify the holder of convertible loan stock holding on to the
security before the option expires? (12 Marks)
c. What recommendation would you make to the holder of the security and why?
(3 Marks)
(Total 20 Marks)
QUESTION 3
Jack Limited is a family-owned business which has grown strongly in the last 50 years.
The key objective of the company is to maximise the family’s wealth through their
shareholdings.
Recently, the directors introduced value-based management, using Economic Value Added
(EVA) as the index for measuring performance.
You are provided with the following financial information.

Statement of Profit or Loss and Other Comprehensive Income for the year ended December 31,
2015.
₦’million
Operating profit 340.0
Finance charges (115.0)
Profit before tax 225.0
Tax at 25% (56.3)
Profit after tax 168.7
Notes 2015 (₦’m) 2014 (₦’m)

(i) Capital employed – from the Statement of 6,285 6,185
Financial Position
(ii) Operating costs:
Depreciation 295 285
Provision for doubtful debts 10 2.5
Research and development 60 –
Other non-cash expenses 35 30
Marketing expenses 50 45
(iii) Economic depreciation is assessed to be ₦415 in 2015. Economic depreciation

includes any appropriate amortisation adjustments.
In previous years, it can be assumed that economic and accounting depreciation
were the same.
(iv) Tax is the cash paid in the current year (₦45million) and an adjustment of
₦2.5million for deferred tax provisions. There was no deferred tax balance prior to
2015.
(v) The provision for doubtful debts was ₦22.5million on the 2015 Statement of
Financial Position.
(vi) Research and development cost is not capitalised in the accounts. It relates to a new
project that will be developed over five years and is expected to be of long-term
benefit to the company. The first year of this project is 2015.
(vii) The company has been spending heavily on marketing each year to build its brand
long term.
(viii) Estimated cost of capital of the company:
Equity 16%
Debt (pre-tax) 5%
(ix) Gearing (Debt/Equity) Ratio 1.5: 1

Required:
a. Calculate, showing all relevant workings, the Economic Value Added (EVA) for
year ended December 31, 2015. Make use of the adjusted opening capital
employed. Comment on your result and make appropriate recommendations.
(15 Marks)
b. Irrespective of your answer in (a) above, assume the company’s current EVA is
₦120million and that this will decline annually by 2% for the next ten years and then
increase by 4% per annum in perpetuity. Assume the following for this part only:
 Cost of equity 14%
 WACC 10%
Calculate the market value added (MVA) by the company.
Show all workings (5 Marks)
(Total 20 Marks)
QUESTION 4
Gugi Plc. is a highly successful manufacturing company operating in Nigeria. In addition to

sales within Nigeria, the company also exports to a foreign country (with currency F$) along
the ECOWAS sub-region. The export sales generate annual net cash inflow of ₦50,000,000.
Gugi Plc. is now considering whether to establish a factory in the foreign country and stop
export from Nigeria to the country. The project is expected to cost F$1 billion, including
F$200million for working capital.
A suitable existing factory has been located and production could commence immediately. A
payment of F$950million would be required immediately with the remainder payable at the
end of year one. The following additional information is available:
 Annual production and sales in units 110,000

 Unit selling price F$5,000
 Unit variable cost F$2,000
 Unit royalty payable to Gugi Plc ₦300
 Incremental annual cash fixed costs F$50million
Assume that the above cash items will remain constant throughout the expected life of
the project of 4 years. At the end of year 4, it is estimated that the net realisable value
of the non-current assets will be F$1.40billion.
It is the policy of the company to remit the maximum funds possible to the parent (i.e. Gugi
Plc.) at the end of each year. Assume that there are no legal complications to prevent this.

If the new factory is set up and export to the foreign country is stopped, it is expected that new
export markets of a similar worth in North Africa could replace the existing exports.
Production in Nigeria is at full capacity and there are no plans for further capacity expansion.
Tax on the company’s profits is at a rate of 40% in both countries, payable one year in arrears.
A double taxation agreement exists between Nigeria and the foreign country and no double
taxation is expected to arise. No withholding tax is levied on royalties payable from the foreign
country to Nigeria.
Tax allowable “depreciation” is at a rate of 25% on a straight line basis on all non-current
assets.
The Directors of Gugi Plc. believe that the appropriate risk-adjusted cost of capital of the
project is 13%.
Annual inflation rates in Nigeria and the foreign country are currently 5.6% and 10%
respectively. These rates are expected to remain constant in the foreseeable future. The current
spot exchange rate is F$1.60 = N1. You may assume that exchange rate reflects the
purchasing power parity theorem.
Required:
a. Evaluate the proposed investment from the view point of Gugi Plc.
Notes
i. Show all workings and all calculations to the nearest million.
ii. State all reasonable assumptions. (18 Marks)
b. State TWO further information and analysis that might be useful in the
evaluation of this project? (2 Marks)
(Total 20 Marks)
SECTION C: YOU ARE REQUIRED TO ANSWER ANY TWO OUT OF THREE QUESTIONS IN
QUESTION 5
a. Capital Asset Pricing Model (CAPL) is an equilibrium model of the trade–off

between expected portfolio return and unavoidable risk.
What are the basic assumptions on which this model is based? (6 Marks)

b. Currently, the rate of return on the Federal Government Bond redeemable at par
in the year 2018 is 5%. The securities of four companies, Akira Plc., Bombadia
Plc., Courage Plc. and Divine Plc. have expected returns of 12%, 9.5%, 10.5% and
13% respectively. The average expected return on market portfolio is 10%
subject to a 6% risk (standard deviation). Other relevant information relating to
the four securities of the companies is as stated below:
Standard Correlation
Deviation Coefficient
Akira Plc 0.080 0.975
Bombadia Plc 0.075 0.640
Courage Plc 0.090 0.740
Divine Plc 0.150 0.680
You are required to show which of the companies is/are overvalued. (9 Marks)
(Total 15 Marks)
QUESTION 6
Osamco Limited, manufacturer of wire and cables, was bought from its conglomerate
parent company in a management buyout deal in August, 2010. Six years after, the
managers are considering the possibility of listing the company’s shares on the
Nigerian Stock Exchange.
The following information is made available:
OSAMCO LIMITED
INCOME STATEMENT FOR THE YEAR ENDED JUNE 30, 2016
N’million
Turnover 91.25
Cost of sales (79.00)
Profit before interest and taxation 12.25
Interest (3.25)
Profit before taxation 9.00
Taxation (1.25)
Profit attributable to ordinary shareholders 7.75
Dividend (0.75)
Retained profit 7.00

STATEMENT OF FINANCIAL POSITION AS AT JUNE 30, 2016
N’million N’million
Non–current assets (at cost less accumulated depreciation)
Land and buildings 9.00
Plant and machinery 24.75
33.75
Current assets
Inventories 11.00
Accounts receivable 11.75
Cash at bank 2.50
25.25
59.00
Ordinary shares of N1 each 6.75
Reserves 24.25
31.00
Accounts payable due after more than one year:
12% Debenture 2018 5.50
Current Liabilities
Trade accounts payable 17.5
Bank overdraft 5.0
22.50
59.00
Average performance ratios for the industry sector in which Osamco Limited.
operates are as stated below:
Industry sector ratios

Return before interest and tax on long term capital employed 24%
Return after tax on equity 16%
Operating profit as percentage of sales 11%
Current ratio 1.6:1
Quick (acid test) ratio 1.0:1
Total debt: equity (gearing) 24%
Dividend cover 4.0
Interest cover 4.5
Required:
a. Evaluate the financial state and performance of Osamco Limited by comparing it
with that of its industry sector. (10 Marks)
b. Discuss FOUR probable reasons why the management of Osamco Limited. is
considering Stock Exchange listing (5 Marks)
(Total 15 Marks)

QUESTION 7
One of the means by which companies expand is through mergers and acquisition.
However, there are other means of expansion aside these methods.
Inkline Plc. is one of your client companies intending to expand its business by means
of merger or acquisition.
Your firm of management consultants has been asked to advise the management of
the company on what steps to take, while considering the merger and acquisition
methods, and whether it should go ahead with the expansion programme or
otherwise.
Required:
Advise your client on:

a. (i) FOUR benefits derivable from its proposed means of expansion.
(4 Marks)
(ii). THREE probable demerits of employing its proposed method of
expansion. (3 Marks)
b. State TWO alternatives to merger and acquisition in your report. (2 Marks)
c. Where the company decides to go ahead with either of these methods, indicate
THREE criteria the company may consider in choosing its target company.
(6 Marks)
(Total 15 Marks)

Formulae
= + ( − ) (1 − )
Asset Beta
(1 − )
= +
( + (1 − )) ( + (1 − ))
Equity Beta
= +( − ) (1 − )
Growing Annuity
1+
= 1−
− 1+
= (1 + ) − 1

-rt
C0 = S0N(d1) – Ee N(d2)
+ ( + 0.5 )
=
√
d2 = d1 - √
The Put Call Parity
-rt
C + Ee = S + P
×√ /
=
d = 1/u
/
=
−
=
−
/
The Miller-Orr Model
Return Point = Lower Limit + ( x spread)
x Transaction Cost x Variance of Cash lows

=3x
Interest rate

Annuity Table
-n
Present value of an annuity of 1 i.e. 1 - (1 + r)
r
Discount rate (r)

Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1
2 1·970 1·942 1·913 1·886 1·859 1·833 1·808 1·783 1·759 1·736 2
3 2·941 2·884 2·829 2·775 2·723 2·673 2·624 2·577 2·531 2.487 3
4 3·902 3·808 3.717 3·630 3.546 3.465 3·387 3·312 3·240 3·170 4
5 4·853 4·713 4·580 4·452 4·329 4·212 4·100 3·993 3.890 3·791 5
6 5·795 5·601 5·417 5·242 5·076 4·917 4·767 4·623 4.486 4·355 6
7 6·728 6.472 6·230 6·002 5·786 5·582 5·389 5·206 5·033 4·868 7
8 7·652 7·325 7·020 6·733 6·463 6·210 5·971 5·747 5·535 5·335 8
9 8·566 8·162 7·786 7.435 7·108 6·802 6·515 6·247 5·995 5·759 9
10 9·471 8·983 8·530 8·111 7·722 7·360 7·024 6·710 6.418 6·145 10
11 10·368 9·787 9·253 8·760 8·306 7·887 7.499 7·139 6·805 6.495 11
12 11·255 10·575 9·954 9·385 8·863 8·384 7·943 7·536 7'161 6·814 12
13 12·134 11·348 10·635 9·986 9·394 8·853 8·358 7·904 7·487 7·103 13
14 13·004 12·106 11·296 10·563 9·899 9·295 8·745 8·244 7·786 7·367 14
15 13·865 12·849 11·938 11·118 10·380 9·712 9·108 8·559 8·061 7·606 15
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1
2 1·713 1·690 1·668 1·647 1·626 1·605 1·585 1·566 1·547 1·528 2
3 2.444 2.402 2·361 2·322 2·283 2·246 2·210 2·174 2·140 2·106 3
4 3·102 3·037 2·974 2·914 2·855 2·798 2·743 2.690 2·639 2.589 4
5 3·696 3·605 3·517 3·433 3·352 3·274 3·199 3·127 3·058 2·991 5
6 4·231 4·111 3·998 3·889 3·784 3·685 3·589 3.498 3.410 3·326 6
7 4·712 4·564 4.423 4·288 4·160 4·039 3·922 3·812 3·706 3·605 7
8 5·146 4·968 4.799 4·639 4.487 4·344 4·207 4·078 3·954 3·837 8
9 5·537 5·328 5·132 4·946 4·772 4·607 4.451 4·303 4·163 4·031 9
10 5·889 5·650 5.426 5·216 5·019 4·833 4·659 4.494 4·339 4·192 10
11 6·207 5·938 5·687 5.453 5·234 5·029 4·836 4·656 4.486 4·327 11
12 6·492 6·194 5·918 5·660 5·421 5·197 4·988 4·793 4·611 4.439 12
13 6·750 6.424 6·122 5·842 5·583 5·342 5·118 4·910 4·715 4·533 13
14 6·982 6·628 6·302 6·002 5·724 5.468 5·229 5·008 4·802 4·611 14
15 7·191 6·811 6.462 6·142 5·847 5·575 5·324 5·092 4·876 4·675 15


SOLUTIONS

SOLUTION 1
a) i) Current value of equity
Using FCFE model, the current value of equity
0 (1 ) 153(1.025) 156.825
= = = = ₦1,845million
0.11 0.025 0.085
ii) ● Cost of the bond = Risk-free rate of return plus the credit spread
= 4% + 0.80% = 4.80%
● Current market value of bond with ₦1,000 face value
= 54 + 54 + 54 + 1054 = ₦1,021.37
. . . .
 Total market value:
= ₦760m × 1,021.37/1,000 = ₦776.24million
b) Calculation of project’s risk-adjusted cost of capital:
The cost of capital should reflect the systematic business risk of the project. This should be
calculated from the information given about AP.
 Abako Plc. (AP) asset beta
AP’s equity value = ₦4.50 × 80m = ₦360m
AP’s debt value = 1.05 × ₦340m = ₦357m

∙
= (1 )
(Beta of debt = 0)
1.6 × 360
= = 0.89
360 (357×0.8)
 Project’s asset beta (x)
0.89 = 0.15 + (0.80 × 0.85)
= 1.4

TP
 Project’s risk adjusted equity beta

776.24
= +( − ) (1 − ) = 1.4 + (1.4 − 0) (0.8) = 1.87
1,845
 Project’s risk adjusted cost of equity
Using CAPM: Rs = Rf + (Rm – Rf)
NB: Rm - Rf = Market Risk Premium = C
 Rs = 4 + 1.87 (6) = 15.22%
 Project’s risk adjusted cost of capital

15.22 × 1,845 4.8 × 0.8 × 776.24
WACC = + = 11.85 or 12%
1,845 776.24 1,845 776.24
c) Where WACC = Weighted Average Cost of Capital
i) Value of the project without the offer from Feedwell Limited (FL)
Year 1 2 3 4
Cash flow (₦’000) 6,555.20 32,268.6 73,009.4 71,367.20
Present value at 12% 5,852.90 25,724.3 51,966.6 45,355.10
Total PV years 1 – 4 = ₦128,898,900 Possibility A
50% of PV of years 1 – 4 = ₦64,449,450 Possibility B
Total PV years 2 – 4 = ₦123,046,000
40% PV years 2 – 4 = ₦49,218,400
Add PV of year 1 = ₦ 5,852,900

55,071,300 Possibility C

Summary
Possibility Cash Flow Probability Expected

₦ value
₦
A 128,898,900 0.60 * 77,339,340
B 64,449,450 0.25 16,112,363
C 55,071,300 0.15 ** 8,260,695
Total PV of inflows 101,712,398
Initial outlay (84,000,000)
Expected NPV (ENPV) 17,712,398
* 0.75 × 0.80 = 0.60

** 0.75 × 0.20 = 0.15
0.75
ii) Expected value of the project with the offer from Feedwell Limited (FL)
PV of ₦100m = 100,000,000/1.12 = ₦89,286,000
If the Graduate Back To Land (GBTL) does not grow as expected in the first year, then
it is more beneficial for Tinko Plc. to exercise the offer made by FL, given that FL’s
offer of ₦89.27 million (PV of ₦100 million) is greater than the PV of years two to four
cash flows, that is, 50% × ₦(25.72m + 51.97m + 45.36m) = ₦61.53m for that
possible outcome.
This figure is then incorporated into the expected net present value calculations. Thus,
for possible outcome B:
₦
Year 1: 50% × ₦5,852,900 2,926,000
2: PV of ₦100million 89,286,000
92,212,000
The revised NPV is as follows:
Possibility CF Probability Expected value

₦ ₦
A 128,898,900 0.60 77,339,000
B 92,212,000 0.25 23,053,000
C 55,071,300 0.15 8,260,695
PV of inflows 108,652,695
Initial outlay 84,000,000
ENPV 24,652,695

Note
The analysis above is the intended solution. Another method is to make use of decision
tree. Alhough, a longer process, it is included here for educational purposes.
Year 1 Year 2 - 4
(All cash flows are in present value terms in ₦m)

* PV of cash flows in years 2 – 4
** 40% of PV of cash flows in years 2 – 4
The final value of ₦108.60million is derived as follows:
₦[(5.9 + 108.2) × 0.75] + [(2.9 + 89) × 0.25]million = ₦108.60million.
Removing the initial outlay of ₦84million produces ENPV of ₦24.60million.
d) Key assumptions
 It is assumed that the capital structure of the company will not change substantially
when the new project is taken on. Since the initial cost of the project is significantly
smaller than the value of TP itself, it is not an unreasonable assumption.
 There may be more possible outcomes in practice than the ones given and financial
impact of the outcomes may not be known with such certainty. The Black-Scholes
Option Pricing Model may provide an alternative and more accurate way of assessing
the value of the project.
 It is assumed that TP can rely on FL paying the ₦100m at the beginning of year two
with certainty.
 It is assumed that all the figures relating to the beta, growth rates, risk adjusted cost of
capital and probabilities are accurate.

MARKING GUIDE
MARKS MARKS
(a)i Current value of equity 3
ii. Current value of bond 4
7
(b)i AP’s asset beta 3½
ii. Project’s asset beta 1½
iii. TP’s equity beta 2½
iv. Project’s cost of equity ½
v. Project’s cost of capital (WACC) 2
10
(c)i. Identification of all possible outcomes and related cash flows 3
ii. Present value calculations 2
iii. Relevant cash flows with abandonment option 3

iv. Calculation of present value 2
10
(d) ½ mark for each well-discussed point: max 3
TOTAL 30
EXAMINER’S REPORT
The question tests candidates’ knowledge of valuation of equity and bond, calculation of risk-
adjusted cost of capital and evaluation of capital project involving risk and uncertainty.
Being a compulsory question, almost all the candidates attempted the question. However, it is
highly disappointing that most of them did not understand the concepts being tested as they
could not generate the required solutions to parts ‘b’ and ‘c’ of the question, hence
performance was poor.
Candidates’ commonest pitfalls were their inability to calculate the equity beta needed for the
project and their failure to sort out its cash flows.
Candidates are advised to cover the syllabus adequately, work on past questions in the
Institute’s Study Texts, Pathfinders and other relevant text books for better results in future
examination.

SOLUTION 2
(a) The value of the security as a simple unconvertible loan stock is the present value of
the future interest (years 1 – 10) and the present value of the face value due in year 10.
Item Year CF PVF at 12% PV

₦ ₦
Interest 1 – 10 100 5.650 565
Face Value 10 1,000 0.322 322
887
(b) For the holder to convert, the current market value of the convertible must at
least equal the present value of interest for the next two years and the present
value of the conversion value. The conversion value:
= Po (1 + g)n x R,
Where:
Po = current VPS = N3
g = growth rate in share price to be determined
n = years to expiration of the option to convert = 2 years
R = conversion ratio = 250 shares
Thus:
Correct Market Value = The Present Value Interest for the next two years + Present
Value of the conversion value.
3(1 g)2 X 250
i.e 960 =  100
(1.12)
100
+ (1.12)2 + (1.12)2
750(1 g)2
960 = 169 +
(1.12)2
791 = 597.90 (1 + g)2

791
= (1 + g)2
597.90
791
g= ½
- 1 = 15%
597.90

(c) The key to hold or sell, lies in the expected growth in the value of the equity. If
growth of 15% cannot be achieved, he should sell the convertible loan stock now
because the failure to achieve the growth implies that the present value of
interest and equity is below N960.00. This will not be a problem if the market
is not paying a premium on the basis of expected growth. However, the value
of the convertible loan stock is around N890 and a N70 premium is paid on the
value basis of growth in the value of shares. The share price must increase
beyond N890/N250 i.e N3.56 to make conversion a possibility. This is because
it is only at prices in excess of N3.56 that the convertible is worth more as
shares than as a debenture.
MARKING GUIDE
MARKS MARKS
(a) Calculation of value as an unconvertible bond 5
(b)i. Setting out the conversion price equation 2

ii. Substituting the relevant values 2
iii. Computing the growth rate 8
12
(c) Comments and recommendations 3
TOTAL 20
EXAMINER’S REPORT
The question tests candidates’ knowledge of convertible bonds, Part ‘a’ of the question tests
candidates’ knowledge of bond valuation, while part ‘b’ tests analysis of convertibles.
About 40 percent of the candidates attempted the question and performance was generally
poor. A few of the candidates that attempted the question displayed good understanding
while some had problems in providing appropriate solutions hence poor performance.
Candidates’ commonest pitfalls were their inability to recognize the requirements of the
question in part ‘a’ which was simply the valuation of bonds and their failure to work out the
growth rate in part ‘b’.
Candidates are advised to read, understand and interpret questions appropriately and note
their specific requirements before attempting them.

SOLUTION 3
a)
 Calculation of Net Operating Profit After Tax (NOPAT)
₦m ₦m
Operating profit 340.00
Add back:
Non-cash items 35.00
Accounting depreciation 295.00
Doubtful debts 10.00
Research and development 60.00
Marketing expenses 50.00 450.00
Less
Economic depreciation 415.00
Tax cash paid (45 – 2.5) 42.50
Loss tax relief on interest 28.75 (486.25)
(25% of N115m)
NOPAT 303.75
Adjusted opening capital employed (AOCE)
₦m ₦m
Per 2014 Statement of Financial Position 6,185.00
Add back:
Provision for doubtful debt at the end of 2014
(22.50 – 10) 12.50
Other non-cash expenses (2014) 30.00
Marketing expenses (2014) 45.00 87.50
Adjusted opening capital employed (AOCE) 6,272.50
 Weighted Average Cost of Capital (WACC)
WACC = 16 × 2 5 + 5 × 3 5 × 0.75 = 8.65%
 EVA (Economic Value Added)
EVA = NOPAT – (AOCE × WACC)
= ₦303.75 – (₦6,272.50m × 0.0865) = – ₦238.82 million

Comments and recommendations
The company is currently destroying value as it is failing to meet the economic cost of
its own capital. This is an unsustainable position in the long term and will lead to
shareholders’ dissatisfaction.
To improve EVA, the following are recommended:
 Dispose assets in excess of requirement to minimize capital cost.

 Exercise tighter expenditure control to reduce expenses.
 Adopt a more aggressive sales drive to improve revenue.
 Market Value Added (MVA) is the present value (using WACC) of future EVA.
 First 10 years when g= –2%. It is faster to work with growing annuity in this
case.
1 1
PV = 1−
1
1 0.02 10
120(1 0.02) 1
1.10
= = ₦671.28m
0.10 0.02
 Years 11 to infinity
EVA11 = 120 (1 – 0.02)10 × 1.04 = 101.97m
101.97 10
PV = × (1.10) = ₦655.23m
0.10 0.04
Total MVA = ₦671.28m + ₦655.23m = ₦1,326.51million
MARKING GUIDE
MARKS MARKS
(a)i. Adjusted NOPAT 5
ii. Adjusted opening capital employed 5
iii. Calculation of WACC 1
iv. Calculation of EVA 1
v. Comments and recommendations 3
15
(b) Calculation of MVA 5
TOTAL 20

EXAMINER’S REPORT
The question tests candidates’ knowledge of value-based management. It requires candidates

to calculate Economic Value Added (EVA).
About 50% of the candidates attempted the question but most of them did not have a clear
and accurate understanding of both parts of the question hence their performance was poor.
Candidates’ commonest pitfalls were their inability to carry out the accounting adjustments
required to determine the Net Operating Profit After Tax (NOPAT) and the Opening Capital
Employed (OCE).
Candidates are advised to make use of the Institute’s Study Texts in their preparation for the
Institute’s examinations.

SOLUTION 4
a) Calculation of (NPV) (₦million)
Year 0 1 2 3 4 5
Receipts from foreign project (W4) (594) 99 118 112 957 (289)
Royalty received in Nigeria - 33 33 33 33 -
Related tax in Nigeria (at 40%) - (13) (13) (13) (13)
Net cash flow (594) 132 138 132 977 (302)
PVF at 13% 1 0.885 0.783 0.693 0.613 0.543
PV (594) 117 108 91 599 (164)
 NPV = - 594 + 117 + 108 + 91 + 599 – 154 = ₦157,000

Based on the above calculation, the project is viable with a positive net present value of
₦157,000,000.
Note: The loss of exports to the foreign country is not a relevant cash flow since it will be
replaced by equivalent exports to North Africa.
Working Notes
1. Exchange rate
The rate of change of the value of the foreign currency is given as:
− 1, here
= domestic inflation rate

= foreign inflation rate
In this case, we expect the foreign currency to depreciate by 4% p.a., i.e.
.
– 1 = - 4%
.
The current value of F$1 = 1/1.60 = ₦0.625. This is expected to depreciate by

4% p.a.

Year ₦per F$1
0 0.625
1 0.625 × 0.96 0.600
2 0.600 × 0.96 0.576
3 0.576 × 0.96 0.5530
4 0.5530 × 0.96 0.5309
5 0.5309 × 0.96 0.5097
2. Royalty payable to Gugi Plc. converted to F$

F$ million
Year 1 110,000 × 300/0.6 55
2 110,000 × 300/0.576 57
3 110,000 × 300/0.553 60
4 110,000 × 300/0.5309 62
3. Profit after tax (F$ million)

Year 1 2 3 4
Contribution (110,000 × (5,000 – 2,000)) 330 330 330 330
Cash fixed costs (50) (50) (50) (50)
Royalty (W2) (55) (57) (60) (62)
Tax depreciation (200) (200) (200) (200)
Taxable profit 25 23 20 18
Tax at 40% (10) (9) (8) (7)
Profit after tax 15 14 12 11
4. Project Cash Flows (F$ million)

Year 0 1 2 3 4 5
Profit after tax 15 14 12 11
Add depreciation 200 200 200 200
Initial investment (950) (50)
Tax (10) (9) (8) (7)
Realisable value of non- 1,400
current assets
Related tax at 40% (560)
Working capital recovery 200
NCF available to Gugi Plc. (950) 165 204 203 1,803 (567)
Exchange rate 0.625 0.600 0.576 0.553 0.5309 0.5097
Available CF (₦million) (594) 99 118 112 957 (289)
b) Further information and analysis might include:

i) Information on political and economic factors of both countries; for example, how
stable is the foreign government policy, the exchange rate, taxation, exchange control,
attitudes towards foreign investment etc.

ii) How accurate are the cash flow forecasts? How have they been established?
iii) Risk: Risk is taken into account by using a Capital Assets Pricing Model (CAPM) derived
discount rate. For an international project, risk is best handled using the international
version of CAPM. It might also be helpful to consider the use of sensitivity analysis or
simulation.
iv) Why has a 4-year planning horizon been chosen? The valuation of non-current assets at
Year 4 is highly significant to the NPV solution. How has this valuation been
established? Is this valuation based upon future earnings as a going concern? It would
be more desirable to evaluate the project over the whole of its projected life.
v) Legal requirements of the foreign country.
MARKING GUIDE
HEADING MARKS MARKS
(a)i Calculation of exchange rates 3
ii. Conversion of royalty to F$ 1
iii. Computation of profit after tax F$ 4
iv. Projects’ cash flows in N 5
v. Computation of NPV and conclusion 5
18
(b) 1 mark per point, max 2 2
TOTAL 20
EXAMINER’S REPORT
The question tests candidates’ knowledge of the analysis of foreign projects under International
Investment decisions aspect of the syllabus.
About 80 percent of the candidates attempted the question. They however demonstrated
insufficient knowledge of this area of the syllabus hence performance was very poor.
Candidates’ commonest pitfalls include their inability to:
(a) calculate the appropriate exchange rates to use;
(b) sort out the appropriate cash flows;
(c) remove working capital from the initial investment before computing tax depreciation;
(d) convert the royalty paid in Naira to the F$ for the purpose of computing the foreign tax;
(e) account for tax on the resale value of the investment even when the asset has been fully
depreciated for tax purposes;
(f) account for Nigerian tax on royalty collected in Nigeria.
Candidates are advised to always cover the syllabus adequately and make use of the Institute’s
Pathfinders, Study Texts and other relevant text books in their preparations for the Institute’s future
examinations. They should also endeavour to pay attention to and improve their knowledge on
International Investment decisions aspect of the syllabus. However, it is extremely important for
candidates to note that future examination questions will continue to be set to cover all areas of the
syllabus.

SOLUTION 5
(a). Assumptions of Capital Asset Pricing Model (CAPM) include the following:
i. Investors only need to know the expected returns, the variances, and the co-
variances of returns to determine which portfolios are optimal for them;
ii. Investors have identical views about risky assets’ mean returns,
variances of returns, and correlations;
iii. Investors can buy and sell assets in any quantity without affecting price; all
assets are marketable (can be traded);
iv. Investors can borrow and lend at the risk-free rate without limit, and they can
sell short any asset in any quantity;
v. Investors pay no taxes on return;
vi. Investors pay no transaction costs on trades;
vii. All investors’ decisions are based on a single time period.
(b) Computation of the beta of each security:
(Correlaon with market)(Standard deviaon of the project)

=
Standard deviaon of the market
( . )( )
Akira (A) = = 1.30
( . )( . )
Bombadia (B) = = 0.80
( . )( )
Courage (C) = = 1.11
.
Divine (D) = = 1.70
 Computation of the required returns:
= + i
( - )
A: RA = 5 + 1.30 (10 – 5) = 11.50%

B: RB = 5 + 0.80 (10 – 5) = 9%
C: RC = 5 + 1.11 (10 – 5) = 10.55%
D: RD = 5 + 1.70 (10 – 5) = 13.5%

 Calculation of the alpha of each security and make conclusion
C1 C2 C3 C4 C5
Security Expected Required Alpha Remarks
return return C2 – C3
A 12% 11.5% 0.5% Undervalued
B 9.5% 9% 0.5% Undervalued
C 10.5% 10.55% -0.05% Overvalued
D 13% 13.5% -0.5% Overvalued
 Conclusion
Securities with positive alpha are undervalued and securities with negative
alpha are overvalued and should be sold.
MARKING GUIDE
MARKS MARKS
(a) Any 6 points at 1 mark each 6
(b)i. Calculation of alpha 3

ii. Calculation of required return 2
iii. Calculation of alpha value and its interpretation 4
9
TOTAL 15
EXAMINER’S REPORT
The question tests candidates’ knowledge on Capital Asset Pricing Model (CAPM).
About 25 percent of the candidates attempted the question. The few that attempted it showed
a good understanding of ‘part b’ of the question but others had problems in providing
appropriate solutions hence performance was average.
Candidates’ commonest pitfalls were their mix up of the assumptions of Capital Asset Pricing
Model (CAPM) with those of capital market generally in part ‘a’ of the question and their
failure to apply the appropriate formula to calculate beta factor in part ‘b’.
Candidates are advised to read, understand and interpret questions appropriately and note
their specific requirements before attempting them.

SOLUTION 6
(a). The performance and financial health of Osamco Limited in relation to that of
the industry sector as a whole can be evaluated by comparing its financial
ratios with the industry averages, as follows:
Osamco Ltd. Company’s Average Industry Average
Returns on (long-term) Capital Employed.

Operating profit (PBIT):Equity + long term debt
₦12.25 : (N31m +₦5.5m) 33.6% 24%
Returns On Equity
Profit attributable to ordinary shareholders: Equity
₦7.75m : ₦31m 25% 16%
Operating Profit Margin

Operating profit : Sales
₦12.25m : ₦91.25m 13.4% 11%
Current Ratio
Current assets : Current Liabilities
₦25.25m : ₦22.5m 1.12:1 1.6:1
Acid Test Ratio

Current assets excluding inventory: Current liabilities
₦14.25m : ₦22.5m 0.63:1 1.01:1
Gearing Ratio
Debt : Equity
(₦5m + ₦5.5): ₦31m 33.9% 24%
Dividend Cover
Profit attributable to equity: Dividend
₦7.75m : ₦0.75 10.3 times 4.0 times
Interest Cover
Profit before interest and tax (PBIT): Interest
₦12.25m : ₦3.25 3.77 times 4.5 times
These ratios can be used to evaluate performance in terms of profitability, liquidity

and financial stability.

Profitability
Osamco Limited’s return on capital employed, return on equity and operating profit
margin are all significantly above the industry averages. Although, the first two
measures could be inflated due to asset being shown at book values, the profit margin
indicates that OSAMCO LTD is managing to make good profit which could be due to
successful marketing, a low cost base or to its occupation of a particularly profitable
niche in the market.
Liquidity
Both the current and the quick (acid test) ratios are well below the industry averages.
This suggests that Osamco Limited is either short of liquid resources or is managing its
working capital poorly.
However, the three key working capital ratios modify this impression as follows:
.
Receivable days :  = 47 days
.
.
Inventory Turnover days:  = 51 days
.
.
Payment Period days  = 81 days
.
Although, the industry averages are not given, these ratios appear to be good by
general standards.
Financial Stability
Gearing ratio is high in comparison with the rest of the industry and 48% of the debt is
in the form of overdraft which is generally repayable on demand. This is therefore a
risky form of debt to use in large amounts. The debenture is repayable in two years
and will need to be refinanced since Osamco Limited cannot redeem it out of existing
resources. Interest cover is also poor, and this together with the poor liquidity
probably account for the low payment ratio (the inverse of the dividend cover).
In summary, profit performance is strong, but there are significant weaknesses in both
the liquidity and financial stability. These problems need to be addressed if Osamco
Limited is to be able to maintain its record of strong and consistent growth.

b) A company such as Osamco Limited may seek a stock market listing for the
following reasons:
i. To allow access to a wider pool of finance: Companies that are growing
fast may need to raise large sums than is possible privately. Obtaining a
listing widens the potential number of equity investors and may also
result in an improved credit rating thus reducing the cost of additional
debt finance.
ii. To improve marketability of the shares: Shares that are traded on the
stock market can be bought and sold in relatively small quantities at any
time. This means that it is easier for existing investors to realise a part of
their holding.
iii. To allow capital to be transferred to other ventures: Founder owners may
wish to liquidate the major part of their holdings either for personal
reasons or for investment in other new business opportunities.
iv. To improve the company’s image: Quoted companies are commonly
believed to be more financially stable, and this may improve their image
with their customers and suppliers, allowing them to gain additional
business and improve their buying power.
v. Growth by acquisition is easier: A listed company is in a better position to
make an offer for a target company than an unlisted one.
MARKING GUIDE
MARKS MARKS
(a)i. Calculation of the given ratios 6
ii. Interpretation 4
10
(b) 1¼ per point (for any four points) 5
TOTAL 15
EXAMINER’S REPORT
The question tests candidates’ ability to calculate and interpret basic financial ratios.
About 90% of the candidates attempted the question and performance was average. Some of
the candidates displayed good understanding of the question while some had problems in
providing appropriate solutions.
Candidates’ commonest pitfalls were their failure to calculate some of the ratios correctly and
their inability to provide appropriate interpretations of the computed ratios.
Candidates are advised to ensure adequate coverage of all sections of the syllabus.

SOLUTION 7
ABC Management Consultants

6, Ajase Street, Yaba, Lagos
Abcmanagmentconsultants.com
Date: November 16, 2016
The Directors
Inkline Plc
34, Ojodu Street
Ikeja, Lagos
Dear Sirs,
RE: PROPOSED EXPANSION VIA MERGER AND ACQUISITON
We have gone through your request asking us to offer advice on your proposed
expansion via merger and acquisition, we advise as follows:
a. (i) The benefits derivable from the proposed method of expansion include:
 Your company will experience faster growth than when the internal
development is pursued.
 If your company’s expansion is made through acquisition of another
company, there is greater likelihood that your company may inherit new
products, new markets and new/additional customers from the acquired
company which may be difficult to obtain through internal development.
 Your mode of expansion will enable your company enter a new market
and set up a new business which would have been difficult because of
high entry barriers.
 Your acquisition of a competitor will prevent it from acquiring yours.
 Your company may save cost and earn higher profits from synergy effects
(ii) The probable demerits of employing your proposed method of expansion

include:
 It might be very expensive since bid price should be high enough to make
the target company sell their shares. This may as well result in low return
on your investment.
 A proportional loss of ownership may result from acquisition of another
company.
 Merger of two organisations having different structures, management
styles, cultures, etc may be difficult and might result in loss of employees.
Employees may feel threatened by possible redundancies which may

bring about downsizing. Resolution of likely disruption might take
considerable time.
 Convergence of different individuals may result in ‘clash of culture’ since
they are from differing backgrounds. This will make working together
difficult.
b. Alternatives to merger and acquisition:

From the foregoing, a comparison of the merits and demerits of your expansion
proposal might result in searching for alternatives. The following are alternative
expansion programmes which your company may pursue:
i. Growth through internal development of the business; (organic growth)
ii. Growth by means of a joint venture;
iii. Licensing;
iv. Franchising; and
v. Strategic alliance.
c. Criteria for choosing an acquisition target include:

i) Strategic aims and objectives: Target company should be one that will
help to grow the acquiring company in terms of existing market
expansion, increase in new products and entry into new geographical
area;
ii) Cost and relative size: Although there are occasional examples of small
companies acquiring much larger ones in a reverse take over, target
companies are usually selected because they are affordable;
iii) Opportunity and availability: In many cases, targets for acquisition are
selected because of circumstances. An opportunity to acquire a particular
company might arise, and the acquiring company might decide to take
the opportunity whilst it is available;
iv) Potential synergy: Targets for acquisition might possibly be selected
because they provide an opportunity to increase total profits through
improvements in efficiency.
We hope this will meet your quest for advice for your proposed expansion bid. If you
need further clarification, do not hesitate to contact us.
Yours faithfully,
Signed:
Name
For: ABC Management Consultants

MARKING GUIDE
MARKS MARKS
Report format 3
(a) 1 mark per point 4
(b) 1 mark per point 3
7
(c) 1 mark each 2
(d) 1 mark each 3
TOTAL 15
EXAMINER’S REPORT
The question tests candidates’ knowledge of Mergers and Acquisitions with specific emphasis
on candidates’ ability to identify advantages and disadvantages of growth by mergers and
acquisition and its alternative means of growth.
About 90% of the candidates attempted the question and performance was good. However,
some of the candidates lost some marks for their failure to present their solution in a report
format.
Candidates are advised to always ensure that they read, understand, interpret questions
correctly and note their specific requirements before attempting them to avoid loss of marks.

PATHFINDER
MAY 2017 DIET
Question Papers
Suggested Solutions
Marking Guides
Plus
Examiner‟s Reports

INSTRUCTION: YOU ARE REQUIRED TO ANSWER FIVE OUT OF THE SEVEN

QUESTIONS IN THIS PAPER
QUESTION 1
K Plc., a listed company based in Warri, Delta state, has been involved in producing boats
(but excluding the engines). The company is now considering diversifying into the
production of a major component of outboard engine. For this purpose, the company has
recently purchased the patent rights for ₦15million to produce the component.
K Plc. has spent ₦20million developing prototypes of the component and undertaking
market studies. The research studies came to the conclusion that the component will
have a significant commercial potential for a period of five years, after which, newer
components would come into the market and the sales revenue from the component
would virtually fall to zero. The research studies have also found that in the first two
years (the development phase), there will be considerable training and development
costs and fewer components will be produced and sold. However, sales revenue is
expected to grow rapidly in the following three years (the commercial phase).
It is estimated that in the first year, the selling price would be ₦2,000 per component, the
variable costs would be ₦800 per component and the total direct fixed costs would be
₦6,000,000. Thereafter, while the selling price is expected to increase by 8% per year, the
variable and fixed costs are expected to increase by 5% per year for the next four years.
Training and development costs are expected to be 120% of variable costs in the first year,
40% in the second year, and 10% in each of the following three years.
The estimated average number of outboard engine components produced and sold per
year is given below:
Year 1 2 3 4 5
Units produced and sold 15,000 40,000 100,000 120,000 190,000
Machinery, costing ₦480,000,000, will need to be installed prior to commencement of the

component production. K Plc. has enough space in its factory to manufacture the
components and therefore will incur no additional rental costs. Tax allowable depreciation
is available on the machinery at 10% on straight-line basis. The machinery is expected to
be sold for ₦160,000,000 at the end of year 5. The company makes sufficient profits from
its other activities to take advantage of any tax loss relief available from this project.
69

Initially, K Plc. will require additional working capital for the project of 20% of the first
year‟s sales revenue. Thereafter, every ₦1 increase in sales revenue will require a 10%
increase in working capital.
Although this would be a major undertaking for the company, it is confident that it can
raise the finance required for the machinery and the first year‟s working capital. The
financing will be through a mixture of a rights issue and a bank loan, in the same
proportion as the market values of current equity and debt capital. Any annual increase in
working capital after the first year, will be financed by internally generated funds.
Marine Engineers (ME) Plc. is a listed company involved in the manufacture of outboard
engine components for many years.
Additional data
Extracts from Statement of Financial Position:
K Plc. ME Plc.
₦’m ₦’m
Working capital 296 628
6% Bank loan 624 -
5% Loan notes (2020 – 2022) - 368
Share capital - ₦0.50 per share 208 -
- ₦1.00 per share - 500
Reserves 808 1,428
Current market value per share (₦) 3.50 3.00
Quoted beta 1.3 1.8
The loan notes of ME Plc. are quoted at ₦102 per ₦100
Other data
Tax rate applicable to K Plc. and ME Plc.: 20%
It can be assumed that tax is payable in the same year as the profits on which it is
charged.
Estimated risk-free rate of return : 3%
Historic equity market risk premium : 6%
Required:
a. Given the information on ME Plc. and the project financing mix, including any other
relevant information, calculate the project specific cost of capital. (5 Marks)
b. Assess whether K Plc. should undertake the project of developing and

commercialising the major component of outboard engine, assuming a discount rate
of 12% as being applicable for the assessment, irrespective of your calculations in (a)
above. (22 Marks)
c. State any THREE relevant assumptions made for your calculations in (a) and (b)
above. (3 Marks)
(Total 30 Marks)
70

SECTION B: YOU ARE REQUIRED TO ANSWER ANY TWO OUT OF THE THREE
QUESTIONS IN THIS SECTION (40 MARKS)
QUESTION 2
LL Plc. is a large engineering company. Its ordinary shares are quoted on the Stock
Exchange.
LL Plc.‟s Board is concerned that the company‟s gearing level is too high and that
this is having a detrimental impact on its market capitalisation. As a result, the
Board is considering a restructuring of LL Plc. long term funds, details of which are
shown here as at 28 February, 2017:
Total par value Market value
Nm
Ordinary share capital (50k) 67.5 N2.65/share ex-div
7% Preference share capital (N1) 60.0 N1.44/share ex div
4% Redeemable debentures (N100) 45.0 N90% ex-int
The debentures are redeemable in 2022. LL Plc.‟s earnings for the year to 28
February, 2017 were N32.4 million and are expected to remain at this level for the
foreseeable future. Retained earnings, as at 28 February, 2017 was N73.2 million.
The Board is considering a 1 for 9 rights issue of ordinary shares and this additional
funding would be used to redeem 60% of LL Plc.‟s redeemable debentures at par.
However, some of LL Plc.‟s directors are concerned that this issue of extra ordinary
shares will cause the company‟s ordinary share price and its earnings per share
(EPS) to fall by an excessive amount, to the detriment of LL Plc.‟s shareholders.
Accordingly, they are arguing that the rights issue should be designed so that the
EPS is not diluted by more than 5%.
The Directors wish to assume that the income tax rate will be 21% for the
foreseeable future and the tax will be payable in the same year as the cash flows to
which it relates.
Required:
a. i. Calculate LL Plc.‟s gearing ratio using both book and market values
(5 Marks)
ii. Discuss, with reference to relevant theories, why LL Plc.‟s Board might
have concerns over the level of gearing and its impact on LL Plc.‟s
market capitalisation. (6 Marks)
b. Assuming that a 1 for 9 rights issue goes ahead, calculate the theoretical ex-
rights price of LL Plc.‟s ordinary share and the value of a right. (3 Marks)
c. Discuss the Directors‟ view that the rights issue will cause the share price and
the EPS to fall by an excessive amount, to the detriment of LL Plc.‟s ordinary
shareholders. Your discussion should be supported by relevant calculations.
(6 Marks)
(Total 20 Marks)
71

QUESTION 3
LA Ltd., a food packaging company, has operated as a private company for the past 10
years. The company has been growing rapidly over the last few years. The Directors are
now considering listing the company on the stock market. Preparatory to this, the Directors
are interested in determining a fair price per share for the company. Assume today is
November 1, 2016.
The following information has been extracted from the most recent audited financial
statements of LA Ltd:
Statement of Profit or Loss, October 31, 2016:

₦million
Costs of sales (13,514)
EBITDA 2,276
Depreciation (440)
EBIT 1,836
Interest expense (330)
Earnings before tax 1,506
Tax at 30% (452)
Profit after tax 1,054
Statement of Financial Position as at October 31:

2016 2015
₦m ₦m
Current Assets
Cash and bank 476 542
Account receivables 1,072 980
Inventory 2,542 2,078
Total Current Assets 4,090 3,600
Total Assets 10,314 9,542
Equity and Liabilities
Non-current liabilities (Bonds) 2,400 2,500
Current Liabilities
Short-term loans 1,936 1,432
Account payables 3,084 2,792
Total current liabilities 5,020 4,224
Equity 2,894 2,818
Total Equity and Liabilities 10,314 9,542
The following additional facts are available:

 The Directors believe that the free cash flow to equity model should provide
appropriate valuation for the company‟s shares.
72

 An investment banker has provided the following estimates of cost of capital:
- Cost of equity 15%
- Post-tax cost of debt 4%
- WACC 12.5%
 The Directors believe that the free cash flow to equity will grow by 18% for the next 5
years and by 5% thereafter.
 The company currently has 600 million shares in issue.
Required:
a. Calculate the free cash flow available to equity for the year ended October 31,
2016. (7 Marks)
b. Use Free Cash Flow to Equity model to calculate the current value per share.
(5 Marks)
c. What are the key advantages and disadvantages of stock exchange listing?
(8 Marks)
(Total 20 Marks)
QUESTION 4
You are a financial consultant to a major company based in Kano. The company
plans to build a major warehouse in Abuja. You plan to convince the company‟s
manager to raise the needed funds through a convertible bond issue. Based on the
company‟s current bond rating of BBB, you have projected the following offer
terms:
Maturity: 6 years
Annual coupon: 1%
Conversion ratio: 50 shares
Par value per bond: N1,000
Issue price: 98% of par value
Current stock price: N16
Risk-free rate: 0.5%
Coupon on straight bonds: 2% (trading at par)
The proposal suggests raising up to N20,000,000. However, with key financial

ratios close to the boundaries of the rating category, offering the full amount could
threaten the BBB rating. Given an average business risk profile, the following
rating guidelines apply:
Rating Category Minimum interest Default spread

cover
BBB 2.39 0.5%
BBB – 2.04 1.0%
73

Selected financial data about the company:
Estimated EBIT N2,200,000
Current Interest Expenses N800,000
Required:
a. i. Determine the value of the convertible bond offer (5 Marks)
ii. Discuss why the convertible bond cannot generally be considered as
„cheap debt‟ despite its low coupon, given its financing advantage
quantified in economic terms. (3 Marks)
b. i. Compute the company‟s current interest coverage ratio. (1 Mark)
ii. How much money should be raised with the convertible bond issue (in
thousands of naira in order to avoid the threat of a rating downgrade,
based on the quoted rating guidelines? (4 Marks)
c. Advise the company on the advantages of convertible bond for companies on
one hand and for investors on the other hand. (7 Marks)
(Total 20 Marks)
SECTION C: YOU ARE REQUIRED TO ANSWER ANY TWO OUT OF THE THREE
QUESTION 5
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)
QUESTION 6
Large Plc. (LP) wishes to borrow N200 million for five years to finance the purchase
of new non-current assets. The preference of the company‟s Directors is that these
funds are borrowed at a fixed rate of interest. The company‟s long-term debt is
currently rated BBB, meaning LP would have to pay 6.5% p.a. for fixed rate
borrowing. Alternatively, LP could borrow at a floating rate, i.e. the prime lending
rate (PLR) + 2.25% at the present time.
74

The Directors of LP have recently been informed by its bank that TK Plc. is also
currently looking to borrow N200 million for five years at floating rate of interest
and its AA rating gives it access to floating rate borrowing at PLR + 1.50% per
annum. TK Plc. would pay 5.50% per annum for fixed rate borrowing at the present
time.
Required:
a. State FIVE reasons that a company might have for entering into an interest
rate swap. (5 Marks)
b. Show how an interest rate swap could be used to the equal benefit of both
companies, assuming that the terms of the swap agreement are such that LP‟s
swap payment to TK Plc. is to be 5.5% fixed per annum. (7 Marks)
c. Identify, with a supporting brief explanation, which of the two companies
would be disadvantaged, if PLR were to fall consistently within the five-year
term of the interest rate swap. (1 Mark)
d. Identify TWO risks that both companies will face, should they decide to enter
into the interest rate swap agreement. (2 Marks)
(Total 15 Marks)
QUESTION 7
You were recently appointed by a major manufacturing company as the senior
accountant at one of the divisions of the company, which is located in Makurdi. You
have received the following memorandum from the divisional manager:
“I tried to see you today, but you were busy with the auditors.
I have to go to a meeting at the head office on Friday about the new project. We
sent to the head office its projected cash flow figures before you arrived.
Apparently one of the head office finance people has discounted our figures, using
a rate which was calculated from the Capital Asset Pricing Model. I do not know
why they are discounting the figures, because inflation is predicted to be negligible
over the next few years. I think that this is all a ploy to stop us from going ahead
with the project and let another division have the cash.
I looked up Capital Asset Pricing Model in a finance book which was lying in your
office, but I could not make a head or tail of it, and anyway it all seemed to be
about buying shares and nothing about our project.
We always use payback for the smaller projects which we do not have to refer to
head office. I am going to argue for it now because the project has a payback of
less than five years, which is our normal yardstick.
I am very keen to go ahead with the project because I feel that it will secure the
medium-term future of our division.
75

I will be tied up all day tomorrow, so again I will not be able to see you. Could you
please make a few notes for me which I can read on the way on Friday morning?
I want to know how the Capital Asset Pricing Model is supposed to work, plus any
other things which you feel I ought to know for the meeting. I do not want to look
like a fool or lose the project because they blind me with science.
As you have probably discovered, I do not know much about finance, so please do
not use any technical jargon or complicated maths”.
Required:
Prepare notes for the divisional manager which provide helpful background for the
meeting. (Total 15 Marks)
76

Formulae
𝑉𝐷
𝑉𝐸𝐺
Asset Beta
𝑉𝐸 𝑉𝐷 (1 − 𝑡)
(𝑉𝐸 + 𝑉𝐷 (1 − 𝑡)) (𝑉𝐸 + 𝑉𝐷 (1 − 𝑡)) 𝐷
Equity Beta
𝑉𝐷
𝛽𝐸 = 𝛽𝐴 + (𝛽𝐴 − 𝛽𝐷 ) (1 − 𝑡)
𝑉𝐸
Growing Annuity
𝑛
𝐴1 1+𝑔
𝑃𝑉 = 1−
𝑟−𝑔 1+𝑟
1
𝑃𝑉𝑅 𝑛
𝑀𝐼𝑅𝑅 = 1 + 𝑟𝑒 − 1
𝑃𝑉𝐼
C0 = S0N(d1) – Ee-rt N(d2)
𝑆
𝐼𝑛 𝐸0 + (𝑟 + 0.5𝜎 2 )𝑇
𝑑1 =
𝜎 𝑇
d2= d1 - 𝜎 𝑇
The Put Call Parity
C + Ee-rt = S + P

d = 1/u
𝑎−𝑑
𝜋=
𝑢−𝑑
1
3 3
x Transaction Cost x Variance of Cash flows
𝑆𝑝𝑟𝑒𝑎𝑑 = 3 x 4
Interest rate as a proportion
77

Annuity Table
1 - (1 + r)-n
Present value of an annuity of 1 =
r
Discount rate (r)
Period
s
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1
2 1·970 1·942 1·913 1·886 1·859 1·833 1·808 1·783 1·759 1·736 2
3 2·941 2·884 2·829 2·775 2·723 2·673 2·624 2·577 2·531 2.487 3
4 3·902 3·808 3.717 3·630 3.546 3.465 3·387 3·312 3·240 3·170 4
5 4·853 4·713 4·580 4·452 4·329 4·212 4·100 3·993 3.890 3·791 5
6 5·795 5·601 5·417 5·242 5·076 4·917 4·767 4·623 4.486 4·355 6
7 6·728 6.472 6·230 6·002 5·786 5·582 5·389 5·206 5·033 4·868 7
8 7·652 7·325 7·020 6·733 6·463 6·210 5·971 5·747 5·535 5·335 8
9 8·566 8·162 7·786 7.435 7·108 6·802 6·515 6·247 5·995 5·759 9
10 9·471 8·983 8·530 8·111 7·722 7·360 7·024 6·710 6.418 6·145 10
11 10·368 9·787 9·253 8·760 8·306 7·887 7.499 7·139 6·805 6.495 11
12 11·255 10·575 9·954 9·385 8·863 8·384 7·943 7·536 7'161 6·814 12
13 12·134 11·348 10·635 9·986 9·394 8·853 8·358 7·904 7·487 7·103 13
14 13·004 12·106 11·296 10·563 9·899 9·295 8·745 8·244 7·786 7·367 14
15 13·865 12·849 11·938 11·118 10·380 9·712 9·108 8·559 8·061 7·606 15
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1
2 1·713 1·690 1·668 1·647 1·626 1·605 1·585 1·566 1·547 1·528 2
3 2.444 2.402 2·361 2·322 2·283 2·246 2·210 2·174 2·140 2·106 3
4 3·102 3·037 2·974 2·914 2·855 2·798 2·743 2.690 2·639 2.589 4
5 3·696 3·605 3·517 3·433 3·352 3·274 3·199 3·127 3·058 2·991 5
6 4·231 4·111 3·998 3·889 3·784 3·685 3·589 3.498 3.410 3·326 6
7 4·712 4·564 4.423 4·288 4·160 4·039 3·922 3·812 3·706 3·605 7
8 5·146 4·968 4.799 4·639 4.487 4·344 4·207 4·078 3·954 3·837 8
9 5·537 5·328 5·132 4·946 4·772 4·607 4.451 4·303 4·163 4·031 9
10 5·889 5·650 5.426 5·216 5·019 4·833 4·659 4.494 4·339 4·192 10
11 6·207 5·938 5·687 5.453 5·234 5·029 4·836 4·656 4.486 4·327 11
12 6·492 6·194 5·918 5·660 5·421 5·197 4·988 4·793 4·611 4.439 12
13 6·750 6.424 6·122 5·842 5·583 5·342 5·118 4·910 4·715 4·533 13
14 6·982 6·628 6·302 6·002 5·724 5.468 5·229 5·008 4·802 4·611 14
15 7·191 6·811 6.462 6·142 5·847 5·575 5·324 5·092 4·876 4·675 15
A.1
78

79

SOLUTION 1
(a) For K Plc. the new project is a diversification from boat making into outboard
engine components making. We must make use of the asset beta of ME Plc. which is
currently producing outboard engine components.
Asset beta – using the leverage of ME Plc.
𝛽𝐸 ∙ 𝑉𝐸 𝛽𝐷 𝑉𝐷(1 − 𝑡 )
𝛽𝐴 = +
𝑉𝐸 + 𝑉𝐷(1 − 𝑡 ) 𝑉𝐸 + 𝑉𝐷(1 − 𝑡 )
VE = 500m × ₦3 = ₦1,500m
VD = ₦368m × 1.02 = ₦375.36m

1.8 × 1,500
𝛽𝐴 = 1,500 + 375.36(1−0.2) + 0 = 1.5
Equity beta – using the leverage of K Plc.

𝑉𝐷
 𝛽𝐸 = 𝛽𝐴 + 𝛽𝐴 − 𝛽𝐷 𝑉𝐸
1−𝑡
208
𝑉𝐸 = 0.5
× ₦3.50 = ₦1,456m
𝑉𝐷 = 624 (from statement of financial position)

624
𝛽𝐸 = 1.5 + (1.5 – 0) 1,456
(1 – 0.2) = 2.014
Cost of equity = KE = 3 + 2.014(6) = 15.08%
Weighted Average Cost of Capital (WACC)

1,456 × 15.08 624 × 6 × 0.8
WACC = Ko = + = 12%
1,456 + 624 1,456 + 624
80

(b) Calculation of NPV
Year 0 1 2 3 4 5
₦’000 ₦’000 ₦’000 ₦’000 ₦’000 ₦’000
Sales revenue 30,000 86,400 233,300 302,280 516,990
Variable costs (12,000) (33,600) (88,200) (111,120) (184,680)
Fixed costs (6,000) (6,300) (6,615) (6,946) (7,293)
Training & development (14,400) (13,440) (8,820) (11,112) (18,468)
Cash operating profit (2,400) 33,060 129,665 173,102 306,549
Tax at 20% 480 (6,612) (25,933) (34,620) (61,310)
Tax savings on depr. (W2) 9,600 9,600 9,600 9,600 25,600
Working capital (W1) (6,000) (5,640) (14,690) (6,898) (21,471) 54,699
Machinery (480,000) 160,000
NCF (486,000) 2,040 21,358 106,434 126,611 485,538
PVF at 12% 1 0.893 0.797 0.712 0.636 0.567
Present value (486,000) 1,822 17,022 75,781 80,525 275,300
NPV = (₦35,550,000)
RECOMMENDATION
The project is not viable because the NPV is negative. Therefore, it should be rejected.
Working Notes
W1: Incremental WC
Year 1 2 3 4 5
Incremental revenue (₦‟000) - 56,400 146,900 68,980 214,710
Incremental WC (10%) (₦‟000) - 5,640 14,690 6,898 21,471
Year due - 1 2 3 4
W2: Tax savings on tax allowable depreciation

Depreciation Tax savings @ 20%
₦‟000 ₦‟000
Year 1 10% of ₦480,000 48,000 9,600
2 48,000 9,600
3 48,000 9,600
4 48,000 9,600
192,000
Balance = ₦(480,000 – 192,000) = 288,000
Year 5: Sales proceeds (160,000)
Balancing allowance 128,000 25,600
(c) Assumptions
(i) In computing both the asset beta and the equity beta, it is assumed that
debt is risk-free with beta of 0 (zero).
(ii) Unless where stated otherwise, it is assumed that cash flows occur at the
end of the year.
81

(iii) The patent purchase cost and the market survey costs are past costs and
therefore irrelevant.
(vi) The book value of the bank loan is approximately its market value.
EXAMINER‟S REPORT
This question tests candidates‟ knowledge of the computation of cost of capital and
appraisal of capital project.
Being a compulsory question, almost all the candidates attempted it. Generally, the
performance in the question was disappointing. This is difficult to understand because the
scenario is straightforward and well defined in the question.
In part (a), many candidates could not properly differentiate between the given equity
beta and the computed asset beta.
In part (b) most of the candidates could not calculate the incremental working capital and
the tax savings associated with tax allowable depreciation.
We recommend that candidates presenting themselves for the Institute‟s future

examinations should cover the syllabus comprehensively.
MARKING GUIDE
SOLUTION 1 MARKS MARKS
(a) Asset beta 1.5
Equity beta 1.5
Cost of equity 0.5
After tax cost of debt 0.5
WACC 1.0 5.0
(b) Sales revenue 2.5

Variable costs 2.5
Fixed costs 1.5
Training & Development 2.5
Tax @ 20% 2.5
Tax savings on depreciation 2.5
Working capital 3.0
Machinery 0.5
Discount factor – 12% 0.5
PV/NPV 3.0
Assessment 1.0 22.0
(c) Recommendation (1 mark per valid point – max 3) 3.0

Total 30.0
82

SOLUTION 2
a)
i.
Gearing level Book Market value
value
Nm Nm
Ordinary share capital (50k) 67.50 (135m x N2.65) 357.75
Retained earnings 73.20
7% Preference share capital
(N1) 60.00 (60m x N1.44) 86.40
4% Redeemable debentures
(2022) 45.00 (45m x 0.9) 40.50
Total funds 245.70 484.65
Total geared funds (Nm) 105.00 126.90
Gearing % 1 (Gearing/Total
Funds) 42.7% 26.2%
Or
Gearing % 2 (Gearing/Equity) 74.6% 35.5%
ii. Traditional view

Loan finance is cheap because
 It‟s associated risk is low
 The interest thereon is tax deductible.
This means that as gearing increases, WACC decreases.

Shareholders and lenders are relatively unconcerned about increased
risk at lower levels of gearing. As gearing increases, both groups start
to be concerned–higher returns are demanded and so WACC increases.
Thus, WACC decreases (value of equity increases) as gearing is
introduced. It reaches a minimum and then starts to increase again.
This is the optimal level of gearing.
Modigliani and Miller (M&M) view

Shareholders immediately become concerned by the existence of any
gearing.
Ignoring taxes, the cost of „cheap‟ loan finance is precisely offset by the
increasing cost of equity, so WACC remains constant at all levels of gearing.
There is no optimal level – managers should not concern themselves with
gearing questions. M&M position in 1958 states that
Vg = Vu (where Vg is value of geared company and Vu is value of
ungeared company).
83

Taking taxation into account, interest is cheap enough to cause WACC to fall
despite increasing cost of equity. This leads to an all-debt financing
conclusion. M&M ‟63 position: Vg = Vu+ DT(Tax shield).
Modern view
M&M are probably right that gearing is only beneficial because of tax relief.
At high levels of gearing, an investor worries about the costs of the business
going into enforced liquidation („bankruptcy‟). This becomes significant as
required returns (both equity and debt) would increase at high levels of
gearing.
Conclusion–a business should gear up to a point where the benefits of tax
relief are balanced by potential costs of bankruptcy and interest rate
increases – here WACC will be at a minimum and value of the business at a
maximum.
Presumably, the directors feel that the current level of gearing is beyond the
optimum i.e. where the WACC is minimised and the company‟s value is
maximised (perhaps because as an engineering company, its operational
risk is very high and gearing adds additional financial risk). Alternatively,
they are incorrectly looking at the book value gearing ratio, as the market
value ratio doesn‟t look particularly bad.
Nm
b) Value of current ordinary shareholding 135m x N2.65 = 357.750
Rights issue (135m/9) 15m x N1.80 = 27.000
Theoretical ex-rights values 150m 384.750
Theoretical ex-rights share price (TERP) (N384.75m/150m) N2.565

Value of a right (N2.565 – N1.800) per new share N0.765
OR per existing share = N0.765/9 = N0.085
c) Current earnings per share (EPS) = N32.4m/135m = N0.240

Current P/E ratio N2.65/N0.24 = 11.04
Nm
Current earnings figure 32.400
Savings on debenture interest = (N45m x 60% x 4% x 79%) 0.853
Adjusted earnings figure 33.253
New EPS = N33.253m/150m = N0.222
New P/E ratio (using TERP) = N2.565/N0.222 = 11.55
The earnings per share figure will fall by 7.5% (from N0.240 to N0.222).
The proposed rights issue will, as the Board suggests, cause a dilution of the
EPS figure as the additional shares issued have a greater negative impact
than the interest saved from the debenture redemption. Whilst in theory,
(TERP) the market price of LL Plc‟s ordinary shares will fall, at least initially,
84

it is very difficult to predict what will happen to the market value of the
shares in practice.
As gearing reduces, the market may react favourably (i.e. there would be a
share price increase). However, based on market values, the gearing level is
currently not high (26.2% or 35.5%), and so the market may react negatively
(i.e. there would be a share price decrease) if it considers that insufficient
use is being made of the tax savings that gearing affords.
EXAMINER‟S REPORT
The question tests candidates‟ knowledge of financial gearing, capital structure theories
and basic calculations in rights issue.
More than 50% of the candidates attempted the question, but the level of performance was
very low.
The key challenges identified include:
 The book value of equity often excluded retained earnings.

 When calculating the market value, majority of candidates included retained
earnings in the equity value.
 Several candidates included preference shares as equity.
 Some candidates made no reference to the theories of capital structure.
It is important that students should always prepare adequately for the Institute‟s future
examinations.
MARKING GUIDE
(a) i. Calculation of gearing level using per value 2.0
Calculation of gearing level using market value 3.0 5.0
ii. Traditional view 2.0
Modigliani & Miller‟s (M & M) view 2.0
Modern view 1.0
Conclusion 1.0 6.0
(b) Theoretical ex-rights share price (TERP) 2.0

Value of a right per new share 1.0 3.0
(c) Calculation of current P/E ratio 1.0

Calculation of New EPS 2.0
Calculation of new P/E ratio (using TERP) 0.5
Calculation of the percentage fall in EPS 0.5
Discussion 2.0 6.0
Total 20.0
85

SOLUTION 3
a) Calculation of free cash flow to equity (FCFE)
₦’m
EBIT 1,836
Less tax at 30% 551
1,285
Add depreciation 440
1,725
Less interest, net of tax = N330 (1– 0.30)
million (231)
1,494
Change in working capital (W1) (264)
Purchase of non-current assets (W2) (722)
Additional borrowings (W3) 404
FCFE 912
Alternative method
₦’m
Change in working capital (264)
Purchase of non-current assets (722)
Additional borrowings 404
FCFE 912
Working Notes
1) Changes in working capital*
₦’m
Inventory ₦(2,078 – 2,542) = (464)
Receivables ₦(980 – 1,072) = (92)
Payables ₦(3,084 – 2,792) = 292
Changes in working capital (264)
* This calculation must exclude cash and bank balances. In addition, short-term loans
are excluded because they represent financing items.
2) Purchase of non-current assets

₦‟m
Closing balance of NBV 6,224
Less: opening NBV 5,942
Purchase of non-current assets 722
86

3) Additional borrowings
₦‟m ₦‟m
Opening short-term loan 1,432 -
Opening non-current liabilities 2,500 3,932
Closing short-term loan 1,936 -

Closing non-current liabilities 2,400 4,336
Additional borrowings 404
b. The total market value of equity is given by the present value of FCFE. The
appropriate discount rate to use is the cost of equity and not the WACC (since we
are pricing equity rather than the company as a whole).
₦‟m
1
Year 1 N912m × 1.18 × = 936
1.15
1 2
2 N912m × (1.18)2 × = 960
1.15
1 3
3 N912m × (1.18)3 × = 985
1.15
1 4
4 N912m × (1.18)4 × = 1,011
1.15
1 5
5 N912m × (1.18)5 × = 1,037
1.15
4,929
6 – infinity:
5
N912𝑚 × (1.18)5 × 1.05 1
0.15 − 0.05
×
1.15 = 10,892
Total value of equity 15,821
Note: The present value of FCFE for the first 5 years when the growth rate is 18%
per annum could have been calculated using growing annuity as follows:
𝑛
FCFE1 1+𝑔
PV = × 1−
𝑟−𝑔 1+𝑟
5
N912𝑚(1.18) 1.18
= 0.15 − 0.18 × 1 − 1.15 = N4,930million
VPS = Total value of equity/number of shares

= ₦15,821 million/600 million = ₦26.37
87

c. The advantages of a company obtaining a stock exchange listing include:
i. Share transferability: As mentioned above, shares that are listed on a Stock
Exchange can be transferred with ease and this, in turn, should encourage
investment.
ii. Cost of capital: Shares in listed companies are perceived by investors as being
less risky than shares in equivalent unlisted companies because of their
marketability. As the risks associated with listed shares are lower, the returns
required by investors will also be lower. Hence, the cost of capital for listed
companies will be lower.
iii. Share price: Shares that are traded on a stock exchange are closely
scrutinized by investors, who will take account of all available information
when assessing their worth. This results in shares that are efficiently priced,
which should give investors confidence when buying or selling shares.
iv. Company Profile: Companies listed on a stock exchange have a higher profile
among investors, and the wider business community than unlisted companies.
This higher profile may help in establishing new contacts or in developing
business opportunities.
v. Credit rating: A listed company may be viewed by the business community as

being more substantial and, therefore, more creditworthy than an equivalent
unlisted company. This may help in obtaining loans and credit facilities.
vi. Business combinations: A stock exchange listing can facilitate takeovers and
mergers. A listed company can use its shares, as a form of bid consideration
when proposing a takeover of another company.
Shareholders in a target company will usually be more prepared to accept a

share-for-share exchange when the shares offered are marketable and have
been efficiently priced. Furthermore, when two companies propose to
combine, the shareholders of each company can assess the attractiveness of
the proposal more easily if the shares are listed.
The disadvantages of obtaining a stock exchange listing include:

i. Floatation costs: The costs of floating a company on a stock exchange can be
high. The fees paid to professional advisors, such as lawyers and accountants,
as well as under writing fees, often account for a large part of the total cost
incurred.
ii. Regulatory costs: Once the company is floated, the cost of maintaining a stock
exchange listing can be high. An important reason for this is the cost of
additional regulatory requirements surrounding listed companies. The
regulations of modern stock exchanges require greater transparency between
management and owners and this causes some of the additional costs.
88

iii. Control: A company seeking a stock exchange listing must normally ensure
that a substantial quantity of its total issued share capital is available to new
investors. This means that the existing shareholders may suffer loss of control.
iv. Investors‟ expectations: There is a widely-held view that investors‟

expectations often put the Directors of companies under pressure to produce
gains over the short term. To do this, the Directors may take decisions that
have an adverse effect on the long-term profitability of the business. However,
the evidence to support this view is flimsy.
v. Public scrutiny: Listed companies attract much attention from investors, the
financial press and the broadcasting media. Being in the public spot light
makes it difficult for a company to engage in controversial activities or to
conduct sensitive negotiations. It also makes it difficult for Directors to
hide poor decisions.
vi. Takeover target: The existence of a ready market for shares in a listed
company means that listed company is much more vulnerable to a takeover
than an unlisted company. A listed company may be particularly vulnerable
when there is a fall in its share price, perhaps caused by disillusionment with
the level of returns that are being provided.
EXAMINER‟S REPORT
The question tests candidates‟ knowledge of computing the ratio of Free Cash Flow to
Equity (FCFE) and its use in valuation.
About 60% of the candidates attempted the question but the level of performance was
poor.
Key challenges identified include:
 Confusing FCFE with Free Cash Flow to the Firm (FCFF).

 Inability to calculate additional non-current asset acquired during the period.
 Exclusion of additional borrowing.
 Inclusion of cash and short-term borrowings in changes in working capital.
Candidates are advised to make comprehensive use of the Institute‟s Study Text in their
preparations for the Institute‟s future examinations.
89

MARKING GUIDE
MARKS MARKS
(a) EBIT less interest and tax 1.0
Depreciation 1.0
Change in working capital 2.0
Purchase of non-current assets 1.0
Additional borrowings 1.0
Free cash flow to equity (FCFE) 1.0 7.0
(b) Calculation of the PV of FCFE using cost of equity for the

first 5 years 3.0
Calculation of the PV of FCFE from the 6th year to infinity 1.0
Total value of equity 0.5
Calculation of value per share (VPS) 0.5 5.0
(c) Advantages of obtaining stock exchange listing – 1 mark

per valid point (max 4) 4.0
Disadvantages of obtaining stock exchange listing – 1
mark per valid point (max 4) 4.0 8.0
Total 20.0
90

SOLUTION 4
a. i. The value of the convertible bond offer can be calculated by

discounting the annual interest payments of N10 (1% of N1,000) for 6 years
and the face value due in year 6. We discount at 2% (the coupon rate) YTM
on the straight bond.
Price = 10 (5.601 + 1000 (5.601 – 4.713)

Price = N10 (5.601) + N1,000 (0.888) = N944
ii. This convertible bond, should not be considered as „cheap‟ debt

because by issuing a convertible bond the firm also sells an equity
option to investors. Hence, the convertible bond consists of a debt
and an equity component and the relative advantage reflects the
value of the equity option.
b. i. Interest coverage before the transaction

𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝐸𝐵𝐼𝑇
= 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐸𝑥𝑝𝑒𝑛𝑠𝑒𝑠
2,200,000
= N = 2.75
800,000
ii. We solve for the amount (rounded to ₦1,000) by which interest expense can
rise without affecting the current BBB rating, i.e. at which the interest
coverage ratio is 2.39.
2,200,000
2.39 = N
800,000  x
where x = maximum additional interest expenses allowed)
2.39 N (800,000 + x ) = N2,200,000
x = N120,502
𝑁120,502
With an annual coupon of 1% up to N12,050,000 (i.e. can be raised
0.01
without threatening the current rating.
c. Advantages of Convertible bonds to the company include:
i. Lower interest rate than on a similar debenture: The firm can ask
investors to accept a lower interest rate on convertibles because the
investor values the conversion right.
91

ii. The interest is tax deductible: Because convertible bonds are a form of
debt, the interest payment can be regarded as a cost to the business
and can therefore be used to reduce taxable profit.
iii. Self Liquidating: When the share price reaches a level at which
conversion is worthwhile, the bonds will (normally) be exchanged for
shares so the company does not have to find cash to pay off the loan
principal – it simply issues more shares. This has obvious cash flow
benefits. However, the disadvantage is that the other equity holders
may experience a reduction in EPS.
iv. Fewer restrictive covenants: The directors have greater operating and
financial flexibility than they would, with a secured debenture.
Investors accept that a convertible bond is a hybrid between debt and
equity finance and do not tend to ask for high-level security, impose
strong operating restrictions on managerial action or insist on strict
financial boundaries.
v. Underpriced shares: A company which wishes to raise equity finance

over medium term, but judges that the stock market is temporarily
underpricing its shares, may turn to convertible bonds (if we do not
believe in the efficient market hypothesis). If the firm does perform as
the managers expect and the share price rises, the convertible will be
exchanged for equity.
Advantages of Convertible Bonds to the Investors include:
i. They are able to wait and see how the share price moves before
investing in equity.
ii. In the short term, there is greater security for their principal,
compared with equity investment, and the annual coupon (interest) is
usually higher than the dividend yield.
iii. Investors receive a minimum annual income up to the conversion date

in the form of fixed interest.
iv. In addition, investors in convertible bond, will be able to benefit from

a rise in the company‟s share price, and hope to make an immediate
capital gain on conversion.
92

EXAMINER‟S REPORT
The question tests candidates‟ knowledge of the analysis of convertible bonds.
Common mistakes include:
 Inability to identify the relevant cash flows.

 The use of wrong discount rates
 In part (c), failure to distinguish between advantages of convertible bond to the
company and to the investors.
We recommend adequate coverage of the syllabus and judicious use of the Institute‟s
Study Text and other relevant texts.
MARKING GUIDE
MARKS MARKS
(a) i. Calculation of the value of the convertible bond offer 5.0
ii. Discussion 3.0 8.0
(b) i. Calculation of interest coverage ratio 1.0

ii. Calculation of max. additional interest expenses allowed 3.0
Calculation of the amount to be raised 1.0 4.0
(c) Advantages of convertible bonds to the company

– 1 mark per valid point (max 4) 4.0
Advantages of convertible bonds to the investors
– 1 mark per valid point (max 3) 3.0 7.0
Total 20.0
93

SOLUTION 5
(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).
(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.
94

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.
EXAMINER‟S REPORT
This question tests candidates‟ knowledge of the stakeholders‟ groups and possible inter-
group conflict of interest.
More than 75% of the candidates attempted the question and surprisingly the performance
is very disappointing.
Two major mistakes were identified:
 Generic solutions were produced thereby ignoring the specific scenario of each part
of the question.
 The same sets of stakeholders were repeated in the three different parts of the
question.
95

Students are advised to make use of the past editions of the Institute‟s Pathfinders when
preparing for future examinations.
MARKING GUIDE

Stakeholders involved in potential conflicts in respect of
the following:
(a) Large conglomerate „spinning off its division‟ 5.0
(b) A private company converting into a public company 5.0
(c) Japanese manufacturing companies building new parts in

other countries 5.0
Total 15.0
96

SOLUTION 6
(a) Reasons why a company might enter into an interest rate swap include:
i. To obtain a lower rate of interest on its preferred type of debt by
exploiting the quality spread differential between two counterparties.
ii. To achieve a better match of assets and liabilities
iii. To access interest rate markets that might otherwise be closed to the
firm (or only accessible at excessive cost)
iv. To hedge interest rate exposure by converting a floating rate
commitment to a fixed rate commitment (or vice versa).
v. To restructure the interest rate profile of existing debts (avoiding new
loans/fees)
vi. To speculate on the future course of interest rates
vii. Availability for longer terms than other methods of hedging interest
rate exposure
(b) LP has a comparative advantage in floating rate borrowing, whilst TK Plc.

has a comparative advantage in fixed rate borrowing – so LP should borrow
N200 million at PLR + 2.25% whilst TK Plc. should borrow N200 million at
5.50%.
The quality spread differential = 1.00% - 0.75% = 0.25% (each company

saving 0.125% i.e. 0.25%/2).
LP:
 Pay PLR + 2.25% to lenders
 Pay TK Plc. 5.5%
 Receive from TK Plc. PLR + 1.375%
 Net borrowing cost 6.375% (saving 0.125% on its own fixed rate
borrowing).
TK Plc.:
 Pay 5.5% fixed to lenders
 Pay LP PLR + 1.375% toLP
 Receive from LP 5.5%
 Net borrowing cost PLR + 1.375% (saving 0.125% on its own floating rate
borrowing cost).
(c) LP will be disadvantaged as it has contracted to make fixed rate payments

under the interest rate swap agreement and will, therefore, not see its
payments benefit from the reduction in interest rates during the term of the
swap agreement.
97

(d) i. The risk that the other counterparty to the swap agreement will
default on their commitment before completion of the swap
agreement.
ii. The risk of unfavourable changes in market interest rates after

entering into the swap.
iii. Transparency risk, that is, the risk that the impact of swap transaction
will undermine the clarity and transparency of the firm‟s financial
statements.
EXAMINER‟S REPORT
The question tests candidates‟ knowledge of the mechanism involved in the Interest Rate
Swap.
Less than 30% of the candidates attempted the question. There is evidence that most of the
candidates do not have sufficient knowledge of Interest Rate Swap.
Virtually all the candidates who attempted the question could not produce the required
elementary calculations in part (b).
We recommend that students should create more time to cover the syllabus adequately.
MARKING GUIDE
(a) Reasons - 1 mark per valid point (max 5) 5.0
(b) - Amount to be borrowed and the rate (both companies) 2.0

- Quality spread differential (both companies) 1.0
- Transaction details re LP 2.0
- Transaction details re TK 2.0 7.0
(c) Identification of the company 1.0
(d) Identification of risks (both companies)

1 mark per valid point (max 2) 2.0
Total 15.0
98

SOLUTION 7
Notes for the Divisional Manager
Discounting
Discounting of future cash flows is a technique used to place less value on cash
flows which are received further into the future. This reflects the fact that our
investors would rather receive money now than in the future. This preference for
money now, which is known as the time value of money, is increased if there is
inflation in the economy, as investors also need to be compensated for the buying
power of their money being reduced in the future.
Therefore, the discount rate is a combination of both the time value of money and
inflation. Even if inflation is negligible, cash flows still need discounting to reflect
the time value of money.
Discount rate/Capital Asset Pricing Model

Finding the correct discount rate can be a difficult exercise and this is where the
Capital Asset Pricing Model (CAPM) can be very useful.
The use of CAPM considers the returns paid on shares on the stock market,
compared to the risk or variation in returns of those shares. Because investors in
general are risk averse, they will expect a higher average return by way of
dividends and capital gains to compensate for a higher risk.
The logic then follows that if shareholders can earn a given return on the stock
market for a certain level of risk, then any project that may be undertaken must, at
least, satisfy that target return.
Where CAPM is special, is in the way it considers risk. A company or project looked
at on its own may have a very high level of risk. However, if it is added to the
shareholders' portfolio of investments, some of the investment risks will be removed
or diversified away.
This is because two different causes of the total risk of a company can be identified.
Systematic risk – Due to the economy, such as interest rates, exchange rates, etc.
which affect all companies.
Unsystematic risk – Due to events specific to a company, such as new product

developments, fires, strikes, etc.
Systematic risk cannot be diversified away; however, the unsystematic risk will
cancel out across companies, as bad events in one company are evened out by
good events in another.
99

Therefore as shareholders suffer only systematic risk if they hold a wide-ranging or
well-diversified portfolio, a company only needs to pay a return based on that risk.
CAPM measures the systematic risk as a beta. A beta of 1 indicates that the
company has the same level of risk as the average of all shares in the stock market,
called the market portfolio. A beta of 0.5 would indicate that it has only half the
risk of the market portfolio, and therefore does not need to give such a high return.
This can be expressed in the following equation:
Required return = Rf + β(Rm - Rf)

where Rf = return on risk-free investments such as treasury bills
Rm= average return on the market portfolio.
β = level of risk
Using CAPM to derive a cost of capital to be used in investment decision is entirely

logical. Since betas are typically derived from published equity performance, they
reflect a market determined risk/return trade off for a particular type of business.
CAPM is only logical where the shareholders are well-diversified.
When using CAPM to derive a discount rate, it is the beta of the project which
should be used, rather than that of the company.
100

Payback
Payback is a good technique in that it uses earlier cash flows which are more
certain and useful if a company is short of cash. However, it has the following
drawbacks:
i. It ignores the time value of money

ii. It ignores cash flows after the payback period
iii. It does not measure the change in shareholder wealth
iv. Target paybacks are chosen subjectively.
The technique of using discounted cash flows, although more complicated,

overcomes all of these problems.
EXAMINER‟S REPORT
The question tests candidates‟ knowledge of some elementary concepts in finance like,
discounting, discount rate, CAPM, payback period.
Most of the candidates attempted the question and the performance level was most
disappointing.
Most of the candidates could not explain the above elementary terms in a non-technical
manner as required by the question.
Students need to improve on their question-answering skills using the Institute‟s

Pathfinders and Study Text as a guide.
MARKING GUIDE
Discounting – Discussion 3.0
Discount rate: CAPM discussion 2.0
- Systematic risk discussion 2.0
- Unsystematic risk discussion 2.0
- CAPM formula for calculating required Return 2.0
Payback – the drawbacks – 1 mark per valid point (max 3) 3.0
Conclusion 1.0 15.0
101

PATHFINDER
NOVEMBER 2017 DIET
Question Papers
Suggested Solutions
Marking Guides
Plus


Time Allowed: 31/4 hours (including 15 minutes reading time)
INSTRUCTION: YOU ARE REQUIRED TO ANSWER FIVE OUT OF SEVEN

QUESTION 1
Lekki Plc. is a supplier of specialist engineering components to the defence and

airline industries. In spite of the impact of the global recession, demand for the
company's products has gone up in recent times and is expected to pick up further
in the next two years.
As part of a recent strategic review, the directors have made the following
projections for the years ending March 31, 2018 and 2019:
(i) An anticipated increase in annual revenues of 8% per year in each of the
years;
(ii) An anticipated increase in operating costs (excluding depreciation) of 4%
per year in each of the years;
(iii) For the next two years, tax will continue to be paid at a rate of 21% and
payable in the year in which the liability arose;
(iv) The ratio of trade receivables to revenue will remain the same in each of
the next two years as well as the ratio of trade payables to operating costs
(excluding depreciation);
(v) An anticipated increase in inventory levels of 10% in the year ending March
31, 2018 but remaining stable thereafter;
(vi) The Non-current assets in the company's Statement of Financial Position are
Lekki Plc.‟s headquarters and main factory complex, both of which are
freehold premises. The company's accounting policy is that these assets are
not depreciated. Capital allowances on them are negligible and can be
ignored;
(vii) The company's annual dividend growth rate will remain at 6% per year.
Annual dividends are declared at the year end and paid in full during the
following financial year;
75

(viii) To cope with the anticipated growth in business, the company will shortly
purchase a new machinery at a cost of N8million. All the existing
machinery are rented and their rental costs are included in operating costs.
The company does not intend to seek any equity or long-term debt
financing in respect of the machinery purchase, as it intends to
accommodate the purchase within existing overdraft facilities available to
the company. The new machinery will be depreciated on a straight-line
basis over 8 years (assuming a residual value of N1million) with a full
year's depreciation to be charged in the year of purchase. Capital
allowances on a reducing balance basis at a rate of 18% per year will be
applicable on the new machinery from the year of acquisition; and
(ix) As a result of the machinery purchase, there will be an anticipated increase

in finance costs of 50% in the year ending March 31, 2018, but remaining
stable in the following year.
Extracts from the company's most recent financial statements are provided
below:
Income Statement for the year ended March 31, 2017
N'000
Revenue 60,240
Operating costs (49,500)
Operating profit 10,740
Finance costs (800)
Profit before tax 9,940
Tax (2,286)
Statement of Financial Position as at March 31, 2017

N'000 N'000
Assets
Current assets
Inventories 9,020
Trade receivables 9,036
Cash and cash equivalents 396
18,452
47,302
Equity and liabilities
Equity
Ordinary share capital 16,700
Retained earnings 12,482
29,182
6% Debentures (2025) 8,000
76

Current liabilities
Dividends 2,784
10,120
47,302
Assume today is April 1, 2017.
Required:
a. Prepare a Forecast Financial Statement (comprising Income Statement,
Statement of Financial Position and Cash Flow Statement) for each of the
years ending March 31, 2018 and March 31, 2019. (24 Marks)
Note: All calculations should be rounded up to the nearest N'000.
b. Beyond March 31, 2019 the directors are considering a suggestion by the
Finance Director that one of Lekki Plc.‟s smaller subsidiaries be disposed of
because, relative to most of the other company‟s operations, it is performing
poorly. Whilst the directors are broadly supportive of the Finance Director's
suggestion, they are keen to avoid liquidation of the subsidiary as they are
conscious of the industrial relations problems that might arise from the
consequent redundancies.
Required:
Discuss THREE methods, other than liquidation, that the firm might consider to
effect the divestment of this subsidiary company. (6 Marks)
(Total 30 Marks)
SECTION B: YOU ARE REQUIRED TO ANSWER ANY TWO OUT OF THREE QUESTIONS
(40 MARKS)
QUESTION 2
Raymond Plc. is a successful IT services company incorporated 10 years ago. It was

listed on the Stock Exchange 3 years ago. The company has a broad customers base
mainly consisting of small and medium sized companies. Raymond Plc. has
achieved rapid growth in recent years by obtaining regular business from satisfied
customers and also by acquiring other IT services companies.
The Directors of Raymond Plc. have identified Harold Limited, an unlisted company,
as a possible acquisition target. Harold Limited has a number of large
multinational clients and, in general, its clients tend to be larger than those of
Raymond Plc. If successful, the acquisition would go ahead on January 1, 2018.
Forecast financial data for Raymond Plc. and Harold Limited as at December 31,
2017 are summarised below:
77

Raymond Plc. Harold Limited
Share capital (Ordinary ₦1 shares) ₦150m ₦40m
Market share price ₦4.90 N/A
N/A: Not applicable (not listed).
(i) If Harold Limited were to remain an independent company, its Directors
estimate that reported Profit After Tax would be ₦15million for 2018 and
then grow by 2% yearly in perpetuity;
(ii) If the acquisition were to go ahead, Raymond Plc.‟s Directors estimate that
Harold Limited‟s profit after tax would be 5% higher for 2018 than if the
company remains an independent company and that profit after tax would
then grow by 3% yearly in perpetuity;
(iii) The average ungeared Cost of Equity for the industry is 8%;
(iv) Both Raymond Plc. and Harold Limited are wholly equity financed; and
(v) Profit after tax can be assumed to be a good approximation of free cash flow
attributable to investors.
The Directors of Raymond Plc. are considering offering to purchase Harold Limited
at a price of ₦7.00 per share. It is estimated that transaction costs of ₦8million
would be payable on the acquisition and that ₦2million would be required in the
first year to cover the costs of integrating the two companies.
Required:
a. Calculate:
i. The value of Raymond Plc. as at December 31, 2017.
ii. The value of Harold Limited as at December 31, 2017 before taking the
possible acquisition of the company by Raymond Plc. into account.
iii. The overall increase in value created by the acquisition of Harold Limited
by Raymond Plc. (8 Marks)
b. i. Explain how value might be created by the proposed acquisition.

(2 Marks)
ii. Comment on the difficulties which Raymond Plc. is likely to face in
realising the potential added-value, after the acquisition. (2 Marks)
c. Evaluate the proposed offer price of ₦7.00 per share for Harold Limited from the
point of view of:
i. Harold Limited‟s shareholders.
ii. Raymond Plc.‟s shareholders. (8 Marks)
(Total 20 Marks)
78

QUESTION 3
Peter Plc. is a large, listed manufacturing company that is currently considering

how best to raise new equity finance. One option is to undertake a public issue of
new shares, a course of action that was recently approved by the shareholders.
Alternatively, the company is considering a 1 for 4 rights issue at a 10% discount to
the current market price of N5.00 per share.
The company has approached a number of investment banks regarding the

potential new rights issue and public issue. During these discussions, one
investment bank stated that the precise timing of a rights issue would be of no
consequence. The bank is of the opinion that a public issue of new shares should
not be undertaken at the present time. It therefore recommended that if the
company wishes to pursue a public issue, it should be deferred for a minimum of
six months. The bank explained that at the present time, the stock market is
significantly undervaluing Peter Plc.‟s shares. Consequently, the company would
have to issue far more shares to raise the required amount of finance than it would
have to raise in six months.
The Finance Director of Peter Plc. is, however, uncertain about this and at a recent
board meeting where the matters were discussed, she made the following
statement:
„According to the Efficient Market Hypothesis, all share prices are correct at all
times, with prices moving randomly when new information is publicly announced.
The analysts at investment banks are unable to predict future share prices.‟
Required:
a. Calculate the theoretical ex-rights price per share and the value of the rights
per existing share, assuming the company chooses this option. (2 Marks)
b. Discuss the alternative courses of action open to the owner of 500 shares in
Peter Plc. as regards the rights issue, in each case, determining the effect on
the wealth of the investor. (4 Marks)
c. Discuss the factors that will influence the actual ex-rights price per share.
(4 Marks)
d. Discuss the meaning and significance of the three forms of the Efficient
Market Hypothesis and, with specific reference to these, discuss both the
recommendation that the company waits for six months before undertaking a
public issue and the Finance Director‟s statement. (10 Marks)
(Total 20 Marks)
79

QUESTION 4
You are the Financial Director of Kudi Limited, a Nigerian Company that imports
raw materials mainly from Tiko (with T$ as currency) and exports finished products
to Katuga (with K$ as currency). Kudi is partly financed by loan raised in the
domestic market and usually hedges its foreign currency exposure by using the
forward or money markets. Most customers are allowed 3 months‟ credit. The
company has recently sold some products to a customer in Katuga for K$20 million.
The following information is available:
Exchange rate K$ per N T$ per N
Spot rate 1.9600 1.4600
1 month forward rate 1.9580 1.4579
Central Bank base rate per annum Nigeria Katuga Tiko
5.5% 4.25% 3.75%
Required:
a. Comment on the Interest Rate Parity and Purchasing Power Parity methods for
estimating exchange rates. (6 Marks)
In answering each of the following questions, include appropriate
calculations, where relevant, to aid your discussion:
i. As interest rates are higher in Nigeria than in Tiko, should T$ be
depreciating against naira, hence trading at a discount? (3 Marks)
ii. What 3-month K$ forward rate of exchange is implied by the
information given, and therefore what naira receipts can the company
expect in 3 months‟ time from the customer in Katuga?
(3 Marks)
iii. Would a sensible policy be: to buy T$ on the spot market now and place
it on deposit until when needed by Kudi? (3 Marks)
b. Discuss the concept and the significance of foreign exchange economic

exposure to a multinational company. (5 Marks)
Total 20 Marks)
80

SECTION C: YOU ARE REQUIRED TO ANSWER ANY TWO OUT OF THREE QUESTIONS
(30 MARKS)
QUESTION 5
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)
QUESTION 6
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)
QUESTION 7
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)
81

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)
82

Formulae
𝑉𝐷
𝑉𝐸𝐺
Asset Beta
𝑉𝐸 𝑉𝐷 (1 − 𝑇)
𝛽𝐴 = 𝛽 + 𝛽
(𝑉𝐸 + 𝑉𝐷 (1 − 𝑇)) 𝐸 (𝑉𝐸 + 𝑉𝐷 (1 − 𝑇)) 𝐷
Equity Beta
𝑉𝐷
𝛽𝐸 = 𝛽𝐴 + (𝛽𝐴 − 𝛽𝐷 ) (1 − 𝑡)
𝑉𝐸
Growing Annuity
𝑛
𝐴1 1+𝑔
𝑃𝑉 = 1−
𝑟−𝑔 1+𝑟

1
𝑃𝑉𝑅 𝑛
𝑀𝐼𝑅𝑅 = 1 + 𝑟𝑒 − 1
𝑃𝑉𝐼
C0 = S0N(d1) – Ee-rt N(d2)
𝑆
𝐼𝑛 0 + (𝑟 + 0.5𝜎 2 )𝑇
𝑑1 = 𝐸
𝜎 𝑇
d2= d1 - 𝜎 𝑇
The Put Call Parity
C + Ee-rt = S + P

d = 1/u
𝑎 = 𝑒 𝑟𝑇 /𝑛
𝑎−𝑑
𝜋=
𝑢−𝑑
The discount factor per step is given by = 𝑒 −𝑟𝑇 /𝑛

1
3 3
83

Annuity Table
Present value of an annuity of 1 = 1 - (1 + r)-n
(()discount rate 1 r
Discount rate (r)

Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1
2 1·970 1·942 1·913 1·886 1·859 1·833 1·808 1·783 1·759 1·736 2
3 2·941 2·884 2·829 2·775 2·723 2·673 2·624 2·577 2·531 2.487 3
4 3·902 3·808 3.717 3·630 3.546 3.465 3·387 3·312 3·240 3·170 4
5 4·853 4·713 4·580 4·452 4·329 4·212 4·100 3·993 3.890 3·791 5
6 5·795 5·601 5·417 5·242 5·076 4·917 4·767 4·623 4.486 4·355 6
7 6·728 6.472 6·230 6·002 5·786 5·582 5·389 5·206 5·033 4·868 7
8 7·652 7·325 7·020 6·733 6·463 6·210 5·971 5·747 5·535 5·335 8
9 8·566 8·162 7·786 7.435 7·108 6·802 6·515 6·247 5·995 5·759 9
10 9·471 8·983 8·530 8·111 7·722 7·360 7·024 6·710 6.418 6·145 10
11 10·368 9·787 9·253 8·760 8·306 7·887 7.499 7·139 6·805 6.495 11
12 11·255 10·575 9·954 9·385 8·863 8·384 7·943 7·536 7'161 6·814 12
13 12·134 11·348 10·635 9·986 9·394 8·853 8·358 7·904 7·487 7·103 13
14 13·004 12·106 11·296 10·563 9·899 9·295 8·745 8·244 7·786 7·367 14
15 13·865 12·849 11·938 11·118 10·380 9·712 9·108 8·559 8·061 7·606 15
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1
2 1·713 1·690 1·668 1·647 1·626 1·605 1·585 1·566 1·547 1·528 2
3 2.444 2.402 2·361 2·322 2·283 2·246 2·210 2·174 2·140 2·106 3
4 3·102 3·037 2·974 2·914 2·855 2·798 2·743 2.690 2·639 2.589 4
5 3·696 3·605 3·517 3·433 3·352 3·274 3·199 3·127 3·058 2·991 5
6 4·231 4·111 3·998 3·889 3·784 3·685 3·589 3.498 3.410 3·326 6
7 4·712 4·564 4.423 4·288 4·160 4·039 3·922 3·812 3·706 3·605 7
8 5·146 4·968 4.799 4·639 4.487 4·344 4·207 4·078 3·954 3·837 8
9 5·537 5·328 5·132 4·946 4·772 4·607 4.451 4·303 4·163 4·031 9
10 5·889 5·650 5.426 5·216 5·019 4·833 4·659 4.494 4·339 4·192 10
11 6·207 5·938 5·687 5.453 5·234 5·029 4·836 4·656 4.486 4·327 11
12 6·492 6·194 5·918 5·660 5·421 5·197 4·988 4·793 4·611 4.439 12
13 6·750 6.424 6·122 5·842 5·583 5·342 5·118 4·910 4·715 4·533 13
14 6·982 6·628 6·302 6·002 5·724 5.468 5·229 5·008 4·802 4·611 14
84

7·191 6·811 6.462 6·142 5·847 5·575 5·324 5·092 4·876 4·675 15
15
85

SOLUTION 1
a) (i) Forecast Income Statements for the years ending 31 March
N'000 N'000
Revenue 65,059 70,264

Operating costs (excluding depreciation) (51,480) (53,539)
Depreciation (875) (875)
Operating profit 12,704 15,850
Finance costs (1,200) (1,200)
Profit before tax 11,504 14,650
Tax (W1) (2,297) (3,012)
Profit after tax 9,207 11,638
Dividends (2,951) 3,128
Retained profit 6,256 8,510
WORKINGS (W1)
Tax
Add back depreciation 875 875
Capital allowances (1,440) (1,181)
Taxable profits 10,939 14,344
Tax@ 21% 2,297 3,012
(ii) Forecast Statements of Financial Position as at 31 March

2018 2019
N'000 N'000
ASSETS
Inventories 9,922 9,922
Receivables 9,759 10,540
Cash (balancing figure) - 7,449
TOTAL ASSETS 55,656 63,011
EQUITY AND LIABILITIES
Ordinary share capital 16,700 16,700
Retained earnings 18,738 27,248
Debentures 8,000 8,000
Payables 7,629 7,935
Bank overdraft (balancing figure) 1,638 -
Dividends 2,951 3,128
TOTAL EQUITY AND LIABILITIES 55,656 63,011
86

(iii) Forecast Cash Flow Statements for the years ending 31 March
2018 2019
N'000 N'000
Depreciation 875 875
Increase in inventories (902) -
Increase in receivables (723) (781)
Increase in payables 293 306
Purchase of non-current assets (8,000) -
Tax paid (2,297) (3,012)
Dividends paid (2,784) (2,951)
Net cash flow (2,034) 9,087
Cash balance brought forward 396 (1,638)
Cash balance carried forward (1,638) 7,449
b)
(i) Management Buy-out: a new company acquires either the trade and
assets or the shares of the subsidiary to be sold, with the purchase
usually funded by a mix of debt and equity provided by the managers
(equity), venture capital providers (debt and equity) and other financiers
(debt).
(ii) Management Buy-in: as in (i) above, but with purchase by a group of
external managers.
(iii) Spin-off (demerger): shareholders are given shares in the new entity pro-
rata to their shareholdings in the parent company - there is no change in
ownership; with separate legal identities established; used to avoid the
problems of the conglomerate discount; sometimes used as a defence
against takeover of the entire business.
(iv) Sell-off: The business is sold to another company usually for cash.
(v) Carve-out: where shares of the subsidiary are sold to the public through
initial public offer resulting in cash inflow to the holding company.
(vi) Split-off: a means of re-organising an existing corporate structure in
which the share of a business division, subsidiary or newly affiliated
company is transferred to the shareholders of the parent company in
exchange for shares in the latter.
87

ALTERNATIVE SOLUTION TO A(iii)
FORECAST CASH FLOW STATEMENTS FOR THE YEAR ENDING 31 MARCH -
RECEIPTS AND PAYMENTS METHOD
2018 2019
N‟000 N‟000
Sales collection* (K) 64,336 69,483
Payments:
Operating costs** 51,187 53,233
Additional inventory 902 -
Non-current assets 8,000 -
Finance cost 1,200 1,200
Tax 2,297 3,012
Dividend 2,784 2,951
Total payments (T) 66,370 60,396
Excess of receipts Over payments (K – T) (2,034) 9,087

Opening balance 396 (1,638)
Closing balance (1,638) 7,499
Opening receivable 9,036 9,759

Sales 65,059 70,264
Closing receivable (9,759) (10,540)
Collection * 64,336 69,483
Balance b/f 7,336 7,629

Operating costs 51,480 53,539
Balance c/f (7,629) (7,935)
Amount paid ** 51,187 53,233
EXAMINER‟S REPORT
Part „a‟ of the question tests the ability of the candidates to project financial
statements using a given scenario, while Part „b‟ deals with various methods of
divestment.
Being a compulsory question, virtually all the candidates attempted the question.
Although, we have some exceptionally good scripts, the average level of
performance was very poor.
The key pitfalls include:

 Failure to include depreciation and finance cost in the income statement;
 Calculation of income tax based on accounting profit rather than adjusted
profit (i.e. not adjusting for depreciation and capital allowances);
 Incorrect calculation of retained earnings; and
88

 Basing dividend cash flow on current year‟s dividend rather than the
preceeding year‟s as clearly instructed in the question.
Candidates are strongly advised to practise examination-type questions.
Marking Guide
(a) i) Income statement Marks Marks

Revenue 1
Operating costs 1
Depreciation ½
Operating profit 1
Finance costs ½
Profit before tax ½
Tax 3
Profit after tax 1
Dividends 1
Retained profit ½ 10
ii) Statement of financial position

Payables 1
Receivables 1
Cash/overdraft 2
Others 4 8
iii) Cash flow

Dividend paid 1
Others 5 6
24
b) 2 points per method 6
30
89

SOLUTION 2
a) ₦m
Pre-acquisition value:
(i) Raymond Plc. ₦4.90 × 150m = 735
(ii) Harold Limited 𝑁15𝑚 = 250
0.08 − 0.02
985
(iii) Post-acquisition value: ₦m

Harold Limited 𝑁15𝑚 × 1.05 = 315.00
0.08 − 0.03
Raymond Plc. = 735.00
Transaction costs = (8.00)
𝑁2𝑚
Integration costs 1.08 = (1.85)
Total value 1,040.15
Pre-acquisition total value (985.00)
Incremental value 55.15
b) i) Value can be created by combining the two companies through the

achievement of synergies and economies of scale. In most business
combinations, there are likely to be savings generated from combining
operations and reducing the amount of resources needed to fund central
functions such as human resources, finance and treasury. The cost savings
are likely to have an almost immediate impact on the cash flow and hence
are likely to be reflected in 5% growth in free cash flow in the first year.
Synergies might also arise in respect of the cross-selling of services between
the two companies to their respective client bases. It is possible that the
directors of Raymond Plc. anticipate that there are opportunities to enhance
the cash flows of Harold Limited by utilising the expertise of Raymond Plc.
leading to a higher growth rate of 3% a year compared to 2%.
ii) Key challenges in realising the potential added value after the merger are:
 Success depends on the extent that Harold's management and staff
accept the transfer of ownership and remain committed to servicing
Harold Limited‟s clients to the best of their ability. To overcome this
challenge, Raymond Plc. should consider introducing an incentive
scheme such as a bonus payment or employee‟s share option scheme;
 It also depends on whether Harold's clients are happy with the new
arrangement and are confident of receiving the same level of service as
before; and
 The reliability of the forecast improvement in earnings and growth is also
key to successful realisation of the potential added value.
90

c) Consideration paid: ₦7 × 40 million shares = ₦280 million
Comparison of shareholders‟ wealth before and after the acquisition:
Raymond Plc. Harold Total value

Limited
Before the acquisition ₦735million ₦250million ₦985million
After the acquisition N760million ₦280million ₦1,040million

(proceeds)
=(N1,040m - N 280m)
₦30million
Share of synergistic benefits ₦25million
Harold Limited‟s shareholder‟s perspective: Very attractive. Harold Limited‟s

shareholders can expect to receive 55% of the synergistic benefits of the merger
which does not seem to be a fair split considering:
 Harold Limited is the smaller company and contributing less to the merger;
 Harold Limited‟s shareholders do not carry any of the risks that the
synergistic benefits cannot be realized; and
 Harold Limited is unlisted and it is therefore very difficult for the
shareholders to realise their investment at all, let alone at such a generous
price which is above the company‟s own bullish value estimates derived
from discounted cash flow analysis.
Raymond Plc.‟s shareholders‟ perspective: Possibly too high a price for comfort.
The main reasons for this conclusion are as follows:
 The reverse of the above: Raymond Plc.‟s shareholders take all the risk and
contribute most value to the combined business and yet only expect to
receive 45% of the increase in value; and
 It is likely that Harold Limited has a higher business risk than Raymond Plc.
despite being in the same industry because of the different clients profile. If
one customer were to be lost by Harold Limited, then this could have a
significant impact on cash flow and hence the variability of Harold Limited‟s
cash flows is likely to be higher than for Raymond Plc. Therefore, it is
possible that a higher discount rate should be used to value Harold Limited
which would have the effect of reducing its value.
Conclusion: The price needs to be reduced. The proposed price is not fair to
Raymold Plc‟s shareholders and Harold Limited is potentially over-valued at a
discount rate of 8%.
91

EXAMINER‟S REPORT
The question tests candidates‟ ability to value companies for acquisition.
About 40% of the candidates attempted the question and performance was very
poor with some candidates scoring zero.
About 80 percent of the candidates that attempted the question made use of wrong
formulae in discounting the given cash flows and could not carry out the required
analysis of their results.
It is recommended that candidates preparing for this examination need to practise

past examination questions.
Marking Guide Marks Marks

a) Pre-acquisition value:
Raymond Plc. 1
Harold Limited 2
Post-acquisition
- Harold Limited 2
- Transaction costs ½
- Integration costs 1
Incremental value 1½ 8
b) i) Sensible suggestions 2
ii) 1 mark per explained point (max 2) 2 4
c) Share of synergy
- Raymond Plc. 1½
- Harold Limited 1½
Evaluation – Raymond Plc. 2
– Harold Limited 2
Conclusion 1 8
20
SOLUTION 3
92

(a) The rights issue price =N5.00 x 0.90 = N4.50
The theoretical ex-rights price =[(4 x N5.00) + (1 x N4.50)]/5 = N4.90
The value of the rights per existing share = (4.90 – 4.50)/4 = N0.10
(b) The value of 625 shares after the rights issue =625 x N4.90 = N3,062.50
The value of 500 shares before the rights issue =500 x N5.00 = N2,500.00
The value of 500 shares after the rights issue =500 x N4.90 = N2,450.00
The amount of cash subscribed for the new shares =125 x N4.50 = N562.50
The amount of cash raised from the sale of rights =500 x N0.10 = N50.00
Options:
The shareholder could either do nothing, take up the rights, sell the rights or
exercise his rights in respect of part of the issue and sell the remaining to pay
or part pay for the issue taken up.
The effect on the shareholder‟s wealth depends on the action taken:

i) If the shareholder takes up the rights, the rights issue will have a
neutral effect on his wealth. As an owner of 500 shares, he will
purchase an additional 125 shares and the value of the total 625 shares
(N3,062.50) will be the same as the value of 500 shares before the
rights issue (N2,500.00) plus the cash subscribed for the new shares
(N562.50). The make-up of the shareholder‟s wealth will have changed
(less cash, more shares), but not his total wealth;
ii) If the shareholder sells his rights, the rights issue will also have a
neutral effect on his wealth. The value of 500 shares after the rights
issue (N2,450.00) plus the cash received from selling the rights
(N50.00) equals the value of 500 shares before the rights issue
(N2,500.00). Again, the make-up of the shareholder‟s wealth will have
changed (more cash, less shares), but not his total wealth;
iii) If the shareholder neither takes up the rights nor sells the rights, a loss of
wealth of N50 will occur, representing the difference between the value
of 500 shares before the rights issue (N2,500.00) and the value of 500
shares after the rights issue (N2,450.00); and
iv) If the shareholder takes up 75 of the rights issue and sells the remaining
50 shares, it will have a neutral effect on his wealth.
(c) Factors that may influence the actual share price following the rights issue
include:
i) The expectations of investors/the stock market regarding the company‟s
future;
ii) The level of take-up of the rights issue – if the issue was not fully taken
up, for example, the share price might fall;
93

iii) Information regarding the use to which the proceeds will be put and the
market‟s reaction to that information – possibly being used to restructure
finances in a way that affects the company‟s cost of capital; or being
used in a project with a positive net present value;
iv) General stock market conditions/sentiment at the time of the issue, or
conditions/sentiment within the company‟s particular sector of the stock
market;
v) The existence of specific information (positive or negative) regarding the
company or its sector at the time of the issue; and
vi) It is assumed that the details of any new investment/strategy are
communicated to and believed by, the stock market. If this is not the
case, then the share price will differ from the theoretical ex-rights price.
In other words, the degree of efficiency of the market could impact on
the actual share price.
(d) The three forms of theoretical stock market efficiency are weak, semi-strong
and strong.
If a stock market has weak form efficiency then only past information is
currently reflected in share prices. Weak form efficiency, therefore, implies
that share prices fully and fairly reflect all past information about the share
and investors cannot, therefore, make abnormal gains by studying and acting
upon any past information.
If a stock market has semi-strong form efficiency then not only all past
information but also all publicly available current information (eg financial
statements, press reports) are currently reflected in share prices. Semi-strong
form efficiency, therefore, implies that share prices fully and fairly reflect all
past and current publicly available information and investors cannot,
therefore, make abnormal gains by studying and acting upon any such
information.
If a stock market has strong form efficiency then not only all past and current
publicly available information but also all relevant private information (eg
board minutes) is currently reflected in share prices. Strong form efficiency,
therefore, implies that share prices fully and fairly reflect all past, current
publicly available and private information and investors cannot, therefore,
make abnormal gains by acting upon information of any sort.
The implication of all these, is that, if the stock market is efficient in all the
three forms, investors cannot beat the market by having superior information
as it does not, by definition, exist. However, if the stock market is not strong
form efficient then abnormal gains can be made from possession of private
(insider) information.
94

Discussion
Empirical evidence suggests that stock markets are uncertainly not strong
form efficient, so the bank‟s claim appears misguided. There is much
empirical evidence however, that most stock markets are semi-strong efficient
and so, it is unlikely that the company‟s shares are undervalued and certainly
not to any extent that might justify deferring a public issue.
Regarding the Finance Director‟s statement, its accuracy depends in part, on

which form of market efficiency is evident. Strong form efficiency does
suggest that share prices are „correct‟ (they reflect true values) at all times,
but the other two forms of efficiency would not generate „correct‟ share prices
as they do not fully consider all information. However, even with a strong
form efficient market, there may be a time lag between the emergence of new,
relevant information and the market reaction to it, meaning that for a time
prices will not be „correct‟.
Finally, as regards the ability of analysts to predict future share prices, if the
stock market is strong form efficient then analysts will be unable to achieve
consistently superior rates of return. But that does not mean they cannot
predict share prices – by chance they may do so on occasions, but the
implication is that they will be unable to do so consistently. However, if the
market is only semi-strong form efficient, then if the analysts have access to
any private information then they may be able to predict the future share
price and make superior rates of return.
EXAMINER‟S REPORT
The first part of the question tests candidates‟ knowledge of the analysis of right
issue while the second part tests the knowledge of Efficient Market Hypothesis.
More than 80% of the candidates attempted the question but, the level of
performance was disappointing. It is highly troubling that candidates writing the
final examination could not compute ex-right price and for those who did, they
could not analyse the effect of the right issue on shareholders‟ wealth.
In future, candidates are advised to improve their analytical skill. They need to
read widely and practise with past examination questions.

(a) Ex-rights price ½
Theoretical ex-rights/price 1
Value of a right ½ 2
(b) Analysis of wealth

- right taken up 1
95

- right sold 1
- no action taken 1
- Part of the right taken up and
Balance sold 1 4
(c) 1 mark per point (max 4) 4

(d) 2 marks for each (2 x 3) 6
Conclusion 1
Discussion 3 10
20
SOLUTION 4
a) There are two important theories linking exchange rates, interest rates and
inflation rates which need to be considered when determining strategies in
this area.
Interest Rate Parity
Interest Rate Parity (IRP) is based on the hypothesis that the difference
between interest rates in the two countries should offset the difference
between the spot rates and the forward foreign exchange rates over the same
period. Specifically, if investors can obtain a higher risk-free rate in one
currency than they can in the other, the country offering the higher rate will
have its currency depreciated against the other. For example, if risk-free rate
in Ghana is 10% and it is 6% in Nigeria, the Cedi will depreciate against the
Naira by approximately 4% per year.
The relevant formula is:
1 + 𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝐴 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒
Forward rate currency 𝐴 B = Spot 𝐴 𝐵 ×
1 + 𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝐵 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒
Where A and B are two different countries.
Purchasing Power Parity

Purchasing Power Parity (PPP) states that the exchange rate between two
currencies is equal to the ratio of the currencies‟ respective purchasing power.
It states that the rate of appreciation of a currency is equal to the difference in
inflation rates between the foreign and the home country. For example, if
South Africa has an inflation rate of 1% and Nigeria has an inflation rate of
3%, the Nigerian Naira will depreciate against the South African rand by 2%
per year.
The relevant formula is:

1 + 𝐴 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒
Forward rate currency 𝐴 B = Spot 𝐴 𝐵 ×
1 + 𝐵 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒
i) T$ forward rate
96

ii) The forward rate between T$ and Naira (N) is predicted by IRP.
1 + 0.0375 12
One month forward rate T$/N = 1.4600 × = 1.4579
1 + 0.0550 12
The difference between the spot rate and the forward rate of T$0.0021
represents a small discount on Naira (or a premium on T$) suggesting
that the Naira is depreciating (or T$ is appreciating).
The net effect is that a Nigerian investor can either

 Invest in Nigeria at 5.5%, or
 Invest in Country T at 3.75% but also benefit from an appreciating
currency giving the same overall return.
ii) Again IRP can be used to estimate the forward rate.

1 + 0.0425 4
3 − month forward rate K$/N = 1.960 ×
1 + 0.0550 4
= 1.9540
With forward contract, the expected receipt = K$20,000,000 ÷ 1.9540
= N10,235,415
iii) Placing T$ on deposit
The arrangement described is money market hedge, buying the currency,
putting it on deposit and using the principal and interest to make the T$
payment when it falls due.
Money market hedging may be slightly more beneficial than using the
forward exchange markets, but the difference is likely to be small, as the
premium or discount on the forward exchange rates will reflect interest
rate differentials. Money market hedging is currently a strategy that the
company uses.
Therefore, the policy described above is more sensible and should be
adopted.
b) Economic exposure is the risk that the present value of a company's future
cash flows might be reduced by unexpected adverse exchange rate
movements. Economic exposure includes transaction exposure, that is, the risk
of adverse exchange rate movements occurring in the course of normal
international trading transactions.
Implications of economic exposure:
i) Effect on international competitiveness

This can affect companies through its purchases (where raw materials
from abroad become more expensive because of a devaluation of the
home currency) or its sales (where an appreciation in the home currency
97

will mean that sales priced in foreign currencies will be worth less in
home currency terms).
ii) Effect on remittances from abroad

If a subsidiary is set up in an overseas country, and that country's
exchange rate depreciates against the home exchange rate, the
remittances will be worth less in home currency terms each year.
iii) Effect on accounts
Investors will identify economic exposure as having an adverse effect on
accounts if the markets are efficient.
iv) Effect on operations and financing

In order to hedge the adverse effects of economic exposure, companies
will consider diversification of operations, so that sales and purchases
are made in a number of different currencies. The financing of
operations can also be done in a large number of currencies.
EXAMINER‟S REPORT
This question tests candidates‟ knowledge of the use of interest rate parity theorem
and purchasing power parity theorem to estimate foreign exchange rate.
More than 60% of the candidates attempted the question but majority of them
generated unacceptable solutions hence, performance was very poor.
Key pitfalls include:
 Failure of the candidates to cover the risk management part of the syllabus;
 Inability to identify the difference between direct and indirect quotes;
 Use of inappropriate formulae; and
 Use of annual interest rates to calculate 3-month forward rate, etc.
Candidates are reminded that questions for each examination are designed to cover
all sections of the syllabus, hence, they are advised to cover all aspects of the
syllabus when preparing for the examinations of the Institute.

(a) Interest parity 3
Purchasing power parity 3 6
Calculation and conclusion

i. T$ forward rate 3
ii. R$ 3 months forward rate 2
Expected receipt 1 3
iii. Correctly identifying the scenario as
money market hedge 2
98

Recommendation 1 3
(b) Explanation of economic exposure 2

Implications 3 5
20
SOLUTION 5
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
99

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.
b) The directors of companies can be encouraged to achieve the objective of

maximising shareholders‟ wealth through managerial reward schemes and
through regulatory requirements.
100

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.
101

EXAMINER‟S REPORT
This question tests candidates‟ knowledge of stakeholder groups and their

objectives.
Almost all the candidates attempted the question and performance was good with
some candidates scoring all the marks. Surprisingly though, we also have some
few candidates scoring zero.
Candidates are advised to cover all aspect of the syllabus in their preparation for
future examinations.

(a) 2 marks per well explained stakeholder (max 5) 10
(b) Managerial rewards schemes 3

Regulatory requirements 2 5
15
SOLUTION 6
(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
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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
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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.
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.
EXAMINER‟S REPORT
The question tests candidates understanding of ethical issues in capital investment

decisions and the use of Black-Scholes option pricing model in company valuation.
Less than 20% of the candidates attempted the question and performance was very
poor.
In part „a‟ of the question, candidates could not offer any meaningful ethical issues.
In part „b‟, the very few candidates that were able to identify the key variables in
Black-Scholes model failed to identify the relevant proxy for each variable within
the context of company valuation.
We recommend that candidates should make effort to cover the entire syllabus
when preparing for future examinations.
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a) 2 marks per ethical issues

raised and explained (max 4 points) 8
b) Circumstances of use 2
1 mark per each valid variable identified 5 7
15
SOLUTION 7
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.
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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%.
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.
EXAMINER‟S REPORT
The question tests candidates‟ understanding of some basic principles of portfolio

diversification.
About 90% of the candidates attempted the question and performance was average.
Part „b‟ of the question was however poorly answered with some candidates
describing alpha value as a risk measurement.
Alpha value is well discussed and illustrated in the ICAN Study Text. Candidates are
therefore advised to make use of the ICAN Study Text and other relevant materials
when preparing for the Institute‟s future examinations.
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(a) Discussion and explanation of:
(i) Unsystematic risk 3
(ii) Total risk 3
(iii) Market rate of return 3 9
(b) The meaning and purpose of equity beta 3

The meaning and purpose of equity alpha value 3 6
15
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ADVANCED AUDIT AND ASSURANCE
Time Allowed: 3¼ hours (including 15 minutes reading time)

SECTION A: COMPULSORY (30 MARKS)
QUESTION 1
Bode, Ugo, Musa and Company is a firm of Chartered Accountants that has existed
for over 20 years and achieved a strong reputation for quality audit work. The firm
has expanded significantly over the past ten years - doubling its client base across
the different sectors of the Nigerian economy. The firm currently audits two banks,
five listed entities and over seventy other companies. It has also increased its audit
staff base and grown the number of its partners from two to seven over the same
period.
However in the last two years, the firm has series of regulatory reviews due to a
number of instances of errors noted in some financial statements audited by the
firm. One of the clients, the shareholders of NigerKap Plc, petitioned the regulator
over a misstatement in the value of their investment property. This resulted in
overstatement of profit and overpayment of taxes by the company based on the
financial statements for the year ended December 31, 2015. The shareholders also
threatened to take legal action against the firm.
The Managing Partner (MP) of the firm is apparently very concerned about this
situation and has commenced internal procedures to evaluate the quality of audits
performed by the firm especially for the NigerKap audit of 2015. A committee set
up by him has conducted a review of a number of audit files and has noted among
others, that very poor audit work was performed by the NigerKap engagement
team of 2015 led by Amy Smith, one of the partners who is supposed to retire in
2018. The MP has therefore instructed that Oluwatoyin Bede-Nwokoye, a new
partner of the firm, should perform the 2016 audit of NigerKap Plc. The Statement
of Financial Position of NigerKap Plc as at December 31, 2016 has been provided to
the firm and some of the balances therein are shown below:
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2016 2015
N'million N'million
Extract from Non-current assets
Property, plant and equipment 2,640 2,620
Intangible assets 1,200 900
Investment property 3,700 6,150
Deferred tax* 2,800 -
Extract from current assets

Inventories 1,350 1,100
Trade receivables 250 310
*The deferred tax relates to unused tax losses that have accumulated during the
past three years. Management is confident that there will be sufficient future
operating profits to claim the benefit of the tax losses in full in future years.
Required:
a. Discuss FOUR consequences of the poor audit work on the firm of Bode, Ugo,
Musa and Company (Chartered Accountants). (5 Marks)
b. Recommend SIX actions that the new partner should implement to ensure that
a high overall quality of the audit of 2016 financial statements of NigerKap plc
is achieved. (9 Marks)
c. What are the FOUR key audit procedures that should be carried out by the
engagement team to determine whether the recognition of the deferred tax
asset of the company in 2016 is appropriate? (8 Marks)
d. What specific audit procedures should be carried out by the audit team in
respect of the following balances in the financial statements of the company
(other than casting and agreement of amounts per schedule to the general
ledger/trial balance)?
i. Inventories balance (4 Marks)
ii. Intangible assets (4 Marks)

(Total 30 Marks)
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SECTION B: YOU ARE REQUIRED TO ANSWER ANY TWO OUT OF THREE QUESTIONS
IN THIS SECTION (40 MARKS)
QUESTION 2
Chuks Roberts Plc (CRP) operates as auto-parts manufacturing company in Nigeria

and has its head office in Lagos. It has plans to manufacture drones for the
distribution of parcels within Africa. To actualise this, it has just acquired Zaka
Roberts Limited (ZRL), a South African company operating in Johannesburg, to
make the drone production a reality.
Zaka manufactures computer-controlled equipment for university laboratories and

other industries in Africa and the Middle East. It was owned by a group of five
friends who graduated from a South African University and were the directors and
shareholders of the company.
On February 1, 2016 they accepted CRP‟s offer to buy Zaka‟s manufacturing

equipment and technology, which is protected by patent rights, the factory
premises in Cape Town and the head office in Johannesburg for US$450million,
being 75 percent of the value of Zaka. Management notified the employees,
suppliers, customers and other stakeholders that Zaka would cease all
manufacturing undertakings on March 31, 2016.
All employees, apart from a few in the marketing, accounts and administration
departments were rendered redundant, and were given one month‟s notice with
effect from March 31, 2016.
Zaka would now operate under the new name, Chuks Zaka Limited (CZL) from its
former head office in Johannesburg as a marketing company selling CRP‟s drones
in the South African Region. To this effect, CRP will take up 55 percent of CZL, for
which payment was due by February 1, 2017.
Your firm of Chartered Accountants has been the external auditors to CRP and the
company has now engaged your firm to also audit its subsidiary, CZL.
a. Analyse and evaluate the business risks that would be assessed by the
management of CZL. (6 Marks)
b. Analyse and evaluate the business risks that would be assessed by the directors
of CRP. (6 Marks)
c. Assess and advise on the financial statements‟ risks to be considered in

planning the audit of CZL for the year ended December 31, 2016. (8 Marks)
(Total 20 Marks)
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QUESTION 3
Tophem Bank Nigeria Plc has been operating for 20 years and your firm took over
the audit 5 years ago.
Tophem Bank‟s investment in Accra Insurance Limited, a foreign associate acquired

during the year and accounted for by the equity method, is carried at ₦575 million
on the Statement of Financial Position at December 31, 2016. Tophem‟s share of
Accra‟s net income is included in Tophem‟s income for the year then ended.
However, you were denied access to the management, auditors and the financial
information of Accra Insurance Limited.
Your partner has reviewed the audit file for the year ended December 31, 2016 and
has approved the issuance of a modified opinion. He drew a titular sketch of the
audit report and has asked you to fill up some gaps.
NB: Assume the underlying financial reporting frameworks are applicable to

Tophem Bank Nigeria Plc – Financial Reporting Council of Nigeria Act 2011,
Companies and Allied Matters Act, CAP C20 LFN 2004, International Financial
Reporting Standards, Banks and Other Financial Institutions Act CAP B3 LFN 2004
and other Central Bank of Nigeria guidelines and circulars.
a. Evaluate the circumstance in which a matter could be both material and

pervasive in its effect on the financial statements. (4 Marks)
b. Explain EIGHT of the appropriate procedures to be followed in the audit

assignment before reaching the audit opinion. (8 Marks)
c. Draft appropriate basis of opinion paragraph suitable for inclusion in the

auditor‟s report. (4 Marks)
d. Draft appropriate opinion paragraph suitable for inclusion in the auditor‟s

report. (4 Marks)
(Total 20 Marks)
QUESTION 4
The management of Pony Bank Plc. and its fully owned subsidiary Ponte Micro
Finance Bank Limited arranged and invented bogus loans that totalled N5.5 billion
worthless assets which the former auditors did not detect.
The former auditors claimed that a clique of highly clever and organised swindlers
among the staff of Pony Bank deceived the auditors and devoted themselves to
defeating the audit and covering up their nefarious acts.
111

Your firm of chartered accountants, Vic Viv & Co, has just taken up the audit of Pony
Bank Plc.
a. Advise the engagement partner on the risks involved in taking up the audit.
(4 Marks)
b. Recommend appropriate actions on the part of management and your firm

to overcome the financial statements‟ risks. (8 Marks)
c. Prepare a management letter which includes two matters suitable for

submission to the directors. (8 Marks)
(Total 20 Marks)
SECTION C: YOU ARE REQUIRED TO ANSWER ANY TWO OUT OF THREE QUESTIONS
IN THIS SECTION (30 MARKS)
QUESTION 5
You are the audit manager for XYZ Bank Limited for the year ended December 31,
2016.
From your review of the Bank‟s Board of Directors minutes of meetings, you noted
that during the year, the Board was concerned about a litigation issue involving the
Bank and another company named BBB Limited, in which the Bank is the
defendant.
BBB Limited had sued the Bank for converting a cheque worth N2.1billion and the
high court has declared the Bank guilty and imposed a penalty in the sum of N2.1
billion (i.e. the value of the cheque) on the Bank.
From the available information, it was noted that the claimant (i.e. BBB Limited)
had commenced the process to claim the judgment amount from the Bank.
The Bank was not satisfied with the case and had immediately filed for objection at
the Court of Appeal. The Directors of the Bank, based on the professional legal
counsel obtained, are of the opinion that the judgment issued by the Federal High
Court is baseless and unjustifiable, and that a favourable judgment would be
obtained at the Court of Appeal.
The summary of financial information of the Bank is as follows:

Provision for litigation (already recognised in the Bank‟s financial statements)
N96 million
Number of existing litigation cases as defendant 50 cases
Number of existing litigation cases as plaintiff 10 cases
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Litigation claims in favour of the Bank N2.7 billion
Litigation claims made against the Bank including the N2.1
billion above N3.2 billion
a. Discuss FOUR of ISA 501 Audit evidence - specific consideration for selected
items requirements on the procedures the auditors can perform to obtain
sufficient and appropriate audit evidence on the litigation provision.
(5 Marks)
b. Comment on the adequacy or otherwise of the amount recognised as
provision for litigation in the financial statements as at December 31, 2016.
(5 Marks)
c. Prepare a summary disclosure of the entity‟s litigation status for inclusion in
the notes to the financial statements as at December 31, 2016. (5 Marks)
(Total 15 Marks)
QUESTION 6
During the course of your audit of fixed assets of Next Engineering Plc at December
31, 2016 two problems arose:
(i) The calculations of the cost of direct labour incurred on assets in the course
of construction by the company‟s employees have been accidentally
destroyed for the early part of the year. The direct labour cost involved is
₦20,000,000.00; and
(ii) The company has received a government grant of ₦50,000,000.00 towards

the cost of plant and equipment acquired during the year and expected to
last for ten years. The grant has been credited in full to the income statement
as exceptional item.
Required:
a. Discuss the general forms of modifications available to the auditors in
drafting their report in accordance with appropriate standards and state the
circumstance in which each form is appropriate. (6 Marks)
b. On the assumption that you decide that a modified audit report would be
necessary with respect to the treatment of government grant, prepare a draft
of the section that deals with the matter (whole report not required).
(5 Marks)
c. Analyse the auditor‟s general responsibility with regard to the statement in

the directors‟ report concerning the valuation of land and building.
(4 Marks)
(Total 15 Marks)
113

QUESTION 7
Young Entrepreneur Trading (YET) is an on-line trading business established by

Yemisi Tumfere. The business buys assorted household goods from different
manufacturers locally and abroad. Orders are made on-line from suppliers.
Customers also order goods on-line from YET and their invoices are processed and
transmitted to the store from where the goods are dispatched to the customers
through the delivery stores scattered all over the country.
YET has not been satisfied with the work of the previous auditors and has
approached your firm to be appointed as the new auditors. Appropriate
professional clearance has been resolved for the work to commence. You are the
audit manager responsible for the engagement. You have also been assigned on
the job with some new trainees who are not conversant with controls in on-line
businesses.
Required:
a. Discuss FIVE of the controls an auditor should focus on to assess the
effectiveness of controls in an on-line system such as YET. (5 Marks)
b. Evaluate FOUR risks associated with the business of YET in the application of
electronic data interchange in an on-line business and FOUR effective controls
that may be put in place to minimise the risks. (10 Marks)
(Total 15 Marks)
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SOLUTION I
i. a. The consequences of the poor audit work could be the following:
(i) legal damages and legal costs;

(ii) losing the client;
(iii) adverse publicity and damage to the reputation of the audit
firm;
(iv) disciplinary proceedings by a professional body such as ICAN
(v) loss of high performing employees who would not wish to be
associated with poor image; and
(vi) increased regulatory focus and the associated time lost in
regulatory inspections and reporting
b. The new engagement partner should put procedures in place to ensure

that:
(i) ethical standards are complied with and appropriate action taken
if there is evidence to the contrary;
(ii) independence requirements are met, including:
- identifying circumstances and relationships that might give
rise to threats to independence;
- assessing the impact of breaches of the firm‟s independence
policies and procedures and whether such breaches create a
threat to
- independence; and
- taking suitable action to eliminate identified threats or to
withdraw from the engagement if appropriate.
(iii) the audit is carried out by an audit team with the appropriate
competence and capabilities;
(iv) appropriate management of the engagement is in place, including
the direction and supervision of staff and the review of audit
work;
(v) on or before the date of the audit report, the engagement partner
must, through a review of audit documentation and discussion
with the audit team, be satisfied that sufficient and appropriate
evidence has been obtained to support the conclusions reached.
(vi) adequate consultations have taken place on difficult or
contentious matters and the conclusions from such consultations
implemented;
115

(vii) relevant specialists within the audit firm or experts to be engaged
by the audit team are involved to assist in auditing relevant
difficult areas of the engagement;
(viii) the following matters are documented:
- issues in respect of compliance with ethical requirements and
how they were resolved;
- conclusions on compliance with independence requirements;
- conclusions in respect of new and continuing engagements;
and
- the nature and scope of conclusions from consultations
undertaken.
(ix) Appropriate materiality amount is determined for the financial

statements as a whole and may consider lower performance
materiality at account balance level, in order to focus on high risk
areas and achieve improved audit quality;
(x) An engagement quality control reviewer is appointed and

involved on the engagement to perform an objective evaluation of
the significant judgements made by the audit team, the
conclusions reached and to evaluate the appropriateness of the
audit report;
(xi) Adequate planning of the audit to ensure proper coverage; and
(xii) Review of prior year working papers.
c. The auditor should assess whether it is appropriate to include a deferred tax

asset in the financial statements and so needs evidence about whether the
tax losses will be recoverable. The procedures involved are:
(i) Obtain a copy of the client‟s tax computations and agree the figures in
the calculation to the accounting records. Also consider recalculating
the amount to check it‟s accuracy;
(ii) Review any correspondence about tax that may exist with a view to
verifying the propriety of the tax losses used in the calculation;
(iii) Make an assessment about whether the tax losses will be recoverable,
by obtaining forecasts from the client of future profitability. The
assumptions used in the forecast should be assessed for
reasonableness in the context of the auditor‟s understanding of the
client‟s business;
(iv) If the forecasts of future profitability are reasonable, the auditor should
assess how long it will be before the losses are recovered in full. This
116

period should be checked against tax regulations, to confirm that there is
no statutory limit on carrying forward tax losses;
(v) Determine from the tests above, whether the deferred tax asset should be
recognised in full or whether some amounts should not be fully
recognised; and
(vi) Check that relevant disclosures required in respect of deferred taxes have
been made in the financial statements.
di Inventories
Important specific audit procedures for inventories include the following:
 Evaluation of carrying amount of inventories to ensure that it is stated at

the lower of cost and net realisable value, on an item-by-item basis;
 Evaluation of the valuation method used to estimate inventory cost to
ensure that an acceptable method per IAS 2 was used (Remember that
LIFO is not permitted by IAS 2.);
 Observe physical count of inventory items;
 Obtain evidence that an appropriate method has been used for the
treatment of overheads (overhead absorption);
 Check that any obsolete inventory items have been isolated and written
down/off; and
 Check that relevant disclosures have been made in the financial
statements in respect of inventories.
(ii) Intangible Assets
Important specific audit procedures for Intangible assets include the following:
 Evaluate whether purchased intangible assets have been recognised and

measured in accordance with IAS 38;
 Obtain evidence that the useful lives of intangible assets have been
estimated in a reasonable way;
 Obtain evidence to support the non-amortisation of intangible assets with an
indefinite useful life where applicable;
 Check that intangible assets have been appropriately subjected to annual
impairment reviews and that the resulting adjustments (if any) have been
appropriately determined and recorded;
 Evaluate that the relevant disclosures contained in the relevant movement
schedules have been appropriately presented; and
 Obtain evidence with respect to disposals during the year and that the
relevant gain or loss has been appropriately recorded in the books.
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EXAMINER‟S REPORT
The question tests candidates understanding of Audit Quality.
Almost all the candidates attempted the question and performance was average.
MARKING GUIDE MARKS

i. a. 1¼ marks each for any four points 5
B. 1½ marks each for any six points 9
c. 2 marks each for any four points 8
d(i) 1 mark each for any four points 4
(ii) 1 mark each for any four points 4
TOTAL 30
SOLUTION 2
(a) Business risks that will be assessed by CZL‟s management are:
i. The parent company operates in another country with different laws and
regulations;
ii. The parent company operates in high-tech environment and inventories

might be subject to obsolescence, and this will affect the survival of CZL
being a subsidiary;
iii. CZL is now a new company selling items different from its erstwhile
products. New customers would be sought and new marketing efforts
would be employed, yet only skeletal staff were retained;
iv. Staff of Zaka may sue for redundancy costs. Redundancy payments have
not been made. There may be need to make provisions;
v. Possibility of increased errors in processing accounting transactions

because the skeletal staff retained may not allow for segregation of
duties;
vi. The change in line of business will affect after-sales service for customers
of the old company and they may sue for damages;
vii. Receiving products for sale only from its parent company is a limitation
to going concern of the company; and
viii. The parent company is yet to pay for its investment.
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(b) Business risks that will be assessed by the directors of CRP are:
i. The subsidiary company operates in another country with different laws

and regulations;
ii. The company operates in high-tech environment and inventories might
be subject to obsolescence;
iii. The factory in South Africa may have been acquired at an amount far
more than its value;
iv. The engineering expertise belonged to another company, which had
ceased from existence. It might be difficult getting technical help;
v. Moving from auto parts manufacture to the manufacturing of drones is a
dramatic shift requiring new expertise in manufacturing and sales;
vi. There is need to patronise national carriers and international
organisations like DHL for economically sustainable sales to be attained
since these have had arrangements with airlines for the lifting of mails
and parcels; and
vii. There are no plans yet for the distribution of the products, beyond using
the subsidiary the acquisition of which is yet to be consummated by
making payment.
(c) Financial Statement risks to be considered in planning the audit of CZL

includes:
i. Due to the possibility of rapid obsolescence, inventories in the financial

statements might be overstated. Serious attention needs to be paid to net
realisable value in the valuation;
ii. The worth of the factory in South Africa may have been overstated, as it was
acquired from another company. There is need to do proper valuation of the
net assets acquired so as to determine the right amount of goodwill or
bargain purchase as relevant;
iii. Provision must be made for 55 percent of the value of the subsidiary CZL, (55
percent of US$450 million) payable in February 2017.
iv. There is need to consolidate the accounts of CZL in the financial statements
of CRP;
v. Exchange rate volatility will affect transactions between the company and its
parent company; and
vi. Risk of misstatement of opening balances.
EXAMINER‟S REPORT
The question tests candidates understanding of analysis, assessment and

evaluation of business risks.
About 95% of the candidates attempted the question but performance was poor.
119

Candidates‟ commonest pitfall is lack of understanding of the question.
Candidates are enjoined to use the Institute‟s study text extensively.
a Different regulatory environment 1¼ marks each for

High-tech environment any 4 points 6
New product
Redundancy payments
Errors in accounting transactions
After sales service
Going concern
Part of company sold on credit
b Different regulatory environment 1¼ mark each for
High-tech environment any 4 points 6
Over-valued factory
Technical help needed
New expertise
Patronage for product
Distribution of product in other
regions
c Valuation of inventories 2 marks each for
Valuation of factory any
Payment for subsidiary – provisions four points
Consolidated financial statements
Exchange rate volatility 8
Total 20
SOLUTION 3
(a) Generally, a matter will be material when it impacts the financial/economic

decision of the users of the financial statements.
„Pervasive‟ effects on the financial statements are defined by ISA 705 as

those that, in the auditor‟s judgement:
i. are not confined to specific elements, accounts or items of the financial

statements; or
120

ii. are confined to specific elements in the financial statements, but these
represent (or could represent) a substantial proportion of the financial
statements; or
iii. in relation to disclosures in the financial statements, are fundamental to
users‟ understanding of those statements.
When a „material‟ issue becomes „pervasive‟ then it is significant and affects

substantial proportion of the financial statements. This calls for a modification
of the auditors‟ opinion.
(b) REACHING THE AUDIT OPINION
In reaching his audit opinion, the auditor is required to evaluate whether:
i. He has obtained sufficient appropriate audit evidence as to whether the

financial statements are free from material misstatements;
ii. Uncorrected misstatements are material, individually or in aggregate
iii. The financial statements give a true and fair view;
iv. The financial statements have been prepared in accordance with the
relevant financial reporting framework and in particular whether:
- The financial statements adequately describe the relevant financial
reporting framework;
- The financial statements adequately disclose the entity‟s significant
accounting policies;
- The significant accounting policies are appropriate and consistent
with the relevant financial reporting framework;
- Accounting estimates are reasonable;
- The information in the financial statements is relevant, reliable,
comparable and understandable;
- The financial statements provide adequate disclosures; and
- The terminology used in the financial statements is appropriate.
c. Basis for qualified opinion
Tophem Bank Plc.‟s investment in Accra Insurance Ltd, a foreign associate,

acquired during the year and accounted for by the equity method, is carried
at ₦575 million on the Statement of Financial Position at 31 December 2016.
Tophem Bank Plc‟s share of Accra Insurance‟s net income is included in
Tophem Bank Plc‟s income for the year then ended. We were unable to
obtain sufficient appropriate audit evidence about the carrying amount of
Tophem Bank Plc‟s investment in Accra Insurance Limited at 31 December
121

2016 and Tophem Bank Plc‟s share of Accra Insurance‟s net income for the
year because we were denied access to the management, auditors and the
financial information of Accra Insurance Limited. Consequently, we were
unable to determine whether any adjustments to these amounts were
necessary.
d. Qualified opinion
In our opinion, except for the possible effects of the matter described in the
basis for Qualified Opinion paragraph, the accompanying financial
statements give a true and fair view of the financial position of Tophem Bank
Plc as at 31 December 2016 and the financial performance and cash flows
for the year then ended in accordance with the International Financial
Reporting Standards, the Companies and Allied Matters Act Cap C20 LFN
2004, the Banks and other Financial Institutions Act CAP B3 LFN 2004, the
Financial Reporting Council of Nigeria Act, 2011, and other relevant Central
Bank of Nigeria guidelines and circulars.
EXAMINER‟S REPORT
The question tests candidates understanding of the concept of materiality as

regards financial statements.
Candidates lacked understanding of the question.
Candidates are advised to prepare adequately for the examination by reading the
Institute‟s study text in detail.
MARKING GUIDE
POINTS TO MENTION Marks Marks

3a Material 1
Pervasive 2
Material and pervasive- impact on Audit report 1
SUB TOTAL 4
3b He has obtained sufficient appropriate audit evidence 1 mark
as to whether the financial statements are free from each for
material misstatements any 8
Uncorrected misstatements are material, individually or points 8
in aggregate
122

The financial statements give a true and fair view
The financial statements have been prepared in
accordance with the relevant financial reporting
framework and in particular whether:
- The financial statements adequately describe the
relevant financial reporting framework
- The financial statements adequately disclose the
entity‟s significant accounting policies
- - The significant accounting policies are appropriate

and consistent with the relevant financial reporting
framework
- Accounting estimates are reasonable
- The information in the financial statements is
relevant, reliable, comparable and understandable
- The financial statements provide adequate
disclosures
- The terminology used in the financial statements is
appropriate
3c Basis of Qualified Opinion – as title 1

Reference to foreign investment 1
Unable to obtain appropriate audit evidence 1
Denied access to the management, auditors and the
financial information 1
Unable to determine the necessary adjustments 1 (Any
four
points)
SUB TOTAL 4
Qualified Opinion – as title 0.25
Except for 0.5
Reference to Basis of Qualified Opinion 0.5
Accompanying financial statements 0.25
True and fair view 0.5
Name of company 0.25
Date of financial statements 0.25
Financial Position, Financial Performance & Cash flows 0.5
International Financial Reporting Standards 0.25
Companies and Allied Matters Act Cap C20 LFN 2004 0.25
Banks & Other Financial Institutions Act CAP B3 LFN
2004 0.25
Financial Reporting Council of Nigeria Act, 2011 0.25
SUB TOTAL 4
Total 20
123

SOLUTION 4
a. The engagement partner should take cognisance of the following risks that the
firm could be exposed to, if it takes up the audit:
i. The client‟s working environment has been corrupted with lack of integrity
among staff leading to the creation of non-existent loans;
ii. Internal evidence therefore cannot be relied upon, as they have no weight;
and
iii. The opening balances cannot be relied upon because the financial
statements of prior years have been misstated.
b ACTIONS TO REDUCE THE RISKS
Granted that the business risks are high and that these will create financial
statements risks, the partner must take appropriate actions to reduce their
effects on the financial statements.
The firm must be cautious in dealings with client‟s staff. External evidence
should be used to corroborate whatever internal evidence that would be
presented. Management representation should be obtained, covering
significant matters in the financial statements.
It is important to remember that the firm has taken professional indemnity

insurance. The insurance broker should be notified of this new client and
legal counsel should be obtained.
The specific actions to be taken include the following:
i. Client to conduct an investigation into the activities that created the

fictitious loans;
ii. Do a 100 percent review work on the loans and advances;
iii. Change or modify the accounting package and give new passwords to
new set of staff that would handle the general ledger;
iv. Do a complete overhaul of the credit and marketing department;
v. Stop inter-company loans between the bank and the subsidiary, at
least in the short term. There should be no joint loan syndication
within the Group; and
vi. Obtain further information from culpable staff and block all loopholes.
c MANAGEMENT LETTER
124

Date: 15 April, 2017 Viv Vic & Co
(Chartered Accountants)
The Directors
Pony Bank Plc.
Dear Sir
MANAGEMENT LETTER
We have completed the audit of your Bank‟s financial statements for the year ended
31 December 2016 and we made some observations during the course of the audit.
The observations are presented below.
1. CREATION OF FICTITIOUS ASSETS
Observation
The staff of your bank and the subsidiary Micro Finance Bank colluded and created
bogus loans totalling N5.5 billion over a period of seven years.
Implication
This means that assets have been overstated by N5.5 billion.
Recommendation
There is an urgent need to write off this fictitious asset from the books.
Response
2. BREAKDOWN OF INTERNAL CONTROLS
Observation
The staff of your bank colluded to cover up fraud and gross misstatement.
Implication
This means that the backbone of the internal control system has been broken and it
is difficult to rely on the system for the preparation of the financial statements.
Recommendation
There is an urgent need to overhaul the human resource of the bank. There is need
for thorough investigation and those found culpable should be relieved of their
positions.
125

Response
Conclusion
Please provide a response and action plan for each weakness identified in the
report. This should be inserted in the space provided. Additional sheets could be
attached for further explanation that could help us to serve you better. The contents
of this letter and your response thereupon will be followed up in future audits.
Thank you.
Truly yours,
Engagement Partner.
EXAMINER‟S REPORT
The question tests candidates understanding of audit risks associated with financial
statements.
Candidates displayed inadequate preparation, and lack in-depth knowledge of audit risks.
Candidates are advised to read the Institute‟s study text thoroughly before attempting the
examination.
MARKING GUIDE

4a Client staff lacked integrity. 2 marks
Internal evidence cannot be relied upon. each for
The opening balances cannot be relied upon. any 2
points
SUB TOTAL 4
4b The firm should: 1 mark
Be cautious in dealings with staff. each for
Use external evidence to corroborate. any 3
Obtain management representation letter. points
Inform Insurance Broker
Client should:
Conduct an investigation into the fictitious loans.
Change or modify the accounting package 1 mark
New set of staff to handle the general ledger. each for
Do complete overhaul of credit & marketing any 5
126

department. points
Do a 100 percent review work on the loans and
advances.
Stop inter-company loans or loan syndication.
Obtain further information from culpable staff
SUB TOTAL 8
4c Letter format 0.5
Proper Introduction 0.25
First observation, Implications, recommendations 3
Second observation, Implications, 3
recommendations 0.5
Space for management response 0.5
Conclusion 0.25
Signed by Partner
SUB TOTAL 8
TOTAL 20
SOLUTION 5
(a) ISA 501 states that the auditor shall design and perform audit procedures in
order to identify litigation and claims involving the entity which may give
rise to a risk of material misstatements, including:
i inquiry of management and, where applicable, others within the

entity, including in-house legal counsel;
ii direct communication with the entity‟s external legal counsel. The

auditor shall do so through a letter of inquiry, prepared by
management and sent by the auditor, requesting the entity‟s external
legal counsel to communicate directly with the auditor;
iii reviewing minutes of meetings of those charged with governance and

correspondence between the entity and its external legal counsel;
iv reviewing adequacy of existing litigation provisions;
v) review legal expense account; and
vi) obtain written representation: The auditor shall request management

and, where appropriate, those charged with governance to provide
written representations that all known actual or possible litigations
and claims whose effects should be considered when preparing the
financial statements have been disclosed to the auditor and
127

accounted for and disclosed in accordance with the applicable
financial reporting framework.
(b) The existing provision of N96million is inadequate since it has not

been updated to include the liability arising from the High Court
judgment of N2.1 billion obtained in current year.
The auditor should consider proposing audit adjustment for an

additional N2.1 billion to the existing litigation provision based on the
following:
There is a past event - the relevant past event for the litigation
provision is the event that gives rise to the claim, i.e. the high court
judgment.
The adjusted litigation provision as at 31 December 2016 should then

be N2.196 billion.
(c) Typical disclosure on litigation in the financial statement is presented

below:
“The Bank, in its ordinary course of business, is presently involved in
50 litigation cases as a defendant and 10 cases as a plaintiff. The total
amount claimed in the 10 cases instituted by the Bank is estimated at
N2.7 billion, while the total amount claimed in the 50 cases instituted
against the Bank is N3.2 billion, for which provisions amounting to
N2.196 billion have been made.
The Directors are of the opinion that no other significant liability will
arise therefrom in excess of the provision made in the financial
statements.”
EXAMINER‟S REPORT
The question tests candidates‟ understanding of the specific consideration of

litigation provision of ISA 501- Audit Evidence.
About 65% of the candidates‟ attempted the question but performance was poor.
The commonest pitfall of the candidates was that they applied general knowledge
rather than being specific. They were not familiar with ISA 501 requirement.
The extensive use of the Institute‟s study text is recommended for improved
performance.
128

, MARKING GUIDE
POINTS TO MENTION MARKS

5a. 1¼ marks each for any four points 5
b. - Existing provision of N96m not adequate 2
- Consider proposing audit adjustment for an additional
N2.1b 1
- Relevant past event for the litigation provision re High Court
Judgement 1
- Adjusted litigation provision at 31 December 2016 should be
N2.1966 1
SUB TOTAL 5
c. Mentioning of -
- 50 Litigation cases 1
- N2.7billion in respect of litigation cases 1
- Total amount of claim to be N3.2b 1
- Provision of N2.196b ½
- Directors opinion that no other significant liability will arise 1½
SUB TOTAL 5
TOTAL 15
129

SOLUTION 6
a. The general forms of modifications available to the auditors in drafting their

report as stated in ISA 705 are as follows:
Qualified Opinion
This is issued when financial statements are materially misstated, but in the
auditor‟s judgment, the effect of the misstatement is not considered
pervasive.
OR
Issued when the auditor is unable to obtain sufficient appropriate audit

evidence (limitation scope), but in the auditor‟s judgment, the possible effect
of the misstatement is not considered pervasive.
Adverse opinion
Issued when financial statements are materially misstated, and in the
auditor‟s judgment, the effect of the misstatement is pervasive on these
financial statements.
Disclaimer of opinion
Issued when the auditor is unable to obtain sufficient appropriate audit
evidence and the possible effect of the misstatement is material and
pervasive on the financial statements.
b Basis for modified opinion

“As explained in note xx an amount of ₦50,000,000 has been credited to the
Income Statement and included as exceptional items. International Financial
Reporting Standards require that such items should be recognised and
credited to Income Statement over the expected useful economic lives of the
related plant and machinery. The effect of the charge would be to make
operating profit ₦yy instead of ₦zz with a corresponding change in
shareholders‟ funds”.
c The directors are solely responsible for the Directors‟ report and the auditors
have no general responsibility for it.
However, they are required to consider whether the information in the
Directors‟ report is consistent with the information in the financial
statements and information they are aware of in the course of their audit.
130

If they are of the opinion that the valuation of land and building are
inconsistent with any information given in the accounts then, they must get
the directors to change that or say so in their report.
This is unlikely, but any information at all in the Directors‟ report which
seems to the auditor as dubious would put the auditor on enquiry.
EXAMINER‟S REPORT
The question tests candidates‟ knowledge on Audit Report on financial statements.
About 45% of the candidates attempted the question, but performance was poor.
The commonest pitfall of the candidates was lack of practical knowledge to be

applied in answering the question.
Constant use of the Institute‟s study text is recommended. Also reading of

published financial statements to get the feel of practical approach is
recommended.
MARKING GUIDE

a. Discussing/indicating when each form is required 2 marks
each for
any three
points 6
b. - The draft of the modification section ( 1 mark
- Reference to IFRS each for
- Reference to appropriation of plant and machinery any of the
- Inclusion of effect on profit five (5)
points)
- Description of the error and indication of right
treatment 5
c. - Disclosure of directors‟ responsibility
- Auditors‟ duty to ensure information is consistent
with financial statements and/or information
already known to the auditor in the cause of the
audit. 1 mark
- Stating that directors are responsible 1 mark
- Indicating the action the auditor will take, if 2 marks

there is inconsistency 4
Total 15
131

SOLUTION 7
a) Although on-line systems are usually efficient and effective for the users,
they create additional problems for the auditor who needs to assess the
effectiveness of the system‟s controls. There are two categories of system
controls in an on-line system. These are general and application controls.
General controls in an on-line system could include the following:

i. Access Control - There must be effective controls over access to the
system and its file. This is because in online systems, transactions are
processed as soon as they are inputted;
ii. Software Control -There should be controls written into the system
software to prevent or detect unauthorised changes to programs;
iii. Transaction Log Control - Transaction logs should be used to create an

“audit trail”. The computer program should be written in such a way
as to generate the audit trail for any transaction on request; and
iv. Internet Access Control - Firewalls should be used for systems that
have access to the internet.
Application controls in an on-line system could include the following:
i) Pre-processing authorisation Control - such as logging on to the

system, and the user‟ names and passwords;
ii) Data Validation Control
Data validation checks is the software to check the completeness and
accuracy of processing such as checking that a product code has been
entered with the correct number of digits; and
iii) Balancing Control “Balancing”- checking control totals of data
submitted from remote terminals before and after processing.
b. Electronic Data Interchange (EDI) systems can improve the operational

efficiency of an entity, but they may generate the following problems for the
auditor who has to access the efficiency of the system controls:
i) The lack of proper audit trail;

ii) An increased level of dependency on the computer systems of the
organization and possibly the computer systems of other entities. Any
132

failure or control weakness in one computer system may have an
impact on the computer system that is being audited;
iii) There may be a risk of loss or corruption of data in the process of
transmission; and
iv) There will be security risk in the transmission of data.
Auditors should expect to find effective controls in place to minimise the risk
inherent in EDI systems. Typically, controls will cover such matters as:
i) Control over transmission of data such as the encryption of data

before transmission, acknowledgement systems, and the use of
authentication codes for senders of data;
ii) Monitoring and checking of output;
iii) Virus protection systems; and
iv) Contingency plans and back-up arrangements.
EXAMINER‟S REPORT
The question tests candidates‟ knowledge of on-line real-time business audit.

About 90% of the candidates attempted the question but performance was poor.
The commonest pitfall of the candidates was that their solutions tend towards
controls in a Non-Electronic Data Processing.
Candidates are enjoined to read the question and interpret it correctly before
attempting it. Also, the Institute‟s study text should be used by the candidates in
preparing for future examinations.
Marking Guide
a Any 5 (five) controls, I mark each 5

b Points on operational efficiency -1¼ mark each for four 5
Any 4 (four) controls, 1¼ mark each 5
15
133

CASE STUDY
Time Allowed: 4 hours (including reading time)
INSTRUCTION: YOU ARE TO USE THE CASE STUDY ANSWER BOOKLET FOR THIS
PAPER
TOSTOL DRINKS NIGERIA LIMITED
Requirement
You are Dave Chukwurah, a recently qualified Chartered Accountant and a Junior
Consultant in the firm of Dauda, Eporum, Bala & Co, a firm of consulting accountants
and tax practitioners. One of your Senior Partners, Jaja Eporum, has sent you an email
(Exhibit 1) requiring you to prepare a report to be submitted to Joel Ramsey, Chief
Executive Officer (CEO) of Tostol Drinks Nigeria Limited, one of your clients. Tostol
Drinks Nigeria Limited (TDNL) has requested from your firm an advice in respect of the
company‟s proposed strategic plan aimed at increasing the company‟s shareholders‟
value while at the same time satisfy the company‟s other stakeholders.
The following time allocation is suggested:
Reading 1 hour
Planning and calculations 1 hour
Drafting report 2 hours
4 hours
134

LISTS OF EXHIBITS
EXHIBIT DESCRIPTION
1. Email from Jaja Eporum, a Senior Partner in Dauda, Eporum, Bala

& Co, to you Dave Chukwurah, a Junior Consultant.
2. Email from Joel Ramsey, CEO of Tostol Drinks Nigeria Limited, one
of your clients, to Jaja Eporum.
3. Information on TDNL‟s Business Model and current strategic plan.
4. Five years summarised financial statements of Tostol Drinks

Nigeria Limited.
5. Additional information on TDNL‟s financial statements.
6. Five years summarised financial statements of Brilliant Bottles

Nigeria Limited (BBNL).
7. Additional information on BBNL‟s financial statements.
8. Additional information on the proposed acquisition of Brilliant

Bottles Nigeria Limited.
135

Exhibit 1
Dauda, Eporum, Bala & Co
Chartered Accountants
Email
From: Jaja Eporum – Senior Partner
To: Dave Chukwurah – Junior Consultant
Re: Tostol Drinks Nigeria Limited
Date: April 11, 2017
Further to my discussions with you this morning in my office in respect of our above named
client, I will like you to go through the attachments to this email (Exhibit 2 – 7) and
prepare a report as requested by Joel Ramsey, the Chief Executive Officer (CEO) of Tostol
Drinks Nigeria Limited (TDNL) for my review.
As I made it clear to you, the board of TDNL is concluding the company‟s strategic plan for
the next five years with a central focus on “increase in shareholders‟ value”. The board has
decided to carry out a backward integration by acquiring all the shares of Brilliant Bottles
Nigeria Limited (BBNL). Therefore, the board has asked our firm to carry out a financial
due diligence on the financial statements of BBNL together with additional notes provided.
We are also required to recommend a range of prices that TDNL can offer for the
acquisition.
Further, as part of the input to the strategic plan, TDNL‟s board will want us to review the
company‟s last five years financial statements with a focus on shareholders‟ value analysis
using Economic Value Added (EVA) approach to determine how the company‟s
shareholders‟ value has grown over the years to enable the board set target for the
strategic plan period. The CEO of TDNL has asked us to assume a weighted average cost of
capital of 15% and has availed us with the company‟s financial statements for the last five
years with some additional information.
Required:
Using the attached exhibits, prepare a draft report to Jaja Eporum, your Senior Partner, for
his review before forwarding same to TDNL‟s board. Your report should include:
1. Appraisal of TDNL‟s performance in the past five years based on the company‟s
business model and this should include the additional value added to the
shareholders of TDNL using EVA approach; and
2. A report on the financial due diligence of BBNL to determine its future financial
performance, and whether its acquisition will result in increase in TDNL‟s
shareholders value. You are also to recommend a range of prices that TDNL should
offer to the shareholders of BBNL, based on the share valuation models agreed with
the board of BBNL.
136

Exhibit 2
Email
From: Joel Ramsey – CEO, Tostol Drinks Nigeria Limited

To: Jaja Eporum – Senior Partner, Dauda, Eporum, Bala & Co
Re: TDNL‟s Strategic Plan 2018 – 2022
Date: April 10 2017
Dear Jaja,
Further to my telephone conversation with you this morning, I write to confirm our Board‟s
approval for your firm to assist us in carrying out a financial due diligence for the
acquisition of BBNL which we hope to conclude before the last quarter of the year and also
appraise TDNL performance.
Your firm is required to make input into our strategic plan as follows:
1. Carry out an appraisal of our financial performance in the last five years, taking into
consideration our business model. We need to know how we are faring in respect of
each component of our business model. You are also to determine the value that has
been added to our shareholders in each of the past five years to enable us set targets
for the strategic plan period. You are to use economic value added (EVA) model to
determine value added in those years. I attach herewith our summarised financial
statements for 2012 to 2016 together with some additional information. I also attach
a summary of our business model which is at the heart of our business and also
determines our key performance indicators (KPIs); and
2. In respect of our plan to acquire all the shares of Brilliant Bottles Nigeria Limited, as
a step towards backward integration during the plan period, recommend whether the
acquisition will result in net value added to our present performance. Enclosed
herewith are the company‟s summarised five years financial statements with some
additional information to enable you carry out a financial due diligence on the
company. Your recommendation should also include the range of prices we can offer
to the shareholders of the company.
I hope I can count on you, as usual, to get the report out on time.
Joel Ramsey
CEO, Tostol Drinks Nigeria Limited
137

Exhibit 3
BUSINESS MODEL AND STRATEGIC PLAN
Our vision is “to be a business organisation managed responsibly, sustainably and

with passion for creating value for our shareholders, employees, customers,
consumers and the communities where we do business”.
Our business model is developed along this vision. Our business model therefore, is
to manage our business responsibly, sustainably and delivering superior value to
our shareholders by satisfying our other stakeholders. We believe this will bring
opportunity for superior business growth through our presence in emerging
markets coupled with expanding margins to those achieved in the previous years.
We recognise that creating shared value for shareholders, employees, customers,

consumers and the communities is critical to our long term success. We have
therefore incorporated responsibility and sustainability into all aspects of our
business management, making long term investments that are aimed at building
value over time.
To maintain our consumers in the face of increasing campaign for healthy living,
we have decided to focus on healthy, active lifestyles, while still maintaining our
old range of products, thus significantly broadened our product portfolio by
offering consumers a choice of soft drinks that contains zero sugar and with low
calories. We are also providing more information on our products‟ labels to help
consumers make informed choices between our wide range of product offerings.
Our business model is at the heart of everything we do. It defines the activities we
engage in, the relationships we depend on and the outputs and outcomes we aim
to achieve in order to create value for all our stakeholders in the short, medium and
long term. This is being achieved through constant value creation.
138

VALUE CREATION
We create value for our stakeholders and our business by carefully managing the
use of and return on all capitals or inputs. Also, additional values created are
being shared among the various stakeholders regularly.
VALUE SHARING
By running a profitable, sustainable and responsible business, we are yearly

creating value which is partly retained in the business, making it stronger.
However, the larger part is shared among all our stakeholders as follows:
Shareholders: Through the process of managing all inputs to our business well, we
create value for our shareholders through dividend payments and increase in our
share value.
Suppliers: As we create value, we support businesses throughout our value chain,

and support job creation beyond our business.
Employees: By recognising, developing and rewarding talents of our people, we

secure a skilled and motivated workforce that is remunerated well above the
industry average.
Customers: We strive to produce products‟ efficiently and responsibly thus building

value for our customers‟ businesses.
Consumers: We constantly rejuvenate our products offerings to ensure that our

consumers have a wide range of products to select from while at the same time
making sure they get value for every Naira spent.
Communities: When our business is profitable, sustainable and responsible, the

communities where we operate benefit through job creation, payment of tax to the
governments, useful products and services, and minimisation of environmental
impact. We also consistently invest 3% of our pre–tax profits on programmes to
support communities where our business operates.
All these are aimed at continuous achievement of sustainable growth through

improvement in sales value, market share and profitability.
139

Exhibit 4
SUMMARISED FINANCIAL STATEMENTS 2012 – 2016
Income Statements
Years 2012 2013 2014 2015 2016

N‟m N‟m N‟m N‟m N‟m
Revenue 979.6 1,167.1 1,330.9 1,433.3 1,594.6
Cost of sales (573.7) (665.4) (763.0) (801.0) (839.2)
Gross profit 405.9 501.7 567.9 632.3 755.4
Marketing & distribution expenses (145.3) (188.7) (209.3) (216.9) (259.0)
Administrative expenses (45.5) (53.1) (60.2) (73.4) (76.9)
Finance expenses (3.3) (9.4) (21.5) (47.5) (44.3)
Profit before income tax 211.8 250.5 276.9 294.5 375.2
Income tax expense (17.0) (39.1) (37.9) (22.1) (55.9)
Profit after tax expense 194.8 211.4 239.0 272.4 319.3

Years 2012 2013 2014 2015 2016
Assets:
Property, plant and equipment 550.2 621.6 658.8 675.1 691.5
Current assets:
Inventories 99.0 87.8 98.5 109.6 108.1
Trade receivables 109.8 134.6 178.8 223.3 244.5
Prepayments 2.6 3.0 3.0 4.0 5.3
Cash and cash equivalents 10.7 38.1 66.5 37.0 129.3
Total current assets 222.1 263.5 346.8 373.9 487.2
Total assets 772.3 885.1 1,005.6 1,049.0 1,178.7
Equity
Share capital 4.0 4.0 4.0 4.0 4.0
Retained earnings 227.0 278.4 325.4 389.8 489.1
Total equity 231.0 282.4 329.4 393.8 493.1
Liabilities:
Long term loans 258.7 235.6 264.7 183.9 125.3
Employee benefit 7.2 10.8 18.2 18.3 23.8
30.7 49.6 60.9 52.7 65.6
140

Deferred tax liabilities
Total non – current liabilities 296.6 296.0 343.8 254.9 214.7
Bank overdraft - 49.5 - 12.4 3.1
Current tax liabilities 23.8 23.5 28.0 34.8 50.4
Short term loans 26.6 34.6 9.5 127.3 171.1
Trade and other payables 191.3 195.4 290.7 220.5 240.1
Provisions 3.0 3.7 4.2 5.3 6.2
Total current liabilities 244.7 306.7 332.4 400.3 470.9
Total equity and liabilities 772.3 885.1 1,005.6 1,049.0 1,178.7
141

Exhibit 5

ADDITIONAL INFORMATION ON FINANCIAL STATEMENTS, 2012 -2016
1. Profit before income tax:

Profit before income tax is stated after charging:
2012 2013 2014 2015 2016
Depreciation 29.9 39.4 48.9 58.5 59.358.0
Personnel costs 11.3 13.2 14.5 16.3 18.8
2. Personnel Information:
No of staff 2,168 2,179 2,182 2,245 2,356
Retirements/resignations in the year 20 19 28 32 35
Least paid staff N1.4m N1.6m N1.7m N1.8m N2.0m
3. Social responsibility report:

Expenses on community and
social services during the year N6.0m N8.0m N8.0m N7.5m N7.6m
4. Dividend declared:
During the year (per share) N20.0 N24.0 N26.0 N27.5 N28.0
5. Authorised and issued share capital:
Ordinary share capital of 50 Kobo each 8m 8m 8m 8m 8m
6. Inventories:
Inventories comprise:
Finished goods 10.2 9.4 9.2 8.5 8.6
Raw materials:
Concentrates 30.0 25.2 25.0 32.0 31.0
Sugar 16.0 8.5 14.1 15.5 15.0
Components:
Bottles 40.5 42.3 48.1 50.4 50.5
Crown cocks 2.3 2.4 2.1 3.2 3.0
142

7. Retained earnings is stated after adjusting for dividend paid during the year.
Details of profit after tax and dividend proposed are as follows:
Year Profit after tax Proposed dividend Retained Profit

N‟m N‟m N‟m
2011 160.5 144.0 16.5
2012 194.8 160 34.8
2013 211.4 192.0 19.4
2014 239.0 208.0 31.0
2015 272.4 220.0 52.4
2016 319.3 224.0 95.3
Retained earnings as at December 31, 2011 is N176.2m. Tax rate of 25% is

assumed.
143

Exhibit 6
BRILLIANT BOTTLES NIGERIA LIMITED
SUMMARISED FINANCIAL STATEMENTS 2012 – 2016
Income Statements
Years 2012 2013 2014 2015 2016

Revenue 78.4 82.5 80.6 90.5 101.2
Cost of sales (36.8) (41.2) (39.6) (42.6) (46.2)
Gross profit 41.6 41.3 41.0 47.9 55.0
Marketing & distribution expenses (10.3) (11.5) (12.8) (13.9) (15.2)
Administrative expenses (11.2) (14.8) (15.1) (16.2) (17.0)
Finance expenses (2.0) (3.1) (2.5) (2.1) (1.8)
Income tax expense (3.8) (2.9) (3.6) (5.8) (6.8)
Profit after tax expense 14.3 9.0 7.0 9.9 14.2
Years 2012 2013 2014 2015 2016

Assets:
Current assets:
Inventories 5.0 6.2 6.1 8.9 8.8
Other receivables and prepayment 0.5 0.6 0.9 0.8 0.9
Short term deposit - - 5.0 5.0 12.5
Total assets 25.0 24.9 28.8 31.5 37.5
Equity
Share capital - 50 kobo each 10.0 10.0 10.0 10.0 10.0
Total equity 17.8 18.8 21.1 21.6 25.8
Trade payables 3.2 2.8 3.5 3.6 4.1

Tax liabilities 3.8 2.9 3.6 5.8 6.8
Other payables and accrued 0.2 0.4 0.6 0.5 0.8
expenses
Total equity and liabilities 25.0 24.9 28.8 31.5 37.5
144

Exhibit 7
BRILLIANT BOTTLES NIGERIAL LIMITED
ADDITIONAL INFORMATION ON THE FINANCIAL STATEMENTS: 2012 – 2016
1. Retained earnings:
Retained earnings are stated as follows:
Years 2011 2012 2013 2014 2015 2016
N‟000 N‟000 N‟000 N‟000 N‟000 N‟000
Profit after tax - 14.3 9.0 7.0 9.0 14.2
Dividend paid during the year - 12.1 8.0 4.7 8.5 10.0
Transfer to retained earnings - 2.2 1.0 2.3 0.5 4.2
Retained earnings B/F - 5.6 7.8 8.8 11.1 11.6
Retained earnings C/F 5.6 7.8 8.8 11.1 11.6 15.8
2. Tax expense:
Tax expense as calculated is settled on preceding year basis. The company
has no outstanding tax liability other than the current year tax liability which
is payable the following year. However, the Federal Inland Revenue Service
(FIRS) carried out an audit of the company‟s income tax liabilities from 2011
to 2015 and came up with an additional tax liability of N10.5m. The company
has objected to this tax liability within the stipulated time but the issue has
not been resolved. No provision has been made in the financial statement of
2016 for this liability. It is projected that the final liability will be N8.5m.
3. Personal income tax liability:
The state government carried out tax audit on the company for 2015 and 2016
personal income tax liabilities. Additional liabilities of N1.45m and N1.02m
have been raised. The company has objected to these liabilities but
reconciliation meeting has not been held with the tax authority. Based on the
company‟s tax consultant‟s assessment, the final liabilities are expected to be
N0.8m and
N0.65m for the two years respectively.
4. Contingent liability:
Apart from the specific potential liabilities mentioned, the company has no
other contingent liability.
145

Exhibit 8
ADDITIONAL INFORMATION ON THE PROPOSED ACQUISITION OF

BRILLIANT BOTTLES NIGERIAL LIMITED
1. Purchase consideration:
The acquisition will be done through payment of cash. TDNL is not under any
obligation whatsoever to absorb any of the existing directors of BBNL.
2. Valuations:
From the preliminary discussions with the board of BBNL, the company will
accept a valuation of the average of the net assets per share and 5 years profit
after tax with a growth rate of 10 percent per annum. The average profit for
the last five years is to be taken as the annual maintainable profit.
3. Fair value of BBNL:

The fair value of BBNL‟s property, plant and equipment is agreed to be N15m
while all other assets and liabilities are considered to worth their book values.
4. Benefits of the acquisition to TDNL:

The following benefits are projected to be accruable from the proposed
acquisition:
a. It is estimated that the current BBNL‟s plant and machinery will meet
TDNL‟s bottle requirements for the next five years. However, TDNL will
make additional investment in plant and machinery of N15m to acquire
a recycling plant to recycle used bottles in line with TDNL‟s business
model of environmental responsible business practice; and
b. It is projected that the acquisition will reduce the cost of bottles of TDNL
by 25 per cent. The cost of bottles in TDNL‟s cost of sales is currently 20
per cent.
146

5. Appraisal of the investment in BBNL:
Although the proposed acquisition of BBNL is part of the current strategic plan
of TDNL, the directors of TDNL want assurance that this acquisition will result
in increase in the company‟s shareholders‟ value. The board has therefore
agreed to evaluate this acquisition with a cost of capital of 15% as calculated
by TDNL‟s Chief Financial Officer (CFO). The CFO has also provided the
following additional information:
a. The savings from the cost of bottles should be based on the average cost
of bottles for the last five years with a growth rate of 12 per cent per
annum in the next five years which is the estimated life of BBNL‟s
production plant; and
b. The residual value of BBNL‟s production plant is estimated to be N1.2m.
147

ICAN CASE STUDY 2017
First Marking
DATE CADIDATE NO.
DATE MARKER NUMBER
Req 1 Req 2 Overall TOTAL

SA
CA
BC
NC
V
Total 8 8 4 20
SUPERVISOR CHECKER
SIGNATURE SIGNATURE
Change made?
148

REQUIREMENT 1 - TDNL's financial analysis and shareholders' value added.
USES DATA AND INFORMATION APPROPRIATELY IDENTIFIES ISSUES AND OPTIONS
Identifies that industry comparative data is not

 Uses information provided in Exhibit 1  provided.
 Uses information provided in Exhibit 2  Identifies that TDNL's market share is not provided.
Identifies that the market size of the soft drinks

 Uses information in financial statements .  industry is not provided
.
Uses information provided in Exhibit 5 -
additional information
Identifies that TDNL's position vis -a- vis its competitors
 in the market is not provided.
Uses information in exhibit 3 - information on
 TDNL's business model
Identifies that TDNL's competitive profile is not
 provided.
V NC BC CA SA V NC BC CA SA
USES PROFESSIONAL TOOLS AND KNOWLEDGE APPLIES PROFESSIONAL SCEPTICISM AND ETHICS
Recognises that we are not told whether the

summarised financial statements is from the
 Calculates profitability ratios  audited accounts of TDNL.
 Recognises that we cannot determine whether the rate

of growth in TDNL's operating performance is due to
general increase in the market size or due to TDNL's
 Calculates activity ratios operational efficiency.
Recognises that we do not have the industry average

Prepares trend analysis to determine growth in  figure to determine whether TDNL's performance is
 performance of TDNL above the industry average or below it.
Prepares common size analysis to show trends Recognises that we do not have the indication on the
 in the components of the financial statements.  movement in TDNL's share value.
-
USES ANALYTICAL SKILLS (material points)

written report EVALUATIVE SKILLS AND JUDGEMENT
Determines the rate of growth in TDNL's operating Recognises that TDNL's performance is increasing
 performance.  yearly.
Determines the key performance indicators

relevant to the various aspect of TDNL's Recognises that TDNL has followed its business model
 business model  by taking care of all the stakeholders.
Understand the concept of economic value Recognises that TDNL has a high dividend pay out
 added (EVA).  ratio.
Recognises that as a result of the high dividend payout

Determines the level of economic value added ratio, the company has to result to long term
 to TDNL's shareholders from 2012 to 2016.  borrowing to finance its growth.
149

CONCLUSIONS
(Draws distinct conclusions under a heading)
Concludes on the level of growth of shareholders'

value
Concludes on the need to manage receivables

very well to avoid bad debts and excessive cost of
funds.
TDNL should try to pay its supplier as at when

due so that they will not lose confidence in the
company.
 Concludes on shareholders' value analysis.
V NC BC CA SA
RECOMMENDATIONS (commercial / relevant)
 TDNL should continuously seek improvement in

operatioanal performance.
TDNL should find out what other firms in the

 industry
are doing so as to know how to respond to
competition.
 TDNL should continue with its business model.

TDNL should strive to reduce cost of sale as much as
possible.
If possible, TDNL should reduce its dividend payout

ratio to provide funds for further expansion without
 borrowing.
V NC BC CA SA
SA
CA
BC
150

NC
V
151

REQUIREMENT 2 -Financial Due Diligence of BBNL
USES DATA AND INFORMATION

APPROPRIATELY IDENTIFIES ISSUES AND OPTIONS
Need to consider the state of BBNL's

 Uses BBNL's financial statements - Exhibit 6  manufacturing plants.
- Income Statement
- Statement of financial position
Need to consider how to integrate BBNL's staff into

 Uses additional information on BBNL's financial statement-  the culture of TDNL.
Exhibit 7.
 Uses information in email provided in Exhibit 1  Need to consider trade unions issues.
Need to consider how to raise fund required to pay

 Uses information in email provided in Exhibit 2  off the shareholders of BBNL.
Uses information provided in additional points on the

 proposed acquisition - Exhibit 8  Need to consider non-financial factors
V NC BC CA SA V
NC BC CA SA
USES PROFESSIONAL TOOLS AND KNOWLEDGE (written APPLYING PROFESSIONAL SCEPTICISM AND
into report) ETHICS
Performs appropriate calculation to determine BBNL's Considers whether the summarised financial
 net assets  statement is from the audited accounts of BBNL
Performs appropriate calculation to determine the value Considers the correctness of the estimated tax
 of BBNL based on five years maintainable earnings.  payable on the two tax audits.
Considers the maintenance culture of BBNL on its

 Prepares expected cash flow from the acquisition by TDNL.  manufacturing plant.
Recognises the treatment of potential liabilities of the Ensures that other analysis & evaluation are
 tax audits.  considered
Calculates the savings expected from the cost of bottles on Considers whether all the shareholders of BBNL
 TDNL's operations.  will agree to the acquisition.
Considers the correctness of the cost of capital

 to be used for the appraisal and other estimates
-
USESG ANALYTICAL SKILLS (material points) EVALUATIVE SKILLS AND JUDGEMENT

(uses analytical headings)
Considers the costs required to finalise the
 Calculates appropriate ratios.  acquisition.
 Prepares trends analysis of BBNL's financials.  Considers use of other appraisal methods
Questions use of cost of capital - could be higher?

 Prepares common size analysis of BBNL's financials.  lower? how derived?
Calculates the net present value of cash flows to determine Considers likely savings in BBNL's operating costs
 whether the acquisition is worthwhile.  because of the acquisition.
Considers the response of competitors to this

 acquisition.
152

CONCLUSIONS
(Draws distinct conclusions under a heading)
 Concludes on net assets value of BBNL.
Concludes range of prices to be offered to the

 shareholders of BBNL.
 Concludes on other financial factors not considered
 Concludes on other non-financial factors
Concludes on whether the acquisition will add value to

 the shareholders of TDNL.
V NC BC CA SA
RECOMMENDATIONS (commercial / relevant)
Recommends the range of prices to be offered for BBNs

 Shares.
TDNL should consider the accuracy of all the estimates

 used.
Determines and recommends whether to go on with the

 acquisition based on the appraisal.
TDNL should determine the cost involved in the

acquisition so as to consider it as part of the cash flow in
 the appraisal pricess.
The acquisition of BBNL will increase the shareholders'

 valu so TDNL so TDNL should proceeed.
V NC BC CA SA
SA
CA
BC
NC
V
Total 8
153

154

Appendices Main Report
Appendices R1: Content and style Report: Structure
 Shows TDNL financial ratios.  Sufficient appropriate headings
Appropriate use of paragraphs /

 Shows the TDNL's trend analysis  sentences
Shows TDNL's common size financial

 statements.  Legible
Shows the economic value added for

 each year.  Correctly numbered pages
Appendices R2: Content and Report: Style and language
Shows the valuation of BBNL based on net

 assets.  Relevant disclaimer (external report)
Shows the valuation of BBNL based

 on 5 years maintainable earnings.  Suitable language for the board
Shows the range of prices to be

 offered to BBNL's shareholders.  Tactful / ethical comments
Shows the net present value

 calculations.  Acceptable spelling and punctuation
 Shows the financial ratios of BBNL.
CC
SC
IC
ID
NA
Total
155

156

Tostol Drinks Nigeria Limited
Trend Analysis - 2012 - 2016
Income Statement
YEARS 2012 2013 CHANGE 2014 CHANGE 2015 CHANGE 2016 CHANGE
N'm N'm N'm % N'm N'm % N'm N'm % N'm N'm %
-
Revenue 979.6 1,167.1 - 187.5 19.1 1330.9 163.8 14.0 1433.3 102.4 7.7 1594.6 161.3 11.3
-
Cost of sales - 573.7 - 665.4 91.7 16.0 -763 (97.6) 14.7 -801.0 -38.0 5.0 -839.2 -38.2 4.8
-
Gross Profit 405.9 501.7 - 95.8 23.6 567.9 66.2 13.2 632.3 64.4 11.3 755.4 123.1 19.5
Marketing & Distribution expenses - 145.3 - 188.7 43.4 - 29.9 -209.3 (20.6) 10.9 -216.9 -7.6 3.6 -259 -42.1 19.4
Administrative expenses - 45.5 - 53.1 7.6 - 16.7 -60.2 (7.1) 13.4 -73.4 -13.2 21.9 -76.9 -42.1 57.4
Finance expenses - 3.3 - 9.4 6.1 - 184.8 -21.5 (12.1) 128.7 -47.5 -26.0 120.9 -44.3 -84.2 177.3
-
Profit before income tax 211.8 250.5 - 38.7 18.3 276.9 26.4 10.5 294.5 17.6 6.4 375.2 -126.3 -42.9
Income tax expenses - 17.0 - 39.1 22.1 - 130.0 -37.9 1.2 -3.1 -22.1 15.8 -41.7 -55.9 -33.8 152.9
Profit after income tax expenses 194.8 211.4 - 16.6 - 8.5 239.0 27.6 13.1 272.4 33.4 14.0 319.3 46.9 17.2
Statement of Financil Position

2012 2013 CHANGE 2014 CHANGE 2015 CHANGE 2016 CHANGE
N'm N'm N'm % N'm N'm % N'm N'm % N'm N'm %
Assets:
Property, plant and equipment 550.2 622 71 13.0 658.8 37 6.0 675.1 16.3 2.5 691.5 16.4 2.4
Current assets:
Inventories 99 87.8 - 11 (11.3) 98.5 11 12.2 109.6 11.1 11.3 108.1 -1.5 -1.4
Trade receivables 109.8 134.6 25 22.6 178.8 44 32.8 223.3 44.5 24.9 244.5 21.2 9.5
Prepayments 2.6 3 0 15.4 3 - - 4 1 33.3 5.3 1.3 32.5
Cash and cash equivalents 10.7 38.1 27 256.1 66.5 28 74.5 37 -29.5 -44.4 129.3 92.3 249.5
Total current assets 222.1 263.5 41 18.6 346.8 83 31.6 373.9 27.1 7.8 487.2 113.3 30.3
Total assets 772.3 885.1 113 14.6 1005.6 121 13.6 1049 43.4 4.3 1178.7 129.7 12.4
Equity:
Share capital 4 4 0 - 4 0 - 4 0 - 4 0 -
Retained earnings 227 278.4 51.4 22.6 325.4 47 16.9 389.8 64.4 19.8 489.1 99.3 25.5

Total equity 231 282.4 51.4 22.3 329.4 47 16.6 393.8 64.4 19.6 493.1 99.3 25.2
0
Liabilities: 0
Long term loans 258.7 235.6 -23.1 - 8.9 264.7 29.1 12.4 183.9 -80.8 - 30.5 125.3 -58.6 - 31.9
Employee benefir 7.2 10.8 3.6 50.0 18.2 7.4 68.5 18.3 0.1 0.5 23.8 5.5 30.1
Deferred tax liabilities 30.7 49.6 18.9 61.6 60.9 11.3 22.8 52.7 -8.2 - 13.5 65.6 12.9 24.5
- -
Total non - current liabilities 296.6 296 -0.6 0.2 343.8 47.8 16.1 254.9 -88.9 - 25.9 214.7 -40.2 15.8
Bank overdraft 0 49.5 49.5 0 -49.5 - 100.0 12.4 12.4 3.1 -9.3 -75.0
Short term loans 23.8 23.5 -0.3 - 1.3 28 4.5 19.1 34.8 6.8 24.3 50.4 15.6 44.8
-
Trade and other payables 26.6 34.6 8 30.1 9.5 -25.1 72.5 127.3 117.8 1,240.0 171.1 43.8 34.4
Provisions 191.3 195.4 4.1 2.1 290.7 95.3 48.8 220.5 -70.2 - 24.1 240.1 19.6 8.9
Total current liabilities 3 3.7 0.7 23.3 4.2 0.5 13.5 5.3 1.1 26.2 6.2 0.9 17.0
Total equity and liabilities 244.7 306.7 62 25.3 332.4 25.7 8.4 400.3 67.9 20.4 470.9 70.6 17.6
772.3 885.1 112.8 14.6 1005.6 120.5 13.6 1049 43.4 4.3 1178.7 129.7 12.4
Tostol drinks Nigeria Limited

Common Size Analysis 2012 – 2016
Income Statement
2012 2013 2014 2015 2016
Revenue 100.0 100.0 100.0 100.0 100.0
Cost of sales - 58.6 - 57.0 - 57.3 - 55.9 - 52.6
Gross Profit 41.4 43.0 42.7 44.1 47.4
- - - - -
Marketing & Distribution expenses - 14.8 - 16.2 - 15.7 - 15.1 - 16.2
Administrative expenses - 4.6 - 4.5 - 4.5 - 5.1 - 4.8
Finance expenses - 0.3 - 0.8 - 1.6 - 3.3 - 2.8
Income tax expenses - 1.7 - 3.4 - 2.8 - 1.5 - 3.5
Profit after income tax expenses 19.9 18.1 18.0 19.0 20.0

2012 2013 2014 2015 2016
Assets:
Current assets:
Inventories 12.8 9.9 9.8 10.4 9.2
158

Prepayments 0.3 0.3 0.3 0.4 0.4
Total assets 100.0 100.0 100.0 100.0 100.0
Equity:
Share capital 0.5 0.5 0.4 0.4 0.3
Total equity 29.9 31.9 32.8 37.5 41.8
Liabilities:
Long term loans 33.5 26.6 26.3 17.5 10.6
Employee benefir 0.9 1.2 1.8 1.7 2.0
Deferred tax liabilities 4.0 5.6 6.1 5.0 5.6
Total non - current liabilities 38.4 33.4 34.2 24.3 18.2
Bank overdraft - 5.6 - 1.2 0.3

Short term loans 3.1 2.7 2.8 3.3 4.3
Provisions 24.8 22.1 28.9 21.0 20.4
100.0 100.0 100.0 100.0 100.0
159

RATIOS ANALYSIS 2012 2013 2014 2015 2016
PROFITABILITY
Gross profit margin 405.9/979.6% 501.7/1167.1% 567.9/1330.8% 632.3/1433.3% 755.4/1594.6%
41.44% 43.00% 42.70% 44.10% 47.40%
Net profit margin 211.8/979.1% 250.5/1167.1% 276.9/1330.8% 294.5/1433.3% 375.2/1594.6%
21.60% 21.50% 20.80% 20.50% 23.53%
Returns on total assets 211.8/772.3% 250.5/885.1% 276.9/1005.6% 294.5/1049.0% 375.2/1178.7%
27.40% 28.30% 27.50% 28.00% 31.80%
Returns on capital employed (ROCE) 215.1/527.6% 259.9/578.4% 298.4/673.2% 342.0/648.7% 419.5/707.8%
40.80% 44.90% 44.40% 52.70% 59.30%
Returns on equity 194.8/231.0% 211.4/282.4% 239.0/329.4% 272.4/393.8% 319.3/493.1%
84.30% 74.90% 72.60% 69.20% 64.80%
LIQUIDITY
Current ratio 222.1/244.7 263.5/306.7 346.8/332.4 373.9/400.3 487.2/470.9
0.9:1.0 0.9:1.0 1.0:1.0 0.9:1.0 1.0:1.0
Quick ratio 123.1/244.7 175.7/306.7 248.3/332.4 263.3/400.3 129.3/470.9
0.5:1.0 0.6:1.0 0.7:1.0 0.7:1.0 0.8:1.0
cash ratio 10.7/244.7 38.1/306.7 55.5/332.4 37.0/400.3 129.3/470.9
00:01.0 0.1:1.0 0.2:1.0 0.1:1.0 0.3:1.0
ACTIVITY
Net assets turnover 979.6/527.6 1167.1/578.4 1330.9/673.2 1433.3/648.7 1594.6/707.8
1.9 2 2 2.2 2.3
Fixed assets turnover 979.6/550.2 1167.1/621.6 1330.9/658.8 1433.3/675.1 1594.6/691.5
1.8 1.9 2 2.1 2.3
Total assets turnover 979.6/772.3 1167.1/885.1 1330.9/1005.6 1433.3/1049.0 1594.6/1178.7
1.3 1.3 1.3 1.4 1.4
Inventory turnover 573.7/99 665.4/93.4 763.0/93.2 801.0/104.1 839.2/108.9
5.8 7.1 8.2 7.7 7.7
Average days inventory 365/5.8 365/7.1 365/8.2 365/7/7 365/7.7
63days 51days 43days 47days 47days
Receivable turnover 979.6/109.8 1167.1/122.2 1330.9/156.7 1433.3/201.1 1594.6/233.9
8.9 9.6 8.5 7.1 6.8
Average days in receivable 365/8.9 365/9.6 365/8.5 365/7.1 365/6.8
Payable turnover
573.7/191.3 665.4/193.4 763.0/243.1 801.0/255.6 839.2/230.3
3 3.4 3.1 3.1 3.6
Average days in payable 365/3.0 365/3.4 365/3.1 365/3.1 365/3.6
SOLVENCY
Debts to equity 296.6/231.0 296.0/282.4 343.8/329.4 254.9/393.8 214.7/493.1
1.28 1.05 1.04 0.65 0.44
Debts/equity+debts 296.6/527.6 296.0/578.4 343.8/673.2 254.9/648.7 214.7/707.8
0.56 0.51 0.51 0.39 0.3
Interest cover 215.1/3.3 259.9/9.4 298.4/21.5 342.0/47.5 419.5/44.3

65.2 27.6 13.9 7.2 9.5
Personnel ratios
Staff turnover 20/2168 19/2179 28/2182 32/2245 35/2356
0.90% 0.90% 1.30% 1.40% 1.50%
160

Average profit after tax per staff 194.8/2168 211.4/2179 239.0/2182 272.4/2245 319.3/2356
N0.09m N0.10m N0.11m N0.12m N0.14m
average salary per staff N1.4m N1.6 N1.7m N1.8m N2.0m
Social responsibility report( % of pre tax profit) 6/211.8% 8/250.5% 8/276.9% 7.5/294.5% 7.6/375.2%
2.83% 3.19% 2.90% 2.55% 2.03%
2012 2013 2014 2015 2016

CALCULATION OF ECONOMIC VALUE ADDED N'm N'm N'm N'm N'm
Calculation of NOPAT
Net profit after tax 194.8 211.4 239 272.4 319.3
Add: Interest expenses (net of taxation) 2.24 6.39 14.62 32.3 30.12
197.04 217.79 253.62 304.7 349.42
CAPITAL EMPLOYED 527.6 578.4 673.2 648.7 707.8
Cost of capital at 15% 79.1 86.8 101 97.31 106.17
Adjusted Net profit after tax 197.04 217.79 253.62 304.7 349.42
Less: cost of capital 79.1 79.1 86.8 101 97.31
Economic value added 117.94 138.69 166.82 203.7 252.11
NOTE:
Usually, the opening capital is used to calculate cost of capital, but because we were not given the opening
capital for 2012, we have used the closing capital for 2012 caculation while for other years we used opening capital.
161

APPENDICE TO REQUIREMENT 2
Brilliant Bottles Nigeria Limited
Trend Analysis - 2012 - 2016
Income Statetement
YEARS 2012 2013 CHANGE 2014 CHANGE 2015 CHANGE
N'm N'm N'm % N'm N'm % N'm N'm % %
Revenue 78.4 82.5 4.1 5.2 80.6 - 1.9 - 2.3 90.5 9.9 12.3 11.8
- - -
Cost of sales 36.8 - 41.2 4.4 12.0 39.6 1.6 - 3.9 - 40.6 - 1.0 2.5 13.8
- -
Gross Profit 41.6 41.3 0.3 0.7 41.0 - 0.3 - 0.7 47.9 6.9 16.8 14.8
- - -
Marketing & Distribution expenses 10.3 - 11.5 1.2 11.7 12.8 - 1.3 11.3 - 13.9 - 1.1 8.6 9.4
- - -
Administrative expenses 11.2 - 14.8 3.6 32.1 15.1 - 0.3 2.0 - 16.2 - 1.1 7.3 4.9
- - -
Finance expenses 2.0 - 3.1 1.1 55.0 2.5 0.6 - 19.4 - 2.1 0.4 - 16.0 - 14.3
- -
Profit before income tax 18.1 11.9 6.2 34.3 10.6 - 1.3 - 10.9 15.7 5.1 48.1 33.8
- - -
Income tax expenses 3.8 - 2.9 0.9 23.7 3.6 - 0.7 24.1 - 5.8 - 2.2 61.1 17.2
- -
Profit after income tax expenses 14.3 9.0 5.3 37.1 7.0 - 2.0 - 22.2 9.9 2.9 41.4 43.4
Statement of Financil Position

2012 2013 CHANGE 2014 CHANGE 2015 CHANGE
N'm N'm N'm % N'm N'm % N'm N'm % %
Assets:
- -
Property, plant and equipment 15.0 13.5 1.5 10.0 12.0 - 1.5 - 11.1 10.5 - 1.5 - 12.5 - 14.3
Current assets:
Inventories 5.0 6.2 1.2 24.0 6.1 - 0.1 - 1.6 8.9 2.8 45.9 - 1.1
- -
Trade receivables 3.0 2.8 0.2 6.7 3.2 0.4 14.3 5.1 1.9 59.4 - 9.8
Short term deposit - - - 5.0 5.0 5.0 - -

Other receivables and
prepayments 0.5 0.6 0.1 20.0 0.9 0.3 50.0 0.8 - 0.1 - 11.1 12.5
Cash and cash equivalents 1.5 1.8 0.3 20.0 1.6 - 0.2 - 11.1 1.2 - 0.4 - 25.0 41.7
Total current assets 10.0 11.4 1.4 14.0 16.8 5.4 47.4 21.0 4.2 25.0 35.7
- -
Total assets 25.0 24.9 0.1 0.4 28.8 3.9 15.7 31.5 2.7 9.4 19.0
162

Equity:
Share capital 10.0 10.0 - - 10.0 - - 10.0 - - -
Retained earnings 7.8 8.8 1.0 12.8 11.1 2.3 26.1 11.6 0.5 4.5 36.2
Total equity 17.8 18.8 1.0 5.6 21.1 2.3 12.2 21.6 0.5 2.4 19.4
Liabilities:
- -
Trade and other payables 3.2 2.8 0.4 12.5 3.5 0.7 25.0 3.6 0.1 2.9 13.9
- -
Tax liabilities 3.8 2.9 0.9 23.7 3.6 0.7 24.1 5.8 2.2 61.1
Other payables and acrued
expenses 0.2 0.4 0.2 100.0 0.6 0.2 50.0 0.5 - 0.1 - 16.7 60.0
- -
Total current liabilities 7.2 6.1 1.1 15.3 7.7 1.6 26.2 9.9 2.2 28.6 18.2
- -
Total equity and liabilities 25.0 24.9 0.1 0.4 28.8 3.9 15.7 31.5 2.7 9.4 19.0
163

Common size Analysis - 2012 – 2016
Income Statement
YEARS 2012 2013 2014 2015 2016
N'm N'm
Revenue 100.0 100.0 100.0 100.0 100.0
Cost of sales - 46.9 (49.9) - 49.1 - 44.9 (45.7)
Gross Profit 53.1 50.1 50.9 52.9 54.3
- - - -
Marketing & Distribution expenses - 13.1 (13.9) - 15.9 - 15.4 (15.0)
Administrative expenses - 14.3 (17.9) - 18.7 - 17.9 (16.8)
Finance expenses - 2.6 (3.8) - 3.1 - 2.3 (1.8)
Income tax expenses - 4.8 (3.5) - 4.5 - 6.4 (6.7)
Profit after income tax expenses 18.2 10.9 8.7 10.9 14.0

2012 2013 2014 2015 2016
Assets:
Current assets:
Inventories 20.0 24.9 21.2 28.3 23.5
Short term deposit - - 17.4 15.9 33.3
Other receivables and prepayments 2.0 2.4 3.1 2.5 2.4
Total assets 100.0 100.0 100.0 100.0 100.0
Equity:
Share capital 40.0 40.2 34.7 31.7 26.7
Total equity 71.2 75.5 73.3 68.6 68.8
-
Liabilities: -
Tax liabilities 15.2 11.6 12.5 18.4 18.1
Other payables and accrued expenses 0.8 1.6 2.1 1.6 2.1
164

2012 2013 2014 2015 2016
RATIOS ANALYSIS
PROFITABILITY
Gross profit margin 41.6/78.4% 41.3/82.5% 41.0/80.6% 47.9/90.5% 55./101.2%
53.10% 50.10% 50.90% 52.90% 54.30%
Net profit margin 18.1/78.4 11.9/82.5 10.6/80.6 15.7/90.5 21./101.2%
23.10% 14.40% 13.20% 17.20% 20.80%
Returns on total assets 18.1/25% 11.9/24.9% 10.6/28.8% 15.7/31.5% 21.0/37.5
72.40% 47.80% 36.80% 49.80% 56.00%
Returns on capital employed (ROCE) 20.1/17.8% 15/18.8% 13.1/21.1% 17.8/21.6% 22.8/25.8%
112.90% 79.80% 62.10% 82.40% 88.40%
Returns on equity 14.3/17.8% 9.0/18.8% 7.0/21.1% 9.9/21.6% 14.2/25.8%
80.30% 47.90% 33.25% 45.80% 55.00%
LIQUIDITY
Current ratio 10/7.2 11.4/6.1 16.8/7.7 21.0/9.9 28.5/11.7
1.4:1 1.9:1 2.2:1 2.1:1 2.4:1
Quick ratio 5.0/7.0 5.2/6.1 10.7/7.7 12.1/9.9 19.7/11.7
0.7:1.0 0.9:1.0 1.4:1.0 1.2:1.0 1.7:1.0
cash ratio 1.5/7.2 1.8/6.1 6.6/7.7 6.2/9.9 14.2/11.7
0.2: 1 0.3:1.0 0.9:1.0 0.6:1.0 1.2:1.0
ACTIVITY
Net assets turnover 78.4/17.8 82.5/18.8 80.6/21,1 90.5/21.6 101.2/25.8
4.4 4.4 3.8 4.2 3.9
Fixed assets turnover 78.4/15 82.5/13.5 80.6/12 90.5/10.5 101.2/9.0

5.2 6.1 6.7 8.6 11.2
Total assets turnover 78.4/25.0 82.5/24.9 80.5/28.8 90.5/31.5 101.2/37.5
3.1 3.3 2.8 2.9 2.7
Inventory turnover 36.8/5 41.2/5.6 39.6/6.1 42.6/7.5 46.2/8.8
7.4 7.4 6.5 5.7 5.3
Average days inventory 365/7.4 365/7.4 365/6.5 365/5.7 365/5.3
Receivable turnover 78.0/3.0 82.5/2.9 80.6/3.0 90.5/3.6 101.2/4.8
26 27.4 28.9 25.1 21.1
Average days in receivable 365/26 365/27.4 365/28.9 365/25.1 365/21.1
Payable turnover 36.8/3.2 41.2/3.0 39.6/3.1 42.6/3.6 46.2/3.8
11.3 13.3 12.8 11.8 12.2
Average days in payable 365/11.3 365/13.3 365/12.8 365/11.8 365/12.2
SOLVENCY
Liabilities/total assets 7.2/25 6.1/24.9 7.7/28.8 9.9/31.5 11.7/37.5
0.3 0.2 0.3 0.3 0.3
165

BBNL VALUATION REPORT
1 Average net assets per share: Nm
Total assets at fair value N(15+ 28.5) 43.50
Less liabilities 11.70
Potential tax liabilities:
CIT 8.50
PIT 1.45 21.65
21.85
No of shares in issue 20,000,000
Net assets per share 21,850,000/20,000,000
N1.09
2 Five years average profit

Average profit: Nm
2012 14.3
2013 9
2014 7
2015 9.9
2016 14.2
54.4 54.4/5 N10.88m
annual maintainable profit: Nm
year 1 10.88
year 2= 10.88x 1.1 11.968
year 3= 11.968 x 1.1 13.165
year 4 = 13.165 x 1.1 14.481
year 5= 14481 x 1.1 15.929
66.423
Less contingent liabilities: 9.950
56.473
No of shares in issue 20,000,000
Price per share 56.473/20.0
N2.82
TDNL should offer between N1.09 t0 N2.82 per share.
APPRAISAL OF INVESTMENT IN BBNL

Purchase consideration N21.85m or N56.473m
New plant N15.0m
Cash inflow for five years: Year Cost of salesCost of bottles Savings
20% 25%
Nm Nm Nm
2012 573.7 114.74 28.685
2013 665.4 133.08 33.27
166

2014 763 152.6 38.15
2015 801 160.2 40.05
2016 839.2 167.84 41.96
Total savings 182.115
Average savings 182.115/5 N36.423m
Annual growth rate: N36.423m

Year 0
Year 1 36.423 x 1.12 N40.794
Year 2 40.794 x 1.12 N45.689
Year 3 45.689 x 1,12 N51.172
Year 4 51.172 x 1.12 N57.312
Year 5 57.312 x 1.12 N64.19
Year cash flow DCF NPV

Nm Nm
Purchase of BBNL 0 -21.85 1 -21.85
Purchase of new plant 0 -15 1 -15
Savings on cost of bottles 1 40.794 0.8696 35.474
Residual value of plant 5 1.2 0.4972 0.597
132.098
If the purchase price of BBNL is N2.82 per share, then the NPV will be:
132.098 - (56.473 - 21.850) N97.475m
167

168

EXAMINER‟S REPORT
There are two requirements the candidates are expected to address in their report
on the case. The requirements are:
(a) Evaluation of Tostol Drinks Nigeria Limited‟s operating performance, taking

into consideration the company‟s business model and economic value added
to its shareholders; and
(b) Financial due diligence on Brilliant Bottles Nigeria Limited to determine

whether it is worthwhile to acquire it or not. Candidates are expected to
calculate net present value to determine post-acquisition additional value
that will be added to Tostol Drinks Nigeria Limited.
To be able to write a good report and perform very well in the paper, candidates
are expected to prepare the following appendices:
(a) Relevant financial ratios for Tostol Drinks Nigeria Limited, including trend
analysis, taking into consideration the company‟s business model;
(b) Calculation of economic value added for Tostol Drinks Nigeria Limited, from
2012 to 2016;
(c) Relevant financial ratios for Brilliant Bottles Nigeria Limited, including trend
analysis for 2012 to 2016;
(d) Valuation of Brilliant Bottles Nigeria Limited based on net assets basis and
average maintainable earnings; and
(e) Net present value calculation to show the effect of the acquisition on the
performance of Tostol Drinks Nigeria Limited.
Candidates‟ performance was poor as only few candidates scored 50% or above.
The candidates pitfalls are:
(a) Lack of proper understanding of the requirements of the case;
(b) Inability to correctly calculate economic value added of Tostol Drinks Nigeria
Limited;
(c) Inability to calculate correctly the appropriate performance ratios for Tostol
Drinks Nigeria Limited based on its business model;
(d) Inability to carry out correct valuation of Brilliant Bottles Nigeria Limited
based on the two indicated valuation models;
174

(e) Inability to calculate appropriate ratios correctly;
(f) Inability to understand how to generate figures required to calculate the net
present value from the financial data provided; and
(g) Inability to write a good report with appropriate headings and subheadings.
(h) Poor communication skill of the candidates.
Candidates are advised to go through the previous examinations‟ pathfinders

and appraise themselves with the examiner‟s comments so as to properly
understand how to approach Case Study examination. Also, candidates
should come to terms with the fact that all the knowledge and skills they
have gained in the subjects of previous examinations would be needed while
dealing with Case Study examination.
175

PATHFINDER
MAY 2018 DIET
Question Papers
Suggested Solutions
Plus
Marking Guides



QUESTION 1
Plateau Plc. (PT) is a Nigerian company that manufactures and sells innovative
products. Following favourable market research that cost N4,000,000, PT has
developed a new product. It plans to set up a production facility in Kano, although
its board had contemplated setting up the facility in an overseas country. The
project will have a life of four years.
The selling price of the new product will be N5,900 per unit and sales in the first
year to December 31, 2019 are expected to be 120,000 units, increasing by 5% p.a.
thereafter. Relevant direct labour and material costs are expected to be N3,400 per
unit and incremental fixed production costs are expected to be N60million p.a. The
selling price and costs are stated in December 31, 2018 prices and are expected to
increase at the rate of 3% p.a. Research and development costs to December 31, will
amount to N25 million.
Investment in working capital will be N30million on December 31, 2018 and this
will increase in line with sales volumes and inflation. Working capital will be fully
recoverable on December 31, 2022.
The company will need to rent a factory during the life of the project. Annual rent
of N20million will be payable in advance on December 31 each year and will not
increase over the life of the project.
Plant and machinery will cost N1billion on December 31, 2018. The plant and
machinery is expected to have a resale value of N300million (at December 31, 2022
prices) at the end of the project. The plant and machinery will attract 20%
(reducing balance) capital allowances in the year of expenditure and in every
subsequent year of ownership by the company, except in the final year when there
will be a balancing allowance or charge.
68

Assume a corporate tax rate of 20% p.a. in the foreseeable future and that tax flows
arise in the same year as the cash flows which gave rise to them.
The directors are concerned by rumours in the industry of research by a rival
company into a much cheaper alternative product. However, the rumours suggest
that this research will take another year to complete and, if it is successful, it will
take a further year before the alternative product comes on to the market.
An appropriate weighted average cost of capital for the project is 10% p.a.
Required:
a. Calculate, using money cash flows, the NPV of the project on December 31,
2018 and advise the company whether to proceed with the project or not.
(15 Marks)
b. Calculate and interpret the sensitivity of the project to a change in:
(i) The annual rent of the factory (2 Marks)
(ii) The weighted average cost of capital. (4 Marks)
c. If the board of PT decided to set up the manufacturing facility overseas,

advise the board on how political risk could change the value of the project
and how it might limit its effects. (4 Marks)
d. Discuss briefly FOUR real options available to PT in relation to the new

project. 5 Marks)
(Total 30 Marks)
SECTION B: YOU ARE REQUIRED TO ANSWER ANY TWO OUT OF THREE

QUESTION 2
Kazaure Limited has a cash surplus of N20m which the financial manager is keen
to invest in corporate bonds. He has identified two potential investment
opportunities in two different companies which are both rated A by the major credit
rating agencies.
Bond A
The issuer plans to raise N500m 2-year bond with a coupon rate of 10%. The bond is
redeemable at a premium of 8% to nominal value.
69

Bond B
The issuer plans to raise an N800m 3-year bond with a coupon rate of 12% and
redeemable at par.
The annual spot yield curve for government bonds is:

1-Year 9.50%
2-Year 10.40%
3-Year 10.50%
Extract from a major credit rating agency‟s website:

Table of spreads (in basis points)
Rating 1 -Year 2 -Year 3- Year
AAA 6 16 28
AA 15 25 40
A 20 30 50
Required:
a. For a nominal value of N1,000, calculate the theoretical issue prices of the
two bonds and indicate how many of each of the bonds Kazaure Limited can
buy assuming it invests in only one of them. (5 Marks)
Note: Calculate issue prices to the nearest N.
b. Irrespective of your answer in (a), assume Bond A is issued at ₦1,054 and

Bond B is issued at N1,026, calculate the yield to maturity of each bond at
the time of issue. (5 Marks)
c. Calculate the duration of each bond. What does duration measure?
(6 Marks)
d. If you expect interest rates to increase in the market, which of the two bonds,
A or B, would you like to buy and why? (4 Marks)
(No calculation is required) (Total 20 Marks)
QUESTION 3
Kehinde is a wholesaler who buys and sells a wide range of products, one of which
is electrical component TK. Kehinde sells 24,000 units of TK each year at a unit
price of N2,000. Sales of TK normally follow an even pattern throughout the year
but to protect the business against possible stock-out, Kehinde keeps a minimum
inventory of 1,000 units. Further supplies of TK are ordered whenever the inventory
falls to this minimum level and the time lag between ordering and delivery is small
and can be ignored.
70

At present, Kehinde buys all his supplies of TK from Ajoke Limited and usually
purchases them in batches of 5,000 units. His most recent invoice from Ajoke
Limited was as follows:
N‟000
Basic price: 5,000 units of TK at N1,500 per unit 7,500
Delivery charges:
Transport at N50 per unit 250
Fixed shipment charge per order 100
7,850
In addition, Kehinde estimates that each order he places costs him N50,000,
comprising administrative costs and the cost of sample checks. This cost does not
vary with the size of the order.
Kehinde stores TK in a warehouse which he rents on a long lease for N500 per
square metre per annum. Warehouse space available exceeds current requirements
and, as the lease cannot be cancelled, spare capacity is sublet on annual contracts
at N400 per square metre per annum. Each unit of TK in inventory requires 2
square metres of space.
Kehinde estimates that other holding costs amount to N1,000 per TK per annum.
Kehinde has recently learnt that another supplier of TK, Ema Limited offers
discounts on large orders. Ema Limited sells TK at the following prices:
Order size Price per unit

N
1 – 2,999 1,525
3,000 – 4,999 1,450
5,000 and over 1,425
In other respects, (i.e. delivery charges and the time between ordering and
delivery), Ema Limited‟s terms are identical to those of Ajoke Limited.
Required:
a. Calculate the relevant
i. cost per order
ii. holding cost per unit per annum (4 Marks)
b. Irrespective of your answers in (a) above and assuming cost per order of
N150,000 and holding cost per unit per annum of N1,800, calculate the
optimal re-order quantity for TK and the associated annual profit Kehinde
can expect from their purchase and sale, assuming that he continues to buy
from Ajoke Limited. (6 Marks)
71

c. Prepare calculations to show whether Kehinde should buy TK from Ema
Limited rather than from Ajoke Limited and, if so, in what batch size.
(7 Marks)
d. Discuss the key limitations of the method of analysis you have used?
(3 Marks)
(Total 20 Marks)
QUESTION 4
Sunmola Funds (SF) Plc. has a portfolio of short-term investments in the shares of
four quoted companies.
Company Holding
Tomiwa (T) 100,000 shares
Pascal (P) 155,000 shares
Binta (B) 260,000 shares
Yetunde (Y) 420,000 shares
You have the following additional information:
Company Beta Market Value Per Expected total return

Share on investment p.a
(Kobo) (%)
T 1.55 280 21.0
P 0.65 340 12.5
B 1.26 150 18.0
Y 1.14 9.5 18.5
The market risk premium is 10% per year and the risk free rate is 6% per year.
Required:
a. Estimate the Beta of SF Plc.‟s short-term investment portfolio. (4 Marks)
b. Recommend, giving your reasons, whether the composition of SF Plc.‟s short-

term investment portfolio should be changed using relevant calculations.
(10 Marks)
(Hint: Consider the alpha values of the shares and the propriety of investing
short-term funds in equity).
c. Explain THREE factors that a financial manager should take into account
when investing in marketable securities. (6 Marks)
(Total 20 Marks)
72

SECTION C: YOU ARE REQUIRED TO ANSWER ANY TWO OUT OF THREE
QUESTION 5
Katangwa Limited will need to borrow ₦50 million in three months‟ time for a
period of six months. The company is concerned that interest rates are expected to
rise over the next few months.
Interest rates and forward rate agreements (FRAs) are currently quoted as follows:
● Spot 5.75 – 5.50
● 3 – 6 FRA 5.82 – 5.59
● 3 – 9 FRA 5.94 – 5.64
Required:
a. Explain how a forward rate agreement (FRA) may be useful to the company.
Illustrate this on the basis that interest rates
i. Rise to 6.50%
ii. Fall to 4.50% (8 Marks)
b. Compare the use of interest rate futures with FRA in this instance (4 Marks)
c. Explain how interest rate guarantees or short-term interest rate cap could be
used. (3 Marks)
(Total 15 Marks)
QUESTION 6
Okpara Plc. is a large publicly quoted company in the eastern part of Nigeria. It
operates in the home appliances industry with significant market share. In a recent
strategy meeting, the directors decided to pursue aggressive growth through
mergers in other parts of the country and along the ECOWAS sub-region.
Required:
Prepare a report to the Board of Directors of Okpara Plc. to address the following
matters:
a. SIX factors to be considered when choosing a target for acquisition.

(9 Marks)
b. FOUR factors which a bidding company should take into account in deciding
the form of consideration to be offered. (6 Marks)
(Total 15 Marks)
73

QUESTION 7
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)
74

Formulae
𝑉𝐷
𝑉𝐸𝐺
Asset Beta
𝑉𝐸 𝑉𝐷 (1 − 𝑇)
(𝑉𝐸 + 𝑉𝐷 (1 − 𝑇)) (𝑉𝐸 + 𝑉𝐷 (1 − 𝑇)) 𝐷
Equity Beta
𝑉𝐷
𝛽𝐸 = 𝛽𝐴 + (𝛽𝐴 − 𝛽𝐷 ) (1 − 𝑡)
𝑉𝐸
Growing Annuity
𝑛
𝐴1 1+𝑔
𝑃𝑉 = 1−
𝑟−𝑔 1+𝑟

1
𝑃𝑉𝑅 𝑛
𝑀𝐼𝑅𝑅 = 1 + 𝑟𝑒 − 1
𝑃𝑉𝐼
C0 = S0N(d1) – Ee-rt N(d2)
𝑆
𝐼𝑛 0 + (𝑟 + 0.5𝜎 2 )𝑇
𝑑1 = 𝐸
𝜎 𝑇
d2= d1 - 𝜎 𝑇
The Put Call Parity
C + Ee-rt = S + P

d = 1/u
𝑎−𝑑
𝜋=
𝑢−𝑑

1
3 3
75

Annuity Table
r
Discount rate (r)

Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1
2 1·970 1·942 1·913 1·886 1·859 1·833 1·808 1·783 1·759 1·736 2
3 2·941 2·884 2·829 2·775 2·723 2·673 2·624 2·577 2·531 2.487 3
4 3·902 3·808 3.717 3·630 3.546 3.465 3·387 3·312 3·240 3·170 4
5 4·853 4·713 4·580 4·452 4·329 4·212 4·100 3·993 3.890 3·791 5
6 5·795 5·601 5·417 5·242 5·076 4·917 4·767 4·623 4.486 4·355 6
7 6·728 6.472 6·230 6·002 5·786 5·582 5·389 5·206 5·033 4·868 7
8 7·652 7·325 7·020 6·733 6·463 6·210 5·971 5·747 5·535 5·335 8
9 8·566 8·162 7·786 7.435 7·108 6·802 6·515 6·247 5·995 5·759 9
10 9·471 8·983 8·530 8·111 7·722 7·360 7·024 6·710 6.418 6·145 10
11 10·368 9·787 9·253 8·760 8·306 7·887 7.499 7·139 6·805 6.495 11
12 11·255 10·575 9·954 9·385 8·863 8·384 7·943 7·536 7'161 6·814 12
13 12·134 11·348 10·635 9·986 9·394 8·853 8·358 7·904 7·487 7·103 13
14 13·004 12·106 11·296 10·563 9·899 9·295 8·745 8·244 7·786 7·367 14
15 13·865 12·849 11·938 11·118 10·380 9·712 9·108 8·559 8·061 7·606 15
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1
2 1·713 1·690 1·668 1·647 1·626 1·605 1·585 1·566 1·547 1·528 2
3 2.444 2.402 2·361 2·322 2·283 2·246 2·210 2·174 2·140 2·106 3
4 3·102 3·037 2·974 2·914 2·855 2·798 2·743 2.690 2·639 2.589 4
5 3·696 3·605 3·517 3·433 3·352 3·274 3·199 3·127 3·058 2·991 5
6 4·231 4·111 3·998 3·889 3·784 3·685 3·589 3.498 3.410 3·326 6
7 4·712 4·564 4.423 4·288 4·160 4·039 3·922 3·812 3·706 3·605 7
8 5·146 4·968 4.799 4·639 4.487 4·344 4·207 4·078 3·954 3·837 8
9 5·537 5·328 5·132 4·946 4·772 4·607 4.451 4·303 4·163 4·031 9
10 5·889 5·650 5.426 5·216 5·019 4·833 4·659 4.494 4·339 4·192 10
11 6·207 5·938 5·687 5.453 5·234 5·029 4·836 4·656 4.486 4·327 11
12 6·492 6·194 5·918 5·660 5·421 5·197 4·988 4·793 4·611 4.439 12
13 6·750 6.424 6·122 5·842 5·583 5·342 5·118 4·910 4·715 4·533 13
14 6·982 6·628 6·302 6·002 5·724 5.468 5·229 5·008 4·802 4·611 14
76

SOLUTION ONE
(a) Calculation of NPV (N million)
Year 2018 2019 2020 2021 2022
Contribution (W1) 0 309 334 361 391

Fixed costs 0 (62) (64) (66) (68)
Rent (20) (20) (20) (20) 0
(20) 227 250 275 323
Tax (Company Tax) 4 (45) (50) (55) (65)
Plant & equipment/Scrap value (1,000) 38
Tax saved on C.A (W2 40 32 26 20 22
Working capital (W3) (30) (2) (3) (3) 300
NCF (1,006) 212 223 237 618
PVF at 10% 1 0.909 0.826 0.751 0.683
PV (1,006) 193 184 178 422
NPV = (N29,000,000)
Decision: Negative NPV therefore reject the project.

Workings
(1) Contribution per unit = N5,900 – N3,400 = N2,500
Year Nmillion
1 120,000 × N2,500 × (1.03) 309
2 120,000 × (1.05) × N2,500 × (1.03) 2
334
3 120,000 × (1.05) × N2,500 × (1.03)
2 3
361
4 120,000 × (1.05) × N2,500 × (1.03)
3 4
391
(2) Capital allowances (Nmillion)
Year Cost/WDV CAs at 20% Tax at 20%
0 1,000 200 40
1 800 160 32
2 640 128 26
3 512 102 20
4 410
Sale (300) 110 22
(3) Working capital (Nmillion)

Year 1 N30 × 1.05 × 1.03 = N32
2 N32 × 1.05 × 1.03 = N35
3 N35 × 1.05 × 1.03 = N38
77

SOLUTION ONE
(a) Calculation of NPV (N million)
Year 2018 2019 2020 2021 2022
Contribution (W1) 0 309 334 361 391

Fixed costs 0 (62) (64) (66) (68)
Rent (20) (20) (20) (20) 0
(20) 227 250 275 323
Tax (Company Tax) 4 (45) (50) (55) (65)
Plant & equipment/Scrap value (1,000) 38
Tax saved on C.A (W2) 40 32 26 20 22
Working capital (W3) (30) (2) (3) (3) 300
NCF (1,006) 212 223 237 618
PVF at 10% 1 0.909 0.826 0.751 0.683
PV (1,006) 193 184 178 422
NPV = (N29,000,000)
Decision: Negative NPV therefore reject the project.

Workings
(1) Contribution per unit = N5,900 – N3,400 = N2,500
Year Nmillion
1 120,000 × N2,500 × (1.03) 309
2 120,000 × (1.05) × N2,500 × (1.03) 2
334
3 120,000 × (1.05) × N2,500 × (1.03)
2 3
361
4 120,000 × (1.05) × N2,500 × (1.03)
3 4
391
(2) Capital allowances (Nmillion)
Year Cost/WDV CAs at 20% Tax at 20%
0 1,000 200 40
1 800 160 32
2 640 128 26
3 512 102 20
4 410
Sale (300) 110 22
(3) Working capital (Nmillion)

Year 1 N30 × 1.05 × 1.03 = N32
2 N32 × 1.05 × 1.03 = N35
3 N35 × 1.05 × 1.03 = N38
78

(b) (i) The PV of the factory annual rent after tax is(N million):
N20 (1 – 0.2) × 3.487* = N56
(* = annuity factor at 10% years 0 - 3)
Sensitivity margin = 29/56 = 51.8%
The rent must fall by 51.8% to make the project viable.
(ii) Need to compute the IRR of the project.

Try 7%
Year 0 1 2 3 4
NCF (1,006) 212 223 237 618
PVF at 7% 1 0.935 0.873 0.816 0.763
PV (1,006) 198 195 193 472
NPV = 52
52
IRR = 7 + × 10 − 7 = 8.93 approx. 8.9
29 + 52
= 8.9%
The WACC would have to fall by (10 – 8.9)/10 = 0.11 = 11%.
(b) The risk is that political action will reduce the value of the project.
The measures that a foreign government might use include: Quotas;
Tariffs; Non-tariff barriers; Restrictions; Nationalisation; Minimum
shareholding; Blocked funds.
Strategies that can be used to limit the effects of political risk include:
Negotiations with the host government; Insurance; Production
strategies; Management structure.
(d) NPV only considers the cash flows associated with the new project. It
is possible that the project may be worthwhile as a result of the real
options associated with it and these include:
(i) Follow on options – PT has the opportunity at the end of four

years to continue production of the product. This might be
profitable or not. This is a call option.
79

(ii) Abandonment options – If the product is not popular and is a
failures, PT has the right to terminate the project early and sell
the equipment. This is a put option.
(iii) Timing options – It may be possible for PT to delay the
production of the product and wait until the rumours about the
rival company are either dispelled or are based on fact. This is
a call option.
(iv) Growth options – The rumours of an alternative product also
create growth options. PT could invest and hope that the
alternative product does not materialise. Wait and see if the
alternative product comes to market but competitors might
take a lead and not wait.
(v) Flexibility Options - If the new product is successful and

demand is greater than estimated, PT may expand production.
This is a call option.
EXAMINER‟S REPORT
This is a four-part question which tests the candidates‟ understanding of
investment decisions. The question covers NPV analysis, inflation, relevant and
irrelevant cash flows, working capital requirements and taxation.
Part (b) requires candidates to calculate and comment on the sensitivity of the
project to two of the inputs in the NPV analysis.
Part (c) requires candidates to consider the political risk of setting up the
manufacturing facility overseas and how the company may limit its effects.
About 95% of the candidates attempted the question.
In part (a), most candidates did not pay full attention to the timing of cash flows
and when they should be increased for price inflation and growth in quantity sold.
In part (b), most of the candidates had some difficulty, as the project produced a
negative NPV.
In part (c), a large number of the candidates could not identify political risks and
those who did, could not state how to limit its effects.
In part (d), very few candidates were able to identify the real options available to
the company. However, a disappointing number of them did not refer to the
scenario of the question.
Candidates should be prepared to apply their knowledge to varying scenarios.
80

MARKING GUIDE Marks Marks
a) Contribution 4
Fixed costs 1
Rent 1
Tax (Company Tax) 1
Plant 1
Tax savings on C.A 2
Working capital 2
Discount factor 1
NPV 1
Negative NPV and reject 1 15
b) i) PV of factory rent 1
Sensitivity ½
Interpretation ½ 2
ii) IRR 3
Sensitivity ½
Interpretation ½ 4
c) Possible political measures taken

by government 2
Strategies to limit effects 2 4
d) ½ mark per valid option, max 2

¾ mark per explanation of the point 3 5
30
SOLUTION TWO
(a) The government bond yield curve needs to be adjusted by the credit spread
for an A-rated company.
1-Year 2-Year 3-Year

Government bond annual spot yield curve 9.5 10.4 10.5
A-rated spread 0.2 0.3 0.5
A-rated yield curve 9.7 10.7 11.0
81

Calculation of issue price
Bond A
2
1 1
P0 = 𝑁100 + 𝑁1,180 = 𝑁1,054
1.097 1.107
Bond B
1 1 2 1 3
P0 = 𝑁120 + 𝑁120 + 𝑁1,120 = 𝑁1,026
1.097 1.107 1.11
Number of bonds that can be bought:

Bond A: N20,000,000/N1,054 = 18,975 bonds
Bond B: N20,000,000/N1,026 = 19,493 bonds
(b) Calculation of Yield to Maturity (YTM)

The YTM of each bond is the IRR of the related cash flows.
Bond A
Try 10%: NPV = -N1,054 + N1,00(1.736) + N1,080(0.826) = N11.68
Try 11%: NPV = -N1,054 + N1,00(1.713) + N1,080(0.812) = -N5.74
11.68
𝑌𝑇𝑀 = 10 + (11 − 10) = 10.67%
\
11.68 + 5.74
Bond B
Try11%: NPV = -N1,026 + N120(2.444) + N1,000(0.731) = -N1.72
YTM is approximately 11% (actually about 10.94%).
(c) Calculation of duration of the bonds

Bond A
Year CF PVF at 10.67% PV at 10.67% PV × n
(n) N N N
1 100 0.904 90.40 90.40
2 1,180 0.817 964.06 1,928.12
1,054.46 2,018.52
Duration = 2,018.52/1,054.46 = 1.914
Bond B
Year CF PVF at 11% PV PV × n
(n) N N
1 120 0.901 108.12 108.12
2 120 0.812 97.44 194.88
3 1,120 0.731 818.72 2,456.16
1,024.28 2,759.16
Duration = N2,759.16/N1,024.28 = 2.69
82

Duration measures the sensitivity of a bond‟s price to changes in interest
rates. It is a measure of interest rate risk associated with a bond. The higher
the duration, the higher the sensitivity and the higher the risk. Generally, the
higher the maturity of the bond, the lower the coupon rate and the lower the
yield to maturity (YTM), the higher the risk.
(d) If interest rates increase, prices of bonds are expected to fall. Bonds with
relatively higher durations will experience higher percentage drop in price in
response to the same percentage increase in interest rate. Therefore, to
minimise the risk of drop in price, Bond A, with lower duration will be
selected, holding other factors constant.
EXAMINER‟S REPORT
This question tests candidates‟ knowledge of key bond analysis, that is, pricing,
yield and duration.
About 20% of the candidates attempted the question. Only two candidates
produced excellent solutions, but the performance of the other candidates was
disappointing.
Despite the clear instruction that candidates should work with nominal value of
N1,000, about 80% of the candidates who attempted the question elected, at their
own risk, to work with a nominal value of N100.
The key challenges which the candidates faced in the question include the
following:
 Inability to deal with the credit spread and thereby incorrectly pricing the
bonds;
 Inability to calculate the YTM even when the bond prices were given; and
 Lack of understanding of the concept of duration and its meaning.
Candidates are advised to practise past examination questions as found in the

Pathfinders as a question similar to this was in a very recent examination.
83

MARKING GUIDE
Marks Marks
a) A rated yield curve 1
Issue price of bond A 1½
Issue price of bond B 1½
Number of bonds 1 5
b) Calculation of the yield to maturity of

- Bond A 2½
- Bond B 2½ 5
c) Calculation of duration
- Bond A 2
- Bond B 2
Interpretation of duration 2 6
d) Recommendation with appropriate

justification 4
20
SOLUTION THREE
(a) (i) Cost per order
₦
Fixed shipment charge 100,000
Administration cost 50,000
Total 150,000
Note: The variable delivery charge of ₦50 per unit is not relevant
when computing cost per order because it does not vary with the
number of orders made.
(ii) Holding costs per unit per annum.

₦
Opportunity cost of warehousing space = 2 × ₦400 800
Others 1,000
Total 1,800
84

(b) Calculation of EOQ
Annual demand = D = 24,000 units
Ordering cost = K = ₦150,000
Holding cost = H = ₦1,800
2𝐷𝐾 2 × 24,000 × 150,000

𝐸𝑂𝑄 = = = 2,000 𝑢𝑛𝑖𝑡𝑠
𝐻 1,800
Calculation of total costs

₦000
Holding Cost =
2,000
x N1,800 = 1,800
2
24,000
Ordering Cost = 2,000 x N150,000 = 1,800
Cost of holding base stock = 1,000 × ₦1,800 = 1,800
Purchase cost = 24,000 units × N1,550* = 37,200
Total relevant cost = 42,600
Total revenue = 24,000 × ₦2,000 = 48,000
Profit = 5,400
(* includes variable delivery charge of ₦50 per unit)
(c) Evaluation of quantity discount

We need to evaluate the following re-order quantities (ROQ)
ROQ Purchase price per unit
2,000 ₦1,500 + ₦50 = ₦1,550**
3,000 ₦1,450 + ₦50 = ₦1,500
5,000 ₦1,425 + ₦50 = ₦1,475
(** Assumed bought from Ajoke Ltd)
ROQ 2,000 3,000 5,000

Price (P) ₦1,550 ₦1,500 ₦1,475
₦000 ₦000 ₦000
𝑅𝑂𝑄
𝐻𝑜𝑙𝑑𝑖𝑛𝑔 𝑐𝑜𝑠𝑡 = × 𝑁1,800 1,800 2,700 4,500
2
24,000
𝑂𝑟𝑑𝑒𝑟𝑖𝑛𝑔 𝑐𝑜𝑠𝑡 = × 𝑁150,000 1,800 1,200 720
𝑅𝑂𝑄
Cost of holding base stock (no change) 1,800 1,800 1,800
Purchase cost = 24,000 × P 37,200 36,000 35,400
Total cost 42,600 41,700 42,420
Recommendation: Based on the above computations, Kehinde should

purchase batches of 3,000 from Ema Ltd. in order to minimise costs.
85

(d) The limitations of the above analysis are as follows:
(i) The model assumes that annual demand can be predicted and
constant usage applies throughout the year.
(ii) The relevant order cost (incremental cost) per unit is extremely
difficult to estimate. In practice most of the order costs are likely to be
semi-fixed.
(iii) The costs of placing an order are assumed to be constant and not to
vary with the size of the order.
(iv) Some of the holding costs are extremely difficult to estimate.

Examples include materials handling and obsolescence.
EXAMINER‟S REPORT
This question tests the candidates‟ knowledge of Economic Order Quantity (EOQ).
Part (a) tests the ability of the candidates to identify the relevant cost per order and
the holding cost per unit.
Part (b) tests the calculation of basic EOQ and part (c) tests their ability to evaluate
quantity discount.
Though some very few candidates produced very good solutions, large number of
them were found wanting.
The key problems include:
 The use of wrong formula;

 Inability to identify the values of the variables in the model (demand etc.);
and
 Inability to evaluate the variables needed when evaluating the quantity
discounted.
EOQ and discount were also tested in a recent examination. Candidates are
advised to make better use of past editions of the Pathfinders in their preparation
for the Institute‟s future examinations.
MARKING GUIDE
Marks Marks
a) i) Shipment charge ¾
Admin cost ¾
Total ½ 2
86

ii) Opportunity cost of
warehousing 1
Others ½
Total ½ 2
b) EOQ 2
Holding cost 1
Ordering cost 1
Base stock 1
Purchase cost ½
Total revenue ½ 6
c) Appropriate unit cost 1

Alternative ROQs 1
Holding costs 1
Ordering costs 1
Base stock 1
Total cost 1
Recommendation 1 7
d) 1 mark per valid point, max 3

20
SOLUTION FOUR
(a) The risk of Sunmola Funds (SF) plc.‟s short-term investment portfolio may be
measured by the weighted average beta of the four shares. The weighting is
by the market value of the shares.
Market value
N Beta N
T 280,000 1.55 434,000
P 527,000 0.65 342,550
B 390,000 1.26 491,400
Y 39,900 1.14 45,486
1,236,900 1,313,436
Portfolio beta = N1,313,436/N1,236,900 = 1.06
SF Plc.‟s short-term investment portfolio is slightly riskier than what is
obtainable in the capital market.
87

(b) The composition of the short-term investment may be examined from the
following two questions:
 Is the performance of the individual investments within the portfolio

satisfactory?
 Does the portfolio provide the most suitable form of short-term
investments for SF Plc.?
(i) The individual shares may be examined to establish if they are

expected to provide satisfactory return for the systematic risk
involved.
Using CAPM, the required return of each share is computed as follows:

T 6 + 1.55(16 - 6) = 21.5%
P 6 + 0.65(16 - 6) = 12.5%
B 6 + 1.26(16 - 6) = 18.6%
Y 6 + 1.14(16 - 6) = 17.4%
Next, we compute the expected excess return (i.e. the alpha value =
) and make recommendation.
Expected Required Alpha Remark/

return value value Recommendation
% % %
(a) (b) (a - b)
T 21.0 21.5 -0.5 Over-valued, sell
P 12.5 12.5 0 Properly valued, hold
B 18.0 18.6 -0.6 Over-valued, sell
Y 18.5 17.4 1.1 Under-valued, buy more
Based on the computations above, the shares in companies T and B are
not expected to give a satisfactory return relative to their systematic
risk and should be sold. The shares in P should be held, and further
shares should be purchased in Y.
However, none of the abnormal returns is large and any decision to buy
or sell might be influenced by this, as will the existence of transaction
costs. We are also assuming that the capital market is not efficient.
In addition, the analysis considers only systematic risk. If SF Plc. does

not have other investment and is not well diversified, systematic risk is
likely to under-estimate the risk to SF Plc. of these investments.
88

(ii) The portfolio is unusual for short-term investments. Short-term
investments are usually made for a specific purpose; for example, to
ensure cash is available for purchase of assets, payment of dividends,
taxes or creditors where a known amount of funds is required. Most
companies are not willing to tolerate much risk of price movement in
their short-term investments. This portfolio of investments, in ordinary
shares, is exposed to substantial price movements as share prices
change and the possibility that one or more of the companies could fail.
Although, the expected returns are relatively high, the risk of this
portfolio is very high relative to most portfolios of marketable
securities. Unless SF Plc. is happy to take such risks, it is recommended
that short-term investments should concentrate upon fixed interest
marketable securities such as Treasury Bills, Certificates of Deposit and
Bills of Exchange. Such investments involve much less risk of price
movement and default, and if held short-term, possible inflation may
not be a concern.
(c) The factors that a financial manager should take into account when
investing in marketable securities include:
i) Default risk. The risk that interest and/or principal will not be paid on
schedule on fixed interest investments. Most short-term investments in
marketable securities are confined to investments with negligible risk of
default;
ii) Price risk. The risk of the value of the investment changing, for
example, when interest rates change. Financial managers normally
wish to avoid substantial price risk;
iii) Marketability. Securities should normally be marketable at short

notice at close to the quoted market price;
iv) Taxation. Whether there are any special tax effects on the selected
marketable securities;
v) Yield. Managers will usually try to achieve the maximum yield possible
consistent with a satisfactory level of risk and marketability;
vi) Foreign exchange risk. If marketable securities are not denominated in

the domestic currency of the investor, foreign exchange risk must be
taken into account;
89

vii) The amount of funds to be invested. Some types of investment require a
minimum size of investment; and
viii) The period for which the investment is to be made. The type of
investment should be matched with the timing requirements of future
need for funds.
EXAMINER‟S REPORT
The question tests some basic concepts of portfolio theory and CAPM.
About 80% of the candidates attempted the question. 40% of the candidates who
attempted the question, scored 50% or above of the allocated marks.
Commonest pitfalls include the following:
 In part (a), using nominal value of the shares rather than market values;
 Wrongly calculating alpha value as required return minus expected return
rather than expected return minus required return;
 Wrong interpretation of alpha values; and
 Inability of the candidates to apply their knowledge to examination
questions. For example, in the final part of question (b), would any of the
candidate invest money needed to pay rent in six months time in equity?
This is just common sense!
We recommend that students should read widely, making use of the Institute‟s
Study Text, Pathfinder and other examination related text books.
MARKING GUIDE
Marks Marks
a) Computing market value 3
Portfolio beta 1 4
b) Required returns 2
Alpha values 2
Buy/hold/sell decision with Reasons 3
Propriety of the investment 3 10
c) ½ mark each for mentioning, max 1½

1½ marks each for explanation, max 4½ 6
20
90

SOLUTION FIVE
(a) Forward Rate Agreement (FRA)
Entering into a FRA will allow the company to effectively lock in an interest
rate for a specified future period, here for a six-month period, starting in 3
months' time and ending in 9 months' time. That is, we should use a 3 to 9
FRA which should lock us in to a borrowing rate of 5.94%.
The FRA is independent of the loan itself upon which the prevailing rate
must be paid. However, any difference between the actual rate and the FRA
rate will result in a cash flow from the FRA that offsets the higher or lower
interest cost.
Fixed Interest Rate
Net outcome 4.50% 6.50%
Actual rate 4.50% 6.50%
FRA rate (5.94%) (5.94%)
Gain/(loss) (1.44%) 0.56%
FRA Receipt/(Payment) ₦50m × (1.44%) × 6/12 = ₦50m ×0.56% x 6/12
= (₦360,000) = ₦140,000
Interest on ₦50m for 6 months (₦1,125,000) (₦1,625,000)
Net payment (₦1,485,000) (₦1,485,000)
Net payment at 5.94% is ₦50m × 5.94% x 6/12 = ₦1,485,000

Hence, the FRA has locked us in to a rate of 5.94%.
(b) Interest Rate Futures vs FRA

Interest rate futures have the same effect as FRAs, in effect locking in to an
interest rate. Unlike FRAs, however, they are standardised in terms of size,
duration and term and they are tradable on exchanges.
They are generally closed out prior to maturity with any gain or loss
offsetting any higher or lower interest cost when borrowing.
The standardisation in terms of size, duration and term may appear to
make them limited compared to FRAs, however, the ability to trade them
means that any hedge can be easily released at any time if conditions
change which is not the case for FRAs.
Since we, as borrowers, are concerned that rates may rise, we are looking
for a profit on these futures to offset the interest cost.
*
If rates rise, then futures‟ prices‟ fall (futures‟ price = 100  rate), hence, to
gain, we must sell interest rate futures.
91

(c) Interest rate guarantees or short-term interest rate caps offer the opportunity
to limit the impact of any adverse movement in interest rates whilst still
benefiting from any favourable rate movement.
They represent an interest rate option giving the holder the right, but not the
obligation, to deal at an agreed interest rate at a future maturity date.
This means that if rates rise, the option would be exercised by Katangwa Ltd.
locking the rate. If rates fall, however, Katangwa Ltd. would allow the option
to expire without exercising it, and benefit from the lower interest rate in the
market.
EXAMINER‟S REPORT
The question tests candidates‟ knowledge of interest rate risk management
techniques.
Less than 20% of the candidates attempted it. Candidates demonstrated lack of
knowledge of the risk management section of the syllabus.
Commonest pitfalls exhibited by the candidates include:
 Lack of knowledge of the FRA terms;

 Inability to identify the particular term of the FRA to use; and
 Inability to analyse the outcomes of FRA.
Candidates are advised to make better use of the Institute‟s Study Text, past
editions of the Pathfinder and any other relevant text books.
MARKING GUIDE
Marks Marks
a) Explanation of the use of FRA in
hedging interest rate risk 2
Calculation of the net outcome of

fixed interest rate @:
4.5% 2½
6.5% 2½
Calculation of net payment @ 5.94% ½
Comment on the result of the
calculation of net payment @ 5.94% ½ 8
92

b) 1 mark per valid comparison, max 4
c) 1 mark per valid point given, max 3
15
SOLUTION SIX
Date: May 16, 2018
To: Board of Directors
From: Finance Controller
Topic: Acquisition targets and mode of financing
(a) Choosing acquisition targets
The criteria that should be used to assess whether a target is appropriate will
depend on the motive for the acquisition.
The main criteria that are consistent with the underlying motives include:
i. Benefit for acquiring undervalued company

The target firm should trade at a price below the estimated value of
the company when acquired. This is true of companies which have
assets that are not exploited;
ii. Diversification
If the objective is risk reduction, the target firm should be in a
business which is different from our own business and the correlation
in earnings should be low;
iii. Operating Synergy

The target firm should have characteristics that create the operating
synergy. Thus, the target firm should be in the same business in order
to create cost savings through economies of scale. Alternatively, it
should be able to create a higher growth rate through increased
monopoly power;
iv. Tax Savings

The acquisition of the target firm should provide a tax benefit in the
form of unused capital allowances to us;
93

v. Increase in debt capacity
This happens when the target firm is unable to borrow money or is
forced to pay high interest rates. The target firm should have capital
structure such that its acquisition will reduce bankruptcy risk and will
result in increasing its debt capacity;
vi. Access to cash resources

A company, with a number of cash intensive projects or products in
their pipeline, or heavy investment in Research and Development,
might seek a company that has significant cash resources or highly
cash generative product lines to support their own needs; and
vii. Access to technology

Some companies do not invest significantly in Research and
Development but acquire their enabling technologies by acquisition.
b. Purchase Consideration
The key factors that determine the form of purchase consideration include:
i. Liquidity
Clearly, the use of cash as consideration depends upon having
sufficient liquid resources available. Equity or debt securities, if used,
will not affect the firm‟s cash position;
ii. Control
The use of cash will not transfer control from the existing shareholders
but the use of equity shares and convertible bonds will lead to loss of
control;
iii. Gearing
The use of debt securities leads to increase in financial gearing and
associated financial risk. This may be acceptable if the takeover is
small or if there is previously unused debt capacity;
iv. Uncertainty over the value of the consideration

Shareholders in the target company are often less willing to accept
shares or convertible securities than cash because the value of shares
and hence the consideration is liable to fluctuation. With a cash offer
and an offer of bonds, the value of the consideration is known; and
94

v. Tax consideration
Cash as consideration will mean shareholders will be subject, if a
capital gain has accrued, to an immediate capital gains tax liability
on the profit on the sale of their shares in the target company. An
offer in the form of securities (equity or bond) will enable
shareholders to defer a capital gain tax payment until the gains are
realised.
Signed
Name
EXAMINER‟S REPORT
The question tests candidates‟ knowledge of some basic theoretical concepts of

mergers and acquisitions.
More than 80% of the candidates attempted the question. About 10% of the
candidates that attempted the question scored zero.
Candidates are advised to put in greater effort to ensure their success in the
Institute‟s examinations.
MARKING GUIDE
Marks Marks
a) Report format 1
½ mark per valid factor mentioned, max 3
1 mark for explanation of the valid
points, max 5 9
b) ½ mark per valid factor mentioned 2

1 mark for explanation of the factors 4 6
Maximum 15
SOLUTION SEVEN
(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.
95

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.
(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
96

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
97

viii. Employees Covenant: This requires the regulation of the employment
and dismissal of key employees.
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.
EXAMINER‟S REPORT
The question tests candidates‟ knowledge of basic concepts in finance, such as
agency problems, conflict of interest etc.
Over 80% of the candidates attempted the question, but performance was very
poor.
The major pitfall was lack of basic knowledge and understanding of rudimentary
concepts in financial management.
Candidates are advised to pay more attention to basic concepts in Strategic

Financial Management.
MARKING GUIDE
Marks Marks
a) Reasonable comment on roles
of executive directors 4
b) Identification of 3 areas of conflict
(1/2mark each) 1½
Discussion on the 3 areas identified
(11/2mark each) 41/2 6
c) Identification of any FIVE covenants
mentioned with explanations 5
15
98

PATHFINDER
NOVEMBER 2018 DIET

Question Papers
Suggested Solutions
Marking Guides
Plus
151



QUESTION 1
Eko Plc. (Eko) is a listed company in food retailing sector and has large stores in all
major cities in the country. Eko‟s board is considering diversifying by opening
holiday travel shops in all of its stores.
At a recent board meeting, the directors discussed how the holiday travel shops
project (the project) should be appraised. The sales director insisted that Eko‟s
current weighted average cost of capital (WACC) should be used to evaluate the
project as majority of its operations will still be in food retailing. The finance
director disagreed because the existing cost of equity does not take into account the
systematic risk of new projects. He said that the company‟s overall WACC, which
reflects all of the company‟s activities, would change as a result of the project‟s
acceptance. The board was also concerned about the market‟s reaction to its
diversification plans. Another board meeting was scheduled at which Eko‟s advisors
would be asked to make a presentation on the project.
You work for Eko‟s advisors and have been asked to prepare information for the
presentation. You have established the following:
Eko intends to raise the capital required for the project in such a way as to leave its
existing debt to equity ratio (by market value) unchanged following the diversification.
Extracts from Eko‟s most recent management accounts are shown below:
Statement of financial position as at May 31, 2017
N‟M
Ordinary share capital (10 kobo shares) 233
5,263
6% Redeemable debentures at nominal value (redeemable 2021) 1,900
Long term bank loans (interest rate 4%) 635
7,798
73

On May 31, 2017, Eko‟s ordinary shares had a market value of 276 kobo (ex-div)
and an equity beta of 0.60. For the year ended May 31, 2017, the dividend yield
was 4.2% and the earnings per share was 25 kobo. The return on the market is
expected to be 8% p.a and the risk free rate is 2% p.a.
Eko‟s debentures had a market value of N108 (ex-interest) per N100 nominal value
on May 31, 2017 and they are redeemable at par on May 31, 2021.
Companies operating solely in the holiday travel industry have an average equity
beta of 1.40 and an average debt to equity ratio (by market value) of 3:5. It is
estimated that if the project goes ahead, the overall equity beta of Eko will be
made up of 90% food retailing and 10% holiday travel shops.
Assume that the income tax rate will be 20% p.a for the foreseeable future.
Required:
a. Ignoring the project, calculate the current WACC of Eko using:
i. The Capital Asset Pricing Model (CAPM) (8 Marks)
ii. The Gordon‟s Growth Model (6 Marks)
b. Use the CAPM to calculate the cost of equity that should be included in a
WACC suitable for appraising the project and explain your reason.
(5 Marks)
c. By calculating an overall equity beta and using the CAPM, estimate the
overall WACC of Eko assuming that the project goes ahead and comment on
the implications of a permanent change in the overall WACC. (5 Marks)
d. Advise whether Eko should diversify its operations and how the stock market
might react to the proposed project. (3 Marks)
e. Identify the appropriate project appraisal methodology that should be used

when a project‟s financing results in a major increase in a company‟s market
gearing ratio and using the data relating to Eko, calculate the project
discount rate that should be used in this circumstance. (3 Marks)
(Total 30 Marks)
74

SECTION B: YOU ARE REQUIRED TO ANSWER TWO OUT OF THREE QUESTIONS IN
QUESTION 2
Tamilore Limited (TL) is an agro-based firm, specialising in yam and rice
production in Benue State of Nigeria. One of the harvesters is due to be replaced on
November 30, 2018, the last day of TL‟s current financial year. An investment
appraisal exercise has recently been completed which confirmed that it is
financially beneficial to replace the machine at this point. TL is now considering
how best to finance the acquisition of the harvester to be replaced. TL is already
highly geared.
A government development agency has offered the following two alternative

methods of financing the machine:
Alternative 1
A loan of N49,200,000 at 6% interest rate to buy the machine on November 30,
2018. If this option is selected, the machine will be depreciated on a straight-line
basis over its estimated useful life of 5 years.
Alternative 2
Enter into a finance lease. This will involve payment of annual rental of N12 million
with first payment due on November 30, 2019. The lease payments will be for the
entire estimated useful life of the machine which is 5 years when the ownership
will pass to TL without further payment.
Other information
(i) Whether leased or purchased outrightly, maintenance would remain the
responsibility of TL and would be N450,000 payable annually in advance.
(ii) TL is liable to tax at a rate of 25%, payable annually at the end of the year in
which the tax charge or tax saving arises.
(iii) TL is able to claim capital allowances on the full capital cost of the machine
in equal installments over the first four years of the machine.
(iv) Assume that TL has sufficient taxable profits to benefit from any savings
arising therefrom.
(v) All workings in N‟000.
Required:
a. Show that the implied interest rate in the lease agreement is 7%. (3 Marks)
75

b. Advise, using present value method, whether Tamilore Limited should
borrow to buy the machine or lease it. (12 Marks)
c. Instead of lease financing, one director has suggested an equivalent Islamic

finance.
i. Explain briefly the principles of Islamic finance. (2 Marks)
ii. Explain three main advantages of Islamic finance. (3 Marks)

(Total 20 Marks)
QUESTION 3
Lagelu Plc. (LP) is a very successful entity. The company has consistently followed a
business strategy of aggressive acquisitions, looking to buy companies that it
believes were poorly managed and hence undervalued. LP can be described as a
modern day conglomerate with business interests stretching far and wide.
Its board of directors has chosen the takeover targets with care. LP has maintained
its price earnings (P/E) ratio on the stock market at 12.2.
LP‟s figures show a profit after tax of ₦4,430 million, and it has 375 million shares.
Lam Technical (LT) is a well-established owner-managed business. It has had its

ups and downs, in financial terms, corresponding directly with the state of the
global economy. Since 2001, its profits have fallen each year with the 2017 results
as stated below:
₦‟Million
Revenue 7,500
Operating profit 2,400
Interest (685)
Taxation @ 25% (429)
Number of shares in issue 150 million
Earnings Per Share(EPS) ₦8.57
With economists predicting an upturn in the global economy, LT‟s management

team feels that revenue will increase by 6% per annum up to and including year
2021. The company‟s operating profit margin is not expected to change in the
foreseeable future.
Operating profits are shown after deducting non-cash expenses (including tax
allowable depreciation) of ₦650m. This is expected to increase in line with sales.
However, the company has recently spent ₦1,050m on purchase of non-current
76

assets. LT‟s management believes this value will have to increase by 10% per
annum until year 2021 to enable the company remain competitive.
LT is currently financed by debt and equity. It has maintained a constant debt to

total asset ratio of 40% and there is no intention to change this financing mix in the
nearest future.
The company has a cost of equity of 17% and weighted average cost of capital of
12%.
Assume tax rate of 25% in all cases.
Some of LT‟s major shareholders are not so confident about the future and would
like to sell the business as a going concern. The minimum price they would
consider would be the fair value of the shares, plus 10% premium. LT‟s Chief
Financial Officer believes the best way to find the fair value of the shares is to
discount the forecast Free Cash Flows to the firm, assuming that beyond year 2021
these will grow at a rate of 3% per annum indefinitely.
Required:
a. Prepare a schedule of forecast Free Cash Flows to the firm for each of the
years from December 31, 2018 to 2021. (5 Marks)
b. Estimate the fair value of LT‟s equity on per share basis. (6 Marks)
c. LP intends to make an offer to LT based on a share for share swap. LP will

exchange one of its shares for every two LT shares. Assuming that LP can
maintain its price earnings (P/E) ratio of 12.2, calculate the percentage gain
in equity value that will be earned by both groups of shareholders. (6 Marks)
d. What factors should the LT shareholders consider before deciding whether to

accept or reject the offer made by LP? (3 Marks)
(Total 20 Marks)
QUESTION 4
Yemi John Plc. (YJ) is planning to raise N30 million new finance for a major
expansion of existing business and is considering a rights issue, a placing or an
issue of bonds. The corporate objectives of YJ, as stated in its annual report, are to
maximise the wealth of its shareholders and to achieve continuous growth in
earnings per share. Recent financial information on YJ is as follows:
2017 2016 2015 2014
Turnover (Nm) 28.0 24.0 19.1 16.8
Earnings before interest and tax (EBIT) (Nm) 9.8 8.5 7.5 6.8
Profit after tax (PAT) (Nm) 5.5 4.7 4.1 3.6
Dividends (Nm) 2.2 1.9 1.6 1.6
Ordinary shares (Nm) 5.5 5.5 5.5 5.5
77

Reserves (Nm) 13.7 10.4 7.6 5.1
8% Bonds, redeemable 2024 (Nm) 20 20 20 20
Share price (N) 8.64 5.74 3.35 2.67
The par value of the shares of YJ is N1.00 per share. The general level of inflation
has averaged 4% per year in the period under consideration. The bonds of YJ are
currently trading at their par value of N100. The values for the business sector of
YJ are as follows:
Average return on capital employed * 25%
Average return on shareholders‟ fund 20%
Average interest coverage 20 times
Average debt/equity ratio (market value basis) 50%
Return predicted by the capital asset pricing model 14%
* EBIT/closing total capital employed
Required:
a. Evaluate the financial performance of YJ, analyse and discuss the extent to
which the company has achieved its stated objectives of:
i. maximising the wealth of its shareholders; and
ii. achieving continuous growth in earnings per share (13 Marks)
Note: Up to 8 marks are available for financial analysis.
b. Analyse and discuss the relative merits of a rights issue, a placing and an
issue of bonds as ways of raising finance for the expansion. (7 Marks)
(Total 20 Marks)
SECTION C: YOU ARE REQUIRED TO ANSWER TWO OUT OF THREE

QUESTION 5
Kuku Plc. had a need for a machine. After four years of purchase, the machine will
no more be capable of efficient working at the level of use by the company.
Meanwhile, it has been the company‟s practice to replace machines every four
years. The production manager has pointed out that in the fourth year, the
machine will need additional maintenance to keep it working at normal efficiency.
The question has therefore arisen as to whether the machine should be replaced
after three years instead of four years, in line with the company‟s practice.
78

Relevant information is as follows:
(i) A new machine will cost N240,000. If the machine is retained for four years,
it will have a zero scrap value at the end of the period. If it is retained for
three years, it will have an estimated disposal value of N30,000. The
machine will attract capital allowance of 20% (reducing balance tax
allowance) in the years of being owned by the company except the last year.
In the last year, the difference between the machine‟s written-down value
for tax purposes and its disposal proceeds will be allowed to the company as
an additional tax relief if the disposal proceeds are less than the tax written-
down value.
It is assumed that the machine will be bought and disposed of on the last
day of the company‟s accounting year.
(ii) The company tax rate is 30% and tax is payable on the last day of the
accounting year concerned.
(iii) During the first year of ownership, the supplier takes responsibility for any
necessary maintenance work. In the second and third years, maintenance
costs average N30,000 a year. During the fourth year, these will rise to
N60,000. Maintenance charges are payable on the first day of the company‟s
accounting year and are allowable for tax.
(iv) The company‟s cost of capital is estimated at 15%.
Required:
a. Prepare calculations to show whether it would be economically beneficial to

replace the machine after three years or four years. (12 Marks)
b. Discuss two other issues that could influence the company‟s replacement
decision. This should include any weakness. (3 Marks)
(Total 15 Marks)
QUESTION 6
Alpha Plc. is a Nigerian manufacturer of plastic containers, which it sells in many
West African and other African countries. In three months‟ time, Alpha Plc. is due
to receive 70 million Kudi from a country in Central Africa whose currency is Kudi.
At a board meeting slated for today, the directors will be discussing whether or not
there is a need to hedge the foreign exchange exposure associated with this
transaction and if so, how best this might be achieved. At the board meeting, three
possible alternatives will be considered:
(i) Not to hedge this transaction;
79

(ii) Use a forward contract. Exchange rates quoted by Alpha Plc.‟s bank today
are:
Spot 1.1548 - 1.1608 Kudi/N; and
3 months forward 1.1438 - 1.1508 Kudi/N; and
(iii) Use an over-the-counter currency option on Kudi which is available through
Alpha Plc.‟s bank. Current premiums at an exercise price of 1.1650 Kudi /N
are N1.10 per 100 Kudi for a call option and N1.25 per 100 Kudi for a put
option.
Required:
a. State four reasons why a firm might reasonably choose not to hedge its
exposure to exchange rate risk. (4 Marks)
b. Show the effect of each of the three alternatives being considered, assuming
that the spot-exchange rate in three months‟ time is:
i. 1.1850 – 1.1880 Kudi/N
ii. 1.1295 – 1.1320 Kudi/N (7 Marks)
c. State four methods available to firms to reduce their exposure to foreign
exchange risks which do not involve the use of financial contracts.
(4 Marks)
(Total 15 Marks)
QUESTION 7
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)
80

Formulae
𝑉𝐷
𝑉𝐸𝐺
Asset Beta
𝑉𝐸 𝑉𝐷 (1 − 𝑇)
(𝑉𝐸 + 𝑉𝐷 (1 − 𝑇)) (𝑉𝐸 + 𝑉𝐷 (1 − 𝑇)) 𝐷
Equity Beta
𝑉𝐷
𝛽𝐸 = 𝛽𝐴 + (𝛽𝐴 − 𝛽𝐷 ) (1 − 𝑡)
𝑉𝐸
Growing Annuity
𝑛
𝐴1 1+𝑔
𝑃𝑉 = 1−
𝑟−𝑔 1+𝑟

1
𝑃𝑉𝑅 𝑛
𝑀𝐼𝑅𝑅 = 1 + 𝑟𝑒 − 1
𝑃𝑉𝐼
C0 = S0N(d1) – Ee-rt N(d2)
𝑆
𝐼𝑛 0 + (𝑟 + 0.5𝜎 2 )𝑇
𝑑1 = 𝐸
𝜎 𝑇
d2= d1 - 𝜎 𝑇
The Put Call Parity
C + Ee-rt = S + P

d = 1/u
𝑎−𝑑
𝜋=
𝑢−𝑑

1
3 3
81

Annuity Table
r
Discount rate (r)

Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1
2 1·970 1·942 1·913 1·886 1·859 1·833 1·808 1·783 1·759 1·736 2
3 2·941 2·884 2·829 2·775 2·723 2·673 2·624 2·577 2·531 2.487 3
4 3·902 3·808 3.717 3·630 3.546 3.465 3·387 3·312 3·240 3·170 4
5 4·853 4·713 4·580 4·452 4·329 4·212 4·100 3·993 3.890 3·791 5
6 5·795 5·601 5·417 5·242 5·076 4·917 4·767 4·623 4.486 4·355 6
7 6·728 6.472 6·230 6·002 5·786 5·582 5·389 5·206 5·033 4·868 7
8 7·652 7·325 7·020 6·733 6·463 6·210 5·971 5·747 5·535 5·335 8
9 8·566 8·162 7·786 7.435 7·108 6·802 6·515 6·247 5·995 5·759 9
10 9·471 8·983 8·530 8·111 7·722 7·360 7·024 6·710 6.418 6·145 10
11 10·368 9·787 9·253 8·760 8·306 7·887 7.499 7·139 6·805 6.495 11
12 11·255 10·575 9·954 9·385 8·863 8·384 7·943 7·536 7'161 6·814 12
13 12·134 11·348 10·635 9·986 9·394 8·853 8·358 7·904 7·487 7·103 13
14 13·004 12·106 11·296 10·563 9·899 9·295 8·745 8·244 7·786 7·367 14
15 13·865 12·849 11·938 11·118 10·380 9·712 9·108 8·559 8·061 7·606 15
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1
2 1·713 1·690 1·668 1·647 1·626 1·605 1·585 1·566 1·547 1·528 2
3 2.444 2.402 2·361 2·322 2·283 2·246 2·210 2·174 2·140 2·106 3
4 3·102 3·037 2·974 2·914 2·855 2·798 2·743 2.690 2·639 2.589 4
5 3·696 3·605 3·517 3·433 3·352 3·274 3·199 3·127 3·058 2·991 5
6 4·231 4·111 3·998 3·889 3·784 3·685 3·589 3.498 3.410 3·326 6
7 4·712 4·564 4.423 4·288 4·160 4·039 3·922 3·812 3·706 3·605 7
8 5·146 4·968 4.799 4·639 4.487 4·344 4·207 4·078 3·954 3·837 8
9 5·537 5·328 5·132 4·946 4·772 4·607 4.451 4·303 4·163 4·031 9
10 5·889 5·650 5.426 5·216 5·019 4·833 4·659 4.494 4·339 4·192 10
11 6·207 5·938 5·687 5.453 5·234 5·029 4·836 4·656 4.486 4·327 11
12 6·492 6·194 5·918 5·660 5·421 5·197 4·988 4·793 4·611 4.439 12
13 6·750 6.424 6·122 5·842 5·583 5·342 5·118 4·910 4·715 4·533 13
14 6·982 6·628 6·302 6·002 5·724 5.468 5·229 5·008 4·802 4·611 14
15 7·191 6·811 6.462 6·142 5·847 5·575 5·324 5·092 4·876 4·675 15
82

SOLUTION ONE
a) i) Using CAPM to compute cost of equity (KE)

 KE = Rf +  (Rm - Rf)
= 2 + 0.60(8 - 2) = 5.6%
 Cost of redeemable debt
We need the IRR of:
Year 0 Current market value = (108)
Years 1 – 4 Interest, net of tax = 6 (1 – 0.2) = 4.8
Year 4 Redemption value = 100
Try 2%: NPV = -108 + 4.8(3.808) + 100(0.924) = 2.678
Try 3%: NPV = -108 + 4.8(3.717) + 100(0.889) = -1.258
 Cost of bank loan = 4(1 – 0.20) = 3.20%

 Market values
Nm
Equity: 2,330 shares × N2.76 = 6,430.80
Debentures: N1,900m × 108/100 = 2,052.00
Loans = 635.00
9,117.80
ii) Using Gordon growth model to compute KE

g = (r)(b)
Return on Capital Employed (r)
Retention rate (b)
83

SOLUTION ONE
a) i) Using CAPM to compute cost of equity (KE)

 KE = Rf +  (Rm - Rf)
= 2 + 0.60(8 - 2) = 5.6%
 Cost of redeemable debt
We need the IRR of:
Year 0 Current market value = (108)
Years 1 – 4 Interest, net of tax = 6 (1 – 0.2) = 4.8
Year 4 Redemption value = 100
Try 2%: NPV = -108 + 4.8(3.808) + 100(0.924) = 2.678
Try 3%: NPV = -108 + 4.8(3.717) + 100(0.889) = -1.258
2.678
IRR = K 𝐷 = 2 + × 3 − 2 = 2.68%
2.678 + 1.258
 Cost of bank loan = 4(1 – 0.20) = 3.20%
 Market values
Nm
Equity: 2,330 shares × N2.76 = 6,430.80
Debentures: N1,900m × 108/100 = 2,052.00
Loans = 635.00
9,117.80
𝑁6,430.80 𝑁2,052 𝑁635
WACC = × 5.6 + × 2.68 + × 3.20 = 4.8%
𝑁9117.80 𝑁9,117.80 𝑁9,117.80
ii) Using Gordon growth model to compute KE

g = (r)(b)
Return on Capital Employed (r)
Retention rate (b)
Dividend = share price × dividend yield
=N2.76 × 4.2% = 11.6kobo
Retention = 25kobo – 11.6kobo = 13.4kobo
:. b = 13.4k/25k = 53.60%
𝑃𝐴𝑇
Return (r) = (PAT = Profit after Tax)
𝑂𝑝𝑒𝑛𝑖𝑛𝑔 𝑠𝑕𝑎𝑟𝑒 𝑕𝑜𝑙𝑑𝑒𝑟𝑠 ′ 𝑓𝑢𝑛𝑑
(𝑁0.25 × 2,330)
= = 11.77%
N5,263 − N(2,330 × 0.134)
(Note: In the above calculation, opening shareholders‟ fund has been used as the
preferred method. If average shareholders fund is used, it will be fully rewarded
but for future examinations, the former is preferred)
84

Growth rate (g) = 0.1177 × 0.5360 = 6.3%
𝐷𝑂 (1 + 𝑔)
 K𝐸 = +𝑔
𝑉𝐸
11.6(1.063)𝑘
= + 0.063 = 0.1077 = 10.77%
276𝑘
Cost of debt and market values are as in (a)(i) above.
𝑁6,430.80 𝑁2,052 𝑁635

 WACC = × 10.77% + × 2.68% + × 3.20% = 8.42%
𝑁9117.80 𝑁9,117.80 𝑁9,117.80
b) The cost of equity should be adjusted to reflect the systematic risk of the new
project. The equity beta for the holiday travel industry should be adjusted for
gearing. It is assumed that debt is risk free, since we are not given beta of
debt.
 Asset beta (βA) of the holiday travel industry will be:
1.40 ×5
β𝐴 = = 0.95 while
5+3(1−0.2)
 Equity beta for the project is

𝑁2,687
β𝐸 = 0.95 + (0.95 − 0) (1 − 0.20) = 1.27, hence
𝑁6,431
 KE = 2+ 1.27(8 - 2) = 0.0962 = 9.62%
The WACC to be used for the project should reflect the business risk of the
project and the financial risk of the company.
c) If the diversification goes ahead, cost of equity will reflect the systematic risk
of both divisions.
 Weighted average beta of the enlarged group

= (1.27× 0.10) + (0.6 × 0.90) = 0.667
 KE = 2 + 0.667(8 - 2) = 0.06 = 6%
 WACC of the enlarged group

= (6% × N6,431) + (2.68% × N2,052) + (3.20% ×N635) /9,118 = 5.06%
The implications of a permanent change in the company‟s WACC from 4.8% to

5.06% are less clear. An increase in the WACC is usually associated with
reductions in value. On the other hand, if the new project has a positive NPV,
it could result in an increase in the market capitalisation.
85

d) The diversification plans may not be welcomed by the market. From portfolio
theory, we know that rational shareholders would hold a well-diversified
portfolio and that they might not welcome the company diversifying.
Conglomerate companies often trade at a discount.
e) If the gearing changes dramatically, then, it is not suitable to use WACC/NPV

to appraise the project. Instead, adjusted present value (APV) should be used.
The discount rate will be that of an all equity company using the βA of 0.95 to
reflect the systematic risk. Therefore, the discount rate will be:
2 + 0.95(8 - 2) = 0.077 or 7.7%.
This will be used to calculate the base case NPV. The NPV will then be
adjusted for the financing side effects.
EXAMINER‟S REPORT
This question tests candidates‟ understanding of various aspects of cost of capital,

which include cost of equity (using CAPM and Gordon model), cost of redeemable
debt and cost of bank loan. It also tests candidates‟ knowledge of adjustment for
financial gearing in calculating cost of equity.
About 95% of the candidates attempted the question. Candidates were expected to
calculate weighted average cost of capital (WACC) under varying scenarios and to
comment on the results. Generally, the performance of the candidates was poor.
Major pitfalls of candidates include the following:
 Inability to calculate the Gordon growth model;

 Inability to adjust beta factor for financial risk and business risk;
 Failure to identify the appropriate cost of capital to use when there is a
significant change in gearing; and
 Inability to identify the appropriate investment appraisal methodology to
use when there is a significant change in gearing.
It is recommended that success at this level of the examination demands that

candidates should cover comprehensively the Institute‟s syllabus and make use of
the Study Texts and the Pathfinders.
86

MARKING GUIDE
Mark Mark
(a) i. Computation of :
- cost of equity using CAPM 1
- cost of redeemable debt using IRR 3
- cost of bank loan ½
Summary of the market values of equity & debt 1½
Calculation of WACC using CAPM 2 8
ii. Calculation of:

- dividend paid ½
- retained earnings ½
- retention rate ½
- Return on capital employed (ROCE) 1
- growth rate ½
- cost of equity using growth rate 1
- WACC using gordon‟s growth model 2 6
(b) Calculation of:

- asset beta of the holiday travel industry 1½
- equity beta for the project 1½
- cost of equity using CAPM 1
Recommendation on the WACC to be used for the project 1 5
(c) Computation of:

- weighted average beta of the group 1½
- cost of equity (KE) 1
- WACC of the enlarged group 1½
Comment on the change in the company‟s WACC 1 5
Z(d) Discussion on diversification plans 3
(e) Identification of the appropriate appraisal method to be

used - APV as against WACC/NPV 1
Calculation of the project‟s discount rate and
recommendation for adjustment to take care of the
financing side effects 2 3
30
87

SECTION B
SOLUTION TWO
a) Implied interest rate in the lease
Cost of machine/annual lease rental = N49,200/N12,000 = 4.100
From the annuity table under „5 years‟, this gives an implied rate of 7%.
Candidates can also use IRR to determine the implicit interest rate using the
following figures.
Year 0 (49,200)
1-5 12,000
However, the method is longer.
b) Notes
In the following evaluation of the financing options, the following items are
ignored because they are common to the two alternatives:
i) tax savings on capital allowances; and

ii) maintenance charges and related tax savings.
Alternative 1 – Outright purchase
The net relevant cost is the purchase cost of N49,200,000.
Alternative 2 – Lease finance
 After tax cost of borrowing = 6% x (1 – 0.25) = 4.5%
 Interest component of lease rental (N‟000)
(a) (b) (c) (b + c) (a + b) – (b + c)
Year Opening Interest at Principal Rental Closing balance

balance 7% repayment payment
N„000 N„000 N„000 N„000 N„000
1 49,200 3,444 8,556 12,000 40,644
2 40,644 2,845 9,155 12,000 31,489
3 31,489 2,204 9,796 12,000 21,693
4 21,693 1,519 10,481 12,000 11,212
5 11,212 785* 10,427 12,000* 0
88

(* rounded up)
NPV of lease option in (N‟000)

Year 1 2 3 4 5
Lease rental (12,000) (12,000) (12,000) (12,000) (12,000)
Tax relief
on interest 861 711 551 380 197
NCF (11,139) (11,289) (11,449) (11,620) (11,803)
PVF at 4.5% 0.957 0.916 0.876 0.839 0.803
PV (10,660) (10,341) (10,029) (9,749) (9,478)
Total = (50,257) or (N50,257,000)
Recommendation
An outright purchase of the machine at a cost of N49,200,000 is relatively
cheaper and therefore recommended.
c (i) The main principles of Islamic finance include:
 Wealth must be generated from legitimate trade and asset-based

investment (the use of money for the purposes of making money is
expressly forbidden);
 Investment should have a social and an ethical benefit to the wider
society beyond pure return;
 Risk should be shared; and
 Harmful activities (haram) should be avoided.
The intention is to avoid injustice, asymmetric risk and moral hazard and
unfair enrichment at the expense of another party.
ii) The key advantages of Islamic Finance include:
 Gharar (uncertainty, risk of speculation) is not allowed, reducing

the risk of losses;
 Excessive profiteering is also not allowed, only reasonable mark-
ups are allowed;
 Banks cannot use excessive leverage and are therefore less likely to
collapse;
 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; and
 The emphasis of Islamic finance is on mutual interest and co-
operation, with a partnership based on profit creation through
ethical and fair activity benefiting the community as a whole.
89

EXAMINER‟S REPORT
Parts „a‟ and „b‟ of the question test candidates‟ understanding of the analysis of
lease or buy decision, while part „c‟ tests candidates‟ knowledge of the basic
principles of Islamic finance.
About 80% of the candidates attempted the question. Candidates are expected to
calculate implicit interest rate on a lease and assess the desirability of lease or buy.
Despite the fact that a similar question was tested in a recent examination, the
level of performance was below average.
Major pitfalls include:
 Inclusion of common cost in their analysis, thereby wasting valuable

examination time;
 Failure to include tax savings on interest; and
 Apparent lack of knowledge of basic principles of Islamic finance.
Candidates are advised to make effective use of the Institute‟s Study Text and the
Pathfinder.
MARKING GUIDE
Mark Mark
(a) Confirmation of the 7% implied interest rate with relevant
computation 3
(b) Identifying the relevant cost 1

Determining the after tax cost of borrowing 1
Calculation of interest component of lease rental using
amortisation table 4½
Calculation of the NPV of lease option 4½
Recommendation 1 12
(c) i. 1 mark per relevant point, max 2 points 2

ii. 1 mark per relevant point, max 3 points 3 5
20
90

SOLUTION THREE
a)
2018 2019 2020 2021

₦m ₦m ₦m ₦m
Revenue 7,950 8,427 8,933 9,469
Operating profits (32% of revenue) 2,544 2,697 2,859 3,030
Tax at 25% (636) (674) (715) (758)
Non cash expenses 689 730 774 821
Capital expenditures (1,155) (1,271) (1,398) (1,538)
Free cash flow to the firm 1,442 1,482 1,520 1,555
Note: It is also possible to calculate forecast free cash flow to the firm (FCFF)
starting from profit after tax. In this question however, it is faster starting from
operating profit (EBIT).
Note: Operating profit (as % of revenue)
=2,400/7,500 = 32%
b) Calculation of total value of the company.
This is given as the present value of the future FCFF.
₦m
2018 1,442 (1.12) –1
= 1,288
2019 1,482 (1.12) – 2 = 1,181
2020 1,520 (1.12) – 3 = 1,082
2021 1,555 (1.12) – 4 = 988

4,539
2021 – Infinity:
1,555 × 1.03
× (1.12) – 4 = 11,310
0.12 − 0.03
Total value of the company 15,849

Value of debt (40%) (6,339)
Total value of equity (60%) 9,510
Number of shares 150m
Value per share (9,510/150) = ₦63.40
P/E ratio (₦63.40/8.57) = 7.40
91

c) Total current value of LP = (total profit after tax) × P/E
= 4,430m × 12.2 = ₦54,046m
Number of shares 375m
Current value per share (₦54,046 ÷ 375) = ₦144.12
LP expects to maintain its P/E ratio after acquiring LT. Therefore, the post-
acquisition value of the two entities combined can be ascertained by
applying LP‟s P/E ratio to the sum of the latest earnings of each company (as
the P/E ratio of LP (12.2), exceeds that of LT, (7.4), this is known as
“bootstrapping”).
Current profit after tax for: ₦m
LP 4,430
LT 1,286
5,716
P/E ratio-LP 12.20
Post-acquisition total value of the

combined companies = ₦5,716m × 12.20 = ₦69,735.20m
Total post-acquisition number of shares:
Currently in LP 375
Issued to shareholders in LT (150m/2) 75
Revised number of shares 450
Revised value per share (VPS) in LP (₦69,735.20m / 450) = ₦154.97
Revised market value per existing

share in LT: ₦154.97 × ½ = ₦ 77.49
Percentage gain by:
Shareholders in LP
154.97 − 144.12
= × 100 = 7.53%
144.12
Shareholders in LT
77.49 − 63.39
= × 100 = 22.24%
63.39
92

d) Factors to consider by shareholders of LT include:
i. LT shareholders wanted a gain of 10% on the fair value of their shares.

Based on the above calculations, they are getting about 22%, which is
likely to encourage them to accept the offer;
ii. LT may decide to reject the offer believing that LP will make a more
lucrative offer in the future;
iii. The fair value of the LT shares has been based on forecasts and
estimates. Some sensitivity analysis needs to be carried out to ensure
the value is robust;
iv. There is no guarantee that LP can maintain its P/E ratio at 12.2.
Hence, the post-acquisition value is then uncertain;
v. LT shareholders may feel that as the economic conditions are
improving, their business prospects and value will get better. They
may reject the offer and stay independent; and
vi. Not all shareholders of LT want to sell the company. The constitution
of the company may allow the takeover to be blocked unless a certain
percentage majority of the shareholders agree.
EXAMINER‟S REPORT
The question tests candidates‟ knowledge of valuation of equity using free cash
flow to the firm. It also tests candidates‟ understanding of various discounting
techniques (growing annuity, delayed growth etc).
About 40% of the candidates attempted the question. Candidates were expected to
calculate free cash flow to the firm, market value of equity and analysis of gain of
the various stakeholders. However, candidates‟ failure to understand the basic
requirements of the question led to their poor performance.
Major pitfalls of candidates include:
 Failure to adjust for depreciation and tax; and

 Poor understanding of simple discounting principles.
Candidates are advised to use the Institute‟s Study Text, the Pathfinder and cover
the syllabus comprehensively when preparing for the Institute‟s examinations in
future.
MARKING GUIDE
Mark Mark
(a) Calculations of:
- Revenue 1
- Operating profit 1
- Tax 1
Non cash expenses 1
Capital expenditure 1 5
93

(b) Computations of:
- total value of the company 4¼
- value of debt ¼
- total value of equity ½
- value per share 1 6
(c) Calculations of:

- total current value of LP ½
- LP‟s current value per share ½
- post-acquisition value of the combined companies 1
- post-acquisition number of shares 1
- post-acquisition value per share in LP ½
- post-acquisition value per existing shares in LT ½
- percentage gain by LP shareholders 1
- percentage gain by LT shareholders 1 6
(d) 1 mark per correct point explained, max 3 points 3

20
SOLUTION FOUR
a) Financial Analysis
2017 2016 2015 2014
Turnover growth 17% 26% 14% -
Geometric average growth: 19%
EBIT growth 15% 18% 10% -
Geometric average growth 13%
EPS (kobo) 100 85 75 66
EPS growth 18% 13% 14% -
Dividend per share (kobo) 40 35 29 29
DPS growth 14% 21% - -
Shareholders‟ Fund (ordinary shares + reserves

(Nm) 19.2 15.9 13.1 10.6
8% bonds (Nm) 20.0 20.0 20.0 20.0
Capital employed (Nm) 39.2 35.9 33.1 30.6
Return on capital employed 25% 24% 23% 22%
Return on Shareholders‟ Funds 29% 30% 31% 34%
Debt/Equity ratio (market value) 42% 63% 109% 136%
Total Shareholders‟ return 58% 82% 36% -
[(Capital gain + dividend) / opening share price] for 2017:
[(864 – 574) + 40]/574 = 58%
94

Achievement of Corporate Objectives
YJ has shareholder wealth maximisation as an objective. The wealth of
shareholders is increased by dividends received and capital gains on shares
owned. Total shareholder return compares the sum of dividend received and the
capital gain with the opening share price. The shareholders of YJ had a return of
58% in 2017, compared with a return predicted by CAPM of 14%. The lowest
return which shareholders have received was 36% and the highest return was
82%. On this basis, the shareholders of the company have experienced a
significant increase in wealth. It is debatable whether this has been as a result
of actions of the company. Share prices may increase irrespective of the actions
and decisions of managers. In fact, looking at the dividend per share history of
the company, there were two years (2014 & 2015) when dividends were
constant, though earnings per share increased.
Another objective of the company was to achieve a continuous increase in EPS.

Analysis shows that EPS increased every year by an average of 14.9%. This
objective appears to have been achieved.
Comments on Financial performance

 Return on capital employed (ROCE) has been growing towards the
sector average of 25% on a year-by-year basis from 22% in 2014. This
steady growth in the primary accounting ratio can be contrasted with
irregular growth in turnover, the reasons for which are unknown.
 Return on Shareholders‟ Funds has been consistently higher than the

average for the sector. This may be due more to the capital structure
of the company than to good performance. In every previous year
except 2017, the gearing of the company was higher than the sector
average.
The current debt/equity ratio of the company is 42% (20/47.5). Although, this is less
than the sector average value of 50%, it is more useful from a financial risk
perspective to look at the extent to which interest payments are covered by profits.
2017 2016 2015 2014
EBIT (Nm) 9.8 8.5 7.5 6.8
Bond interest (Nm) 1.6 1.6 1.6 1.6
Interest coverage ratio (times) 6.1 5.3 4.7 4.3
The interest coverage ratio is not only below the sector average, it is also low
enough to be a cause for concern. While the ratio shows an upward trend
over the period under consideration, it still indicates that an issue of further
debt would be unwise.
95

A placing, or any issue of new equity shares such as rights issue or a public
offer, would decrease gearing. If the expansion of business results in an
increase in profit before interest and tax, the interest coverage ratio will
increase and financial risk will fall. Given the current financial position of
the company, a decrease in financial risk is certainly preferable to an
increase.
(b) A placing will dilute ownership and control, provided a new equity issue is
taken up by new institutional investors, while a rights issue will not dilute
ownership and control, provided existing shareholders take up their rights.
A bond issue does not have ownership and control implications, although
restrictive or negative covenants in bond issue document can limit the
actions of a company and its managers.
All the three financing choices are long-term sources of finance and so are
appropriate for a long-term investment such as the proposed expansion of
existing business.
Equity issues such as a placing and a rights issue do not require security. No
information is provided on the non-current assets of the company, but it is
likely that the existing bond issue is secured. If a new bond issue was being
considered, the company would need to consider whether it has sufficient
non-current assets to offer as security, although it is likely that new non-
current assets would be bought as part of the business expansion.
EXAMINER‟S REPORT
The question tests candidates‟ knowledge of key accounting ratios and their use in
performance evaluation. It also tests candidates‟ understanding of the relative
merits of placing, rights and bonds issues.
Candidates were expected to calculate and interprete, from the given data, some
key accounting ratios. They were also expected to discuss relative merits of
placing, rights and bonds issues.
Candidates‟ commonest pitfalls were their inability to make use of the calculated
accounting ratios to assess the performance of the given company and their failure
to understand the concept of placing as they wrote completely irrelevant things.
Candidates are advised to practise more examination questions on financial

analysis and capital market operations.
96

Marking Guide
Mark Mark
(a) Computation of growth rates and accounting ratios e.g.:
- Turnover growth rate 1
- EBIT growth rate 1
- EPS growth rate 1
- DPS growth rate 1
- Return on capital employed (ROCE) 1
- Return on shareholders‟ funds 1
- Debt/Equity ratio (gearing ratio) market value 1
- Total shareholders‟ return 1
Discussions on the achievement of corporate objective -
Shareholders wealth maximisation 3
Comments on financial performance 2 13
(b) Analysis and discussion of the relative merits of:

- rights issue 3
- Placing 2
- bonds issue 2 7
20
SECTION C
SOLUTION FIVE
(a)
3-Year Life
Year 0 1 2 3
N N N N
Outlay (240,000)
Tax savings on capital allowances 14,400 11,520 9,216 27,864
Maintenance cost (30,000) (30,000)
Tax savings on Maintenance cost 9,000 9,000
Scrap value _________ ________ ________ 30,000
Net Cash Flows (225,600) (18,480) (11,784) 66,864
DCF @15% 1 0.897 0.756 0.658
PV (225,600) (16,577) (8,909) 43,997
NPV = (N207,089)
97

4-Year Life
Year 0 1 2 3 4
N N N N N
Outlay (240,000)
Tax savings on capital allow. 14,400 11,520 9,216 7,373 29,491
Maintenance cost (30,000) (30,000) (60,000) -
Tax savings on Maintenance cost 9,000 9,000 18,000
_________ ________ ________ _______ ______
Net Cash Flows (225,600) (18,480) (11,784) (43,627) 47,491
DCF @15% 1 0.897 0.756 0.658 0.572
PV (225,600) (16,577) (8,909) (28,707) 27,165
NPV = (N252,623)
Summary:
3 year (Option) 4 year (Option)
N N
NPV as above (207,089) (252,623)
Annuity factor @ 15% 2.283 2.855
Equivalent Annual cost (EAC) (90,709) (88,484)
Recommendation: A four year life is marginally more economical and should

therefore be adopted.
WORKINGS
Time/ Year
Tax @ 30%
N N
0 Cost 240,000
Capital allowance (20%) (48,000) 14,400
1 Tax written down value 192,000
2 Tax written down value 153,600
Tax written down value 122,880*
Proceeds (30,000)
Balancing allowance if sold in year 3 92,880 27,864
3 Tax written down value 122,880*
Balancing allowance if sold in year 4 98,304 29,491
*Represents tax written down value if machine is not sold at the end of the
3rd year.
98

(b) Relevant issues include the following:
(i) The analysis in (a) ignores price changes of all descriptions as a
change in the price of a new machine, for example, could easily alter
the conclusion. Same will be true for all of the input factors;
(ii) The approach taken assumes that replacement will take place with an
identical machine. The machine may be technologically superseded.
The company may conclude that it no longer has a need for such a
machine. In practice, it seems unlikely that many such assets are
replaced with identical models on a continuing basis; and
(iii) The timing of the cash outflows on new machines could be an issue in
practice, i.e making payments every fourth year may cause less of a
cash flow problem than every third year.
EXAMINER‟S REPORT
This question tests candidates‟ ability to analyse and explain capital asset
replacement.
About 85% of the candidates attempted the question and performance was very
poor.
Candidates‟ commonest pitfalls were their inability to accurately calculate the

appropriate capital allowances, the related tax savings and their failure to correctly
identify the relevant cash flows together with their timings.
Candidates are advised to practise past examination questions using the

Pathfinders, the students‟ Study Text and other relevant materials.
MARKING GUIDE
Mark Mark
(a) Computation and recognition of capital allowances and tax
saving thereon for the two years (3 & 4 years respectively)
2 marks for each year 4
Recognition of maintenance cost and the tax savings
thereon for the two years – 1 mark for each year 2
Recognition of the scrap value for the third year /4
1
Computation of the NPV for the 3rd & 4th years 1¾

Calculations of equivalent annual cost (EAC) for the 3rd &
4th years 2
Recommendation 2 12
(b) 1½ marks per correct points discussed, max 2 points 3

15
99

SOLUTION SIX
(a) Reasons why a firm might reasonably choose not to hedge its exposure to
exchange rate risk include:
(i) Costs (direct and implicit);

(ii) Materiality of the exposure;
(iii) Attitude to risk may lead the firm to decide to leave the upside potential
open;
(iv) Portfolio effect; and
(v) If shareholdings are fully diversified, the shareholders‟ exposure to
systematic risk will not be affected. So, there will be no benefits for
them from hedging.
(b) Alternative 1 – Do not hedge

If the company does not hedge, the receivables will be converted at the
appropriate spot rates in 3 months‟ time.
Note that the company is selling Kudi and the bank is buying. The relevant
buying rate should be used, i.e 1.1880 and 1.1320.
If the spot rate is 1.1880 1.1320
Value of receivables is 70,000,000 Kudi/1.1880 Kudi/N 70,000,000 Kudi/1.1320 Kudi/N

= N58,922,559 = N61,837,456
Alternative 2 – Forward contract

With this alternative, the receivables will be converted at the agreed rate of
1.1508, irrespective of the spot rate in 3 months‟ time.
Amount due is 70,000,000 Kudi/1.1508 Kudi/ N = N60,827,251.
Alternative 3 – Currency option
As the company is hedging a foreign asset, a put option (the right to sell) is
needed. A premium of N1.25 per 100 Kudi will be paid, i.e
(70,000,000 Kudi/100) x N1.25 = N875,000.
100

Evaluation
Sport rate in 3 months‟ time is 1.1880 or 1.1320
Exercise rate 1.1650 1.1650
Exercise? Yes No
Applicable rate 1.1650 Kudi/N 1.1320 Kudi/N
Gross amount due
70m Kudi/1.1650 Kudi/N = N60,085,837 70m Kudi/1.1320 Kudi/N = N61,837,456
Premium payable (875,000) (875,000)
Net amount receivable N59,210,837 N60,962,456
(c) Methods available to firms to reduce their exposure to foreign exchange risk
which do not involve the use of financial contracts include:
(i) Appropriate choice of invoice currency;
(ii) Matching payments and receipts (e.g creating payables and receivables
in same currency);
(iii) Matching assets and liabilities (e.g creating overdraft borrowing in
respect of a receivable);
(iv) Leading and lagging payments; and
(v) Maintaining currency accounts.
EXAMINER‟S REPORT
The question tests candidates‟ ability to analyse various foreign currency hedging
techniques. In particular, they are to analyse the use of forward contract and over
the counter (OTC) option.
Candidates are expected to use certain financial derivative instruments to hedge

foreign exchange risk. However, candidates‟ lack of understanding of the basic
requirements of the question led to their poor performance. About 50% of the
candidates attempted the question.
Candidates‟ commonest pitfalls were their inability to identify the appropriate

exchange rate to use and their inability to identify which financial option to use.
Candidates are advised to familiarise themselves with foreign exchange

transactions to be able to perform well in this topic in future.
101

MARKING GUIDE
Mark Mark
(a) 1 mark per identified correct point, max 4 points - 4
(b) Alternative 1 – do not hedge:

- Identifying the correct spot rates 1
- Calculation of the value of the receivables 1
Alternative 2 – forward contract
- Identifying the correct rate to use 1
- Calculation of the amount due 1
Alternative 3 – current option
- Calculations of the premium payable and the net
amount receivable 3 7
(c) 1 mark per reasonable method stated, max 4 points 4

15
SOLUTION SEVEN
(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;
102

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
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;
103

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.
EXAMINER‟S REPORT
The question tests candidates‟ understanding of various agency conflicts in finance.
About 95% of the candidates attempted the question. The performance was
generally satisfactory with some candidates producing excellent solutions.
Candidates are expected to discuss the various possible conflicts of interest
between managers and shareholders. They are also required to identify mitigating
factors.
Candidates‟ commonest pitfalls were their inability to explain correctly the major
conflict areas identified by them and their lack of knowledge of the mitigating
factors.
Candidates are advised to study the Institute‟s Study Text, Pathfinders and other
materials relating to agency conflicts and costs to be able to perform better in
future examinations.
104

MARKING GUIDE
Mark Mark
(a) 2¼ marks per correct point mentioned and discussed, max
4 points 9
(b) 1½ marks per correct method stated, max 4 points 6

15
105

PATHFINDER
MAY 2019 DIET
Question Papers
Suggested Solutions
Plus
Marking Guides


QUESTION 1
Pako Plc. will soon announce a take-over bid for Ronke Tina (RT) Plc., a company in
the same industry. The initial bid will be an all-share bid of four Pako shares for
every five RT Plc. shares. The most recent annual data relating to the two
companies are shown below:
N000 N000
Pako RT
Sales revenue 13,333 9,400
Operating costs ( 8,683) (5,450)
Tax-allowable depreciation ( 1,450) (1,100)
Earnings before interest and tax 3,200 2,850
Net interest ( 715) (1,660)
Taxable income 2,485 1,190
Taxation (30%) ( 746) ( 357)
After-tax income 1,739 833
Dividend 870 458
Other information
Annual replacement capital expenditure (N000) 1,600 1,240
Expected annual growth rate in sales, operating costs
(including depreciation), replacement investment and
dividends for the next four years 5% 6.5%
Expected annual growth rate in sales, operating costs
(including depreciation), replacement investment and
dividends after four years 4% 5%
Gearing (long-term debt/long-term debt plus equity
by market value) 30% 55%
Market price per share (kobo) 298 192
Number of issued shares (million) 7 8
Current market cost, before tax, of fixed-interest debt 6% 7.5%
Equity beta 1.18 1.38
Risk-free rate 4%
Market return 11%
77

The take-over is expected to result in cost saving in advertising and distribution,
reducing the operating costs (including depreciation) of Pako from 76% of sales to
70% of sales. The growth rate of the combined company is expected to be 6% per
year for four years, and 5% per year thereafter. RT's debt obligations will be taken
over by Pako. The corporate tax rate is expected to remain at 30%.
Sales and costs relevant to the decision may be assumed to be in cash terms.
Required:
a. Estimate how much synergy is expected to be created from the take-over,

using free cash flow to the firm analysis for each individual company and
the potential combined company. State clearly any assumptions that you
make.
Note: The weighted average cost of capital of the combined company is

assumed to be 9%. (20 Marks)
b. Discuss any five limitations of the above estimates. (5 Marks)
c. Explain, generally, three advantages and two disadvantages of expansion

through merger and acquisition rather than through organic growth.
(5 Marks)
(Total 30 Marks)
SECTION B: YOU ARE REQUIRED TO ANSWER ANY TWO OUT OF THREE

QUESTION 2
The following financial information is available for PH Plc:
2014 2015 2016 2017

Earnings attributed to ordinary
shareholders ₦200m ₦225m ₦205m ₦230m
Number of ordinary shares 2,000m 2,100m 2,100m 1,900m
Price per share (kobo) 220 305 290 260
Dividend per share (kobo) 5 7 8 8
Assume that share prices are as at the last day of each year.
78

Required:
a. Calculate PH Plc.‟s earnings per share, dividend yield, dividend cover and
price/earnings ratio. Explain the meaning of each of these terms and state
the limitations they may have. (14 Marks)
b. Explain why the changes that occurred in the figures calculated in (a) above
over the past four years might have happened. (6 Marks)
(Total 20 Marks)
QUESTION 3
Able bank, on April 24, 2019 received the following statement of financial position
prepared for its customers, Pinko Limited (PL):
Statement of financial position as at April 20, 2019
Non-Current Assets N‘000

Freehold property at cost 20,000
Plant (carrying amount) 172,000
192,000
Current assets
Inventories 67,000
Receivables 26,000
93,000
Total assets 285,000
Equity
Issued share capital (N1 each) 50,000
Reserves 23,000
73,000
10% loan notes (secured on freehold property) 50,000
Current liabilities
Bank overdraft 45,000
Sundry payables 117,000
162,000
Total liabilities 285,000
PL is a long established company which traded profitably until a few years ago.
Following the expiration of exclusive patent rights on a particularly profitable
product line, results declined dramatically. Over the last twelve months, the
company‟s cash flow problems have steadily increased. The overdraft facility at
79

present stands at N45m and carries a second charge on the company‟s freehold
property.
A meeting has been arranged to consider the company‟s future. The above
statement of financial position will be presented at the meeting and the following
proposals will be discussed:
(a) Immediate liquidation of the company

In these circumstances, it is estimated that the freehold property would
realise N65,000,000, the plant N21,000,000, the inventory N40,000,000
and the receivables would pay up in full. Preferential payables, included
in the statement of financial position figure for payables, amounted to
N27,000,000;
(b) Tayo Limited (TL) has made an offer to take over the entire business
activities of PL: Under the terms of the offer, Able Bank would receive 80%
of the balance due, but repayment would not be made until exactly one
year from the date of the creditors‟ meeting. No further interest would be
considered to accrue on the balance due to Able Bank (AB) during the
twelve month period.
(c) Reorganisation and capital reconstruction: The management of PL is

planning a reorganisation of the company‟s activities which will restore
profitability to reasonable levels almost immediately. The reorganisation
will be linked with a capital reconstruction scheme. Under this scheme,
the existing shareholders will be asked to accept two ₦1 shares in
exchange for every five shares currently held. The bank will be asked to
accept 10,000,000 ₦1 shares as consideration for one half of the present
overdraft. If this proposal is acceptable to creditors, the shareholders have
indicated their willingness to take up a further 30,000,000 ₦1 shares for
cash and the balance remaining outstanding to the bank would be repaid
from the proceeds of this issue. The directors are confident that, if this
proposal is put into effect, profits of ₦40,500,000 per annum will be
earned for the foreseeable future, of which two-thirds will be paid out as
dividends and the remainder reinvested.
Notes: Assume that the Bank earns 15% per annum on all its lending
and that the amounts in the statement of financial position include
interest that accrued to date. Assume, for convenience, that any adopted
proposal would be implemented immediately with payments received
immediately unless otherwise stated.
80

Ignore expenses of realisation and liquidation and assume that no
changes have occurred between April 20 and April 24, 2019.
Required:
a. Calculate the amounts which Able Bank would receive under each of
the three proposals. (10 Marks)
b. Examine the relative financial merits of the proposals from the

viewpoint of Able Bank. (10 Marks)
(Total 20 Marks)
QUESTION 4
The managers of a pension fund follow an active portfolio management strategy.
They try to purchase shares and bonds that show a positive abnormal return
(positive alpha factor in the case of shares). The pension fund is required by law to
hold at least 40% of its investments in bonds. N100million is currently available for
investment.
Three shares and three bonds are being considered for purchase.
The required return on bonds may be measured using a model similar to the capital
asset pricing model, where beta is replaced by the relative duration of the
individual bond (Di) and the bond market portfolio (Dm) i.e. Di/Dm.
Expected return Standard deviation Correlation coefficient of
Shares (%) of returns returns with the markets
Equity
market 10.5 15 1
A Plc 11.0 25 0.76
B Plc 9.5 18 0.54
C Plc 13.5 35 0.63
Redemption yield
Bonds Duration (years) Coupons (%) (%)
Bond market 7.5 - 5.8
Federal Govt. 1.5 8 4.5
D Plc 8.6 6 5.3
E Plc 14.2 9 7.2
81

Note: Assume risk free rate of 4 per cent per year.
Required:
a. Evaluate whether or not any of the shares or bonds is expected to offer a
positive abnormal return. (10 Marks)
b. The pension fund currently has the maximum permitted investment in shares
and wishes to continue this strategy. It has a market value of N1,000 million
and a beta of 0.62.
Required:
Calculate the required return from the pension fund if any shares and bond with
positive abnormal returns are purchased.
State clearly any assumptions that you make. (4 Marks)
c. Discuss possible problems with the pension funds investment strategy.

(6 Marks)
(Total 20 Marks)
SECTION C: YOU ARE REQUIRED TO ANSWER ANY TWO OUT OF THREE

QUESTION 5
You are the portfolio manager of an asset management company based in Kano.
Your company has in its portfolio 27,750,000 shares of Yaro Plc., a company listed
on the Nigerian Stock Exchange. The shares are currently trading at N3.60 per
share.
Your company plans to sell the shares in six months‟ time to pay dividend and you
plan to hedge the risk of Yaro‟s shares falling by more than 5% from their current
market value. A decision has therefore been taken to buy an over the counter
option to protect the shares. A merchant bank has offered to sell an appropriate six
month option to your company for N1,250,000.
Yaro‟s share price has annual standard deviation of 13% and the risk-free rate of 4%
per year.
Required:
a. Evaluate whether or not the price at which the merchant bank is willing to sell
the option is a fair price. (11 Marks)
82

b. Explain briefly (without any calculations) how a decrease in the value of each
of the following variables is likely to change the value of a call option:
i. Volatility of the stock price (2 Marks)
ii. Risk-free rate (2 Marks)

(Total 15 Marks)
QUESTION 6
You are the head of the treasury group of Top Flight Aviation (TFA), a Nigerian
company. The company operates chartered international flights for the elites in the
country.
It is now December 31 and TFA needs to borrow £60 million from a UK bank to
finance a new air jet. The borrowing and the purchase will be in three months‟ time
and the borrowing will be for a period of six months.
You have decided to hedge the relevant interest rate risk using interest rate futures.
Your expectation is that interest rates will increase from 13% by 2% over the next
three months.
In the month of March, the current price of Sterling 3-month futures is 87.25. The
standard contract size is £500,000.
Required:
a. Set out calculations of the effect of using the futures market to hedge against
movements in the interest rate if:
(i) Interest rates increase from 13% by 2% and the futures market price
moves by 2%;
(ii) Interest rates increase from 13% by 2% and the futures market price
moves by 1.75%; and
(iii) Interest rates fall from 13% by 1.5% and the futures market price moves
by 1.25%.
In each case, show the hedge efficiency.
The time value of money, taxation and margin requirements should be

ignored. (11 Marks)
83

b. Show, for the situations in (a) above, whether the total cost of the loan after
hedging would have been lower with the futures hedge chosen by the
treasurer or with an interest rate guarantee which the treasurer could have
purchased at 13% for a premium of 0.25% of the size of the loan to be
guaranteed.
The time value of money, taxation and margin requirements are to be ignored.
(4 Marks)
(Total 15 Marks)
QUESTION 7
V Plc. manufactures engineering equipment. The company has received an order
from a new customer for five machines at N5,000,000 each. V Plc.‟s terms of sale
are 10 percent of the sales value payable with the order. The deposit has been
received from the new customer. The balance is payable 12 months after
acceptance of the order by V Plc.
V Plc.'s past experience has been that only 60 percent of similar customers pay
within 12 months.
Customers who do not pay within 12 months are referred to a debt collection
agency to pursue the debt. The agency has in the past, had a 50 percent success
rate of obtaining immediate payment once they became involved. When they are
unsuccessful, the debt is written off by V Plc. The agency‟s fee is N500,000 per
order, payable by V Plc. with the request for service. This fee is not refundable if the
debt is not recovered.
As an accountant in V Plc.‟s credit control department, and based on the company's

past experience and on discussions with the sales and credit managers, you do not
expect the pattern of payment and collection to change.
Incremental costs associated with the new customer's order are expected to be
N3,600,000 per machine, 70 percent of these costs are for materials and are
incurred shortly after the order has been accepted. The remaining 30 percent is for
all other costs which you can assume are paid shortly before delivery, that is in 12
months‟ time. The company is not at present operating at full production capacity.
A credit bureau has offered to provide an error-free credit information about the
new customer if the price is right.
V Plc.‟s opportunity cost of capital is 16 percent. Ignore taxation.
84

Required:
Write a report to the Credit Control Manager which:
a. Evaluates, from a purely financial point of view, if V Plc. should accept the
order from the new customer on the basis of the above information; and
(12 Marks)
b. Comments on what other factors should be considered before a decision to

grant credit is taken. (3 Marks)
(Total 15 Marks)
85

Formulae
𝑉𝐷
𝑉𝐸𝐺
Asset Beta
𝑉𝐸 𝑉𝐷 (1 − 𝑇)
(𝑉𝐸 + 𝑉𝐷 (1 − 𝑇)) 𝐸 (𝑉𝐸 + 𝑉𝐷 (1 − 𝑇)) 𝐷
Equity Beta
𝑉𝐷
𝛽𝐸 = 𝛽𝐴 + (𝛽𝐴 − 𝛽𝐷 ) (1 − 𝑡)
𝑉𝐸
Growing Annuity
𝑛
𝐴1 1+𝑔
𝑃𝑉 = 1−
𝑟−𝑔 1+𝑟

1
𝑃𝑉𝑅 𝑛
𝑀𝐼𝑅𝑅 = 1 + 𝑟𝑒 − 1
𝑃𝑉𝐼
C0 = S0N(d1) – Ee-rt N(d2)
𝑆
𝐼𝑛 0 + (𝑟 + 0.5𝜎 2 )𝑇
𝑑1 = 𝐸
𝜎 𝑇
d2= d1 - 𝜎 𝑇
The Put Call Parity
C + Ee-rt = S + P

d = 1/u
𝑎−𝑑
𝜋=
𝑢−𝑑

1
3 3
86

Annuity Table
r
Discount rate (r)

Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1
2 1·970 1·942 1·913 1·886 1·859 1·833 1·808 1·783 1·759 1·736 2
3 2·941 2·884 2·829 2·775 2·723 2·673 2·624 2·577 2·531 2.487 3
4 3·902 3·808 3.717 3·630 3.546 3.465 3·387 3·312 3·240 3·170 4
5 4·853 4·713 4·580 4·452 4·329 4·212 4·100 3·993 3.890 3·791 5
6 5·795 5·601 5·417 5·242 5·076 4·917 4·767 4·623 4.486 4·355 6
7 6·728 6.472 6·230 6·002 5·786 5·582 5·389 5·206 5·033 4·868 7
8 7·652 7·325 7·020 6·733 6·463 6·210 5·971 5·747 5·535 5·335 8
9 8·566 8·162 7·786 7.435 7·108 6·802 6·515 6·247 5·995 5·759 9
10 9·471 8·983 8·530 8·111 7·722 7·360 7·024 6·710 6.418 6·145 10
11 10·368 9·787 9·253 8·760 8·306 7·887 7.499 7·139 6·805 6.495 11
12 11·255 10·575 9·954 9·385 8·863 8·384 7·943 7·536 7'161 6·814 12
13 12·134 11·348 10·635 9·986 9·394 8·853 8·358 7·904 7·487 7·103 13
14 13·004 12·106 11·296 10·563 9·899 9·295 8·745 8·244 7·786 7·367 14
15 13·865 12·849 11·938 11·118 10·380 9·712 9·108 8·559 8·061 7·606 15
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1
2 1·713 1·690 1·668 1·647 1·626 1·605 1·585 1·566 1·547 1·528 2
3 2.444 2.402 2·361 2·322 2·283 2·246 2·210 2·174 2·140 2·106 3
4 3·102 3·037 2·974 2·914 2·855 2·798 2·743 2.690 2·639 2.589 4
5 3·696 3·605 3·517 3·433 3·352 3·274 3·199 3·127 3·058 2·991 5
6 4·231 4·111 3·998 3·889 3·784 3·685 3·589 3.498 3.410 3·326 6
7 4·712 4·564 4.423 4·288 4·160 4·039 3·922 3·812 3·706 3·605 7
8 5·146 4·968 4.799 4·639 4.487 4·344 4·207 4·078 3·954 3·837 8
9 5·537 5·328 5·132 4·946 4·772 4·607 4.451 4·303 4·163 4·031 9
10 5·889 5·650 5.426 5·216 5·019 4·833 4·659 4.494 4·339 4·192 10
11 6·207 5·938 5·687 5.453 5·234 5·029 4·836 4·656 4.486 4·327 11
12 6·492 6·194 5·918 5·660 5·421 5·197 4·988 4·793 4·611 4.439 12
13 6·750 6.424 6·122 5·842 5·583 5·342 5·118 4·910 4·715 4·533 13
14 6·982 6·628 6·302 6·002 5·724 5.468 5·229 5·008 4·802 4·611 14
15 7·191 6·811 6.462 6·142 5·847 5·575 5·324 5·092 4·876 4·675 15
87

Solution 1
a) The amount of expected synergy created may be estimated by comparing the

sum of the pre-acquisition values of the individual companies with the
expected post- acquisition value of the combined company.
Pako Plc.
Cost of equity using CAPM:
Ke = 4% + 1.18 (11 % - 4%) = 12.26%
Weighted average cost of capital:
= 12.26%(0.7) + 6%(1 – 0.3)(0.3) = 9.84%
Note: Rounded discount rates, for example 10%, are also acceptable in the
solution.
Free cash flow to the firm (FCFF)
Year 1 2 3 4
Sales revenue N‟000 N‟000 N‟000 N‟000
14,000 14,700 15,435 16,206
Operating costs (10,640) (11,172) (11,730) ( 12,317)
EBIT 3,360 3,528 3,705 3,889
Tax (30%) (1,008) (1,058) ( 1,112) ( 1,167)
Add back depreciation 1,523 1,599 1,679 1,762
Replacement investment (1,680) (1,764) (1,852) (1,945)
FCFF 2,195 2,305 2,420 2,539
Discount factors (9.84%) 0.910 0.829 0.755 0.687
Present values 1,997 1,911 1,827 1,744
The estimated value of Pako is N38,542,000 (N7,479,000 + N31,063,000)
Note: Interest is ignored as financing costs and their associated tax effects are
included in the company's discount rate.
RT Plc.
Cost of equity using CAPM:
88

Ke = 4% + 1.38 (11% - 4%) = 13.66%
Weighted average cost of capital:
WACC = 13.66%(0.45) + 7.5%(1 – 0.3)(0.55) = 9.03%
RT
Year 1 2 3 4
Sales revenue N‟000 N‟000 N‟000 N‟000
10,011 10,662 11,355 12,093
Operating costs (6,976) (7,429) (7,912) (8,426)
EBIT 3,035 3,233 3,443 3,667
Tax (30%) (911) (970) (1,033) (1,100)
FCFF 1,975 2,105 2,241 2,387
Discount factors (9.3%) 0.917 0.841 0.772 0.708
Present values 1,811 1,770 1,730 1,690
2,387(1.05)
Value beyond year 4 is estimated = x 0.708  44,032
0.0903  0.05
Total estimated value of RT = ₦51,033,000 (₦7,001,000 + N44,032,000)
Combined company
Year 1 2 3 4
N‟000 N‟000 N‟000 N‟000
Sales revenue 24,097 25,543 27,075 28,700
Operating costs (70%) (16,868) (17,880) (18,953) (20,090)
EBIT 7,229 7,663 8,122 8,610
Tax (30%) 2,169) (2,299) (2,437) (2,583)
FCFF 4,753 5,038 5,340 5,661
Discount factors (9%) 0.917 0.842 0.772 0.708
Present values 4,359 4,242 4,122 4,008
5.661(1.05)
Value beyond year 4 is estimated to be =  0.708  105,210
0.0900  0.05
The estimated value of the combined company
= N(16,731,000 + 105,210,000) = N121, 941,000
89

The sum of the individual companies
= N38,542,000 + ₦51,033,000
= N89,575,000
The expected synergy is

N121,941,000 – N89,575,000 = N32,366,000
90

Alternative method
A faster method of computing the present value of the FCFF for the first
4 years and for each of the 3 valuations is to use growing annuity.
Pako Plc. N‟000)

Every component of the FCFF calculations grows by 5%. Therefore, the FCFF must
grow by the same 5%.
Check:
Year 2 = 2,195 x 1.05
3 = 2,195 x 1.052, etc
Calculate the FCFF for Year 1 and then apply the growing annuity formula.
  1.05  4 
PV of FCFF Years 1 – 4 = 1    7,480
2,195
 
  1.0984  
0.0984 −0.05
Add PV of FCFF years 5-infinity as computed above, i.e.

*
2,643
0.0984 −0.04
x 0.687 = 31,091
PV of FCFF from year 1-infinity 38,571
(*FCFF in Year 5 = 2,195 x (1.05)3 x 1.04)

RT Plc. (N‟000)
Year 1 FCFF as computed above 1,975
Growth rate first 4 years 6.5%
  1.065  4 
1      6,997
1,975
PV of FCFF years 1 – 4 =
  1.0903 
0.0903 −0.065
*
= 44,008
2,505 𝑋 0.708
Years 5 – infinity =
0.0903 −0.05
PV of FCFF from year 1-infinity 51,005
(* FCFF5 = 1,975 x (1.065)3 x 1.05)

Combined company (N‟000)
Year 1 FCFF 4,753
Growth rate, years 1 – 4 6%
  1.06  4 
1      16,735
4,753
PV =
  1.09  
0.09−0.06
*
5,944 𝑋 0.708
Years 5 – infinity = = 105,209
0.09−0.05
121,944
(* FCFF5 = 4,753 x (1.06) x 1.05 = 5,944)
3
The sum of the individual companies = N38.571,000 + N51,005,000

= N89,576,000
Expected synergy = N121,944,000 – N89,576,000 = N32,368,000
91

b) The estimates are based upon unrealistic assumptions and are subject to
considerable margin of error. Possible limitations include:
i) Sales, operating costs, replacement investments, and dividends are
unlikely to increase by the same amount;
ii) Forecasts of future growth rates may not be accurate. Pako is unlikely
to have access to enough internal information about the activities of RK
to make accurate projections;
iii) The expected reduction in operating costs might not be achieved;
iv) The estimates are based upon present values to infinity of expected free
cash flows. A shorter time horizon might be more realistic;
v) The cost of capital for the combined company could differ from that
estimated, depending on how the market evaluates the risk of the
combined entity;
vi) The analysis is based upon the assumption that the initial offer price is
accepted;
vii) There is no information about the fees and other costs associated with
the proposed acquisition. In many cases, these are substantial, and
must be included in the analysis; and
viii) The post-acquisition integration of organisations often involves
unforeseen costs that would reduce the benefit of any potential
synergy.
c) Advantages of merger as an expansion strategy

As an expansion strategy, mergers are thought to provide a quicker way of
acquiring productive capacity, intangible assets and accessing overseas
markets.
There are four main advantages that have been put forward in the literature
and these are summarised below:
i) Speed
The acquisition of another company is a quicker way of implementing a
business plan, as the company acquires another organisation that is
already in operation. An acquisition also allows a company to reach a
certain optimal level of production much quicker than through organic
growth. Acquisition, as a strategy for expansion, is particularly suitable
for management with rather short time horizons.
92

ii) Lower cost
An acquisition may be a cheaper way of acquiring production capacity
than through organic growth. An acquisition can take place, for instance
through an exchange of shares which does not have an impact on the
financial resources of the firm.
iii) Acquisition of intangible assets

A firm through an acquisition will acquire not only tangible assets but
also intangible assets, such as brand recognition, reputation, customer
loyalty and intellectual property, which are more difficult to achieve with
organic growth.
iv) Access to overseas markets

When a company wants to expand its operations in an overseas market,
acquiring a local firm may be the only option of breaking into the
overseas market.
Disadvantages of mergers as an expansion strategy

An expansion strategy through acquisition is associated with exposure to a
higher level of business and financial risk.
The risks associated with expansion through acquisitions are:
i) Exposure to business risk

Acquisitions normally represent large investments by the bidding
company and account for a large proportion of its financial resources. If
the acquired company does not perform as well as it was envisaged,
then the effect on the acquiring firm may be catastrophic.
ii) Exposure to financial risk

During the acquisition process, the acquiring firm may have less than
complete information on the target company, and there may exist
aspects that have been kept hidden from outsiders.
iii) Acquisition premium

When a company acquires another company, it normally pays a premium
over its present market value. This premium is normally justified by the
management of the bidding company as necessary for the benefits that
will accrue from the acquisition. However, too large a premium may
render the acquisition unprofitable.
93

iv) Managerial competence
When a firm is acquired, which is larger than the acquiring firm, the
management of the acquiring firm may not have the experience or
ability to deal with operations on the new larger scale, even if the
acquired company retains its own management.
v) Integration problems
Most acquisitions are beset with problems of integration, as each
company has its own culture, history and ways of operation.
EXAMINER‟S REPORT
The part „a‟ of the question tests candidates‟ understanding of valuation of

business using free cash flow model, while in part „b‟, candidates were asked to
determine the value of possible synergy expected from a take-over and to also
explain its limitation.
In par (c) candidates‟ were asked to discuss the key advantages and disadvantages
of merger and acquisition rather than organic growth.
Being a compulsory question, visually all the candidates attempted it, more than
75% of the candidates did not attempt part (a) of the question and those who did,
showed a real lack of understanding of free cash flow model despite the fact that
the topic has been tested severally in recent examination, hence performance was
poor.
Candidates‟ commonest pitfalls were their failure to:
- Adjust the cash flows for growth;

- Identify the relevant cash flows;
- Determine the appropriate cost of capital; and
- Determine the terminal values of the companies at the end of year 4
Candidates are advised to practise examination type questions using the Institutes‟
pathfinder.
Marking Guide
Question 1 Marks Marks
Calculation of Pako‟s cost of equity using CAPM – Pako 1
Calculation of Pako‟s weighted cost of capital (WACC) 1
Calculating the changes in Pako‟s statement of profit or loss:
- Sales revenue ½
94

- Operating costs ½
- EBIT ¼
- Tax ½
- Replacement investment ½
Adding back depreciation ½
Calculating free cash flow to the Firm (FCFF) ¼
Discount factors ¼
Present values ¼
Calculation of value beyond year 4 1
Estimated value of Pako Plc ½
Calculation of RT Plc‟s cost of equity using CAPM 1
Calculation of RT Plc‟s weighted cost of capital (WACC) 1
Calculating the changes in RT Plc‟s statement of profit or loss:
- Sales revenue ½
- EBIT ¼
- Tax ½
Calculating free cash flow to the firm (FCFF) ¼
Discount factor ¼
Present value ¼
Calculation of value beyond year 4 1
Estimated value of RT Plc. ½
Calculating the changes in the combined company‟s statement of profit
or loss:
- Sales revenue ½
- EBIT ¼
- Tax ½
Calculation of Free cash flow to the firm (FCFF) ¼
Discount factors ¼
Present value ¼
Calculation of value beyond 4 years 1
Estimated value of the combined company ¼
Sum of the estimated values of the individual companies ¼
Expected synergy 1 20
1 mark per point, max. 5 marks 5
95

1 mark per advantages given, max. 3 marks 3
1 mark per disadvantages stated, max. 2 marks 2 5
30
Solution 2
(a) Data 2014 2015 2016 2017
1 Equity earnings (Nm) 200 225 205 230
2 Number of shares (m) 2,000 2,100 2,100 1,900
3 Price per share (kobo) 220 305 290 260
4 Dividend per share (kobo) 5 7 8 8
5 Earnings per share (= 1 ÷ 2) (kobo) 10.0 10.7 9.8 12.1
Dividend yield (= 4 ÷ 3) 2.3% 2.3% 2.8% 3.1%
Dividend cover (= 5 ÷ 4) 2.0 1.5 1.2 1.5
Price/earnings ratio (= 3 ÷ 5) 22.0 28.5 29.6 21.5
Earnings per share

Earnings per share (EPS) shows the amount of profit after tax attributable to
each ordinary share. Although a high EPS generally indicates success, care must
be taken in interpreting the trend in EPS when there have been share issues,
especially rights issues at heavily discounted prices or bonus issues, both of
which result in a fall in EPS. Similar problems are encountered when warrants
or convertible loan notes are issued.
Dividend yield
The dividend yield shows the ordinary dividend as a rate of return on the share
value. The figure is of limited use because it shows only part of the return to the
equity investor.
Dividend cover
The dividend cover shows how many times EPS is bigger than the dividend per
share. A high dividend cover shows that a large proportion of equity earnings is
being reinvested for growth.
Price/earnings ratio
The price/earnings ratio (P/E ratio) shows how many times the share price is
bigger than the EPS. In general, the bigger the EPS, the more the share is in
demand, though care must be taken when making comparisons because
whereas EPS is a historical result, the share price is based on future
expectations and is affected by both risk and growth factors. Consequently,
abnormal results can often arise from a crude use of P/E ratios.
96

b) Trends in 2015
In 2015, share capital was increased by 5%, probably through a rights issue.
Equity earnings increased more than proportionately, resulting in a 7% increase
in EPS, indicating a successful year. Demand for the company‟s share rose
swiftly, either because of a general stock market rise or because of high
expectations of PH Plc.‟s future growth, and the share price rose by
approximately 40%. This caused a big rise in P/E ratio and allowed a 40%
increase in dividend per share without any fall in dividend yield. The dividend
cover fell because the dividend increased much more than earnings.
Trends in 2016
The company‟s earnings and EPS fell in 2016, either because of normal cyclical
business risks or possibly because the high 2015 dividend left insufficient cash
for reinvestment. However, the company gave a „bullish‟ signal to the market by
increasing its dividend per share, indicating future prospects of a swift recovery
and increased growth. As a result, the dividend yield increased and, although
the share price fell in line with earnings, there was no disproportionate drop in
demand for the company‟s shares, as shown by the stability of the P/E ratio.
Trends in 2017
There was 12% earnings growth in 2017. The company used some of its cash to
buy back ordinary shares. This is possibly because it offered shareholders the
choice between a cash and a scrip dividend. Share capital reduced by about
10%, resulting in a big increase in earnings per share. Although 2017 was a
successful year for earnings, demand for the company's shares fell, as shown by
the drop in share price and P/E ratio. It is possible that the market has become
uncertain of the company's future plans, as a result of the share issue and share
buy-back in quick succession.
EXAMINER‟S REPORT
The question test candidates‟ knowledge of some basic stock market financial
ratios. Candidates were expected to calculate, interpret and assess the trend in the
given ratios over a number of years.
Almost all the candidates attempted the question, but performance was average.
Whereas most of the candidates were able to calculate the ratios, large number of
them could neither interpret nor assess the given trend.
In interpreting the trend, it is very disappointing that no single candidate made

reference to the fact that there were changes to the number of shares in issues.
Once again, we recommend adequate preparation on the part of students.
97

Marking Guide
Calculation of earnings per share 2
Calculation of dividend yield 2
Calculation of dividend cover 2
Calculation of P/E ratio 2
Explaining the meaning of earnings per share and 1
Its limitation ½
Stating the meaning of dividend yield and 1
its limitations ½
Explaining the meaning of dividend cover and 1
Its limitap[]ions ½
Explaining the meaning of P/E ratio and 1
Its limitation ½ 14
2 marks each for explaining the reason for the changes over the years
2015 – 2017 6
20
Solution 3
a) (i) In a liquidation: the assets would realise the following amounts:
₦’000 ₦’000
Freehold property 65,000
Plant 21,000
Inventory 40,000
152,000
The proceeds from the freehold property would be used to repay the 10% loan
notes of ₦50,000,000 (which has a first charge on the property) and the
remaining ₦15,000,000 would be used to repay some of the overdraft (which
has a second charge). This leaves ₦(45,000,000 – 15,000,000) = ₦30,000,000 of
the overdraft as an unsecured creditor.
Liquidation expenses are ignored, as indicated in the note to the question.
Priority for payment ₦’000 ₦’000
Secured creditors:
10% loan notes 50,000
Bank overdraft (balance of property value) 15,000
65,000
Preferential creditors 27,000
92,000
Realisable sales value of assets 152,000
98

Money left over to pay unsecured creditors 60,000
Unsecured creditors:
Bank overdraft 30,000
Sundry other creditors (N117,000,000 minus
Preferential creditors of ₦27,000,000) 90,000
120,000
Shortfall of money needed to pay unsecured creditors 60,000
Unsecured creditors will receive a payment of 50 kobo in the ₦1 (₦60m/₦120m)
₦’000
The Able Bank would receive:
Secured part of overdraft 15,000
Unsecured part of overdraft (50% of ₦30,000,000) 15,000
30,000
The money would be received at once.
ii. With the offer of Tayo Ltd:

Able Bank would receive 80% of ₦45,000,000 = ₦36,000,000, but only in one
year‟s time.
iii. Reconstruction scheme:
The share in the reconstructed company will be: No. of shares („000)
Receivables by Able Bank 10,000
Receivables by shareholder (two-fifths of 50,000,000) 20,000
30,000
Issued for cash 30,000
Total shares of ₦1 in issue 60,000
Able Bank will hold one-sixth of the equity. Able Bank‟s share of the dividend
will be
1 2
× × ₦40,500,000 = ₦4,500,000
6 3
The first dividend will be received after one year but further dividends should
be expected in subsequent years.
In addition, Able Bank will be repaid one-half of the debt at once, i.e. 50% of
₦45,000,000 = ₦22,500,000
99

4. Summary Proposal (a) Proposal (b) Proposal (c)
₦’000 ₦’000 ₦’000
Cash now 30,000 - 22,500
Cash after 1 year - 36,000 4,500
Cash in later years Future dividends in perpetuity
b) The return from the three proposals may be compared by calculating their
present value using the given interest rate of 15%.
Proposal (a) ₦’000
Overdraft due now 30,000
Proposal (b) ₦’000
PV of payment from Tayo Ltd: N36,000,000/1.15 31,304
Proposal (c) ₦’000
Overdraft received now: 50% × N45,000,000 22,500
Dividends: ₦4,500,000 from Year 1 to infinity:
₦4,500,000/0.15 30,000
Total present value 52,500
Proposal (c) offers, by far, the highest return, but it is perhaps the most risky
option. If the reconstructed company fails to make the expected profits, the
bank might receive only ₦22,500,000. On the other hand. If the reconstruction
ends in success, the bank will make a „profit‟ on its current overdraft
investments in Pinko Ltd. (which is only ₦45 million).
Proposal (b) is marginally preferable to proposal (a), although there must be

some risk that Tayo Ltd. may default on payment of its debt.
Liquidation (proposal (a) is the least risky option, but it offers the lowest return.
The choice between the three proposals will depend on the judgement of the
management of Able Bank, and in particular, on an assessment of the degree of
risk with each option.
EXAMINER‟S REPORT
The question tests candidates‟ knowledge of financial reconstruction, etc.
Candidates were expected to identify how to distribute available assets in
liquidation, among other things.
100

About 50% of the candidates attempted the question. The overall performance was
extremely poor with large number of the candidates scoring less than 5% of the
allocated marks.
A great number of the candidates demonstrated lack of knowledge of the priority of

asset distribution in liquidation. Besides large number of them could not recognise
the need to bring cash flows occurring at different time period to a common base
through discounting.
Candidates for future examinations are advised to cover the entire syllabus
comprehensively.
Marking Guide
a Recognising priority payment to secured creditors:
- 10% loan notes ½
- Bank Overdraft (Able Bank) ½
- Payment to preferential creditors 1
Calculating balance due to Able bank and other creditors 1
Calculation of dividend due to the unsecured creditors 1
Calculation of payment due to Able bank as an unsecured creditor 1
Calculation of payment due to Able bank under proposal (b) 2
Calculation of payment due to Able bank under proposal (c) 3 10
b Comparative analysis of the relative financial merits of the 3 proposals
to Able bank applying the given 15% interest rate:
- Proposal (a) 1
- Proposal (b) 1
- Proposal (c) 2
Comments on the result of the comparative figures arrived at under
the 3 proposals, 2 marks each 6 10
20
Solution 4
a) A positive abnormal return will exist if the expected return from a security is
higher than the required return. This may be established by using the Capital
Asset Pricing Model (CAPM).
101

The beta of the individual share may be found using:
correlation coefficient × investment standard deviation

Beta =
market standard deviation
0.76 × 25
βA= 15
= 1.27
0.54 × 18
βB= = 0.65
15
0.63 × 35
βC= = 1.47
15
Using the CAPM, the required return is given by Ri = Rf + βi(Rm - Rf)
Company Expected return Required Return Alpha

Ri Ri Ri - Ri
% % %
A Plc. 11 4 + 1.27(10.5 - 4) = 12.26 -1.26
B Plc. 9.5 4 + 0.65(10.5 - 4) = 8.22 1.28
C Plc. 13.5 4 + 1.47(10.5 – 4) = 13.56 -0.06
For the bonds, the relative durations are:

1.5
Federal Govt. = = 0.20
7.5
8.6
D Plc. = = 1.15
7.5
14.2
E Plc. = = 1.89
7.5
Organisation Expected Return Required return Alpha

Ri Ri Ri – Ri
(%) (%) (%)
Fed. Govt. 4.5 4 + 0.20(5.8 - 4) = 4.36 0.14
D Plc. 5.3 4 + 1.15(5.8 - 4) = 6.07 -0.77
E Plc. 7.2 4 + 1.89(5.8 - 4) = 7.40 -0.20
If these data are accurate, the shares of B Plc. and the Federal Government
bond offers a positive abnormal return.
102

b) The beta of the revised portfolio is the weighted average of the betas of the
components of the portfolio.
Investment Market Value Beta Hash

₦ total
N
Existing portfolio 1,000 0.62 620
Shares in B Plc 60 0.65 39
FG bond 40 .20 8
1,100 667
Beta = 667/1,100 = 0.61

Required return = 4 + 0.61(10.5 - 4) = 7.97%
c) The company‟s strategy relies upon the pension fund managers being able to
regularly and correctly identify underpriced securities. The implication is that
the securities‟ markets are not continuously efficient, and that excess returns
can be earned by trading in mispriced securities. Markets are certainly not
perfectly efficient, but whether or not mispriced securities can be regularly
found that will lead to an abnormal return, after any administrative and
transactions costs, is debatable.
A policy of selecting only mispriced securities might mean that the portfolio risk
and return are not consistent with the objectives of the portfolio or desire of the
investment clients.
The strategy is based on using the capital asset pricing model, and presumes
that the model presents an accurate measure of the required returns from
securities. The CAPM, however, is based on a number of unrealistic
assumptions, such as existence of a perfect capital market, borrowing and
lending can take place at the risk free rate, investors have the same
expectations about risk and return, investors are well diversified, and all
investors consider only the same single time period. It also states that
systematic risk is the only relevant measure of risk. It is likely that multifactor
models such as the arbitrage pricing theory offer better explanations of the
relation between risk and return. Accurate data input for elements of the CAPM
such as the market return and relevant betas are difficult to estimate, and the
CAPM has empirical anomalies, for example, it appears to overstate the
required return on high beta securities and understate the required return on
low beta securities.
103

EXAMINER‟S REPORT
The question tests candidates‟ knowledge of capital asset pricing model (CAPM).
They were expected to calculate, for each security, beta factor, required return and
alpha value (abnormal return).
Surprisingly and despite the regularity of testing these concepts in previous

examinations, the performance of the candidates was poor. Meanwhile, many
Candidates commonest pitfalls were:
 Use of wrong formulae to calculate beta factor;

 Inability to identify the appropriate risk-free rate and market return;
 Some candidates‟ use of the same market return for the equity shares and
the bonds; and
 Wrong interpretation of the calculated alpha value.
Success in the Institute‟s examinations can only be earned through diligent study
and adequate use of various study support materials provided by the Institute.
Marking Guide
a Calculations of the beta of the individual share – A, B & C Plc‟s 1½

3
Calculations of Alpha i.e R i - Ri of A, B & C Plc
Calculations of the relative durations for the bonds: Federal Govt., D Plc &
E Plc 1½

Calculations of Alpha i.e R i - Ri for the bonds: Federal Govt., D Plc & E Plc
3

1 10
Comment on the result of the Alpha ( R i-Ri) calculations
b Calculation of the beta for the revised portfolio 3
Calculation of the required return 1 4
c Discussion on the possible problems with the pension funds – Para. 1 (2
marks), Para. 2 (1 mark) and Para. 3 (3 marks) 6
20
Solution 5
a) Put options are required to hedge the price of the shares.
Step 1: Determine d1and d2
In S/E + (r + σ2 /2)T
d1 =
σ T
104

S = 360
E = 360 × 0.95* = 342
* The exercise price is 5% lower than the market price as that is the protection
required.
r = 0.04
 = 13% = 0.13
T = 6/12 = 0.5
360
In 342 + (0.04 + 0.132 /2)(0.5)
d1 = = 0.8215
0.13 0.5
d2 = d1– ()( T) = 0.8215 – (0.13) 0.5 = 0.7296
Step 2: Determine N(d1) and N(d2)

N(d1) = N(0.8215) = 0.2939 + 0.15(0.2967 - 0.2939) = 0.2943
Since d1 is positive, we add 0.5 to get 0.5 + 0.2943 = 0.7943
N(d2) = N(0.7296) = 0.2642 + 0.96(0.2673 - 0.2642) = 0.2672
We also need to add 0.5 to get 0.7672
Step 3: Determine the value of call

C = SN(d1) - Ee-rTN(d2) = 360(0.7943) – 342e-0.04(0.5)(0.7672) = 28.76
Step 4: Using Put Call Parity (PCP), determine the value of put option
2,876 + 342e-0.04(0.5)= P + 360
P = 3.99 kobo
On the assumption that one put option is bought per share:
Total value of Option = 27.75 million × 3.99kobo = ₦1,107,225
Overcharge by bank: ₦1,250,000 - ₦1,107,225 = ₦142,775
b) • Volatility of the stock price: A decrease in volatility will mean that a call option
becomes less valuable. A decrease in volatility will decrease the chance that the
stock price will be above the exercise price when the option expires.
• Risk free rate of return: A decrease in the risk free rate will mean that a call
option becomes less valuable. The purchase of an option rather than the
underlying will mean that the option holder has spare cash available which
can be invested at the risk free rate of return. A decrease in that rate will
mean that it becomes less worthwhile to have spare cash available, and hence
to have an option rather than having to buy the underlying security.
105

EXAMINER‟S REPORT
Part (a) of the question tests candidates‟ ability to make use of the Black-Scholes
option pricing model to price a put option. Candidates were expected to identify
the appropriate option required for the hedge and to price the option accordingly.
In part (b), candidates were required to discuss some option „greeks‟.
poor. There is a clear evidence that candidates lack knowledge of this important
topic in finance.
 Failure to identify the type of option needed;

 Using the wrong strike price;
 Wrong use of the various formulae; and
 Inability to use the normal distribution table
Granted the poor level of performance, candidates should note that the examiners
are motivated to revisit this topic area in future examination. The study test
contains good illustrations for students‟ practice.
Marking Guide
a Stating the purpose of the put option 1
Calculation of:
- The exercise price (E) ½
- di 2
- d2 1
- N (di) 1
- N (d2) 1
Determination of the value of call option 1½
Determination of the value of put option 1
Calculation of the total value of options 1
Overcharge by bank 1 11
b Comment on the volatility of the stock price 2
Comment on the risk free rate of return 2 4
15
106

Solution 6
a) Note:
For each of the scenarios of interest rate movements given in the question, we
need to identify the appropriate market price of the futures contracts. Generally,
the movements in interest rates and futures prices should be in the same
direction but not necessarily „one-on-one‟.
Scenario (i) Cash Market Future Market

Current interest rate (%) 13 (100 – 87.25) = 12.75
Expected (%) 15 12.75 + 2 = 14.75*
(*This gives expected future price of 100 – 14.75 = 85.25)
Scenario (ii) Cash Market Future Market

Expected rate (%) 15 (12.75 + 1.75) = 14.5*
(* implied price = 100 – 14.5 = 85.5)
Scenario (iii) Cash Market Future Market
Expected rate (%) 11.50 (12.75 – 1.25) =
11.50*
(* Implied price = 100 - 11.50 = 88.5)
Note: Because borrowing (rather than lending) is involved, we „sell futures‟.

Evaluation of hedge
Cash market (i) (ii) (iii)
Actual interest rate (R) 15% 15% 11.5%
Actual interest cost
= £60m × R × 6/12 = (T) £4,500,000 £4,500,000 £3,450,000
Target interest cost
= £60m × 13% × 6/12 £3,900,000 £3,900,000 £3,900,000
Gain/(loss) on target = (Y) (£600,000) (£600,000) £450,000
Future Market (i) (ii) (iii)

Sell futures 87.25 87.25 87.25
Buy futures 85.25 85.50 88.50
Gain/(loss) = (P) = 2% 1.75% (1.25%)
Monetary gain/(loss)
= £60 × 6/12 × P = (N) £600,000 £525,000 (£375,000)
Net interest cost = (T - N) (£3,900,000) (£3,975,000) (£3,825,000)
Hedge efficiency = Gain/Loss = 100% 87.5% 120%
107

b) Interest rate guarantee (IRG)
Premium for the guarantee is:
£60m × 0.25% = £150,000.
The guarantee would be used in cases (i) and (ii) because the actual rate (15%)
is greater than the target rate (13%).
Then, total cost limiting interest rates to 13% is actual interest of £3,900,000
plus premium £150,000, that is, £4,050,000.
This costs more than the futures contracts hedge in cases (i) and (ii). In case
(iii), the guarantee is not used because the prevailing interest rate of 11.5% is
less than the guarantee rate of 13%.
Interest costs at 11.5% are:
Interest paid at 11.5% = £3,450,000

Add premium 150,000
£3,600,000
This costs less than the futures hedge, reflecting the fact that declining to take
up the interest rate option in the case of the guarantee, has allowed the
company to take advantage of the lower interest rates in the cash market.
EXAMINER‟S REPORT
The question tests candidates‟ understanding of the risk management element of

the syllabus.
Candidates‟ commonest pitfalls were their inability to:
 determine whether to buy or sell futures;

 evaluate the hedge; and
 calculate the hedge efficiency, as required by the question.
Candidates are advised to give a comprehensive coverage to all aspects of the

syllabus as future examinations will continue to draw on all elements of the
syllabus.
108

Marking Guide
a Scenario (i) Calculation of expected future price 1½

Scenario (ii) Calculation of expected rate 1½
Scenario (iii) Calculation of expected rate 1½
Comment on the decision to sell futures ½
Evaluation of hedge – Cash market 3
Evaluation of hedge – Future market 3 11
b Interest rate guarantee:
Calculation of the premium for the guarantee 1
Calculation of total cost limiting interest rate 1
Calculation of interest costs at 11.5% 1
Comment on the comparative futures hedge and the interest rate
guarantee 1 4
15
Solution 7
a) From: Finance Manager

To: Credit Control Manager, V plc.
Date: 15May 2019
Subject: Order from new customer
As required, I have looked into the above subject matter. There are three
possible outcomes. These are:
i) If all things go as expected, we will receive the balance due from the
customer (probability 60%);
ii) we have to pay a ₦500,000 collection fee, as a result of which the
balance is received (probability 20%); and
iii) we pay the ₦500,000, but the balance is not forthcoming (probability
20%).
These can be evaluated, and a statistically expected figure calculated, as
follows:
Outcome
(i) (ii) (iii)
₦000 ₦000 ₦000
Now Receive 10% of ₦25m 2,500 2,500 2,500
(Pay)70% of ₦18m (12,600) (12,600) (12,600)
Net (K) (10,100) (10,100) ( 10,100)
109

Year 1 (Pay) 30% of ₦18m (5,400) (5,400) ( 5,400)
(Pay) collection fee - (500) (500)
Receive balance 22,500 22,500 -
Net receipt/(payment) 17,100 16,600 ( 5,900)
Discount factor 16% p.a 0.862 0.862 0.862
Present value at 16% p.a (T) 14,740 14,310 (5,086)
Net present value (K+T) 4,640 4,210 (15,186)
Probability 60% 20% 20%
Expected value 2,784 842 (3,037)
= ₦589,000
The expected value being positive, the order is financially viable
b) Other factors worthy of consideration include the following:

• Although the expected value is positive, there are only three possible
outcomes: ₦4,640,000 positive, ₦4,210,000 positive and ₦15,186,000
negative.
Depending on your aversion to risk, the size of the negative outcome
may dissuade you from accepting the order;
• The possibility/cost of insuring against default‟
• The possibility of using other forms of payment, e.g. bills of exchange or
different terms (discount for early payment);
• The likelihood of getting further orders as a consequence of accepting
this (e.g. repeat or recommendation);
• The possibility of recovering some of the balance at a later date (e.g, on
the insolvency of the buyer);
• Opportunity cost, e.g. penalties/layoffs if order is not accepted; and
• The question of whether the 16% already includes a component to reflect
uncertainty/risk aversion.
Please let me know if you want me to elaborate on any of the above or take
any aspect further.
Signed: Finance Manager
EXAMINER‟S REPORT
The question tests candidates‟ understanding of the analysis of working capital.
Candidates were expected to identify the possible outcomes of a customer‟s order,

isolate the relevant cash flows (and their timing) and compute the expected present
110

value of the cash flows. Over 60% of the candidates attempted the question, but
the level of performance was below average.
 Inability to identify the various possible outcomes;

 Inability to identify the appropriate cash flows and their timing;
 Failure to consider the time value of money; and
 Inappropriate use of the given probabilities
Candidates need to prepare adequately for the Institute‟s examinations and avail
themselves of the study materials made available by the Institute.
Marking Guide
a Report format; From, To, Date and Signature ¼ each, subject matter ½ 1½
Stating the three possible outcomes 1½
Calculating the three outcomes (now) – K 2
Calculating the three outcomes (in Year 1) – T 4
Calculation of the net present value(K + T) 1
Calculation of the expected value 1
Comment on the result 1 12
b 1 mark for each reasonable factor stated, max. 3 marks 3
15
111

PATHFINDER
NOVEMBRT 2019 DIET
Question Papers
Suggested Solutions
Plus
Marking Guides

INSTRUCTION: YOU ARE REQUIRED TO ANSWER FOUR OUT OF SIX QUESTIONS

IN THIS PAPER
QUESTION 1
Agbeloba Limited (AL) is an unlisted company based in Akure, Nigeria. Over the
years, the company has been producing and selling agricultural support tools. AL is
now considering the production and sale of yam pounders.
Although this is a completely new venture for AL, it will be in addition to the
company‟s core business. AL‟s directors plan to develop the project for a period of
four years and then sell it for N24million to a group of young investors.
The government is excited about the project and has offered AL a subsidised loan of
up to 80% of the investment funds needed at the beginning of the project, at a rate
of 200 basis points below AL‟s borrowing rate. Currently AL can borrow at 300 basis
points above the five-year government debt yield rate.
A feasibility study commissioned by the directors, at a cost of N5,000,000, has
produced the following information:
 The company can buy an existing suitable factory at a cost of N16.5m payable
now;
 N4.5m is required now to buy and install the necessary plant and machinery;
 The company will produce and sell 1,300 units in the first year. Unit sales will
grow by 40% in each of the next two years before falling to an annual growth
rate of 5% for the final year;
 Unit selling price for the first year will be N3,750 but this will increase by 3%
per year thereafter;
 In the first year, total variable cost per unit will be N1,800 but this will increase
by 8% per year thereafter;
 In the first year, the fixed overhead costs will be N3.75m, of which 60% are
centrally allocated overheads. The fixed overheads will increase by 5% per year
after the first year;
85
 AL will require working capital of 15% of the anticipated sales revenue for the
year, at the beginning of each year. The working capital is expected to be
released at the end of the fourth year when the project is sold;
 AL‟s tax rate is 25% per year on taxable profits. Tax is payable in the same year
as when the profits are earned. Tax allowable deprecation is available on the
plant and machinery on a straight-line basis. It is anticipated that the value
attributable to the plant and machinery after four years is N600,000 of the price
at which the project is sold. No tax allowable depreciation is available on the
factory;
 AL uses 12% as its discount rate for new projects but feels that this rate may not
be appropriate for this new type of investment. It intends to raise the full
amount of funds through debt finance and take advantage of the government‟s
offer of a subsidised loan;
 Issue costs are 4% of the gross finance required. It can be assumed that the debt
capacity available to the company is equivalent to the actual amount of debt
finance to be raised for the project;
 Although no other companies produce yam pounders in the country, Casscare

plc. (CL) produces cassava crushing machines, using almost similar technology
to that required for yam pounder. CL‟s cost of equity is estimated to be 14% and
it pays tax at 28%. CL has 15 million shares in issue, trading at N2.53 each and
N40 million bonds, trading at N94.88 per N100; and
 The five-year government debt yield is currently estimated at 4.5% and the
market risk premium at 4%.
Required:
a. Evaluate, on financial grounds, whether AL should proceed with the project.
(28 Marks)
b. Discuss the appropriateness of the evaluation method used and explain the
assumptions made in part (a). (5 Marks)
c. Provide examples of ethical issues that might affect capital investment

decisions, and discuss the importance of such issues for strategic financial
management. (7 Marks)
(Total 40 Marks)
SECTION B: YOU ARE REQUIRED TO ANSWER ANY THREE OUT OF FIVE
QUESTION 2
a. Two neighbouring countries, A and B have chosen to organise their

electricity supply industries in different ways.
86
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 nationalised 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)
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)
QUESTION 3
R Plc. is a successful IT services company formed ten years ago. It was listed on the
stock exchange three years ago. The company has a broad customer base mainly
consisting of small and medium sized companies. R Plc. has achieved rapid growth
in recent years by obtaining repeat business from satisfied customers and also by
acquiring other IT services companies.
The directors of R Plc. have identified H Limited, an unlisted company, as a possible

acquisition target. H Limited appears to have a larger number of large
multinational clients than those of R Plc. If the negotiation is successful, the
acquisition would commence on January 1, 2020.
Forecast financial data for R Plc. and H Limited as at December 31, 2019 is
summarised below:
R Plc. H Limited
Share capital (ordinary N1 shares) N150m N40m
Market share price N 4.90 N/A
N/A: Not applicable as unlisted.

Additional information
(i) If H Limited were to remain an independent company, its directors estimate
that reported profit after tax would be N15million for 2020 and then grow by
2% a year in perpetuity.
(ii) If the acquisition were to go ahead, R Plc‟s directors estimate that H
Limited‟s profit after tax would be 5% higher for 2020 than if the company
remains an independent company and that profit after tax would then grow
by 3% a year in perpetuity.
(iii) The average ungeared cost of equity for the industry is 8%.
87
(iv) Both R Plc. and H Limited are wholly equity financed.
(v) Profit after tax can be assumed to be a good approximation of free cash flow
attributable to investors.
The directors of R Plc. are considering offering to purchase H Limited at a price of

N7.00 per share. It is estimated that transaction costs of N8million would be
payable on the acquisition and that N2million would be required in the first year to
cover the costs of integrating the two companies.
Required:
a. Calculate
 The value of R Plc. on December 31, 2019.
 The value of H Limited on December 31, 2019 before taking the possible
acquisition of the company by R Plc. into account.
 The overall increase in value created by the acquisition of H Limited by R
Plc. (6 Marks)
b. i. Explain how value might be created by the proposed acquisition. (3 Marks)

ii. Advise on the challenges that R Plc is likely to face in realising the potential
added value after the acquisition. (3 Marks)
c. Evaluate the proposed offer price of N7.00 per share for H Limited from the
viewpoint of:
 H Limited‟s shareholders
 R Plc.‟s shareholders. (8 Marks)
(Total 20 Marks)
QUESTION 4
You are the portfolio manager of an asset management company. A client has
approached you for the creation of his portfolio. The client is considering three
stocks A, B and C. Your research department has provided you with the
following annualised details concerning the three stocks and the market index.
Assets Expected Standard Beta

Return (%) Deviation (%)
Stock A 12.8 17.8 0.75
Stock B 15.2 25.4 1.12
Stock C 5.6 12.6 0.22
Market index 5.615.0 21.2 1.00
Risk-free rate is 3 %.
Required:
a. Explain which of the three stocks A, B and C will lie on the capital market
line (CML). (2 Marks)
88
b. Using the security market line (SML), which of the three stocks is the most
attractive to buy. Show all relevant calculations. (4 Marks)
c. Using the CAPM theory and the above tabulated data, calculate the
correlation coefficient with the market index for each of the three stocks.
(2 Marks)
d. Your client wants to invest 10% in stock B and the rest in stock A and C as
suggested by you. Also he wants to have a market exposure of 1 (i.e. a
portfolio beta of 1).
Calculate what will be the investments in the other two assets to reach the
client's objective. Also calculate the expected return of the resulting
portfolio.
(Assume you can sell short any quantity of any stock). (4 Marks)
e. Now assume the client wants to invest only in stock B and the risk-free
asset. He wants portfolio‟s standard deviation of 10%. Calculate what the
weight on stock B should be in order to achieve the stated objective.
(3 Marks)
f. The equity beta of Zinta Plc., another client of yours, is 0.95 and the alpha
value is 1.5%. Explain the meaning and significance of these values to the
company. (5 Marks)
(Total 20 Marks)
QUESTION 5
a. You have worked with a major oil servicing company in Nigeria, with
headquarters in the USA, for the past six years. Recently you completed your
ICAN examinations and have been asked to join the international treasury
department in New York City for a two-year attachment.
The company is due to pay a UK supplier the sum of ₤5million in three

months‟ time. Your team is considering alternative methods of hedging the
expected payment against adverse movements in exchange rate.
Exchange rate information
US$ per ₤1
Spot rate 1.9410 – 1.9531
One – month forward rate 1.9339 – 1.9452
Three – month forward rate 1.9223 – 1.9339
Futures market (contract size of ₤62,500, Quotation: US$ per ₤)
2-month expiry 1.9305
89
Options market (₤31,250 contracts size, premiums are quoted in cents per
₤1)
Call option Put option
Exercise price 2-month 5-month 2-month 5-month
expiry expiry expiry expiry
1.9000 2.88 3.55 0.15 0.28
1.9200 1.59 2.32 1.00 1.85
1.9400 0.96 1.15 2.05 2.95
You are required to advise the company which of the following hedging
strategies should be adopted for the payment due in three months. Show all
workings.
i. Forward contract
ii. Currency futures
iii. Currency options (15 Marks)
b. In your personal investment portfolio, you have gone short (i.e. you have sold)
110,000 units of Big Bank plc. Call and put options exist on the bank‟s shares.
You decide to hedge your position using put options on the bank‟s shares. For
the relevant option you know that;
N (d1) = 0.45
You are required to calculate how many put options you will need to buy or
sell in order to delta-hedge.
Be specific. (5 Marks)
(Total 20 Marks)
QUESTION 6
The directors of Jaleyemi plc. (JP), an Abuja-based entertainment company, are
currently considering the appropriate cost of capital to use in appraising capital
investments. It is the policy of the company to assess the financial viability of all
capital projects using net present value criterion.
You have been provided with the following financial information of the company.
Most recent statement of financial position
Nm Nm
Equity finance
Ordinary shares (N1 nominal value) 200
Reserves 120 320
7% Convertible bonds (N100 nominal value) 160
5% Preference shares (N1 nominal value) 80 240
90
Current liabilities
Trade payables 80
Overdraft 120 200
Total liabilities 760
JP has an equity beta of 1.2 and the ex-dividend market value of the company‟s
equity is N1 billion. The ex-interest market value of the convertible bonds is N168
million and the ex-dividend market value of the preference shares is N50 million.
The convertible bonds of JP have a conversion ratio of 19 ordinary shares per bond.
The conversion date and redemption date are both on the same date in five years‟
time. The current ordinary share price of JP is expected to increase by 4% per year
for the foreseeable future.
The equity risk premium is 5% per year and the risk-free rate of return is 4% per
year. JP pays profit tax at an annual rate of 30% per year.
Required:
a. Calculate the market value after-tax weighted average cost of capital of JP,
explaining clearly any assumptions you made. (10 Marks)
b. Discuss why market value weighted average cost of capital is preferred to

book value weighted average cost of capital when making investment
decisions. (4 Marks)
c. Discuss how the capital asset pricing model can be used to calculate a
project - specific cost of capital for JP, referring in your discussion to the key
concepts of systematic risk, business risk and financial risk. (6 Marks)
(Total 20 Marks)
91
Formulae
𝑉𝐷
𝑉𝐸𝐺
Asset Beta
𝑉𝐸 𝑉𝐷 (1 − 𝑇)
(𝑉𝐸 + 𝑉𝐷 (1 − 𝑇)) (𝑉𝐸 + 𝑉𝐷 (1 − 𝑇)) 𝐷
Equity Beta
𝑉𝐷
𝛽𝐸 = 𝛽𝐴 + (𝛽𝐴 − 𝛽𝐷 ) (1 − 𝑡)
𝑉𝐸
Growing Annuity
𝑛
𝐴1 1+𝑔
𝑃𝑉 = 1−
𝑟−𝑔 1+𝑟
1
𝑃𝑉𝑅 𝑛
𝑀𝐼𝑅𝑅 = 1 + 𝑟𝑒 − 1
𝑃𝑉𝐼
C0 = S0N(d1) – Ee-rt N(d2)
𝑆
𝐼𝑛 0 + (𝑟 + 0.5𝜎 2 )𝑇
𝑑1 = 𝐸
𝜎 𝑇
d2= d1 - 𝜎 𝑇
The Put Call Parity
C + Ee-rt = S + P
d = 1/u
𝑎−𝑑
𝜋=
𝑢−𝑑
92
Annuity Table
Present value of an annuity of 1 i.e. 1 - (1 + r) -n
r
Discount rate (r)

Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1
2 1·970 1·942 1·913 1·886 1·859 1·833 1·808 1·783 1·759 1·736 2
3 2·941 2·884 2·829 2·775 2·723 2·673 2·624 2·577 2·531 2.487 3
4 3·902 3·808 3.717 3·630 3.546 3.465 3·387 3·312 3·240 3·170 4
5 4·853 4·713 4·580 4·452 4·329 4·212 4·100 3·993 3.890 3·791 5
6 5·795 5·601 5·417 5·242 5·076 4·917 4·767 4·623 4.486 4·355 6
7 6·728 6.472 6·230 6·002 5·786 5·582 5·389 5·206 5·033 4·868 7
8 7·652 7·325 7·020 6·733 6·463 6·210 5·971 5·747 5·535 5·335 8
9 8·566 8·162 7·786 7.435 7·108 6·802 6·515 6·247 5·995 5·759 9
10 9·471 8·983 8·530 8·111 7·722 7·360 7·024 6·710 6.418 6·145 10
11 10·368 9·787 9·253 8·760 8·306 7·887 7.499 7·139 6·805 6.495 11
12 11·255 10·575 9·954 9·385 8·863 8·384 7·943 7·536 7'161 6·814 12
13 12·134 11·348 10·635 9·986 9·394 8·853 8·358 7·904 7·487 7·103 13
14 13·004 12·106 11·296 10·563 9·899 9·295 8·745 8·244 7·786 7·367 14
15 13·865 12·849 11·938 11·118 10·380 9·712 9·108 8·559 8·061 7·606 15
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1
2 1·713 1·690 1·668 1·647 1·626 1·605 1·585 1·566 1·547 1·528 2
3 2.444 2.402 2·361 2·322 2·283 2·246 2·210 2·174 2·140 2·106 3
4 3·102 3·037 2·974 2·914 2·855 2·798 2·743 2.690 2·639 2.589 4
5 3·696 3·605 3·517 3·433 3·352 3·274 3·199 3·127 3·058 2·991 5
6 4·231 4·111 3·998 3·889 3·784 3·685 3·589 3.498 3.410 3·326 6
7 4·712 4·564 4.423 4·288 4·160 4·039 3·922 3·812 3·706 3·605 7
8 5·146 4·968 4.799 4·639 4.487 4·344 4·207 4·078 3·954 3·837 8
9 5·537 5·328 5·132 4·946 4·772 4·607 4.451 4·303 4·163 4·031 9
10 5·889 5·650 5.426 5·216 5·019 4·833 4·659 4.494 4·339 4·192 10
11 6·207 5·938 5·687 5.453 5·234 5·029 4·836 4·656 4.486 4·327 11
12 6·492 6·194 5·918 5·660 5·421 5·197 4·988 4·793 4·611 4.439 12
13 6·750 6.424 6·122 5·842 5·583 5·342 5·118 4·910 4·715 4·533 13
14 6·982 6·628 6·302 6·002 5·724 5.468 5·229 5·008 4·802 4·611 14
15 7·191 6·811 6.462 6·142 5·847 5·575 5·324 5·092 4·876 4·675 15
93
94
SOLUTION 1
a)
i) Base-case NPV (₦‟000)
Year 0 1 2 3 4
Sales revenue (W1) 4,875 7,031 10,136 10,962
Direct costs (W2) (2,340) (3,538) (5,351) (6,064)
Fixed overheads (1,500) (1,575) (1,654) (1,736)
Cash profit 1,035 1,918 3,131 3,162
Tax on cash profit (259) (480) (783) (791)
Tax savings on tax depr. (W5) 244 244 244 244
Investment/sale (21,000) 24,000
Working capital (W3) (731) (324) (465) (124) 1,644
Net cash flows (21,731) 696 1,217 2,468 28,259
D F@ 10% 1.0 0.909 0.826 0.75 0.683
PV (21,731) 633 1,005 1,853 19,301
Base case NPV = ₦1,061,000

NOTE: The sales price of the project, that is, N24million at the end of the 4th year
includes the N600,000 scrap value of the plant and machinery since the business is
sold as a going concern.
Working notes
1. Sales revenue
Year 1 2 3 4
Qty sold (q) 1,300 1,820 2,548 2,675
Selling price (₦) 3,750 3,863 3,978 4,098
Sales revenue (₦‟000) 4,875 7,031 10,136 10,962
2. Direct materials, etc
Qty sold (q) 1,300 1,820 2,548 2,675

Cost per unit (v) in ₦ 1,800 1,944 2,100 2,267
Total (q × v) in ₦‟000 2,340 3,538 5,351 6,064
3. Working capital
Year 0 1 2 3 4
₦‟000 ₦‟000 ₦‟000 ₦‟000 ₦‟000
Cumulative (15% of sales) 731 1,055 1,520 1,644
Incremental cash flows (731) (324) (465) (124) 1,644
95
4. Ungeared cost of equity
This has to be calculated from the information given in respect of

CL.
From CAPM, we compute the equity beta of CL:
14 = 4.5 +  E (4)
 E (4) = 14 – 4.5 = 9.5

 E = 2.375
Asset beta (  A ) is computed using
 E x VE  D x V D (1  t )
A = 
V E  V D (1  t ) V E  V D (1  t )
=VE =N2.53 x 15m = ₦37.95m

= VD = N40m × 0.9488 = ₦37.952m
2.375 × 37.95
A = 0 = 1.3808
37.95  37.952(0.72)
(Since we are not given the beta of debt, we assume it has a beta of 0).
Cost of equity of ungeared is:
KEU = 4.5 + 1.3808 (4) = 10.023 or (say) 10%

Note: An alternative method of computing the ungeared cost of equity is to
use M and M formula as given in the question paper.
VD
KEG = KEU + (KEU – KD) (1 – t)
V EG
 37.952
14 = x + ( x – 4.5)   (1  0.28)
 37.95 
14 = x + 0.72 x – 3.24
17.24 = 1.72 x
x = 17.24/1.72 = 10.02% = 10%
5. Tax savings on tax depreciation
Annual tax savings:
 4.50m  0.60m 
  x 25% = ₦243,750
 4 years 
96
ii) Financing side effects
Note: It is assumed that the net amount needed is ₦21,731,000 (i.e. it

includes the required working capital in year 0). Alternative assumption
that excludes working capital will be fully rewarded.
Issue costs (₦’000)
Government Commercial
loan loan
Net amount (0.8 × N21,731) 17,384.80 (0.2 × N21,731) 4,346.20
Issue costs (4/96 × N 17,384.80) 724.37 (4/96 × N4,346.20) 181.09
Gross amount needed 18,109.17 4,527.29
 Tax savings on issue costs (due in year 1) N‟000
25% × (₦724.37 + N181.09) = ₦226.37

 Tax savings on interest (₦’000)
Govt. loan 0.055 × N18,109.17 × 0.25 = 249.00

Commercial loan 0.075 × N4,527.29 × 0.25 = 84.89
Total tax savings due years 1 – 4 333.89
 Net interest saved on govt. subsidised loan (₦’000)
Gross interest saved = ₦18,109.17 × 0.02 = 362.18

Less tax at 25% (90.55)
Net interest savings (years 1 – 4) 271.63
 Present value of financing side effect (₦’000)
Year NCF PVF PV

At 7.5%
Issue costs (724.37 + 181.09) 0 (905.46) 1 (905.46)
Tax savings on issue costs 1 226.37 0.93 210.52
Tax savings on interest 1–4 333.89 3.349 1,118.20
Net interest saved on subsidised loan 1–4 271.63 3.349 909.69
Net financing effect 1,332.95
 Adjusted present value (₦’000)
Base-case NPV 1,061.00

Financing side effect 1,332.95
APV 2,393.95
97
Recommendation – With positive APV, the project is viable.
b) The adjusted present value can be used where the impact of using debt
financing is significant. Here the impact of each of the financing side
effects from debt is shown separately rather than being imputed into the
weighted average cost of capital. The project is initially evaluated by only
taking into account the business risk element of the new venture. This
shows that, although the project results in a positive net present value, it is
fairly marginal and volatility in the input factors could turn the project to a
negative net present value. However, sensitivity analysis can be used to
examine the sensitivity of the factors. The financing side effects show that
almost 110% value is added when the positive impact of the tax shields and
subsidy benefits are taken into account even after the issue costs.
Assumptions
1. CL ungeared cost of equity is used because it is assumed that this
represents the business risk attributable to the new line of business.
2. The ungeared cost of equity is calculated on the assumption that

Modigliani and Miller's (MM) proposition 2 which assumes that there
are no bankruptcy nor agency cost and no tax.
3. It is assumed that initial working capital requirement will form part

of the funds borrowed but the subsequent requirements will be
available from the funds generated from the project.
4. The feasibility study is ignored as a past cost.
5. It is assumed that the five-year debt yield is equivalent to the risk-

free rate.
6. It is assumed that the annual reinvestment needed on plant and

machinery is equivalent to the tax allowable depreciation.
7. It is assumed that all cash flows occur at the end of the year unless
specified otherwise.
8. All amounts are given either in ₦'000 or to the nearest ₦'000. When
calculating the units produced and sold, the nearest approximation
for each year is taken.
Assumptions 4, 5, 6, 7 are standard assumptions made for a question of this

nature. Assumptions 1, 2 and 3 warrant further discussion. Taking
assumption 3 first, it is reasonable to assume that before the project starts,
the company would need to borrow the initial working capital as it may not
have access to the working capital needed. In subsequent years, the cash
flows generated from the operation of the Project may be sufficient to fund
the extra working capital required. In the case of AL, because of an expected
rapid growth in sales in years 2 and 3, the working capital requirement
98
remains high and the management need to assess how to make sufficient
funds available.
Considering assumptions 1 and 2, the adjusted present values methodology
assumes that MM proposition 2 applies and the equivalent ungeared cost of
equity does not take into account the cost of financial distress. This may be
an unreasonable assumption. The ungeared cost of equity is based on
another company which is in a similar line of business to the new project,
but it is not exactly the same. It can be difficult to determine an accurate
ungeared cost of equity in practice. Generally, the discount rate (cost of
funds) tends to be the least sensitive factor in investment appraisal and
therefore some latitude can be allowed.
c. There are many possible answers to this question. The solution suggested
below is indicative only.
Ethics impact on many aspects of investment decisions. In theory, companies

seek to maximise shareholder‟s wealth which is often subject to constraining
secondary objectives. Such secondary objectives include the welfare of the
public. Companies are affected by ethical standards relating to:
• Health and safety. Employees and the public should be protected from
danger, which includes working conditions, effective employment law
and product safety;
• Environmental issues such as controlling pollution, protecting wildlife

and the countryside. Fully satisfying these issues might be an
expensive element in a capital investment;
• 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;
• Corporate governance. Many examples exist of companies, e.g. Enrons,

where the results of investments and the true financial position have
been hidden from shareholders and the public;
• Taxation. Companies may try to minimise their tax liability. Tax
evasion is illegal, but there is an ethical question over the
sophisticated tax avoidance measures, especially in developing
countries;
• Wage levels. Should a company pay low wages to maximise

shareholders‟ wealth, especially in countries where the standard of
living is very low?
99
• 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 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.
EXAMINER‟S REPORT
This was a three-part question that tested the candidates‟ understanding of capital
investment element of the syllabus. In addition, it tested candidates‟ understanding
of ethical issues in capital investment decisions.
Part (a) of the question implicitly required candidates to appraise a capital project
using adjusted present value (APV).
Part (b) asked candidates to discuss the appropriateness of the evaluation method
used in Part (a).
Being a compulsory question, virtually all the candidates attempted it but the level
of performance was disappointing.
The poor performance emanated from the following areas:
• A failure to omit irrelevant costs;

• Inaccurate calculation of the working capital impact of the investment
proposal;
• Failure to recognise that the use of APV was required;
• Confusion regarding the appropriate cost of capital to use; and
• Identification of the relevant financing costs and their timing.
Candidates must be aware that the Institute‟s examinations demand comprehensive

study covering the entire syllabus. It is necessary to practise examination type
questions during revision.
100
MARKING GUIDE
MARKS MARKS
(a) i. Base case NPV
Sales revenue 4
Direct costs 4
Fixed overheads 2
Tax on cash profits 1
Tax savings on tax depreciations 1
Investment/sale ½
Working capital calculations 2
Net cash flows 1
Discount factor @ 10% ½
Present values @ 10% 1
Computation of equity beta of CL ½
Calculation of asset beta 2
Calculation of Tax savings on tax depreciation 1
ii. Financing side effects:

Calculation of:
- Issue cost – Government loan/commercial loan 2
- Tax savings on issue cost due in year 1 ½
- Tax savings on interest 1
- Net interest saved on govt. Subsidised loan ½
- Present value of financing side effect 2½
- Adjusted present value/recommendation 1 28
(b) Evaluation of the project 2

1 mark per valid assumption (3 assumptions) 3 5
(c) 1½ marks per valid point (5 points), max 7 marks 7

40
SOLUTION 2
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.
101
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 investors‟ 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
102
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.
103
EXAMINER‟S REPORT
This was a two-part question. The first part tested the candidates‟ understanding of
the key objectives of nationalised industry vs those of private sector companies. The
second part tested candidates‟ understanding of the circumstances under which the
Black-Scholes option pricing model can be used to value companies.
Large number of the candidates attempted the first part of the question and
performance was average. Less than half of the candidates attempted the second
part with below average level of performance.
In the first part of the question, most of the candidates could not relate their
discussion to “investment planning and appraisal techniques” as required by the
question.
In part (b), most of the candidates could not identify the required variables of the
model despite the fact that the Black-Scholes formula is given in the formula sheet.
Those who identified the variables could not relate them to the special case of
company valuation.
It is recommended that students should cover the entire syllabus in their

preparation for the Institute‟s examination.
MARKING GUIDE
(a) i. 1 mark per well explained objective of a nationalised

Industry – essential to mention provision of service,
not for profit etc, (Max 3) 3
1 mark per well explained objective of a private
sector industry – essential to mention maximisation
of shareholders‟ wealth, profit maximisation and
non-financial objectives such as corporate social 3 6
responsibility
ii. 1 mark per valid point discussed
- Nationalised industry - 3 points 3
- Private sector industry - 3 points 3 6
SOLUTION 3
a)
 Pre-acquisition value: ₦’m
R Plc. ₦4.90 × 150m = 735.00
15𝑚
H Ltd. 0.08 − 0.02 = 250.00
985.00
104
 Post-acquisition value: ₦’m
15𝑚 × 1.05
H Ltd. 0.08 − 0.03 = 315.00
R Plc. 735.00
Transaction costs (8.00)
2𝑚
Integration costs 1.08 = (1.85)
Total value 1,040.15
Pre-acquisition total value (985.00)
Incremental value 55.15
b) i) Value can be created by combining the two companies through the

achievement of synergies and economies of scale. In most business
combinations there are likely to be savings generated from combining
operations and reducing the amount of resources needed to fund central
functions such as human resources, finance and treasury. The cost savings
are likely to have an almost immediate impact on the cash flow and hence
are likely to be reflected in 5% growth in free cash flow in the first year.
Synergies might also arise in respect of the cross-selling of services between

the two companies to their respective client bases. It's possible that the
directors of R Plc anticipate that there are opportunities to enhance the cash
flows of H Ltd by utilising the expertise of R Plc leading to a higher growth
rate of 3% a year compared to 2%.
ii) Key challenges in realising the potential added value after the merger
 Success depends on the extent that H's management and staff accept the
transfer of ownership and remain committed to servicing H's clients to
the best of their ability. Consider introducing an incentive scheme such as
a bonus payment or employee share option scheme.
 It also depends on whether H's clients are happy with the new
arrangement and are confident of receiving the same level of service as
before.
 The reliability of the forecast improvement in earnings and growth is also
key to successful realisation of the potential added value.
105
c) Consideration paid: ₦7 × 40 million shares = ₦280 million
Comparison of shareholders‟ wealth before and after the acquisition:
R Plc. H Limited Total value
Before the acquisition ₦735 million ₦250 million ₦985 million
After the acquisition ₦760 million ₦280 million ₦1,040 million
(i.e. ₦1,040 million – ₦280 million) (proceeds)

Share of synergistic benefits ₦25 million ₦30 million
H Ltd.‟s shareholders‟ perspective: Very attractive. H Ltd‟s shareholders can

expect to receive 54% of the synergistic benefits of the merger which does not
seem to be a fair split considering that:
 H Ltd. is the smaller company and contributing less to the merger;
 H Ltd.‟s shareholders do not carry any of the risks that the synergistic
benefits cannot be realised; and
 H Ltd. is unlisted and it is therefore very difficult for the shareholders to
realise their investment at all, let alone at such a generous price which is
above the company‟s own bullish value estimates derived from discounted
cash flow analysis.
R Plc.‟s shareholders‟ perspective: Possibly too high a price for comfort. The
main reasons for this conclusion are as follows:
 The reverse of the above: R Plc.‟s shareholders take all the risk and
contribute most value to the combined business and yet only expect to
receive 45% of the increase in value; and
 It is likely that H Ltd. has a higher business risk than R Plc. despite being in
the same industry because of the different client profile. If one customer
were to be lost by H Ltd. then this could have a significant impact on cash
flow and hence the variability of H Ltd.‟s cash flows is likely to be higher
than for R Plc. Therefore it is possible that a higher discount rate should be
used to value H Ltd. which would have effect of reducing its value.
Conclusion: The price needs to be reduced. The proposed price is not fair to R
Plc.‟s shareholders and H Ltd. is potentially over-valued at a discount rate of 8%.
EXAMINER‟S REPORT
The question tested the candidates‟ understanding of business valuation. It was a

replica of one of the questions set in a recent examination. Candidates were
expected to place value on each of the two companies separately and eventually
106
the combined company in order to determine the appropriate synergy. Candidates
were also expected to identify the problems of realising synergies in practice.
Surprisingly, the level of performance was very disappointing as many of the

candidates could not make effective use of the perpetual growth formula. The
discussion part of the question was also poorly handled.
It is recommended that students should make effective use of the learning

materials, especially the pathfinder, provided by the Institute when preparing for
the examination.
MARKING GUIDE
(a) Calculation of :
Pre-acquisition value 2
- Post acquisition value 4 6
(b) i. 1½ marks per well explained point – essential to

consider economies of scale and cross-selling of
services (max 2 points) 3
ii. 1½ marks per well explained challenges
(2 key challenges) 3
(c) Computation and comparison of shareholders‟ wealth

before and after the acquisition:
- R Plc. 2
- H Ltd. 2
Evaluation of the computed shareholders‟ wealth:
H Ltd.‟s shareholders‟ perspective 2
R Plc.‟s shareholders perspective 2 8
20
SOLUTION 4
a) None of the stocks lies on the Capital Market Line (CML). The CML describes
the risk-return relationship applicable only to efficient portfolios. It does not
apply to individual assets or non-efficient portfolios.
b) First, we determine the required return of each stock using CAPM:

Ri = RF + i (Rm + RF)
A 3 + 0.75 (15 - 3) = 12%
B 3 + 1.12 (15 – 3) = 16.44%
C 3 + 0.22 (15 – 3) = 5.64%
Next, we determine the alpha (α) of each stock.
107
α = Expected return – Required return
A 12.8 – 12 = 0.8
B 15.2 – 16.44 = - 1.24
C 5.6 – 5.64 = - 0.04
Stock with positive alpha are undervalued and worth buying and stocks with
negative alpha are overvalued and are not worth buying. Therefore, only stock
A is worth buying.
c) Correlation between stock, i, and the market, m, is given by:

βi . σm
R i, m =
σi
0.75 X 21.2
A = 0.89
17.8
1.12 × 21.2
B = 0.93
25.4
0.22 × 21.2
C
12.6
= 0.37
d) The client wants a 10% investment in stock B, thus remaining 90% should be
invested in stock A and/or stock C. The client also wants his portfolio beta to be
1.
Let w = weight in stock A
Weight in stock C = 0.9 – w
Portfolio beta is a weighted average of the betas of securities in the portfolio.
Thus:
(0.75w) + (1.12 × 0.1) + 0.22 (0.9 – w) = 1
0.75w + 0.112 + 0.198 – 0.22w = 1
0.53w = 0.69
w = 1.3019 (i.e. 130.19%)
Hence the effective investments to meet the client‟s objective will be:
Stock A = 130.19%
Stock B = 10%
Stock C = 0.90 – 1.3019 = - 0.4019 = - 40.19%
The client will therefore have to short sell stock C to meet his objective.
Check:
(0.75 × 1.3019) + (1.12 × 0.1) – (0.22 × 0.4019) = 1
With beta of 1, the portfolio return should be the same as the market return.
108
Check:
E(Rp) = (12 × 1.3019) + (16.4 × 0.10) – (5.6 × 0.4019) = 15%
e) Let w = weight of stock B.

1 – w = weight of risk-free asset
Noting that the risk-free asset is not correlated with any asset (i.e. R(B,RF) = 0)
and the risk-free asset is riskless σRF = 0 , the standard deviation of a portfolio
comprising of only stock B and risk-free asset becomes:
𝜎𝑝2 = 𝑤 2 . 𝜎𝐵2
102 = 𝑤 2 25.4 2
2
w 2 = 10 25.4 2 = 0.155
𝑤 = 0.155 = 0.3937 = 39.37%

Thus, 39.37% should be invested in stock B and 60.63% in risk-free asset.
Check
 p  39 .37 % of 25.4 = 10%
f) 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 0.95 suggests that Zinta Plc shares are less
risky than the market as a whole which has a beta of 1. If average market
returns change, for example increase by 4% the return of Zinta Plc shares would
be expected to increase to 0.95 × 4% = 3.8%.
The alpha value measures the abnormal return on a share. An alpha value of
1.5% means that the returns on Zinta Plc shares are currently 1.5% more than
would be expected given the shares 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 1.5% 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.
EXAMINER‟S REPORT
This multi-part question tested the candidates‟ knowledge of some elementary
calculations in portfolio theory and capital asset pricing model (CAPM). Candidates
were expected to show an understanding of capital market line (CML) and security
market line (SML).
109
About 50% of the candidates attempted the question with the level of performance
being below average.
The most common pitfall in parts (a) and (b) was the inability of the candidates to
differentiate between CML and SML.
In parts (c) – (f), candidates demonstrated complete lack of understanding of the

basic concepts being tested. For example, most of the candidates did not
understand that the volatility (standard deviation) of a risk-free asset is zero! They
also did not recognise that the correlation of a risk-free asset with any other asset is
zero.
Candidates are advised to ensure adequate preparation for future examination.
MARKING GUIDE
4. (a) 2 marks for a well explained point 2
(b) Computation of the required return of each stock

using CAPM 1½
Computation of the alpha of each stock 1½
Recommendation 1 4
(c) Calculation of the correlation coefficient with the

market index for each of the three stocks 2
(d) Determining the weights of stocks A and C 1

Computing the effective investments in stocks A & C
that meet the client‟s objective 2½
Recommendation on the negative result of stock C ½ 4
(e) Determining the weights of stock B and the risk-free

asset 1
Calculation of the weight on stock B that will achieve
the stated objective 1
Recommendation 1 3
(f) Explanation of the meaning and significance of equity beta 2½

Explanation of the meaning and significance of alpha
value 2½ 5
20
110
SOLUTION 5
a)
i. Forward Contract
Since the payment is due in three months, the three-month forward contract
should be used. The company is to buy pounds and the currency dealer is
selling. We therefore make use of the selling rate of $1.9339.
The cost = ₤5 million × $1.9339 = $9,669,500
ii. Currency Futures
 Buy or sell futures?
You need to sell dollars in other to buy pounds, so we need to buy
futures.
 Which expiry date?
The first futures to mature after the expected payment date
(transaction date) are choosen. We therefore select the 5-month expiry
date.
 How many contracts?
₤5,000,000 ÷ ₤62,500 = 80 contracts
So we buy 80 contracts at $1.9170/₤
 Predicted futures rate
Current basis = spot price – futures price = $(1.9339 – 1.9170)=
$0.0169
Unexpired basis on the transaction date =1/2 x 0.0169 =
0.0067
Lock-in exchange rate = opening futures price + unexpired basis
= $1.9170 + $0.0067 = $1.9237
Expected total cost = ₤5,000,000 × $1.9237 = ₤9,618,500
NOTE: Alternative approaches are available and allowed.
iii. Currency options
 Put or Call?
We are required to buy pounds so we must buy a call option on
pounds.
₤5,000,000 ÷ ₤31,250 = 160 contracts

Same as under futures – we select the 5-month expiry date.
111
 Which exercise price?
We should choose the cheapest one that includes the exercise price
and the premium. Since we are buying pounds we add the premium
to the exercise price:
Exercise price + Premium = Net cost
$ $ $
1.9000 + 0.0355 = 1.9355
1.9200 + 0.0232 = 1.9432
1.9400 + 0.115 = 1.9515
To minimise cost, an exercise price of $1.900 should be selected.
Summary of total cost $

Payment through option = ₤5,000,000 × $1.9000 = 9,500,000
Add option premium = 160 × ₤31,250 × $0.0355 = 177,500
Net cost = 9,677,500
Comment and recommendations
Based on cost, currency futures offer the best choice. However, these
calculations ignore margin requirements on futures and problems of basis
risk.
b. Put delta = 0.45 – 1 = –0.55
Let x = number of puts needed:

Delta of stock = – 110,000
Delta of put = – 0.55x
Total delta of portfolio = – 110,000 – 0.55x
For delta hedging:
– 110,000 – 0.55x =0
x = – 200,000 put options
Because this figure is negative, 200,000 put options should be sold.
EXAMINER‟S REPORT
The question tested candidates‟ understanding of key derivative instruments used
to hedge foreign exchange risk. They were expected to make use of forward
contract, futures and options.
112
Less than 20% of the candidates attempted the question and performance was
simply woeful! It would appear that the candidates have made up their minds not
to study the risk management section of the syllabus.
MARKING GUIDE
(a) i. Forward contract:
- Determining the rate and cost to adopt for the
payment due in 3 months 3
ii. Currency futures:
Determining the rate and calculation of the
expected total cost 3½
iii. Currency options
Determining the rate and calculation of the
expected cost 7½
Comment/recommendation 1 15
(b) Calculation of the put options to be bought or sold in

order to delta hedge 4
Recommendation 1 5
20
SOLUTION 6
a)
 Cost of equity (KE), using CAPM
KE = 4 + (1.2 × 5) = 10%
 Cost of convertible bonds
Current market value of bonds =100 × 168/160 = N105 per bond
Current share price = N1 billion/200m = N5 per share
VPS in five years‟ time = N5 × 1.045 = N6.08
Conversion value = 19 × N6.08 = N115.52
Redemption value (assumed at par) = N100
Since the conversion value is higher than the redemption value, it is

assumed that the bondholders will likely convert.
After-tax interest payment = 0.07 × 100 × (1- 0.3) =N4.90 per bond
Using linear interpolation to calculate the Internal Rate of Return (IRR):
Year cash flow N Discount at 7% PV (N)

0 Market price (105.00) 1.000 (105.00)
1-5 Interest 4.90 4.100 20.09
5 Conversion value 115.52 0.713 82.37
(2.54)
113
0 Market price (105.00) 1.000 (105.00)
1-5 Interest 4.90 4.212 20.64
1.93
After-tax KD = 6 + ((7-6) × 1.93)/(1.93 + 2.54)) = 6 + 0.43 = 6.43%
 Calculation of cost of preference shares

KD = 100 × (0.05 × 80m/50m) = 8%
Alternatively, the preference dividend per share can be compared with the
preference share price to find the cost of preference shares.
 Calculation of weighted average after-tax cost of capital

Total value of company = N(1000m+50m+168m)= N1,218million
After-tax WACC=((10% ×N1,000) + (8% × N50m) + (6.43% ×N168m))/N1,218m =
9.4%
It is assumed that the overdraft can be ignored in calculating the WACC,
even though it persists from year to year and is a significant source of
finance for JP.
b) Market values of different sources of finance are preferred to their book

values when calculating weighted average cost of capital (WACC) because
market values reflect the current conditions in the capital market. The
relative proportions of the different sources of finance in the capital structure
reflect more appropriately their relative importance to a company, if market
values are used as weights. For example, the market value of equity is
usually much greater than its book value, so using book values for weights
would seriously underestimate the relative importance of the cost of equity
in the weighted average cost of capital.
If book values are used as weights, the WACC will be lower than if market
values were used, due to the understatement of the contribution of the cost
of equity, which is higher than the cost of capital of other sources of finance.
This can be seen in the case of JP, where the market value after-tax WACC
was found to be 9.4% and the book value after-tax WACC is 8.7% (10% × 320
+ 8% × 80 + 6.43% × 160/560).
If book value WACC were used as the discount rate in investment appraisal,
investment projects would be accepted that would be rejected if market
value WACC were used. Using book value WACC as the discount rate will
therefore lead to sub-optimal investment decisions.
114
As far as the cost of debt is concerned, using book values rather than market
values for weights may make little difference to the WACC, since bonds often
trade on the capital market at or close to their nominal (par) value. In
addition, the cost of debt is lower than the cost of equity and will therefore
make a smaller contribution to the WACC. It is still possible, however, that
using book values as weights may under – or over-estimate the contribution
of the cost of debt to the WACC.
c) The capital asset pricing model (CAPM) assumes that investors hold
diversified portfolios, so that unsystematic risk has been diversified away.
Companies using the CAPM to calculate a project-specific discount rate are
therefore concerned only with determining the minimum return that must be
generated by an investment project as compensation for its systematic risk.
The CAPM is useful where the business risk of an investment project is

different from the business risk of the investing company‟s existing business
operations. In such a situation, one or more proxy companies are identified
that have similar business risk to the investment project. The equity beta of
the proxy companies represents the systematic risk of the proxy company,
and reflects both the business risk of the proxy company‟s business
operations and the financial risk arising from the proxy company‟s capital
structure.
Since the investing companies is only interested in the business risk of the
proxy company, the proxy company‟s equity beta is „ungeared‟ to remove the
effect of its capital structure. „ungearing‟ converts the proxy company‟s
equity beta into an asset beta, which represents business risk alone. The
asset betas of several proxy companies can be averaged in order to remove
any small differences in business operations.
The asset beta can then be „regeared‟, giving an equity beta whose
systematic risk takes account of the financial risk of the investing company
as well as the business risk of an investment project. Both ungearing and
regearing use the weighted average beta formula, which equates the asset
beta with the weighted average of the equity beta and the debt beta.
The project-specific equity beta resulting from the regearing process can
then be used to calculate a project-specific cost of equity using the CAPM.
This can be used as the discount rate when evaluating the investment
project with a discounted cash (DCF) flow investment appraisal method such
as net present value or internal rate of return. Alternatively, the project-
specific cost of equity can be used in calculating a project-specific weighted
average cost of capital, which can also be used in a DCF evaluation.
115
EXAMINER‟S REPORT
The question tested the candidates‟ understanding of cost of capital. In part (a),
they were expected to calculate:
• Cost of equity;
• Cost of preference shares; and
• Cost of convertible bond, and WACC.
Part (b) asked candidates to explain the preference of market value over book
value when computing WACC.
In part (c), candidates were asked to explain how CAPM can be used to estimate
project-specific cost of capital.
About 60% of the candidates attempted the question and the level of performance
was just about average.
In part (a), some of the candidates were able to calculate cost of equity and cost of
preference shares. However, majority of them struggled with the calculation of cost
of convertible bond.
In parts (b) and (c), most of the answers submitted were completely meaningless.
Cost of capital is one of the pillars of Financial Management and students

preparing for this examination cannot afford to gamble with it.
MARKING GUIDE
(a) Calculation of cost of equity using CAPM 1

Calculation of cost of convertible bonds:
- Computing the market value of bonds ½
- Computing the conversion value of the 1½
bonds
- Computing the after tax interest 1
payment
- IRR calculations 4
Calculation of cost of preference shares 1
Calculation of weighted average after tax cost 1 10
of capital
(b) 1 mark each for discussion of issue (4 points) 4
116
(c) 1½ marks per points, max 4 points - essential
to discuss business risk, systematic risk and
financial risk 6
20
117
PATHFINDER
MARCH/JULY 2020 DIET
Question Papers
Suggested Solutions
Marking Guides
and

TABLE OF CONTENTS
PAGE
FOREWARD
CORPORATE REPORTING 3-34
ADVANCED TAXATION 35-68
STRATEGIC FINANCIAL MANAGEMENT 69 – 105
ADVANCED AUDIT AND ASSURANCE 106-141
CASE STUDY 142-172

PROFESSIONAL LEVEL EXAMINATION – MARCH/JULY 2020
INSTRUCTION: YOU ARE REQUIRED TO ANSWER FOUR OUT OF SIX

QUESTION 1
Toluwalase plc (TP) is a multi-divisional company operating in many sectors of the

Nigerian economy. All major capital expenditure proposals are appraised and
approved (or rejected) at the group corporate head office.
At the moment, Division A and Division B have submitted the under listed projects
for review.
Division A
This division manufactures household appliances for sale in Nigeria and ECOWAS
sub-region. The division is considering the development of a new product with a
planned selling price of ₦10,000.
It is expected that the selling price will be held constant over the initial planning
period of five years.
The company is uncertain about the scale of demand (at the selling price of
₦10,000). It is estimated that two states of demand are equally likely: State A and
State B. Once the state has been identified, there remains some uncertainty about
the actual level of demand as a result of general economic conditions.
State A State B
Volume per annum Probability Volume per annum Probability
(units) (%) (units) (%)
8,000 20 12,000 20
11,000 60 15,000 60
15,000 20 19,000 20
It is possible to commission a market research to discover with certainty whether

State A or State B prevails.
The manufacture of the product would require the purchase of a machine.
69

Two models are available, one which costs ₦80 million and has a capacity of
12,000 units per annum and one which costs ₦120 million and has capacity of
20,000 units per annum. Both models would have lives of five years and no scrap
value at the end of that time. In addition to the costs of a machine, the
manufacture of the product would involve variable costs of ₦5,000 per unit and an
incremental annual cash fixed cost of ₦20 million.
The division has cost of equity of 20% and cost of debt, net of tax of 10%. The target
debt/equity ratio is 1. Ignore taxation and inflation.
Division B
This division runs staff canteens for a number of major corporate organisations in
Abuja. The meals are prepared at a central location.
The division is in the process of purchasing a new industrial dishwasher. The

division has received quotes from two suppliers, Yaro and Tony, both quotes meet
the necessary requirements.
Yaro is offering a dishwasher that will cost ₦9,000,000 and has an expected life of
ten years, after which it is expected to have a ₦200,000 scrap value. A warranty is
included for the first year, however after that, continuing maintenance is available
at ₦5,400,000 for a single payment to cover the remaining nine-year period; or
alternatively by an annual charge of ₦750,000, payable in advance of the year of
cover.
Tony is offering a dishwasher at ₦7,350,000. This machine is only expected to last

five years, after which it will have a scrap value of ₦1,100,000. The supplier offers
maintenance service at an annual cost of ₦720,000, payable annually in advance.
The first year‟s maintenance is covered by the manufacturer‟s warranty.
Division B‟s cost of capital is 6%.
The purchase of the new dishwasher is essential to comply with the new hygiene
regulations introduced by central government to reduce food poisoning outbreaks.
Required:
a. For division A, assess and recommend which of the two models of the Machine
should be purchased, if any. In this part, ignore the market research.
(18 Marks)
b. If the market research is undertaken, recommend the maximum sum division A
should be prepared to pay for the market research survey, assuming the
decision would be based on a calculation of expected net present value.
(2 Marks)
c. Explain, the major limitations of expected value criterion in a decision of this

nature. (4 Marks)
70

d. For division B, provide an appraisal of the proposals from the two suppliers
and recommend the more appropriate proposal (state any assumptions you
made). (12 Marks)
e. Provide a justification why it is not appropriate to use the same cost of capital
to appraise the two projects under consideration. (4 Marks)
(Total 40 Marks)

QUESTION 2
Mr. Big Heart is a Nigerian highly successful business man with interest in
manufacturing, transportation, telecommunication and aviation. He has recently
shown interest in acquiring one of the La liga league football clubs in Spain.
Negotiation with the current owners of the club is now completed and price
agreed.
Mr. Big Heart‟s group of companies have been able to raise a significant portion
of the total amount needed for the purchase consideration of the club but there
is a shortfall of $150 million today September 16, 2020 and the total payment for
the acquisition must be made by December 16, 2020. A two-month loan of $150
million, commencing from December 16, 2020 is therefore being considered.
The group finance director (GFD) has spoken to the bankers in Madrid who have
agreed to provide the $150 million needed. Given Mr. Big Heart‟s credit rating,
the short-term loan will be at a rate of 90 basis points above LIBOR. Currently,
LIBOR is at 6%. The bank has also suggested that, due to the current economic
uncertainty, LIBOR may rise by 1% or even fall by 0.5% over the coming months.
With this in mind, the group treasury department has been mandated to manage
this risk in a manner it thinks will best minimise the inherent interest risk. The
department has obtained the following data from the money and traded
derivatives markets.
Derivative contracts may be assumed to mature at the end of the month.
Three months sterling future ($500,000 contract size, $12.50 tick size)
Sept. 93.870
Dec. 93.790
March 93.680
Options on three months sterling futures
($500,000 contract size, premium cost in annual %)
71

Exercise Calls Puts
price Sept. Dec. March Sept. Dec. March
93750 0.120 0.195 0.270 0.020 0.085 0.180
94000 0.015 0.075 0.115 0.165 0.255 0.335
94250 0 0.030 0.085 0.400 0.480 0.555
FRA prices:
3 v 6 7.01 – 6.91
3 v 5 7.08 – 7.00
3 v 8 7.28 – 7.20
Required:
Demonstrate and explain the possible ways in which the interest rate risk may be
managed in relation to the purchase of the club, using the information provided.
Based on your analysis, advise on an appropriate course of action.
Note: Your analysis should be based on the three derivatives identified in the
scenario, that is:
 FRA
 Financial futures
 Traded options (Total 20 Marks)
QUESTION 3
Tanko Limited (TL) is currently evaluating two different investments (Investment 1

and Investment 2), each of which represents strategic investment in different
business sectors.
At the request of the Finance Director, the Board of Directors has convened a
special board meeting to consider the appropriate discount rate, or rates, to use to
evaluate the two investments. Each of the two investments being considered is in a
non-listed company and will be financed by 60% equity and 40% debt.
In the past, TL has used an estimated post-tax weighted average cost of capital of
12% to calculate the net present value (NPV) of all investments. The Managing
Director thinks this rate should continue to be used, adjusted if necessary by plus or
minus 1% or 2% to reflect greater or lesser risk than the “average” investment.
The Finance Director disagrees and suggests using the capital asset pricing model
(CAPM) to determine a discount rate that reflects the unsystematic risk of each of
the proposed investments based on proxy companies that operate in similar
businesses. The Finance Director has obtained the betas and debt ratio of two listed
companies (Company A and Company B) that could be used as proxies. These are:
72

Equity Debt Ratio
Beta Beta (debt:
equity)
Company A (proxy for investment 1) 1.3 0.3 1:3

Company B (proxy for investment 2) 0.9 0 1:6
Other information
- The expected annual post-tax return on the market is 8% and the risk-free rate
is 3%.
- Assume the debt that TL raises to finance the investment is risk-free.
- All three companies (TL, Company A and Company B) pay corporate tax at 25%.
- TL has one financial objective, which is to increase earnings each year to enable
its dividend payment to increase by 4% per annum.
The Managing Director and the other Board members are confused about the
terminology being used in the CAPM calculation and do not understand why they
are being asked to consider a different method of calculating discount rates for use
in evaluating the proposed investments.
Required:
a. Discuss the meaning of the term “systematic” and “unsystematic” risk and
their relationship to a company‟s equity beta. (6 Marks)
b. Using CAPM and the information given in the scenario about TL and
companies A and B, calculate for each of TL‟s proposed investments:
i. An asset beta. (4 Marks)

ii. An appropriate discount rate to be used in the evaluation of
the investments. (4 Marks)
c. Discuss briefly, how an asset beta differs from an equity beta and why the
former is more appropriate to TL‟s investment decision. Include in your
discussion some references on how the use of CAPM can assist TL to achieve its
financial objective. (6 Marks)
(Total 20 Marks)
73

QUESTION 4
You are the portfolio manager of Aka Asset Management Limited. You have
collected the following data for three possible investments.
Price
Stock Price Forecast Dividend Beta
Today Price*
X 25 31 2 1.6
Y 105 110 1 1.2
Z 10 10.80 0 0.5
* Forecast Price = expected price one year from today.

The expected return on the market is 12 percent and the risk-free rate is 4 percent.
Required:
a. Using the security market line (SML), identify in which of the three stocks you
will invest. Show all relevant calculations. (6 Marks)
Security „A' has an expected rate of return of 12%, with a standard deviation of
32.65%.
The expected rate of return is derived from three equal possibilities
(i) that the actual rate of return will be the same as the expected rate of return;
(ii) that the actual rate of return will be higher than the expected rate of return by
x%;
(iii) that the actual rate of return will be lower than the expected rate of return by
x%.
b. You are required to calculate the two probable actual rates of return under
(ii) and (iii) above (6 Marks)
c. What information is conveyed to a potential investor by the standard

deviation statistic; (2 Marks)
d. What factors would be taken into account by an investor when deciding

whether to add to his portfolio, either security „A' or another security having
lower values for standard deviation and expected rate of return. (4 Marks)
e. Given that the correlation coefficient of the return on security' A' with the
return on the market portfolio is 0.25 and that the standard deviation for the
market portfolio is 13.5%, you are required to calculate the Beta factor for
security „A' and to interpret the result you obtain. (2 Marks)
(Total 20 Marks)
74

QUESTION 5
PT is a public listed company based in Abuja, Nigeria. The company produces and
sells roofing sheets in Nigeria and a number of ECOWAS countries. It has a central
treasury function based in Nigeria.
PT has defined its three financial objectives as follows:
(1) To increase dividends by 10% a year;
(2) To keep gearing (Debt/(Debt + Equity)) below 40%; and
(3) To expand by internal growth and/or by horizontal integration via

acquisition of companies operating in the same industry sector.
PT has identified a potential takeover candidate, Company K, which produces

cement in a Central African country with currency A$. PT is considering a cash offer
for K of approximately A$23,000 million but it has not yet been decided whether
this would be financed by debt (at an after tax cost of 5% per annum) or equity. If
equity were used then shares would be issued on the open market at the current
share price of ₦2.90 per share.
Extracts from PT‟s latest financial statements are as follows:
₦million
Long term borrowings 9,500
Share capital (₦1 shares) 5,000
Retained reserves 4,000
Last year PT paid a dividend of 16kobo per share, representing a dividend pay-out
ratio of 40%. Earnings have grown by 8% a year on average over the last 5years and
dividend pay-out ratio has been between 30% and 50% over the period.
Company K has a current market capitalisation of A$20,000 million and the current
A$/₦ spot exchange rate is 9.20. K has a P/E ratio of 10 and earnings are expected
to grow at 6% a year in future years.
Required:
Advise the directors of PT on:
a. The extent to which the company meets its financial objectives both before and
after the proposed acquisition of Company K. (17 marks)
b. The appropriateness of the stated financial objectives of PT and how they could
be improved. (3 marks)
(Total 20 marks)
75

QUESTION 6
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)
76

Formulae
𝑉𝐷
𝑉𝐸𝐺
Asset Beta
𝑉𝐸 𝑉𝐷 (1 − 𝑇)
(𝑉𝐸 + 𝑉𝐷 (1 − 𝑇)) 𝐸 (𝑉𝐸 + 𝑉𝐷 (1 − 𝑇)) 𝐷
Equity Beta
𝑉𝐷
𝛽𝐸 = 𝛽𝐴 + (𝛽𝐴 − 𝛽𝐷 ) (1 − 𝑡)
𝑉𝐸
Growing Annuity
𝑛
𝐴1 1+𝑔
𝑃𝑉 = 1−
𝑟−𝑔 1+𝑟

1
𝑃𝑉𝑅 𝑛
𝑀𝐼𝑅𝑅 = 1 + 𝑟𝑒 − 1
𝑃𝑉𝐼
C0 = S0N(d1) – Ee-rt N(d2)
𝑆0
𝐼𝑛 + (𝑟 + 0.5𝜎 2 )𝑇
𝑑1 = 𝐸
𝜎 𝑇
d2= d1 - 𝜎 𝑇
The Put Call Parity
C + Ee-rt = S + P

d = 1/u
𝑎−𝑑
𝜋=
𝑢−𝑑
77

Annuity Table
r
Discount rate (r)

Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1
2 1·970 1·942 1·913 1·886 1·859 1·833 1·808 1·783 1·759 1·736 2
3 2·941 2·884 2·829 2·775 2·723 2·673 2·624 2·577 2·531 2.487 3
4 3·902 3·808 3.717 3·630 3.546 3.465 3·387 3·312 3·240 3·170 4
5 4·853 4·713 4·580 4·452 4·329 4·212 4·100 3·993 3.890 3·791 5
6 5·795 5·601 5·417 5·242 5·076 4·917 4·767 4·623 4.486 4·355 6
7 6·728 6.472 6·230 6·002 5·786 5·582 5·389 5·206 5·033 4·868 7
8 7·652 7·325 7·020 6·733 6·463 6·210 5·971 5·747 5·535 5·335 8
9 8·566 8·162 7·786 7.435 7·108 6·802 6·515 6·247 5·995 5·759 9
10 9·471 8·983 8·530 8·111 7·722 7·360 7·024 6·710 6.418 6·145 10
11 10·368 9·787 9·253 8·760 8·306 7·887 7.499 7·139 6·805 6.495 11
12 11·255 10·575 9·954 9·385 8·863 8·384 7·943 7·536 7'161 6·814 12
13 12·134 11·348 10·635 9·986 9·394 8·853 8·358 7·904 7·487 7·103 13
14 13·004 12·106 11·296 10·563 9·899 9·295 8·745 8·244 7·786 7·367 14
15 13·865 12·849 11·938 11·118 10·380 9·712 9·108 8·559 8·061 7·606 15
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1
2 1·713 1·690 1·668 1·647 1·626 1·605 1·585 1·566 1·547 1·528 2
3 2.444 2.402 2·361 2·322 2·283 2·246 2·210 2·174 2·140 2·106 3
4 3·102 3·037 2·974 2·914 2·855 2·798 2·743 2.690 2·639 2.589 4
5 3·696 3·605 3·517 3·433 3·352 3·274 3·199 3·127 3·058 2·991 5
6 4·231 4·111 3·998 3·889 3·784 3·685 3·589 3.498 3.410 3·326 6
7 4·712 4·564 4.423 4·288 4·160 4·039 3·922 3·812 3·706 3·605 7
8 5·146 4·968 4.799 4·639 4.487 4·344 4·207 4·078 3·954 3·837 8
9 5·537 5·328 5·132 4·946 4·772 4·607 4.451 4·303 4·163 4·031 9
10 5·889 5·650 5.426 5·216 5·019 4·833 4·659 4.494 4·339 4·192 10
11 6·207 5·938 5·687 5.453 5·234 5·029 4·836 4·656 4.486 4·327 11
12 6·492 6·194 5·918 5·660 5·421 5·197 4·988 4·793 4·611 4.439 12
13 6·750 6.424 6·122 5·842 5·583 5·342 5·118 4·910 4·715 4·533 13
14 6·982 6·628 6·302 6·002 5·724 5.468 5·229 5·008 4·802 4·611 14
15 7·191 6·811 6.462 6·142 5·847 5·575 5·324 5·092 4·876 4·675 15
78

79

Solution 1
a) i) Division A
Small machine – State A
Expected sales (units)
Possible Sale Probability Expected
value
8,000 0.2 1,600
11,000 0.6 6,600
12,000* 0.2 2,400
10,600
(* Restricted to maximum capacity of machine)
Annual contribution = 10,600 × ₦5,000 = ₦53,000,000
Small machine - State B
Possible Sale Probability Expected
value
12,000* 0.2 2,400
12,000* 0.6 7,200
12,000* 0.2 2,400
12,000
(* Restricted to maximum capacity of machine)
Weighted average cost of capital
WACC = (20 × 0.5) + (10 × 0.5) = 15%
(Note: If D/E = 1, it means D = E and D/(D + E) = 0.5)
Calculation of expected net present value (ENPV)
State A State B
Contribution (₦000) 53,000 60,000
Fixed costs (₦000) (20,000) (20,000)
Net Cash flow (₦000) 33,000 40,000
Cumulative Discount
Factor at 15% 3.352 3.352
Present Value (₦000) 110,616 134,080
Outlay (₦000) (80,000) (80,000)
NPV (₦000) 30,616 54,080
Probability 0.5 0.5
15,308 27,040
ENPV = 15,308,000 + 27,040,000 = ₦ 42,348,000
80

Big machine - State A
Possible Probability Expected
Sale value
8,000 0.2 1,600
11,000 0.6 6,600
15,000 0.2 3,000
11,200

Big machine - State B
Expected sales in units
Possible Probability Expected

Sale value
12,00 0.2 2,400
15,000 0.6 9,000
19,000 0.2 3,800
15,200
Calculation of expected net present value (ENPV)
State A State B
Contribution (₦000) 56,000 76,000
Fixed costs (₦000) (20,000) (20,000)
Net Cash flow (₦000) 36,000 56,000
Cumulative Discount Factor at 15% 3.352 3.352
Present Value (₦000) 120,672 187,712
Outlay (₦000) (120,000) (120,000)
NPV (₦000) 672 67,712
Probability 0.5 0.5
336 33,856
ENPV = 336,000 + 33,856,000 = ₦34,192,000
81

Alternative method
After computing the expected sales in units for each state and for each model, some
candidates could proceed as follows:
Model 1 Model 2
Expected sales (q) 11,300* 13,200*
Annual NCF (N‟000) =5000q – 20m 36,500 46,000
CDF at 15% 3.352 3.352
PV (N‟000) 122,348 154,192
Outlay (N‟000) (80,000) (120,000)
ENPV (N‟000) 42,348 34,192
*Expected sales in units:

Model 1: (10,600 x 0.5) + (12,000 x 0.5) = 11,300
Model 2: (11,200 x 0.5) + (15,200 x 0.5) = 13,200
Recommendation
In the absence of the market research, the company should buy the small
machine, with ENPV of ₦42,348,000.
b) Expected value of perfect information

If the state of demand is known with certainty, the company will choose the
machine which shows the higher NPV for that state. From the calculations in (a)
above, the following summary can be prepared:
Machine State A State B

₦000 ₦000
Small 30,616 54,080
Big 672 67,712
Choice Small Big
ENPV with perfect information = (30,616 × 0.5) + (67,712 × 0.5)

= 49,164
ENPV without information = per (a) above = (42,348)
Incremental ENPV= Value of perfect information = maximum sum payable
= 6,816
82

c) The limitations of expected values include:
i. The probabilities of the different possible outcomes may be difficult to

Estimate. It is possible to use:
- Objective probabilities based on past experience of similar projects; or
- Subjective probabilities, e.g. from the results of market research,
where there is no past experience, as a guide to the future;
ii. The expected value may not correspond to any of the possible expected
outcomes;
iii. Unless the same decision has to be made many times, the expected value
will not be achieved. It is therefore not a valid way of making a decision
in 'one-off' situations unless the firm has a number of independent projects
and there is a portfolio effect; and
iv. The average gives no indication of the spread of possible results, i.e. it
ignores risk.
d) Yaro:- The first decision to make is the choice between a single maintenance
payment of ₦5,400,000 or a series of annual payment of ₦750,000 from year
1 to year 9. The present value of ₦750,000 from year 1 to year 9 at 6% is
₦750,000 × 6.80 = ₦5,100,000. This is less than the single payment of
₦5,400,000. Therefore the annual payment of ₦750,000 is recommended. We
can now determine the net present value of Yaro‟s offer.
Item Year NCF PVF at 6% PV

Outlay 0 (9,000,000) 1 (9,000,000)
Maintenance 1-9 (750,000) 6.80 (5,100,000)
Scrap value 10 200,000 0.56 112,000
NPV (13,988,000)
Tony
Item Year NCF PVF PV
Outlay 0 (7,350,000) 1 (7,350,000)
Maintenance 1-4 (720,000) 3.47 (2,498,400)
Scrap value 10 1,100,000 0.75 825,000
(9,023,400)
83

These two NPVs cannot be directly compared because they cover different lives. We
must therefore compute the annual equivalent cost (AEC).
Supplier NPV Annuity AEC

Factor
₦ ₦
Yaro (13,988,000) 7.36* (1,900,543)
Tony (9,023,400) 4.21** (2,143,325)
* Annuity factor at 6% for 10 years ** Annuity factor at 6% for 5 years

Recommendation:-Yaro has the lower AEC and should therefore be selected.
Assumptions
i. The two suppliers offer the same terms of payment.
ii. The two suppliers will offer the same after sales service
iii. The use of AEC assumes that there will be perpetual replacement at the
same costs and terms of the dishwasher.
e) The cost of capital used to appraise a capital project should reflect both the
business risk associated with the project (not necessarily the company) and the
financial risk associated with the method of financing the project.
Business risk: It is not likely that the two projects have the same business risk as
they belong to two different business sectors. Division A, operating in the
manufacturing sector, will be expected to have higher asset beta (higher
business risk) than Division B that operates in food sub-sector.
The higher business risk of Division A will demand higher rate of return.
Financial risk: We know the target debt/equity ratio of Division A but that of
Division B is not given. If the funding of the two projects results in the two
Divisions having different financial leverage, their financial risk will not be the
same. This will result in different equity beta and different required return.
Thus, for organisations operating in different industrial sectors, a different

divisional cost of capital will be required – reflecting their different business
risk and financial risk.
84

Examiner’s Report
This was a five-part question that tests the candidates‟ understanding investment
decision.
The question covers NPV analysis, treatment of risk and uncertainly, calculation of
value of perfect information and calculation of WACC.
Being a compulsory question, virtually all the candidates attempted the question
but performance was extremely disappointing. Candidates lost considerable marks
due to:
 Inability to handle the capacity limitation of the small machine when
calculating expected sales in units;
 Disorderly presentation of calculations;
 Failure to recognise the need to calculate equivalent annual cost in part (d); and
 Inability to calculate the required WACC in part (a);
It is highly recommended that candidates presenting themselves for the Institute‟s
examinations should cover the entire syllabus and practise past examination
questions.
Marking guide
Marks Marks
a. Calculation of expected sales (units):
Small machine - State A 1
- State B 1
Calculation of WACC 1
Computation of ENPV – Small machine – State A 3
Small machine – State B 3
Calculations of expected sales (units)
Big machine - State A 1
- State B 1
Computation of ENPV – Big machine – State A 3
Big machine – State B 3
Recommendation 1 18
b. Determination of the choice of machine to chose

with perfect information - State A 0.5
- State B 0.5
Calculation of ENPV with perfect information: 0.5
85

Determining the incremental ENPV i.e. value of
perfect information 0.5 02
c. Limitations of expected values:

1 mark per valid point, max 4 points 04
d. Determination of the best maintenance payment

to accept for Yaro 1
Calculation of the NPV of Yaro‟s offer 3
“ “ ” Tony‟s offer 3
Computation of the Annual Equivalent Cost (AEC) of
Yaro‟s offer 1
Tony‟s offer 1
Recommendation based on the result of the AEC 1
Assumption 1 mark per valid point mentioned, max 2 points 2 12
e. Mentioning the fact that the cost of capital for appraising

capital project should reflect a combination of both
business and financial risk 0.5
Acceptable justification relating cost of capital to inherent

risk: Business risk 1.5
Financial risk 1.5
Conclusion 0.5 04
Total 40
Solution 2
The treasury department could take the following two strategies to manage the
short-term interest rate risk:
 Lock or fix the rate today. This will remove both upside and downside
movement in LIBOR. This can be achieved by using a FRA or an interest rate
future; and
 Create a cap or ceiling rate. The department will then know what the
maximum interest rate on the loan will be. They will use an appropriate
interest rate option to create the ceiling rate.
86

FRA
Today (16/09/2020)
Big Heart will obtain a $150 million FRA 3 v 5 at a rate of 7.08% p.a. from OTC
market. This will lock the LIBOR at that annual rate.
September 15, 2019
Irrespective of whether LIBOR rises or falls, the effective annual cost of the short-
term finance will be 7.08 + 0.9 = 7.98%
Financial Future
September 16, 2020:
 Sell December contracts at 93.79%.
 Number of contracts:
$150m 2
× = 200 contracts
$0.50m 3
*Basis
Today June 15
LIBOR (cash market) 6.00%
Less futures (100 – 93.790) (6.21)
Current basis –0.21
Basis will reduce to zero by the expiry date of the contract (December 31).
Assuming basis reduces in a linear manner, the basis at December 16, when the
hedge is lifted is:
0.5
× −0.21 = −0.03
3.5
Lock-in rate %
Current futures implied as above 6.21
Outstanding basis – 0.03
Spread over LIBOR 0.90
Lock-in rate 7.08
The lock-in rate is the same irrespective of the actual LIBOR rate at the point of
borrowing.
87

Note: The lock-in rate could alternatively be calculated as follows:
LIBOR (6 – 0.5) 5.50% (6 + 1) 7.00%
Expected closing price of
futures: 100 – 5.5 – 0.03
94.47 100 – 7 – 0.03 92.97
Original price
93.79 93.79
$ $ $
Cost of borrowing in the cash market:
(5.50 + 0.9)% × 2/12 × $150m (1,600,000) (7+0.9)% × 2/12 × $150m (1,975,000)
(Loss)/Gain on futures:
(9379 – 9447) )× $12.50 × 200 (170,000) (9379–9297)×$12.50× 200 205,000
Net cost of borrowing (1,770,000) (1,770,000)
Effective cost of borrowing:

1,770,000
×
12
× 100% 7.08% 7.08%
150,000,000 2
(Note: Either of the approaches could be used but the former is preferred
because it saves time)
Traded Options
Today September 16:
There are various ways in which the company can choose a rate at which to cap the
interest rate. One method is to choose an option, which caps the value at the
current LIBOR of 6%.
Therefore, we should buy December put at 94,000.

 Number of contracts will be as for futures above = 200
 The premium payable now is
0.255% × 200 × $500,000 × 3/12 = $63,750
Evaluation
LIBOR 5.500% 7.00%
Expected future price as per
futures above 94.470 92.970
Implied interest rate (100 - 94.47) 5.530% (100 – 92.970) 7.030%
Exercise price 6.000% 6.000%
Exercise? No Yes
Gain – (7.030–6.000) 1.030
88

Actual interest cost % (5.5 + 0.9) (6.400) (7 + 0.90) (7.900)
Premium (%) (0.255) (0.255)
Net cost of loan (%) (6.655) (7.125)
Summary and Advice
LIBOR (%) 5.5 7.00

No hedge (5.5 + 0.9) 6.40 (7 +0.9) 7.9
FRA 7.98 7.98
Futures 7.08 7.08
Options 6.655 7.125
The facility is needed for a short period of time. Locking the rate will provide the
company with certainty. The treasury department will know what the cash cost of
the loan will be and can plan accordingly. The FRA is more expensive in this case
compared to futures.
However, the options will provide an element of flexibility should rates fall.
Examiner’s report
The question tests the candidates‟ knowledge of the risk management aspect of the
syllabus. Specifically, candidates were required to analyse the following derivative
interest rate risk hedging techniques:
 FRA
 Financial futures; and
 Traded options.
Like in the previous examinations, less than 5% of the candidates attempted the
question and the performance was extremely disappointing.
For the three derivatives, the candidates lost marks due to the following reasons:
 Failure to identify the appropriate „maturing‟ date to use;
 Inability to analyse the selected derivatives;
 Providing unnecessary and time-wasting calculations; and
 In the case of traded options, inability to identify whether to make use of „put‟
option or „call‟ option.
Due to very high volatility in the global financial market, it should be very
apparent to discerning candidates, that the risk management aspect of the syllabus
has come to stay in the Institute‟s examination! Future candidates are therefore
expected to pay greater attention to this part of the syllabus.
89

Marking guide
Marks Marks
FRA
Determination of the FRA rate 02
Determination of the effective annual cost of the short-
term finance 02
Financial futures:
Decision to SELL and the applicable month DEC 01
Computation of number of contracts 01
Determination of the current basis 0.5
Determination of the basis at December 16 when the
hedge is to be lifted 0.5
Calculation of the lock-in rate 03
Traded options:
Decision to BUY (put option) and when (DEC) 01
Determination of the number of contracts 01
Calculation of the immediate premium 01
Computation of expected future price and decision to
exercise or not 02
Calculation of net cost of loan 02
Summary and advice 03 20
Total 20
Solution 3
a) Systematic and unsystematic risk
Risk that cannot be diversified away is called systematic risk. This risk is due to
economic factors which affect the economy as a whole (such as interest rates,
recession etc.).
Risk that can be reduced by diversifying the securities in a portfolio is

unsystematic risk. This risk relates to factors which are unique to a company or
of the industry in which it operates.
Total risk is the combination of systematic and non-systematic risk. The total
risk of a share can be measured by its standard deviation. Systematic risk of a
share is measured by its equity beta.
90

Beta is the measurement of systematic risk estimated by considering the
volatility of an individual share price movement against the movement in the
market as a whole. This is usually undertaken by plotting on a graph
movements over time of the individual share price on the vertical axis against
movements in the market over the same time period on the horizontal axis.
Regression analysis is used to estimate the slope of the line, which is then
referred to as beta.
An entity with an equity beta greater than 1 would be expected to have

systematic risk proportionately greater than the risk of the market. Conversely
an equity beta which is less than 1 would suggest systematic risk for that
company proportionately less than the risk of the market. However, to use
betas it is necessary to assume that betas calculated on the basis of historic
information are reliable indicators of current and future risks.
b) Calculations of beta and discount rates

Step 1:“Ungear” the equity beta of the two proxy companies using:
VE VD (1 − t)
βA = βE + βD
VE + VD (1 − t) VD 1 − t + VE
Company A
1.3 ×3 0.3 ×1(1−0.25)

βA = 3+ 1(1−0.25) + = 1.10
3+ 1(1−0.25)
Company B
0.9×6
βA = 6+ 1(1−0.25) + 0 = 0.8
Step 2: To reflect the financial risk of the method of financing; the above asset
betas must now be “regeared”.
VD
βE = βA + (βA − βD ) (1 − t)
VE
Investment 1 (Proxy Company A)

βE = 1.1 + (1.10 - 0) (2/3)(1 – 0.25) = 1.65
Investment 2 (Proxy Company B)
βE = 0.8 + (0.8 - 0)(2/3)(1 – 0.25) = 1.20
91

The „regeared‟ betas can now be used in the CAPM formula to calculate the
relevant cost of equity capital.
kE = RF+ βE(Rm- Rf)
Investment 1: kE= 3 + 1.65(8 - 3) = 11.25%
Investment 2: kE= 3 + 1.20(8 - 3) = 9.0%
Next, we compute the WACC for each investment. We are not given cost of debt.
We therefore make use of the post-tax risk-free rate of 3%.
Investment 1: WACC = (0.6 × 11.25) + (0.4 × 3) = 7.95%
Investment 2: WACC = (0.6 × 9) + (0.4 × 3) = 6.6%
c) Explanation of asset and equity betas, investment appraisal and objectives

An equity beta is the beta that is attached to a company‟s shares; it is this beta
that is published. An asset beta reflects business risk, assuming a company is
ungeared.
An asset beta is more useful than an equity beta in Proxy companies A and B
because it incorporates the total business risk inherent in those companies, but
tripping out the impact of the financing structures of the individual companies.
Companies A and B have been selected as proxy companies primarily because
they have the same business risk characteristics as Investments 1 and 2.
However, the asset beta does not take into account the financing structure of
the investments, therefore the asset beta needs to be adjusted. This is achieved
by regearing the asset (that is, the ungeared) beta and inserting it in the CAPM
formula to obtain a geared cost of equity which reflects both
• The business risk of the investment (based on the business risk of the
proxy company); and
• The long-term financing structure.
Using CAPM-derived rates could help determine if TL‟s current use of 12% for all
investments is appropriate. For example, the CAPM-derived rates calculated in
part (b) suggest that for the investments under consideration lower rates, i.e.
less than 12% would be more appropriate. TL would have rejected investment
opportunities that would have been profitable and therefore contributed to the
achievement of its objective.
On the other hand if the CAPM had suggested rates above 12% then TL would
not be fully compensating shareholders for the risks inherent in its investments,
which in the long term might threaten the viability of its business and not just
its dividends.
92

Examiner’s report
The question tests the following:
 Systematic risk vs unsystematic risk
 How the above relate to equity beta
 Calculation of project specific risk-adjusted cost of capital.
Most of the candidates attempted the question with very few of them scoring very
high marks in part (a). However, no candidate was able to relate the concepts to
equity beta!
In the part (b), fewer numbers of the candidates successfully calculated the risk-
adjusted cost of capital. This is very disappointing because this topic has been
tested consistently in every examination in the last few years.
For the candidates that attempted the question, the common mistakes include:
i. Mixing up systematic risk and unsystematic risk;

ii. Inability to correctly apply the relevant formulae of asset beta and equity
beta;
iii. Inability to distinguish between asset beta and equity beta, etc.
It is recommended that candidates should cover the syllabus comprehensively and
practise past examination questions when preparing for future examination.
Marking guide
a. Discussion of systematic risk 2
Discussion of unsystematic risk 2
Discussion of the relationship of both systematic risk and
unsystematic to a company‟s equity beta 2 6
bi. Calculation of company‟s A asset beta 2

Calculation of company‟s B asset beta 2 04
ii. Computation of equity beta for proxy company A (Inv. 1) 0.5

Computation of equity beta for proxy company B (Inv. 2) 0.5
Calculation of cost of equity capital (Inv. 1) 0.5
Calculation of cost of equity capital (Inv. 2) 0.5
Usage of post-tax risk free rate of 3% in the computation
of WACC for each investment 1.0
Computation of WACC for Inv. 1 0.5
Computation of WACC for Inv. 2 0.5 04
93

c. Discussion of the differences between equity beta and
asset beta 2.0
Discussion of the appropriateness of asset beta of TL‟s

investment decision 2.0
References on how the use of CAPM can assist TL to
achieve its financial objective 2.0 06
Total 20
Solution 4
a) In the context of the SML, a security is underpriced if the required return is less
than the holding period (or expected) return, it is overpriced if the required
return is greater than the holding period (or expected) return, and it is correctly
priced if the required return equals the holding period (or expected) return.
The holding period returns and the required returns are computed as follows:
Holding period (expected) return
closing price +dividend
= −1
opening price
31+2
Stock X = − 1 = 32%
25
110+1
Y= − 1 = 5.7%
105
10.80+0
Z= − 1 = 8%
10
Required return
Ri = Rf + βi(Rm - Rf)
X 4 + 1.6(12 - 4) = 16.8%
Y 4 + 1.2(12 - 4) = 13.6%
Z 4 + 0.5 (12 - 4) = 8%
Next, we compute the alpha value of each stock:

Stock Expected return Required return Alpha Value
X 32% 16.8% 15.20%
Y 5.7% 13.6% -7.9%
Z 8% 8% 0%
Conclusion: Stock Y has a negative alpha value. This means it is undervalued. I

will therefore buy stock Y.
94

b) Expected rate of return 12%
Standard deviation 32.65%
Variance = (32.65)2 1,066.0225
Return Probability Expected Deviation Variance

Value
R P RP R- R P(R - R )2-
12 1/3 4 4 0
𝑥
12 + x 1/3 4+3 +x 1 2
x
3
𝑥
12 -x 1/3 4-3 -x 1 2
x
3
2 2
Expected return = R =12 𝑥
3
2
𝑥 2 must also equal the variance so:
3
2 2
𝑥 = 1,066.0225
3
X2 = 1,600
X =40 or -40
The two probable actual returns therefore are
12 +40 =52%
12 – 40 = -28%
c) The standard deviation statistic is a measure of dispersion from an average, a

measure of spread. The standard deviation of an investment shows the potential
investor the spread of the possible returns from the expected return for that
investment. It conveys to the investor a measure of the risk of the investment.
d) The aim of rational investors is to reduce the risk of their portfolio of

investments whilst still maintaining an acceptable rate of return. Therefore an
investor might compare security 'A' and another security and decide to invest in
the other security as it had a lower standard deviation, therefore lower risk, but
still an acceptable rate of return.
However, under portfolio theory the investor would not choose between the two
investments by simply comparing their relative risks and returns. The objective
is to reduce the risk of the investor's overall portfolio, and his investment taken
together. The risk of the whole portfolio does not depend on the standard
deviation or risk of the individual security but on the effect that those securities
will have on the risk of the portfolio as a whole.
95

Therefore the investor should look at the combination of security 'A' with his
present portfolio and the combination of the other security with his portfolio to
decide which combination reduces his overall risk.
It may be that, although security' A' has a higher standard deviation or risk, in
combination with the existing portfolio the overall standard deviation or risk is
reduced. This would be because the returns from security' A' move in the
opposite direction to the portfolio returns i.e. they are negatively correlated to
the portfolio returns, and therefore, will reduce the overall risk.
e)
(𝑟 𝐴 ,𝑚 )(𝜎𝐴 ) (0.25)(0.3265 )
𝛽= = = 0.6
𝜎𝑀 0.135
Beta factor of 0.60 means that if the market return moves up or down by say
4% then the return from security „A‟ will move by 0.6 × 4% = 2.40%
Examiner’s report
The question tests a number of key principles in CAPM and portfolio theory. About
70% of the candidates attempted the question but the performance was
disappointing.
In part (a), the candidates could not calculate the expected return of the stocks and
therefore, could not estimate the alpha value of each of the stocks.
Part (b) offered the greatest challenge to the candidates as they could not decode
the question.
In part (d), it is surprising that candidates could not make reference to the use of
correlation in portfolio selection.
We strongly recommend that future candidates really need to practise past

examination questions when preparing for this examination.
96

Marking guide
a. Calculation of holding period (expected) return:
Stock X 1
Stock Y 1
Stock Z 1
Computation of required return:

Stock X 0.5
Stock Y 0.5
Stock Z 0.5
Computation of the alpha values of stocks XYZ 0.5

Conclusion 1.0 6
b. Calculation of variance of the two probable rate of returns 4.5

Solving for x 1.0
Substituting the solved figure for x to determine the two
probable returns 0.5 6
c. Interpretation of standard deviation 2
d. Explanation of acceptable relevant factors 4
e. Calculation of the beta factor for security A 1.0

Interpretation of the result obtained 1.0 2
Total 20
Solution 5
a) Financial objective 1: To increase dividends by 10% a year
Before the acquisition, PT‟s earnings have grown by 8% per annum on
average. The target growth in dividends of 10% is therefore not sustainable
over the long term without significant growth in earnings in the future.
Company K‟s long term earnings growth prospects are lower at 6% per year
and so the acquisition risks reducing long term earnings growth.
However, the target earnings growth of 10% can be expected to be achieved

in the year of acquisition due to the addition of K‟s earnings. Growth in
earnings is expected to be boosted by 4.6% if funded by debt and by 10.85%
if funded by equity (see workings).
97

Note that the impact on earnings per share varies considerably according to
how the deal is financed. If financed by equity, earnings per share can be
expected to fall as a result of the acquisition due to the greater number of
shares in issue.
Workings: Earnings per share calculations

 Pre-acquisition
Earnings ₦’m
PT 0.16/40% x 5,000million shares 2,000m
K A$20,000/10 = A$2,000 217m
EPS: PT …… ₦0.16/40% 0.40
 Post-acquisition: Funded by debt
₦’m
Current earnings of PT 2,000
Current earnings of K 217
Interest on loan on purchase
consideration converted to naira
= 5% × 23,000/9.2 (125)
2,092
EPS = 2,092/5,000 shares 41.84kobo
Percentage increase in:
earnings (2,092/2,000) – 1 4.6%
EPS (41.84/40) – 1 4.6%
 Post-acquisition: Funded by equity

₦’m
(Note: We assume no change in share price 1)
Total earnings (see above) 2,000m + 217m 2,217
Total number of shares:
5,000 + [(23,000 ÷ 9.2) ÷ ₦2.90] 5,862
EPS = ₦2,217m/5,862million shares 38kobo
2,217
Percentage increase in earnings 2,000 -1 10.85%
Percentage decrease in EPS (38/40) – 1 5%
Financial objective 2: To keep gearing below 40%

Based on market values the current gearing is 39.6%, which is only just under
the target level of 40%. Gearing exceeds the limit if the acquisition is funded by
debt (at 45%) but falls markedly to 35.8% if funded by equity (see workings
below).
98

Using book values of equities, the gearing target is exceeded in all cases.
Gearing improves if the acquisition is funded by equity but remains well above
the target level of 40%.
Workings: Gearing calculations

 Pre-acquisition
 Using market value 39.6%

9,500/[9,500 + (5,000 × 2.90)]
 Using book value:
9,500/(9,500 + 5,000 + 4,000) 51.4%
 Post-acquisition
₦’m
 Debt funding
** Using market value
Existing debt 9,500
New debt to pay for acquisition
(A$23,000/9.2) 2,500
Total value of debt 12,000
Total value of equity (5,000 + ₦2.90) 14,500
Gearing ratio = 12,000/(12,000 + 14,500) 45.3%

** Using book value
Gearing ratio = 12,000/(12,000 + 9,000) 57.1%
₦’m
 Equity funding:
** Using market value
Existing equity 14,500
New issue (A$23,000/9.2) 2,500
Total value of equity 17,000
Debt (no change) 9,500
Gearing ratio = 9,500/(9,500 + 17,000) 35.8%

** Using book value
Gearing ratio = 9,500/(9,500 + 2,500 + 9,000) 45.2%
Financial objective 3: To expand by internal growth and/or by horizontal

integration via acquisition of companies operating in the same industry sector.
99

The acquisition clearly helps towards the growth target. Company K represents
horizontal integration in the same broad energy industry sector.
b) The financial objectives are a rather strange combination. Dividend growth is a

useful target but appears to be too high at 10% per annum and is not linked to
company performance. It may be better replacing this objective with a lower
minimum dividend growth figure coupled with a dividend payout target and
an earnings or earnings per share growth target.
A dividend growth target without an earnings target could lead to payment of

dividends in excess of what the company can afford – it is an easy target to
meet if sufficient retained profits and cash are available or investments are cut
but is not sustainable over the longer term if not underpinned by earnings
growth.
The gearing target objective is reasonable, although it would be better if it

defined whether gearing is based on book values or market values. Debt
covenants may require this target to be met. Interest cover may also be
important to lenders and may be stated in debt covenants. PT should consider
adding an interest cover target to its financial objectives.
The general growth target does not have any number attached. An earnings
growth target or a growth in market capitalisation target could be added in
order to enable this target to be quantified and success measured in financial
terms.
Examiner’s report
The question tests the candidates‟ ability to appraise a set of corporate objectives,
assess the success of an acquisition, manipulate foreign currency conversion, etc.
About 80% of the candidates attempted the question but performance was very
poor.
In analysing the first objective, candidates were expected to calculate the EPS,
before and after acquisition, and determine the growth rate in EPS. More than 90%
of the candidates attempted the question with very low level of performance.
In part (b), candidates were expected to assess the impact of acquisition on
financial leverage. Candidates performed poorly because they could not logically
analyse the impact of the method of financing the acquisition on the value of debt
and value of equity.
100

We recommend that candidates should pay significant attention to examination
standard questions in their revision.
Marking guide
Marks Marks
Mentioning financial objective 1 – To increase dividend by
10% a year 2.0
Calculation of pre-acquisition earnings:

PT 0.5
K 0.5
EPS 0.5
Computation of post-acquisition – Funded by debt:

Current earnings of PT 0.5
Current earnings of K 0.5
Conversion of interest on loan to Naira on purchase 1.0
Calculating EPS – Post acquisition 0.5
Determination of percentage increase in:

Earnings 0.25
EPS 0.25
Computations of Post acquisition – Funded by equity

Total earnings 0.5
Total number of shares 0.5
EPS 0.5
Percentage increase in earnings 0.25

Percentage decrease in EPS 0.25
Financial objective decision 2-To keep gearing below 40% 1.0
Calculation of gearing – Pre-acquisition:

Using market value 0.5
Using book value 0.5
Post acquisition – Using market value of existing debt 0.5

- Using new debt 0.5
101

Calculation of gearing ratio using market value or book
value 1.0
Calculation of equity funding using market value or book

value:
Existing equity 0.5
New issue 1.0
Recognition of no change in debt 0.5

Computation of gearing ratio 1.0
Mentioning financial objective 3 i.e. to expand by internal
growth 1.0 17
1 Mark per valid point, max 3 points 03
Total 20
Solution 6
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. 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.
102

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

 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.
 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.
 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.
 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.
 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.
103

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.
Examiner’s Report
The question tests candidates‟ knowledge of:
 Risk/return trade-off;
 Role of financial intermediaries; and
 The effects on private sector businesses of public sector budget deficit.
Being a theoretical question, almost all the candidates attempted it. However, only
few candidates were able to score average marks in the question. Common
problems indentified include:
 Lack of understanding of the concept of risk/return trade-off;
 Not answering the question asked;
 Complete lack of knowledge of government budget deficit and
 Poor use of English!
It is recommended that candidates should always cover the Institute‟s syllabus and
practise past examination questions.
104

Marking guide
a. Explanation of the risk/return trade-off 4
b. Explanation of financial intermediaries with relevant

examples 2
Stating the benefits of financial intermediaries -
2 Marks per point, max 3 points 6 8
c. Explanation of the meaning of public sector budget deficit 2

Stating the effects a higher level of government spending
will have on private sector business
1 Mark per valid point, max 4 points 4 6
General: Setting of report

From i.e. Officer reporting 0.25
Addressee of report 0.25
Subject matter: Title of the report 1.00
Date 0.25
Signature of officer reporting 0.25 2
Total 20
105

PATHFINDER
NOVEMBER 2020 DIET
Question Papers
Suggested Solutions
Marking Guides
and
Examiner‘s Reports
162

QUESTION 1
Assume today is November 20, 2019. In 2018, the Oyin Division of Aba plc
successfully launched a new premium wine- ‗Aladun‘, in Nigeria. The Divisional
Board of Oyin Division is now considering plans put forward by the Divisional
Marketing Manager to launch the full range of Aladun in another country ‗‘Linder‘‘.
Linder has Linderian dollar (L$) as currency and the launch is planned for January
1, 2020.
It is well known within the industry that it can be very difficult for a foreign
company to break into the Linderian market for fruit wine because there is
significant loyalty towards local Linderian brands and imported South African
brands. Initial market research based on free tasting sessions has met an
encouraging response but there is still some uncertainty over the success of the
launch. However, the greatest danger to the success of Aladun in Linder is
considered to be the risk that a Nigerian competitor might launch a similar range
of products in the same market.
Financial data for the project

To date, N5 million has been spent on initial market research for the Linderian
market. If the project is approved, an additional N20 million will be required for
detailed market research and packaging design. The cost of the launch itself
includes an expensive radio and television advertising, campaign in Linder and it is
expected to cost about N10 million. Both of these costs are tax deductible in
Nigeria. In addition, L$84 million will be spent on a distribution centre in Linder.
All of these one-off costs are payable on January 1, 2020.
Estimates of net operating cash flows for the project vary considerably according to
assumptions made regarding consumer and competitor reaction to the launch of
‗Aladun‘ in Linder. Forecast cash flow figures for sales revenue and associated costs
for the project for the year ending December 31, 2020 have been estimated based
on two possible outcomes, known as Scenario A and Scenario B. The forecasts are:
Forecast operating cash flow figures for the year ending December 31, 2020.
73

Scenario A: Sales revenue L$100 million
Costs L$10 million plus N20 million
Scenario B: Sales revenue L$55 million
Costs L$10 million plus N15 million
All operating cash flows shown above are expected to grow by 5% per annum in
subsequent years for the duration of the project.
It can be assumed that if Scenario A occurs in 2020, it will also occur in all
subsequent years. The same is true for Scenario B. It is estimated that there is a
70% probability of occurrence of Scenario A and a 30% probability of Scenario B.
Other relevant financial information:
 Oyin Division evaluates projects of this nature at a risk-adjusted after-tax

discount rate of 15% over a 4 year period.
 The proposed new distribution centre to be built in Linder is expected to
have a residual value of L$52 million after 4 years.
 Corporate income tax is charged in Nigeria at 35% on taxable profits and is

paid at the end of the year in which the taxable profit arises. No separate tax
is charged in Linder. Tax depreciation allowances are available in Nigeria on
all capital expenditure (incurred both in Nigeria and Linder) at a rate of
100%. Balancing charges will arise on any residual value. There are
sufficient profits elsewhere in the group to be able to take advantage of
these tax benefits or any taxable losses that occur.
 Operating cash flows should be assumed to arise at the end of the year to
which they relate.
 The exchange rate is expected to be N1 = L$1.2000 on January 1, 2020 and

the naira is expected to strengthen against the L$ by 2% a year in each of the
next 4 years.
 The project could be abandoned on January 1, 2021 and the distribution
centre sold for an estimated L$70 million. If the project were abandoned on
January 1, 2021, no further cash inflows or outflows would arise from then
onwards and there would be no penalties for pulling out of the market.
Required:
a. Ignoring the abandonment option:
i. Calculate the NPV for the project as at January 1, 2020 for Scenarios A
and B individually as well as the overall total expected NPV.
(17 Marks)
ii. Calculate the payback period for the project for each of Scenarios A and B.
(4 Marks)
74

iii. Interpret your results from (a)(i) and (a)(ii) (4 Marks)
b. Evaluate whether or not the project should be abandoned on January 1,

2021 if Scenario B occurs. (7 Marks)
c. Advise how real options and other strategic financial issues might influence
the initial investment decision. (8 Marks)
(Total 40 Marks)

QUESTION 2
Peter John plc (PJP) is considering a takeover bid for Yekin plc (YP).
PJP's board of directors has issued the following statement:
'Our superior P/E ratio and synergistic effects of the acquisition will lead to a post-
acquisition increase in earnings per share and in the combined market value of the
companies'.
Summarised financial data for the companies:

N Million
PJP YP
Sales 480.0 353.0
Profit before tax 63.0 41.0
Tax (18.9) (12.3)
Profit after tax 44.1 28.7
Dividends 20.0 11.0
Non-current assets (net) 284.0 265.0
Current assets 226.4 173.0
Total assets 510.4 438.0
Ordinary shares (10 kobo par value) 40.0 30.0
Reserves 211.2 192.0
Medium and long term borrowing 86.0 114.0
Current liabilities 173.2 102.0
510.4 438.0
Notes:
(i) After tax saving in cash operating costs of N7,500,000 per year indefinitely
are expected as a result of the acquisition
(ii) Initial redundancy costs will be ₦ 10 million before tax
75

(iii) PJP's cost of capital is 12%
iv) Current shares prices are: PJP N29, YP N18
(v) The proposed terms of the takeover are payment of 2 PJP shares for every 3
YP shares.
Required:
a. Calculate the current P/E ratios of PJP and YP (2 Marks)
b. Estimate the expected post acquisition earnings per share and
comment upon the importance of increasing the earnings per share.
(4 Marks)
c. Estimate the effect on the combined market value as a result of the
takeover using:
i. P/E based valuation
ii. Cash flow based valuation
State clearly any assumptions that you make (5 Marks)
d. Discuss the limitations of your estimates in (c) above (3 Marks)
e. Evaluate the strategic implications of making a hostile bid for a
company compared with an aggressive investment programme of
organic growth. (6 Marks)
(Total 20 Marks)
QUESTION 3
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)
QUESTION 4
a. What risks might an industrial company face as a result of interest

movements? (8 Marks)
b. A plc wants to borrow N200 million for five years with interest payable at
six-monthly intervals. It can borrow from a bank at a floating rate of NIBOR
plus 1% but wants to obtain a fixed rate for the full five-year period. A swap
bank has indicated that it will be willing to receive a fixed rate of 8.5% in
exchange for payments of six-month NIBOR.
76

Required:
Calculate the fixed interest six-monthly payment with the swap in place.
(4 Marks)
c. Calculate:
i. The interest payments if NIBOR is 10% (4 Marks)
ii. The interest payments if NIBOR is 7.5% (4 Marks)

(Total 20 Marks)
QUESTION 5
Yinko plc operates in the hospitality and leisure industry. The board of directors
met recently to discuss a number of financial proposals.
Proposal 1
To increase the company‘s level of debt by borrowing a further N100 million and
use the funds raised to buy back its shares.
Proposal 2
To increase the company‘s level of debt by borrowing a further N100 million and
use these funds to invest in additional non-current assets in the form of expansion
in available rooms in one of their hotels.
Proposal 3
To sell excess non-current assets in another hotel. The net book value of the assets
is ₦100 million and they will be sold for N135 million. This will enable the
company to focus on the other high-performing hotel units. These other hotel units
will require no additional investment in non-current assets. All the funds raised
from the sale of the non-current assets will be used to reduce the company‘s debt.
Yinko plc Financial Information
Extracts from the Forecast Financial Position for the coming Year
Nmillion
Current assets 330
Total assets 1,740
Equity and liability:
Share capital (40 kobo per share par value) 240
Retained earnings 615
Total equity 855
Non-current liabilities 700
Total liabilities and capital 1,740
77

Yinko‘s forecast after tax profit for the coming year (in the absence of the above
proposals) is expected to be N130 million. The current share price is N3.20 per
share.
The non-current liabilities consist solely of a 6% medium term loan redeemable
within seven years. The term of the loan contract stipulates that an increase in
borrowing will result in an increase in the coupon payable of 25 basis points on the
total amount borrowed, while a reduction in borrowing will lower the coupon
payable by 15 basis points on the total amount borrowed.
Yinko‘s effective tax rate is 20%. The company‘s estimated after tax rate of return on
investment is expected to be 15% on any new investment. It is expected that any
reduction in investment would suffer the same rate of return.
Required:
a. Estimate the impact of each of the three proposals on the forecast statement
of financial position, the earnings per share, and the financial gearing (Total
Debt/Total Assets) of Yinko Plc.
Show your workings. (16 Marks)

b. Discuss your results. (4 Marks)
(Total 20 Marks)
QUESTION 6
Binko Industrial Services plc is an all equity financed and a Stock Exchange listed
company. Over recent years the company's management has adopted a fairly
cautious and conservative policy of not seeking expansion, but has been contented
to earn a steady level of profits, most of which have been distributed as dividends.
Recently there have been some personnel changes at board level with the result
that the company has more actively been seeking new investment opportunities. In
the financial year which has just ended the company reported profits of ₦50
million, a similar figure to that of recent years.
It has been estimated that the company's cost of equity is 15% per annum.
Four investment projects have been identified, all of which could commence
immediately. The estimated cash flows and timings of these projects are as follows.
78

Project A B C D
₦m ₦m ₦m ₦m
Year 0 (20) (20) (30) (10.0)
1 7.5 6.5 8.0 5.0
2 7.5 6.5 8.0 5.0
3 7.5 6.5 8.0 5.0
4 6.5 8.0
5 6.5 8.0
Each of these projects is in the same risk class as the company's existing projects.
You have been asked by the board to give your advice on dividend policy at next
week's board meeting.
Required:
a. Calculate how much Binko Industrial Services plc should pay to shareholders
as dividend in respect of the company's financial year which has just ended,
assuming that Modigliani and Miller were correct in their original 1961
proposition on dividend policy.
You should ignore taxation in this calculation. (5 Marks)
b. Prepare notes on which you will base your contribution to the board
meeting. These should include a brief explanation of the Modigliani and
Miller proposition on dividend policy and reasons why the company's board
may decide not to pay the level of dividend which you indicated in (a). You
should bear in mind the fact that most members of the board have little or
no accounting or financial knowledge. Your comments must relate to the
particular circumstances of Binko Industrial Services plc
Ignore inflation.
Work to the nearest ₦1,000 (15 Marks)
(Total 20 Marks)
79

Formulae
𝑉𝐷
𝑉𝐸𝐺
Asset Beta
𝑉𝐸 𝑉𝐷 (1 − 𝑇)
(𝑉𝐸 + 𝑉𝐷 (1 − 𝑇)) 𝐸 (𝑉𝐸 + 𝑉𝐷 (1 − 𝑇)) 𝐷
Equity Beta
𝑉𝐷
𝛽𝐸 = 𝛽𝐴 + (𝛽𝐴 − 𝛽𝐷 ) (1 − 𝑡)
𝑉𝐸
Growing Annuity
𝑛
𝐴1 1+𝑔
𝑃𝑉 = 1−
𝑟−𝑔 1+𝑟

1
𝑃𝑉𝑅 𝑛
𝑀𝐼𝑅𝑅 = 1 + 𝑟𝑒 − 1
𝑃𝑉𝐼
C0 = S0N(d1) – Ee-rt N(d2)
𝑆
𝐼𝑛 0 + (𝑟 + 0.5𝜎 2 )𝑇
𝑑1 = 𝐸
𝜎 𝑇
d2= d1 - 𝜎 𝑇
The Put Call Parity
C + Ee-rt = S + P

d = 1/u
𝑎−𝑑
𝜋=
𝑢−𝑑
80

Annuity Table
r
Discount rate (r)

Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1
2 1·970 1·942 1·913 1·886 1·859 1·833 1·808 1·783 1·759 1·736 2
3 2·941 2·884 2·829 2·775 2·723 2·673 2·624 2·577 2·531 2.487 3
4 3·902 3·808 3.717 3·630 3.546 3.465 3·387 3·312 3·240 3·170 4
5 4·853 4·713 4·580 4·452 4·329 4·212 4·100 3·993 3.890 3·791 5
6 5·795 5·601 5·417 5·242 5·076 4·917 4·767 4·623 4.486 4·355 6
7 6·728 6.472 6·230 6·002 5·786 5·582 5·389 5·206 5·033 4·868 7
8 7·652 7·325 7·020 6·733 6·463 6·210 5·971 5·747 5·535 5·335 8
9 8·566 8·162 7·786 7.435 7·108 6·802 6·515 6·247 5·995 5·759 9
10 9·471 8·983 8·530 8·111 7·722 7·360 7·024 6·710 6.418 6·145 10
11 10·368 9·787 9·253 8·760 8·306 7·887 7.499 7·139 6·805 6.495 11
12 11·255 10·575 9·954 9·385 8·863 8·384 7·943 7·536 7'161 6·814 12
13 12·134 11·348 10·635 9·986 9·394 8·853 8·358 7·904 7·487 7·103 13
14 13·004 12·106 11·296 10·563 9·899 9·295 8·745 8·244 7·786 7·367 14
15 13·865 12·849 11·938 11·118 10·380 9·712 9·108 8·559 8·061 7·606 15
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1
2 1·713 1·690 1·668 1·647 1·626 1·605 1·585 1·566 1·547 1·528 2
3 2.444 2.402 2·361 2·322 2·283 2·246 2·210 2·174 2·140 2·106 3
4 3·102 3·037 2·974 2·914 2·855 2·798 2·743 2.690 2·639 2.589 4
5 3·696 3·605 3·517 3·433 3·352 3·274 3·199 3·127 3·058 2·991 5
6 4·231 4·111 3·998 3·889 3·784 3·685 3·589 3.498 3.410 3·326 6
7 4·712 4·564 4.423 4·288 4·160 4·039 3·922 3·812 3·706 3·605 7
8 5·146 4·968 4.799 4·639 4.487 4·344 4·207 4·078 3·954 3·837 8
9 5·537 5·328 5·132 4·946 4·772 4·607 4.451 4·303 4·163 4·031 9
10 5·889 5·650 5.426 5·216 5·019 4·833 4·659 4.494 4·339 4·192 10
11 6·207 5·938 5·687 5.453 5·234 5·029 4·836 4·656 4.486 4·327 11
12 6·492 6·194 5·918 5·660 5·421 5·197 4·988 4·793 4·611 4.439 12
13 6·750 6.424 6·122 5·842 5·583 5·342 5·118 4·910 4·715 4·533 13
14 6·982 6·628 6·302 6·002 5·724 5.468 5·229 5·008 4·802 4·611 14
15 7·191 6·811 6.462 6·142 5·847 5·575 5·324 5·092 4·876 4·675 15
81

82

SOLUTION 1
a.(i). Scenario A
Year 0 1 2 3 4
Distribution centre (L$
million) (84) 52
Net L$ cash flows growing at
5% (L$ million) 0 90 94.50 99.23 104.19
Exchange rate 1.200 1.2240 1.2485 1.2734 1.2989
Naira equivalent cash flows
(₦million) (70) 73.53 75.69 77.93 120.25
Market research/launch (30)
Naira cash outflows, growing
at 5% (₦million) _ 0__ _(20) (21)_ (22.05) (23.15)
Net (100) 53.53 54.69 55.88 97.10
Tax relief on distribution
centre (₦m) (w1) 0 24.02 (14.01)
Tax relief on market
research/launch(₦m) 0 10.50
Tax payable on NCF
excluding residual (₦m) 0___ (18.74) (19.14) (19.56) (19.97)
NCF (100) 69.31 35.55 36.32 63.12
PVF at 15% 1.000 0.870 0.756 0.658 0.572
PV (₦m) (100) 60.30 26.88 23.90 36.10
Total NPV=₦47.18 million.
Scenario B
Year 0 1 2 3 4
Distribution centre (L$
million) (84) 52
Net L$ CF growing at 5% (L$
million) 45 47.25 49.61 52.09
Exchange rate 1.2000 1.2240 1.2485 1.2734 1.2989
Naira equivalent CF
(₦million) (70) 36.76 37.85 38.96 80.14
Market research/launch (₦
million) (30)
Naira cash outflows
growing at 5% (₦million) ____ (15) (15.75) (16.54) (17.36)
NCF (₦m) (100) 21.76 22.10 22.42 62.78
Tax impact of capital

allowances (w1) (₦million) 0 24.02 (14.01)
Tax relief on market
research/launch(₦million) 0 10.50
Tax payable on NCF
excluding residual (₦million) 0_ (7.62) (7.74) (7.85) (7.96)
Naira NCF (100) 48.66 14.36 14.57 40.81

PVF at 15% 1 0.870 0.756 0.658 0.572
PV (₦million) (100) 42.33 10.86 9.59 23.34
Total NPV = - ₦13.88million.
83

Expected Values
Scenario NPV Prob ENP
V
₦m
A 47.18 0.7 33.03
0
B -13.88 0.30 -4.16
ENPV 28.87
Working Notes
Tax relief on distribution centre
- On cost = 84m/1.2240 × 35% = ₦24.02m
(Tax savings due in year 1)
- On scrap value:
52m/1.2989 × 35% = ₦14.01m
(Tax liability due in year 4)
ii) Payback
Scenario A
Year NCF Cumulative

(₦m) NCF (₦m)
0 (100) (100.00)
1 69.31 (30.69)
2 35.55 4.86
Payback = 1 + 30.69/35.55 = 1.86 years
Scenario B
Year NCF Cumulative NCF
(₦m) (₦m)
0 (100) (100.00)
1 48.66 (51.34)
2 14.36 (36.98)
3 14.57 (22.41)
4 40.81 18.40
Payback = 3 + 22.41/40.81 = 3.55years
84

iii) Interpretation of results
The results of the NPV and payback investment appraisal exercise can be
summarized in the following table:
Scenario A Scenario B Expected result

NPV (₦m) 47.18 Loss of 13.88 28.8
Payback 1.86 years 3.55 years -
The expected NPV of the project is ₦28.8 million and therefore we might
conclude that the project should go ahead on basis of a positive NPV.
However, it is dangerous to make decisions on the basis of expected values in

the case of one-off projects. Such action implies a risk-neutral attitude to the
possibilities. An assessment of the risk appetite and risk capacity of the
company is important when looking at the implications of a loss under Scenario
B.
Expected value is a more useful tool where there are a large number of
repeated projects with independent results. There is some indication that the
company may be undertaking a number of product launches at the same time,
but details are not available for analysis here.
The payback results also reinforce the conclusion that the project is risky under
Scenario B. Payback is not achieved until mid-way through year 4 (toward the
end of the project) under Scenario B, indicating that the project struggles to pay
back the funds invested at all, let alone show a profit.
In this case, it is important to consider the results for each of the two Scenarios
separately. Under Scenario A, there are strong positive results for both NPV and
Payback. However, the results are poor under Scenario B, with a negative NPV
for the project. This is telling us therefore that there is a chance that the
Linderian launch will not be successful (and we have estimated this chance at
30%). Whether the project will be accepted or not will therefore depend on the
risk attitude of the Board and whether it is willing to accept the possibility of
such losses.
b. Evaluation of the abandonment option

We know that it would be possible to abandon the project at the end of the first
year without penalty and retain the ability to realise a residual value of L$70
million on the investment in the distribution centre. This would however be
subject to a balancing charge in respect of tax depreciation allowances already
claimed. Given that ‗if the project were abandoned‘, the L$70 million would be
received on the first day of the financial year, this balancing charge would not
crystalise into a cash flow until the end of the financial year – ie: 31 December
2021.
85

All costs incurred prior to 1 January 2021 such as the marketing, and launch
costs and the investment in the distribution centre should be ignored as they
would have become sunk costs. The net operating cash flows for the year ending
31 December 2020 should also be ignored, although the net operating cash
flows for the years ending 31 December 2021, 2022 and 2023 are still relevant.
Net present value calculations:

Scenario B – Abandon 1.1.21 31.12.21
₦ ₦
Distribution centre – sale
(₦57.19 =L$ 70.00/1.2240) 57.190
Balancing charge ₦57.19 million × 35% (20)
Discount factor 1.000 0.870
PV 57.190 (17.400)
Total NPV: ₦39.79 million,
i.e. appropriately ₦40 million
31Dec: 2021 2022 2023

Scenario B – Do not abandon ₦ ₦ ₦
Net naira equivalent cash flows 14.360 14.570 40.810
Discount factor 0.870 0.756 0.658
PV 12.490 11.010 26.850
Total NPV: ₦50.35 million i.e. approximately ₦50 million
Examiner‘s Note: Valid alternative approaches will be given full credit. For
example, recalculating Scenario B assuming that the project is abandoned early.
Evaluation:
 The PV of the remaining cash flows is greater if the project is not abandoned at
this point (NPV of ₦50 million versus ₦40 million if the project were to be
abandoned)
 The ultimate decision will also depend on the sensitivity of the cash flows – is it
possible that cash flows could be low in early years but increase in later years
once the product has gained acceptance in the market?
 It will also depend on other factors such as the possible loss of reputation as a
consequence of early withdrawal from the market or loss of market share to a
competitor.
 The development of this new market may be a key element required to meet the
company‘s strategic aim of increased market share in both domestic and
overseas markets.
86

Conclusion:
There are strong arguments for continuing with the project rather than abandoning
it on 1 January 2021, even if Scenario B holds true for the remaining term of the
project. Based on a financial evaluation of future present values and possibility of
other benefits of developing a market presence in the Linderian market at this time.
c) Advise how real options and other strategic financial issues might
influence the initial investment decision.
Even under the ‗worst case‘ scenario, Scenario B, it is unlikely that the
project would be abandoned and therefore the abandonment option has
little influence on the investment decision and little value on 1 January
2020. The abandonment option is ‗out-of-the-money‘, on that date. However,
it does not follow that the option has no value on 1 January 2020 because
there is always a possibility that out-turn results are even worse than
predicted by Scenario B and the option would then be exercised. The
‗insurance‘ provided by the abandonment option has some value, linked to
the extent of loss that would be avoided and the probability that the option
would move to being ‘in-the-money‘ by the end of the year. Depending on
the risk appetite of the company, this insurance against an even larger loss
may be sufficient to influence the investment decision in favour of
proceeding with the investment.
Other real options include ‗wait‘ and ‗follow on‘.
A ‗follow on‘ would seem to be the most likely to apply in this instance. If,
for example, ‗Aladun‘ were to be successful in Linder, it might open up the
possibility of the launch of further product lines in Linder. This option could
therefore have significant value and should be evaluated and built into the
investment appraisal of this project.
A ‗wait‘ option could be dangerous in this case as it could give competitors
time to break into the market ahead of us and establish a market lead.
Other strategic financial issues that might be raised in discussion include:
 Availability of finance. What is the company‘s credit worthiness and
credit rating? Is there a refinancing risk? Are sufficient funds available to
fund this expansion?
 Do some areas of the business need to be sold in order to release capital
for expansion?
 Impact on shareholder returns such as earnings per share. Under
Scenario A the project returns more than 15% on the investment on an
NPV basis, but under Scenario B the project would damage earnings per
share due to its loss making position.
 Impact on gearing. The impact of the project on gearing is likely to be
immaterial due to the relatively small size of the project in relation to the
group as a whole. However, group gearing is quite high and this could
87

limit the scope for pursuing aggressive growth in both product range and
geographical spread in the near future.
 Risk appetite. What would be the likely response of shareholders of a
failure of this project? To what extent could a loss be absorbed by other
parts of the group?
Marking Guide
Mark Mark
a (i) Scenario A
- Recognition of the amount spent on distribution centre
and the residual value in years 0 and 4 0.5
- Calculation of the growing cash flows-years 1 to 4 1.0
Calculation of the exchange rate-years 1 to 4 1.0
Conversion of the foreign currency to Naira 0.5
Recognition of the cost of market research/launch in year 0 0.5
Calculation of the Naira cash out/flows for years 1 to 4 1.0
Computation of the tax relief on distribution centre 0.5
Computation of the tax relief on market research/launch 0.5
Computation of tax payable on net cash flow 1.0
Determination of the present value factor for years 0 to 4 0.5
Calculation of the present value for years 0 to 4 0.5
Computation of the net present value 0.5
Scenario B
- Recognition of the amount spent on distribution centre and the
residual values in years 0 and 4 0.5
- Calculation of the growing cash flows for years 1 to 4 1.0
- Calculation of the exchange rate for years 1 to 4 1.0
- Conversion of the foreign currency to Naira=years 1 to 4 0.5
- Recognition of the cost of market research /launch in year O 0.5
- Calculations of the Naira cash outflows for years 1 to 4 1.0
- Computation of the tax relief on: Distribution centre 0.5
: Market Research/launch 0.5
- Computation of tax payable on net cash flow 1.0
- Determination of the present value factor for years 0 to 4 0.5
- Calculations of the present value for years 0 to 4 0.5
- Computation of the net present value 0.5
- Computations of the expected values for scenarios A & B 1.0 17
ii) Computation of payback period-Scenario A 2
Computation of payback period-Scenario B 2 4
iii) Summary of the result of calculations of the NPV and payback
investment appraisal exercise 0.5
Comment on the result of the calculated NPV 1.5
Conclusion on the pay back results of Scenarios A and B 0.5
Comment on the result of the payback years 1.5 4
88

b) Recognition of sunk costs 1.0
Computation of the PV in case of Abandonment - Scenerio B 1.5
Computation of the PV in case of non-abandonment – Scenerio B 1.5
Evaluation of the result of the PV 2.0
Conclusion 1.0 7
c) Advice on how real options and other strategic financial issues

might influence the initial investment decision 8
40
Examiner’s Report
The question tests candidates‘ knowledge of foreign capital project. They were
expected to calculate expected net present value and payback period. They were
also expected to evaluate an option to abandon the project after the first year.
Being a compulsory question, almost all the candidates attempted the question but
the level of performance was very poor.
Common mistakes include:
 Computing capital allowances on advertising costs, cost of market research, etc;
 Adding together figures given in foreign currency and in naira;
 Inability to calculate the appropriate exchange rates;
 Applying the Black-Schole option pricing model to part (b) despite the fact that
the key variables needed for model are not available in the question; and
 Producing generic comments in parts (a)(iii) and (c).
We recommend that candidates should supplement their reading with examination-
type of questions from time to time.
SOLUTION 2
a) PJP currently has 400 million ordinary shares, and Fader 300 million.
Earnings per share:
PJP YP
N44.10 N28.70
= 11.025 kobo = 9.57 kobo
400m 300m
P/E ratios
PJP YP
2,900 1,800
= 263.04 = 188.09
N11.025 N9.57
89

b) A 2-for-3 share exchange will result in the issue of 300 million x 2/3 new shares,
or 200 million shares, giving a total of 600 million shares.
₦ million
Current combined earnings after tax 72.80
Additional earnings from operating savings 7.50
80.30
Ignoring the one-off redundancy payments the expected earnings per share is:
N80.30m
= 13.383kobo
600m
Increasing earnings per share alone is not enough. The effect on the market
value is the crucial factor. When a relatively high P/E company acquires a
company with a lower P/E, the expected earnings per share will increase, but
not necessarily the total market value of the companies.
c) i) The current combined value of the two companies is:

(400m shares x ₦29) + (300m shares x ₦18) = ₦17 billion.
If the market is efficient, ignoring any synergistic or other effects of the

takeover, the post-acquisition P/E will be the weighted average (by earnings) of
the current P/E ratios.
263.04 × N44.10m + (188.09 × ₦28.70m)

= 233.50
N72.80m
The new EPS takes into account the operating savings.
Multiplying the P/E by the new EPS 233.5 x 13.383 = 3,124.93

3124.93 x 600 million shares gives a market value of ₦18.750billion.
However, this ignores the impact of the redundancy costs, ₦7,000,000 after
tax.
When this is included the combined value of the companies is still expected to
substantially increase.
ii) Changes in expected cash flows as a result of the takeover are as follows:
₦7,500,000
PV of operating savings (to infinity) = = ₦62,500,000
0.12
Redundancy costs, after tax relief (₦7,000,000)

Net effect on NPV ₦55,500,000
90

If the market is efficient the market value of the combined company should
increase by ₦55,500,000 as a result of the expected increase in NPV, much
less than the estimate using P/E based valuation.
d) Both estimates are likely to be inaccurate. Many other factors are likely to affect
the post-acquisition share price. For example:
 The effect of the acquisition on corporate growth rates.

 There may be problems integrating the operations and workforce of the two
companies.
 PJP's managers may not be able to apply enhanced management skills to
YP's operations.
 The effect of the change in risk and capital structure is not known.
 With respect to the P/E estimate:
 P/E ratios use accounting data rather than cash flow data.
 Accurate estimates of future earnings are very difficult, and earnings can
rapidly change.
With respect to cash flows:

 The value of all expected cash flows pre and post-acquisition should be
compared, not just the changes in a few cash flows. However, post-
acquisition cash flows are very difficult to determine.
 Cash flows savings of ₦7,500,000 per year forever are unrealistic.
 The cost of capital of PJP is likely to change as a result of the acquisition of
YP.
The implications of making a hostile bid

The board should be clear about the strategic implications of making a hostile bid
for a company rather than carrying out an aggressive investment programme of
organic growth.
A hostile bid involves:

• A reduction in competition. The company may be buying a competitor who will
no longer be competing against it and its competitive position should be
improved.
• A much faster speed of growth. It is much quicker to buy an existing company
with existing staff and existing contracts.
• Buying an under-performer. The challenge would be to tighten up the company
and release its full potential.
• More expense than the organic alternative. A bidding company has to pay a
premium to acquire a target company. However, there may be synergistic
benefits from the merger that would make paying the premium worthwhile.
• Possible culture clash between ourselves and the target company managers and
employees
91

• The use of cash resources to finance any cash alternative to the paper offer. If
cash is tight, then the company should offer an unattractive cash alternative to
try and persuade the target shareholders to accept paper rather than cash.
Organic growth involves:
• Less risk. Steady organic growth is a much safer option, where individual
problems can be addressed as they arise, rather than having to deal with all the
problems in an entire company from day one of ownership.
• Less damage to the stock price in the market. It is traditionally the case that the
market will mark down the price of a bidding company's stock/shares on
announcement of the bid, recognising the risk inherent in the deal and the fact
that managers may concentrate on the deal rather than on running the existing
business.
• More choice on precisely where to expand. Organic growth allows a company to
choose more carefully the geographical areas and business areas that you wish
to operate in.
Marking Guide
a) Calculations of earning per share (EPS) for PJP & YP 1.0
Calculations of price earnings ratios P/E ratios – PJP & YP 1.0 2
b) Calculation of number of shares after merger 1.0
Calculation of total earnings after merger 1.0
Computation of the earnings per share after merger 1.0
Comment on the importance of increasing EPS 1.0 4
i) Computation of the current combined value of PJP&YP 1.0
Computation of the post- acquisition P/E ratio 0.5
Calculation of the post acquisition market value 1.0
ii) Calculation of PV of operating savings (to infinity) 1.5
Adjustment of redundancy cost, after tax relief, to determine
net effect on PV 0.5
Comment on the net effect on NPV 0.5 5
c) ½ mark per valid listed limitation factor, max 6 points 3
d) 1 mark per valid point on hostile bid, max 4 points 4
1 mark per valid point on organic growth, max 2 points 2 6
20
Examiner’s Report
The question tests candidates‘ knowledge of take over and some related basic
calculations like EPS, pre-and-post-takeover P/E ratios, capitalization of synergies,
etc.
Most candidates attempted the question and once again, the level of performance
was very poor.
92

In computing the post-takeover P/E ratio, candidates did not realize the need to
make use of the pre-takeover total earnings of each of the two companies to
estimate post-takeover weighted average P/E ratio. Furthermore, almost all the
candidates could not isolate and capitalize the relevant cashflows required in
section (c) (ii).
We recommend that candidates should cover the entire syllabus when preparing for
the Institute‘s examinations and solve past examination questions.
SOLUTION 3
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.
93

ii) 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
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.
94

iii) 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.
Marking Guide Mark Mark

a) ½ mark for each listed point, max 4 points 2
2 marks for explaining the listed point 8 10
b) ½ mark for each main functional areas listed, max 4 points 2
2 marks for explaining the main functional areas listed 8 10
20
95

Examiner’s Report
This question tests the candidates‘ knowledge of ethical issues in finance. Most of
the candidates attempted the question but performance was below average.
Candidates were expected to discuss and provide examples of ethical issues in

various functional areas of a firm. More than 90% of the candidates who attempted
the question could not produce meaningful solution.
It is required that they should make efforts to read widely and apply their work
experiences in examination situations.
SOLUTION 4
a) There are a number of different risks facing commercial organisations. All

businesses have to contend with the ups and downs of business life, booms
and slumps, risky decisions about what to produce, what prices to charge,
how and where to market their goods and so on. Firms which have borrowed
money, or are about to borrow money in the near future, face the additional
risk of exposure to interest rate changes. If a company has a considerable
amount of variable rate debt (for example a large overdraft or variable rate
bank loan) then it faces the risk that interest rates may rise and its
repayments increase.
The effect of this on the business could be dramatic, reducing cashflow and
profit and perhaps, if the rise in rates is a large one and the company is
highly geared (with a high proportion of debt), bringing the risk of
liquidation. Alternatively, a business with a large amount of fixed rate
borrowing (for example a fixed rate loan or fixed interest preference shares
or bonds) is exposed to a fall in interest rates. If the company has borrowed
large sums at 10% fixed, and a short time later rates fall to 8%, it will be
paying more for its debt than it needs to. Cashflow and profits could be
better if only the debt were not a fixed rate.
Companies thinking about borrowing in the near future also face risk. Should
they borrow at a fixed rate now because they are worried about a rise in
interest rates or should they wait in the hope that rates may fall shortly? A
wrong decision could be costly.
Finally, there are companies with debt capital maturing that will need to be
replaced. A company may have issued N5million of bonds due to mature
between 2024 and 2026. The company itself will have the choice as to
exactly when they will repay the holders of the debt. If they think that
96

interest rates are likely to be lower in 2024 than in 2026 they can repay the
bond holder early in 2024 and replace the debt with a new issue of bonds
then. If they think rates will be lower in 2026 they can wait and replace the
debt when it is cheaper to do so. Decisions like this are risky: making the
wrong choice could cost millions of naira.
b) A Plc borrows N200million with interest rate at 6-month NIBOR plus 1%. This
transaction is in the cash market. In the swap market, it receives 6-month
NIBOR and pays fixed interest at 8.5%. The net effect is to acquire a fixed
rate obligation at 9.5% for the full term of the swap.
(In the following analysis, N stands for NIBOR)
%
Cash market: borrow at N + 1% (N+1)
Swap market: receive (floating) N
pay (fixed) (8.5)
Net payment (fixed) (9.5%)
A Plc will therefore fix its payments at N9.50m – (N200m × 9.5% × 6/12) every
six months for the five year.
At each six-monthly fixing (re-setting) date for the swap, the payment due
from A to the swaps bank or from the bank to A will depend on the market
rate for six-month NIBOR at that date.
c) i) NIBOR 10%
Suppose that on the first re-set date for the swap, at the end of month 6
in the first year, 6-month NIBOR is 10%. The payment due to each party to
the swap will be as follows:
Nm
Due from A-8.5% (N200m × 8.5% × /12)6
= (8.5)
Due to A-10%(N200m × 10% × 6/12) = 10
Net amount due to A Plc 1.5
A Plc will receive this amount six months later at the end of 12 months of
the first year- rates are fixed in advance and payments made in arrears. A
plc will pay interest on its cash market loan at NIBOR + 1% which for this
six-month period is 11% (10% + 1%). Taken with the amount received
under the swap agreement, the net cost to A Plc is equivalent to interest
payable at 9.5%.
Nm
Interest on loan = (N200m × 11% × /12) =
6
(11)
Net receipt from swap 1.5_
Net interest payment (for 6 months) (9.50)
Effective annual rate = /200 × /6
9.5 12
= 9.5%
97

ii) NIBOR 7.5%
With the principles set up above, we can speed up the calculations as

detailed below:
₦m
Swap payments:
- Due from A-at 8.5% (8.5)
- Due to A -7.5% (N200m × 7.5% × /12)
6
7.5
- Net amount (Net Payment from Swap (1.0)
Cash market:
Interest on loan – at 8.5% (7.5% + 1%)
= (N200m × 8.5% × 6/12) (8.5)
Net payment from Swap (1.0)
Net interest payment (9.5%)
Effective annual cost (as above) 9.5%

a) 2 marks per valid risk discussed, max 4 risks 8
b) Calculation of the fixed interest six monthly payment 3
Comment on the result of the calculation 1 4
c) Calculation of the interest payment when: NIBOR is 10% 4
NIBOR is 7.5% 4 8
20
Examiner’s Report
This question tests candidates‘ knowledge of interest rate risk generally and
hedging using interest rate swap in particular. Less than 20% of the candidates
attempted the question but performance was very poor.
Candidates were expected to discuss how changes in interest rates affect both
lenders and borrowers. They were also expected to illustrate the effect of pre-
designed swap arrangement. Most of the candidates that attempted the question
demonstrated lack of knowledge of this area of the syllabus.
Candidates are advised to cover every section of the Institute‘s syllabus when
preparing for the examinations
98

SOLUTION 5
a) Forecast Financial Position – Yinko Plc
Current Proposal Proposal 2 Proposal

1 ₦m 3
₦m ₦m ₦m
Non-current assets 1,410.00 1,410.00 1,510.00 1,310.00
Current assets 330.00 323.60 338.60 322.16
Total assets 1,740.00 1,733.60 1,848.60 1,632.16
Current liabilities 185.00 185.00 185.00 185.00
Non-current liabilities 700.00 800.00 800.00 565.00
Total liabilities 885.00 985.00 985.00 750.00
Share capital (40kobo/share) 240.00 227.50 240.00 240.00
Retained earnings 615.00 521.10 623.60 642.16
Total equity 855.00 748.60 863.60 882.16
Total liabilities and capital 1,740.00 1,733.60 1,848.60 1,632.16
Number of shares 600m 568.75m 600m 600m
Profit after tax (adjusted) ₦130m ₦123.60m ₦138.60m ₦157.158m
EPS (kobo) 21.67 21.73 23.10 26.19
Financial leverage 50.9% 56.8% 53.3% 46.8%
Working Notes
Proposal 1
Debt is increased by ₦100million and shareholders fund reduced by the same
amount as follows:
₦000
Share capital-par value*:
40𝑘𝑜𝑏𝑜
₦100m × 12,500
320𝑘𝑜𝑏𝑜
Retained earnings:
320−40
₦100m × 87,500
320
100,000
(* Only the par value can be removed from share capital. This is very important
please)
Additional interest net of tax

₦‘000
 On additional borrowing:
100m × 6.25% × (1 – 0.20) 5,000
 Extra coupon on existing debt
= 700m × 0.25% × (1 – 0.20) 1,400
6,400
99

This is taken from retained earnings.
Balance of retained earnings
= ₦615m – (87.50m + 6.40m) = ₦521.10m
Furthermore, the additional interest of ₦6.40m is taken off current assets
because presumably it is paid out of cash.
Balance of current assets = 330m – 6.40m = ₦323.60m
The alternative is to assume that the additional interest has not been paid
and therefore taken to interest payable in current liabilities. That leaves
current assets constant at ₦330m and increases current liabilities to
₦191.40m.
Adjusted PAT = ₦130m – 6.40m = ₦123.60m
Proposal 2
 Borrowing of ₦100m increases non-current assets and non-current liabilities

by the same amount.
 Retained earnings and current assets are impacted as follows
Retained Current
earnings assets
₦000 ₦000
Additional interest as above (6,400) (6,400)
Return on additional non-current assets
= ₦100m × 15% 15,000 15,000*
Net change 8,600 8,600
(* If cash sales, it will be part of cash or bank and if credit sales, it will be in
receivables)
Adjusted PAT = ₦130m + ₦8.60m = ₦138.60m
Proposal 3
Non-current assets are reduced by ₦100m (the net book value of the assets
sold). The profit on disposal of ₦100m increases retained earnings (through
profit and loss account). The net change in retained earnings and current assets
are as follows:
Retained Current
earnings assets
₦000 ₦000
Profit on disposal 35,000
Interest savings on loan paid:
₦135,000,000 × 0.06 × (1 – 0.2) 6,480 6,480
Reduction of interest on remaining loan
= ₦565,000,000 × 0.0015 × (1 – 0.2) 678 678
Return lost due to reduction in investment
100

= ₦100,000,000 × 0.15 (15,000) (15,000)
Net change 27,158 (7,842)
Note: If the profit from the sale of the asset is assumed to be ₦28million (₦35m
less tax of 20%), then the statement of financial position, EPS and gearing
figures will all change to reflect this.
Adjusted PAT = ₦130m + 27.158m = ₦157.158
b) Discussion
Proposals 1 appears to produce opposite results to others. Proposal 1 would lead
to a small increase in the earnings per share (EPS) due to reduction in the
number of shares. However, the level of gearing would reduce substantially (by
about 12%)
With proposal 3, although the overall profits would increase. because of the
profit from sale of assets with interest savings is larger than the lost earnings
due to downsizing. It has the lowest gearing.
Proposal 2 would give a significant boost in the EPS from 21.67kobo to
23.10kobo. This is mainly due to increase in earnings through extra investment.
However, the amount of gearing would increase by more than 4.7%.
Overall proposal 1 appears to be the least attractive option. The choice between
proposals 2 and 3 would be between sustainability of earning and less gearing
Proposal 3, may not be sustainable because profit from sales of asset is a one-
off transaction.
Other factors to consider are the capital structure of the competitors, the
reaction of the equity market to the proposal, the implications of the change in
the risk profile of the company and the resultant impact on the cost of capital.
(Note: Credit will be given for alternative relevant comments and suggestions)

a)
Proposal 1
Calculation of change in current asset 0.5
Adjustment in non-current liabilities 1.0
Adjustment of share capital 0.5
Adjustment of retained earnings 0.5
Calculation of new number of shares 1.0
Adjustment in profit after tax 0.5
Calculation of new EPS 1.0
Computation of new financial leverage 1.0 6
101

Proposal 2
Adjustment of non-current asset 1.0
Adjustment of current asset 0.5
Adjustment of non-current liabilities 0.5
Adjustment of Retained earnings 0.5
Calculation of new profit after tax 0.5
Calculation of EPS 0.5
Calculation of financial leverage 0.5 4
Proposal 3
Computation of the new balance on non-current assets 1.0
Adjustment of current assets 0.5
Calculation of new balance on non-current liabilities 1.0
Adjustment of retained earnings 0.5
Adjustment of profit after tax 1.0
Calculation of the new EPS 1.0
Calculation of the new financial leverage 1.0 6
b)
1 mark per acceptable discussion, max 4 points 4 20
Examiner' Report
The question tests candidates‘ knowledge of financial projection, using given
scenarios. Only about 50% of the candidates attempted the question and again the
level of performance was poor.
There were numerous calculation errors in candidates‘ solutions. The various

impacts of the given proposals on income, equity, leverage, etc were not well
thought out.
It is recommended that candidates should practice with past examination

questions.
102

SOLUTION 6
a) Net present value of projects
A = -20m + (7.5m × 2.283) = ₦2.88m
B = -20m + (6.5m × 3.352) = ₦1.79m
C = -30m + (8m × 3.352) = ₦3.18m
D = -10m + (5m × 2.283) = ₦1.42m
As there is sufficient capital to undertake all positive NPV projects, the company
should invest in Band D and use ₦30m.
The dividend under the Modigliani and Miller policy is the residue,
i.e. ₦50m – ₦30m = ₦20m. It could also be argued that under M&M's
assumptions any dividend would do, as shortfalls of cash could be replaced by
new equity issues.
b) Notes for board meeting
i) Modigliani and Miller proposition

M&M suggested that, under the assumption of a perfect capital market, the
dividend valuation model would give the share price exactly. It followed that
if the share price was the present value of future dividends, the actual
pattern of those dividends did not matter to the share price as long as the
present value of these remained unchanged. For example, shareholders
would be indifferent in valuing a share between a constant stream of
dividends and a large lump sum dividend paid at some point in the future, if
the value in present value terms were the same.
M&M therefore concluded that the only way to enhance the share price was
to invest in positive NPV projects, as these would result in a higher present
value of dividends reflecting the beneficial project cash flows being paid out
as dividends.
The current dividend should be whatever was not needed for investing in
Positive NPV projects (residual dividend policy).
M&M suggested that any shareholders who require income (i.e. dividends)
and who are unhappy with the level of dividend paid can sell some of their
shares. These shares will have increased in value as a result of the company
accepting positive NPV projects.
This is in effect the manufacture of 'home-made' dividends.

No loss of wealth would result as in a perfect market there are no
transactions costs.
103

ii) Reasons the company may not pay ₦20m dividend
• Imperfections in the capital market

The above analysis assumes a perfect capital market and that any
imperfections will impair the conclusion. The major imperfections that
may cause Binko Industrial Services Plc. to reconsider its dividend are
discussed below.
• Information content of dividends

In a perfect market investors know everything about a company and its
intentions, and in particular know that a dividend is reduced only in
order to fund attractive projects.
In reality, information is restricted and many investors may not be aware

of the reasons – (information asymmetry).
The dividend itself is taken as an important indicator of company health,

and cutting the dividend from its previous fairly constant level may
convince the investors of problems in the company.
If enough shareholders decide to sell their holding the share price will
drop.
• Tax preferences of shareholders

A perfect capital market assumes indifference between income in the
form of dividends and capital gains made as the share price rises.
In reality, however, the different tax positions of investors will mean that
some prefer dividend income, while some prefer an increase in share
prices.
• Transaction costs
The buying and selling of shares is not costless in the real world.
Therefore, the 'manufacture' of home-made dividends would cause a loss
in the wealth of shareholders, leading to a preference for payouts
(dividends) rather than retentions.
• Clientele theory
It follows that Binko Industrial Services Plc. should discover whether its
shareholders prefer dividends or capital gains.
However, as the company has been following a policy of paying out most
of its profits as dividends for a number of years, it is likely to have
attracted those investors (or the clientele) who prefer this policy.
A change to one of retaining profits in order to give a capital gain may
well be unpopular with these current investors, and may prompt a wide
trading of the shares as they are replaced by investors who prefer a
policy of retention.
104

• Preference for cash now
Some investors will prefer to take the dividend now, rather than rely on
an increase in future years.
In a perfect market this will be fully reflected in the discount rate (cost of
equity) used and so be compensated in the share price; in real life this
may not be so.
• Other sources of finance

While there are arguments for continuing to payout nearly all the profits
as dividend, it must be recognised that viable projects need funding, and
that using retained earnings is far cheaper than any other source of
equity finance.
However, the company currently has no debt, and finance could be
raised with a reasonably cheap redeemable or irredeemable debenture.
Management, however, normally consider retained earnings to be more
convenient than external equity or debt, and it is likely that the company
will want to retain some of the ₦50m profit for projects and for
unexpected needs.
• Project estimates
The calculation of the dividend depended upon the net present value of
the projects, which in turn depended upon estimates of the cash flows
and the company's cost of capital.
Reassessment of any of these estimates may lead to a different dividend,
and the company may want to undertake some sensitivity analysis on
these net present values.
• Future fund raising

If the firm is about to embark upon a major expansion programme, it is
likely to need external equity in the near future. It could therefore be
unwise to cut dividends too sharply, as this could undermine shareholder
confidence in the new management and make later issues of new equity
difficult.
Marking Guide
a)
Calculation of NPV of project A 1.0
Calculation of NPV of project B 1.0
Calculation of NPV of project C 1.0
Calculation of NPV of project D 1.0
Comment on the result of the calculations of net interest values
of A, B, C, & D 1.0 5
105

b)
i) Explanations of Modigliani & Miller proposition)
1 mark per valid point, max 3 points 3.0
ii) 2 marks for each reason given in support of the company
not being able to pay a N20m dividend, max 6 reasons 12.0 15
20
Examiner’s Report
The question tests candidates‘ knowledge of dividend policy, especially the residual
theory of dividend.
Candidates were expected to calculate the net present values of a given set of
capital projects. This is needed to determine how much is required to finance
profitable projects and how much fund is left for the payment of dividend. They
were also required to explain other factors that influence payment of dividend.
Almost 90% of the candidates attempted the question but only the (a) part was
properly answered.
Candidates could not provide acceptable solutions to section (b).
Once again, we recommend complete coverage of the Institute‘s syllabus when

preparing for this examination.
106

PATHFINDER
MAY 2021 DIET
Question Papers
Suggested Solutions
Marking Guides
and


QUESTION 1
Palemo Temidayo (PT) is a large engineering company listed on the stock market.
The company is considering the purchase of Zinco, an unlisted company that
produces a number of engineering components.
The board of directors is concerned about the appropriate price to pay for Zinco. As
a starting point, it has been decided to provide a range of valuations based on
different industry recognised techniques.
Summarised financial statements of Zinco Limited for the last two years are shown
below:
Statements of profit or loss for the years ended 30 June

2020 2019
N’000 N’000
Sales revenue 112,400 101,090
Opening profit before exceptional items 6,510 4,100
Exceptional items (10,025) -
Interest paid (net) (1,400) (890)
Profit/(Loss) before tax (4,915) 3,210
Taxation (1,050) (890)
Profit/(Loss) after tax (5,965) 2,320
Note: Dividend 1,000 500
Statement of financial position as at 31 March (N000)

2020 2019
Non-current assets (net)
Tangible assets 27,150 25,240
Goodwill 850 1,000
Current asset
Inventory 17,000 13,900
79

Cash and bank 240 240
Total assets 59,030 52,940

Call-up share capital (50 kobo par) 20,000 10,000
Retained profits 5,185 17,150
Other reserves 6,245 1,675
Total equity 31,430 28,825
Current liabilities – payable 27,600 24,115
59,030 52,940
Additional information relating to Zinco:

(i) If the acquisition succeeds, there will be revenue synergy leading to increase
in annual sales revenue of Zinco of 25% for three years, and of 10% per year
thereafter.
(ii) Non-cash expenses, including depreciation, were N4,100,000 in 2020.
(iii) Income tax rate is 30% p.a.
(iv) Capital expenditure was N5 million in 2020, and is expected to grow at
approximately the same rate as revenue.
(v) Working capital, interest payments and non-cash expenses are expected to
increase at the same rate as revenue.
(vi) Zinco has a patent with current market value of N50million. This has not
been included in the non-current assets.
(vii) Operating profit is expected to be approximately 8% of revenue in 2021, and
to remain at the same percentage in future years.
(viii) Dividends are expected to grow at the same rate as revenue.
(ix) The realisable value of inventory is expected to be 70% of its book value.
(x) The estimated cost of equity is 12%.
(xi) The average P/E ratio of listed companies of similar size of Zinco is 30:1.
(xii) Average earnings growth in the industry is 6% per year.
Required:
a. Prepare a report that gives an estimate of Zinco using:
(i) Asset based valuation (8 Marks)
(ii) P/E ratios (6 Marks)
(iii) Dividend based valuation (6 Marks)
(iv) The present value of expected future cash flows (5 Marks)
(v) Discuss the potential accuracy of each of the methods used and
recommend, with reasons, a value or range of values that PT might bid
for Zinco. State clearly any assumptions that you make.
(10 Marks)
80

b. The directors of PT are considering issuing some ₦100 nominal value ten year
bonds to finance the purchase of Zinco. To make the bonds look attractive to
potential investors, the bonds are to be issued at a discount of 10%. Based on
PT‟s credit rating, investors are expected to require a return of 7% per year
from such bonds.
You are required:

To estimate the coupon rate that PT will have to pay on these bonds in order to
satisfy the investors. (5 Marks)
(Total 40 Marks)
SECTION B: OPEN-ENDED QUESTIONS (60 MARKS)
INSTRUCTION: YOU ARE REQUIRED TO ANSWER ANY THREE OUT OF FIVE

QUESTIONS IN THIS SECTION
QUESTION 2
You should assume that the current date is 31 December 2019
You work for Eko Corporate Finance (ECF). One of the clients for whom you are
responsible is Gap Plc (GP).
Gap Plc is a listed company and is seeking to raise ₦560 million to invest in new
projects during 2020. Currently Gap Plc is financed by equity. However, at recent
board meeting, the finance director stated that, since other companies in Gap‟s Plc
industry have average gearing ratios (measured by debt/equity by market value) of
30% (with a maximum of 40%) and an average interest cover of 6 times (with a
minimum of 5 times), perhaps the company should access the debt markets. The
finance director presented to the board two alternative sources of finance to raise
the ₦560 million.
Equity issue: The ₦560 million would be raised by a 1 for 2 rights issue, priced at a
discount on the current market value of GP‟s shares.
Debt issue: The ₦560 million would be raised by an issue of 7% coupon bonds,
redeemable on 31 December 2029. The yield to maturity (YTM) of the bonds would
be equal to the YTM of the bonds of Eko Ventures (EV), another listed company in
Gap‟s Plc market sector. Eko Ventures has a similar risk profile to Gap Plc and has
recently issued its bonds. Eko Ventures‟ bonds have a coupon of 7%, will be
redeemed in four years at par and their current market price is ₦110 per ₦100
nominal value.
There were concerns expressed by a number of board members regarding the debt
issue since it has been the long-standing policy of the company not to borrow. Their
concerns were how Gap‟s Plc shareholders and the stock market would react. The
81

company‟s cost of capital would increase as a result of the borrowing, leading to a
fall in the company‟s value.
An extract from Gap’s Plc most recent management accounts is shown below:
₦m
Operating profit 200
Taxations at 20% (40)
Profit after tax 160
(i.) Gap Plc has an equity beta of 1.1
(ii.) The risk free rate is expected to be 3% p.a.
(iii.) The market return is expected to be 8% p.a.
(iv.) Gap‟s Plc current share price is ₦5 per share ex-div
(v.) Gap Plc has 320 million shares ordinary shares in issue.
Required:
a. Calculate, using the CAPM, Gap‟s Plc cost of capital on 31 December 2019
(1 Mark)
b. Assuming a 1 for 2 rights issue is made on 1 January 2020:
i. Calculate the discount, the rights issue represents on Gap‟s Plc
current share price (1 Mark)
ii. Calculate the theoretical ex-rights price per share (1 Mark)
iii. Discuss whether the actual share price is likely to be equal to
the theoretical ex-rights price. (4 Marks)
c. Alternatively, assuming debt is issued on 1 January 2020:

i. Calculate the issue price and total nominal value of the bonds that will
have to be issued to give a YTM equal to that of Eko Ventures‟ bonds in
the above calculation. (5 Marks)
ii. Discuss the validity of the use of the YTM of Eko Ventures‟ bonds in the
above calculations. (3 Marks)
d. Outline the advantages and disadvantages of the two alternative sources for
raising the ₦560 million, discuss the concerns of the board regarding the bond
issue (using the gearing and interest cover information provided by the
finance director) and advise Gap‟s Plc board on which source of finance should
be used. (5 Marks)
(Total 20 Marks)
82

QUESTION 3
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)
QUESTION 4
Kingston Plc. (KP) is a Nigerian company based in Aba. KP exports finished

products to and imports raw materials from a company in Central Africa, with
currency of Central Dollar (C$).
KP has the following expected transactions:

C$
One month: Expected receipt 4,800,000
One month: Expected payment 2,800,000
Three month: Expected receipts 6,000,000
You have collected the following information:

C$ per ₦ 1
Spot rate 1.7818 – 1.7822
One month forward rate 1.7826 – 1.7832
Three months forward rate 1.7842 – 1.7850
Money market rate for KP:

Deposit Borrowing
% %
Nigeria 9 12
Central Africa 13 15
83

Required:
a. Discuss the significance to a multinational company of economic exposure.
(5 Marks)
b. Explain how inflation rates can be used to forecast exchange rates. (3 Marks)
c. Calculate the expected naira receipts in one month and in three months
using the forward market. (3 Marks)
d. Calculate the expected naira receipts in three months using a money-market
hedge and recommend whether a forward market hedge or a money-market
hedge should be used. (5 Marks)
e. Discuss FOUR possible problems of using futures contracts to hedge
exchange rate risks. (4 Marks)
(Total 20 Marks)
QUESTION 5
Ponk Plc is a market research company. It has seen significant growth in recent
years and obtained a stock market listing 5 years ago. Due to current economic and
political turmoil in the country, there has been a significant drop in revenue and
profit.
Ponk Plc is planning a takeover bid for XY, a rival market research company
specialising in the telecommunication industry – an industry that has been very
resistant to the current economic turbulence in the country. XY has an advanced
information technology and information system which was developed in-house and
which Ponk Plc would acquire the rights to use. Ponk Plc plans to adopt XY‟s
information technology and information system following the acquisition and this is
expected to be a major contributor to the overall estimated synergistic benefits of
the acquisition. These benefits are believed to worth ₦8million (in cash flow) at the
end of the first year of acquisition and growing annually at 5%.
Ponk Plc has 30 million shares in issue and a current share price of ₦69 before any
public announcement of the planned takeover.
XY has 5 million shares in issue and a current share price of ₦128.40.

It is believed that the WACC of the combined company will be 15% p.a.
The directors of Ponk are considering 2 alternative bid offers:
Bid offer 1 – Share based bid of 2 Ponk Plc shares for each of XY share.
Bid offer 2 – Cash offer of ₦135 per XY share.
Required:
a. Assuming synergistic benefits are realised, evaluate bid offer 1 and bid offer 2
from the viewpoint of:
(i) Ponk‟s existing shareholders
(ii) XY‟s shareholders. (10 Marks)
84

NOTE: (Up to 6 marks are available for calculations)
Advise the directors of Ponk Plc on:

b. (i) The potential impact on the shareholders of both Ponk and XY of not
successfully realising the potential synergistic benefits after the takeover.
(6 Marks)
NOTE: (Up to 4 marks are available for calculations)
(ii) The steps that could be taken to minimise the risk of failing to realise the
potential synergistic benefits arising from the adoption of XY‟s
information technology and information system (4 Marks)
(Total 20 Marks)
QUESTION 6
Tico Plc is comprised of only four major investment projects, details of which are as
follows:
Project % of Annual % return Risk Correlation
company during the last 5 % standard with the
market years deviation market
value
1 28 10 15 0.55
2 17 18 20 0.75
3 31 15 14 0.84
4 24 13 18 0.62
The risk free rate is expected to be 5% per year, the market return 14% per year, and
the standard deviation of market returns 13%.
Required:
a. Assume that Tico Plc‟s shares are currently priced based upon the assumption
that the last five years‟ experience of returns will continue for the foreseeable
future. Evaluate whether or not the share price of Tico Plc. is undervalued or
overvalued. (8 Marks)
b. Discuss why your results in (a) above might not correctly identify whether or
not the share price of Tico Plc. is undervalued or overvalued. (6 Marks)
c. Briefly discuss the key limitations of portfolio theory in the analysis of physical
investment decisions in practice. (6 Marks)
(Total 20 Marks)
85

Formulae
𝑉𝐷
𝑉𝐸𝐺
Asset Beta
𝑉𝐸 𝑉𝐷 (1 − 𝑇)
(𝑉𝐸 + 𝑉𝐷 (1 − 𝑇)) 𝐸 (𝑉𝐸 + 𝑉𝐷 (1 − 𝑇)) 𝐷
Equity Beta
𝑉𝐷
𝛽𝐸 = 𝛽𝐴 + (𝛽𝐴 − 𝛽𝐷 ) (1 − 𝑡)
𝑉𝐸
Growing Annuity
𝑛
𝐴1 1+𝑔
𝑃𝑉 = 1−
𝑟−𝑔 1+𝑟

1
𝑃𝑉𝑅 𝑛
𝑀𝐼𝑅𝑅 = 1 + 𝑟𝑒 − 1
𝑃𝑉𝐼
C0 = S0N(d1) – Ee-rt N(d2)
𝑆
𝐼𝑛 0 + (𝑟 + 0.5𝜎 2 )𝑇
𝑑1 = 𝐸
𝜎 𝑇
d2= d1 - 𝜎 𝑇
The Put Call Parity
C + Ee-rt = S + P

d = 1/u
𝑎−𝑑
𝜋=
𝑢−𝑑
86

Annuity Table
r
Discount rate (r)

Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1
2 1·970 1·942 1·913 1·886 1·859 1·833 1·808 1·783 1·759 1·736 2
3 2·941 2·884 2·829 2·775 2·723 2·673 2·624 2·577 2·531 2.487 3
4 3·902 3·808 3.717 3·630 3.546 3.465 3·387 3·312 3·240 3·170 4
5 4·853 4·713 4·580 4·452 4·329 4·212 4·100 3·993 3.890 3·791 5
6 5·795 5·601 5·417 5·242 5·076 4·917 4·767 4·623 4.486 4·355 6
7 6·728 6.472 6·230 6·002 5·786 5·582 5·389 5·206 5·033 4·868 7
8 7·652 7·325 7·020 6·733 6·463 6·210 5·971 5·747 5·535 5·335 8
9 8·566 8·162 7·786 7.435 7·108 6·802 6·515 6·247 5·995 5·759 9
10 9·471 8·983 8·530 8·111 7·722 7·360 7·024 6·710 6.418 6·145 10
11 10·368 9·787 9·253 8·760 8·306 7·887 7.499 7·139 6·805 6.495 11
12 11·255 10·575 9·954 9·385 8·863 8·384 7·943 7·536 7'161 6·814 12
13 12·134 11·348 10·635 9·986 9·394 8·853 8·358 7·904 7·487 7·103 13
14 13·004 12·106 11·296 10·563 9·899 9·295 8·745 8·244 7·786 7·367 14
15 13·865 12·849 11·938 11·118 10·380 9·712 9·108 8·559 8·061 7·606 15
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1
2 1·713 1·690 1·668 1·647 1·626 1·605 1·585 1·566 1·547 1·528 2
3 2.444 2.402 2·361 2·322 2·283 2·246 2·210 2·174 2·140 2·106 3
4 3·102 3·037 2·974 2·914 2·855 2·798 2·743 2.690 2·639 2.589 4
5 3·696 3·605 3·517 3·433 3·352 3·274 3·199 3·127 3·058 2·991 5
6 4·231 4·111 3·998 3·889 3·784 3·685 3·589 3.498 3.410 3·326 6
7 4·712 4·564 4.423 4·288 4·160 4·039 3·922 3·812 3·706 3·605 7
8 5·146 4·968 4.799 4·639 4.487 4·344 4·207 4·078 3·954 3·837 8
9 5·537 5·328 5·132 4·946 4·772 4·607 4.451 4·303 4·163 4·031 9
10 5·889 5·650 5.426 5·216 5·019 4·833 4·659 4.494 4·339 4·192 10
11 6·207 5·938 5·687 5.453 5·234 5·029 4·836 4·656 4.486 4·327 11
12 6·492 6·194 5·918 5·660 5·421 5·197 4·988 4·793 4·611 4.439 12
13 6·750 6.424 6·122 5·842 5·583 5·342 5·118 4·910 4·715 4·533 13
14 6·982 6·628 6·302 6·002 5·724 5.468 5·229 5·008 4·802 4·611 14
15 7·191 6·811 6.462 6·142 5·847 5·575 5·324 5·092 4·876 4·675 15
87

88

SECTION A
SOLUTION 1
a) Report
The valuation of private companies involves considerable subjectivity. Many
alternative solutions to one presented below are possible and equally valid.
As PT is considering the purchase of Zinco, this will involve gaining ownership
through the purchase of Zinco‟s shares, hence an equity valuation is required.
Before undertaking any valuations it is advisable to recalculate the earnings for
2020 without the exceptional item. It is assumed that this is a one-off expense,
which was not fully tax allowable.
The revised profit or loss is:
2020
₦‟000
Operating profit before exceptional items 6,510
Interest paid (net) (1,400)
Taxation (30%) (1,533)
Dividend 1,000
Change in equity 2,577
Estimated value = N3,577,000 x 30 = N107,310,000
i) Asset-based valuation
An asset valuation might be regarded as the absolute minimum value of the
company. Asset-based valuations are most useful when the company is being
liquidated and the assets disposed of. In an acquisition, where the company is a
going concern, asset-based values do not fully value future cash flows, or items
such as the value of human capital, market position, etc.
Asset values may be estimated using book values, which are of little use,
replacement cost values, or disposal values. The information provided does not
permit a full disposal value, although some adjustments to book value are
possible. In this case, an asset valuation might be:
₦000
Net assets 31,430
Patent 50,000
Inventory adjustment (5,100)
76,330
89

The value is not likely to be accurate as it assumes the economic value of non-
current assets is the same as book value, which is very unlikely. The same argument
may also be related to current assets and liabilities other than inventory.
ii) P/E ratios
P/E ratios of companies are sometimes used in order to value unlisted companies.
This is problematic as the characteristics of all companies differ, and a P/E ratio
valid for one company might not be relevant to another.
There is also a question of whether or not the P/E ratio should be adjusted
downwards for an unlisted company, and how different expected growth rates
should be allowed for.
Expected earnings growth for Zinco is much higher than the average for the
industry, especially during the next three years. In view of this, it might be
reasonable to apply a P/E ratio of at least the industry average when attempting to
value Zinco.
The after-tax earnings of Zinco, based upon the revised statement of profit or loss,
are ₦3,577,000.
Using P/E ratio of 30, this gives an estimated value of ₦3,577,000 × 30 =
₦107,310,000.
It could be argued that the value should be based upon the anticipated earnings
rather than the past earnings months ago.
This is estimated to be:
2021
₦000
Operating profit before exceptional items 11,240
Interest paid (net) (1,750)
Profit before taxation 9,490
Taxation at 30% (2,847)
Estimated value = ₦6,643,000 × 30 = 199,290
This is a much higher value.

P/E – based valuation might also be criticised as it is based upon profits rather than
cash flows.
90

iii) Dividend-based valuation
Dividend-based valuation assumes that the value of the company may be
estimated as the present value of future dividends.
Using 2-Stage dividend model:

₦000
Year 1 (2021) 1,000(1.25) × (1.12) =
-1
1,116
Year 2 (2022) 1,000(1.25)2× (1.12)-2 = 1,246
Year 3 (2023) 1,000(1.25)3× (1.12)-3 = 1,390
Years 4 – infinity:
= 76,461
Total value 80,213

This is a rather low estimated value and might be the result of Zinco having a
relatively low dividend payout ratio, and no value being available for a final
liquidating dividend.
iv) The present value of expected future cash flows

The present value of future cash flows will be estimated using the expected free
cash flow to equity (FCFE). In theory, this is probably the best valuation method,
but in reality, it is impossible for an acquiring company to make accurate estimates
of these cash flows. The data below rely upon many assumptions about future
growth rates and relationships between variables.
2021 2022 2023

₦000 ₦000 ₦000
Sales revenue 140,500 175,625 219,531
Operating profit 11,240 14,050 17,562
Interest paid (net) (1,750) (2,188) (2,734)
Profit before tax 9,490 11,862 14,828
Tax at 30% (2,847) (3,559) (4,448)
Profit after tax 6,643 8,303 10,380
Add back non-cash expenses 5,125 6,406 8,008
Less increase in working capital (858) (1,073) (1,341)
Less capital expenditure (6,250) (7,813) (9,766)
FCFE 4,660 5,823 7,281
91

The present value of FCFE is computed as follows:
₦000
Year 1 (2021) 4,660 × (1.12) -1
= 4,161
2 (2022) 5,823 × (1.12)-2 = 4,642
3 (2023) 7,281 × (1.12)-3 = 5,182
4 – infinity:
= 285,036
Total = 299,021
Recommended valuation
It is impossible to produce an accurate valuation. The valuation using the
dividend growth model is out of line with all others and will be ignored.
On the basis of this data, the minimum value should be the adjusted asset value,
a little over ₦76,880,000, and the maximum approximately ₦299,021,000.
b) Let x = coupon rate
Annual coupon = 100X

Issue price = ₦90 (90% of ₦100)
The yield of 7% is the IRR of the cash flows associated with the bond. Therefore:
Year CF PVF at 7% PV
0 (90) 1.000 (90.00)
1 – 10 100X 7.024 702.40X
10 100 0.508 50.80
NPV 702.40X – 39.20
By definition, this must equal to zero i.e

702.40X – 39.20 = 0
X = 5.58%
Examiner’s Report
The question tests candidates‟ knowledge of basic methods of valuation.

Candidates were expected to value a company using the following methods:
 Asset basis
 P/E ratios
 Dividend basis
 Free cash flow to equity
They were also to comment on the accuracy of each of the methods:
92

Part (b) of the question tests basic knowledge of bond valuation.
Being a compulsory question, almost all the candidates attempted it. It is highly
troubling that majority of the candidates could not provide any meaningful
analysis.
Among the major challenges candidates faced in answering the question include:
 Inability to determine what constitutes cash flows in (a)(iv)

 Identifying the appropriate P/E to use in (a)(ii)
 Inability to identify the relevant present value formulae to use in (a)(iii) and (iv)
It is recommended that the students should practice examination-type questions

and read extensively when preparing for the Institute‟s examination.
Marking guide
Marks Marks
(a) (i) Asset based valuation adjusting for inventory. 8
(ii) P/E ratio based valuation adjusting for exceptional items
thereby increasing the tax charge. 6
(iii) Dividend based valuation using the expected present
value of future dividends 6
(iv) Present value of expected future cash flows based valuation
using the adjusted figures and ignoring exceptional items 5
(v) Discussing the potential accuracy of each of the valuation
methods above (i-iv) and making recommendations giving
reasons for a value or range of value that PT might bid for
the purchase of Zinco 10 35
(b) Calculation of coupon rate 5
40
93

SOLUTION 2
a) Gaps Plc‟s cost of capital on December 2019 = 3 + (1.1 × (8 - 3)) = 8.5%
b) i) A 1 for 2 rights issue will require 320/2 = 160 million new shares to be
issued.
The price per share = ₦560 million/160 million = ₦3.50
A discount on the current market price of (₦5 – 3.50)/5 = 30% (or
₦1.50).
ii) The theoretical ex-right price is:

No of shares Value per share No per Value
₦ ₦
Existing shares 2 5.00 10.00
New shares 1 3.50 3.50
Total shares 3 Total value 13.50
Theoretical ex-rights price = ₦13.50/3 = ₦4.50

iii) The actual share price will depend on the market‟s reaction to the
rights issue e.g. whether it is fully taken up, and whether the proceeds
are invested in positive net present value projects.
If we were told the net present value of the projects, this could be
incorporated in the theoretical ex-rights price of ₦4.50, giving a more
realistic estimate of the actual share price post rights issue.
c) (i) The yield to maturity of the Eko Ventures bonds is calculated as

follows:
Timing Cash Flow Factors at PV Factors at PV
year ₦ 3% ₦ 10% ₦
0 (110) 1 (110.00) 1 (110.00)
1–4 7 3.717 26.02 3.170 22.19
4 100 0.888 88.80 0.683 68.30
4.82 (19.51)
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IRR = 3 + (4.82/(4.82 + 19.51) × 7 = 4.39% say 4%
The issue price is:
Timing Cash Flow Factors at PV

years ₦ 4.00% ₦
1 – 10 7 8.111 56.78
10 100 0.676 67.60
Issue price 124.38
The total nominal value will be = 560/(124.38/100) = ₦450.23 million
ii) EV has similar risk to GP so it may be reasonable to assume that bond holders
would require the same yield to maturity (YTM) in return for investing with
either company. But how similar is similar? Eg, how comparable is EV to GP
in terms of gearing?.
However the EV bonds have only four years until redemption, whilst the GP
bonds mature in ten years. It is likely that bond holders would require a
higher yield to redemption for investing in the GP bonds to compensate them
for the risk of investing for a further six years.
d) The gearing and interest cover ratios of GP immediately after the bond issue
will be as follows:
Interest cover: Interest ₦450.23 × 7% = ₦31.52m. Interest cover =

(₦200/₦31.52) million = 6.35 times.
Gearing by market values assuming the current market price per share:
Market capitalisation 320 × 5 = ₦1,600 million. Gearing (D/E) 560/1,600 =
35% In time, both interest cover (more operating profits) and gearing
(greater equity value) are likely to improve with the acceptance of positive
NPV projects and any favourable market reaction to the issuance of debt and
its tax shield.
An outline of general advantages and disadvantages of debt vs equity

 Control: if all the rights are not taken up by the existing shareholders, there
will be dilution of control. Debt issue has neutral effect on control.
 Cost: debt should have lower cost of capital due to lower risk (both income
and capital repayment) and the fact that interest on debt is allowed for
corporate tax.
 Security: providers of debt finance will usually require some form of tangible
security for any debt capital.
 Cash flows: while debt finance is cheaper than equity, it place on the
company mandatory payment of interest. Payment of dividend depends on
the availability of cash flow.
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 Issue cost: generally, it is cheaper to issue equity (especially right-issue) than
bonds.
Note: Candidates might also comment on EPS and produce the following
figures:
Current EPS = ₦160m/320 = 50k
EPS with rights issue = ₦160m/480 = 33k
EPS with a bond issue: ((₦200m – 31.52) × 0.80)/320 = 42k
Addressing the concerns of the board:
The company will have a gearing ratio of 35% and an interest cover of 6.35
times. Gearing is between the industry maximum and average of 40% and
30% respectively. The interest cover is slightly above the industry average of
6. Since this is the first time that GP has borrowed, both shareholders and the
stock market might be concerned and prefer these ratios to be around the
averages or better.
Borrowing should reduce the current 8.5% cost of capital of the company
since debt is generally less expensive than equity because it is less risky than
equity for the debt holders. Also the company receives tax relief on the
interest that it pays. Because there is increased financial risk when a
company borrows the shareholders may require a higher return but this is
unlikely to offset the cheaper proportion of debt finance. The company value
should increase as a result of the cost of capital reducing and new funds
being invested in positive NPV projects.
Advice: It would be prudent for the company to restrict its borrowing to the
industry average gearing level especially since its interest cover is slightly
above the industry average. I would advise the company not to borrow the
full ₦560 million, perhaps this could be achieved by revising its plans for
raising the finance. For example an issue of both debt and equity to ensure
that gearing and interest cover ratios are more favourable. Or selling surplus
assets.
Examiner’s Report
The question tests candidates‟ knowledge of sundry issues on sources of long-term

finance. Candidates were expected to compute ex-right price, issue price, YTM and
to comment on the advantages and problems of equity issue vs bond issue.
More than 60% of the candidates attempted the question and again the level of
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Most of the candidates that attempted the question could not correctly calculate the
issue price of the right issue; furthermore, they could also not calculate the issue
price of the bond.
It is recommended that students should prepare adequately before presenting

themselves for the Institute‟s examinations.
Marking guide
Marks Marks
(a) Calculation of cost of capital – using CAPM 1
(b) (i) Calculation of the discount on the current market
price 1
(ii) Calculation of the theoretical ex-rights price 1
(iii) Discussion on the actual share price viz-a-viz its likely
equality with the theoretical ex-rights price 4 6
(c) (i) Calculations of the issue price and the total nominal
Value of the shares of Eko Ventures bonds 5
(ii) Discussion of the validity of the use of YTM of Eko Ventures
bonds in the calculations 3 8
(d) Calculation of the gearing and interest cover ratios of GP,

immediately after the bond issue 2
Outlining the general advantages and disadvantages of debt Vs
equity. 2
Addressing the concerns of the board 0.50
Advice 0.50 5
Total 20
SOLUTION 3
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
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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.
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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.
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Examiner’s report
The question tests the candidates‟ knowledge of non-financial objectives and
ethical issues in finance.
In part (a), candidates were expected to discuss the types of non-financial, ethical
and environmental factors that shape company‟s financial objectives.
In part (b), they were expected to discuss the nature of financial objectives in a not-
for-profit organisations.
Large number of the candidates attempted the question and surprisingly, the level
of performance was below average.
In both parts of the question, candidates could not provide meaningful response to
the requirements.
It is our view that the only insurance against poor performance is wide reading.
Marking guide
Marks Marks
(a) Discussing and providing examples of non-financial issues and
considering its impacts on the achievement of primary financial
objectives – 1 mark per valid point max 5 points 5
Discussing and providing examples of ethical issues and
considering the impact on the achievement of primary financial
objectives. 1 mark per valid point Max 3 points 3
Discussing and providing examples of environmental issue and
considerations of its impact on the achievement of company‟s
corporate financial objectives – 1 mark per point, max 4 points 4 12
(b) General discussion on the nature of the financial objectives that
may be set in a not-for-profit organizations – 2 max per valid
point, max 4 points 8
Total 20
SOLUTION 4
a) Economic exposure
Economic exposure is the risk that the present value of a company's future cash
flows might be reduced by unexpected adverse exchange rate movements.
Economic exposure includes transaction exposure, the risk of adverse exchange
rate movements occurring in the course of normal international trading
transactions.
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Implications of economic exposure
i) Effect on international competitiveness
This can affect companies through its purchases (where raw materials from
abroad become more expensive because of a devaluation of the home
currency) or its sales (where an appreciation in the home currency will mean
that sales priced in foreign currencies will be worth less in home currency
terms).
ii) Effect on remittances from abroad
If a subsidiary is set up in an overseas country, and that country's exchange
rate depreciates against the home exchange rate, the remittances will be
worth less in home currency terms each year.
iii) Effect on accounts
Investors will identify economic exposure as having an adverse effect on
accounts if the markets are efficient.
iv) Effect on operations and financing
In order to hedge the adverse effects of economic exposure, companies will
consider diversification of operations, so that sales and purchases are made
in a number of different currencies. The financing of operations can also be
done in a large number of currencies.
b) The law of one price suggests that identical goods selling in different countries
should sell at the same price, and that exchange rates relate these identical
values.
This leads on to purchasing power parity theory, which suggests that changes in
exchange rates over time must reflect relative changes in inflation between two
countries. If purchasing power parity holds true, the expected forward exchange
rate (F) can be forecast from the current spot rate (S) using the following
formula:
1 + iF S
= (DC/FC) where:
1 + iD F
iF = foreign inflation rate

iD = domestic inflation rate
This relationship has been found to hold in the longer-term rather than the
shorter-term and so tends to be used for forecasting exchange rates several
years in the future, rather than for periods of less than one year. For shorter
periods, forward rate can be calculated using interest rate parity, which
suggests that changes in exchange rates reflect differences between interest
rates between countries.
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c) The exchange rate can be stated as follows:
C$/₦ ₦/C$
Spot 1.7818 – 1.7822 or 0.5611 – 0.5612
1 – month forward 1.7826 – 1.7832 or 0.5608 – 0.5610
3 – month forward 1.7842 – 1.7850 or 0.5602 – 0.5605
Forward Market
 Net receipt in 1 month = C$4,800,000 - C$2,800,000 = C$2,000,000
Applicable exchange rate = ₦0.5608/C$
Amount in ₦ = 2,000,000 × ₦0.5608 = ₦1,121,600
 Receipt in 3 months = C$6,000,000

Applicable rate = ₦0.5602/C$
Amount in ₦ = 6,000,000 × ₦0.5602 = ₦3,361,200
d) Money market
Expected receipt after 3 months = C$6,000,000
C$ 3 – month borrowing interest rate = 15/4 = 3.75%
C$ to borrow now to have C$ 6,000,000 liability after 3 months =
C$ 6,000,000/1.0375 = C$5,783,133 spot rate for selling = N0.5611/C$
Amount of naira to deposit now = 5,783,133 × 0.5611 = ₦3,244,916
Naira deposit rate over 3 months = 9/4 = 2.25%
Value of deposit in after 3 months = ₦3,244,916 × 1.0225 = ₦3,317,927
Based on the above calculations, the forward market rate provides higher net
receipt.
e) The following problems are encountered in using futures contracts to hedge

exchange rate risks:
• Futures contracts are only available in certain currencies. If you are due to
receive a currency in the future for which futures contracts are not offered,
then you will have to find a different way to hedge the risk.
• Futures contracts are only available for expiry in certain months. If you are
due to receive a foreign currency in the future on a date which does not tie in
with a contract expiry date, then a perfect hedge will not be possible.
• Futures contracts are available in whole numbers of contracts, for a fixed
size. Usually the sum to be hedged will not equate to a whole number of
contracts, leaving the fractional amount either unhedged or to be hedged
using a different method (e.g. a forward FX contract).
• Margin must be paid on futures contracts, both an initial margin payable
immediately that the contact is taken out and a daily variation margin as the
value of the contract fluctuates. A company with poor liquidity may therefore
prefer a different method of hedging, such as forward exchange contract on
which no margin is payable.
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• Futures contracts can be technically difficult to understand, so good training
is required for employees if a company is going to start managing risk using
futures. Such training is expensive but the risk of disaster if no one
understands what is going on is very real, as has been proved over and over
in recent history.
• Futures contracts expose the holder to basis risk, i.e. the risk that when a
hedge is constructed, the size of the basis when the futures position is closed
out is different from the expectation, when the hedge was created, of what
the basis ought to be. It would be possible to hold all contracts to their expiry
date, knowing that the basis must be zero by that date, but in practice nearly
all futures contracts are closed out before expiry, so basis risk will be
inevitable.
Examiner’s report
The questions tests candidates‟ knowledge of management of foreign currency risk.
Part (a) tests the candidates‟ knowledge of economic exposure:
- The importance to multinational companies

- The remaining parts of the question deal with various FX risk hedging
techniques
poor.
In part (a), some of the candidates were discussing advantages of international

trade!
In part (b), the candidates demonstrated absolute lack of knowledge of purchasing

power parity theorem.
Furthermore, in answering parts (c) and (d), most of the candidates failed to
recognise the need to net off the payment and against receipt in month one. In
addition, candidates could not identify the appropriate exchange rates to use.
A complete coverage of the Institute‟s syllabus is a necessity when preparing for

this examination.
103

Marking guide
Marks Marks
(a) Discussing the significance and implications of economic
exposure to a multinational company. 1 mark per valid point,
max 5 points
(b) Explaining the role inflation rates play in forecasting expected
exchange rates 1
Stating the formula normally used in forecasting expected
forward exchange rate from current spot rate. 1
Discussing the relationship between exchange rate, interest
rate, inflation rate and the law of one price 1 3
(c) Computation of net-receipt in 1 month using the forward
market rate 1.50
Computation of the receipt in 3 months using the forward
market rate 1.50 3
(d) Calculations of 3 months borrowing interest rate 0.5
Determining the spot rate for selling i.e. the selling rate 1.0
Computation of the amount of Naira to deposit now 1.0
Computation of the Naira deposit rate over 3 months 0.5
Calculation of the value of deposit after 3 months 1.0
Recommendation 1.0 5
(e) Discussing problems usually encountered in using future
contracts to hedge exchange rates risks. 1 mark per valid point,
max 4 points 4
Total 20
SOLUTION 5
a) The present value of the synergistic benefits is:
₦8million/(0.15 – 0.05) = ₦80 million
Current values
₦million
PK 30 million × ₦69 = 2,070
XY 5 million × ₦128.40 = 642
2,712
i) Share offer
Total market value after take over:
₦million
Existing total value 2,712
Synergies 80
2,792
Total number of shares:
Currently in PK 30 million
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Issued to XY = 5 × 2 10 million
40 million
Post-takeover VPS = 2,792 = ₦69.80 million
40
ii) Cash offer
₦million
Post-takeover total value as above ₦2,792

Cash paid for XY (5 million × ₦135) (675)
Value of existing shareholders in PK 2,117
VPS of PK = 2,117/30 = ₦70.57/share.
Comments
 The above calculations indicate that the bid offer is advantageous to both PK
and XY shareholders assuming that the synergistic benefits are realised.
 PK shareholders can expect to make a higher financial gain under the cash
offer than under the share offer. Under the cash offer, the share price is
expected to increase from ₦69 to ₦70.57, a gain of ₦1.57 per share and
₦47.10 million in total. Under the share offer, a lower rise in the share price
is expected, from ₦69 to ₦69.80 per share, a total gain of ₦24million.
 XY shareholders can expect to benefit from an immediate and certain gain of

₦33 million (₦675 – ₦642) under the cash offer. They need to weigh this up
against a theoretical gain of ₦56 million ((69.80 × 10) – 642) from the share
offer.
However, the share offer carries greater risk for the shareholders of XY
because they are exposed to the risk of a fall in the share price of PK if the
market fails to respond to the merger favourably and/or the potential
synergistic benefits are not realised.
 The cash offer has advantage of protecting the proportionate ownership of

the current shareholders of PK. After the share offer there would be 40
million shares on issue, including 10 million held by the previous
shareholders of XY.
 PK has to consider how to raise ₦675 million cash required under the cash
offer. The impact of such a payment on gearing.
 The share offer also has cash flow implications in paying future dividends on
a large number of shares. This could have an even greater call on over time
but has a delayed impact on cash flow.
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b) i) Assuming no synergistic benefits, the combined entity would be worth ₦80
million less at ₦2,712 million.
Share offer
The new VPS is = 2,712𝑚 40𝑚 = ₦67.80
Revised total value of:

₦’million
 PK 30m shares × ₦67.80 = 2,034

 XY 10m shares × ₦67.80 = 678
2,712
Cash offer
₦’million
Combined total value 2,712

Cash paid for XY (675)
Value of current shareholders in PK 2,037
VPS = 2,037 30 = ₦67.90
Comments
 If the synergistic benefits fail to be realised, the takeover would only be

beneficial to XY‟s shareholders.
 PK‟s shareholders can expect to see a fall in share price under both the
share offer and the cash offer (in the order of ₦36 million for the share
offer and ₦33 million for the cash bid). The acquisition will therefore only
be attractive to PK‟s shareholders if additional benefits can be realised
such as the synergistic benefits arising from improved IT/IS systems to
enhance future growth through the business.
 XY‟s shareholders would expect to benefit from an immediate and certain

financial gain of ₦36 million (₦678m – ₦642m) under the share offer.
However, the share offer carries greater risk for the shareholders of XY
because they are exposed to the risk of a fall in the share price of PK if
the market fails to respond to the merger favourably.
ii) The realisation of synergistic benefits will depend upon a smooth and
efficient integration process, Key issues to discuss:
 Careful planning – detailed timetable, allocated responsibilities, interim

targets.
 Retention of key personnel (programmers and operators) - possibly by
offering enhanced packages and by keeping personnel fully informed.
 Building good relationships between staff transferring from XY to PK.
 Training of key personnel on how to operate the system.
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 Parallel running of the system and possible test data before going live.
 Looking at post completion audit reports of any such projects that have
happened before to see if any lessons can be learnt.
 Proper management control via regular meetings and involvement of key
personnel throughout.
Examiner’s report
The question tests candidates‟ knowledge of various aspects of merger and
acquisition. Candidates were expected to quantify the possible financial gains of
the merger to shareholders of both companies.
About 60% of the candidates attempted the question and once again, performance
was below average. This is despite the fact that the question was in the
examination in the year 2019!
Candidates could not logically analyse the financial impact of the merger on the
shareholders. They also failed to apply the appropriate valuation models in their
solutions. For example, in part (a), they could not recognise the need to apply
perpetual growth model to value the synergy arising from the merger.
The fact that the question was tested in a recent examination underscores the need
for candidates to revise with the Institute‟s pathfinder when preparing for the
examination.
Marking guide
Marks Marks
(a) Calculation of the present value of the synergistic benefit 0.5
Computation of the current values of PK and XY shares 1.0
Calculating the total market value after take over 1.0
Determining the total number of shares after the take over 1.0
Computing the post take over value per shares 1.0
Determining the value of existing shares in PK after the cash offer 1.0
Value of PK shares after the take over 0.5
Comments based on the calculations 4.0 10
(b)(i) Calculation of the new value per share based on share offer 1.0
Determining the revised total value of PK and XY shares based on
share offer 1.0
Calculation of the wealth of the current shareholders in PK
based on cash offer 1.0
Determining the new value per share in PK based on cash offer 1.0
Comments based on the calculations 2.0 6
(ii) Discussing the steps to take in minimizing the risk of failing to
realize the potential synergistic benefits
1 mark per point, max 4 points 4
Total 20
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SOLUTION 6
a) The beta value of each of the four projects may be estimated using:
Correlation coefficient of the project (Rim) and the market multiplied by the
standard deviation of the project‟s returns (i), and all divided by the standard
deviation of returns from the market (m).
The overall company beta is the weighted average of the project betas, the
weighting being by their proportion of total market value. The beta of TK is
estimated to be:
(0.28 × 0.635) + (0.17 × 1.154) + (0.31 × 0.905) + (0.24 × 0.858) = 0.860
Using the capital asset pricing model, the return that might be expected from TK
may be estimated to be:
5% + (14% - 5%) 0.860 = 12.74%
The return historically has been:

(0.28 × 10%) + (0.17 × 18%) + (0.31 × 15%) + (0.24 × 13%) = 13.63%
Assuming these historic returns are expected to continue, the share price of TK
is likely to be undervalued, as the company is yielding a higher return than
expected for its systematic risk.
b) Reasons why the results may not correctly identify whether the share price is
overvalued or undervalued include:
i) The data relating to returns, risk and correlation with the market is
historic and is unlikely to repeat itself in the future. Betas may change
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over time, reflecting changes in the risk of the projects. Ideally CAPM
should use forecasts of data, but these will also be subject to inaccuracy.
ii) The market may not be totally efficient and may not accurately reflect
information available. Alternatively, the market may only be semi-strong
form efficient and not have knowledge of the full information known
internally within the company.
iii) The capital asset pricing model (CAPM) upon which the evaluation is
based relies upon a series of restrictive assumptions, and there is evidence
that it might overstate or understate the required returns on high beta and
low beta securities, small companies, investments with low PE ratios, and
in certain seasons or on certain days of the week. It is only a single period,
single factor model, whereas multi-factor models such as the arbitrage
pricing theory might be more accurate.
iv) The market risk premium may not be constant. The difference between the
market return and the risk free rate can vary over time.
c) Limitations of Portfolio Theory

i. Projects may be of such size that they are not easy to divide in accordance
with recommended diversification principles.
ii. The theory assumes that there are constant returns to scale, in other words
that the percentage returns provided by a project are the same however
much is invested in it. In practice, there may be economics of scale to be
gained from making a larger investment in a single project.
iii. It will be difficult in practical cases to know what are shareholders
preferences between risk and return and therefore to reflect these
preferences in decision-making.
iv. Portfolio theory requires an assessment of probability distribution of the
possible outcomes. An objective probability assessment is difficult in
practice.
v. Portfolio theory is based on the notion of managers assessing the relevant
probabilities and deciding the combination of activities which a business will
be involved. Managers have the security of their jobs to consider, while the
shareholders can easily buy and sell securities. Managers are considerably
less mobile and less well diversified than shareholders who can buy & sell
securities more or less at will. Most managers are therefore more risk-averse
than shareholders resulting in the likelihood of sub-optimal investment
decisions.
vi. The mathematics required to handle portfolio comprising of many assets is
far beyond the comprehension of many managers.
Examiner’s report
The question tests candidates‟ knowledge of securities‟ valuation using CAPM.
Candidates were expected to:
 Calculate the historical beta factor of each of the company‟s projects;
 Calculate the average beta factor of the company;
109

 Calculate, using CAPM, the company‟s required return;
 Calculate the company‟s actual average historical return;
 Conclude whether or not the company‟s share price is undervalued or
overvalued.
They were also required to assess the validity of CAPM conclusion. Almost all the
candidates attempted the question and performance was very poor.
In part (a), most of the candidates were assessing the individual projects rather
than the company as a whole! Besides, some of them made use of wrong formulae
when calculating beta factor. In parts (b) and (c), most of the candidates could not
produce any meaningful answer.
Candidates are advised to read widely and practise examination-type of questions

when preparing for the examination.
Marking guide
Marks Marks
(a) Calculating the „beta‟ for each project. 1 mark for each
calculation 4 projects 4.0
Calculating the overall beta of the projects using WACC 1.5
Calculating the expected return from TK using CAPM 0.5
Computing the historic return on TK shares 1.5
Comment on the result of the historical return 0.5 8
(b)(i) Discussions on why the results of the calculation above may not
correctly identify whether the share price is over-valued or
undervalued. 2 marks per valid point discussed.
Max 3 points 6
(ii) Discussing the steps to take in minimizing the risk of failing to
realize the potential synergistic benefits
11/2 mark per point, max 4 points 6
Total 20
110

PATHFINDER
NOVEMBER 2021 DIET
Question Papers
Suggested Solutions
Marking Guides
and
Examiners‘ Reports

INSTRUCTION: YOU ARE REQUIRED TO ANSWER FIVE OUT OF THE SEVEN

QUESTION 1
Femi Appliances Limited (FAL) is a Nigerian – based manufacturer of household
appliances with many distribution centres across various locations in Nigeria and
along the ECOWAS sub-region. FAL is now considering the development of a new
motor vehicle vacuum cleaner – VC4.
The product can be introduced quickly, and has an expected life of four years
change with a more efficient model. Costs associated with the product are
estimated to be:
Direct costs (per unit)

Labour:
3.5 skilled labour hours at ₦500 per hour.
4 unskilled labour hours at ₦300 per hour.
Materials:
6 kilos of material Z at ₦146 per kilo
Three units of component P at ₦480 per unit
One unit of component Q at ₦640
Other variable costs: ₦210 per unit.
Indirect costs
Apportionment of management salaries: ₦10,500,000 per year
Tax allowable depreciation of machinery: ₦21,000,000 per year
Selling expenses (not including any salaries): ₦16,600,000 per year
Apportionment of head office costs: ₦5,000,000 per year
Rental of buildings: ₦10,000,000 per year
Annual interest charges: ₦10,400,000
Other annual overheads: ₦7,000,000 (including apportionment of building rates
₦2,000,000. N.B. rates are a local tax on property).
80

If the new product is introduced it will be manufactured in an existing factory, and
will have no effect on rates payable. The factory could be rented for ₦12,000,000
per year (not including rates), to another company if the product is not introduced.
New machinery costing ₦86,000,000 will be required. The machinery is to be

depreciated on a straight-line basis over four years, and has an expected salvage
value of ₦2,000,000 after four years. The machinery will be financed by a four year
fixed rate bank loan, at an interest rate of 12% per year. Additional working capital
requirement may be ignored.
The new product will require two additional managers to be recruited at an annual
gross cost of ₦2,500,000 each, and one manager currently costing ₦2,000,000 will
be moved from another factory where he will be replaced by a deputy manager at a
cost of ₦1,700,000 per year. 70,000 kilos of material Z are already in inventory and
are not required for other production. The realisable value of the material is
₦9,900,000.
FAL will use the existing advertising campaigns for its distribution centres to also
advertise the new product. This will save approximately ₦5,000,000 per year in
advertising expenses.
The price per unit of the product in the first year will be ₦11,000, and demand is
projected at 12,000, 17,500, 18,000 and 18,500 units in years 1 to 4 respectively.
The inflation rate is expected to be 5% per year, and prices will be increased in line
with inflation. Wage and salary costs are expected to increase by 7% per year, and
all other costs (including rent) by 5% per year. No price or cost increases are
expected in the first year of production.
Income tax is at the rate of 35% payable in the year the profit occurs. Assume that
all sales and cost are on cash basis and occur at the end of the year, except for the
initial purchase of machinery which would take place immediately. No inventory
will be held at the end of any year.
Required:
a. Calculate the expected internal rate of return (IRR) associated with the
manufacture of VC4. Show all workings to the nearest ₦million.
(19 Marks)
b. i. What is meant by an asset beta and how it is different from an equity
beta? (2 Marks)
ii. If you are told the company‘s equity beta is 1.2, the market return is
15% and the risk free rate is 8%, discuss whether you would recommend
introducing the product. (4 Marks)
81

c. The company is worried that the government might increase corporate tax
rates.
Advise the directors by how much that the tax rate would have to change
before the project is not financially viable. A discount rate of 17% per year may
be assumed for part (c). (5 Marks)
(Total 30 Marks)
INSTRUCTION: YOU ARE REQUIRED TO ANSWER ANY TWO OUT OF THE

THREE QUESTIONS IN THIS SECTION
QUESTION 2
You run a financial consultancy firm and you have been approached by a new client
for advice on a potential acquisition. Kola Plc (KP) is a large engineering company
that was listed on the stock market ten years ago with the founders retaining a 20%
stake in the business. Whilst KP had previously experienced rapid growth in
earnings before tax, problems arose soon after the listing as competition
intensified. Although the company remains profitable, annual growth has declined
significantly and is currently 4%. The board is concerned by the lack of future
growth opportunities. The current share price reflects these concerns, trading well
below the offer price of ten years ago. In response, the directors have decided to
invest in a market development strategy for future growth, utilising significant cash
reserves to acquire companies in other areas of the country where competition is
less intense. The board has identified a potential target, Temidayo Engineering
(TE).
Temidayo Engineering (TE)
TE is a private engineering company, established eight years ago. Accumulated
unrelieved losses were incurred in the early years of development, although the
company is now profitable and achieving growth in earnings before tax of 8% per
annum. However, cash reserves are low. Access to capital has been a serious
constraint to TE‘s investment potential throughout this period. The founders and
their families own 70% of the shares with the balance held by a venture capitalist
who acquired its equity stake around five years ago.
Acquisition information
KP‘s board is keen to ensure that TE‘s founders remain as directors after the
acquisition and the company has sufficient cash reserves to purchase TE outrightly.
It is believed that a cash offer of ₦13.10 per share is likely to encourage TE‘s
shareholders to approve the acquisition. As an alternative, the board is considering
a share-for-share exchange to fund the acquisition in order to preserve cash for
future acquisitions and dividend payments. Recent mergers have attracted an
acquisition premium of around 25% - 30% and TE‘s directors indicated that their
shareholders would be expecting a premium towards the higher end of this scale
82

for a share-for-share offer. KP has therefore asked you to design a share-for-share
offer scheme which will allow for a 30% acquisition premium. You have been
provided with extracts from the latest financial statements of both companies.
Extracts from the most recent financial statements

KP TE
₦m ₦m
Operating profit 8,972 4,036
Earnings before tax 7,638 2,326
Additional financial information:

KP has ₦0.50 ordinary shares of ₦7,500 million with each share currently trading at
₦5.28. It is believed that the company‘s price earnings (P/E) ratio will increase by
10% if the acquisition proceeds.
TE upgraded its main manufacturing facility during the previous year and expects
to make annual pre-tax cost savings of ₦50 million from the start of the current
financial year. The company has ₦0.25 ordinary shares of ₦700 million. Based on
an analysis of companies of comparable size and cost structure, it is estimated that
TE‘s P/E ratio is 20% higher than KP‘s current P/E ratio.
KP‘s chief executive officer estimates annual pre-tax revenue and cost synergies of
₦304 million to arise as a result of the acquisition. Furthermore, the finance
director anticipates annual pre-tax financial synergies of ₦106 million although she
insists this is a cautious estimate after reading an article on recent merger and
acquisition activity where post-acquisition synergies have either been
overestimated or failed to materialise. Assume tax rate of 20%.
Required:
a. Discuss possible sources of financial synergy arising from KP‘s acquisition of
TE. (6 Marks)
b. Advise the directors on a suitable share-for-share exchange offer which meets
the criteria specified by TE‘s shareholders and calculate the effect of the cash
and share-for-share offers on the post-acquisition wealth of both KP‘s and TE‘s
shareholders (14 Marks)
(Total 20 Marks)
83

QUESTION 3
ZY Plc is an all-equity financed and a listed company which operates in the food
processing industry. The ZY family owns 40% of the ordinary shares; the remainder
are held by large financial institutions. There are 10 million, ₦1 ordinary shares
currently in issue.
The company has just finalised a long-term contract to supply a large chain of
restaurants with a variety of food products. The contract requires investment in a
new machinery costing ₦24 million. This machinery would become operational on
1 January 2022, and payment would be made on the same date. Sales would
commence immediately thereafter.
The company policy is to pay out all profits as dividends and, if ZY Plc continues to
be all- equity financed, there will be an annual dividend of ₦9 million in perpetuity
commencing 31 December 2022.
There are two alternatives being considered to finance the required investment of
₦24 million:
1. A 2-for-5 rights issue, in which case the annual dividend would be ₦9
million. The cum rights price per share would be ₦6.60; and
2. Issuing 7.5% irredeemable bonds at par with interest payable annually in a

arrears. For this alternative, interest would be paid out of the ₦9 million
otherwise available to pay dividends.
For either alternative, the directors expect the cost of equity to remain at its present
annual level of 10%.
Required:
a. Calculate the issue and ex-rights share prices of ZY Plc., assuming a 2-for-5
rights issue is used to finance the new project at 1 January 2022. Ignore
taxation. (4 Marks)
b. Calculate the value per ordinary share in ZY Plc at 1 January 2022 if 7.5%
irredeemable bonds are issued to finance the new project. Assume that the
cost of equity remains at 10% each year. Ignore taxation. (4 Marks)
c. Write a report to the directors of ZY Plc which
i. Compare and contrast the rights issue and the bond issue methods
of raising finance – you may refer to the calculations in your answer
to requirements (a) and (b) and to any assumptions made. (6 Marks)
ii. Discuss the appropriateness of the following alternative methods of
issuing equity finance in the specific circumstances of ZY Plc:
 a placing
 an offer for sale
 a public offer for subscription. (6 Marks)
(Total 20 Marks)
84

QUESTION 4
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)
85

SECTION C: OPEN-ENDED QUESTIONS (30 MARKS)
INSTRUCTION: YOU ARE REQUIRED TO ANSWER ANY TWO OUT OF THE
QUESTION 5
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)
86

QUESTION 6
Bettaluck plc has been enjoying a substantial net cash inflow. The funds have been
invested in a small portfolio of short-term equity investments until they are needed
to meet tax, dividend payments and to finance further capital expenditure in
several months‘ time.
Details of the portfolio, which consists of shares in four Nigerian listed companies
are as follows:
Company Holding Market price
Dashing plc 60,000 shares of N1 each par value N4.29

Elegant plc 80,000 shares of 50k each per value N2.92
Fantastic plc 100,000 shares of 25k each per value N2.17
Gaudy plc 125,000 shares of N1 each per value. N3.14
Company Equity beta Dividend Capital gains

Co-efficient yield p.a.(%) yield p,a, (%)
Dashing plc 1.16 6.10 13.4

Elegant plc 1.28 3.40 20.6
Fantastic plc 0.90 5.70 11.8
Gaudy plc 1.50 3.30 19.7
The yield on Treasury Bills is 11% a year and the market return is 19% a year.
Required:
a. On the basis of the data given, calculate the risk (i.e. Beta) of Bettaluck‘s short-
term investment portfolio relative to the market. (4 Marks)
b. Recommend, giving your reasons, whether the composition of the company‘s
short-term investment portfolio should be changed. (Relevant calculations must
be shown). (6 Marks)
c. Discuss the factors that a financial manager should take into account when
investing in marketable securities. (5 Marks)
(Total 15 Marks)
87

QUESTION 7
James Obasi plc is a medium-sized manufacturing firm making drones. It is
considering a 1 for 5 rights issue at a 15% discount to the current market price of
N4.00 per share. Issue costs are expected to be N2m and these costs will be paid
out of the funds raised. It is proposed that the rights issue funds raised will be used
to redeem some of the existing bonds at par. Financial information relating to
James Obasi plc is as follows:
Statement of financial position

N‘000 N‘000 N‘000
Fixed Assets 8,000
Current Assets
Inventory 3,000
Receivables 2,500
Cash 500
6,000
Current liabilities
Overdraft 2,250 4,350
Net current assets 1,650
Total assets less liabilities 9,650
12% bonds 4,500
5,150
Ordinary shares (par value 50k) 4,000
Reserves 1,150
5,150
Other information:
Price/earnings ratio of James Obasi plc 15.24
Overdraft interest rate 6%
Corporate tax rate 30%
Sector averages: debt/equity (book value) 100%
Interest cover 6 times
Required:
a. Ignoring issue costs and any use that may be made of the funds raised by
the rights issue, calculate:
i. the theoretical ex rights price per share;
ii. the value of rights per existing share. (4 Marks)
b. What alternative actions are open to the owner of 1,500 shares in James Obasi
plc as regards the rights issue? Determine the effect of each of these actions
on the wealth of the investor. (6 Marks)
88

c. Calculate the current earnings per share and the revised earnings per share if
the rights issue funds are used to redeem some of the existing bonds.
(5 Marks)
(Total 15 Marks)
Formulae
𝑉𝐷
𝑉𝐸𝐺
Asset Beta
𝑉𝐸 𝑉𝐷 (1 − 𝑇)
(𝑉𝐸 + 𝑉𝐷 (1 − 𝑇)) 𝐸 (𝑉𝐸 + 𝑉𝐷 (1 − 𝑇)) 𝐷
Equity Beta
𝑉𝐷
𝛽𝐸 = 𝛽𝐴 + (𝛽𝐴 − 𝛽𝐷 ) (1 − 𝑡)
𝑉𝐸
Growing Annuity
𝑛
𝐴1 1+𝑔
𝑃𝑉 = 1−
𝑟−𝑔 1+𝑟

1
𝑃𝑉𝑅 𝑛
𝑀𝐼𝑅𝑅 = 1 + 𝑟𝑒 − 1
𝑃𝑉𝐼
C0 = S0N(d1) – Ee-rt N(d2)
𝑆
𝐼𝑛 0 + (𝑟 + 0.5𝜎 2 )𝑇
𝑑1 = 𝐸
𝜎 𝑇
d2= d1 - 𝜎 𝑇
The Put Call Parity
C + Ee-rt = S + P

d = 1/u
𝑎−𝑑
𝜋=
𝑢−𝑑
89

Annuity Table
r
Discount rate (r)

Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1
2 1·970 1·942 1·913 1·886 1·859 1·833 1·808 1·783 1·759 1·736 2
3 2·941 2·884 2·829 2·775 2·723 2·673 2·624 2·577 2·531 2.487 3
4 3·902 3·808 3.717 3·630 3.546 3.465 3·387 3·312 3·240 3·170 4
5 4·853 4·713 4·580 4·452 4·329 4·212 4·100 3·993 3.890 3·791 5
6 5·795 5·601 5·417 5·242 5·076 4·917 4·767 4·623 4.486 4·355 6
7 6·728 6.472 6·230 6·002 5·786 5·582 5·389 5·206 5·033 4·868 7
8 7·652 7·325 7·020 6·733 6·463 6·210 5·971 5·747 5·535 5·335 8
9 8·566 8·162 7·786 7.435 7·108 6·802 6·515 6·247 5·995 5·759 9
10 9·471 8·983 8·530 8·111 7·722 7·360 7·024 6·710 6.418 6·145 10
11 10·368 9·787 9·253 8·760 8·306 7·887 7.499 7·139 6·805 6.495 11
12 11·255 10·575 9·954 9·385 8·863 8·384 7·943 7·536 7'161 6·814 12
13 12·134 11·348 10·635 9·986 9·394 8·853 8·358 7·904 7·487 7·103 13
14 13·004 12·106 11·296 10·563 9·899 9·295 8·745 8·244 7·786 7·367 14
15 13·865 12·849 11·938 11·118 10·380 9·712 9·108 8·559 8·061 7·606 15
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1
2 1·713 1·690 1·668 1·647 1·626 1·605 1·585 1·566 1·547 1·528 2
3 2.444 2.402 2·361 2·322 2·283 2·246 2·210 2·174 2·140 2·106 3
4 3·102 3·037 2·974 2·914 2·855 2·798 2·743 2.690 2·639 2.589 4
5 3·696 3·605 3·517 3·433 3·352 3·274 3·199 3·127 3·058 2·991 5
6 4·231 4·111 3·998 3·889 3·784 3·685 3·589 3.498 3.410 3·326 6
7 4·712 4·564 4.423 4·288 4·160 4·039 3·922 3·812 3·706 3·605 7
8 5·146 4·968 4.799 4·639 4.487 4·344 4·207 4·078 3·954 3·837 8
9 5·537 5·328 5·132 4·946 4·772 4·607 4.451 4·303 4·163 4·031 9
10 5·889 5·650 5.426 5·216 5·019 4·833 4·659 4.494 4·339 4·192 10
11 6·207 5·938 5·687 5.453 5·234 5·029 4·836 4·656 4.486 4·327 11
12 6·492 6·194 5·918 5·660 5·421 5·197 4·988 4·793 4·611 4.439 12
13 6·750 6.424 6·122 5·842 5·583 5·342 5·118 4·910 4·715 4·533 13
14 6·982 6·628 6·302 6·002 5·724 5.468 5·229 5·008 4·802 4·611 14
15 7·191 6·811 6.462 6·142 5·847 5·575 5·324 5·092 4·876 4·675 15
90

91

SOLUTION 1
a. Project‘s Cash Flows (₦ million)
Year 0 1 2 3 4
Costs:
Direct labour (W2) 35 55 61 67
Material Z (W3) 10 16 17 19
Component P (W3) 17 26 29 31
Component Q (W3) 8 12 13 14
Other variable costs (W4) 3 4 4 5
Management salaries (W5) 7 7 8 8
Rental (W6) 12 13 13 14
Other fixed overheads (W7) 5 5 6 6
Selling expenses (W8) 17 17 18 19
Total operating costs 117 155 169 183
Sales (W1) 132 202 218 236
Cash profit 18 47 49 53
Tax (W12) 1 (9) (10) (11)
Machinery (86) 2
NCF (86) 19 38 39 44
Calculation of IRR
Year CF PV at PV at
18% 20%
₦m ₦m ₦m
0 (86) (86) (86)
1 17 14.407 14.167
2 38 27.291 26.389
3 39 23.737 22.569
4 44 22.695 21.219
NPV = 3,825 0.01
At 20%, the NPV is zero and therefore the IRR is approximately 20%.
92

Working notes
1. Sales
Year 1 2 3 4
Qty sold (q) 12,000 17,500 18,000 18,500
Selling price (₦) 11,000 11,550 12,128 12,734
Sales (₦m) 132 202 218 236
2. Direct labour
Cost per unit (₦) = (L) = 2,950 3,157 3,377 3,614
Total cost (₦m) = (q × L) = 35 55 61 67
3. Materials
- Material Ƶ
₦m
Year 1:
Total needed= 6 × 12,000 = 72,000
Available in inventory = 70,000
To be bought 2,000
Opportunity cost of kilos in ₦m

Inventory 9.90
New purchase =2,000 × ₦146 0.292
Total, rounded 10.192 =10
Year 2 17,500×6 kilos ×146 (1.05) =16
Year 3 18,000×6 kilos × 146 (1.05)2 =17
Year 4 18,500 ×6 kilos × 146 (1.05)3 =19
- Component P
Year 1 2 3 4
Cost per unit of VC4 (k) ₦1,440 ₦1,512 ₦1588 ₦1667
Total cost (₦m) = (q × k) 17 26 29 31
- Component Q
Year 1 2 3 4
Cost per unit of VC4 (T) ₦640 ₦672 706 741
Total cost (₦m) = (q × T) 8 12 13 14
4. Other Variable costs

Year 1 2 3 4
Cost per unit of VC4 (k) ₦210 22.1 232 24.3
Total cost (₦m) = (q×k) 3 4 4 5
93

5. Management salaries
Only incremental management salaries are relevant, the two new managers
plus the replacement deputy manager, costing total ₦6,700,000
(₦5,000,000 + ₦1,700,000) in year 1, increasing by 7% per year
subsequently.
6. Rental
The opportunity rental of ₦12 million is the relevant cost in year 1,
increasing by 5% per year subsequently.
7. Other fixed overhead

The only relevant cost is the amount given (₦7millon) less the apportioned
building rates of ₦2m (i.e. ₦5 million in year 1).This will rise by 5% per year
subsequently.
8. Selling expenses
These will be ₦16.60 million (rounded to ₦17 million in year 1 and then
rising by 5% per year subsequently.
9. Interest cost
This is ignored as the cost of finance is encompassed within the discount
rate.
10. Apportioned head office costs do not involve cash flow and therefore
irrelevant.
11. Advertisement cost

No incremental cash flow is involved and therefore irrelevant.
12. Tax
Year 1_ 2_ 3_ 4_
Cash profit 18 47 49 53
Tax allowable depreciation 21 21 21 21
Taxable (6) 26 28 32
Tax at 35% (2) 9 10 11
bi. An asset beta reflects a company‘s systematic business risk and is the
weighted average of the beta of equity and the beta of debt (including any
relevant tax effects). On the other hand, equity beta reflects both systematic
business risk and financial risk. Only systematic risk, the risk that cannot be
diversified away, is considered in an asset beta and equity beta.
94

Using CAPM, the required return (Ri) is:
Ri = RF × i (Rm – Ri)
= 8 × 1.2 (15 - 8) = 16.4%
If 16.4% is the appropriate cost of capital it would appear that the project is
acceptable because the IRR of 19% is higher than the required rate of return
of 16.4%. However, there are several other reasons to consider in arriving at
the appropriate decision.
 Cost of equity vs WACC

The required return calculated above is cost of equity. It will only be the
appropriate required return if the company is pure equity financed.
Information in the question indicates that the project is to be financed by
a bank loan. That introduces financial leverage and financial risk. In
such circumstances the appropriate required return is the weighted
average cost of capital (WACC) and not cost of equity.
 Beta of project vs beta of company

The beta of 1.2 is the beta of the company and not beta of the new
project. If the project belongs to a different risk class (both business and
financial), the calculated required return will be inappropriate.
 Level of diversification
If the company is not well diversified, management may not consider
systematic risk to be an appropriate measure as some unsystematic risk
is present.
 Problems with CAPM

The capital asset pricing model is subject to criticism, both theoretical,
and with respect to practical problems of data collection. The model
might, therefore, be mis-specifying the appropriate rate of return.
 Non-financial factors
Non-financial factors might have an important influence on this
investment decision.
c) Step 1: Compute the NPV of the project, using discount rate of 17%.
Year 0 1 2 3 4
NCF (86) 19 38 39 44
PVF at 17% 1 0.855 0.731 0.624 0.534
PV (86) 16.25 28 24 23
NPV = ₦5.25 million
95

Step 2: Calculate, at 17%, the present value of tax liability.
Year 1 2 3 4
Tax cash flows (1) 9 10 11
PVF at 17% 0.855 0.731 0.624 0.534
PV (0.86) 6.6 6.2 5.9
Total = N17.84million
Step 3: Compute the sensitivity margin (SM)
NPV  5.25 
SM   100     19.4%
PV of tax liability  17.84 
This means that the project can absorb increase in tax rate of 23.53%. Thus,
the maximum tax rate allowed for the project to breakeven is 35 × (1.2353)
= 43.24%.
Examiner’s report
This is a standard investment appraisal question and it is in three parts. Part (a)
tests the candidates‘ understanding of:
 Relevant costs:
 Investment appraisal and inflation and taxation; and
 Calculation of IRR
Part (b) requires the candidates to distinguish between asset beta and equity beta.
It also tests a number of practical issues concerning the appropriate cost of capital
required for the appraisal of a project.
Part (c) of the question deals with sensitivity of the tax rate.
Being a compulsory question, almost all the candidates attempted it.
Generally, the performance on this question was disappointing. This is difficult to

understand because the scenario is straight forward and well defined in the
question.
Most scripts were characterised by errors in the following areas:

 A failure to omit irrelevant costs like interest, advertising, apportioned costs,
etc;
 Accurate handling of taxation and inflation; and
 Confusion regarding arrangement of cash flows.
In part (b), most of the candidates could not explain clearly the difference between
asset beta and equity beta.
96

In part (c), majority of the candidates did not even make any attempt at all.
It is recommended that students preparing for the institute‘s examination should
cover the syllabus comprehensively.
Marking guide
Marks Marks
1a. Computation of direct labour 1
Computation of cost of material Z 2
Computation of cost of component P 1
Computation of cost of component Q 1
Computation of other variable cost 1
Computation of management salaries 2
Computation of rental cost 1
Computation of other fixed overhead 1
Computation of selling expenses 1
Computation of sales 1
Tax computation 2
Cost of machinery and salvage value ½
Determination of net cash flow (NCF) 1
Determination of IRR 2
Ignoring interest cost ½
Ignoring apportioned head office cost ½
Ignoring savings from advert ½ 19
bi. Explanation of asset beta & equity beta 2

bii. Computation of cost of equity using CAPM ½
Recommendation ½
Discussion of the appropriateness of the computed cost of
equity 3 6
c. Computation of project NPV 2

Computation of PV of tax liability 2
Determination of sensitivity margin 1 5
Total 30
97

SOLUTION 2
a) Tutorial notes
It is very important to note that the question asks for FINANCIAL SYNERGY. Any
discussions of revenue synergy or cost synergy will not be rewarded.
Furthermore, the discussion must be within the context of the given scenario
rather than being generic.
Financial synergies
Many acquisitions are justified on the basis that the combined organisation will
be more profitable or grow at a faster rate than the companies operating
independently. The expectation is that the acquisition will generate higher
expected cash flows or a lower cost of capital, creating value for shareholders.
The additional value created is known as synergy, the sources of which can be
categorised into three types: revenue, cost and financial synergies.
Based on the scenario, there are a number of possible sources of financial

synergy. As a private company, TE is experiencing a funding constraint whereas
KP has significant cash reserves but limited growth opportunities. The
combination of the two can create additional value, since TE may be able to
utilise KP‘s cash resources to fund its expansion in a way which would not have
been possible otherwise, leading to an increase in the expected cash flows.
Assuming both companies‘ cash flows are less than perfectly correlated, those of
the combined company will be less volatile than the individual companies
operating independently. This reduction in volatility will enable the combined
company to borrow more and possibly cheaper financing than would otherwise
have been possible. This increase in debt capacity, and therefore, the present
value of the tax shield, increases the value of the combined company in the form
of a lower cost of capital.
Further benefits may arise if KP is able to utilise TE‘s unrelieved tax losses.
Whilst TE is no longer loss making and could offset these tax losses
independently, the combined company may be able to obtain tax relief earlier
since the acquisition increases the availability of profits against which carried
forward tax losses can be offset. The present value of the tax saved will therefore
be greater in the combined company.
If both companies were publicly traded, there would be no benefit from

diversification since investors are capable of diversifying at a lower cost and
with greater ease than the company, However, TE is privately owned and the
shareholders are therefore exposed to diversifiable unsystematic risk. Therefore,
the acquisition may lead to potential diversification and risk reduction benefits.
The reduction in the cost of the capital increases the value of the combined
company.
98

b) Pre-acquisition valuations
Number of shares in KP = 7,500m/0.5 = 15,000m
KP‘s total value = 15,000m × ₦5.28 = ₦79,200m
Future maintainable earnings (FME) = ₦7,638m × (1 – 0.20) = ₦6,110.40m
Current P/E ratio = ₦79,200m/₦6,110.40m = 12.96
TE FME = (₦2,326m + ₦50m) (1.02) = ₦1,900.80m
TE P/E ratio = 12.96 × 1.20 = 15.55
TE current value = 15.55 × ₦1,900.80m = ₦29,557.44m
Total pre-acquisition value = ₦79,200m + ₦29,557.44m = ₦108,757.44m
Post-acquisition Valuation
₦m ₦m
Current FME - KP 6,110.40
- TE 1,900.80 8,011.20
Synergies - revenue and cost 304.00
- financial 106.00
410.00
Less tax at 20% (82.00) 328
Post-acquisition total FME 8,339.20
Combined P/E ratio = 12.96 × 1.1 = 14.26
Combined post-merger value=14.26 × ₦8,339.20m ₦118,917m
Combined pre-merger value = 108.757m
Value created based on synergies = 10,160m
Share-for-share offer
KP TE
₦m ₦m
Pre-acquisition value 79,200 29,557.44
Add 30% premium 8,867,24
-
Balance of excess value due to KP (₦10,162.77 – 8,856) 1,293
Post-acquisition value 80,493 38,424.68
Relative value 2.1 1
Shares to be issued to TE‘s current shareholders = 15,000m × 1/2.1 = 7,142.86m

or (say) 7,143m.
Existing shares in TE = ₦700m/₦0.25 = 2,800m
Share exchange ratio = 7,143/2,800m = 2.55
99

This means that every current share in TE will receive approximately 2.55 shares
in KP. The shareholding structure in KP will be as follows:
Current shareholders in: Post-acquisition shares in KP % Holding in KP

KP 15,000m 67.74
TE 7,143m 32.26
Total 22,143 100
Impact on shareholder wealth

KP TE
₦m ₦m
Pre-acquisition value 79,200 29,557.44
Cash offer
Cash paid to TE = 2,800m × ₦13.10 36,680
KP post-acquisition value
= ₦118,882.77m – 36,680m = 82,237
% increase in wealth 3.83% 24.01%
Share-for-share offer
Post-acquisition value:
₦118,882.77 × 67.74% 80,554.38
₦118,882.77 × 32.26% 38,362.62
% increase in wealth 1.71% 29.79%
Thus, the terms of the share-for-share offer meet the criteria specified by the
directors of TE.
Examiner’s report
This is a question on business valuation and merger. In part (a), candidates are
expected to identify, from the given scenario, possible financial synergy. In part (b),
candidates were expected to value a company for takeover, using P/E ratio and to
design a share-for-share payment scheme.
Only very few candidates attempted the question and the performance was poor.
In part (a), common errors include:
 Discussion of revenue and cost synergies rather than financial synergy; and
 Failure to relate discussion to the given scenario. Generic discussion earned
very little or no credit.
In part (b), it is apparent that majority of the candidates were ill-equipped in
business valuation. They could not sort out the appropriate earnings to use with
the given P/E ratio – thereby losing significant marks.
Candidates are advised to practise standard examination questions when preparing

for this examination in the future.
100

Marking guide
Marks Marks
2a. Explanation of Synergy 1
Discussion of possible sources of financial
Synergy in line with the question 5 6
2b. Computation of number of shares of Kola Plc. ¼

Computation of capitalisation value of Kola Plc. ¼
Computation of future maintainable earnings of Kola Plc ½
Determination of current P/E ratio of Kola Plc. ½
Computation of future maintainable earnings (FME) of TE ½
Determination of current P/E ratio of TE ¼
Computation of current capitalisation of TE ¼
Total pre-acquisition value ½
Computation of Post-acquisition FME 1½
Computation of combined P/E ratio ½
Computation of value of synergies 1
Determination of share exchange ratio 4
Analysis of the impact on shareholders wealth 4 14
Total 20
SOLUTION 3
a) Rights issue
Finance needed ₦24m

Offer price = = = ₦6 per share
Number of shares issued 4m
5 × ₦6.60 + 2 × ₦6
Ex − rights price = = ₦6.43
7
b) Irredeemable bonds
Dividends per annum = ₦9m – (7.5% × ₦24m) = ₦7.2m
Dividend per share = ₦0.72 pa
0.72
Share price = PV of dividends = 0.1 = ₦7.20
c) REPORT
To: Directors of ZY Plc
From: Accountant
Date: xx of 20xx
101

Raising new finance
The project represents a sizeable increase in the company‘s operations and
the financing of it will have a material impact on the capital structure and
the shareholders‘ wealth.
i) Bond issue or rights issue

The bonds would introduce significant gearing, and may include
restrictive covenants which dictate the repayment timings. In addition,
there may be restrictions on the operations of the business in order to
maintain certain gearing ratios or interest cover. They will probably
require security over assets, or compensate for the additional risk of
less than full security by applying a higher interest charge.
However, the issue costs associated with the bonds are likely to be
lower than those incurred on a rights issue. In addition, the fixed
income and asset security will lead to a cheaper cost than the equity
which is enhanced by the tax relief available on debt interest.
The calculations in (b) have assumed the cost of equity (and hence the
total market value) would stay the same under a bond issue. However,
the risk to the shareholders would increase (as the financial risk of the
interest being paid out of profits increases the fluctuation in returns)
and so the return required would increase. It therefore may not be as
beneficial to shareholders as it appears, as the share value may drop
from the price calculated.
Finally, it is possible that not all shareholders will want to take up

their rights, which will involve the company selling the rights to other
shareholders or the general public if possible. The family would see its
shareholding reduced if it could not finance its share of the rights
issue.
ii) Alternative methods of issuing equity

A wider issue of equity than a rights issue would have more chance of
success but would reduce the holding of current shareholders such as
the family, and is likely to have higher issue costs.
A placing is where an issuing house places shares with clients, and is

likely to have relatively low costs as it avoids underwriting and much
of the advertising. It is likely, however, to concentrate shareholdings
which will threaten the family‘s control.
An offer for sale is when an issuing house buys the shares and then
offers them to the public, at a fixed price or via a tender, by
circulating a prospectus. The costs are likely to be higher as the fees
effectively incorporate underwriting of the issue.
102

A public offer for subscription means that Y Plc itself would issue the
prospectus and invite subscription from the public at a fixed price.
Costs are likely to be high, as they will have to cover underwriting,
publicity and specialist advice.
Examiner’s report
This is a question on sources of long-term finance. Part (a) deals with the
calculation of issue price and ex-right price. Part (b) requires candidates to
compute value of equity after the issue of an irredeemable bonds. Part (c)(i) asks
the candidates to compare right issues and bond issues. In part (c)(ii), candidates
are expected to discuss the appropriateness of three methods of raising equity
finance: placing, offer for sale and public offer.
Almost all the candidates attempted the question and performance was fair.
Some of the candidates were able to make the required calculations in parts (a) and
(b).
Part (c) of the question proved to be a major discriminator between stronger and
weaker candidates, with some picking up fairly good marks, while many others
showed complete lack of understanding. Between these two extremes, the most
common error was failure to relate their answers to the circumstances of the
company.
To hedge against failure in future examinations, candidates are advised to read

widely and practise past examination questions.
Marking guide
Marks Marks
3a. Computation of offer price 2
Computation of ex-right price 2 4
b. Computation of total dividend 1½

Determination of dividend per share ½
Determining share price 2 4
ci. Memo format 1
Explanation of bond issue and right issue 5 6
cii. Explanation of placing, offer for sale and offer for

subscription 6 6
Total 20
103

SOLUTION 4
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.
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.
104

b) 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.
105

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 – not least because the rate sought by
competitors will be lower.
Examiner’s report
This is a question of two parts. Part (a) deals with appropriate corporate objective
for a large private company and part (b) deals with the factors treasury department
should consider in financing strategies. Almost all the candidates attempted the
question.
Part (a) was reasonably well answered. However it was disappointing to note that
most candidates did not relate their answers to the circumstances of the company.
For example, the fact that the company is not quoted means that an ‗appropriate‘
value does not exist.
In part (b), either through a lack of attention to the precise question being asked or,
more probably, an inability to answer that precise question, a good number of the
candidates simply reproduced all that they know about sources of finance.
At this level of the Institute‘s examinations, students are advised to pay critical
attention to questions‘ requirements and avoid generic answers.
106

Marking guide
Marks Marks
4a. Evaluation of the current objectives and finance directors 5
suggestion
Disadvantages/issues to be considered 2
Recommendation 3 10
4b. Detailed discussion of the factors to be considered in

financing strategies and re-financing strategies 10 10
Total 20
SOLUTION 5
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.
107

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?

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.
Examiner’s report
This question which is closely related to the preceding question, tests candidates‘
understanding of corporate objective setting in the public sector - a local
government. A large number of the candidates attempted the question but
performance was very disappointing.
Candidates made it clear that most of them are lacking in the elementary
knowledge of business and finance by writing ‗maximisation of shareholders
wealth‘, ‗maximisation of profit, etc., in a local government! Those candidates
therefore lost easy marks.
Once again, it is very important that students prepare adequately for this
examination, making use of all the study supports made available by the Institute.
Marking guide
Marks
5. Detailing the criteria of ibile 5
Detailing the criteria of Layo 5
Explanation of the consequences 5
Total 15
108

SOLUTION 6
a) The beta of the portfolio is the weighted average of the beta of each of the
companies. The weighting is by the market value of shares.
Company Total Market Beta Hash Total

Value
Dashing (D) 257,400 1.16 298,540
Elegant (E) 233,600 1.28 299,008
Fantastic (F) 217,000 0.90 195,300
Gaudy (G) 392,500 1.50 588,750
1,100,500 1,381,598
Portfolio Beta = 1,381,598/1,100,500 = 1.26

Since the beta is more than 1, the short-term investment portfolio is more risky
than the market (which has a beta of 1).
b) The composition of the short term investment portfolio may be considered

from two viewpoints:
i. Is the expected performance of the individual investments within the
portfolio satisfactory?
ii. Does the portfolio provide the most suitable form of short-term
investments for the company?
The individual shares may be examined to establish if they are expected to

provide a satisfactory return for the systematic risk they involve.
Using CAPM, the required return is:
Ri= Rf + β (Rm - Rf)
= 11 + βi (19 - 11)
= 11 + 8βi
D 11 + 8(1.16) = 20.28%
E 11 + 8(1.28) = 21.24%
F 11 + 8(0.9) = 18.20%
G 11 + 8(1.50) = 23.00%
109

For each stock, the expected return (= the total return) is the dividend yield
plus the capital gains yield.
Company Expected return Required Abnormal Recommendation

(%) return (%) return (%)
(K) (T) (K - T)
D 19.50 20.28 -0.78 Sell shares
E 24.00 21.24 2.76 Buy more shares
F 17.50 18.20 -0.70 Sell shares
G 23.00 23.00 0 Hold
If the above data are accurate, the shares in companies D and F are not
expected to give a satisfactory return relative to their systematic risk and
should be sold. Further shares in company E should be bought because they
offer a return higher than what is required by the level of systematic risk.
Shares in company G should be held because alpha value is zero.
This analysis considers only systematic risk. If Bettaluck does not have other
investments and is not well diversified, systematic risk is likely to under
estimate the risk to Bettaluck of these investments.
ii) The portfolio is unusual for a short-term investment portfolio. Short-term

investments are usually made for a specific purpose, for example to ensure
cash is available for purchase of assets, payment of dividends, taxes or
payables where a known amount of funds is required. Most companies are
not willing to tolerate much risk of price movement in their short-term
investments. This portfolio of investments in ordinary shares is exposed to
substantial price movements as share prices change and the possibility that
one or more of the companies could fail. Although the expected returns are
relatively high, the risk of this portfolio is very high relative to most portfolios
of marketable securities. Unless Bettaluck is happy to take such risks it is
recommended that short-term investments should concentrate upon fixed
interest marketable securities such as Treasury Bills, certificate of deposit
and bills of exchange. Such investments involve much less risk of price
movement and default, and, if held short-term, possible inflation is not a
concern.
c) The factors that a financial manager should take into account when investing
in marketable securities include:
i. Default risk: The risk that interest and/or principal will not be paid on
schedule on fixed interest investments. Most short-term investment in
marketable securities is confined to investments with negligible risk of
default;
ii. Price risk: The risk of the value of the investment changing for example
when interest rates change. Financial managers normally wish to avoid
substantial price risk;
110

iii. Marketability. Securities should normally be marketable at short notice at
close to the quoted market price;
iv. Taxation: Are there any special tax effects of the selected marketable
securities?
v. Yield: Managers will usually try to achieve the maximum yield possible
consistent with a satisfactory level of risk and marketability;
vi. Foreign exchange risk: If marketable securities are not denominated in
the domestic currency of the investor, foreign exchange risk must be
taken into account;
vii. The amount of funds to be invested. Some types of investment require a
minimum size of investment; and
viii. The period for which the investment is to be made. The type of
investment should be matched with the timing requirements of the future
need for funds.
Examiner’s report
This is a three – part question. Part (a) deals with calculation of portfolio beta. In
part (b), candidates are expected to calculate, using CAPM, securities‘ required
returns and the relevant alpha values. Part (c) requires candidates to identify
factors to consider when investing in marketable securities.
Almost all the candidates attempted the question. Part (a) was reasonably well
answered by a number of the candidates. Major errors include:
 Calculation of market values of the given companies using par values of
shares rather than market values; and
 Calculation of portfolio beta using quantity of shares rather than total
market values.
Part (b) was poorly answered virtually by all the candidates because they
could not figure out the appropriate expected return. They failed to realise
that return to shareholders is a combination of dividend yield and capital
gain.
Some good answers were given to part (c) and a number of candidates
cleared all the allocated 5 marks.
To increase the chance of success in future examinations, candidates need to

practise standard examination questions.
111

Marking guide
Marks Marks
6a. Determination of total market value 2
Determination of weight of coys 1
Computation of portfolio beta 1 4
6b. Computation of expected return 1

Computation of required return 2
Recommendation 1
Reasons for the recommendation 2 6
6c. Explanation of factors to be considered 5 5

Total 15
SOLUTION 7
a) Right issue price = ₦4 × 0.85 = ₦3.40

₦
i) 5 existing shares @ ₦4 = 20.00
1 new share @ ₦3.40 = 3.40
6 23.40
Theoretical ex-right price (TERP)= ₦23.40/6 = ₦3.90

ii) Value of right per existing share = (₦3.90 – ₦3.40)/5 = ₦0.10
b) A number of options are available to the owner of the 1,500 shares:

i) Do–nothing
₦
Pre - right value = 1,500 × ₦4 = 6,000
Post- right value = 1,500 × ₦3.90 = 5,850
Loss in value (1,500 × ₦0.10) = 150
If the investor does nothing, he will suffer a loss of ₦150
ii) Take up the rights

Ex- right holding = 1,500 × 6/5= 1,800 shares
Ex – right value =1,800 × ₦3.90 = ₦7,020
Cash paid for additional shares = 300 × ₦3.40 = (1,020)
Net ex-right wealth 6,000
The rights issue has a neutral effect if the additional shares are taken up.
112

iii) Sell the rights
Ex – right holding 1,500 shares
Ex – right value of holding = 1,500 × ₦3.90 = ₦5,850
Value of rights sold = 1,500 × ₦0.10 = 150
Net ex – right wealth ₦6,000
The rights issue also has a neutral effect on the investor‘s wealth.
iv) Sell some rights and take up the balance

If an investor does not want to gain or lose cash in a right issue, he can
sell some of the rights and then buy the balance of his rights. The
number of rights which should be sold is given by:
Total number of rights × (issue price/ TERP)
= (1,500/5)× (₦3.40/₦3.90) = 262*
(* rounded up because fraction of shares cannot be traded)
Number of rights bought = 300 – 262 = 38
N
Proceeds from right sold = 262 × ₦0.50 131
Cost of additional shares bought = 38 × ₦3.40 129.20*
(* Difference due to the rounding up of number of rights sold).
c) Calculation of EPS
i) Existing EPS
EPS = VPS/PER = ₦4/15.24 = 26.25K
ii) Post – rights EPS
4𝑚 6
= × = 9.6𝑚 𝑠ℎ𝑎𝑟𝑒𝑠
0.50 5
Gross funds raised = 1.6m × ₦3.40 = ₦5.44m
Less issue costs ₦2.00m
Net proceeds = ₦3.44m
Current profit after tax = 26.25k × 8m shares = ₦2.10m
Add bond interest saved, net of tax = 12% × ₦3.44m × (1 – 0.30) = 0.289m
Revised profit after tax = 2.389m
Revised EPS = ₦2.389m/9.6m shares = 24.88k.
113

Examiner’s report
The question tests some basic calculations on rights issues of shares.

Almost all the candidates attempted the question with average level of
performance.
Parts (a) and (b) were reasonably well answered but candidates struggled with
part(c). Avoidable errors were found in candidates solutions. For example,
candidates ignored interest saved on bond repaid when calculating revised profit.
Furthermore, the additional shares arising from the rights issue were ignored when
computing the revised EPS.
Candidates are advised to prepare adequately for future examinations.
Marking guide
7 Marks Marks
a. Computation of right issue price 1
Computation of ex-right price 2
Computation of value of right 1 4
b. Determination of effect on the investor‘s wealth for three 6 6

alternatives
c. Computation of existing EPS 1

Computation of gross fund raised ½
Consideration of issue cost to get net proceeds ½
Computation of current profit after tax 1
Computation of interest saved from retired bond 1
Computation of revised EPS 1 5
Total 15
114

PATHFINDER
MAY 2022 DIET
Question Papers
Suggested Solutions
Marking Guides
and
Examiner’s Reports

INSTRUCTION: YOU ARE REQUIRED TO ATTEMPT FIVE OUT OF THE SEVEN

QUESTION 1
Vico Tony (VT) is a software design company established six years ago. The company
is owned by five directors. Since establishment, the company has developed rapidly.
VT finds it difficult to obtain bank finance and relies on a long-term strategy of using
internally generated funds to finance expansion. The directors are therefore giving
consideration to the possibility of floating the company on the stock market. As a first
step, you have been appointed by the directors to advise on the current value of the
business under their ownership.
The company’s most recent statement of profit or loss and the extracted balances
from the latest statement of financial position are as follows:
Statement of Profit or loss
N’Million
Sales 10,000
Cost of sales (6,000)
Gross profit 4,000
Other operating costs (3,754)
Operating profits 246
Interest on loan (148)
Profit before tax 98
N’Million
Opening non-current assets 2,400
Additions 132
Non-current assets (at cost) 2,532
Accumulated depreciation (734)
Net book value 1,798
Current assets
Cash and bank 100
Receivables 520
Inventory 280
900
Total assets 2,698
81

Non-current liability: Loan 1,980
Current liabilities
Payables 182
Tax payables 30
Interest payable 148
360
Shareholders Equity 358
During the current year:
(i) Depreciation is charged at 10% per annum on the year end non-current assets
balance before accumulated depreciation, and is included in other operating
costs in the statement of profit or loss.
(ii) The investment in net working capital is expected to increase in line with the
growth in gross profit.
(iii) Other operating costs consisted of:

N’Million
• Variable component at 15% of sales 1,500
• Fixed costs 2,000
• Depreciation on non-current assets 254
(iv) Sales and variable costs are projected to grow at 9% per annum and fixed costs
are projected to grow at 6% per annum.
(v) The company pays interest on its outstanding loan of 7.5% per annum and
incurs tax on its profits at 30%, payable in the following year. The company
does not currently pay dividends.
One of your first tasks is to prepare for the directors a forward cash flow projection
for three years and to value the firm on the basis of its expected free cash flow to
equity. In discussion with them, you note the following:
• The company will not dispose of any of its non-current assets but will increase
its investment in new non-current assets by 20% per annum. The company’s
depreciation policy matches the currently available tax allowable depreciation.
This straight-line write off policy is not likely to change;
• The directors will not take a dividend for the next three years but will then review
the position taking into account the company’s sustainable cash flow at that
time;
• The level of loan will be maintained at ₦1.98 billion and interest rates are not
expected to change;
82

• For estimating the appropriate required return on equity, it is decided to make
use of the capital asset pricing model (CAPM). The challenge however, is that
since the company is not quoted, an appropriate beta factor does not exist. You
have found a listed company, Konputer Limited (KL) that is into software
development. KL is also into computer hardware retailing. It has the following
financial statistics:
Equity beta 1.40
Debt beta 0.20
Debt/Equity ratio 40%
Effective tax rate 25%
• About 60% of the market value of KL is attributed to software development

division while 40% of the value is attributed to computer hardware retailing. The
computer hardware retailing division has equity beta of 0.8;
• Risk-free rate is 4% and the market risk premium is 8%; and

• VT has maintained a long-term debt/ (debt+equity) ratio of 20%.
Required:
a. Provide an estimate of the appropriate rate of return to be used for the valuation
of VT. Round your answer to the nearest whole number. (7 Marks)
b. Prepare a three-year cash flow forecast for the business on the basis described
above highlighting the free cash flow to equity in each year. (14 Marks)
c. Estimate the value of the business based on the expected free cash flow to equity
and a terminal value based on a sustainable growth rate of 4% per annum
thereafter. (Note: Irrespective of your answer in (a), assume required return of
17%). (5 Marks)
d. Advise the directors on the assumptions and the uncertainties within your
valuation. (4 Marks)
(Total 30 Marks)
83

SECTION B OPEN-ENDED QUESTIONS (40 MARKS)
INSTRUCTION: YOU ARE REQUIRED TO ATTEMPT ANY TWO OUT OF THE THREE
QUESTION 2
Effe is a Nigerian company specialising in the provision of information systems

solutions to large corporate organisations. It is going through a period of rapid
expansion and requires additional funds to finance the long-term working capital
needs of the business.
Effe has issued one hundred million N1 ordinary shares, which are listed on the stock
market at a current market price of N15 with typical increases of 10% per annum
expected in the next five years. Dividend payout is kept constant at a level of 10% of
post-tax profits. Effe also has N1,000 million of bank borrowings.
It is estimated that a further N300 million is required to satisfy the funding

requirements of the business for the next five-years beginning July 1, 2021. Two
major institutional shareholders have indicated that they are not prepared to invest
further in Effe at the present time and so a rights issue is unlikely to succeed. The
directors are therefore considering various forms of debt finance. Three alternative
structures are under discussion as shown below:
• Five-year unsecured bank loan at a fixed interest rate of 7% per annum;

• Five-year unsecured bond with a coupon of 5% per annum, redeemable at par
and issued at a 6% discount; and
• A convertible bond, issued at par, with an annual coupon rate of 4.5% and a
conversion option in five years’ time of five shares for each ₦100 nominal of debt.
There have been lengthy boardroom discussions on the relative merits of each
instrument. Summarised below are the queries of three different directors concerning
the instruments.
Director A: “The bank loan would seem to be more expensive than the unsecured
bond. Is this actually the case?”
Director B: “Surely, the convertible bond would be the cheapest form of borrowing
with such a low interest rate?”
Director C: “If we want to increase our equity base, why use a convertible bond,
rather, than a straight equity issue?”
Required:
a. Write a response to the queries raised by the three directors and advise on the
most appropriate financing instrument for Effe. In your answer, include
calculations of appropriate yield for each instrument.
Ignore tax. (15 Marks)
b. Advise a prospective investor in the five-year unsecured bond issued by Effe
on what information he should expect to be provided with and what further
84

analysis he should undertake in order to assess the credit worthiness of the
proposed investment. (5 Marks)
(Total 20 Marks)
QUESTION 3
Opeyemi operates in an economy that has almost zero inflation. Management ignores
inflation when evaluating investment projects because it is very low and considered
insignificant. Opeyemi is evaluating a number of similar, alternative investments.
The company uses an after tax cost of capital of 6% and has already completed the
evaluation of two investments. The third investment is a new product that would be
produced on a just-in-time basis and is expected to have a life of three years. This
investment requires an immediate cash outflow of N200,000, which does not qualify
for tax depreciation. The expected residual value at the end of the project’s life is
N50,000. A draft financial statement showing the values that are specific to this
investment for the three years is as follows:
Year 1 Year 2 Year 3
N N N
Sales 230,000 350,000 270,000
Production costs:
Materials 54,000 102,000 66,000
Labour 60,000 80,000 70,000
Other* 80,000 90,000 80,000
Profit 36,000 78,000 54,000
Closing receivables 20,000 30,000 25,000
Closing payables 6,000 9,000 8,000
*Other production costs shown above include depreciation calculated using the
straight line method.
The company is liable to pay corporate tax at a rate of 30% of its profits. One half of
this is payable in the same year as the profit is earned, the remainder is payable in
the following year.
Required:
a. Calculate the net present value of the above investment proposal.
(14 Marks)
b. Explain how the above investment project would be appraised if there were
to be a change in the rate of inflation, so that it became too significant to be
ignored. (3 Marks)
85

c. The evaluation of the other two investments are shown below:
Investment Initial investment Net Present Value
N N
W 300,000 75,000
Y 100,000 27,000
The company only has N400,000 of funds available. All of the investment
proposals are non-divisible. None of the investments may be repeated.
Required:
Recommend, with supporting calculations, which of the three investment
proposals should be accepted. (3 Marks)
(Total 20 Marks)
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)
INSTRUCTION: YOU ARE REQUIRED TO ATTEMPT ANY TWO OUT OF THE THREE
QUESTION 5
The directors of Jindadi Plc. (JP), an Abuja-based entertainment company, are

currently considering the appropriate cost of capital to use in appraising capital
investments. It is the policy of the company to assess the financial viability of all
capital projects using net present value criterion.
You have been provided with some financial information of the company.
86

Most recent statement of financial position
Nm Nm
Equity finance
Ordinary shares (N1 nominal value) 200
Reserves 120 320
7% Convertible bonds (N 100 nominal value) 160
5% Preference shares (N 1 nominal value) 80 240
Current liabilities
Trade payables 80
Overdraft 120 200
JP has an equity beta of 1.2 and the ex-dividend market value of the company’s
equity is N1 billion. The ex-interest market value of the convertible bonds is N168
million and the ex-dividend market value of the preference shares is N50 million.
The convertible bonds of JP have a conversion ratio of 19 ordinary shares per bond.
The conversion date and redemption date are both on the same date in five years’
time. The current ordinary share price of JP is expected to increase by 4% per year for
the foreseeable future.
The equity risk premium is 5% per year and the risk-free rate of return is 4% per year.
JP pays profit tax at an annual rate of 30% per year.
Required:
a. Calculate the market value after-tax weighted average cost of capital of JP,
explaining clearly any assumptions you make. (10 Marks)
b. Discuss why market value weighted average cost of capital is preferred to

book value weighted average cost of capital when making investment
decisions. (5 Marks)
(Total 15 Marks)
QUESTION 6
a. You have worked with a major oil servicing company in Nigeria, with
headquarters in the USA, for the past six years. Recently you completed your
ICAN examinations and you have been asked to join the international treasury
department in New York City for a two-year attachment.
The company is due to pay a UK supplier the sum of ₤5million in three months
time. Your team is considering alternative methods of hedging the expected
payment against adverse movements in exchange rate.
87

Exchange rate information
US$ per ₤1
Spot rate 1.9410 – 1.9531
One – month forward rate 1.9339 – 1.9452
Three – month forward rate 1.9223 – 1.9339
Futures market (contract size of ₤62,500, Quotation: US$ per ₤)
Options market (₤31,250 contracts size, premiums are quoted in cents
per ₤1)
Call option Put option
Exercise 2-month 5-month 2-month 5-month
price expiry expiry expiry expiry
1.9000 2.88 3.55 0.15 0.28
1.9200 1.59 2.32 1.00 1.85
1.9400 0.96 1.15 2.05 2.95
You are required to advise the company which of the following hedging strategies
should be adopted for the payment due to be made in three months. Show all
workings.
i. Forward contract (2 Marks)
ii. Currency futures (5 Marks)
iii. Currency options (5 Marks)
b. In your personal investment portfolio, you have gone short (i.e. you have sold)
110,000 units of Big Bank plc. Call and put options exist on the bank’s shares.
You decide to hedge your position using put options on the bank’s shares. For the
relevant option you know that;
N(d1) = 0.45
You are required to calculate how many put options you will need to buy or sell
in order to delta-hedge. Be specific. (3 Marks)
(Total 15 Marks)
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; (3 Marks)
e. The ‘bird-in-the-hand’ argument. (4 Marks)
(Total 15 Marks)
88

Formulae
𝑉𝐷
𝐾𝐸𝐺 = 𝐾𝐸𝑈 + (𝐾𝐸𝑈 − 𝐾𝐷 ) (1 − 𝑡)
𝑉𝐸𝐺
Asset Beta
𝑉𝐸 𝑉𝐷 (1 − 𝑇)
𝛽𝐴 = [ 𝛽 ]+[ 𝛽 ]
(𝑉𝐸 + 𝑉𝐷 (1 − 𝑇)) 𝐸 (𝑉𝐸 + 𝑉𝐷 (1 − 𝑇)) 𝐷
Equity Beta
𝑉𝐷
𝛽𝐸 = 𝛽𝐴 + (𝛽𝐴 − 𝛽𝐷 ) ( ) (1 − 𝑡)
𝑉𝐸
Growing Annuity
𝐴1 1+𝑔 𝑛
𝑃𝑉 = (1 − ( ) )
𝑟−𝑔 1+𝑟

1
𝑃𝑉𝑅 𝑛
𝑀𝐼𝑅𝑅 = [ ] (1 + 𝑟𝑒 ) − 1
𝑃𝑉𝐼
C0 = S0N(d1) – Ee-rt N(d2)
𝑆
𝐼𝑛 ( 0 ) + (𝑟 + 0.5𝜎 2 )𝑇
𝑑1 = 𝐸
𝜎 √𝑇
d2= d1 - 𝜎 √𝑇
The Put Call Parity
C + Ee-rt = S + P

𝑢 = 𝑒 𝜎×√𝑇/𝑛
d = 1/u
𝑎−𝑑
𝜋=
𝑢−𝑑
89

Annuity Table
r
Discount rate (r)

Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1
2 1·970 1·942 1·913 1·886 1·859 1·833 1·808 1·783 1·759 1·736 2
3 2·941 2·884 2·829 2·775 2·723 2·673 2·624 2·577 2·531 2.487 3
4 3·902 3·808 3.717 3·630 3.546 3.465 3·387 3·312 3·240 3·170 4
5 4·853 4·713 4·580 4·452 4·329 4·212 4·100 3·993 3.890 3·791 5
6 5·795 5·601 5·417 5·242 5·076 4·917 4·767 4·623 4.486 4·355 6
7 6·728 6.472 6·230 6·002 5·786 5·582 5·389 5·206 5·033 4·868 7
8 7·652 7·325 7·020 6·733 6·463 6·210 5·971 5·747 5·535 5·335 8
9 8·566 8·162 7·786 7.435 7·108 6·802 6·515 6·247 5·995 5·759 9
10 9·471 8·983 8·530 8·111 7·722 7·360 7·024 6·710 6.418 6·145 10
11 10·368 9·787 9·253 8·760 8·306 7·887 7.499 7·139 6·805 6.495 11
12 11·255 10·575 9·954 9·385 8·863 8·384 7·943 7·536 7'161 6·814 12
13 12·134 11·348 10·635 9·986 9·394 8·853 8·358 7·904 7·487 7·103 13
14 13·004 12·106 11·296 10·563 9·899 9·295 8·745 8·244 7·786 7·367 14
15 13·865 12·849 11·938 11·118 10·380 9·712 9·108 8·559 8·061 7·606 15
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1
2 1·713 1·690 1·668 1·647 1·626 1·605 1·585 1·566 1·547 1·528 2
3 2.444 2.402 2·361 2·322 2·283 2·246 2·210 2·174 2·140 2·106 3
4 3·102 3·037 2·974 2·914 2·855 2·798 2·743 2.690 2·639 2.589 4
5 3·696 3·605 3·517 3·433 3·352 3·274 3·199 3·127 3·058 2·991 5
6 4·231 4·111 3·998 3·889 3·784 3·685 3·589 3.498 3.410 3·326 6
7 4·712 4·564 4.423 4·288 4·160 4·039 3·922 3·812 3·706 3·605 7
8 5·146 4·968 4.799 4·639 4.487 4·344 4·207 4·078 3·954 3·837 8
9 5·537 5·328 5·132 4·946 4·772 4·607 4.451 4·303 4·163 4·031 9
10 5·889 5·650 5.426 5·216 5·019 4·833 4·659 4.494 4·339 4·192 10
11 6·207 5·938 5·687 5.453 5·234 5·029 4·836 4·656 4.486 4·327 11
12 6·492 6·194 5·918 5·660 5·421 5·197 4·988 4·793 4·611 4.439 12
13 6·750 6.424 6·122 5·842 5·583 5·342 5·118 4·910 4·715 4·533 13
14 6·982 6·628 6·302 6·002 5·724 5.468 5·229 5·008 4·802 4·611 14
15 7·191 6·811 6.462 6·142 5·847 5·575 5·324 5·092 4·876 4·675 15
90

91

SOLUTION 1
a) Computing the required return

Step 1: Determine the equity beta of the software development division of KL. It
is this division that has systematic risk similar to that of VT. Meanwhile, the given
equity beta of KL (i.e. 1.40) is a weighted average of the software division (which
is unknown) and that of the hardware retailing (0.8). If x is the unknown equity
beta, then:
0.6X + 0.4(0.8) = 1.40
X = 1.8
This reflects the systematic business risk of the software industry and the financial
risk of KL.
Step 2:Ungear the equity beta calculated above in order to remove the financial
risk of KL. This means converting the equity beta to asset beta.
VE VD (1 − T)
βA = [ βE ] + [ β ]
(VE + VD (1 − T)) (VE + VD (1 − T)) D
βE= equity beta of the software industry = 1.8

βD= beta of debt of KL = 0.2
VE = value of equity of KL = 100*
VD = value of debt of KL = 40*
t = effective tax rate of KL = 0.25
(*Note: We actually do not need to know the absolute values V E and VD. We only
need the relative values. With D/E of 40%, we simply maintain the ratio: D:E =
40:100 = 4:10 = 0.4:1, etc.)
1.8 × 100 0.20 × 40(1 − 0.25)
βA = [ ]+[ ] = 1.43
100 + 40(1 − 0.25) 100 + 40(1 − 0.25)
Step 3:Regear the above asset beta to incorporate the financial risk of VT. This
means converting the above asset beta to equity beta.
VD
βE = βA + (βA − βD ) ( ) (1 − t)
VE
Where
βA = asset beta of the industry (computed above) = 1.43
βD = beta of debt of VT = 0. Not given and we assume the debt is risk-free.
t = effective tax rate of VT = 0.30
VD = value of debt of VT = 20*
VE = value of equity of VT = 80*
(*D/D+E of 20% means 20% of total asset is funded by debt and 80% by equity. Same
as D/E of 20/80 = 0.25)
92

20
βE = 1.43 + (1.43 − 0) ( ) (1 − 0.3) = 1.68
80
Step 4: Compute the required rate of return, using CAPM.

KE = RF + βE (RM - RF)
= 4 + 1.68(8) = 17% approx.
b) Projected statement of profit or loss (₦million)

Sales (9% growth) 10,900 11,881 12,950
Cost of sales (9% growth) 6,540 7,129 7,771
Gross profit 4,360 4,752 5,179
Operating cost (W1) 4,024 4,317 4,636
Operating profit (i.e. EBIT) 336 435 543
Projected cash flows (₦million)

EBIT 336 435 543
Add depreciation (W1) 269 288 311
Less incremental working capital (W3) (40) (43) (47)
Less taxation (W4) (30) (56) (86)
Less interest (148) (148) (148)
Less investment in non-current assets (W2) (158) (190) (228)
Free cash flow to equity (FCFE) 229 289 345
Working notes
1. Operating Costs (₦million)
Variable operating costs (9% growth) 1,635 1,782 1,943
Fixed costs (6% growth) 2,120 2,247 2,382
Depreciation (W2) 269 288 311
Total operating costs 4,024 4,317 4,636
2. Non-current assets and depreciation (₦million)

Opening non-current assets 2,532 2,690 2,880
Additions (20% growth) 158 190 228
Closing balance 2,690 2,880 3,108
Depreciation (10%) 269 288 311
93

3. Working capital (₦million)
- Current position
Total current assets, excluding cash = 800
Total current liabilities = 360 440

- Cumulative (9% growth) 480 523 570
- Incremental 40 43 47
4. Taxation (₦million)
Year 1 (given) 30
Year 2 30%×(336 - 148) 56
Year 3 30%×(435 - 148) 86
c) Calculation of value of the company’s equity (₦million)

The value of the company’s shares is the present value of the calculated FCFE.
Year 1 229 × (1.17)-1 = 196
Year 2 289 × (1.17) -2
= 211
Year 3 345 × (1.17)-3 = 215
622
FCFE3 (1.04)
Add terminal value: = × (1.17)−3
0.17−0.04
345(1.04)
= × (1.17)−3 = 1,723
0.17 − 0.04
Total value 2,345
On the basis of the above projection, the total value of the company shares is
₦2,345,000,000.
d) This valuation is based upon a number of assumptions which you should consider
when reviewing this analysis:
• The required rate of return has been calculated using capital asset pricing
model. A number of problems are associated with the model in this instance.
• It assumes the company is well diversified and therefore no unsystematic risk.
There is no evidence in the scenario that the company is properly diversified.
• Since the company is not quoted, an appropriate beta factor does not exist.
We have made use of the beta factor of a proxy company, with adjustments.
These adjustments are not error-free. In fact, no two companies are completely
identical.
94

• Finally we have assumed a terminal value based upon future cash flows from
year three forward growing at a compound rate of 4% into the indefinite
future. The resulting value will be particularly sensitive to this figure and it
may be that you may wish to consider a different rate depending upon what
you regard as sustainable in the long term for a business of this type.
Examiner’s report
This is a standard question on valuation of business, using free cash flow to equity
(FCFE) model.
Part (a) tests candidates’ understanding of the calculation of specific cost of capital,
using given information of proxy company.
Part (b) requires candidates to project a 3 – year FCFE, using the relevant information
provided.
Part (c) requires candidates to provide a valuation of the company.
Finally, part (c) requires the candidates identify the relevant assumptions and
uncertainties in their calculations.
Being a compulsory question almost all the candidates attempted it.
Generally the performance on the question was very poor.
In part (a), candidates lost marks due to the following errors:
• Failure to recognise that the relevant asset beta is that of the software division.
• The use of wrong leverage ratio.
• Making use of the tax rate of VT (30%) even when the tax rate of the proxy
company was clearly given as 20%.
In part (b), marks were lost due to the following errors:
• Including cash in the calculation of FCFE
• Wrong calculations of purchase of Non – current assets
• Wrong calculation of depreciation
• Failure to adjust for tax
In part (c), the candidates could not calculate the terminal value of the company
at the end of year 3.
It is recommended that students preparing for the institute’s examination
should cover the syllabus comprehensively.
95

Marking Guide
Marks Marks
a. Determination of the equity beta of the software 2
division
Ungearing of the equity beta of the software division to
get asset beta 2
Regearing of the above asset beta 2
Computation of the required rate of return using CAPM 1 7
b. Computation of sales for three years 1½

Computation of cost of sale for three years 1½
Computation of operating cost for three year 3
Computation of addition to non-current assets 2
Computation of depreciation for three years 1
Computation of changes in working capital for three
years 2
Taxation for three years 1½
Computation of free cashflow to equity 1½ 14
c. Discounting of cashflows for the first three years 3

Computation of terminal value and total value 2 5
d. Discussion of assumption and uncertainties 4 4

Total 30
SOLUTION 2
a) Response to Board members:

Director A
• The redemption yield (YTM) allows the cost of the loan and bond to be
compared on the same basis;
• The redemption yield is effectively the IRR of the cash flows under the debt
instrument and so takes into account the time value of money;
• The bond is slightly cheaper than the loan, with a redemption yield of 6.45%
instead of 7%;
• This result would be expected, since the bond is marketed to a wider investor
base and so finer rates can be obtained; and
• Issue costs must also be taken into account; no information is provided in the
question but costs can be expected to be significantly higher for the bond
because of the publicity and underwriting required.
96

Director B
• Looking at coupon rate in isolation, the convertible bond appears to cost less
than the bond: certainly the interest cost would be lower over the five-year
period;
• However, if the share price rises by 10% a year as predicted, each convertible
bond with face value of ₦100 will convert to 5 shares worth ₦120.80 after five
years (W(iii)). The capital gain (₦20.80 = ₦120.80 - 100) is equivalent to a
compound annual yield of 3.85% (= (120.8/100)1/5 - 1)). This is in addition to
the 4.5% coupon on the convertible.
Alternatively, an overall yield can be determined. This is calculated as 8.04%
(working (iii)) compared with the two other sources of borrowing, the
convertible is the most expensive.
• In addition, from year 6 onwards, the entity will need to pay dividends on the
shares created on conversion which is likely to increase the cost of capital,
since the cost of equity is generally higher than the cost of debt.
Director C
• Investors may have concerns about the future growth of the entity and be
reluctant to subscribe to shares at the present time, as indicated by the two
major institutional shareholders.
• The convertible bond gives investors the opportunity to acquire new shares,
but they have the assurance that they do not need to convert the bond into
shares unless the entity performs well in the next five-year period.
• In the meantime, the entity benefits from lower financing costs for five years.
Recommendation
For a rapidly expanding entity such as Effe, the convertible bond may be the most
appropriate. The convertible bond provides low cost finance for five years and may
result in the desired equity base at the end of the five year period.
97

Working notes
Calculation of yield to maturity (YTM)
i) Bank loan: the YTM for the bank loan is equal to the annual coupon of 7%.
ii) Bond: Based on ₦100 nominal value for simplicity:
We try both 6% and 7%
Year Cashflow PV at 6% PV at 7%
₦ ₦ ₦
0 (94*) (94) (94)
1–5 5 21.062 20.501
5 100 74.726 71.299
NPV 1.788 (2.200)
1.788
YTM = IRR = 6 + (7 − 6) = 6.45%
1.7888 + 2.2
(* Recall that the bond is to be issued at a discount of 6%)
Alternative approach based on actual cashflows
₦m ₦m ₦m
0 (300) (300) (300)
1–5 15.958 67.221 65.431
5 319.149* 238.487 227.549
NPV 5.708 (7.020)
5.708
𝑌𝑇𝑀 = 6 + (7 − 6) = 6.45%
5.708 + 7.020
(* Note that cash of ₦300m is needed. With a discount of 6%, the face value of the
bond must be: ₦300m × 100/94 = ₦319.149. Interest is calculated on face value.
Thus, the annual total interest is 5% of ₦319.149)
iii) Convertible bond

The “appropriate yield” that can be calculated here is ‘the yield to conversion
(YTC)’ – on the assumption that the holders will indeed convert.
• Conversion value in year 5 = 15(1.10) × 5 shares = ₦120.788
• Annual interest years 1 – 5 = 4.5% × ₦100 = ₦4.5
• Issue price = ₦100
98

We need the IRR of these cashflows.
Trying 8% and 9%
₦ ₦ ₦
0 (100) (100) (100)
1–5 4.5 17.967 17.503
5 120.788 82.206 78.504
NPV 0.173 (3.993)
0.173
IRR = 8 + (9 − 8) = 8.04%
0.173 + 3.993
b) In assessing creditworthiness, a prospective investor should be provided with the

following information:
• Financial statements for the last three years;
• Cash flow forecasts;
• Long- and short-term ratings from rating agencies of this and similar entities’
bonds;
• Business prospects;
• Prospects for the market sector
and undertake the following analyses:
• Calculate ratios (gearing, interest cover, dividend cover, working capital
ratios);
• Analyse free cash flow; and
• Carry out a risk assessment of the business and the market sector.
Examiner’s report
This question tests candidates’ knowledge of the cost of various sources of debt
financing.
Candidates were expected to calculate the relevant yield for each type of debt
finance.
Only very few candidates attempted the question with very poor level of
performance.
There was a very strong evidence that candidates could not carry out the required
level of analysis. The relevant cash flows needed for the yield calculations could not
be isolated.
Candidates are advised to practise standard examination questions when preparing
for the examinations.
99

Marking guide
Marks Marks
a. Identification of yield of bank loan 1
Computation of yield to maturity of the bond 3
More discussion about the queries of director A 2
Computation of conversion value 1½
Computation of yield of the convertible bond 2½
More discussion about the queries of director B 2
Discussion about the concerns of director C 2
Recommendation 1 15
b. Discussion on assessing credit-worthiness and further

analysis to be undertaken 5 5
Total 20
SOLUTION 3
a) Depreciation has been included in “other costs” but since it is not a cash flow it
must be removed. Annual depreciation using the straight line method is ₦50,000
(₦200,000 – ₦50,000) /3 years).
Revenues and costs need to be further adjusted using the values of receivables
and payables to convert them into cash flows.
Calculations follow below:
Year 0 1 2 3 4
₦ ₦ ₦ ₦ ₦
Investment (200,000) 50,000
Sales 230,000 350,000 270,000

Less closing receivables (20,000) (30,000) (25,000)
Add opening receivables 0____ 20,000 30,000 25,000
210,000 340,000 275,000 25,000
Product costs (144,000) (222,000) (166,000)

Less closing payables 6,000 9,000 8,000
Add opening payables 0___ (6,000) (9,000) (8,000)
(138,000) (219,000) (167,000) (8,000)
Pre-tax net cash flow (200,000) 72,000 121,000 158,000 17,000
Taxation (see note) 25,800 38,400 31,200

Less c/fwd (12,900) (19,200) (15,600)
100

Add b/fwd 0___ 12,900 19,200 15,600
Net tax due (12,900) (32,100) (34,800) (15,600)
Post-tax net cash flow (200,000) 59,100 88,900 123,200 1,400
Discount Factor 1.000 0.943 0.890 0.840 0.792
PV (200,000) 55,731 79,121 103,488 1,109
NPV = ₦39,449
Note: Tax is calculated based on incremental cash profit as follows:

Year 1 (₦230,000 – 144,000) × 30% = ₦25,800
2 (₦350,000 – 222,000)× 30% = ₦38,400
3 (₦270,000 – 166,000)× 30% = ₦31,200
b) If inflation were to become relevant then each of the underlying elements of

the project (that is sales and product costs) would need to be inflated by their
own respective inflation rates. This may require product costs to be analysed
in more detail if different rates of inflation apply.
These would then be converted into cash flows for each year, taking care to
ensure that where receipts and payments relate to previous years sales and
costs then these are at the money values of the year in which they arose.
The net cash flows of each year would then be discounted using the money
cost of capital (that is a rate that includes an allowance for the effects of
inflation). This can be calculated as follows:
(1 + real rate) × (1 + inflation rate) = (1 + money rate).
For example, if the real rate is 6% and if inflation is 4% then the money rate is
approximately 10%.
c) As the projects are non-divisible, then in a capital rationing situation it is

necessary to identify the combinations of projects/investments that are
possible within the funding limitations and maximise the total NPV.
101

Possible project combinations are:
Investment required NPV

W&Y ₦400,000 ₦102,000
Y & Product ₦300,000 ₦66,449
Thus, it is recommended that investments W & Y are undertaken because they

yield a higher total NPV.
Examiner’s report
This question tests candidates’ knowledge of standard investment appraisal.
Part (a) demands the calculation of NPV.
Part (b) asks candidates to explain the treatment of inflation in investment appraisal.
Part (c) deals with elementary single - period capital rationing.
Almost all the candidates attempted the question but surprisingly the level of
Candidates lost marks due to the following factors:
• Failure to adjust the cash flows for receivables and payables.
• Failure to base tax calculations on incremental cash profits.
• Failure to comply with the timing of tax payment.
In part (b), most of the candidates who attempted the question could not explain the
treatment of inflation in investment appraisal.
To hedge against failure in future examinations, candidates are advised to read
widely and practise past examination questions.
Marking guide
Marks Marks
a. Computation of depreciation 1
Computation of investment and scrap value ½
Computation of sales ½
Computation of closing receivables 1
Computation of opening receivables 1
Computation of product cost 1
Computation of closing payables & closing payables 2
Computation of pre-tax net cash flow ½
Computation of taxation 1½
Computation of net tax due 2
Computation of post-tax net cash flow ½
Computation of discount factor 1
Computation of PV ½
Computation of NPV 1 14
102

b. Explanation of appraisal of investment project if
inflation is significant 3 3
c. Identification of possible combination of 2

projects/investments
Recommendation 1 3
Total 20
SOLUTION 4
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 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:
• 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.
104

Examiner’s report
This is a question of two parts, both dealing with treasury department. Part (a) tests
candidates’ knowledge of the functions of treasury department. In part (b)
candidates were expected to discuss the advantages and disadvantages of operating
the treasury department as a profit centre rather than cost centre.
Almost all the candidates attempted the question with average level of performance.
It is apparent that majority of the candidates were ill-equipped in this important area
of finance. They therefore failed to pick up easy marks expected in this type of
question.
To increase the chance of success in the examination, students need to practise
standard examination questions.
Marking guide
Marks Marks
a. Explanation of treasury function 3½
Describing the main responsibility of treasury
department 3
Discussion the advantages of a separate treasury
function 7½ 14
b. Discussion the advantages & disadvantages of

operating the treasury department as a profit centre 6 6
Total 20
105

SOLUTION 5
a)
• Cost of equity (KE), using CAPM
KE = 4 + (1.2 × 5) = 10%
• Cost of convertible bonds
Current market value of bonds =100 × 168/160 = N105 per bond
Current share price = N1 billion/200m = N5 per share
VPS in five years’ time = N5 × 1.045 = N6.08
Conversion value = 19 × N6.08 = N115.52
Redemption value (assumed at par) = N100
Since the conversion value is higher than the redemption value, it is assumed
that the bondholders will likely convert.
After-tax interest payment = 0.07 × 100 × (1- 0.3) =N4.90 per bond
Using linear interpolation:
0 Market price (105.00) 1.000 (105.00)
1-5 Interest 4.90 4.100 20.09
(2.54)

0 Market price (105.00) 1.000 (105.00)
1-5 Interest 4.90 4.212 20.64
1.93
After-tax KD = 6 + ((7-6) × 1.93)/(1.93 + 2.54)) = 6 + 0.43 = 6.43%
106

• Calculation of cost of preference shares
KP = 100 × (0.05 × 80m/50m) = 8%
Alternatively, the preference dividend per share can be compared with the
preference share price to find the cost of preference shares.
• Calculation of weighted average after-tax cost of capital

Total value of company = 1000m+50m+168m=1,218 million
After-tax WACC = ((10% ×1000) + (8% × 50m) + (6.43% ×168m))/1218m =
9.4%
It is assumed that the overdraft can be ignored in calculating the WACC, even
though it persists from year to year and is a significant source of finance for
JP.
b) Market values of different sources of finance are preferred to their book values
when calculating weighted average cost of capital (WACC) because market
values reflect the current conditions in the capital market. The relative
proportions of the different sources of finance in the capital structure reflect
more appropriately their relative importance to a company if market values
are used as weights. For example, the market value of equity is usually much
greater than its book value, so using book values for weights would seriously
underestimate the relative importance of the cost of equity in the weighted
average cost of capital.
If book values are used as weights, the WACC will be lower than if market
values were used, due to the understatement of the contribution of the cost of
equity, which is higher than the cost of capital of other sources of finance. This
can be seen in the case of JP, where the market value after-tax WACC was
found to be 9.4% and the book value after-tax WACC is 8.7% (10% × 320 + 8%
× 80 + 6.43% × 160/560).
If book value WACC were used as the discount rate in investment appraisal,
investment projects would be accepted that would be rejected if market value
WACC were used. Using book value WACC as the discount rate will therefore
lead to sub-optimal investment decisions.
As far as the cost of debt is concerned, using book values rather than market
values for weights may make little difference to the WACC, since bonds often
trade on the capital market at or close to their nominal (par) value. In
addition, the cost of debt is lower than the cost of equity and will therefore
make a smaller contribution to the WACC. It is still possible, however, that
using book values as weights may under – or over-estimate the contribution
of the cost of debt to the WACC.
107

Examiner’s report
The question tests candidates’ knowledge of the calculations of WACC.
Candidates needed to first calculate cost of the individual capital components and
then calculate the WACC.
Large number of the candidates attempted the question with below average level of
performance.
Candidates once again lost valuable cheap marks due to the following avoidable
mistakes:
• In using CAPM to calculate cost of equity, treating equity risk premium as market
return.
• Using nominal values rather than market values
• Failure to identify the appropriate total market values.
• Treating the preference shares as redeemable even when a redemption date was
not given.
• Failure to correctly calculate the conversion value of the convertible bonds.
• Failure to adjust for tax in interest.
Cost of capital is a central topic finance and candidates presenting themselves for
this examination must be properly grounded in this area.
There is a very high probability of this topic coming out in every examination in one
form or the other. Be prepared!
Marking Guide
a. Computation of cost of equity using CAPM 1

Computation of after tax cost of convertible debt 6
Calculation of cost of preference shares 1
Determination of weights of capital components 1
Computation of weighted average cost of capital 1 10
(WACC)
b. Discussion on preference of market value weight to

book value weight 5 5
Total 15
108

SOLUTION 6
a)
i) Forward Contract
Since the payment is due in three months, the three-month forward contract
should be used. The company is to buy pounds and the currency dealer is
selling. We therefore make use of the selling rate of $1.9339.
The cost = ₤5 million × 1.9339 = $9,669,500
ii) Currency Futures
 Buy or sell futures?
You need to sell dollars in other to buy pounds, so we need to buy futures.
The first futures to mature after the expected payment date (transaction date) are
choosen. We therefore select the 5-month expiry date.
₤5,000,000 ÷ ₤62,500 = 80 contracts
So we buy 80 contracts at $1.9170/₤
 Predicted futures rate
Current basis = spot price – futures price = 1.9410 – 1.9170 = 0.0240
2
Unexpired basis on the transaction date = 5 × 0.0240 = 0.0096
Lock-in exchange rate = opening futures price + unexpired basis
= 1.9170 + 0.0096 = 1.9266
Expected total cost = 5,000,000 × $1.9266 = $9,633,000
iii) Currency options

 Put or Call?
We are required to buy pounds so we must buy a call option on pounds.
₤5,000,000 ÷ ₤31,250 = 160 contracts
Same as under futures – we select the 5-month expiry date.
 Which exercise price?
We should choose the cheapest one that includes the exercise price and the
premium. Since we are buying pounds we add the premium to the exercise
price:
Exercise price + Premium = Net cost
1.9000 + 0.0355 = 1.9355
1.9200 + 0.0232 = 1.9432
1.9400 + 0.0115 = 1.9515
109

To minimise cost, an exercise price of 1.900 should be selected.
Summary of total cost $

Payment through option = 5,000,000 × 1.9000 = 9,500,000
Add option premium = 160 × 31,250 × 0.0355 = 177,500
Net cost = 9,677,500
Comment and recommendations

Based on cost, currency futures offer the best choice. However, these calculations
ignore margin requirements on futures and problems of basis risk.
b) Put delta = 0.45 – 1 = –0.55
Let 𝑥 = number of puts needed:
Delta of stock = – 110,000
Delta of put = – 0.55 𝑥
Total delta of portfolio = – 110,000 – 0.55𝑥
For delta hedging:
– 110,000 – 0.55𝑥= 0
𝑥 = – 200,000 put options
Because this figure is negative, 200,000 put options should be sold.
Examiner’s report
The question tests the candidates’ knowledge of foreign exchange risk hedging
techniques of forward contracts, currency futures contracts, and currency options.
Only about 5% of the candidates attempted the question. It is highly disappointing
that despite the fact that the question was a verbatim reproduction of a very recent
past question, candidates’ performance was unacceptably low. This simply means
that students are not making use of the institute’s pathfinder.
It is recommended that students should make effective use of study materials
provided by the institute.
Marking guide
Marks Marks
a. Identification of the appropriate selling rate 1
Computing the cost of the forward contract 1
Decision to buy or sale futures ½
Selecting the 5 months expiry date ½
Computation of contract size ½
Computation of current basis 1
110

Computation of unexpired basis 1
Computation of lock-in exchange rate ½
Computation of expected total cost ½
Decision to buy or sale option ½
Computation of contract size ½
Computation of expiry date ½
Computation of exercise price 1½
Selection of the correct exercise price ½
Computation of payment through option ½
Adding option premium ½
Recommendation 1
Total 12
b. Computation of put delta ½

Computation of delta of stock ¼
Computation of delta of put ¼
Computation of total delta of portfolio ½
Computation of delta hedging ½
Decision 1 3
Total 15
SOLUTION 7
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

or because of uncertainty (‘bird in the hand’), or the tax argument - having
attracted these clients, companies find it difficult to suddenly change their
policy. The empirical evidence on dividend clienteles is generally not supportive.
c) Asymmetric information. In the context of dividends and dividend policy, this

applies to the fact that shareholders and managers have incomplete and
different information. Managers do not know how shareholders will react to a
dividend change; likewise shareholders are not party to the information that is
available to managers. The result of asymmetry in information is the information
content of dividends, where dividends have signalling properties. This is taken
up in (d) below.
d) Signalling properties of dividends. With asymmetry of information as in (c).

above, dividends can be represented as signals from the managers of the
enterprise to the shareholders and financial markets. For the successful
transmission of the signal, it has to be encoded and decoded. Evidence (from a
survey) points to the perception of investors, that dividends are a signalling
device of future company prospects. With some exceptions, empirical studies
indicate that dividend changes do convey some unanticipated information to the
market. There is still some controversy because this would deny the EMH. Thus it
might be that dividend announcements do not signal new information but only
confirm already known or forecasted events.
e) The ‘bird-in-the-hand’ argument. This arises from the existence of uncertainty. If

certainty exists and there are no transaction costs, dividends can be capitalised
into the share price as the enterprise invests them internally at NPVs of 0 or
greater. If shareholders need the cash now, they engage in a home-made
dividend policy ofselling some shares to create the flow of income. With
uncertainty, a series of other issues arise:
i) The required rate of return, KE, rises as dividend pay-out is reduced. Risk-
averse investors are not indifferent to the division of earnings into
dividends and capital gains in the share price;
ii) It follows that to offset a 1% reduction in dividends requires a more than

1% increase (in the Gordon model); and
iii) With volatile stock markets, the maintenance of the increase in share price
is not guaranteed. Shareholders may prefer to have the cash and invest it
or spend it, particularly with the presence of agency costs.
112

Examiner’s report
The question tests candidates’ knowledge of basic dividend concepts.

They were expected to discuss:
• Residual theory of dividends
• Clientele effect
• Asymmetric information
• Signaling properties of dividends, etc.
About 10% of the candidates attempted the question but again the performance level
was very low.
It appears that candidates do not understand these concepts despite the fact that
they are in the syllabus.
Preparation for the institute’s examinations demands a comprehensive coverage of
the entire syllabus.
Marking guide
Marks Marks
Discussion on residual theory of dividend 3
Discussion on clientele effect 3
Discussion on asymmetric information 2
Discussion on signally properties of dividends 3
Discussion on the bird-in-the hand argument 4
Total 15
113

PATHFINDER
NOVEMBER 2022 DIET
Question Papers
Suggested Solutions
and
Marking Guides



QUESTION 1
Abayomi Plc (AP) is a major electrical company in Nigeria. The directors have
recently identified Togo as a priority location for business expansion. Togo uses
currency T$. Assume today is 30 August 2021.
Company K3, located in Togo, has been identified as a potential acquisition target.
AP already manages two business units in Togo, named K1 and K2, and these have
shown strong performance under AP‟s ownership.
K3 is particularly attractive to AP because it has its own warehouse, distribution

and logistics network, all of which could be used by K1 and K2, if the acquisition
goes ahead. Currently, K1 and K2 send goods to customers from AP warehouses
located in Ghana. This involves considerable cost and delay in delivery.
K3 is a private company and 100% of its shares are owned by the family that
founded it. Many shareholders are keen to realise their investment by selling the
company to AP.
Both companies are working towards an effective date for the sale of K3 to AP on 1
January 2022.
Financial data for K3 for 2020
The statement of financial position of K3 as at 31 December 2020 showed the

following balances:
T$ million
Long term borrowings 375
Share capital (T$1 ordinary shares) 90
Reserves 200
665
80

• K3 reported an operating profit of T$75 million in the year ended 31 December
2020. It declared a dividend of T$30 million on 20 December 2020 which was
paid on 30 January 2021.
• K3 pays 7% interest on long term borrowings.
• The corporate income tax rate in Togo is 30%.
Forecast financial data for K3 for year 2022 onwards, following acquisition by AP
Following consultation with the directors of K3, AP‟s Finance Director has prepared
the following forecast data for K3 assuming it is acquired on 1 January 2022.
Forecast data for K3:
• Free cash flow to the firm, ignoring synergistic benefits, of T$54.6 million in
2022, growing by 4% a year in perpetuity.
• One-off synergistic cash flow benefit of T$8.0 million after tax in 2022.
• After tax annual synergistic cash flow benefit, starting with T$5.0 million in
2023 and then increasing by 4% a year in perpetuity.
In any discounted cash flow analysis, cash flows should be assumed to arise at the
end of the year to which they relate.
On acquisition, K3 would be transferred to AP free of debt because K3‟s lenders

would only agree to the sale on condition that their borrowings are repaid prior to
the sale. After acquisition, new borrowings would be arranged in addition to the
equity investment by AP and structured so that K3 would have approximately the
same capital structure as AP. That is, gearing (debt/debt+equity) would be 25%
based on market values. AP would guarantee K3‟s new debt which can be assumed
to have the same risk profile as AP‟s debt.
A proxy company has been identified which is also located in Togo and has a
similar business model to K3.
Proxy company data
• P/E ratio of 12.

• Equity beta of 1.7 and debt beta of 0.4.
• Gearing (debt/debt+equity) based on market values of 35%.
Togo has a risk free rate of 5% and a market risk premium of 4%.
Financial data for AP
Latest data available for AP shows:
• P/E ratio of 14.

• Equity beta of 1.5 and debt beta of 0.3.
• Gearing (debt/debt+equity) based on market values of 25%.
81

• AP pays 6.2% interest on its long term borrowings.
Tax rate in Nigeria is 30%.
The spot rate for T$ against Naira, today is T$7/₦ (that is, ₦1 = T$7.00) and is not
expected to change in the foreseeable future.
Assume that Nigeria has the same risk free rate and market risk premium as Togo.
Required:
Assume you are the Finance Director of AP.
a. Advise on:
i. The types of synergistic benefit that might arise from the acquisition
of K3. (8 Marks)
ii. Possible reasons why both one-off and ongoing synergistic benefits
might not be achieved to the extent expected. (4 Marks)
b. i. Calculate a Weighted Average Cost of Capital (WACC) for use in

valuing K3 based on the proxy company‟s business and country risk
and AP‟s capital structure. (6 Marks)
ii) Calculate a range of values for the equity of K3 in T$ as at 1 January

2022 using the following methods:
• Asset basis. (2 Marks)
• P/E (including bootstrapping). (5 Marks)
• DCF (with and without synergistic benefits) (5 Marks)
(Total 30 Marks)
82

INSTRUCTION: YOU ARE REQUIRED TO ATTEMPT ANY TWO OUT OF

THE THREE QUESTIONS IN THIS SECTION
QUESTION 2
Balama Plc. (Balama) is a listed manufacturer of dairy products. In recent years the
company has experienced only modest level of growth, but following the recent
retirement of the chief executive, his replacement is keen to expand Balama‟s
operations.
The board of directors has recently agreed to support a proposal by the new chief
executive that the company purchase new manufacturing equipment to enable it to
expand its range of dairy products. The new equipment will cost N50 million and
the company is seeking to raise new finance to fund the expenditure in full.
However, the board of directors is undecided as to how the new finance is to be
raised. The directors are considering either a 1 for 5 rights issue at a price of N2.50
per share with a theoretical ex-rights‟ price of N2.92 or a convertible loan of N50
million.
The loan will be secured against the company‟s freehold land and buildings. The
company‟s share is presently quoted at a price of N3.00 per share.
Required:
a. Explain the terms „rights issue‟ and „convertible loans.‟ (3 Marks)
b. Explain how „theoretical ex-rights‟ price of N2.92 is calculated and why the
actual price might be different.
Show your workings. (4 Marks)
c. Prepare a report for the board of directors that fully evaluates the two
potential methods of financing the company‟s expansion plans. (13 Marks)
(Total 20 Marks)
QUESTION 3
Zakai (ZK) Plc is a listed company that owns and operates a large number of farms
throughout the country. A variety of crops are grown.
Financing structure
The following is an extract from the statement of financial position of ZK Plc at 30
September 2021.
₦‟million
Ordinary shares of ₦1 each 200
Reserves 100
9% irredeemable ₦1 preference shares 50
8% loan stock 2022 250
600
83

The ordinary shares were quoted at ₦3 per share ex div on 30 September 2021.
The beta of ZK Plc‟s equity shares is 0.8; the annual yield on treasury bills is 5%,
and financial markets expect an average annual return of 15% on the market index.
The market price per preference share was ₦0.90 ex div on 30 September 2021.
Loan stock interest is paid annually in arrears and is allowable for tax at 30%. The
loan stock was priced at ₦100.57 ex interest per ₦100 nominal on 30 September
2021. Loan stock is redeemable on 30 September 2022.
Assume that taxation is payable at the end of the year in which taxable profits
arise.
A new project
Difficult trading conditions have caused ZK Plc to decide to convert a number of its
farms into camping sites with effect from the 2022 holiday season. Providing the
necessary facilities for campers will require major investment, and this will be
financed by a new issue of loan stock. The returns on the new campsite business
are likely to have a very low correlation with those of the existing farming business.
Required:
a. Using the capital asset pricing model, calculate the required rate of return
on equity of ZK Plc at 30 September 2021. Ignore any impact from the new
campsite project. (3 Marks)
b. Briefly explain the implications of a beta of less than 1, such as that for ZK
Plc. (2 Marks)
c. Calculate the weighted average cost of capital of ZK Plc at 30 September
2021 (use your calculation in answer to requirement (a) above for the cost of
equity). Ignore any impact from the new campsite project. (10 Marks)
d. Without further calculations, identify and explain the factors that may
change ZK Plc‟s equity beta during the year ending 30 September 2022.
(5 Marks)
(Total 20 Marks)
QUESTION 4
Tayo Kayode (TK) is a highly successful beverage company listed on the Nigerian
stock market. Its products are particularly attractive to the younger generation.
Eko Laboratory (EL) has developed an innovative synthetic, alcoholic beverage –

the Younky.
It is believed that the product, if manufactured commercially, will be popular

among the youths.
84

TK has been offered a licence to produce the Younky on the condition that it
commences production within the next twelve months. In the last board meeting,
the Marketing Director, Kehinde Kay, presented the following preliminary
evaluation of the project.
₦‟million
Net present value -250
Present value of future cash flows 4,500
Kehinde recommended that the project should thus be rejected.

However, the Finance Director (FD), Ben Okon, argued that conventional NPV
analysis undervalues projects with high uncertainty as the value of embedded real
options is often ignored. He suggested that the possibility of delaying the project
for up to twelve months effectively gives TK a call option on development and that
if market forecasts improve over the next year, then the company can benefit. To
get the „right answer‟, he concluded, option values must be incorporated.
The current long-term government bond yield is 5%. The expected standard
deviation of future cash flows is estimated to be 35%.
Required:
a. Comment on the views of the Marketing and Finance Directors. (5 Marks)
b. Using the Black-Scholes option pricing model for an European call option,
estimate the value of the option to commercially develop and market the
Younky. Provide a recommendation as to whether or not TK should
manufacture the Younky. (10 Marks)
c. Comment on modeling the possibility of delay as a European call option.
(5 Marks)
(Total 20 Marks)
85

INSTRUCTION: YOU ARE REQUIRED TO ATTEMPT ANY TWO OUT OF THE

QUESTION 5
ADERUPOKO PLC
Aderupoko Plc (ADP), a large listed media group, has been the holding company of
Adamu Publishers Limited. (APL) since 2015. The publishing company (APL) is 100%
owned by ADP since inception.
Recently the directors of APL informed ADP‟s board of their readiness to make a
management buy-out (MBO) of APL. Accordingly, ADP‟s board decided to value APL
using the shareholder value analysis method (SVA). ADP‟s board estimates that APL
has a four-year competitive advantage over its competitors (to 30 September, 2024)
and the following data regarding APL‟s value drivers and additional financial
information has been collected.
Sales for the current year to 30 September, 2020 N80 Million

Annual depreciation (equal to annual replacement of
non-current asset expenditure N2.0 Million
Par value of 6% debentures in issue
(current market value N95.00) nominal value N100 N10.0Million
Short-term investments held N0.8Million
Company tax rate 20%
Current WACC 10%
Year to 30 September budgeted

2021 2022 2023 2024 2025+
Sales growth 5% 4% 3% 2% 0%
Operating profit margin 8% 9% 10% 10% 10%
Incremental non-current asset
Investment (as a % of sales increase) 5% 6% 3% 2% 0%
Incremental working capital
Investment (as a % of sales increase) 6% 5% 4% 4% 0%
Required:
a. Calculate the value of APL‟s equity using SVA (12 Marks)
b. Outline THREE methods by which APL‟s directors might raise the funds
necessary for the proposed MBO of the company (3 Marks)
(Total 15 Marks)
86

QUESTION 6
Companies A, B and C are in the food retailing sector of the stock market. The
following key stock market statistics are provided.
Food Retailers: Ordinary Shares, Key Stock Market Statistics
Share price (kobo) Dividend P/E
Company Current 52 week high 52 week low Yield (%) ratio
A 63 112 54 1.8 14.2
B 291 317 187 2.1 13.0
C 187 201 151 2.3 21.1
Required:
a. Illustrating your answer by use of data from the table above, define and
explain the term P/E ratio, and comment on the way it may be used by an
investor to appraise a possible share purchase. (8 Marks)
b. Using data in the above table, calculate the dividend cover for C and B, and
explain the meaning and significance of the measure from the point of view
of equity investors. (7 Marks)
(Total 15 Marks)
QUESTION 7
The Chairman of Opeyemi plc, a company listed on the Alternative Investment

Market, has circulated a memorandum to the company's directors and senior
managers which contains the following statements.
'Looking to the year ahead, there are a number of measures which I propose to
increase the company's earnings per share (EPS).
Payments to trade creditors should be made as late as possible, even if this means
extending our credit beyond the terms allowed by our suppliers. The company
currently runs a substantial overdraft and this measure will cut the level of bank
interest and charges.
Relatively high capital expenditure in recent years has resulted in substantial

depreciation charges in the profit or loss account. All capital spending, including
that on the Oloro II project – designed to reduce toxic emissions from the
manufacturing plant - should be postponed except where such spending can be
shown to be essential to current operations.
Staff pay should be frozen at this year's level for the forthcoming year. The
company's sponsorship of the local charity events run by the Staff Social Club
should also, regrettably be ended.
87

By boosting profits and therefore EPS, these measures will help us to achieve the
highest possible stock market capitalisation.'
Required:
a. Prepare a response to the Chairman's proposals which examines the possible
consequences of the proposals for the price of the company's shares and for
the company's stakeholders. (9 Marks)
b. Discuss FOUR ways that encourages managers to achieve stakeholder

objectives. (6 Marks)
(Total 15 Marks)
88

Formulae
𝑉𝐷
𝑉𝐸𝐺
Asset Beta
𝑉𝐸 𝑉𝐷 (1 − 𝑇)
(𝑉𝐸 + 𝑉𝐷 (1 − 𝑇)) 𝐸 (𝑉𝐸 + 𝑉𝐷 (1 − 𝑇)) 𝐷
Equity Beta
𝑉𝐷
𝛽𝐸 = 𝛽𝐴 + (𝛽𝐴 − 𝛽𝐷 ) (1 − 𝑡)
𝑉𝐸
Growing Annuity
𝑛
𝐴1 1+𝑔
𝑃𝑉 = 1−
𝑟−𝑔 1+𝑟

1
𝑃𝑉𝑅 𝑛
𝑀𝐼𝑅𝑅 = 1 + 𝑟𝑒 − 1
𝑃𝑉𝐼
C0 = S0N(d1) – Ee-rt N(d2)
𝑆
𝐼𝑛 0 + (𝑟 + 0.5𝜎 2 )𝑇
𝑑1 = 𝐸
𝜎 𝑇
d2= d1 - 𝜎 𝑇
The Put Call Parity
C + Ee-rt = S + P

d = 1/u
𝑎−𝑑
𝜋=
𝑢−𝑑
89

Annuity Table
r
Discount rate (r)

Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1
2 1·970 1·942 1·913 1·886 1·859 1·833 1·808 1·783 1·759 1·736 2
3 2·941 2·884 2·829 2·775 2·723 2·673 2·624 2·577 2·531 2.487 3
4 3·902 3·808 3.717 3·630 3.546 3.465 3·387 3·312 3·240 3·170 4
5 4·853 4·713 4·580 4·452 4·329 4·212 4·100 3·993 3.890 3·791 5
6 5·795 5·601 5·417 5·242 5·076 4·917 4·767 4·623 4.486 4·355 6
7 6·728 6.472 6·230 6·002 5·786 5·582 5·389 5·206 5·033 4·868 7
8 7·652 7·325 7·020 6·733 6·463 6·210 5·971 5·747 5·535 5·335 8
9 8·566 8·162 7·786 7.435 7·108 6·802 6·515 6·247 5·995 5·759 9
10 9·471 8·983 8·530 8·111 7·722 7·360 7·024 6·710 6.418 6·145 10
11 10·368 9·787 9·253 8·760 8·306 7·887 7.499 7·139 6·805 6.495 11
12 11·255 10·575 9·954 9·385 8·863 8·384 7·943 7·536 7'161 6·814 12
13 12·134 11·348 10·635 9·986 9·394 8·853 8·358 7·904 7·487 7·103 13
14 13·004 12·106 11·296 10·563 9·899 9·295 8·745 8·244 7·786 7·367 14
15 13·865 12·849 11·938 11·118 10·380 9·712 9·108 8·559 8·061 7·606 15
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1
2 1·713 1·690 1·668 1·647 1·626 1·605 1·585 1·566 1·547 1·528 2
3 2.444 2.402 2·361 2·322 2·283 2·246 2·210 2·174 2·140 2·106 3
4 3·102 3·037 2·974 2·914 2·855 2·798 2·743 2.690 2·639 2.589 4
5 3·696 3·605 3·517 3·433 3·352 3·274 3·199 3·127 3·058 2·991 5
6 4·231 4·111 3·998 3·889 3·784 3·685 3·589 3.498 3.410 3·326 6
7 4·712 4·564 4.423 4·288 4·160 4·039 3·922 3·812 3·706 3·605 7
8 5·146 4·968 4.799 4·639 4.487 4·344 4·207 4·078 3·954 3·837 8
9 5·537 5·328 5·132 4·946 4·772 4·607 4.451 4·303 4·163 4·031 9
10 5·889 5·650 5.426 5·216 5·019 4·833 4·659 4.494 4·339 4·192 10
11 6·207 5·938 5·687 5.453 5·234 5·029 4·836 4·656 4.486 4·327 11
12 6·492 6·194 5·918 5·660 5·421 5·197 4·988 4·793 4·611 4.439 12
13 6·750 6.424 6·122 5·842 5·583 5·342 5·118 4·910 4·715 4·533 13
14 6·982 6·628 6·302 6·002 5·724 5.468 5·229 5·008 4·802 4·611 14
15 7·191 6·811 6.462 6·142 5·847 5·575 5·324 5·092 4·876 4·675 15
90

91

SOLUTION 1
a.(i) Types of synergistic benefit

Synergistic benefits can generally be broken down into three main types, which
are
• Revenue synergies;
• Cost synergies; and
• Financial synergies.
These can be considered in the context of the acquisition of K3 by AP.
Revenue synergies: These result in higher revenues for the combined entity and
higher return on equity. Examples of these include:
• Elimination of inefficiency – The greater strength of AP‟s marketing
department could also help to enhance K3‟s market penetration;
• Market Power - Horizontal combinations (the type in the scenario) can
enable a company to dominate a market. This is one of AP‟s main objectives
in acquiring K3, to become the market leader in the region; and
• Customer satisfaction – customers will benefit from speedier deliveries,
leading to increased customer satisfaction and growth in sales.
Cost synergies: These result mainly from reducing duplication of functions and
related costs. In this scenario:
• Economies of scale - Savings could be made in respect of existing operations
in Togo by using K3‟s distribution network to service customers of K1 and
K2, saving transport costs and reducing delivery times. Savings could also
be made by removing some local administration in areas such as marketing
and finance, combining these operations more efficiently on a centralised
basis;
• Complementary resources – Increases in efficiency may also be possible by
using AP‟s knowledge and expertise to improve the efficiency of operation of
K3; and
• Bulk purchase of key supplies – leading to bulk purchase discount.
Financial synergies: These are the type of synergies that result from lowering
the cost of capital, which include:
• Diversification: Given that K3 is in a market in which AP already operates it
is unlikely that there will be any significant benefit of diversification;
• Debt finance: It is possible that post acquisition K3 may be able to secure
cheaper debt finance as a result of being part of a larger group. This would
lead to an increase in earnings and a reduction in the cost of capital;
92

• Surplus cash: AP has significant cash in its statement of financial position at
31 December 2020 and therefore, acquiring K3 enables AP to obtain higher
returns from this surplus cash.
(ii) Possible reasons for failure to achieve expected benefits

Reasons why the acquisition might fail to meet expectations are:
Lack of fit syndrome
The success of the acquisition depends on the ability of the current management
of K3 to work within AP‟s management structure and culture.
Lack of industrial or commercial fit
There is also a risk that K3‟s reputation/intangible value is not as high as
anticipated or that the distribution network cannot easily be adapted to
accommodate the needs of K1 and K2.
Integration costs too high
Turn-around costs to adapt the distribution network and integrate K3
management and systems might prove to be considerably higher than
estimated, undermining the expected financial benefits of the acquisition.
Price paid too high
It would clearly also affect expected returns if the price agreed proves too high
in relation to the actual value of K3 to AP. There is a risk that AP over-values K3,
especially given the assumption of growth in perpetuity – the longer the time
frame, the less reliable the forecast.
Failure to integrate
There may be technical or logistic reasons why the distribution networks could
not be integrated or management and systems combined.
Inability to manage change
Careful planning and management is required to oversee the change process.
AP has much experience of acquiring companies and managing change and so
it is likely that it would have the necessary expertise to be able to manage
change effectively.
a) i) WACC for use by K3 following acquisition

 Ungear the proxy company‟s equity beta i.e. convert equity beta to asset
beta.
VE VD (1 − T)
βA = βE + β
(VE + VD (1 − T)) (VE + VD (1 − T)) D
65 × 1.7 35 1 − 0.3 × 0.4

= + = 1.3441
65 + 35(1 − 0.30) 65 + 35(1 − 0.30)
93

• Regear beta i.e. convert the asset beta to equity beta – using AP‟s D:E
ratio and its debt‟s beta:
VD
βE = βA + (βA − βD ) (1 − t)
VE
25
= 1.3441 + 1.3441 − 0.3 1 − 0.3 = 1.5877
75
• Use CAPM to calculate cost of equity (KE)
KE = RF + βE(RM – RF)
= 5 + (1.5877 × 4) = 11.35%
 Compute WACC
WACC = (11.35 × 0.75) + 6.2(1 – 0.3)(0.25) = 9.60%
Alternative approach to calculating WACC

 First ungear the proxy company‟s asset beta as above = 1.3441
 Use CAPM to calculate KEU, i.e. the cost of equity if the company has no
debt finance: KEU = RF + βA(R M – RF)
= 5 + 1.3441(4) = 10.376%
 Calculate WACCg – using the formula:
VD t
WACCg = K EU 1 −
Vg
25 × 0.3
= 10.376 1 − = 9.60%
75 + 25
(Notes: KEU = WACCU, Vg = VEG + VD, using the given D:E ratio of AP)
ii) Calculate a number of values for K3

Asset based approach T$ million
Net asset value: 665
Less borrowings (375)
Book value of equity 290
Alternative approach T$ million

Share capital 90
Reserves 200
Book value of equity 290
94

P/E based approach
The P/E valuation is based on earnings (profit after financing costs and tax),
so first calculate earnings:
T$ million
Operating profit 75
Less financing costs (26) (= T$375 million x 7%)
49
Less tax at 30% (15)
Earnings 34 (= profit after tax)
Value of K3 in T$ million
At the proxy company‟s P/E of 12: 408 (= 12 x 34 m)
At AP‟s P/E of 14 (bootstrapping): 476 (= 14 x 34 m)
DCF approach
- Excluding synergy (T$ million)
PV of free cash flow to the firm (FCFF) = FCFF1/(WACC - g)
= 54.60/(0.096 – 0.04) = 975
Less borrowings 375
Total value of equity 600
- Including synergy (T$ million)
Total as above 600
- One-off synergy = 8/1.096 = 7.3
- Perpetual synergy = (5/(0.096 – 0.04))/1.096 = 81.5 88.80
688.80
Or (say) 689
Summary of results
Method Value of equity

T$ million
Asset 290
P/E (using proxy company‟s P/E) 408
P/E (using P plc‟s P/E, ie bootstrapping) 476
DCF excluding synergistic benefits 600
DCF including synergistic benefits 689
Examiner’s report
The question tests many aspects of acquisition and related business valuation. In
part (a) (i), candidates are expected to identify the types of synergistic benefits
expected from the given acquisition. In part (a) (ii), candidates are expected to
explain why it might be difficult to achieve synergistic benefits in practice.
In question (b) (i), candidates are expected to calculate risk-adjusted WACC needed
for the valuation. In question (b) (ii), candidates are expected to value the equity
of the company using different valuation methods.
Being a compulsory question, large number of the candidates attempted it but the
level of performance was disappointingly low.
95

Question (a) (i) that was designed to be mark booster was badly attempted in the
sense that candidates provided generic solutions having no bearing to the scenario
painted in the question.
In question (b) (i), candidates lost easy marks due to the following factors:
 Use of wrong formulae in the process of „ungearing‟ (computing asset beta)
and „regearing‟ (computing equity beta); and
 Poor understanding of the various financial gearing formulae:
D/E ratio, D/(E + D) ratio, etc. and when to use each one of them.
In question (b) (ii), candidates lost marks due to their:

 Failure to adjust the operating earnings (i.e. EBIT) for interest and tax, when
doing valuation using P/E ratio; and
 Failure to make use of the appropriate formulae when discounting the cash
flows with delayed growth.
Candidates are advised to practise past questions, using the pathfinder and cover
the syllabus comprehensively, when preparing for future examinations.
Marking guide
Marks Marks
a. (i) Explanation on types of Synergistic benefits 8 8
(ii) Discussion on possible reasons for failure to
achieve expected benefits 4 4
b. (i) Ungearing the proxy company‟s equity beta to

get asset beta 2
Regearing the above asset beta 2
Computation of CAPM to get cost of equity 1
Computation of WACC 1 6
(ii) Computation of value of equity using asset
based approach 2
Computation of value of equity using P/E 5
approach
Computation of value of equity using DCF 5 12
approach
Total 30
96

SOLUTION 2
a) Rights issue
A rights issue is an issue of new shares for cash to existing shareholders in

proportion to their existing holdings.
Convertible loans
A convertible loan (or bond) is a loan stock that can be converted, at the
option (but not the obligation), of the holder (i.e. the lender) into ordinary
shares of issue (i.e. the borrower) on or before the maturity of the loan.
b) The theoretical ex-rights price is computed as follows:
5 existing shares@₦3 = 15.00
1 new share@₦2.50 = 2.50
6 17.50
Ex – right price ₦17.50/6 = ₦2.92
The actual market value of the shares may be different from the theoretical
price for the following reasons:
 The existence of specific information (positive or negative) regarding the

company or its sector at the time of the issue;
 The information regarding the use to which the proceeds will be put and
the market‟s reaction to that information; and
 The expectations of investors/ the stock market regarding the company‟s
future.
c) REPORT
To The Board of Balama Plc
From Goodhead Kay, Financial Consultant
Date 16 November 2022
Subject Financing expansion plans
97

Rights issues
For an established listed company, rights issues are much more popular for
the following reasons:
 Rights issues are relatively cheap to make, perhaps less than half as
expensive as a public issue;
 The issue price is relatively unimportant. Since all existing shareholders
benefit from the cheap price in proportion to their shareholding, there is
no disproportionate gain. The company needs to make the rights price
significantly cheaper than the market price. This puts pressure on
shareholders to take up the shares or to sell them to an investor who will.
Thus, rights issue tend not to fail, i.e. the shares tend to be issued and
the required cash raised;
 Control tends to stay with the existing shareholders;
 The need to discount the offer price to ensure that the issue is fully
subscribed and to cover the possibility that the market price of shares
might fall between the announcement of the rights issue and its
conclusion; and
 The use of rights issue leaves the credit line free to finance further
expansion and enables the non-current assets to be used to secure other
lines of finance, if required.
It seems as if a rights issue would provide a cheaper and more practical way
for the company to raise the funds for the expansion.
Convertible loan stock issue
Convertibles are a mixture of loan and equity financing. They are issued as
loan stocks with the right to convert them into equity shares of the same
company at some pre-determined rate and date.
From the investors‟ point of view they are relatively safe, in that there is a
close-to guaranteed interest payment periodically and a right to convert to
equity, if it is beneficial to do so.
From the company‟s viewpoint they are attractive because:
 Cheap to issue: Loan stock is generally cheap to issue, so it becomes, if

all goes well, a cheap way of issuing equity;
 Loan finance is relatively cheap to service because of the tax-
deductibility of interest charges; and
98

 They are self-liquidating, provided the holders convert, the loan
liquidates itself through an equity issue, which saves the company the
problem of raising the cash to replace the expiring loan stock.
Disadvantages of any type of loan financing include:
 The likely need to provide security for the loan; and

 The possibility that lenders will impose covenants, for example,
restricting the level of dividends and/or insisting on a minimum liquidity
ratio.
Raising finance, unless it is from a mixture of debt and equity, will affect the
level of gearing, with probable implications for the risk/return profile and
the cost of capital.
Examiner’s report
The question tests the candidates‟ knowledge of rights issues and convertible loans.
The candidates are expected to compare rights issues and convertible loans as
sources of finance.
Almost all the candidates attempted the question.
Most of the candidates did fairly well in parts (a) and (b) of the question but
performance in part (c) was far below expectation.
Candidates failed to gain good marks because they were discussing equity finance
(rather than rights issue) and debt finance (rather than convertible loans).
At this level of the examination, candidates must understand that they are required
to answer the question asked and not the question they wanted.
Marking guide
Marks Marks
a. Explanation of Right Issues 1½
Explanation of Convertible loans 1½ 3
b. Computation of the theoretical ex-rights 2
Discussion on why the actual price might be different 2 4
c. Report address 1
Evaluation of the right issues financing method 6
Evaluation of the convertible loan financing method 6 13
Total 20
99

SOLUTION 3
a) Required return on equity = 5% + 0.8(15% - 5%) = 13%
b) The beta is a measure of the extent to which historic movements in ZK‟s share
price have correlated with average market returns. A beta of less than 1 means
that the share price is less volatile than the market. Thus, at 0.8, it means that if
the market index rises by 10% then on average the share price of ZK would be
expected to increase by 8%.
This argument does not however mean that the required rate of return on ZK‟s
shares also moves in direct proportion to the required return on the market as
this is also affected by the risk free rate.
9
c) Cost of preference shares = = 10%
90
Total value = ₦50m × 0.9 = ₦45m
Cost of debt
Working with face value of ₦100 nominal
With 1 year to redemption, the following formula can be used to calculate the
cost of debt:
EV
KD = − 1, where:
BV
EV = total cash flow expected in year 1

= redemption value (₦100) + year 1‟s interest, net of tax (₦5.60) =
₦105.60
BV = current market value = ₦100.57
⸫ KD = (105.60/100.57) – 1 = 5%
Total value = ₦250m × (100.57/100) = ₦251.43m
Calculation of WACC
Capital Total value Cost Hash total
₦m % ₦m
Equity 600.00 13 78.00
Pref shares 45.00 10 4.50
Loan stock 251.43 5 12.57
896.42 95.07
WACC = 95.07/896.43 = 10.61%
d) There are three major factors occurring during 2021 which may impact upon the
beta of ZK Plc. These are:
• The opening of a new business venture in campsites;
• The financing of the new venture with a new issue of bonds; and
• The refinancing of the existing debt which is redeemable in 2021.
100

The new business venture
The new business venture is significantly different from the existing business.
This is indicated by the low correlation of the returns of the two businesses.
The low correlation may diversify the unsystematic risk of the business, but its
impact on the beta of the company is uncertain. This will depend on the
correlation of the returns on the campsite project with the market portfolio - not
their correlation with existing company returns.
Ignoring the impact of debt financing, this new equity beta will be the weighted
average of the existing beta and the beta of the new project.
Financing for the new project
The new debt finance will increase financial gearing and thus increase the
variability of equity returns on the project and for the company as a whole. If
the equity returns become more variable in relation to the market index, then
this will increase the equity beta, although the total risk to debt and equity will
be unaffected.
Refinancing existing debt

The impact of refinancing on the beta will depend on the type of financing used
to redeem the existing debt - if any. If there is like-for-like replacement with
new debt, then there will be a minimal impact on the beta, although the terms
of the replacement debt instruments may differ.
If however, the debt is redeemed - totally or partially - with new equity then this
will reduce gearing, reduce the volatility of equity returns and thus lower the
beta.
Other factors
Betas are based on historic returns and may not be stable over time. Past betas
are, thus, not necessarily a good guide to the future, as they are affected by
random events in relation to the company and the market. Even without the
significant operational and financial changes in ZK plc in 2021, the beta would
thus be likely to change anyway through normal ongoing events in the farming
industry. The direction of change would, however, be indeterminant.
Summary
The new beta will be the weighted average of the beta on the existing farming
business and the beta of the new leisure business. Both of these may change
over time.
101

Examiner’s report
This four-part question tests candidates‟ knowledge of various aspects of cost of
capital.
In part (a), candidates are expected to compute cost of equity, using CAPM.
In part (b), candidates are expected to interpret beta factor of 1.
Part (c) tests candidates‟ knowledge of the calculation of WACC.
Finally, part (d) demands that candidates should identify specific factors that drive
beta factor.
A very high proportion of the candidates attempted the question but performance
was only average.
Almost all the candidate that attempted the question scored the full marks of part
(a). On the contrary however, none of the candidates could give meaningful
interpretation of beta of 1 in part (b).
About 40% of the candidates did very well in part (c).
Candidates that lost marks in this part of the question did so because of the
following common errors:
 Computations based on book values rather than market values;
 Wrong calculations of market values;
 Candidates ignoring tax when computing cost of debt; and
 Some candidates applying tax to the calculation of cost of preference shares,
etc.
Large number of the candidates could not provide acceptable solutions to part (d).
It is important that candidates should make efforts to solve past examination
questions when preparing for the examination in the future.
Marking guide
Marks Marks
a. Computation of required return on equity 3 3
b. Explanation of the implication of beta less than 1 2 2
c. Computation of cost of preference share 1
Computation of total value of preference share 1
Computation of the total cash flow expected in year 1 loan 1
stock
Computation of cost of debt 2
Computation of the total value of loan stock 1
Calculation of WACC 4 10
d. Identification and explanation of factors that may change 5 5
equity beta
Total 20
102

SOLUTION 4
a) Both Directors are correct to a point but are failing to see the whole picture.
The Marketing Director is correct in her interpretation of the calculated NPV. The
NPV can normally be interpreted as showing the impact of a project on
shareholder wealth, so a negative NPV would indicate that the investment
would erode shareholder value and should thus be rejected.
The Finance Director (FD) is correct to point out a weakness of conventional NPV
analysis. High uncertainty is usually reflected in a higher discount rate and
hence a lower NPV. However, greater uncertainty will usually result in higher
option values, so the FD is correct to suggest that option values must be
incorporated and that TK has an option to delay investment, giving a call
option.
The FD is wrong to suggest that ignoring options is the only weakness of NPV. A
more complete analysis would also try to incorporate non-financial factors such
as the possible implications for TK‟s image with alcoholic research laboratories
(targeting the younger generation). Some investors and customers may object to
this link and hence future sales would be compromised.
b) Using the Black-Scholes model for European call options (₦million)

 Time, t = 1
 S0 = PV of future cash flows = 4,500
 E = the exercise price = cost of investment = 250 + 4,500 = 4,750
 Interest rate = 0.05
 Volatility = 0.35
S
In E0 + (r + 0.5σ2 )T
d1 =
σ T
In 4500/4750 + 0.05 + 0.5 × 0.352 1

= = 0.1634
0.35 × 1
d2 = d1 − σ T = 0.1634 − 0.35 × 1 = −0.1866

N d1 = 0.5 + 0.0636 + 0.34 0.0675 − 0.0636 = 0.5649
N d2 = N −0.1866 = 1 − N 0.1866
= 1 − 0.5 + [0.0714 + 0.66 0.0753 − 0.0714 ]
= 1 − 0.5740 = 0.4260
Inputting data into call formula:
C0 = S0 N d1 − Ee−rt N d2
= 4,500 0.5649 − 4750e−0.05 1
× 0.426 = 617.24
103

Recommendation
The high value of the call option would suggest that the offer of a licence
should be accepted.
c) The Black - Scholes model was developed for European options. As production
could commence at any time during the 1 year period the option is an
American option rather than a European option.
It can be argued that, where there is no dividend payable and where time
value still exists, it is worthwhile holding an American option to expiry and
thus the valuation as a European call is valid.
In this case, however, it is likely that investment would be commenced (i.e.
the call option exercised) as soon as the forecast NPV became positive due to
revised forecasts. The valuation as a European call would thus give a lower
limit on the value of the option to delay.
Examiner’s report
The entire question 4 tests candidates‟ knowledge of real options.
In part (a), candidates are expected to explain the impact of real option on net
present value of a capital project. In part (b), candidates are expected to value a
call option on a capital project – using Black-Scholes Option Pricing Model.
Part (c), tests the candidates‟ knowledge on the practical limitations of the above
model.
Less than 5% of the candidates attempted the question. Their performance indicates
lack of knowledge of this area of the syllabus.
It is recommended that students preparing for the Institute‟s examination should

not neglect any section of the syllabus.
104

Marking guide
Marks Marks
a. Commenting on the marketing and finance Directors views 5 5
b. Stating time correctly ½
Stating PV of future cash flows ½
Computation of exercise price ½
Stating interest rate correctly ½
Stating volatility rate correctly ½
Computation of d1 2½
Computation of d2 ½
Computation of N (d1) 1½
Computation of N (d2) 1½
Computation of call options 1
Recommendation ½ 10
c. Explanation on modelling the possibility of delay as a
European call option 5 5
Total 20
SOLUTION 5
a)
Year 1 2 3 4 5 – Infinity
₦m ₦m ₦m ₦m ₦m
Sales (see workings) 84.00 87.40 90.00 91.80 91.80
Operating profit 6.72 7.87 9.00 9.18 9.18
Tax at 20% (1.34) (1.57) (1.80) (1.84) (1.84)
Depreciation 2.00 2.00 2.00 2.00 2.00
Operating cash flow 7.38 8.30 9.20 9.34 9.34
Replacement non-current assets (2.00) (2.00) (2.00) (2.00) (2.00)
Capital expenditures (0.20) (0.20) (0.08) (0.04) (0.00)
Working capital (0.24) (0.17) (0.10) (0.07) (0.00)
Free cash flow 4.94 5.93 7.02 7.23 7.34
PVF at 10% 0.909 0.826 0.751 0.683 6.830*
PV 4.49 4.89 5.27 4.94 50.10
₦m
Total PV 69.69
Add short-term investment 0.80
Less market value of debentures = ₦10m × 95/100 = (9.50)
(* Annuity factors at 10% years 5 – infinity)
105

Workings
Year 0 1 2 3 4 5 - Infinity
₦m ₦m ₦m ₦m ₦m ₦m
Sales* 80.0 84.0 87.4 90.0 91.8 91.8
Sales increase - 4.0 3.4 2.6 1.8 0
Capital expenditure* - 0.20 0.20 0.08 0.04 0
Additional working capital* - 0.24 0.17 0.10 0.07 0
(* applying the given rates)
b) An MBO can be financed using the following methods

i) Private loan
Members of the buyout team use unsecured and secured personal
loans to fund the MBO. For secured lending, team members will
provide their homes, pension plans and other non-cash assets as
collateral;
ii) Business loan
Business loans from bank or finance companies may be obtained to
fund the transaction. Depending on the track record and the type of
business being purchased, unsecured lending may be possible.
However, unsecured lending is generally much smaller than secured
lending and, in many cases, the lender will take a lien on the
company and all its assets, including its sales ledger, to secure the
borrowing. Loan terms are typically 3 to 5 years.
iii) Asset finance

Leveraging against the assets in the company, such as property,
stocks, or receivables. If the business owns substantial assets, those
assets may be used as collateral for borrowing. This type of
arrangement is called a leveraged buy-out, as the company‟s assets
are leveraged to buy out the old owner.
iv) Private equity (PE)

This is a steadily increasing source of finance even at the smaller end
of the market. Cash is provided by venture capitalists, hedge funds
and private investors in exchange for shares, board seats, dividends,
fees, and varying degrees of control.
v) Mezzanine finance
A hybrid of debt and equity financing that gives the lender the right
to convert to an equity interest in the company in case of default,
generally, after venture capital companies and other senior lenders
are paid.
106

vi) Seller loan
Also called vendor loans. The seller helps to fund the transaction by
leaving some of their consideration in the company as loan notes to
be repaid over time. In effect, their ownership reduces over an
extended period. The old owner may retain a degree of control until
they are completely paid out.
(Note: For a question of 3 marks, the above points are certainly too
detailed. They are included for educational purposes).
Examiner’s report
This question tests candidates‟ knowledge of the computational aspect of
shareholder value analysis (SVA). Candidates are expected to calculate the freecash
flow using SVA and value the company.
Only very few candidates attempted the question. Based on the candidates
performance level, it is clear that candidates do not have any knowledge of the
subject matter. Performance in the question was therefore extremely poor.
It cannot be overstated that students need to cover the syllabus comprehensively

before presenting themselves for the examination in the future.
Marking guide
Marks Marks
Computation of sales 1
Computation of operation profit 1
Computation of tax 1
Computation of depreciation 1
Computing replacement of non-current assets 1
Computation of capital expenditure 1
Computation of working capital 1
Computation of free cashflow 1
Computation of PVF 1
Computation of PV 1
Computation of value equity 2 12
Discussion on methods of raising funds for the
proposed MBO of the company 3 3
Total 15
107

SOLUTION 6
a) Price-earnings ratio
The price earnings (P/E) ratio is regarded by many as the most important
yardstick for assessing the relative worth of a share. It is calculated as:
Market price of share Total market value of equity
=
EPS Total earnings
The P/E ratio is a measure of the relationship between the market value of a
company's shares and the earnings from those shares. It is an important ratio
because it relates two key variables for investors, the market price of a share
and its earnings capacity.
Stock market appraisal

The value of the P/E ratio reflects the market's appraisal of the share's future
prospects. In other words, if one company has a higher P/E ratio than another it
is because investors either expect its earnings to increase faster than the other's,
or they consider that it is a less risky company or in a more secure industry.
Influence of market efficiency

The level of the ratio will change directly in response to changes in the share
price and may vary widely during the course of the year as events alter
investors' perceptions. The extent and timing of changes will depend on the
efficiency of the market; the stronger the level of efficiency, the more the market
will be able to anticipate events.
Comparisons
Earnings potential is strongly related to the sector in which the business
operates, and therefore P/E comparisons are only valid in respect of companies
in the same market sectors. They can be used in this case since all the
companies are publicly quoted food retailers.
Price earnings ratios of companies being compared

Using the information given in the table, the P/E ratio for B is 13.0. This means
that it would take thirteen years for the earnings from the share to equal the
price paid for it. The ratio for C is 21.1, the higher ratio meaning that the time
taken for the earnings to equal the price of the share is 21.1 years. The reason
for the higher level is that investors expect earnings from C to rise at a faster
rate than those from B. The P/E ratio gives no indication of itself as to why
earnings are expected to increase at different rates, although possibilities
include superior management quality or more aggressive investment plans.
A has a current share price of 63 kobo and a P/E ratio of 14.2. Earnings for last
year were therefore 4.437 kobo per share (63/14.2). At its high point for the year
when the share price was 112, the P/E ratio was 25.2, while at its low point, the
108

P/E ratio was 12.2. The figures also demonstrate that C has the lowest level of
volatility, B the highest. This appears to reinforce the point made above that
investors are confident about C‟s prospects (hence the P/E ratio has not altered
much over the year), but are rather less sure about B‟s future.
b) Dividend cover
The dividend cover is the number of times that the actual dividend could be
paid out of current profits. It indicates the proportion of distributable profits for
the year that is being retained by the company and the level of risk that the
company will not be able to maintain the same dividend payments in future
years, should earnings fall.
Calculation of dividend cover

In this case, the ratio must be approached by means of the dividend yield and
the P/E ratio:
P Market share price
=
E Earnings
Dividend paid
Div yield =
Market share price
Dividend paid
P/E × Div yield = since the market share price cancels out
Earnings
This is the inverse of the dividend cover, and therefore:

Dividend cover = 1÷ (P/E × div yield)
a. P/E Div yield P/E × div yield Dividend cover

b. 21.1 2.3% 0.4853 2.06 times
c. 13.0 2.1% 0.2730 3.66 times
Comparisons
As, with the P/E ratio, comparisons with other companies in the same sector are
a lot more valuable than comparisons with companies in different sectors, as
the 'typical rate' for different business sectors will vary widely.
Dividend covers of companies being compared

The lower level of dividend cover for C means that the company has paid out
nearly half of its earning in the form of dividends, while B has only paid out less
than one third. This suggests that B has retained a higher proportion of profits
for reinvestment within the business. If earnings are very volatile, the figures
could suggest that C might have problems in continuing to payout dividends at
this level in the future.
109

However as indicated above, the market appears confident about C future, and
rates C rather lower despite B retaining more funds for future expansion.
Examiner’s report
This question tests candidates‟ knowledge of key capital market financial ratios.
Part (a) of the question asks the candidates to explain and illustrate P/E ratio. Part
(b) asks candidates to calculate and explain dividend cover.
More than 80% of the candidates attempted the question and surprisingly the level
of performance was very poor.
Almost all the candidates who attempted the question could not correctly calculate
dividend cover. More disappointly however, very large proportion of the candidates
could not give meaningful interpretation of the two ratios.
It is recommended that candidates should always practise with past questions and,
in addition, read financial papers when preparing for future examination.
Marking guide
Marks Marks
a. Definition and explanation of P/E ratio 2
Comment on the way P/E ratio may be used by investor to
appraise a possible share purchase 6 8
b. Meaning of dividend cover 1
Calculation of dividend cover for C and B 4
Significance of the measure of dividend cover for C and B
for investment purpose 2 7
Total 15
110

SOLUTION 7
a) To: Chairman
From: Finance Director
Date: 15 June 2021
Subject: Proposals aimed at maximisation of the share price
Further to our recent discussions, I agree fully with your desire to seek the
maximisation of the company's share price and therefore its market
capitalisation.
However, although I agree that a relationship does exist between reported
profits, earnings per share and the share price, short-term are not in themselves
the principal driver of the share price.
In reality, assuming a reasonably efficient market, the maximisation of the

share price will be brought about by the maximisation of the present value of
the future cash flows. The most effective way to increase the share price
therefore is to concentrate on making investments that generate a positive net
present value (NPV) when discounted at the cost of capital.
I believe that some of the current proposals could damage the position of some
of the groups of stakeholders in the firm and could even have a negative impact
on the share price.
i) Delaying payments to creditors beyond the terms allowed could have a

number of damaging effects, which include:
 Valuable discounts may be lost and credit charges incurred;
 The credit rating of the company could be damaged making it difficult to
obtain further credit from new suppliers in the future, or from other
sources of finance; and
 Supplies of materials could be jeopardised if the company's orders are
moved down the priority list or even placed 'on stop‟.
ii) As explained above, it is necessary to undertake investments that generate a
positive NPV in order to maximise the share price. Minimising capital
expenditure in order to boost short-term profits could therefore mean that
some important opportunities are missed. This in turn means that the value
of the company will be lower than it could be, which will impact badly on
the share price. It could also adversely affect the position of other
stakeholders such as employees and suppliers.
iii) Regarding the Oloro II project, stringent controls on pollution exist, and the
company must be certain that any delay in expenditure on measures to
reduce pollution will not result in environmental standards such as
111

discharge consents being breached. If this does happen, then the company
will be liable for financial penalties, and again the standing in the local
community will be damaged. If the problems are severe, then the company
could come under pressure from environmental pressure groups which could
result in more widespread damaging publicity.
iv) Pegging back wages is likely to damage the morale of the employees, and
could result in good employees being lost, while at the same time making it
harder to recruit the right people. If morale is badly affected this could also
affect both quality and the efficiency of production. Abandonment of charity
sponsorship is likely to meet with opposition, not only from employees
involved in the events, but also from the wider community which has
previously relied on the company's support. This will in turn damage the
standing of the firm in the local community.
I would be pleased to discuss these issues with you further, and to consider some
alternative approaches to increasing the share price.
Signed
Finance Director
b) The achievement of stakeholder objectives by managers can be encouraged by

managerial reward schemes, for example, share option schemes and
performance-related pay (PRP), and by regulatory requirements, such as
corporate governance codes of best practice and stock exchange listing
regulations.
Share option schemes

The agency problem arises due to the separation of ownership and control, and
managers pursuing their own objectives, rather than the objectives of
shareholders, specifically the objectives of maximising shareholder wealth.
Managers can be encouraged to achieve stakeholder objectives by bringing
their own objectives more in line with the objectives of stakeholders such as
shareholders. This increased goal congruence can be achieved by turning the
managers into shareholders through share option schemes, although the criteria
by which shares are awarded need very careful consideration.
Performance-related pay
Part of the remuneration of managers can be made conditional upon their
achieving specified performance targets, so that achieving these performance
targets assists in achieving stakeholder objectives. Achieving a specified
increase in earnings per share, for example, could be consistent with the
112

objective of maximising shareholder wealth. Achieving a specified improvement
in the quality of emissions could be consistent with a government objective of
meeting international environmental targets.
However, PRP performance objectives need very careful consideration if they
are to be effective in encouraging managers to achieve stakeholder targets. In
recent times, long-term incentive plans (LTIPs) have been accepted as more
effective than PRP, especially where a company‟s performance is benchmarked
against that of its competitors.
Corporate governance codes of best practice

Codes of best practice have developed over time into recognised methods of
encouraging managers to achieve stakeholder objectives, applying best practice
to many key areas of corporate governance relating to executive remuneration,
risk assessment and risk management, auditing, internal control, executive
responsibility and board accountability. Codes of best practice have emphasised
and supported the key role played by non-executive directors in supporting
independent judgement and in following the spirit of corporate governance
regulations.
Stock exchange listing regulations

These regulations seek to ensure a fair and efficient market for trading company
securities such as shares and loan notes. They encourage disclosure of price-
sensitive information in supporting pricing efficiency and help to decrease
information asymmetry, one of the causes of the agency problem between
shareholders and managers. Decreasing information asymmetry encourages
managers to achieve stakeholder objectives as the quality and quantity of
information available to stakeholders gives them a clearer picture of the extent
to which managers are attending to their objectives.
Monitoring
One theoretical way of encouraging managers to achieve stakeholder objectives
is to reduce information asymmetry by monitoring the decisions and
performance of managers. One form of monitoring is auditing the financial
statements of a company to confirm the quality and validity of the information
provided to stakeholders.
Note: Only four ways to encourage the achievement of stakeholder objectives
were required to be discussed.
113

Examiner’s report
This is a two-part question. Part (a) tests candidates‟ knowledge of the concept of
short-termism in finance. In part (b), candidates are expected to discuss ways and
means of reducing agency problems in finance.
Almost all the candidates attempted the question and the level of performance was
above average.
Effective revision, using past questions and the pathfinder will always enhance
candidates‟ performance in the examination.
Marking guide
Marks Marks
a. Report on the possible consequences of the proposal 9 9
b. Discussion on ways that encourage managers to achieve
stakeholders objectives 6 6
Total 15
114

ICAN/231/V/C3 Examination No...........................

EXAMINATION INSTRUCTIONS
PLEASE READ THESE INSTRUCTIONS BEFORE THE COMMENCEMENT OF THE PAPER
1. Check your pockets, purse, mathematical set, etc. to ensure that you do not
have prohibited items such as telephone handset, electronic storage device,
programmable devices, wristwatches or any form of written material on you
in the examination hall. You will be stopped from continuing with the
examination and liable to further disciplinary actions including cancellation
of examination result if caught.
2. Write your EXAMINATION NUMBER in the space provided above.
3. Do NOT write anything on your question paper EXCEPT your examination

number.
4. Do NOT write anything on your docket.

5. Read all instructions in each section of the question paper carefully before
6. Do NOT answer more than the number of questions required in each section,
otherwise, you will be penalised.
7. All solutions should be written in BLUE or BLACK INK. Any solution written
in PENCIL or RED INK will not be marked.
8. A formula sheet and discount tables are provided with this examination
paper.
WEDNESDAY, MAY 17, 2023
87



QUESTION 1
KK, a company quoted on the Stock Exchange, has cash balance of ₦230 million
which are currently invested in short-term money market deposits. The cash is
intended to be used primarily for strategic acquisitions, and the company has
formed an acquisition committee with a remit to identify possible acquisition
targets. The committee has suggested the purchase of ZL, a company in a different
industry that is quoted on the AIM (Alternative Investment Market). Although ZL is
quoted, approximately 50% of its shares are still owned by three directors. These
directors have stated that they might be prepared to recommend the sale of ZL, but
they consider that its shares are worth ₦220 million in total.
Summarised financial data
KK ZL
₦’000 ₦’000
Revenue 4,800,000 380,000
Pre tax operating cash flow 510,000 53,000
Taxation (33%) (168,300) (17,490)
Post tax operating cash flow 341,700 35,510
Dividend 110,000 8,420
Non-current assets 1,680,000 84,000

Current assets 1,350,000 47,000
Current liabilities (996,800) (39,000)
2,033,200 92,000
KK ZL
Long-term finance
Ordinary shares (25 kobo par) 100,000 (ZL 10 kobo par) 5,000
Reserves 1,583,200 52,000
12% Bond 200,000 -
10% Bank term loan 150,000 Recent 11% bank loan 35,000
2,033,200 92,000
88

KK ZL
₦‟000 ₦‟000
Current share price 785 kobo 370 kobo
Earnings yield 10.9% 19.2%
Average dividend growth during
the last five years 7% pa 8% pa
Equity beta 0.95 0.8

Industry data:
Average P/E ratio 10:1 6:1
Average P/E of companies
recently taken over, based upon
the offer price 12:1 7:1
The risk free rate of return is 6% per annum and the market return is 14% per
annum.
The rate of inflation is 2.4% per annum and is expected to remain at approximately
this level.
Expected effects of the acquisition:
(i) 50 employees of ZL would immediately be made redundant at an after tax cost
of ₦12 million. Pre-tax annual wage savings are expected to be ₦7.50 million (at
current prices) for the foreseeable future.
(ii) Some land and buildings of ZL would be sold for ₦8 million (after tax).
(iii) Pre-tax advertising and distribution savings of ₦1.50 million per year (at current
prices) would be possible.
(iv) The three existing directors of ZL would each be paid ₦1 million per year for
three years for consultancy services. This amount would not increase with
inflation.
Required:
a. Calculate the value of ZL based upon:
i. The use of comparative P/E ratios (3 Marks)
ii. The dividend valuation model (4 Marks)
iii. The present value of relevant operating cash flows over a 10 year period
(10 Marks)
iv. Provide an evaluation of each of the three valuation methods in (i) to (iii)
above. (7 Marks)
v. Recommend whether KK should go ahead with the offer for ZL. (2 Marks)
b. The regulation of takeovers varies from country to country.

Outline the typical factors that such a regulation includes. (4 Marks)
(Total 30 Marks)
89


QUESTION 2
You are a Financial Analyst at Tayo Research Group (TRG). You begin valuing Aba
Hotels Plc (AHP), a thinly and infrequently traded stock currently selling at 217
kobo, cum 2021 dividend.
For estimating AHP‟s required return on equity, TRG uses the capital asset pricing
model (CAPM) approach, but you think its equity beta of 1.20 is not reliable
because of the stock‟s extremely thin trading volume. You have therefore obtained
the beta and other pertinent data for Eko Hotel Plc (EHP) – (See Table 1), a
midsized company in the same industry with high liquidity trading on the Nigerian
Stock Exchange.
Table 1: Valuation Data for EHP
Asset beta 0.763
Debt beta 0.150
Debt ratio (D/D+E) 0.60
Effective tax rate 30%
Summarised financial data for AHP is shown below:

Statement of profit or loss account
2019 2020 2021*
₦’000 ₦’000 ₦’000
Sales 305,500 357,600 409,200
Taxable income 40,500 49,000 56,700
Taxation (14,175) (17,150) (19,845)
26,325 31,850 36,855
Dividend (9,340) (10,228) (11,200)
Retails earnings 16,985 21,622 25,655
Statement of Financial Position (₦’000)
2021*
Current assets 158,000
Current liabilities (104,800)
270,000
Ordinary Shares (50 kobo par value) 80,000
Reserves 130,000
15% bond 2026(₦100 par value) 60,000
270,000
(*2021 figures are unaudited)
90

Other relevant information
(i) It has been estimated that the debt/equity ratio of AHP is 0.16 and beta of its
debt is 0.2
(ii) The risk free rate is 12% and the market risk premium is 5%.
(iii) AHP has effective tax rate of 35%.
(iv) As a result of recent capital investment, stock market analysts expect post-
tax earnings and dividends to increase by 25% for two years and then to revert
to the company‟s existing growth rates.
Required:
a. Stock market analysts sometimes use fundamental analysis and sometimes
technical analysis to forecast future share prices.
What are fundamental analysis and technical analysis? (4 Marks)
b. Using the dividend valuation model, estimate what a fundamental analyst
might consider to be the intrinsic (or realistic) value of the company‟s shares.
Comment upon the significance of your estimate for the fundamental analyst.
(12 Marks)
c. Explain whether your answer to (b) above is consistent with the semi-strong
and strong forms of the efficient markets hypothesis (EMH), and comment upon
whether financial analysts serve any useful purpose in an efficient market.
(4 Marks)
(Total 20 Marks)
QUESTION 3
Tinco Limited (TL) is considering an expansion project. The project will involve the
acquisition of an automated production machine costing ₦11,000,000 and payable
now. The machine is expected to have a disposal value at the end of 5 years, which
is equal to 10% of the initial expenditure.
The following schedule reflects a recent market survey regarding the estimated
annual sales revenue from the expansion project over the Project‟s five-year life:
Level of demand ₦’000 Probability
High 16,000 0.25
Medium 12,000 0.50
Low 8,000 0.25
It is expected that the contribution to sales ratio will be 50%. Additional
expenditure on fixed overheads is expected to be ₦1,800,000 per annum.
91

TL incurs a 20% tax rate on corporate profits. Corporate tax is paid one year in
arrears.
TL‟s after-tax nominal (money) discount rate is 15.5% per annum. A uniform
inflation rate of 5% per annum will apply to all costs and revenues during the life of
the project.
All of the values above have been expressed in terms of current prices.
You can assume that all cash flows occur at the end of each year and that the initial
investment does not qualify for capital allowances.
Required:
a. i Evaluate the proposed expansion from a financial perspective. (10 Marks)
ii Calculate and interpret the sensitivity of the project to changes in:
 the expected annual contribution (3 Marks)
 the tax rate (2 Marks)
b. You have now been advised that the capital cost of the expansion will qualify for
written down allowances at the rate of 25% per annum on a reducing balance
basis. Also, at the end of the project‟s life, a balancing charge or allowance will
arise equal to the difference between the scrap proceeds and the tax written
down value.
You are required to calculate the financial impact of these allowances. (5 Marks)
(Total 20 Marks)
QUESTION 4
The directors of Kenny plc wish to make an equity issue to finance an ₦800 million
expansion scheme, with an expected net present value of ₦110 million. It is also to
re-finance an existing 15% term loan of N500m and pay off penalty of N35m for
early redemption of the loan. Kenny has obtained approval from its shareholders to
suspend their pre-emptive rights and for the company to make a ₦1,500 million
placement of shares which will be at the price of 185 kobo per share. Issue costs
are estimated to be 4 per cent of gross proceeds. Any surplus funds from the issue
will be invested in commercial paper, which is currently yielding 9 per cent per
year.
Kenny‟s current capital structure is summarised below:

₦million
Ordinary shares (25 kobo per share) 800
Share premium 1,120
Revenue reserves 2,310
4,230
15% term loan 500
11% bond 900
5,630
92

The company‟s current share price is 190 kobo, and bond price ₦102. Kenny can
raise bond or medium-term bank finance at 10 per cent per year.
The stock market may be assumed to be semi-strong form efficient and no
information about the proposed uses of funds from the issue has been made
available to the public.
Taxation may be ignored.
Required:
a. Discuss FOUR factors that Kenny‟s directors should have considered before
deciding which form of financing to use. (6 Marks)
b. Explain what is meant by pre-emptive rights, and discuss their advantages and
disadvantages. (4 Marks)
c. Estimate Kenny‟s expected share price once full details of the placement, and
the uses to which the finance is to be put, are announced. (8 Marks)
d. Suggest two reasons why the share price might not move to the price that you
estimated in (c) above. (2 Marks)
(Total 20 Marks)

QUESTION 5
a. The following financial information relates to TAXIM Plc, a listed company:
Year 2021 2020 2019
Profit before interest and tax (₦m) 18.3 17.7 17.1
Profit after tax (₦m) 12.8 12.4 12.0
Dividends (₦m) 5.1 5.1 4.8
Equity market value (₦m) 56.4 55.2 54.0
TAXIM Plc has 12 million ordinary shares in issue and has not issued any new
shares in the period under review. The company is financed entirely by equity.
The annual report of TAXIM Plc states that the company has three financial
objectives:
Objective 1: To achieve growth in profit before interest and tax of 4% per
year
Objective 2: To achieve growth in earnings per share of 3.5% per year
Objective 3: To achieve total shareholder return of 5% per year
TAXIM Plc has a cost of equity of 12% per year.
93

Required:
Analyse and discuss the extent to which TAXIM Plc has achieved each of its
stated objectives. (9 Marks)
b. Discuss FOUR ways to encourage managers to achieve stakeholder objectives.

(6 Marks)
(Total 15 Marks)
QUESTION 6
Neko Plc has issued the following statement as part of its annual report:
„This company aims at all times to serve its shareholders by paying a high level of
dividends and adopting strategies that will increase the company‟s share price.
Satisfying our shareholders will ensure our success. The company will reduce costs
by manufacturing overseas wherever possible, and will attempt to minimise the
company‟s global tax bill by using tax haven facilities.‟
Required:
a. Discuss the validity and implications of each of the comments and strategies
in the above statement. (10 Marks)
b. Produce a short note outlining how the company should estimate its
dividend capacity. (5 Marks)
(Total 15 Marks)
QUESTION 7
Obong plc recently received a takeover bid from Abdul plc. If the bid for Obong plc
is successful, it will provide Abdul plc the needed competitive edge in research and
development to expand its laboratories into the production of the covid-19 vaccine.
The shareholders of Obong plc will only accept an offer that meets a required
return of 14% on their current shareholdings.
Obong plc recently paid a dividend of N20 and this is expected to grow at a rate of
7% for the foreseeable future.
Required:
a. Estimate the share price of Obong plc today. (2 Marks)
b. If Obong plc accepts the bid from Abdul plc, it is estimated that the new
growth rate will rise to 12% for the first 3 years and thereafter stabilise at 7%.
Calculate the new share price to the shareholders of Obong plc. (2 Marks)
c. As a financial advisor, recommend to the shareholders of Obong Plc whether
the offer from Abdul plc should be accepted. (2 Marks)
d. According to Efficient Market Hypothesis (EMH), it is believed that the
market would react instantly and accurately to the merger announcement
between Obong plc and Abdul plc.
Define briefly the THREE forms of EMH and their implications to the market.
(9 Marks)
(Total 15 Marks)
94

Formulae
𝑉𝐷
𝑉𝐸𝐺
Asset Beta
𝑉𝐸 𝑉𝐷 (1 − 𝑇)
(𝑉𝐸 + 𝑉𝐷 (1 − 𝑇)) (𝑉𝐸 + 𝑉𝐷 (1 − 𝑇)) 𝐷
Equity Beta
𝑉𝐷
𝛽𝐸 = 𝛽𝐴 + (𝛽𝐴 − 𝛽𝐷 ) (1 − 𝑡)
𝑉𝐸
Growing Annuity
𝑛
𝐴1 1+𝑔
𝑃𝑉 = 1−
𝑟−𝑔 1+𝑟

1
𝑃𝑉𝑅 𝑛
𝑀𝐼𝑅𝑅 = 1 + 𝑟𝑒 − 1
𝑃𝑉𝐼
C0 = S0N(d1) – Ee-rt N(d2)
𝑆
𝐼𝑛 0 + (𝑟 + 0.5𝜎 2 )𝑇
𝑑1 = 𝐸
𝜎 𝑇
d2= d1 - 𝜎 𝑇
The Put Call Parity
C + Ee-rt = S + P

d = 1/u
𝑎−𝑑
𝜋=
𝑢−𝑑
95

Annuity Table
r
Discount rate (r)

Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1
2 1·970 1·942 1·913 1·886 1·859 1·833 1·808 1·783 1·759 1·736 2
3 2·941 2·884 2·829 2·775 2·723 2·673 2·624 2·577 2·531 2.487 3
4 3·902 3·808 3.717 3·630 3.546 3.465 3·387 3·312 3·240 3·170 4
5 4·853 4·713 4·580 4·452 4·329 4·212 4·100 3·993 3.890 3·791 5
6 5·795 5·601 5·417 5·242 5·076 4·917 4·767 4·623 4.486 4·355 6
7 6·728 6.472 6·230 6·002 5·786 5·582 5·389 5·206 5·033 4·868 7
8 7·652 7·325 7·020 6·733 6·463 6·210 5·971 5·747 5·535 5·335 8
9 8·566 8·162 7·786 7.435 7·108 6·802 6·515 6·247 5·995 5·759 9
10 9·471 8·983 8·530 8·111 7·722 7·360 7·024 6·710 6.418 6·145 10
11 10·368 9·787 9·253 8·760 8·306 7·887 7.499 7·139 6·805 6.495 11
12 11·255 10·575 9·954 9·385 8·863 8·384 7·943 7·536 7'161 6·814 12
13 12·134 11·348 10·635 9·986 9·394 8·853 8·358 7·904 7·487 7·103 13
14 13·004 12·106 11·296 10·563 9·899 9·295 8·745 8·244 7·786 7·367 14
15 13·865 12·849 11·938 11·118 10·380 9·712 9·108 8·559 8·061 7·606 15
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1
2 1·713 1·690 1·668 1·647 1·626 1·605 1·585 1·566 1·547 1·528 2
3 2.444 2.402 2·361 2·322 2·283 2·246 2·210 2·174 2·140 2·106 3
4 3·102 3·037 2·974 2·914 2·855 2·798 2·743 2.690 2·639 2.589 4
5 3·696 3·605 3·517 3·433 3·352 3·274 3·199 3·127 3·058 2·991 5
6 4·231 4·111 3·998 3·889 3·784 3·685 3·589 3.498 3.410 3·326 6
7 4·712 4·564 4.423 4·288 4·160 4·039 3·922 3·812 3·706 3·605 7
8 5·146 4·968 4.799 4·639 4.487 4·344 4·207 4·078 3·954 3·837 8
9 5·537 5·328 5·132 4·946 4·772 4·607 4.451 4·303 4·163 4·031 9
10 5·889 5·650 5.426 5·216 5·019 4·833 4·659 4.494 4·339 4·192 10
11 6·207 5·938 5·687 5.453 5·234 5·029 4·836 4·656 4.486 4·327 11
12 6·492 6·194 5·918 5·660 5·421 5·197 4·988 4·793 4·611 4.439 12
13 6·750 6.424 6·122 5·842 5·583 5·342 5·118 4·910 4·715 4·533 13
14 6·982 6·628 6·302 6·002 5·724 5.468 5·229 5·008 4·802 4·611 14
15 7·191 6·811 6.462 6·142 5·847 5·575 5·324 5·092 4·876 4·675 15
96

97

SOLUTION 1
a) i) P/E ratio
Since ZL operates in a different industry, the comparative P/E ratio valuation
must be based upon the average P/E ratios in that industry. The P/E ratio of
7:1 will therefore be used.
Current share price 370 kobo
Earnings yield 19.2%
Earnings per share 71.04 kobo (370 × 19.2%)
Price per share 497.28 kobo (71.04 × 7)
Value of ZL ₦248.64m (₦4.9728 × 50m shares)
Problems with calculations

The problem with this approach is that P/E ratios are based on historic
performance, and take no account either of the likely impact of the takeover
on the performance of the company, or of its current earnings projections.
Comparability of companies
In this case, there is further problem in that it is not known whether the
recently taken over companies on which the ratio is based were sufficiently
similar to ZL in terms of size, rate of growth, type of activities and overall
level of risk. It may well be that the average should be adjusted to take into
account the particular situation of ZL.
ii) Dividend valuation model

The dividend valuation method (including growth) for share valuation is:
d0 (1 + g)
P0 =
Ke − g
In the case of ZL:

d0 = ₦8,420,000
g = 8%, assuming that this rate of dividend growth will continue
K e = can be estimated using the Capital Asset Pricing Model CAPM :
E ri = R𝑓 + βi (E rm − R f )
Where E(ri) = cost of equity
R𝑓 = risk free rate of return (6%)
βi = beta factor (0.8)
E rm = market rate of return (14%)
E ri = 6% + 0.8(14% - 6%) = 12.4%
₦8,420,000 (1 + 0.08)
P= = ₦206.67m
(0.124 − 0.08)
98

Weakness of dividend valuation model
The main weakness of this approach is the method used to estimate the
growth rate. This assumes that the historic rate of dividend growth will
continue at a constant rate into the future, but the current rate of dividend
growth is different from that of KK, and could well change following the
acquisition. However, the model does attempt to relate the share price to the
future stream of earnings from the business, and in this sense is more
realistic than the comparative P/E ratio basis of valuation.
iii) Operating cashflows
The first stage is to estimate what the operating cash flows will be following
the acquisition.
₦‘000
Current pre-tax operating cash flow 53,000
Post-acquisition adjustments:
Annual wage savings 7,500
Advertising/distribution savings 1,500
62,000
Taxation (33%) 20,460
Annual post tax cash flow 41,540
The other cash flows to be taken into account are:

₦„000
Year 0: Redundancy costs (after tax) (12,000)
Sale of land and buildings (after tax) 8,000

Years 1 – 3: Consultancy payments of ₦2,010,000 (₦3,000,000
× 0.67) per year after tax.
99

Discount rate
The discount rate used will be the existing weighted average cost of capital
(WACC) for ZL, although it must be recognised that this could be different
after the acquisition since KK is a much larger company and its shares are
quoted on the main market rather than the AIM. The cost of equity has
already been calculated above as 12.4%, and the cost of debt is 11% as per
the statement of financial position. The following expression will be used.
VE VD
WACC = K eg = + Kd 1 − T
VE + VD VE + VD
Where: K eg = cost of equity in geared company

K d = cost of deb𝑡
T = tax rate (33%)
VE = market value of equity (50m × ₦3.70 = ₦185m)
VD = market value of debt (₦35m)
185 35
WACC = 12.4% + 11% (1 − 0.33)
(185 + 35) 185 + 35
WACC = 11.60%
This discount rate has been calculated on the basis of market values, and
therefore, will incorporate inflation. The cash flows (with the exception of the
consultancy fees) all exclude inflation and therefore, either the nominal
discount rate that has been calculated must be adjusted to the real rate, or
the cash flows must be adjusted to include inflation.
If we adjust the discount rate to exclude the expected 2.4% rate of inflation:
1.116 ÷ 1.024 = 1.0898, i.e. the real discount rate to be used is 8.98%, say
9.0%.
PV of cash flow
The present value of the cash flows can now be found.
100

Year 1 Year 2 Year 3 Total
₦’000 ₦’000 ₦’000 ₦’000
Gross payment to directors (after tax) 2,010 2,010 2,010
11.6% discount factors 0.896 0.803 0.720
PV cash flow 1,801 1,614 1,447 (4,862)
Ongoing cash flows for 10 years at 9%
(41,540 × 6.418) 266,604
Income from land and buildings 8,000
Redundancy costs (12,000)
Total PV of relevant operating cash 257,742
flows
Problems with calculations
Although this is theoretically the best method of valuation to use, the
calculations are in reality quite crude. Any likely changes in the pattern of
the cash flows following the acquisition are ignored, as are any strategic
plans that the company may have for such a long time frame. Ten years is a
long period over which to estimate cash flows, inflation rates and discount
rates, and there will inevitably be a large margin for error in the figures.
End of period
In addition, the question of what happens at the end of the ten year period is
not addressed. Is there an appropriate terminal value that could be used in
the calculations to reflect the ongoing value of ZL as a business?
v) Comparison with offer price
Two of the valuation methods used, including the present value of the
operating cash flows (which is possibly the best of the three approaches)
give a valuation greater than the proposed offer price of ₦220m. If KK can
successfully complete negotiations at this price, and if the acquisition of ZL
would be in line with KK‟s long-term strategic objectives, then it is
recommended that the offer should go ahead.
b) The regulation of takeovers usually includes the following factors:

 At the most important time in the company‟s life – when it is subject to a
takeover bid – its directors should act in the best interest of their
shareholders, and should disregard their personal interests;
 All shareholders must be treated equally;
 Shareholders must be given all the relevant information to make an
informed judgement;
 The board of the target company must not take action without the
approval of shareholders, which could result in the offer being defeated;
 All information supplied to shareholders must be prepared to the highest
standards of care and accuracy;
 The assumptions on which profit forecasts are based and the accounting
policies used should be examined and reported on by accountants; and
 An independent valuer should support valuations of assets.
101

Examiner’s report
The question tests many aspects of business valuation.
In part (a), candidates are expected to value the given company using three
different methods.
Part (b) of the question tests the candidates‟ knowledge of regulation of take overs.
Being a compulsory question, a large number of the candidates attempted it but

the level of performance was disappointedly low.
In part (a) of the question, candidates lost marks due to the following factors:
 Use of wrong P/E ratio
 Inability to derive the EPS from the given earnings yield
 Failure to identify the relevant cash flows when using the operating cash
flows method
 Using the wrong WACC.
In part (b), most of the candidates could not provide any meaningful
response.
Candidates need to practise past questions using the Pathfinder and cover the
syllabus comprehensively.
Marking guide
Marks Marks
(a) i. Computation of the value of ZL based on the use
of the comparative P/E ratios:
Selecting the average P/E of companies recently
taken over, based upon the offer price for ZL ½
Stating the current share price ½
Stating the earnings yield ½
Computation of the EPS ½
Computation of price per share ½
Computation of the value of ZL ½ 3
ii. Computation of the value of ZL based upon the

dividend valuation model
Computation of the cost of equity using CAPM 2
Computation of the ZL value 2 4
iii. Computation of the value of ZL using the PV of the

relevant operating cash flows:
Estimation of the operating cash flows 3
Computation of the discount rate using the WACC 2
Calculation of the real discount rate 1
102

Computation of the PV of the cash flow 4 10
iv. Evaluation of the three valuation methods:

Evaluation of the comparative P/E ratios 2
Evaluation of the dividend valuation model 2
Evaluation of the PV of operating cash flows 3 7
v. Recommendation on whether KK should go ahead

with the offer 2
(b) Factors that are considered in the regulation of 4

takeovers
Total 30
SOLUTION 2
a) Fundamental analysis involves the study of a company‟s earnings, dividends

and other financial information to predict future share prices. Fundamental
analysts investigate companies in depth and use various valuation models to
estimate the „intrinsic, realistic or underlying‟ value of a share, which they
believe might differ from the current market price. If the intrinsic value is
estimated to be above the current share price the advice would be to buy the
share in question. Many techniques are used to estimate intrinsic value
including dividend growth models, earnings yield models and regression
models.
The most important form of technical analysis is Chartism. Chartism involves the
study of historic share price and volume information to see if any patterns or
relationships exist. Chartists believe that historic share price behaviour, as
revealed by such patterns, will repeat itself and they analyse charts of current
share price movements to identify whether established historic patterns are
currently occurring. If such patterns are identified the chartists believe that the
historic patterns will reveal future share price movements. Knowledge of
company earnings or other economic data is not required. Technical analysis is
often said to have no underlying economic logic.
b) Cost of equity
• The asset beta of EHP (= 0.763) given in Table 1 reflects the systematic
business risk of the hotel industry. This will be used to calculate the equity
beta of AHP. Note that the other data given in the table are irrelevant since
we are already given the asset beta of the proxy.
103

VD
βE = βA + (βA − βD ) (1 − t)
VE
where
βA = asset beta of the proxy = 0.763
βD = beta of debt of AHP = 0.2
VD/VE = debt/equity ratio of AHP = 0.16
t = effective tax rate of AHP = 0.35
βE = 0.763 + (0.763 – 0.2)(0.16)(1 – 0.35) = 0.82
• KE = 12 + 0.82(5) = 16%
Current growth rate

From the dividend history:
g = (11,200/9,340)1/2 – 1 = 9.5%
Dividend per share

Number of shares = 80m/0.5 = 160 million
Current dividend per share = ₦11,200/160,000 = ₦0.07
This means that the current ex-dividend value per share = 217 – 7 = 210 kobo
Calculation of intrinsic value per share

This is given as the present value of future dividends:
Kobo
1
1
Year 1 7 1.25 = 7.54
1.16
1 2
2
2 7 1.25 = 8.13
1.16
7 1.25 2 (1.095) 1 2
3 − infinity × = 136.93
0.16−0.095 1.16
Intrinsic value per share 152.60
The significance to the fundamental analyst would be that AHP‟s shares,

currently trading at 210 kobo (ex-div), are overpriced and are likely to fall in
value. The analyst would recommend investors owning AHP‟s share to sell their
shares.
c) The semi-strong form of the EMH suggests that share prices quickly and without
bias, fully reflect all relevant publicly available information.
The strong form of the EMH goes one sta ge further in suggesting that share
prices fully reflect all information, including insider information.
If the EMH is correct, in either the semi-strong or strong form, the current
market price will already correctly value AHP‟s shares and there is nothing to be
104

gained by attempting to estimate an intrinsic value. The EMH is not consistent
with fundamental analysis and, in an efficient market, there is no need to
recommend that the share be sold as the share is not overvalued.
A necessary feature of an efficient market is that relevant new information is

quickly and accurately disseminated to interested parties. Financial analysts are
an important means by which such information is communicated, and therefore
help to make the market efficient.
Analysts still serve a useful purpose although their forecasts of future share
prices are of little value in an efficient market.
Examiner’s report
This is a 3-part question. In part (a), candidates are expected to explain
fundamental analysis and technical analysis.
In part (b), they are expected to determine, using dividend valuation model, the
intrinsic value of a company‟s shares. They are also expected to comment on the
relevance of intrinsic to the fundamental analyst.
In part (c), candidates are expected to demonstrate their knowledge of the efficient
market hypothesis.
Only about 20% of the candidates attempted the question. It is absolutely clear that
the candidates lacked any knowledge of this aspect of the syllabus.
In part (b), candidates lost valuable marks due to:

 Inability to calculate the appropriate cost of capital
 The use of WACC rather than cost of equity.
 Failure to calculate the correct growth rate of dividend.
 Inability to handle 2-growth dividend valuation model.
Once again it is important that students preparing for this examination should
cover the syllabus comprehensively.
Marking guide
Mark Marks
s
(a) Explaining what fundamental analysis and technical
analysis are 4
(b) Computation of intrinsic value:

Calculation of effective tax rate of AHP ½
Calculation of the equity beta of AHP 2
Calculation of cost of equity 1
Computation of current growth rate 1
Computation of number of shares ½
105

Computation of current dividend per share ½
Computation of the current ex-dividend value per share ½
Calculation of intrinsic value per share 4
Comment on the estimate for the fundamental analyst 2 12
(c) Explanation on whether your answer is consistent with

semi-strong and strong forms of EMH and their usefulness 4
Total 20
SOLUTION 3
a) i)
 Expected annual sales (₦000) = (16,000 × 0.25) + (12,000 × 0.5) +
(8,000 × 0.25) = ₦12,000
 Expected annual contribution = ₦12,000 × 0.5 = ₦6,000
 Expected annual cash profit = ₦6,000 – 1,800 = ₦4,200
All the above figures are in real terms. Due to the one-year delay in the
payment of tax, the cash profits will be converted to money cash flows and
tax calculated on the money cash profits. The money cash profits are
expected to grow annually by the rate of inflation of 5%.
Calculation of NPV (₦000)

Year 1 2 3 4 5 6
Cash profits 4,410 4,631 4,862 5,105 5,360 -
Tax at 20% - (882) (926) (972) (1,021) (1,072)
Scrap value - - - - 1,404* -
NCF 4,410 3,749 3,936 4,133 5,743 (1,072)
PVF at 15.50% 0.866 0.750 0.649 0.562 0.487 0.421
PV 3,819 2,812 2,554 2,323 2,797 (451)
Total PV ₦13,854
Initial outlay (11,000)
NPV 2,854_
106

(* = 1,100 × (1.05)5 = ₦1,404)
Alternative Approach – Using real cash flows

An alternative approach is to make use of real cash flows and real cost of capital.
 Real cost of capital =
 Tax payment in real terms. Due to the one year delay in payment of tax, the
real tax liability each year, from year 2 - 5 = (₦4,200 × 0.2) × (1.05)-1
= ₦800
Calculation of NPV (₦000)
Outlay 0 (11,000) 1 (11,000)
Cash profit 1-5 4,200 3.791 15,922
Tax 2-6 (800) 3.446* (2,757)
Scrap value 5 1,100 0.621 683__
NPV 2,848_
(* Annuity factor at 10%, years 2 - 6)
The small difference in NPV is due to rounding errors
Recommendation
The project has a positive NPV and if other factors are held constant, it should
be accepted.
ii) Sensitivity – contribution

- Using real cash flows approach (₦000)
Annual real contribution = ₦6,000
Related annual real tax (Years 2 - 6) = ₦6,000 × 0.2 × (1.05)-1 = ₦1,143
Calculation of present value
Contribution 1-5 6,000 3.791 22,746
Related tax 2-6 (1,143) 3.446 (3,939)
Total PV 18,807
Sensitivity = NPV/PV of contribution = ₦2,848/₦18,807 = 15.14%

This means that the total annual contribution can drop by maximum of 15.14%
to avoid negative NPV.
Thus, the minimum annual contribution = ₦6,000,000 × (100% - 15.14%)

= ₦5,091,600.
107

 Sensitivity – tax rate
- Using real cash approach (₦000)
Sensitivity = NPV/PV of tax
= ₦2,848/2,757 = 103.30%
This means that the tax rate can increase by maximum of 103.30% if the
project is to remain viable. The maximum tax rate is therefore:
20% × (100% + 103.30%) = 40.66%.
This means that if the project is to remain viable, the maximum tax rate
allowed is 40.66%.
b) Note:
The annual written down allowances are fixed and do not increase with
inflation. They are already in money terms. Consequently, they decline in
real terms over the years. If real cash flows approach is adopted, the
annual written down allowances (or better still, the related tax savings)
must be converted to real cash flows by dividing by:
(1 + inflation rate)n. An alternate and easier approach to calculate their

impact, is to discount them (note that they are already expressed in
nominal terms) at the nominal discount rate. That is the approach adopted
here.
Computation of written down allowances
Tax
WDA Savings Year
₦000 ₦000 at 20% due
Cost 11,000 - - -
Year 1: WDA, 25% (2,750) 2,750 550 2
8,250
Year 2: WDA, 25% (2,063) 2,063 413 3
6,187
Year 3: WDA, 25% (1,547) 1,547 309 4

4,640
Year 4: WDA, 25% (1,160) 1,160 232 5
3,480
Year 5: Scrap value (1,404)
Bal. allowance (2,076) 2,076 415 6
108

Calculation of PV (₦000)
Year 2 3 4 5 6
Tax savings 550 413 309 232 415
PVF at 15.50% 0.750 0.649 0.562 0.487 0.421
PV 413 268 174 113 175
Total PV = ₦1,143 or ₦1,143,000

This means that the NPV of the project will increase by ₦1,143,000 as a result of
tax savings associated with written down allowances.
Examiner’s report
This question tests candidates‟ knowledge of capital budgeting involving taxation,
inflation, and risk and uncertainty.
Candidates are expected to compute the relevant cash flows and eventually the NPV
of the project.
A very high proportion of the candidates attempted the question but performance
was only average.
Many of the candidates that attempted the question failed to achieve any
reasonable marks due to the following reasons:
 Lack of clear understanding of the treatment of inflation.

 Wrong calculation of tax cash flows
 Wrong calculation of tax depreciation
 Discounting real cashflows with money cost of capital.
It is recommended that students should cover the syllabus comprehensively and

practise past questions.
Marking guide
Marks Marks
(a) i. Evaluation of the proposed expansion:
Computation of expected annual sales 1
Computation of expected annual contribution ½
Computation of annual cash profit ½
Calculation of NPV 7½
Recommendation ½ 10
ii. Computation and interpretation of sensitivity of
the project to changes in expected annual 3
contribution
Computation and interpretation of sensitivity of
the project to changes in the tax rate 2 5
109

(b) Computation of written down allowances 3
Calculation of the PV of tax savings 1½
Explanation of the NPV change as a result of tax
savings ½ 5
Total 20
SOLUTION 4
a. When choosing between alternative forms of finance, the directors of Kenny

might consider the following:
i) Cost. If the market is efficient then the cost paid for any individual financing
source will be the appropriate cost for that source, taking into account the
relative risks of alternative sources. The fact that debt finance is normally
cheaper than equity finance does not necessarily mean that debt finance
should be chosen. Cost is important as it affects the company's overall cost of
capital and therefore, its market value per share. Assuming that financial
structure influences the market value of a company, the company should
attempt to select the financing combination that minimises its overall cost of
capital;
ii) Risk. The effect of financing upon risk can be measured in several ways,
including financial gearing, interest cover, cash-flow cover, and the
company's beta coefficient (systematic risk);
iii) Control. The ownership structure of the company's shares, and hence the
control of the company, will differ according to the financing method
selected;
iv) Market conditions. If share prices are falling, an equity issue might not
succeed or, if interest rates are expected to fall, a fixed-rate debt issue might
be unwise. Market conditions can, therefore, influence the financing choice;
v) Speed of raising finance. Some forms of finance can be raised more
quickly and easily than others. If the need for funds is urgent, speed of
raising finance might outweigh some other considerations; and
vi) Flexibility. Can the finance be redeemed easily and cheaply, or swapped
into another form of commitment (e.g. an interest rate swap)?
(Note: Reasonable alternative factors will be rewarded)
b. Pre-emptive rights mean that companies wishing to make a further issue of

equity shares for cash must first offer the shares to existing shareholders in
proportion to their existing holdings.
110

Their advantages might include:
i) They allow shareholders to maintain a certain percentage holding in
a company.
This might be particularly important to companies that are controlled by a
few large investors, and to institutional investors;
ii) Alternative forms of share issue might have to be made at a lower price than
a rights issue in order to attract new investors, if pre-emptive rights did not
exist.
Disadvantages might include:

i) They are a form of restrictive practice that is not appropriate to modern stock
markets;
ii) Companies can raise finance more quickly and more cheaply when
pre-emptive rights do not exist, for example, through placements.
c. In a semi-strong market the share price should accurately reflect new relevant
information when it becomes publicly available. This would include the effect
on Kenny of the expansion scheme and the redemption of the term loan.
₦m ₦m
Existing value of equity = ₦1.90 × 3,200m shares 6,080
NPV of new project 110
Proceeds of the new issue 1,500
Issue cost (4%) (60)
Future cash flows avoided at present value:
- interest ₦500m × 15% × 3.791* 284.325
- redemption value ₦500m × 0.621** 310.500 594.825
Redemption cost now (500)
Penalty cost now (35) (535.000)
Expected total market value 7,689.825
* Annuity factor at 10% for 5 years

** PV factor at 10% for year 5
The appropriate discounting rate to use is the rate of interest at which the
company can otherwise borrow equivalent amount.
d. i) Changes in factors affecting the value of the company‟s shares between the
setting of the terms of issue and the issue date;
ii) existing shareholder reaction to the issue;
iii) the effect of the extra volume of shares on their marketability;
111

iv) whether forecast earnings from the new funds are considered realistic by the
market.
Examiner’s report
The question tests various aspects of sources of finance. Candidates are expected to
discuss factors that determine the sources of finance to use in a given scenario.
They are expected to discuss pre-emptive rights and the advantages and
disadvantages.
Almost all the candidates attempted the question. It is however, surprising that
students‟ performance was very disappointing. It is very worrisome that candidates
at this level of the examination do not understand „pre-emptive rights‟.
In part (c ), candidate did not provide any meaningful calculations.
Once again we advise that students preparing for this examination should cover the
entire syllabus in their revision.
Marking guide
Marks Marks
(a) Discussion on the four factors to be considered
before deciding which form of financing to use 6
(b) Explanation of pre-emptive rights 2

Advantages of pre-emptive rights 1
Disadvantages of pre-emptive rights 1 4
(c) Computation of expected share price:

Calculation of existing value of equity 1
Stating NPV of new project ½
Stating proceeds of the new issues ½
Calculation of issue cost 1
Calculation of future interest 1
Calculation of future redemption value 1
Redemption cost now ½
Penalty cost now ½
Calculation of the expected total market value ½
Calculation of the expected share price ½
Implications of announcement of placements of
Kenny‟s share and the semi-strong form hypothesis 1 8
(d) Explanation on the two reasons why share price

might not move 2
Total 20
112

SOLUTION 5
a) Objective 1
TAXIM Plc has stated an objective to achieve growth in profit before interest and
tax of 4% per year. Analysis shows that profit before interest and tax growth was
3.4% in 2021 (18.3m/17.7m) and 3.5% in 2020 (17.7m/17.1m). TAXIM Plc has
therefore, not achieved this objective in either year.
Objective 2
Year 2021 2020 2019
Profit after tax ₦12.8m ₦12.4m ₦12.0m
Number of shares 12m 12m 12m
Earnings per share (kobo) 106.67 103.33 100.00
Annual growth 3.2% 3.3%
TAXIM Plc has stated an objective to achieve growth in earnings per share of
3.5% per year. Analysis shows that growth in earnings per share was 3.2% in
2021 (106.67kobo/103.33kobo) and 3.3% in 2020 (103.33kobo/100.00kobo).
TAXIM Plc has therefore, not achieved this objective in either year.
Objective 3
TAXIM Plc has stated an objective to achieve growth in total shareholder return
(TSR) of 5% per year. Analysis shows that growth in TSR was 11.4% in 2021 and
11.7% in 2020. TAXIM Plc has therefore, achieved this objective in both 2021
and 2020.
Year 2021 2020 2019

Equity market value ₦56.4m ₦55.2m ₦54.0m
Share price ₦4.70 ₦4.60 ₦4.50
Dividends ₦5.1m ₦5.1m ₦4.8m
Dividend per share(kobo) 42.5 42.5 40.0
On a per share basis:

2021 TSR = 100 x (470 – 460 + 42.5)/460 = 11.4%
2020 TSR = 100 x (460 – 450 + 42.5)/450 = 11.7%
Alternatively, using total values:
2021 TSR = 100 x (56.4m – 55.2m + 5.1m)/55.2m = 11.4%
2020 TSR = 100 x (55.2m – 54.0m + 5.1m)/54.0m = 11.7%
b) The achievement of stakeholder objectives by managers can be encouraged by

managerial reward schemes, for example, share option schemes and
performance-related pay (PRP), and by regulatory requirements, such as
113

corporate governance codes of best practice and stock exchange listing
regulations.
Share option schemes

The agency problem arises due to the separation of ownership and control, and
managers pursuing their own objectives, rather than the objectives of
shareholders, specifically the objectives of maximising shareholder wealth.
Managers can be encouraged to achieve stakeholder objectives by bringing their
own objectives more in line with the objectives of stakeholders such as
shareholders. This increased goal congruence can be achieved by turning the
managers into shareholders through share option schemes, although the criteria
by which shares are awarded need very careful consideration.
Performance-related pay (PRP)
Part of the remuneration of managers can be made conditional upon their
achieving specified performance targets, so that achieving these performance
targets assists in achieving stakeholder objectives. Achieving a specified increase
in earnings per share, for example, could be consistent with the objective of
maximising shareholder wealth. Achieving a specified improvement in the
quality of emissions could be consistent with a government objective of meeting
international environmental targets.
However, PRP performance objectives need very careful consideration if they are
to be effective in encouraging managers to achieve stakeholder targets. In recent
times, long-term incentive plans (LTIPs) have been accepted as more effective
than PRP, especially where a company‟s performance is benchmarked against
that of its competitors.
Corporate governance codes of best practice
Codes of best practice have developed over time into recognised methods of
encouraging managers to achieve stakeholder objectives, applying best practice
to many key areas of corporate governance relating to executive remuneration,
risk assessment and risk management, auditing, internal control, executive
responsibility and board accountability. Codes of best practice have emphasised
and supported the key role played by non-executive directors in supporting
independent judgement and in following the spirit of corporate governance
regulations.
Stock exchange listing regulations

These regulations seek to ensure a fair and efficient market for trading company
securities such as shares and loan notes. They encourage disclosure of price-
sensitive information in supporting pricing efficiency and help to decrease
information asymmetry, one of the causes of the agency problem between
114

shareholders and managers. Decreasing information asymmetry encourages
managers to achieve stakeholder objectives as the quality and quantity of
information available to stakeholders gives them a clearer picture of the extent
to which managers are attending to their objectives.
Monitoring
One theoretical way of encouraging managers to achieve stakeholder objectives
is to reduce information asymmetry by monitoring the decisions and
performance of managers. One form of monitoring is auditing the financial
statements of a company to confirm the quality and validity of the information
provided to stakeholders.
Note: Only four ways to encourage the achievement of stakeholder objectives
were required to be discussed.
Examiner’s report
Part (a) of the question tests candidates‟ knowledge of basic corporate financial
objectives. Part (b) tests candidates‟ knowledge of how to align managers‟ and
shareholders‟ objectives. Almost all the candidates attempted the question and
performance was average.
In part (a), candidates lost valuable marks because they could not calculate the
basic metrics needed to measure the identified objectives such as growth rates and
total shareholders returns etc.
Part (b) of the question was well answered in most cases.
It is recommended that students should not neglect any section of the syllabus.
Marking guide
Marks Marks
(a) Analysis and discussion on whether objective 1 was
achieved 2
Analysis and discussion on whether objective 2 was
achieved 3
Analysis & discussion on whether objective 3 was
achieved 4 9
(b) Discussion on four ways to encourage managers 6

Total 15
115

SOLUTION 6
a) i) Serving its shareholders by paying high dividends

This assumes that shareholders demand high dividends, whereas
some may not do so and may prefer appreciation of the value of
their shares, particularly if dividends are highly taxed.
A policy of continuing to pay high dividends will mean that
shareholders and the stock market may expect these levels to
continue indefinitely; if dividends fall, these thwarted
expectations may lead to the share price falling as well.
However in the long-term high dividends levels may prove

unsustainable, because insufficient monies are being retained for
investment in projects that will yield the cash surpluses necessary for
dividends.
ii) Adopting strategies that will increase the company‟s share price
Maximising share price is not the same as maximising shareholder
wealth. In addition Gordon‟s growth rate model suggests that the
growth of dividends, and hence share price, is dependent on the
proportion of funds retained; the higher the proportion retained, the
more can be invested in projects that generate surpluses and hence
higher long-term dividends.
iii) Satisfying our shareholders will ensure our success
Other stakeholders, as well as shareholders, are affected by Neko Plc
activities and they will impact on Neko Plc success to varying degrees.
Loss of key employees because of poor working conditions may
impact adversely, also suppliers stopping credit because Neko Plc has
been a slow payer. Neko Plc will also have to fulfil legal and
regulatory requirements imposed by the government and
regulators; failure to do may lead to heavy costs and ultimately
threaten its existence. Neko Plc may also be more attractive to
consumers if it follows what is regarded as ethical and environmental
best practice.
iv) Reducing costs by manufacturing overseas
Manufacturing overseas may reduce the costs of factors of production.
However Neko Plc will have to bear costs of investment, and also
perhaps increased selling and distribution costs. There may also be
increased costs arising from controlling the quality of overseas output
and managing the overseas operations. Neko Plc directors should also
consider the risk implications; perhaps political instability might
116

threaten the value of Neko Plc investment. In addition there are
threats to Neko Plc reputation due to ethical concerns over loss of
home country employment and wealth generation.
v) Minimising global tax bill by using tax haven facilities
Tax haven facilities may mean that Neko Plc has a reduced burden of
certain taxes, including corporate taxes, capital gains taxes and taxes
on remittances. Neko Plc may also benefit from improved tax
efficiencies, if it has a number of subsidiaries and can channel
transactions through the tax haven.
However, there will be some incorporation costs and the benefits of

the tax haven may decrease over the long-term as governments close
tax loopholes and restrict the use of havens. Perhaps also the ethical
climate is becoming less favourable to tax havens because of the loss
of tax to governments and the secrecy surrounding the affairs of some
companies who use tax havens, so Neko Plc might suffer some loss of
reputation when using them.
b) Dividend capacity
The free cash flow is the amount of money that is available for distribution
to the capital contributors. If the project is financed by equity only, then
these funds could be potentially distributed to the shareholders of the
company.
However, if the company is financing the projects by issuing debt, then the
shareholders are entitled to the residual cash flow left over after meeting
interest and principal payments. This residual cash flow (free cash flow to
equity) represents dividends that could potentially be paid to shareholders.
This is usually not the same as actual dividends in a given year because
normally the management of a company deliberately smoothes dividend
payments across time.
The free cash flow to equity is a measure of what is available to the
shareholders after providing for capital expenditures to maintain existing
assets and to create new assets for future growth. Thus, if a firm has
substantial working and capital expenditure requirements then the free
cash flow can be negative even if the earnings are positive.
Accurate financial forecasts covering timing and size of all cash flows are
essential in order to determine the dividend capacity of a company.
117

Examiner’s report
Part (a) of the question tests candidates‟ knowledge of how to assess various stated
corporate objectives.
Part (b) on the other hand asks candidates to explain how dividend capacity can be
estimated.
Part (a) of the question was barely properly attempted by a good number of the
candidates.
In part (b), performance was extremely poor thereby indicating that candidates had
no idea of the subject matter. This is despite the fact that „Free Cash Flow to Equity‟
(FCFE) is a regular topic in this examination.
Effective revision, using past questions and the pathfinder will always enhance
candidates‟ performance in the examination.
Marking guide
Marks
(a) Discussion on the validity and implications of each 10
strategy
(b) Short note outlining how the company should estimate

its dividend capacity 5
Total 15
SOLUTION 7
a) Current share price:
P0 = D1 /(r − g)
= 20(1.07)/(0.14 – 0.07)
= ₦305.71
b) Revised share price

PV of future dividends:
N
Year 1 20 (1.12)/1.14 = 19.65
2 20(1.12)2/ (1.14)2 = 19.30
3 20(1.12)3/ (1.14)3 = 18.97
57.92
Year 4 – Infinity:
20 1.12 3 1.07
1.14 −3
= 289.90
0.14 − 0.07
347.82
118

c) The offer for takeover is expected to increase the share price from ₦305.71 to
₦347.82 and if all other factors remain constant, the offer should be
accepted.
d) The three forms of EMH are:
1) Weak-Form EMH
The weak-form EMH asserts that current stock price fully reflects all
security market information, including the historical sequence of
prices, rates of return, trading volumedata, and other market
generated information, such as block trades, and transactions by
exchange specialists. Because it assumes that current market prices
already reflect all past returns and any other securities market
information. This hypothesis implies that past rates of return and
other historical market data should have no relationship with future
rates of return (that is rates of return should be independent). A
primary implication of the weak form of the EMH is that an investor
cannot consistently earn excess returns using technical analysis
trading rules.
2) Semistrong-Form EMH
The semistrong form of the EMH states that current market prices
reflect all publicly available information. The semistrong hypothesis
encompasses the weak-form hypothesis, because all the market
information considered by the weak-form hypothesis, such as stock
prices, rates of return, and trading volume, is public. Public
information also include all non-market information such as earnings
and dividend announcements, P/E ratios, dividend yield ratios, stock
splits, news about the economy, and political news. The hypothesis
implies that investors who base their decisions on any important
information after it is public should not derive above-average risk-
adjusted profits from their transactions, considering the cost of
trading because the security price already reflects all such new public
information.
A key implication of the semi-strong form is that the calculation of

intrinsic value of shares in order to identify mispricing is fruitless in
an efficient market.
119

3) Strong-Form EMH
The strong-form EMH contends that stock prices fully reflect all
information from public and private sources. This means that no
group of investors has monopolistic access to information relevant to
the formation of prices, Therefore, this hypothesis contends that no
group of investors should be able to consistently derive above-
average risk-adjusted rates of return. The strong form EMH
encompasses both the weak-form and the semistrong-form EMH.
Further, the strong-form EMH extends the assumption of efficient
markets, in which prices adjust rapidly to the release of new public
information, to assume perfect markets, in which all information is
cost-free and available to everyone at the same time.
Examiner’s report
The question tests candidates‟ knowledge of share valuation using dividend
valuation model and the Efficient Market Efficiency (EMH). Almost all the
Part (a) of the question was well answered with most of the candidates scoring the
allocated 2marks. However, in parts (b) most of the candidates could not handle 2 –
stage growth and thereby losing valuable marks.
In part (b) a good number of the candidates provided the required solution and
scored decent marks.
It cannot be overstated that students need to cover the syllabus comprehensively

before presenting themselves for the examination.
Marking guide
Marks
(a) Estimation of current share price 2
(b) Computation of the revised share price 1
(c) Recommendation to shareholders 2
(e) Definition and discussion on implications to the

market of the three forms of EMH 9
Total 15
120

ICAN/232/V/C3 Examination No...........................

EXAMINATION INSTRUCTIONS
PLEASE READ THESE INSTRUCTIONS BEFORE THE COMMENCEMENT OF THE PAPER
1. Check your pockets, purse, mathematical set, etc. to ensure that you do not
have prohibited items such as telephone handset, electronic storage device,
programmable devices, wristwatches or any form of written material on you
in the examination hall. You will be stopped from continuing with the
examination and liable to further disciplinary actions including cancellation
of examination result if caught.
2. Write your EXAMINATION NUMBER in the space provided above.
3. Do NOT write anything on your question paper EXCEPT your

examination number.
4. Do NOT write anything on your docket.
5. Read all instructions in each section of the question paper carefully before
6. Do NOT answer more than the number of questions required in each section,
otherwise, you will be penalised.
7. All solutions should be written in BLUE or BLACK INK. Any solution written
in PENCIL or RED INK will not be marked.
8. A formula sheet and discount tables are provided with this examination
paper.
WEDNESDAY, NOVEMBER 15, 2023
DO NOT TURN OVER UNTIL YOU ARE TOLD TO DO SO
79


QUESTION 1
Finkex Plc (FP) is a listed company which operates in the pharmaceutical sector,
manufacturing a broad range of drugs under licence in a number of countries along
the ECOWAS sub-region. For a number of years the company has grown organically.
Three years ago, the company acquired 20% of the issued share capital of Toba Plc
(TP) for N110 million, as a route to both expansion and diversification. The
acquisition was by private negotiation in exchange for an issue of its own shares.
Toba Plc is involved in a different area of the pharmaceutical sector from FP as it is
primarily a research-driven company involved in the development of new drugs.
To fasten the realisation of its diversification strategy, the directors of FP have now
decided to acquire the remaining 80% of Toba is share capital.
Extracts from the financial statements of Finkex Plc are given below:
Finkex Plc
Extracts from financial statements for last two years
Year 2023 2022
N’m N’m
Non-current assets (including investment in Toba plc) 602.8 499.4
Current assets 265.0 180.4
867.8 679.8
Current liabilities 199.2 136.8
668.6 543.0
Non-current liabilities 149.5 159.4
Net assets 519.1 383.6
Issued share capital
(ordinary shares of ₦1 each) 100.0 73.6
Share premium 84.0 12.4
Profit or loss account 335.1 297.6
519.1 383.6
80

Sales revenue 1320.6 496.0
Earnings after tax 51.50 37.60
Dividend 14.0 14.0
Retained profits 37.5 23.6
All that you know about Toba plc is that it has 114 million shares in issue; total
share capital and reserves are N684 million; earnings after tax in the most recent
year were ₦85.2 million on sales of N1,252.0 million, which were double those of
the previous year; and that it has an investment valued at N80 million (book and
market) in a type of enterprise which might not be of interest to Finkex Plc.
The current stock market prices per share are: Finkex Plc 300k; Toba plc 341k. Both
companies pay tax at 50%.
Required:
a. At the above market prices, how many shares of Finkex Plc would have to be
issued to buy the rest of Toba plc on a share-for-share offer? (4 Marks)
b. With regard to earnings and also the book value of assets per share, how
would the above share-for-share offer affect the position of:
i. existing shareholders in Finkex Plc; (6 Marks)
ii. the 80% shareholders in Toba Plc whose shares were to be acquired?
(4 Marks)
c. Assuming that the 80% shareholders in Toba Plc were prepared to accept ₦80
million 10% Loan Stock as part of the consideration:
i. What advantages might there be for Finkex Plc in this arrangement?

(2 Marks)
ii. What total price could Finkex Plc afford to pay without diluting the
earnings per share of its existing shareholders, as calculated in (b) (i)
above? (6 Marks)
d. If the board of Toba Plc decided to advise its shareholders not to accept an
offer from Finkex Plc, what arguments might they use - including any derived
from the financial information available about Finkex Plc? (8 Marks)
(Total 30 Marks)
81

INSTRUCTION: YOU ARE REQUIRED TO ATTEMPT ANY TWO OUT OF

THE THREE QUESTIONS IN THIS SECTION
QUESTION 2
About one year ago, you were employed by Tesco, an American company based in
New York. You work on-line from home in Nigeria and you are a member of the
international treasury of Tesco.
Tesco supplies medical equipment to the USA and Europe. It also buys some basic
raw materials from Europe.
It is currently 30 November 2024.
On 31, May 2025 Tesco is due to receive CHF16.3 million from a Swiss customer and
also to pay CHF4.0 million to a Swiss supplier.
Exchange rates (quoted as US$/CHF1)

Spot 1.0292 – 1.0309
Three months forward 1.0322 – 1.0341
Six months forward 1.0356 – 1.0378
Annual interest rates available to Tesco:
Investing rate Borrowing rate

Switzerland 3.2% 4.4%
USA 4.6% 5.8%
Currency futures (contract size CHF125,000, futures price quoted as US$ per CHF1)
Future price
December 1.0306
March 1.0336
June 1.0369
Currency options (contract size CHF125,000; exercise price quotation US$ per CHF1,
premium: US cents per CHF1).
82

Calls Puts
Exercise price December March June December March June
1.0375 0.47 0.50 0.53 0.74 0.79 0.86
Required:
Advise Tesco, showing relevant calculations, which of the under listed hedging
strategies the company should adopt for its CHF cash flows on 31 May 2025:
i. Forward contracts (3 Marks)
ii. The money market (5 Marks)
iii. Traded futures (6 Marks)
iv. Traded options (6 Marks)
In the case of options, assume the options are exercised.
Note: Any amount not hedged by a future or option contract will be hedged on the
forward market. (Total 20 Marks)
QUESTION 3
Niko Plc is a large company operating across the country. It is purely equity
financed and has year-end of 31 December.
Currently the company has to fulfill a particular contract in Abuja, and it can do this
in one of two ways.
Under the first (proposal A), it can purchase plant and machinery; while under the
second (proposal B), it can use a machine already owned by the company.
The end-year operating net cash inflows in nominal (i.e. money) terms and before
corporate tax are as follows:
2024 2025 2026

N’000 N’000 N’000
Proposal A 200,000 275,000 350,000
Proposal B 350,000 350,000 -
(Assume today is 31 December 2023).
Proposal A
Under this proposal the company will incur an outlay of N312,500,000 on 31
December 2023 for the purchase of plant and machinery.
83

The labour force required under the proposal will have to be recruited locally, and
budgeted wages have been taken into account in preparing the estimates of future
nominal net cash inflows given above.
The plant and machinery is expected to be scrapped on 31 December 2026, the

nominal cash proceeds at that date being projected as N25,000,000.
Proposal B
The second proposal covers a two year period from 31 December 2023. It will
require the company to use a machine which was purchased for ₦750 million a
number of years ago and has been fully written down for tax purposes. The
company has no current use for the machine, and its net realisable value at 31
December 2023 is N250 million.
However, if retained unused there would be no incremental costs of keeping it, and
it would be sold on 1 January 2025 for an estimated N300 million in nominal
money terms. If used under the second proposal, the expected residual value of the
machine would be zero at the end of the two year period.
The labour force required under the second proposal would be recruited from
elsewhere within the company, and in end-year nominal cash flow terms would be
paid ₦100 million and N108 million respectively for 2024 and 2025. However, the
staff that would have to be taken on in other departments to replace those switched
over to the new project would in corresponding end-year nominal cash flow terms
cost N110 million for 2024 and N118.80 million for 2025.
The end-year nominal net cash inflows of N350 million for both 2024 and 2025
which are associated with the second proposal are after deducting the
remuneration of the work force actually employed on the scheme.
Working Capital
Working capital requirements in nominal money terms at the beginning of each
year are estimated at 10% of the end-year operating net cash inflows referred to in
the table above. The working capital funds will be released when a proposal is
completed.
Other information
Expected annual inflation rates over the next four calendar years are:
2024 2025 2026 2027

10% 8% 6% 5%
84

The company‟s real cost of capital is 10% per annum and is expected to remain at
that rate for the foreseeable future.
Income tax is expected to be 40% over the planning period, tax being payable
twelve months after the accounting year end to which it relates.
Capital allowances are available on plant and machinery at 20% reducing balance.
You can assume that the company generates sufficient taxable profits to relieve all
capital allowances at the earliest opportunity.
Required:
a. Calculate the net present value at 31 December 2023 of each of the two
mutually exclusive projects; (17 Marks)
b. Indicate briefly any reservations you might have in basing an investment

decision on these figures. (3 Marks)
Notes
i. Calculate to the nearest N000
ii. Show all calculations clearly
iii. Repetition of a project is not possible (Total 20 Marks)
QUESTION 4
Xeco is looking to spend N15m to expand its existing business. This expansion is
expected to increase profit before interest and tax by 20%. Recent financial
information relating to Xeco can be summarised as follows:
N’000
Profit before interest and taxation 13,040
Finance charges (interest) (240)
Profit before taxation 12,800
Taxation (3,840)
Profit for the year (earnings) 8,960
Xeco is not sure whether to finance the expansion with debt or with equity. If debt
is chosen, the company will issue N15m of 8% loan notes at their nominal value of
N100 per loan note. If equity is chosen, the company will have a 1 for 4 rights issue
at a 20% discount to the current market price of N6.25 per share. Xeco has 12
million shares in issue. The company pays corporate tax at 30%.
85

Required:
a. Evaluate whether, on financial grounds, Xeco should finance the expansion

with debt or equity. (10 Marks)
b. Explain the relationship between systematic risk and unsystematic risk.

(5 Marks)
c. Discuss the assumptions made by the capital asset pricing model. (5 Marks)
(Total 20 Marks)

QUESTION 5
Ope plc has N10m 5 percent convertible bonds in issue. The option to convert into
40 N1 ordinary shares is open only for one more year; they must be either converted
in one years‟ time or left as ordinary bonds until nine years‟ time when they will be
redeemed at par. The current share price is ₦1.60 and annual growth rate in share
price is 15 percent per annum. The current required return on Ope‟s equity is 25
percent, its business being relatively risky.
The current yield on ordinary non – convertible bonds in similar companies is 11

percent. These interest rates are expected to remain constant.
Ife plc has 100,000 warrants outstanding, each entitling the holder to subscribe for
one N1 ordinary share at 90 kobo any time during the next 3 years. The current
share price is 57 kobo and the capital growth is expected to be constant at 12
percent p.a. in the future. The current price of the warrant is 10 kobo.
Required:
a. Calculate the current value of Ope‟s convertibles as straight debt, i.e. ignoring
the option to convert and the value if conversion were to take place today.
Would you expect the market value of the convertible to be above or below
each of these amounts and why? (5 Marks)
b. By how much should the share price of Ope Plc rise before holders would be
induced to convert, on the last possible date for conversion? (4 Marks)
c. Explain why the market value of a convertible bond is likely to be affected by

the dividend policy of the issuing company. (4 Marks)
86

d. Based on the projected capital growth for Ife Plc, would you expect holders of
the warrants to exercise them before expiry? What is the minimum annual
growth -rate of the share price necessary to induce holders to exercise their
warrants? (2 Marks)
(Total 15 Marks)
QUESTION 6
a. State and explain examples of conflicts of interest that may exist between
shareholders and managers. (9 Marks)
b. Explain the likely implications for a typical company of lower interest rates.
(6 Marks)
(Total 15 Marks)
QUESTION 7
Kayode John just completed his ICAN examinations, picking up prices at every level
of the examinations. John is starting a job as a junior financial analyst for Eko
Assets Management. John is convinced that an in-depth understanding of the
forward P/E ratio is one of the most useful tools for investment decisions. He plans
to use the forward P/E ratio to help his firm identify undervalued stocks.
John is currently reviewing information on a company called Food-is-key Plc (FP).

The company distributes healthy food across the country and has been in business
for over twenty years. John spent many hours analysing the company. He believes
that Nigerians will continue to eat more healthy food and FP may be an attractive
investment.
John is concerned about FP‟s new management team. In a recent news conference,
the new Chief Financial Officer (CFO) of FP stated that FP should have increased
their dividend payout ratio to 60% last year. The CFO stated that a higher dividend
payout ratio would have increased the stock price.
John is evaluating the validity of the CFO‟s statement. John expects that FP‟s Return
on Equity (ROE) and required return would have remained the same if the company
changed their dividend payout ratio to 60%. He is uncertain about the impact on
the price of the stock. (Round all earnings, dividends and prices to the nearest kobo
and round all other figures to four decimal places.)
For further information see Table 1” Statement of Financial Position for FP” and
Table 2 “Income Statement for FP” and “Additional Information”.
87

Required:
a. Provide an estimate of FP‟s ROE in 2023 and use the DuPont identity to
decompose into three factors. (2 Marks)
Notes
 Due to missing information for 2022, use the statement of financial position
values as of December 31, 2023, for your ROE calculation.
 The DuPont identity is given by:
ROE = Profit margin × Total asset turnover × Equity multiplier
ROE = (Net income/Sales) × (Sales/ Total assets) × (Total assets/ Equity)
b. Estimate the sustainable growth rate in 2023. (2 Marks)
c. Using the CAPM, calculate the required return for FP. (1 Mark)
d. Calculate, at the start of 2024, the forward P/E ratio and the stock price under
two scenarios. The first scenario is based on the FP‟s actual dividend payout
ratio in 2023. The second scenario is based on the assumption that the new CFO
changed the dividend payout ratio to 60% in 2023. (Note: Base your
computations on the constant growth dividend model). (6 Marks)
Note: Forward P/E ratio is also called leading P/E ratio = P0 /E1
e. Should FP have changed the dividend payout ratio to 60% in 2023? Explain the
reasons why increasing the dividend payout ratio would have been a good or
bad idea for FP. What is the critical question that the CFO should consider when
making this decision? Explain your answer. (4 Marks)
(Total 15 Marks)
88

Table 1, Statement of financial position, as of December 31, 2023
N’000
Current Assets
Cash 20,000
Accounts receivable 60,000
Inventories 80,000
Total current assets 160,000
Other Assets
Property, plant and equipment 375,000
Accumulated depreciation -75,000
Net property, plant and equipment 300,000
Intangible assets 215,000
Other non-current assets 50,000
Total non-current assets 565,000
Total assets 725,000
Current liabilities
Short-term notes payable 25,000
Accounts payable 35,000
Total current liabilities 60,000
Long-term liabilities
Long-term liabilities 225,000
Other non-current liabilities 35,000
260,000
Total long-term liabilities
Shareholder equity
Ordinary shares 50,000
Total equity 405,000
Total equity and liabilities 725,000
89

Table 2, Income statement for FP, from January 1, 2023 to December 31,
2023
In thousands of naira (except for per share data) N’000

Cost of goods sold 425,000
Gross profit 250,000
170,000
Selling, general and administrative expenses
Earnings b/F interest, taxes, depreciation and 80,000
amortisation (EBITDA)
Depreciation and amortisation 15,000
Earnings, before interest and taxes (EBIT) 65,000
Interest 16,000
Earnings, before taxes 49,000
Income taxes 12,250
Net income 36,750
Additional information
Number of shares outstanding (000) 20,000

Dividend distributed (000) 15,000
Return on 30 year Treasury securities 2.75%
Expected return on a market index 9.50%
Beta for FP 0.8
90

Formulae
Asset Beta
Equity Beta
Growing Annuity

C0 = S0N(d1) – Ee-rt N(d2)
d2= d1 -
The Put Call Parity
C + Ee-rt = S + P
d = 1/u
91

Annuity Table
r
Discount rate (r)

Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1
2 1·970 1·942 1·913 1·886 1·859 1·833 1·808 1·783 1·759 1·736 2
3 2·941 2·884 2·829 2·775 2·723 2·673 2·624 2·577 2·531 2.487 3
4 3·902 3·808 3.717 3·630 3.546 3.465 3·387 3·312 3·240 3·170 4
5 4·853 4·713 4·580 4·452 4·329 4·212 4·100 3·993 3.890 3·791 5
6 5·795 5·601 5·417 5·242 5·076 4·917 4·767 4·623 4.486 4·355 6
7 6·728 6.472 6·230 6·002 5·786 5·582 5·389 5·206 5·033 4·868 7
8 7·652 7·325 7·020 6·733 6·463 6·210 5·971 5·747 5·535 5·335 8
9 8·566 8·162 7·786 7.435 7·108 6·802 6·515 6·247 5·995 5·759 9
10 9·471 8·983 8·530 8·111 7·722 7·360 7·024 6·710 6.418 6·145 10
11 10·368 9·787 9·253 8·760 8·306 7·887 7.499 7·139 6·805 6.495 11
12 11·255 10·575 9·954 9·385 8·863 8·384 7·943 7·536 7'161 6·814 12
13 12·134 11·348 10·635 9·986 9·394 8·853 8·358 7·904 7·487 7·103 13
14 13·004 12·106 11·296 10·563 9·899 9·295 8·745 8·244 7·786 7·367 14
15 13·865 12·849 11·938 11·118 10·380 9·712 9·108 8·559 8·061 7·606 15
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1
2 1·713 1·690 1·668 1·647 1·626 1·605 1·585 1·566 1·547 1·528 2
3 2.444 2.402 2·361 2·322 2·283 2·246 2·210 2·174 2·140 2·106 3
4 3·102 3·037 2·974 2·914 2·855 2·798 2·743 2.690 2·639 2.589 4
5 3·696 3·605 3·517 3·433 3·352 3·274 3·199 3·127 3·058 2·991 5
6 4·231 4·111 3·998 3·889 3·784 3·685 3·589 3.498 3.410 3·326 6
7 4·712 4·564 4.423 4·288 4·160 4·039 3·922 3·812 3·706 3·605 7
8 5·146 4·968 4.799 4·639 4.487 4·344 4·207 4·078 3·954 3·837 8
9 5·537 5·328 5·132 4·946 4·772 4·607 4.451 4·303 4·163 4·031 9
10 5·889 5·650 5.426 5·216 5·019 4·833 4·659 4.494 4·339 4·192 10
11 6·207 5·938 5·687 5.453 5·234 5·029 4·836 4·656 4.486 4·327 11
12 6·492 6·194 5·918 5·660 5·421 5·197 4·988 4·793 4·611 4.439 12
13 6·750 6.424 6·122 5·842 5·583 5·342 5·118 4·910 4·715 4·533 13
14 6·982 6·628 6·302 6·002 5·724 5.468 5·229 5·008 4·802 4·611 14
15 7·191 6·811 6.462 6·142 5·847 5·575 5·324 5·092 4·876 4·675 15
92

93

SOLUTION 1
a. Total value of Toba = 114m × ₦3.41 = ₦388.74m

Value of current holding of FP (20%) = 77.748
Now to be acquired (80%) = 310.992
Number of shares in FP needed = ₦310.992m/₦3 = 103.664m
b. i Earnings: It is assumed that Toba plc is accounted for as an associated

company of FP plc. This means that 20% of the profit of Toba plc is already
included in the existing earnings of FP. After take over, only 80% of the
existing earnings of Toba plc can be added to the earnings of FP.
Expected 2023 2022

No of shares:
- Per SOFP 100.00 100.00 73.60
- Additional (issued to Toba) 103.664 -
Total number of shares (q) 203.664 100.00 73.60
Earnings:
- Per income statements 51.50 51.50 37.60
- 80% of Toba 68.16 -
Total PAT 119.66 51.50 37.60
EPS (PAT ÷ q) 58.75k 51.50k 51.09k
The EPS will therefore increase to 58.75 kobo from a previous average of
about 51 kobo.
Assets
Existing:
Net Asset ₦519.10
No. of shares 100.00
Assets per share ₦5.19
Expected
Existing Net Asset of FP 519.10
Toba‟s net asset 684.0
Investment in associated company (110.0)
1,093.10
No of shares 203.66
Asset per share ₦5.37
So, asset per share is expected to increase.
94

ii) Earnings
Existing EPS in Toba plc = ₦85.20m ÷ 114 = 74.74k
Share exchange ratio = VPS in Toba plc/ VPS in FP = 341/300
Every unit of share in Toba plc that currently earns 74.74, will after acquisition
by FP earn = 58.75 × 341/300 = 66.78k.
This means there will be a loss of earnings by the existing shareholders of

Toba plc.
Asset
Existing asset per share (APS) in Toba plc = ₦684/114 = ₦6
Expected APS in FP is ₦5.37 × ₦341/300 = ₦6.10.
This means that the existing 80% shareholders in Toba plc will have a
marginal increase in APS.
d. i The advantages for FP in the arrangement are as follows:
 The loan interest is a tax deductible expense.

 As long as FP earns more than the 10% before tax on the assets of Toba
plc, the ₦80m loan stock will gear up the return to the shareholders in the
combined company.
 The loan stock will be long-term and the cash flows generated from the
assets acquired in Toba plc may in fact repay the loan stock.
 Instead of issuing approximately 104m shares against an existing share
capital of 100m shares, FP would need only 77m shares, i.e. a market
value of ₦230.992m being ₦310.992m less ₦80m divided by the current
share price of ₦3in FP. This would mean that the existing 80%
shareholders would not hold the majority of the shares in the new
combined company.
ii)
₦’m
PAT, as calculated in (b) (i) 119.66
Add back tax 119.66
Current post-takeover EBIT 239.32
Less interest = 10% × ₦80m (8.00)
EBT 231.32
New PAT 115.66
95

Let the maximum price to pay = ₦x
Total value of the 80% holding in Toba = 0.8 × 114,000,000 × ₦x = 91,200,000x
Number of shares needed = ₦91,200,000x /₦3 = 30,400,000x shares
Expected total shares in FP = 30,400,000x + 100,000,000
Revised EPS in FP = ₦115,660,000/(30,400,000x +100,000,000)
Thus: 115,660,000/(30,400,000x + 100,000,000) = 0.5875
i.e. (30,400,000x + 100,000,000) (0.5875) = 115,660,000
30,400,000x + 100,000,000 = 196,868,085
x = ₦3.1865
Total value of shares = 0.80 × 114m × ₦3.1865 = 290,608,800
Add loan stock 80,000,000
Total purchase consideration =370,608,800
d. If the board of Toba plc decided to advise its shareholders not to accept an
offer from FP the following arguments might be used:
 The earnings per share for the existing shareholders of Toba plc will fall
unless there is a dramatic improvement in the performance of the
combined company compared to the two individual companies.
 FP has an existing share capital of 100 million shares and is proposing to

issue a further 103.664 million shares for 80% of Toba plc. In effect,
therefore Toba plc is taking over FP because the 80% shareholders in
Toba plc will hold the majority of the shares in the new combined
company. However, the board of FP will be in control of the new
combined company and furthermore, the board of Toba plc does not wish
to take over FPbecause of the various reasons given below.
 Toba plc has doubled its turnover from the previous year and presumably
has improved its earnings after tax.
 Following from point 3 above, the prospects of Toba plc may be very
good and the existing shareholders in Toba plc will not reap the full
future benefits because the benefits will be shared with the shareholders
of FP.
 Toba plc has an investment valued at ₦80 million which is in a type of

enterprise which might not be of interest to FP but this investment may
be a major source of income for Toba plc and, therefore for the existing
shareholders of Toba plc.
96

 During the previous year,FP issued 26.40 million ₦1.00 ordinary shares
at ₦98 million (₦26.40 million + share premium of ₦71.60 million)
which is a price of 3.71 naira per share, but the existing market price per
share of FP is only ₦3.00, therefore the share price of FP has declined
since the issue of the previous share capital.
 On sales of ₦1,320.60 million, FP made earnings after tax of only ₦51.50

million which is under 4% of sales, whereas Toba plc with sales of ₦1,252
million, made earnings after tax of ₦85.2 million which is about 7% of
sales.
Examiner’s report
This is a four-part question testing candidates‟ knowledge of various aspects of
acquisition.
In part (a), candidates were expected to calculate share exchange ratio.
In part (b), candidates were expected to use their results in (a) to evaluate the
impact of the acquisition on earnings per share and asset per share of the
respective shareholders.
In part (c), candidates were expected to evaluate the key advantages of paying for
the acquisition using loan stock rather than cash. In addition, they were expected to
estimate the offer price that will not dilute the earnings per share of the existing
shareholders.
Finally in part (d), candidates were expected to provide arguments that might be
used to persuade shareholders in Toba Plc against accepting the offer.
Being a compulsory question, most of the candidates attempted the question but
the level of performance was very poor. Major error committed by most of the
candidates was their inability to recognise the treatment of the initial acquisition of
20% by Finkex Plc as an associated company. Furthermore, candidates that
attempted part (d) of the question merely produced generic solutions rather than
relating their answers to the scenario painted in the question.
Candidates are reminded that success at this level of the examination requires
critical thinking, demonstration of knowledge, and adequate preparation for the
examination.
97

Marking guide
Marks Marks
a. Number of shares required to be issued to buy the rest of
Toba Plc. 4 4
b. How share –for share offer will affect position of:
i Existing Shareholders in Finkex Plc 6
ii 80% Shareholders in Toba Plc 4 10
c. Assuming 80% Shareholders in Toba Plc were prepared to
accept the consideration:
i. What advantages might Finkex Plc have 2
ii. What total price could Finkex Plc afford 6 8
d. Argument not to accept Finkex Plc offer 8 8
Total 30
SOLUTION 2
The amount to be hedged is the net receipt, i.e.

CHF16.3 – CHF4 = CHF12.3 million.
i. Forward contract
6 month rate is used, as it is 6 months between today‟s date
(30 November) and date of settlement (31 May).
Net receipt = CHF12,300,000 × $1.0356 = $12,737,880
(Tutorial note: The quoted rates are direct to dollar. Therefore when converting
the foreign currency, i.e. CHF in this case, to dollar, we multiply. We must
therefore use the lower of the two rates).
ii. Money market hedging

 As foreign net asset is being hedged, borrow today for six months, at the
foreign borrowing rate.
 The PV of the foreign net asset i.e. amount borrowed:
CHF12,300,000/(1.022*) = CHF12,035,225
(* Annual rate = 4.4%, 6 – monthly rate = 4.4/2 = 2.2%)
 Convert the amount borrowed, at spotrate, to dollar.
Receipt = CHF12,035,225 × $1.0292 = $12,386,654
 Invest the dollar receipt in the US for 6 months at 4.6% p.a, i.e. 4.6/2 =
2.3% for 6 months.
Net proceed = 12,386,654 × (1.023) = $12,671,547
98

iii. Futures
 Sell CHF futures now to hedge against sale of CHF when money is
received from Swiss customer.
 June futures (1.0369) to be selected as only date after 31 May.
 Number of contracts = CHF12,300,000/CHF125,000 = 98.4, say 98,
hedging 98 × CHF125,000 = CHF12,250,000.
 Remainder of CHF50,000 (CHF12,300,000 – 12,250,000) to be hedged in
forward market.
Receipt = CHF50,000 × 1.0356 = $51,780
 Futures price: This can be estimated from March and June futures rates.
Predicted futures rate at the end of May = 1.0336 + ((1.0369 – 1.0336)
× 2/3) = 1.0358
(Tutorial note: 31 May is 2/3 of time between 31 March and 30 June, so
use 2/3 of the difference between March futures price of 1.0336 and June
futures price of 1.0369).
Alternatively, the futures price can be calculated from spot rate and June
futures rate. 31 May is 6/7 of time between 30 November and 30 June, so use
6/7 of the difference between spot rate of 1.0292 and Junes rate of 1.0369.
Predicted futures rate at the end of May = 1.0292 + ((1.0369 – 1.0292) × 6/7)
=1.0358
Using either methods, the expected receipt can now be calculated.

Expected receipt = CHF12,250,000 × 1.0358 = CHF12,688,550
 Summary of outcomes
CHF
Futures 12,688,550
Remainder on forward market 51,780
12,740,330
iv. Options
 Call/put options? Buy CHF put options to hedge against sale of CHF when
money is received from Swiss customer.
 Buy June options – the only date after May
 Number of contracts – 98, same as futures
 Total amount hedged, CHF12,250,000 – same as futures
 Remainder to be hedged on the forward contract: CHF50,000 – same as
futures.
99

Premium
Premium = Number of contracts × contract size × 0.0086
= 98 × 125,000 × 0.0086 = $105,350
(Note that the premium is quoted in cents - not US dollars).
Net receipt
Receipt from option US$
CHF125,000 × 98 × 1.0375 12,709,375
Forward contract (as for futures) 51,780
Premium (105,350)
12,655,805
Summary
Hedging Method Net receipt ($)
Forward contract 12,737,880
Money market 12,671,547
Futures 12,740,330
Options 12,655,805
Futures provide a better outcome
Examiner’s Report
The question tests candidate‟s knowledge of foreign exchange risk management.
They were expected to use four different hedging techniques of forward contract,
money market, futures contracts and option contracts.
Only a very few candidates attempted the question and unsurprisingly the level of
performance was very poor. The major problems encountered by the candidates
who attempted it include:
 Failure to recognise the need to match the expected receipt and payment
occurring at the same date and in the same currency;
 Failure of candidates to identify the relevant exchange rates to use;
 Inability to appropriately manipulate the various exchange rates, for
example, dividing instead of multiplying and vice versar, etc.
It is recommended that students preparing for this examination should adequately

cover the entire syllabus.
100

Marking guide
Marks Marks
Determine the best hedging strategy
(i) Forward Contract 3
(ii) The money market 5
(iii) Traded Futures 6
(iv) Traded Options 6 20
SOLUTION 3
a. Proposal A
Time 0 1 2 3 4
(31.12.23) (31.12.24) (31.12.25) (31.12.26) (31.12.27)
N’000 N’000 N’000 N’000 N’000
(Outlay)/Scrap value (312,500) - - 25,000 -
Net inflows - 200,000 275,000 350,000 -
Tax on inflows at 40% - - (80,000) (110,000) (140,000)
Tax savings on cap.
allowances (W1) - 25,000 20,000 16,000 54,000
Working capital (W2) (20,000) (7,500) (7,500) 35,000
NCF (332,500) 217,500 207,500 316,000 (86,000)
PVF (W3) 1 0.826 0.696 0.597 0.517
Present values (332,500) 179,655 144,420 188,652 (44,462)
NPV = ₦135,765 i.e. ₦135,765,000.
Proposal B
Time 0 1 2 3
(31.12.23) (31.12.24) (31.12.25) (31.12.26)
N’000 N’000 N’000 N’000
Net inflow as given - 350,000 350,000 -
Adjustment for labour (W5) - (10,000) (10,800) -
Adjusted net inflows - 340,000 339,200 -
Related tax at 40% - - (136,000) (135,680)
Lost disposal proceeds (W4) - (300,000) - -
Balancing charge avoided at - - - 120,000
40%
Working capital (W6) (35,000) - 35,000 -
NCF (35,000) 40,000 238,200 (15,680)
PVF (W3) 1 0.826 0.696 0.597
Present values (35,000) 33,040 165,787 (9,360)
NPV = ₦173,187 i.e. ₦173,187,000.
101

Proposal B should be chosen because it has the higher NPV.
Working Notes
1. Tax savings on capital allowances year ended
Tax savings at 40% Time due
N’000 N’000
31.12.23 Investment 312,500
WDA at 20% (62,500) 25,000 1
250,000
31.12.24 WDA at 20% (50,000) 20,000 2
200,000
31.12.25 WDA at 20% (40,000) 16,000 3
160,000
31.12.26 Scrap proceeds (25,000)
Bal.allowance 135,000 54,000 4
2. Working capital (N’000)

Time 0 1 2 3
Cum (10% of given operating CF) 20,000 27,500 35,000 -
(Incremental)/recovery (20,000) (7,500) (7,500) 35,000
3. Money cost of capital

Since we are given money cash flows, we must make use of money cost of
capital (MCC).
MCC = (1 + RCC)(1 + inflation rate) -1
2024 MCC = (1.10)(1.10) -1 = 21%
2025 MCC = (1.10)(1.08) -1 = 18.8%
2026 MCC = (1.10)(1.06) -1 = 16.6%
2027 MCC = (1.10)(1.05) -1 = 15.5%
The discount factors are
Time 1 1/1.21 = 0.826
2 1/1.21 × 1/1.188 = 0.696
3 1/1.21 × 1/1.188 × 1/1.166 = 0.597
4 1/1.21 × 1/1.188 × 1/1.166 × 1/1.155 = 0.517
4. Relevant cost of machine – Proposal B

This proposal utilises existing machinery which would otherwise be sold.
Therefore the opportunity cost should be included as cash flow. If proposal B is
not undertaken the company has the choice of either selling the machine at 31
December 2023 for ₦250 million or selling it at 1 January 2025 for ₦300
million.
102

The PV of the two options are:
 Sale at 31 December 2023

N‟000
Sale at 31 December 2023 (Time 0) = 250,000
Bal. charge at 31 December 2024
(Time 1) = ₦250,000 × 0.4 × 0.826 = (82,600)
PV 167,400
 Sale at 1 January 2025 (Time 1)

Sale proceeds (N300,000 × 0.826) = 247,800
Balancing charge at 31 December 2026 = (71,640)
(Time 3) = N120,000 × 0.597
PV 176,160
Therefore the company should sell the machine at 1 January 2025 if Proposal
B is not undertaken and the latter cash flows therefore represent the relevant
cash flows to be included in the analysis.
5. Labour costs - Proposal B

The incremental labour cash flows arising from the project are the amount
paid to the replacement staff, i.e. ₦110 million in 2024 and ₦118.80 million in
2025, but ₦100 million and ₦108 million have been deducted in arriving at
the net cash inflows of ₦350 million for both years. Labour costs have
therefore been under charged. Therefore cash inflow must be reduced by ₦10
million (₦110m – ₦100m) in 2024 and ₦10.80 million (₦118.80m – ₦110m) in
2025.
6. Working capital – Proposal B (N’000)

Time 0 1 2
Cum (=10% of given operating CF 35,000 35,000 -
Incremental (35,000) 0 35,000
b. Reservations relating to the figures used in (a) include:

 The accuracy of the estimated cash flows, inflation rates and discount
rates.
 It is assumed that all cash flows are received at the year-end whereas
they are likely to occur throughout the year.
 The projects may entail different levels of risk but this has been ignored
in the analysis.
103

Examiner’s report
This question tests candidates‟ knowledge of capital budgeting. The candidates
were expected to demonstrate their ability to handle taxation, inflation, relevant
cash flows, etc in capital budgeting.
About sixty percent of the candidates attempted the question but the performance
level was very poor.
Most of the candidates could not identify the relevant cashflows. Furthermore, they
failed to identify the appropriate timing of the tax savings associated capital
allowances.
In addition, almost all the candidates that attempted the question failed to handle
appropriately the yearly changing money cost of capital.
Candidates need to cover the entire syllabus comprehensively and practise past
questions.
Marking guide
Marks Marks
Calculate the NPV of the two projects 17 17
Reservations based on Investment decision 3 3
Total 20
SOLUTION 4
a. Increased EBIT = 13.040m × 1.2 = ₦15,648,000
Financing by debt
Current interest payment = ₦240,000
Increase in interest = 15m × 0.08 = ₦1,200,000
Revised interest payment = 1,200,000 + 240,000 = ₦1,440,000
Revised PBT = 15,648,000 – 1,440,000 = ₦14,208,000
Revised PAT = 14,208,000 × 0.7 = ₦9,945,600
Current EPS = 8,960,000/12,000,000 = ₦0.747 per share
Revised EPS = 9,945,600/12,000,000 = ₦0.829 per share
Current PER = 6.25/0.747 = 8.37 times
Revised share price = 8.37 × 0.829 = ₦6.94 per share
Capital gain = 6.94 – 6.25 = ₦0.69 per share
104

Financing by equity
Revised PBT = 15,648,000 – 240,000 = ₦15,408,000
Revised PAT = 15,408,000 × 0.7 = ₦10,785,600
Revised number of shares = 12m × 1.25 = 15m shares
Revised EPS = 10,785,600/15,000,000 = ₦0.719
Current PER = 6.25/0.747 = 8.37 times
Revised share price = 8.37 × 0.719 = ₦6.02 per share
TERP = ((4 × 6.25) + 5.00)/5 = ₦6.00 per share
Capital gain = 6.02 – 6.00 = ₦0.02 per share
Comment on findings
Financing by debt is recommended as this leads to the larger capital gain for
the shareholders. This recommendation could have been made on the basis of
EPS values alone, as the price/earnings ratio multiplier is the same for both
financing choices. However, it is important to compare the share price arising
from the equity financing option with the theoretical ex rights share price,
rather than with the cum rights share price.
b. With any investment, there is a risk that the actual outcome may be different
from the expected or predicted outcome. This risk can be reduced by holding
several different investments, since different investments are affected to
differing extents by changes in economic variables such as interest rates and
inflation rates. The return from one investment may increase, for example,
when the return from a different investment decreases. Holding a range of
different investments is known as portfolio diversification.
Experience shows that there is a limit to the reduction in total risk that can be
achieved as a result of portfolio diversification. The risk that cannot be
removed by portfolio diversification is called systematic risk. It represents risk
relating to the financial system as a whole that cannot be avoided by any
company in which an investment is made.
The risk that can be removed through portfolio diversification is called

unsystematic risk or specific risk, as it relates to specific companies in which
investments are made.
Experience has shown that investing in the shares of between 20 and 30

companies is sufficient to eliminate almost all of the unsystematic risk from an
investment portfolio.
Systematic risk contains both business risk and financial risk. A company with
no debt finance faces business risk alone, while a company with both equity
and debt finance faces both business risk and financial risk.
105

c. The capital asset pricing model (CAPM) is based on several key assumptions.
Investors hold diversified portfolios
While portfolio theory considers total risk, the CAPM considers only systematic
risk, as it makes the assumption that all investors hold diversified portfolios.
Investors will therefore only require compensation for the systematic risk in
their portfolios.
Single – period transaction horizon

In order to compare the returns on different assets such as shareholdings, the
CAPM assumes that all returns are over a standard single-period transaction
horizon, usually taken to be one year.
Perfect capital market

The CAPM assumes a perfect capital market, with no taxes, no transaction
costs and perfect information freely available to all participants.
Borrowing and lending at the risk-free rate

The CAPM assumes that all investors can borrow and lend at the risk-free rate
of return. This represents a minimum rate of return required by all investors
and is one of the variables in the CAPM equation.
Homogenous expectations
All investors have the same expectations, meaning they all have the same
expectations regarding future assets prices, returns and economic conditions.
Investors are rational

Investors are rational and aim to maximise their utility, making decisions
based on rational assessment of risk and return.
Investors are price takers

Individual investors are price takers, meaning that they accept market prices
and do not have the ability to influence those prices.
No short sale restrictions

Investors are allowed to short sell securities without restrictions, enabling
them to sell securities they do not own with the expectation of buying it back
at a lower price.
Instantaneous adjustment of prices

Prices adjust instantaneously to new information and there is no time lag in
reaction of assets prices to news or events.
106

Investors have a mean variance optimisation objective
Investors make investment decisions based on a mean-variance optimization
framework seeking to maximise expected returns for a given level of risk or
minimise risk for a given level of expected returns.
Examiner’s report
This question tests candidates‟ knowledge of capital budgeting. The candidates
were expected to demonstrate their ability to handle taxation, inflation, relevant
cash flows, etc in capital budgeting.
About sixty percent of the candidates attempted the question but the performance
level was very poor.
Most of the candidates could not identify the relevant cashflows. Furthermore, they
failed to identify the appropriate timing of the tax savings associated capital
allowances.
In addition, almost all the candidates that attempted the question failed to handle
appropriately the yearly changing money cost of capital.
Candidates need to cover the entire syllabus comprehensively and practise past
questions.
Marking guide
Marks Marks
Evaluation: whether to finance with debt or equity 10 10
Explain relationship between systematic and unsystematic risk 5 5
CAPM Assumptions 5 5
20
SOLUTION 5
a. The current value of the convertible bonds as simple straight debt is the PV of
future interest and the redemption value.
PV of interest at 11% for 9 years = N5 × 5.537* = 27.685

PV of redemption value at 11% in year 9 = N100 × 0.391 = 39.100
66.785
(*Annuity factor at 11% for 9 years).

So, the value as debt VD = N66.785.
Conversion value today = (CR) (VPS0), where
107

CR = conversion ratio, i.e. number of shares receivable on conversion = 40
shares
VPS0 = current market value per share = N1.60
Conversion value = 40 × N1.60 = N64
Thus, value as equity (VE) = conversion value = ₦64
(Note: The above calculations are based on face value of ₦100 of the
convertibles.)
The market value of the convertible is expected be higher than both its value
as debt and value of equity because of the option to convert to equity, the
excess of the market value of the convertible over the straight debt value is
directly the value of the option.
The reason for the market value exceeding the conversion value is that holders
have the debt to fall back on if the share price drops and they do not
necessarily have to convert. The debt value here acts as a floor price for the
security which means an investor faces less risk than by simply investing
directly in shares.
b. The last possible date for conversion is one year‟s time. If they are
unconverted then their value is as a straight bond with 8 years to redemption.
The straight debt value at the end of year 1 (i.e. 8 years to redemption) is the
PV of the remaining interest for 8 years and the redemption value in year 8.
PV of interest of ₦5 p.a. for 8 years at 11% = ₦5 × 5.146 = 25.730

PV of redemption value in year 8 at 11% = ₦100 × 0.434 = 43.400
Total value as debt (VD) =69.130
This is the expected value of the bond in one year‟s time. To induce the bond
holders to convert at that point in time, the conversion value must be at least
equal to ₦69.13. Thus:
CV ≥ 69.13
40 × VPS1≥ 69.13
VPS1 ≥ 1.728
The share price must therefore rise by minimum of ₦1.728 – ₦1.60 = ₦0.128
This entails minimum growth rate in share price of 8% ((1.728/1.60)-1).
(Note that the information on equity rate of return of 25% is totally irrelevant).
c. The company‟s dividend policy has a major impact on its share price, and
hence on the perceived value of the convertible bonds.
108

Assuming for the moment that the company is reasonably profitable, any
profit which is not declared as dividend are ploughed back into the business;
more profits should ensue and, other things being equal, the share price will
rise.
Were the company to distribute all of its profits, on the other hand, the share
price is likely to stagnate. Whereas by definition, dividends and retentions
benefit the shareholders, only retentions benefit the convertible bonds
holders.
Thus, payment of dividend is expected to reduce the market value of
convertible bonds.
d. It will be worthwhile to exercise the warrants if the share price exceeds the
exercise price of ₦0.90. At the projected growth rate of 12% p.a., the expected
share price in 3 years‟ time is = 57k (1.12)3 = 80k. It will therefore not be
worthwhile to exercise the warrants.
The minimum growth rate necessary to induce holders to exercise the warrants
is given by:
57k(1 + g)3 = 90k
(1 + g)3 = 90/57
g = (90/57)1/3 − 1 = 16.45%
Examiner’s report
The question tests candidates‟ knowledge of the valuation of convertable bonds and
warrants. Only about twenty percent of the candidates attempted the question but
the level of performance was far below average.
We emphasise once again the need for students to cover the entire syllabus and
practice examination type of questions when preparing for this examination.
Marking guide
Marks Marks
a. Calculate the current value of Ope‟s convertible at
straight debt 5 5
b. Determine how much should share price of Ope‟s Plc
rise 4 4
c. Explain why market value of a convertible bond is
likely to be affected 4 4
d. Minimum annual growth rte required 2 2
15
109

SOLUTION 6
a. Conflicts of interest between shareholders and managers can arise due to
differences in their objectives and priorities. Here are some examples of such
conflicts:
i. Executive Compensation: Managers might be motivated to increase their

own compensation through bonuses, stock options, or other incentives,
even if it does not align with the long-term interests of shareholders. This
can lead to a misalignment of interests between shareholders and
managers.
ii. Risk-Taking: Managers may be tempted to take excessive risks to boost

short-term profits and enhance their reputation, while shareholders may
prioritise long-term stability and sustainable growth. Such risk-taking
can expose shareholders to potential losses.
iii. Dividend Policies: Managers might prefer to retain earnings for

expansion or personal benefit, whereas shareholders may prefer higher
dividends to maximise returns on their investment.
iv. Mergers and Acquisitions: Managers may pursue acquisitions that benefit
their personal interests, such as increased power or job security, even if
they are not in the best interest of shareholders or the company's overall
performance.
v. Related-Party Transactions: Managers could engage in transactions with

companies they have personal interests in, leading to potential conflicts
between their personal gains and the company's financial well-being.
vi. Information Asymmetry: Managers have access to more information

about the company's operations and financials than shareholders. They
may use this advantage to their benefit or selectively disclose
information, causing inequities among shareholders.
vii. Time Horizon: Managers might prioritise short-term results to boost their
performance metrics, while shareholders might be interested in the
company's long-term growth and sustainability.
viii. Corporate Governance: Managers may resist changes that improve

corporate governance or provide more shareholder rights to retain their
power and control over the company.
110

ix. Resource Allocation: Managers may allocate resources to projects that
benefit them personally or their close associates, rather than projects that
generate the highest return for shareholders.
x. Insider Trading: Managers with access to sensitive information may use it

for personal financial gain through insider trading, which is illegal and
unethical.
To mitigate these conflicts of interest, it is essential to have robust corporate

governance mechanisms, independent board oversight, and transparent
reporting to align the interests of shareholders and managers in the best
interest of the company as a whole.
b. The implications of a fall in interest rates for a typical company are:

(i) The cost of floating rate borrowing will fall, making it more attractive
than fixed rate borrowing. For most companies with borrowings, interest
charges will be reduced, resulting in higher profitability and earnings
per share.
(ii) The value of the company‟s shares will rise, both because of the higher
level of company profitability and also because of the lower alternative
returns that investors could earn from banks and deposits, if interest
rates are expected to remain low in the longer term.
(iii) The higher share value results in a lower cost of equity capital, and
hence a lower overall cost of capital for the company. Investment
opportunities that were previously rejected may now become viable.
(iv) As interest rates fall, consumers have more disposable income. This may
increase demand for the company‟s products. Falling returns on deposits
may, however, encourage many people to save more, rather than spend.
Examiner’s report
This two-part question. Part (a) of the question tests candidates‟ knowledge of
agency problems. On the other hand, part (b) tests candidates‟ knowledge of the
implications of reduction in interest rate.
Almost all the candidates answer the question. Candidates showed strong level of
understanding in part (a) but performance in part (b) was very disappointing as
majority of them could not provide any meaningful answer.
Candidates are strongly advised to practise past questions and other examination
type of questions when preparing for this examination.
111

Marking guide
Marks Marks
a. Examples of conflicts of Interest 5 5
b. Implications of lower interest rates on Company 6 6
15
SOLUTION 7
a. ROE = Profit margin × Total asset turnover × Equity multiplier

ROE = (Net income/ Sales) × (Sales / Assets)× (Assets / Equity)
ROE
= (36,750) / (675,000)× (675,000 / 725,000)× (725,000 / 405,000)
= (0.0544) × (0.9310)× (1.7901) = 0.0907 (= 9.07%)
b. Sustainable growth rate (g) = ROE × retention rate (b)

b = 1 – dividend payout ratio
Dividend payout ratio = Dividends/ Net income
= 15,000/36,750 = 0.4082 = 40.82%
g = 9.07% × (1 – 0.4082) = 9.07% × 0.5918 = 5.37%
c. Required return = risk-free rate + Beta × (Expected return on market - risk-

free rate) = 0.0275 + 0.8 × (0.095 – 0.0275) = 0.0815 (= 8.15%)
d. With the constant growth dividend model:

Theoretical stock price:
P0 = D0 × (1 + g)/ (r - g) = D1 / (r - g)
Forward P/E ratio = P0/E1 = (D1 / E1) / (r - g)
g = ROE × b
(D1 / E1) = dividend payout ratio
So, P0 / E1 = (D1 / E1) / (Required return – (ROE × b)) = (1 – b) / (r - g)
Scenario 1: Based on actual dividend payout ratio
 Using justified leading P/E ratio as above
P/E ratio = payout ratio/(r - g)
= D1/E1/(r - g) = 0.4082/ (0.0815 – 0.0537) = 14.68
(Recall that D1/E1 = 1 – b = payout ratio)
P0= (P / E) × E1
= (P / E) × E0 × (1 + g)
= (14.68)(36,750/20,000)(1.0537)
=₦28.48
 An alternative approach is to first compute the theoretical price, using

dividend valuation model with constant growth to infinity.
112

P0 = D0 × (1 + g)/ (r - g)
= D1/(r - g). But:
D1 = E1 × (1 - b) = E0 × (1 + g) (1 - b)
E1 = E0 (1 + g) = (36,750/ 20,000) (1.0537) = ₦1.94
P0 = (1.94) (0.4082)/ (0.0815 – 0.0537) = ₦28.48
P0/E1 = ₦28.48 / 1.94 = 14.68
Scenario 2. Assume the company changed the dividend payout ratio to 60%
in 2023.
 Using justified leading P/E ratio.
Justified leading P/E ratio = P0/E1 = D1/E1/(r - g)
= (1 - b)/(r - g) g = (ROE)(b) = (9.07)(0.4) = 3.63%
P/E ratio = P0/E1 = (1 - b)/ (r - g)
= (1 – 0.4)/ (0.0815 – 0.0363) = 13.27
P0= (P / E) × E1
= (P / E) × E0 × (1 + g)
= (13.27)(36,750/20,000)(1.0363)
=₦25.28
 Alternatively: similar to what we did in scenario 1, we can also proceed

as follows.
D0 = (36,750/20,000) (0.6) = 1.1025
g = 9.07 × 0.4 = 3.63%
D1 = 1.1025(1.0363)
P0 = 1.1025(1.0363)/(0.0815 – 0.0363) = ₦25.28
E1 = E0 (1 + g) = (36,750/20,000)(1.0363) = 1.904
P0/E1 = 25.28/1.904 = 13.27
e. No, FP should not have increased their dividend payout ratio to 60% in 2023.
Increasing the dividend payout ratio from 40.82% to 60% would have
decreased the price of the stock from ₦28.48 to ₦25.28. The CFO does not
realise that paying out a higher percentage of earnings in dividends means
that the company will retain less funds and forego good investments. This
would result in a lower growth rate. (recall, growth = ROE × retention ratio).
In general increasing the dividend payout ratio impacts the stock price in two
ways. The first is clear: a higher naira dividend will increase stock price. The
second is that a higher payout ratio means lower growth which decreases the
stock price. The factor that dominates depends on the simple question. Is the
company making good investments?
If ROE > required return, then the company is making good investments; since
the investments are earning more than the required return. Recall that FP has
an ROE of 9.07% and a required return of 8.15% thus ROE (9.07%) > Required
113

return (8.15%). FP is making good investments. Accordingly, FP increasing the
dividend payout ratio to 60% would lower FP‟s stock price. This is because the
company would be better off if they used their net income to reinvest in the
company and make profitable investments.
Examiner’s report
This is a multi-part question testing some basic knowledge of finance. Part (a) tests
candidates‟ knowledge of the major drivers of return on equity (ROE) using DuPont
analysis. In part (b), candidates were expected to estimate sustainable growth rate.
Part (c) tests candidates‟ knowledge of using CAPM to estimate required return. In
the other part of the question, candidates were expected to estimate the forward
P/E ratio and the appropriate stock price. They were also expected to explain the
impact of payout ratio on stock price.
Most of the candidates attempted the question but generally the level of
performance was very poor. Candidates were able to pick up some marks in parts
(a) – (c). They however demonstrated complete lack knowledge in the remainly part
of the question.
As already noted, students need to cover the entire syllabus when preparing for the
institute examination.
Marking guide
Marks Marks
a. Estimate of FP‟s ROE in 2023 2 2
b. Estimate sustainable growth rate in 2023 2 2
c. Calculate the required return for FP 1 1
d. Calculate forward P/E ratio and stock price 6 6
Justify decision on increasing dividend payout ratio 4 4
15
114

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THE INSTITUTE OF CHARTERED ACCOUNTANTS

NOVEMBER 2014 PROFESSIONAL EXAMINATION

PROFESSIONAL EXAMINATION – NOVEMBER 2014

PROFESSIONAL LEVEL EXAMINATION - NOVEMBER 2014

STRATEGIC FINANCIAL MANAGEMENT

Time Allowed: 3 hours

SECTION A COMPULSORY QUESTION (30 Marks)

AK Plc is a company listed on the Nigerian Stock Exchange. It is involved in property

Production of cement for the next five years is projected as follows:

PROFESSIONAL EXAMINATION – NOVEMBER 2014

Equity beta 1.82

You are required to:

PROFESSIONAL EXAMINATION – NOVEMBER 2014

The board of directors is considering two proposals:

i. To cease trading and close down the company.

PROFESSIONAL EXAMINATION – NOVEMBER 2014

The following additional information has been provided:

iv. The new company’s cost of capital is expected to be 11%.

a. Discuss, briefly, the possible benefits of divesting Bolts division through a

PROFESSIONAL EXAMINATION – NOVEMBER 2014

i. Seeking potential buyers and negotiating the price

ii. Due diligence

2015 2016 2017 2018 2019

The following information are relevant:

i. The forecast profits have been limited to five years.

ii. All sales are for cash.

PROFESSIONAL EXAMINATION – NOVEMBER 2014

vi. In order to maintain the future earnings’ forecast of Synapse Chemical

Years 2015 2016 2017 2018 2019

PROFESSIONAL EXAMINATION – NOVEMBER 2014

SECTION C: ATTEMPT ANY TWO OUT OF THREE QUESTIONS (30 Marks)

a. Nimega Plc. is a Nigeria based multinational company that has subsidiaries in

PROFESSIONAL EXAMINATION – NOVEMBER 2014

b. In another contract in a country in the ECOWAS sub-region (with currency of

Spot exchange rate:

c. Discuss TWO advantages and TWO disadvantages of forward exchange contract.

PROFESSIONAL EXAMINATION – NOVEMBER 2014

0.6x + 0.4 (0.8) = 1.82

 0.6 x = 1.82 – 0.32

0.6x = 1.5 or x = 2.5

Where  A = asset beta of the proxy company

 E = equity beta of the proxy company

 D = beta of debt of the proxy company

V E = value of equity of the proxy company,

Note: We actually do not need to know the absolute value of V E and V D . We

D: E = 40: 100 = 4: 10, etc.

PROFESSIONAL EXAMINATION – NOVEMBER 2014

V D = value of debt of Ak Plc

V E = value of equity of Ak Plc

 E = 2 + (2 – 0.4) (30/100) (1 – 0.25) = 2.36

Step 4: Determine cost of equity, using CAPM

K E = RF +  E ( RM - RF ) = 5 + 2.36 (7) = 21.52%

Step 5: Determine cost of debt, net of tax.

Assumption: In the absence of additional information, we assume that the

Step 6: Compute the WACC

WACC = (100/130 x 21.52) + (30/130 x 6)

= 16.56 + 1.39 = 17.95 = 18% approx

Why the computed WACC is appropriate

The WACC used to appraise a new project should reflect:

i. The business risk of the project and

PROFESSIONAL EXAMINATION – NOVEMBER 2014

b)i. Computation of NPV

ii) Computation of MIRR