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MAF 5102: FINANCIAL MANAGEMENT

CAT 1 20 Marks
INSTRUCTIONS

Attempt all questions

QUESTION ONE

In the past, it was considered prudent and a sign of success for business organizations
to maintain large bank balances and to have as few liabilities as possible. Today this
state of affairs may no longer be satisfactory. Explain (4mks)

High levels of cash on the balance sheet can frequently signal danger ahead. If cash is more or

less a permanent feature of the company's balance sheet, investors need to ask why the money is

not being put to use. Cash could be there because management has run out of investment

opportunities or is too short sighted and doesn't know what to do with the cash.

Sitting on cash can be an expensive luxury because it has an opportunity cost, which amounts to

the difference between the interest earned on holding cash and price paid for having the cash as

measured by the company's cost of capital.

Companies that hold excess cash carry agency costs whereby they are tempted to pursue "empire

building". Top managers can fritter away cash on wasteful acquisitions and bad projects in a bid

to boost their personal power and prestige. With this mind, be wary of balance sheet items like

"strategic reserves" and "restructuring reserves". They are often just excuses for hoarding cash.

Even worse, a cash-rich company runs the risk of being careless. The company may fall prey to

sloppy habits, including inadequate control of spending and an unwillingness continually to

prune growing expenses. Large cash holdings also remove some of managers' pressure to

perform.
QUESTION TWO

A company is considering raising Sh. 500,000 to finance a project. The following three
financing alternatives are possible:
i. The company may issue 50,000 shares at Sh. 10 each
ii. The company may issue 25,000 shares at Sh. 10 each and 2,500 debentures of Sh.
100 each having an interest of 8%.
iii. The company may issue 10,000 shares at Sh.10 each, 10%, 10,000 preference shares at
Sh. 10 each and 3,000 debentures at Sh. 100 each having an interest rate of 8%.
If the company‘s profits before interest are:
(i) Sh. 25,000 (ii) Sh. 50,000 (iii) Sh. 75,000 then what are the respective earnings per
share? (Assume corporation tax rate 50%) (5mks)

is EBIT=25,000
OPTION OPTION Option
One Two Three
Ordinary shares 50,000 25,000 10,000
8% Debentures 0 2,500 3,000
10% preference 0 0 10,000
EBIT 25,000 25,000 25,000
less interest 0 20000 24000
EBT 25,000 5,000 1,000
less tax 12500 2500 500
EAT 12,500 2,500 500
less pref div 0 0 10000
Earning to ordinary
shares 12,500 2,500 -9,500

eps 0.25 0.1 -0.95

is EBIT=50,000
OPTION OPTION Option
One Two Three
Ordinary shares 50,000 25,000 10,000
8% Debentures 0 2,500 3,000
10% preference 0 0 10,000
EBIT 50,000 50,000 50,000
less interest 0 20000 24000
EBT 50,000 30,000 26,000
less tax 25000 15000 13000
EAT 25,000 15,000 13,000
less pref div 0 0 10000
Earning to ordinary
shares 25,000 15,000 3,000

eps 0.5 0.6 0.3

is EBIT=75,000
OPTION OPTION Option
One Two Three
Ordinary shares 50,000 25,000 10,000
8% Debentures 0 2,500 3,000
10% preference 0 0 10,000
EBIT 75,000 75,000 75,000
less interest 0 20000 24000
EBT 75,000 55,000 51,000
less tax 37500 27500 25500
EAT 37,500 27,500 25,500
less pref div 0 0 10000
Earning to ordinary
shares 37,500 27,500 15,500

eps 0.75 1.1 1.55

QUESTION THREE

Explain Modigliani-Miller‘s hypothesis of irrelevance of dividends. Under what


assumptions do they hold good? (3mks)

According to Miller and Modigliani Hypothesis of irrelevance of dividends, dividend policy

has no effect on the price of the shares of the firm and believes that it is the investment policy

that increases the firm’s share value.

The dividend irrelevance theory is the theory that investors do not need to concern themselves

with a company's dividend policy since they have the option to sell a portion of their portfolio of

equities if they want cash.


The dividend irrelevance theory indicates that a company’s declaration and payment of dividends

should have little to no impact on stock price. If this theory holds true, it would mean that

dividends do not add value to a company’s stock price.

Assumptions of Miller and Modigliani Hypothesis of irrelevance of dividends

1. There is a perfect capital market, i.e. investors are rational and have access to all the

information free of cost. There are no floatation or transaction costs, no investor is large

enough to influence the market price, and the securities are infinitely divisible.

2. There are no taxes. Both the dividends and the capital gains are taxed at the similar rate.

3. It is assumed that a company follows a constant investment policy. This implies that

there is no change in the business risk position and the rate of return on the investments

in new projects.

4. There is no uncertainty about the future profits, all the investors are certain about the

future investments, dividends and the profits of the firm, as there is no risk involved.

QUESTION FOUR

A company has 10,000 equity shares of Kshs.10 each. It expects its earnings at Kshs.75,
000 and cost of capital at 8% for the next financial year. Using Walter‘s model, what
dividend policy will you recommend when the rate of return on investment of the
company is estimated at 6% and 10% respectively? What will be the prices of equity
share? (5mks)

Walter’s Model shows the clear relationship between the return on investments or internal rate of
return (r) and the cost of capital (K). The choice of an appropriate dividend policy affects the
overall value of the firm.

If r>K, the firm should retain the earnings because it possesses better investment opportunities
and can gain more than what the shareholder can by re-investing.
If r<K, the firm should pay all its earnings to the shareholders in the form of dividends, because
they have better investment opportunities than a firm. Here the payout ratio is 100%.

If the expected rate of return on investment of the company is estimated at 6 %,( i.e. less
than cost of capital of 8%), then the firm should pay out the entire amount as dividend.

However if the expected rate of return on investment of the company is estimated at 10


%,( i.e. more than cost of capital of 8%), then the firm should retain the entire amount as
dividend.

Using the Walter’s formula to calculate the market price per share (P) is:

P = D/k + {r*(E-D)/k}/k, where

P = market price per share

D = dividend per share

E = earnings per share

r = internal rate of return of the firm

k = cost of capital of the firm

P = 75,000/0.8 = 9.375
QUESTION FIVE

Is it possible for a company to have a very favorable current ratio of 3:1 and still be
unable to pay its bills on time? Explain ( 3mks)

SOLUTION

A high current ratio though considered to be desirable may prove to be otherwise due to
following reasons:

1. In case of slow moving stocks, these will pile up and will lead to higher ratio.
2. In case of slow collection of trade debts it will also lead to higher ratio.
3. Cash and bank balance may be more than necessary consequently significant portion may
remain idle which is not at all desirable:
4. On the other hand if the current ratio is low due to following reasons it is again
undesirable:
5. Lack of sufficient funds to meet current obligations and
6. Trading level beyond the capacity of the business.

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