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 CPA INTERMEDIATE LEVEL

PILOT PAPER

FINANCIAL MANAGEMENT

December 2021. Time Allowed: 3 hours.

Answer ALL questions. Marks allocated to each question are shown at the end of the question. Show ALL your
workings.

QUESTION ONE
(a) Summarise five methods of issuing ordinary shares. (5 marks)

(b) Mountain Mall (MM) Ltd. is considering a project with the following cash flows:
End year Cash flows (Sh.)
0 -40,000
1 100,000
2 -20,000

Additional information:

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1. The firm’s cost of capital is 15%.

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2. Corporation tax rate is 30%.

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Required:

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(i) Compute the two internal rates of return (IRR) associated with these cash flows. (4 marks)

(ii) If the firm’s cost of capital falls between the two IRR values calculated in b(i) above, advice the firm on
whether to accept or reject the project. (3 marks)

(c) KUDS Ltd.’s current earnings per share (EPS) is Sh.24. The firm adopts a 40% dividend payment ratio as its
dividend policy. The firm has in issue 10,000,000 ordinary shares.

The existing capital structure of the firm is given as follows:

Sh. “000”
Ordinary share capital 1,600, 000
Retained profits 600,000
Share premium 200,000
12% debt 800, 000
3,200,000

Additional information:
1. The expected rate of return on market portfolio is 15%.
2. The risk free rate of return is 10%.
3. The firm's equity beta coefficient is 1.4.

Required:
(i) Using the capital asset pricing model (CAPM), determine the minimum required return on the company's
equity shares. (2 marks)

(ii) Using the dividend growth model, compute the current value of each equity share. (6 marks)
(Total: 20 marks)

CA22 Page 1
Out of 3
QUESTION TWO
(a) Describe four main principles of Islamic finance. (4 marks)

(b) Economics Industries Ltd. is an all equity financed company with a cost of capital of 18.75%. The company is
evaluating five annual capital investment projects with the following extended returns and risks as measured by
the Beta factor.

Project Initial outlay Annual cash flows Beta coefficient

(Sh.) (Sh.)
A 300,000 330,000 0.3
B 300,000 340,000 0.5
C 400,000 480,000 1.0
D 500,000 590,000 1.5
E 500,000 600,000 2.0

Additional information:
1. The risk free rate of return is 7.7%.
2. The market rate of return is 16%.

Required:
(i) The beta factor of Economic Industries Ltd. (1 mark)

(ii) Advise the management of Economics Industries Ltd on the project to undertake. (5 marks)

(iii) Compute the beta factor of the accepted project (s) based on results in b (ii) above. (2 marks)

(c) Examine three key differences between behavioral finance and traditional finance. (6 marks)

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(d) Explain the meaning of the term “mutual fund”. (2 marks)

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(Total: 20 marks)

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QUESTION THREE

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Office Point Ltd. is considering two alternative proposals for financing a major expansion scheme requiring an
investment of Sh.100 million. The first is to raise the required funds through a public issue of ordinary shares at the
current market price per share of Sh.2.00.

The other proposal is to raise the finance by way of a term loan at an interest rate of 4% over the base rate of 5% per
annum.

The terms and conditions under which the company's existing loan capital has been raised include the following special
covenants:
1. The company's debt ratio should not exceed 40%.
2. A times interest earned ration of not less than 10 times should be maintained.
Office Point Ltd’s earnings before interest and tax (EBIT) during the financial year ended 31 December 2020 was
Sh.150 million, and the company's latest financial statement reveals the following information:

Sh. “million”
Total Assets 425
Debt 8% loan stock 75
Common stock (200m ordinary 100
shares)
Retained earnings 250
Total liabilities & equity 425

Additional information:
1. Investment of the additional capital of Sh.100 million is expected to result in the earnings before interest and tax
(EBIT) for 2021 being 30% higher than the figure for 2020.
2. Interest at the rate of 8% would continue to be paid on the existing loan capital of Sh.75 million.
3. The company would maintain its existing policy of paying a dividend of Sh.0.25 per share.
4. Corporation tax rate is 30%.
CA22 Page 2
Out of 3
Required:
(i) Assess the impact of the two alternative financing proposals on the company's earnings per share (EPS).
(5 marks)

(ii) Calculate the EBIT - EPS indifference point. (3 marks)

(iii) Calculate Office Point Ltd.’s debt ratio and times interest earned ratio for 2020, and assess the impact of each of
the two alternative financing proposals on these ratios in the company's financial statement for year 2021.
(6 marks)

(iv) Discuss six key factors that are considered by businesses when deciding between debt and equity finance.
(6 marks)
(Total: 20 marks)

QUESTION FOUR
(a) Jade Smith will deposit Sh.500,000 in his savings account on 31 December 2021. He will deposit an additional
Sh.200,000 at the end of each subsequent year in that account, the sum deposited is expected to earn interest at
the rate of 8% per annum, compounded annually.

Required:
(i) Determine the cumulative amount that is expected to be in his account at the end of year 2025.
(6 marks)

(ii) The rate of return expected to be earned over the projected period. (2 marks)

(b) Briefly explain three factors that might influence working capital requirements of a firm. (6 marks)

(c) Merchant Sport Club uses 100 replacement lamps for its street lights. Each lamp costs the Club Sh.8. Ordering
costs are estimated at Sh.27 per order. Holding costs are at 25% of the cost of each lamp. The Club currently
orders according to the EOQ basis.

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The supplier has now offered the club a 2% discount if the Club will buy 600 lamps at a time.

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Required:

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Using suitable calculations, advise the club on whether to accept the discount offer or not. (6 marks)
(Total: 20 marks)

QUESTION FIVE
(a) Utawala Ltd. plans to buy shares of Mcop Ltd. that are currently selling at Sh.20 each at the National Securities
Exchange.

The forecasted price per share and probability of their occurrence on different states of nature are as follows:

State of nature Probability Forecasted Share Price (Sh.)

Excellent 0.30 25
Normal 0.20 22
Poor 0.35 21
Very poor 0.15 19

Required:
(i) Expected rate of return of the company's shares. (3 marks)

(ii) The standard deviation of returns. (4 marks)

(b) Explain four conflicts that could arise in the course of achieving a firm's objectives. (8 marks)

(c) Enumerate five functions of the Central Bank in your country. (5 marks)
(Total: 20 marks)
…………………………………………………………………………………..

CA22 Page 3
Out of 3
 CPA INTERMEDIATE LEVEL

FINANCIAL MANAGEMENT

TUESDAY: 2 August 2022. Afternoon paper. Time Allowed: 3 hours.

Answer ALL questions. Marks allocated to each question are shown at the end of the question. Show ALL your workings.
Do NOT write anything on this paper.

QUESTION ONE
(a) Highlight four costs of issuing shares in the securities exchange in your country. (4 marks)

(b) Dima Ltd. has developed a new product and is considering whether to put it into production. The following
information is available:
1. Development costs will be Sh.4.8 million.
2. Production will require purchase of new machinery at a cost of Sh.2.4 million payable immediately. The
machinery has a production life of four years and a production capacity of 30,000 units per annum.
3. Production costs per unit: Sh.
• Variable material cost 8.00
• Variable labour cost 12.00

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• Variable overheads 12.00

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Fixed production costs including straight line depreciation on plant and machinery will amount to

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Sh.200,000 per annum.
4. Selling price is Sh.80.00 per unit. Demand is projected at 25,000 units per annum.
5. The retail price index is expected to increase at a rate of 5% per annum over the period and selling price will
increase at the same rate. Annual inflation rates on production costs are as follows:
(%)
Variable material cost 4
Variable labour cost 10
Variable overheads 4
Fixed costs 5
6. The weighted average cost of capital (WACC) in nominal terms is 15%.

Required:
Advise the firm whether to undertake the production using the net present value (NPV) approach. (8 marks)

(c) The following information relates to the capital structure of Tamu Caterers Limited for the year ended 31 December
2021:
Capital source Current market value
Sh.“000”
Corporate bond 11,927
Ordinary shares 26,170
Preference shares 7,203

Additional information:
1. The corporate bond has a Sh.1,000 face value, pays interest at a rate of 11% annually and will mature in 10
years time. The bond is currently trading at Sh.1,125 at the securities market and its yield-to-maturity is
9.05%.
2. The ordinary shares paid a dividend of Sh.1.80 last year and each share is selling at Sh.27.50 at the securities
market. The firm’s dividend on ordinary shares is expected to grow at a rate of 7% per annum to perpetuity.
3. The firm’s preference shares pays a 9% dividend on a Sh.100 par value.
4. The corporation tax rate is 30%.

CA22 Page 1
Out of 4
 Required:
(i) The weighted average cost of capital (WACC) for the firm. (6 marks)

(ii) Explain two factors that will determine the cost of capital for Tamu Caterers Limited. (2 marks)
(Total: 20 marks)

QUESTION TWO
(a) Joshua Makau is approaching retirement next year and is expecting a lumpsum pension payment amounting to Sh.20
million.

Required:
Recommend four investment products available in the financial market that he should consider to enable him achieve
financial freedom. (4 marks)

(b) Distinguish between the following terms as used in finance:

(i) “Agency cost” and “agency problem”. (2 marks)

(ii) “Intrinsic value” and “market value”. (2 marks)

(iii) “Liberal credit policy” and “conservative credit policy”. (2 marks)

(c) Horizon Construction Limited wishes to increase the number of its branches in the country.
The board of directors of the company has decided to finance the expansion programme by raising funds from the
existing shareholders through a one for four rights issue.

The published income statement of the company for the year ended 31 December 2021 had the following
information:

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Sh.“000”

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Turnover 250,000

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Profit before interest and tax 9,000
Interest (500)
Profit before tax 8,500
Corporation tax (2,550)
Profit after tax 5,950
Ordinary dividend (2,950)
Retained profit for the year 3,000

The share capital of the company comprises of 10 million ordinary shares which have a par-value of Sh.10 per share.

The shares of the company are currently being traded on the securities exchange with a price-earnings (P/E) ratio of
20 times.

The firm’s board of directors have decided to issue the new shares at a 25% discount on the current market price.

Required:
(i) The theoretical ex-right price of an ordinary share of the company. (2 marks)

(ii) The theoretical value of each right. (1 mark)

Assuming an investor held 5,000 ordinary shares of the company before the rights issue announcement and Sh.15,000
in his savings account. Calculate the following options and identify the best option to the investor if he:

(iii) Exercises all his rights. (3 marks)

(iv) Sells all his rights. (2 marks)

(v) Ignores the rights issue. (2 marks)

(Total: 20 marks)

CA22 Page 2
Out of 4
QUESTION THREE
(a) Examine four shortcomings of the percentage of sales method of forecasting. (4 marks)

(b) Discuss three causes of conflict between shareholders and managers in relation to agency theory. (6 marks)

(c) Explain four sources of finance as used in Islamic Financing. (4 marks)

(d) Explain the following dividend theories:

(i) Bird-in-hand theory. (2 marks)

(ii) Clientele effect theory. (2 marks)

(iii) Information signaling theory. (2 marks)

(Total: 20 marks)

QUESTION FOUR
(a) Cryptocurrency is a digital asset designed to work as a medium of exchange that uses strong cryptograph to secure
financial transactions, control the creation of additional units and verity the transfer of assets.

Required:
In light of the above statement, examine four limitations of cryptocurrency. (8 marks)

(b) The following information relates to inventory relationship of QZ Ltd.:

1. Annual purchases of Sh.2,160,000.

2. Purchase price per unit is Sh.60.
3. Carrying cost is 15% of the purchase price per unit.

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4. Cost per order placed is Sh.240.

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5. Desired stock levels is 300 units. This stock level was in hand initially.

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6. Lead time is 7 days.

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Assume a 365-day year.

Required:
(i) The economic order quantity (EOQ) for the company. (3 marks)

(ii) The optimal number of orders to be placed in a year. (1 mark)

(iii) The re-order level. (2 marks)

(iv) Assuming that for any orders of at least 2,000 units, the firm will get 5% discount on the purchase price.

Analyse whether the company should take advantage of the discount or not. (4 marks)

(c) Digital Ltd. has some computer industrial plant which it intends to replace four years from today. The company’s
director estimates that the cost of the plant to the company at that time will be Sh.30 million. To finance the
operations, the Finance Director has decided to set up a fund with Golden Bank Ltd. Golden Bank Ltd. has assured
the Finance Director that if he opts for this option, the rate of interest will be fixed at 8% per annum. The Finance
Director intends to set aside a constant amount from his annual budgets to finance the plant. The rate of interest will
be compounded semi-annually.

Required:
The amount that the Finance Director should deposit with Golden Bank Ltd. every year to achieve his objective.
(2 marks)
(Total: 20 marks)

CA22 Page 3
Out of 4
QUESTION FIVE
(a) Hamsa Manufacturing Ltd. is considering two alternative investment proposals. The first proposal requires a major
renovation of the company’s manufacturing facility. The second proposal involves replacing a few obsolete items of
equipment in the manufacturing facility. The company is only able to select one of the two proposals.

The cash flows associated with each proposal are shown below:

Year Proposal I (Renovation) Proposal II (replacement of some items)

Sh.“000” Sh.“000”
0 –9,000 –1,000
1 3,500 600
2 3,000 500
3 3,000 400
4 2,800 300
5 2,500 200

The firm discounts cash flows at the rate of 15%.

Required:
(i) Rank the two investment proposals using the net present value (NPV) approach. (4 marks)

(ii) Rank the two investment proposals using the internal rate of return (IRR) approach. (4 marks)

(iii) Compare the rankings under the NPV and IRR approaches and comment on any differences. (3 marks)

(b) A financial expert has provided you with the following data regarding returns on Mebco Ltd.’s shares for the years
2017 – 2021:

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Year Return on Mebco Ltd.’s shares (%)

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2017 18

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2018 16

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2019 10

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2020 6
2021 8

Required:
The risk in Mebco Ltd.’s shares return as measured by the standard deviation. (4 marks)

(c) Koki Ltd. recently paid a dividend of Sh.2.50 per share. The dividend is expected to grow at a rate of 15% per annum
for the first three years, then at a rate of 10% per annum for the next 2 years after which the dividend will grow at a
rate of 5% per annum to perpetuity. The required rate of return for the ordinary share is 12%.

Required:
The intrinsic value of the ordinary share of Koki Ltd. (5 marks)
(Total: 20 marks)
……………………………………………………………………

CA22 Page 4
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