QUESTIONS ON ECONOMICS


The most recent balance sheet for Supremo Ltd is presented here below:

 Supremo Ltd Balance Sheet – 30 November 1995

 

 

Sh.

‘000’

 

Sh.

‘000’

Current Assets

Fixed Assets (net)

8,800

13,200

 

 

 

____

22,000

Trade creditors

Accrued expenses

Current liabilities

Long-term debt

Ordinary shares

Retained earnings

2,200

2,200

4,400

8,800

2,200

6,600

22,000

 The company is about to embark on an advertising campaign which is expected to raise sales from their present level of Sh.27.5 million to Sh.38.5 million by the end of next financial year. The firm is presently operating at full capacity and will have to increase its investment in both current and fixed assets to support the projected level of sales. It is estimated that both categories of assets will rise in direct proportion to the projected increase in sales.

For the year just ended, the firm’s net profits were 6% of the year’s sales but are expected to rise to 7% of projected sales. To help support its anticipated growth in assets needs next year the firm has suspended plans to pay cash dividends to its shareholders. In years past, a dividend of Sh.6.60 per share has been paid annually.

 Supremo’s trade creditors and accrued expenses are expected to vary directly with sales. In addition, notes payable will be used to supply the added funds to finance next years operations that are not forthcoming from other sources.

Required

a) i) Estimate the amount of additional funds to be raised through notes

payable. (4 marks)

ii) What one fundamental assumption have you made in making your estimate? (2 marks)

b) Prepare pro-forma balance sheet of Supremo Ltd. on 30 November 1996. (13 marks)

 c) i) Calculate and compare Supremo Ltd.’s current and debt ratios before and after growth in sales. (4 marks)

ii) What was the effect of the expanded sales on these two dimensions of Supremo’s financial condition? (2 marks)

(Total: 25 marks)

QUESTION TWO

XYZ Ltd is intending to raise capital to finance a new project. The current M.P.S is Sh.43 cum-div of year 2001 declared but not yet paid. For the past 5 years, the company has paid the following stream of dividends.

 Year 1997 1998 1999 2000 2001

D.P.S 1.90 2.25 2.60 2.60 3.00

 The existing capital structure of the firm is as follows:

Sh.M

Ordinary share capital Sh.10 par 40

Retained earnings 35

12% Debenture Sh.100 par 25

100

The debentures are currently selling at Sh.95 ex-interest. The corporate tax rate is 30%.

 Required

a) Distinguish between cum-div and ex-div M.P.S. (4 marks)

b) Compute the ex-div M.P.S. (2 marks)

c) Compute the overall cost of capital. Use dividend growth model

to determine the cost of equity. (9 marks)

d) The company wants to raise additional Sh.20 million as follows:

 50% from retained earnings

30% from issue of debentures at the current market value

20% from issue of new ordinary shares with 10% floatation costs

 i) Compute the number of ordinary shares to issue to raise the amount required. (2 marks)

ii) Compute the marginal cost of capital. (6 marks)

 QUESTION THREE

The Kitale Maize Mills is contemplating the purchase of a new high-speed grinder to replace an existing one. The existing grinder was purchased two years ago at an installed cost of Sh.300,000. The grinder was estimated to have an economic life of 5 years but a critical analysis of its performance now shows it is usable for the next five years with no resale value.

The new grinder would cost Sh.525,000 and require Sh.25,000 in installation costs. It has a five year usable life. The existing grinder can currently be sold for Sh.350,000 without incurring any removal costs. To support the increased business resulting from purchase of the new grinder, accounts receivable would increase by Sh.200,000, inventories by Sh.150,000 and trade creditors by Sh.290,000. At the end of 5 years the new grinder would be sold to net Sh.145,000 after removal costs and before taxes. The company provides for 40% taxes on ordinary income. The estimated profit before depreciation and taxes over the five years for both machines are given as follows:

Year

Existing grinder

Shs.

New grinder

Sh.

1

2

3

4

5

130,000

120,000

110,000

100,000

90,000

215,000

215,000

215,000

215,000

215,000

 The company uses straight line method of depreciation for both machines.

 Required

a) Calculate the initial investment associated with the replacement of the existing grinder with the new one. Show your full workings. (6 marks)

 b) Determine the incremental operating cash flows associated with the proposed grinder replacement. (14 marks)

 c) Calculate the terminal cash flow expected from the proposed grinder replacement. (2 marks)

(Total: 22 marks)

 QUESTION FOUR

Dereva and Makanga are considering purchasing the new 30 passenger “wonder coach” to engage in transport business. They have two alternatives of financing the purchase as shown below:

 First alternative

Purchase the vehicle whose current price is Sh.2,400,000 through a finance lease from Kenya Matatu Finance Company Limited. The terms of the lease will require four equal payments per year for each of the three years. No deposit is required.

 Second alternative

Obtain the vehicle through Mwananchi’s Bank loan scheme being advertised in the papers. Dereva and Makanga will be required to make a down payment of Sh.900,000 and then meet four equal yearly payments of Sh.153,436 each for the three years.

The market rate of interest is currently 16 per cent per annum.

Dereva and Makanga have been informed that as part of your social responsibility, you provide free consultancy services to small scale businessmen.

 Required

a) The finance lease payment to be made by Dereva and Makanga if they opt for finances from Kenya Matatu Finance Company Limited. (4 marks)

 b) The present value of the payment scheme of Mwananchi Bank. (4 marks)

 c) The interest expense charged by Kenya Matatu Finance Company Limited on the third instalment. (6 marks)

 Give reasons why finance leases are referred to as “off-balance sheet” finance.

(4 marks)

e) i) Which of the two alternatives – Finance Lease or Bank Loan scheme is

better in financial terms? (2 marks)

ii) Give one reason why the better alternative may not necessarily be chosen by persons in Dereva and Makanga’s circumstances. (2 marks)

(Total: 22 marks)

 QUESTION FIVE

You are provided with the following information about Marco. Ltd.

 The most recent balance sheet for Supremo Ltd is presented here below:

Supremo Ltd Balance Sheet – 30 November 1995

 

Sh.

‘000’

 

Sh.

‘000’

Current Assets

Fixed Assets (net)

8,800

13,200

____

22,000

Trade creditors

Accrued expenses

Current liabilities

Long-term debt

Ordinary shares

Retained earnings

2,200

2,200

4,400

8,800

2,200

6,600

22,000

 The company is about to embark on an advertising campaign which is expected to raise sales from their present level of Sh.27.5 million to Sh.38.5 million by the end of next financial year. The firm is presently operating at full capacity and will have to increase its investment in both current and fixed assets to support the projected level of sales. It is estimated that both categories of assets will rise in direct proportion to the projected increase in sales.

 For the year just ended, the firm’s net profits were 6% of the year’s sales but are expected to rise to 7% of projected sales. To help support its anticipated growth in assets needs next year the firm has suspended plans to pay cash dividends to its shareholders. In years past, a dividend of Sh.6.60 per share has been paid annually.

 Supremo’s trade creditors and accrued expenses are expected to vary directly with sales. In addition, notes payable will be used to supply the added funds to finance next years operations that are not forthcoming from other sources.

 Required

a) i) Estimate the amount of additional funds to be raised through notes

payable. (4 marks)

ii) What one fundamental assumption have you made in making your estimate? (2 marks)

b) Prepare pro-forma balance sheet of Supremo Ltd. on 30 November 1996. (13 marks)

 c) i) Calculate and compare Supremo Ltd.’s current and debt ratios before and after growth in sales. (4 marks)

ii) What was the effect of the expanded sales on these two dimensions of Supremo’s financial condition? (2 marks)

(Total: 25 marks)

 QUESTION TWO

XYZ Ltd is intending to raise capital to finance a new project. The current M.P.S is Sh.43 cum-div of year 2001 declared but not yet paid. For the past 5 years, the company has paid the following stream of dividends.

 Year 1997 1998 1999 2000 2001

D.P.S 1.90 2.25 2.60 2.60 3.00

 The existing capital structure of the firm is as follows:

Sh.M

Ordinary share capital Sh.10 par 40

Retained earnings 35

12% Debenture Sh.100 par 25

100

The debentures are currently selling at Sh.95 ex-interest. The corporate tax rate is 30%.

Required

a) Distinguish between cum-div and ex-div M.P.S. (4 marks)

b) Compute the ex-div M.P.S. (2 marks)

c) Compute the overall cost of capital. Use dividend growth model

to determine the cost of equity. (9 marks)

d) The company wants to raise additional Sh.20 million as follows:

 50% from retained earnings

30% from issue of debentures at the current market value

20% from issue of new ordinary shares with 10% floatation costs

 i) Compute the number of ordinary shares to issue to raise the amount required. (2 marks)

ii) Compute the marginal cost of capital. (6 marks)

 QUESTION THREE

The Kitale Maize Mills is contemplating the purchase of a new high-speed grinder to replace an existing one. The existing grinder was purchased two years ago at an installed cost of Sh.300,000. The grinder was estimated to have an economic life of 5 years but a critical analysis of its performance now shows it is usable for the next five years with no resale value.

The new grinder would cost Sh.525,000 and require Sh.25,000 in installation costs. It has a five year usable life. The existing grinder can currently be sold for Sh.350,000 without incurring any removal costs. To support the increased business resulting from purchase of the new grinder, accounts receivable would increase by Sh.200,000, inventories by Sh.150,000 and trade creditors by Sh.290,000. At the end of 5 years the new grinder would be sold to net Sh.145,000 after removal costs and before taxes. The company provides for 40% taxes on ordinary income. The estimated profit before depreciation and taxes over the five years for both machines are given as follows:

Year

Existing grinder

Shs.

New grinder

Sh.

1

2

3

4

5

130,000

120,000

110,000

100,000

90,000

215,000

215,000

215,000

215,000

215,000

The company uses straight line method of depreciation for both machines.

Required

a) Calculate the initial investment associated with the replacement of the existing grinder with the new one. Show your full workings. (6 marks)

b) Determine the incremental operating cash flows associated with the proposed grinder replacement. (14 marks)

c) Calculate the terminal cash flow expected from the proposed grinder replacement. (2 marks)

(Total: 22 marks)

QUESTION FOUR

Dereva and Makanga are considering purchasing the new 30 passenger “wonder coach” to engage in transport business. They have two alternatives of financing the purchase as shown below:

First alternative

Purchase the vehicle whose current price is Sh.2,400,000 through a finance lease from Kenya Matatu Finance Company Limited. The terms of the lease will require four equal payments per year for each of the three years. No deposit is required.

Second alternative

Obtain the vehicle through Mwananchi’s Bank loan scheme being advertised in the papers. Dereva and Makanga will be required to make a down payment of Sh.900,000 and then meet four equal yearly payments of Sh.153,436 each for the three years.

The market rate of interest is currently 16 per cent per annum.

Dereva and Makanga have been informed that as part of your social responsibility, you provide free consultancy services to small scale businessmen.

Required

a) The finance lease payment to be made by Dereva and Makanga if they opt for finances from Kenya Matatu Finance Company Limited. (4 marks)

b) The present value of the payment scheme of Mwananchi Bank. (4 marks)

c) The interest expense charged by Kenya Matatu Finance Company Limited on the third instalment. (6 marks)

Give reasons why finance leases are referred to as “off-balance sheet” finance.

(4 marks)

e) i) Which of the two alternatives – Finance Lease or Bank Loan scheme is

better in financial terms? (2 marks)

ii) Give one reason why the better alternative may not necessarily be chosen by persons in Dereva and Makanga’s circumstances. (2 marks)

(Total: 22 marks)

QUESTION FIVE

You are provided with the following information about Marco. Ltd.

i) Number of issued ordinary shares 250,000

ii) Market price per ordinary share Shs.37.50

iii) Total earnings for the year Sh.5,000,000 (before tax).

iv) Rate of corporation tax 30%

v) The total ordinary dividend will be 25% of the earnings for the year after tax.

vi) Preference dividend will be Sh.300,000

From the above information, calculate:

i) Earnings per share

ii) Dividend yield

iii) Earnings yield

iv) Price earnings ratio (P/E) ratio

v) Dividend cover.

i) Number of issued ordinary shares 250,000

ii) Market price per ordinary share Shs.37.50

iii) Total earnings for the year Sh.5,000,000 (before tax).

iv) Rate of corporation tax 30%

v) The total ordinary dividend will be 25% of the earnings for the year after tax.

vi) Preference dividend will be Sh.300,000

 From the above information, calculate:

 i) Earnings per share

ii) Dividend yield

iii) Earnings yield

iv) Price earnings ratio (P/E) ratio

v) Dividend cover.