Financial Management · May 2026

(a) 2025 2024 = 61 days 46 days Alternative calculation of payables days Cost of sales for a manufacturing company includes production wages which are unlikely to have any significant credit period. Trade payables thus relate to only part of the cost of sales figure – around 50% in this case. On this basis, the ratios would be = 122 days 91 days Assumptions Made (i) Year-end balances are representative of average balances.

(ii) All purchases are assumed to be on credit.

(iii) Cost of sales is used as an approximation for credit purchases.

(iv) A 365-day year is assumed Critical appraisal Inventory turnover The inventory turnover ratio indicates the average number of days it would take to sell the existing level of inventories. At 146 days (that is almost five months) the levels of inventory are high, but stable. This ratio, however, has a number of weaknesses:

• Sales and inventories are growing, thus the average level of sales for the year is not representative as the sales at the year-end (on which inventory is probably based) are likely to be higher than the beginning of the year;

• Similarly, if sales are seasonal, then the level of inventory at 30 September should be related to sales in October/November, rather than the average for the year; and

• The year-end inventory figure may have been adjusted by creative accounting procedures to make accounting ratios look more acceptable. 155 = 146 days 146 days = 100 days 100 days Receivables’ turnover The receivables turnover figure shows the average number of days credit taken by customers. In this case at 100 days (that is over three months) it is relatively high, but stable. This ratio, however, has a number of weaknesses these include:

• The receivables’ figure is related to the sales in the months immediately preceding 30 September year-ends, rather than the average sales for the year. The sales in these months are likely to be higher than the average due to (i) high seasonal trade and (ii) the underlying growth rate of the business. The receivables’ days are thus likely to be overstated;

• While the figure is stable, it gives no indication of the receivables turnover that could be achieved, nor the implications for additional sales of a longer credit period;

• The circumstances are unusual in granting credit on the basis of payment by installments financed by the company itself; and

• The year-end receivables figure may have been adjusted by creative accounting procedures to make accounting ratios look more acceptable. Payables turnover The payables’ turnover figure shows the average number of days credit given by suppliers. Using the alternative calculations (adjusted for labour costs) at 107 days, it is high and increasing. This may indicate that payables are already being used to manage liquidity. This ratio, however, has a number of weaknesses, these include:

• In the case of a manufacturing company, the link between payables and cost of sales is unclear as many elements of cost of sales (for example labour costs) are irrelevant to trade payables;

• The above points regarding the months around the year end being unrepresentative of the average due to growth and seasonal trading also apply in this case; and

• The year-end payables figure may have been adjusted by creative accounting procedures to make accounting ratios look more acceptable.

(b) Memorandum To: The Directors From: Management Accountant Subject: Working Capital Management Date: November 20, 2025 Assessment of working capital position The primary problem of working capital depletion appears to arise from over- trading. This is where a business enters into commitments in excess of its short-term resources. It can arise for a number of reasons, but in this case it appears to be 156 caused by a rapid expansion of non-current assets that has not been matched by long term financing. Thus, non-current assets have increased by ₦4.6 million, whereas long term financing has only increased by ₦2 million. As a result, the overdraft has increased to ₦5.2 million and is thus financing non-current assets. Overdrafts are repayable on demand and if it is recalled by the bank this may create significant difficulties. Managing working capital General Taking into account the movement outlined in Appendix A (requirement (a)) there are at the year-end net current liabilities. Cash Given that over-expansion appears to be the root cause of the liquidity problem, it may be wise in the short term not to open any further retails outlets, notwithstanding that these appear to be profitable. Conversion of a significant part of the overdraft into longer-term finance would appear to be appropriate given that it is financing long term assets. This is considered below in more detail under financing. Inventories The supply of inventories appears to be excessive at almost five months of sales. Inventories appear to increase in direct proportion to sales, whereas models such as the EOQ would predict that, while inventory would rise with sales, they would increase at a lower rate. Consideration could perhaps be given to the following:

• IT based information on inventory and sales;

• Making to order rather than selling from inventory. This would depend on the length of the production cycle;

• Suppliers of raw material could be encouraged to move towards a just in time system depending on the circumstances; and

• Central supply of scooters could be considered to save holding large inventories at each retail outlet. Much will depend upon the estimated impact on sales of not holding comprehensive inventories at all retail outlets. Receivables Given that the company is considering extending the credit terms the task of managing receivables becomes more important. In this context, the following points may be relevant.

• There is no mention of bad debts, but consideration may need to be given to this if receivables terms are extended;

• Factoring of debts may produce increased cash, but may be costly. Such a procedure would improve liquidity, but would not actually reduce working capital;

• Similarly, the credit terms offered by the company could be managed via an outside finance company which would extend its own credit terms. This would 157 again have a cost, but would improve liquidity. If all the receivables were sold at the statement of financial position value, this would reduce the overdraft from ₦5.2 to ₦1.9 million; and

• Discounts for cash settlement or reduced credit terms may be offered. Payables Payables are high and increasing. The absolute increase is due to the expansion of the business and consequent expansion of production costs. The payables turnover ratio indicates that there is a further increase in payables even after allowing for expansion. This may be due to the company extending its credit period to improve liquidity, but there are limits on the extent to which this can be done. Also, there may have been large purchases of goods just before the year-end. Suppliers may have extended the credit period offered. If they have not, then may be extended credit terms could be negotiated with suppliers. Signed: Management Accountant

Examiner’s report This compulsory question tests candidates’ knowledge of working capital management. The (a) part requires candidates to calculate the inventory, receivables and payables ratios. While the (b) part of the question requires candidates to provide alternative methods of managing working capital. Virtually all the candidates attempted this question and performance was slightly below average, as only about a third of the candidates scored up to 50% of the marks allotted. The commonest pitfall was the inability of many of the candidates to provide alternative methods of managing working capital. Candidates are admonished to study to comprehend the application of principles and computations to practical situations. Candidates at this level of the examination must develop analytical skills that will enable them apply concepts and principles to simple practical situations, as this is the distinction between Skills and Foundation levels of the examination.

Marking guide Marks a I Inventory turnover period (in days) 2½ marks ii Receivables’ turnover period 2½ marks iii Payables’ turnover period 2½ marks Assumptions 1½ marks Critical Appraisal 6 marks b Memorandum 15 marks Total 30 marks 158

(a) i) Cost of equity(KE) (b)

i) Cost of equity The new bank loan will increase the level of gearing of the company, this will, in turn, increase the required return on equity as it becomes riskier. Investors, being risk averse, thus demand a higher rate of return. The primary reason for the increased risk on equity is that interest costs must be paid before dividends. As the residual claimants, the returns on equity become more volatile and thus riskier. Additionally, debt also ranks in front of equity on liquidation. As a result, the possibility of equity holders gaining a share of the funds from liquidated assets is reduced as debt increases. Also, as interest must be paid, the probability of liquidation (and thus bankruptcy costs) increases as debt increases.

ii) Cost of debt The level of gearing is initially low in market value terms, but the issue of new debt will increase it. One concern, however, is that if the company is liquidated, there may be insufficient assets to repay the debt. In the draft statement of financial position, capital and reserves are ₦150 million. As a result, book net assets are also ₦150 million. This is lower than the initial Total value of equity = 100m shares × ₦10.40 = ₦1,040m ii) Cost of bonds The bonds are redeemable and the cost of capital is the IRR of the related after-tax cash flows. Taking face value of ₦100: Current price (P) = ₦100.84 Annual interest, net of tax (I) = ₦9(1 – 0.30) =₦6.30 Redemption value (R) = ₦100 Years to redemption (n) = 3 So, try 6% NPV = -100.84 + 6.30(2.673*) + 100(0.840) = - ₦0.006 The IRR is approximately 6% (* Annuity at 6% years 1-3) Total value of bonds = ₦200m × 100.84/100 = ₦201.68m 159 nominal value of debt of ₦200 million, and significantly below the new nominal value of debt of ₦230 million, it may be that the statement of financial position reflects the historic cost of assets, and their revalued amount may be greater. This is possible with land and buildings, but unlikely with aircraft. Moreover, the sale of assets under distress conditions of liquidation may yield proceeds below their historic cost. Thus, the new debt is likely to cause the overall cost of debt to rise as:

• the possibility of full payment on liquidation is reduced; and

• the probability of liquidation is increased given the greater interest payments.

iii) Weighted average cost of capital There are two factors with opposite effects on WACC as the amount of debt increases.

• Both the cost of equity and the cost of debt increase because of increased risk for the reasons noted above.

• Debt is lower risk and, therefore, cheaper than equity. Increasing debt increases the proportion of this lower cost source of capital in the financing structure. It is uncertain as to which effect is greater, and thus whether WACC increases or decreases. The traditional theory argues that as debt increases from a zero level of gearing. WACC will initially fall as the perceived risk to equity is small. It continues to fall until it reaches its optimum point, then begins to increase as the perception of risk increases. The impact on Feli Plc’s WACC will, therefore, depend on whether the existing level of gearing is below or above the optimal point.

(c) i) A bond is a secured debt usually backed by specific assets or collateral. If the issuer defaults, bondholders can claim those assets. For example, a Mortgage bond backed by property and has a lower risk.

ii) In contrast, a bank loan is usually with a single bank and is not normally traded. However, large corporate loans can be made by a syndicate of banks or other institutions. Cost of debt differences The cost of debt may differ on the two types of debt as: (i) They cover different periods, thus market interest rates may have changed as might the perception of the company’s risk. Thus, the 9% nominal rate on the existing debt may have been the prevailing rate some time ago;

(ii) The existing debt may also have been issued at a premium or a discount; 160

(iii) The terms of the debt may differ. Thus, if one security has more covenants to protect the lender and reduce risk, then a lower rate of interest may be acceptable;

(iv) The debentures are marketable, while the bank loan is unlikely to be. A lower rate of interest may, therefore, be available on debentures to compensate for lower liquidity risk;

(v) The yield, calculated in requirement (a), of 6% is after tax, while the nominal on rate on the bank loan of 8% is before tax; and

(vi) Bonds require public disclosure, while bank loan is private.

Examiner’s report This question is in three parts. The first two parts test the candidates’ understanding of cost of equity, cost of debt and weighted average cost of capital (WACC). The last part requires candidates to distinguish between two types of medium/long term sources of finance, namely bonds and bank loans. About 60% of the candidates attempted this question, however performance was poor as less than 30% of them scored up to 50% of the marks allotted to the question. The commonest pitfall was the inability of many candidates to articulate the impact of a new loan on the cost of equity, cost of debt ad weighted average cost of capital (WACC). This is a reflection of candidates’ inability to apply concepts to practical situations. Candidates at this level of the examination must develop analytical skills that will enable them apply concepts and principles to simple practical situations, as this is the distinction between Skills and Foundation levels of the examination.

Marking guide Marks 2 a To calculate the Weighted Average Cost of Capital (WACC) of Feli Plc 7 marks b To calculate the impact of the new bank loan on Feli Plc’s:

i) Cost of Equity ii) Cost of Debt and iii) WACC (using the traditional model) 9 marks c To explain each and distinguish between:

i) bonds ii) a bank loan 4 marks Total 20 marks 161

(a)

i) Compare IRR to Division-Specific WACC A project is accepted if IRR\>WACC for its respective division. Project Division IRR (%) Division- Specific WACC(%) Decision A Light Engineering 16% 16.5% Reject (IRR \< WACC) B Food Retailing 16% 15.3% Accept (IRR \> WACC) C Luxury Goods 18% 18.9% Reject (IRR \< WACC)

ii) What Happens with a Single WACC of 17%? If Kolawole Ltd applies a uniform WACC of 17%: Project Division IRR (%) Division- Specific WACC(%) Decision A Light Engineering 16% 17% Reject (IRR \< WACC) B Food Retailing 16% 17% Reject (IRR \< WACC) C Luxury Goods 18% 17% Accept (IRR \> WACC) Observations and risks

• Using risk-adjusted WACC, only Project B (Food Retailing) is viable.

• Using the single WACC (17%), the company rejects a good investment (Project B) and accepts a risky one (Project C).

• This misallocation of capital arises because a single WACC ignores division-specific risks.

iii) Key risks of using a single WACC Underinvestment in low-risk divisions

• Project B (Food Retailing) has an IRR of 16%, which is higher than its actual risk-adjusted WACC (15.3%) but lower than the company-wide WACC (17%).

• This means good, low-risk investments may be unfairly rejected. Overinvestment in high-risk Divisions

• Project C (Luxury Goods) is approved under the single WACC, even though its risk-adjusted WACC is higher. 162

• This means high-risk projects may be accepted when they should not be. Incorrect capital allocation Applying a single WACC assumes all divisions have the same risk, leading to poor capital budgeting decisions.

iv) Improving risk assessment for better decisions

• Use division-specific WACC for investment decisions.

• Adjust project discount rates based on business and financial risks.

• Apply the pure-play method to determine more accurate betas for each division.

• Regularly update WACC to reflect changes in capital structure and market conditions. (b)

i) Systematic business risk This is the part of a company’s operating risk that comes from general economic or industry-wide factors that affect all firms in that sector. It cannot be eliminated by diversification. Examples:

• During the COVID-19 pandemic, airlines like British Airways and Delta saw a collapse in passenger demand. This was not unique to one airline but a systematic business risk affecting the whole aviation industry.

• An oil price crash (e.g., 2014) reduced revenues for virtually all oil exploration companies (Shell, Exxon, Total). The downturn was industry-wide, not firm specific.

ii) Unsystematic financial risk This is firm-specific risk linked to how a particular company finances its activities. It arises from events or arrangements unique to that firm, and it can be diversified away by investors. Examples:

• In 2008, Lehman Brothers had unusually high reliance on short- term repo financing. When that market froze. Lehman collapsed. Other banks with different funding structures did not fail immediately. This was unsystematic financial risk because it was tied to Lehman’s own financing choices.

• A Nigerian manufacturing company that borrows heavily in US dollars without hedging exposes itself to FX losses if the naira devalues. Another Nigerian firm with naira-based loans would not 163 face the same problem. That FX mismatch is a firm-specific (unsystematic) financial risk.

• A company with strict loan covenants (e.g., “must keep debt-to- equity below 1.5”) could face default if it breaches them, while another firm in the same industry with loser covenants would not.

iii) Systematic financial risk This is the market-wide financial risk created by financial leverage. When a company uses debt, it amplifies how its equity returns move with the overall market. It is non-diversifiable because it changes the firm’s exposure to the market as a whole. Examples:

• In the 2008 financial crisis, banks such as Citigroup and RBS had very high leverage. When the market fell, their equity values collapsed far more than the average stock because debt magnified their losses. The extra volatility in their shares was systematic financial risk.

• A real estate investment trust (REIT) that finances properties 80% with debt will see its equity value swing much more with property market cycles than another REIT with only 30% debt. Investors cannot diversify that away – the high leverage permanently makes the stock more sensitive to market swings.

• In Nigeria, if Dangote Cement were to double its borrowings, its equity would become more sensitive to downturns in the Nigerian economy or stock market. That additional sensitivity is systematic financial risk.

Examiner’s report This question is in two parts. The first part test candidates’ understanding of capital budgeting decisions with emphasis on internal rate of return (IRR), risk assessment, and risk-adjusted WACC, while part (b) tests candidates’ understanding of systematic and unsystematic risks. About 70% of the candidates attempted this question. Performance was just average, as only half of them scored more than 50% of the marks allotted. A good number of the candidates could not arrive at the right decisions as they could not apply the correct rates. 164 Candidates at this level of the examination must develop analytical skills that will enable them apply concepts and principles to simple practical situations, as this is the distinction between Skills and Foundation levels of the examination.

Marking guide Marks 3a i To determine which projects should be accepted or rejected using the correct risk-adjusted WACC 3 marks ii To explain how the investment decision would change if Emeka Ltd still applied the simple company-wide WACC of 17%. 3 marks iii To highlight the key risks of using a single WACC for project evaluations in a diversified company like Emeka Ltd 2 marks iv To explain how the company can improve its risk assessment to make more accurate capital budgeting decisions. 2 marks b i To explain and illustrate Systematic Business Risk 3 marks ii To explain and illustrate Unsystematic financial Risk 3 marks iii To explain and illustrate Systematic financial Risk 4 marks Total 20 marks

a) The Interest Rate Parity (IRP) theorem is a fundamental concept in international finance that establishes the relationship between the spot exchange rate (S), the forward exchange rate (F), and the interest rates of two countries (domestic and foreign). Concept and no-arbitrage condition IRP is essentially a no-arbitrage condition that suggests that the returns from investing in two different countries, when hedged against foreign exchange risk, should be equal when expressed in a common currency. In simpler terms: An investor should be indifferent between investing domestically or investing abroad and covering the currency risk. The core equation The theorem states that any differential between the interest rates of two countries must be offset by the difference between the spot and forward exchange rates (known as the forward premium or discount). The algebraic expression for the relationship is: 165 Where:

• S is the current Spot Exchange Rate.

• F is the Forward Exchange Rate for the investment period.

• domestic is the risk-free interest rate in the domestic currency.

• foreign is the risk-free interest rate in the foreign currency. Mechanism If the market's forward exchange rate (F market) does not equal the theoretical rate (F theory) implied by the IRP formula, a Covered Interest Arbitrage (CIA) opportunity exists. Arbitrageurs would immediately exploit this by: (i) Borrowing in the currency with the lower implied return;

(ii) Converting it to the currency with the higher implied return;

(iii) Investing at the foreign interest rate; and

(iv) Simultaneously locking in the future exchange rate via a forward contract to convert the maturity proceeds back to the original currency. This mass movement of capital would instantly adjust the spot rate, forward rate, and/or interest rates until the IRP condition is restored, and the arbitrage profit is eliminated.

b) If there is covered interest arbitrage, the following must hold: (1 + RD) = F/S (1 + RF), where: RD = domestic interest rate = 10% = 0.10 RF = foreign interest rate = 2% = 0.023 S = current spot rate (DC/FC) = ₦1,200 per $1 F = 1- year forward rate (DC/FC) = ₦1,300 per $1 In this case: (1.10) vs 1,300/1,200(1.02) 1.10 \<1.105 The left hand side (LHS) is less than the right hand side (RHS) of the quote, indicating that the CIA is NOT holding and there is arbitrage opportunity in the market. 166

c) Arbitrage strategy

(i) Borrow in Nigeria today, the equivalent of $500,000 to give 500,000 × 1,200 = ₦600,000,000. This grows to become ₦600,000,000 × 1.10 = ₦660,000,000 in one year’s time. (ii) Convert the ₦660 million to dollar at the spot rate of ₦1,200 to produce $500,000. (iii) Invest $500,000 at 2% for 1 year. This grows to become: $500,000 × 1.02 = $510,000. (iv) Sell forward – at ₦1,300, the expected proceed of the US investment. This will generate 510,000 ×₦1,300 = ₦663 million in one year’s time. (v) Repay the Nigerian loan of ₦660 million. Calculate profit: ₦m Proceed of US invest as detailed above 663 Loan repayment (660) Risk from profit 3_

d) The profit is risk-free because the dealer has locked in all the variables through contracts, such that

• The forward contract hedges the exchange rate risk, ensuring the dealer knows the exact amount that will be received when the U.S investment is converted back into JPY;

• The interest rates are known and fixed when the investment and borrowing are made; and

• Variables (the borrowing rate, the investment return and the future exchange rate) are predetermined, the dealer is not exposed to uncertainty or market fluctuations. However the result in (c) does not imply the existence of permanent “money machines” in the market. Arbitrage opportunities arise when markets are temporarily inefficient, meaning prices deviate from their theoretical values (e.g. forward rates not aligned with interest rate parity). However, once these arbitrage opportunities are identified and exploited by traders, market forces typically bring the prices back into alignment. In this case, exploiting the arbitrage would push the forward rate toward the theoretical rate, eliminating the arbitrage opportunity over time. Thus, arbitrage opportunities are temporary and self-correcting rather than on-going cash machines.

Examiner’s report This question tests candidates' knowledge of international finance. It is in four parts, covering aspects of international finance, including spot and forward exchange rates, interest parity and arbitrage. 167 Only about 40% of the candidates attempted this question and only about a quarter of them scored up to half of the marks allotted. Many of the candidates could neither show whether covered interest rate parity existed in the data given, nor able to demonstrate existence of arbitrage opportunity. Candidates at this level of the examination must develop analytical skills that will enable them apply concepts and principles to simple practical situations, as this is the distinction between Skills and Foundation levels of the examination.

Marking guide Marks 4 a To explain the concept of interest rate parity theorem 5 marks b To show whether covered interest parity (CIP) hold in the data given. 4 marks c To calculate the profit available to the dealer at maturity, if there is an arbitrage opportunity 7 marks d To explain why the profit in (C), if any, considered risk- free 4 marks Total 20 marks

a) Advantages and disadvantages of a full stock exchange listing Advantages i) Access to capital – Listing would give Omega access to large pools of finance from institutional and retail investors to fund expansion into renewable energy projects.

ii) Liquidity of shares – Current shareholders can sell their shares more easily: new investors will be more willing to invest knowing an active market exists.

iii) Enhanced reputation – A listing improves the company’s visibility, public image, and credibility with lenders, suppliers and customers.

iv) Valuation transparency – The company’s shares will have a quoted market price, useful in mergers or acquisitions.

v) Employee incentives – Share options can be offered to employee enhancing motivation.

vi) Diversification of shareholder base – Attracts institutional investors and reduces reliance on a few private shareholders. Disadvantages: i) Loss of control – Existing owners may lose decision-making power as ownership becomes dispersed.

ii) Regulatory and disclosure burden – Compliance with NGX and SEC regulations increases costs and reduces confidentiality.

iii) Short-termism – Pressure to meet quarterly results may conflict with long-term strategy (e.g. renewable investments).

iv) Takeover risk – A more widely held share structure could expose Omega to hostile bids.

v) Flotation and on-going costs – Underwriting, legal and advisory fees are high; annual compliance costs also increase.

b) Factors in setting the issue price of new equity

i) Profit record and future growth – Omega’s history of profitability and renewable energy growth plans will justify a stronger valuation.

ii) Dividend policy – Investors will consider expected dividend yield when evaluating the issue price.

iii) Comparable companies – P/E ratios and dividend yields of other listed Nigerian manufacturing firms will guide pricing.

iv) Asset base / net asset value – The company’s tangible assets provide a benchmark for pricing, especially if growth prospects are modest.

v) Market conditions – General stock market climate and investor appetite for IPOs affect achievable pricing.

vi) Level of subscription desired – Price should ensure adequate demand; too high risks undersubscription, too low may undervalue shares.

vii) Advisors’ guidance – Underwriters and financial advisers will recommend a realistic price based on market testing.

viii) Reputation and confidence – As a first-time issuer, a slightly conservative price may build goodwill and ensure strong aftermarket performance.

Examiner’s report This question, which is in two parts, tests candidates’ knowledge of long term financing/raising of corporate capital. Part (a) tests advantages and disadvantages of full stock exchange listing. Part (b) requires candidates to state factors affecting the process of setting new equity shares prices. About 80% of the candidates attempted this question. Performance in part (a) was good, but many could not analyse the factors to be considered when setting an issue price for new equity shares in a floatation. Candidates at this level of the examination must develop analytical skills that will enable them apply concepts and principles to simple practical situations, as this is the distinction between Skills and Foundation levels of the examination.

MARKING GUIDE Marks 5 A To discuss the potential advantages and disadvantages of obtaining a full stock exchange listing 10 marks B To analyze the key factors that should be considered when setting an issue price for new equity shares in a flotation 5 marks Total 15 marks

(a)

i) Reasons why a company may decide to finance a new project with the issue of a new bond

• Preserve ownership control Unlike issuing new equity, bonds do not dilute existing shareholders’ control over the company.

• Tax advantages Interest payments on bonds are tax-deductible, lowering the effective cost of financing.

• Matching maturity with project life If the project has a defined useful life (say 5 years), issuing a bond with similar maturity provides a good financing match.

• Predictability of cash outflow Bonds carry fixed interest obligations, allowing the company to plan project cash flows accordingly.

• Possibility of lower cost of capital If market conditions make debt relatively cheaper than equity, bonds can reduce the overall cost of capital.

• Flexibility in structuring terms Bonds can be tailored (convertible, callable, fixed vs. floating interest, etc.) to suit company and investor needs.

• Market access and investor demand If investor appetite is high for fixed-income securities, bonds provide a viable financing source.

ii) Should the project be appraised using the cost of capital of 15% (the coupon rate of the bond)? Answer: No — the coupon rate (15%) is not automatically the correct discount rate for project appraisal. Reasons: o Cost of debt ≠ Coupon rate

• The relevant cost of debt is the yield to maturity (YTM) of the bond, i.e., the market-determined return required by investors, not just the nominal coupon.

• If market interest rates differ from 15%, the actual cost of debt will be higher or lower than the coupon. o Project appraisal should use WACC (weighted average cost of capital), not just debt cost

• Projects should generally be appraised at the company’s overall cost of capital (WACC), which reflects the weighted mix of debt and equity financing, unless the project is financed as a standalone with no recourse to equity holders.

• Even if debt is used exclusively, equity holders ultimately bear risk; hence WACC reflects the opportunity cost of capital. o Risk-adjusted discount rate

• The correct discount rate should reflect the systematic risk of the project.

• If the project has similar risk to the company’s existing business, WACC is appropriate.

• If risk differs significantly, an adjusted cost of capital should be used (sometimes based on a “pure play” approach). o Tax shield consideration

• The effective cost of debt is after-tax cost of debt = YTM × (1 – tax rate).

• Appraising at 15% coupon ignores the tax benefit of debt financing. (b)

i) Investor’s rate of return in dollars Dollar return = 5%

ii) Investor’s rate of return in euros First convert both values into euros:

• Initial value in €: 1,000,000 × 1 = €1,000,000

• Final value in €: 1,050,000 × 1.02 = €1,071,000

• Rate of return in €: Euro return = 7.1% iii) Is the difference exactly equal to the percentage movement exchange rate?

• Exchange rate change: Given

• Initial portfolio value = $1,000,000

• Final portfolio value = $1,050,000

• Initial exchange rate = €1 per $1

• Final exchange rate = €1.02 per $1

• Dollar return = 5%

• Exchange rate effect = 2%

• Expected combined return (approximate) = 5% + 2% = 7% But actual euro return = 7.1%, slightly higher. Why not exactly equal? Because returns compound multiplicatively, not additively. The euro return is given by: (1 + r€) = (1 + r$) × (1 + rFX) Substitute values: (1 + r€) = (1.05) (1.02) = 1.071 r€= 7.1% So, the difference comes from the interaction term (5% × 2% = 0.1%), which makes the euro return slightly larger than the sum.

Examiner’s report This question tests candidates understanding of local and international bond investing. Part (a) of the question tests candidates’ knowledge of local bonds investment, while part (b) tests international bond investing. Only about 40% of the candidates attempted this question. Many of them performed well in part (a) of the question, but most did not have a clue to part (b), leading to just average performance overall. Candidates at this level of the examination must develop analytical skills that will enable them apply concepts and principles to simple practical situations, as this is the distinction between Skills and Foundation levels of the examination.

MARKING GUIDE Marks 6a i To provide reasons why a company may decide to finance a new project with issue of a new bond. 5 marks ii To explain with adequate justification whether the project should be appraised using cost of capital of 15% (the coupon rate of the bond). 5 marks b i To calculate the investor’s rate of return in dollar. 3 marks ii To calculate the rate of return in Euros. 1 mark iii To determine whether the difference exactly equals to the percentage movement in exchange rate and if not why? 1 mark Total 15 marks

e) Usually, the actual price at which a convertible bond trades in the bond market is higher than the conversion value as well as the straight value of the convertible bond. The difference between the actual market price and the conversion value is called the market conversion premium (MCP). MCP = Market price of bond – Conversion value = ₦1100 – ₦1040 = ₦60 This is often expressed on a per share basis, i.e. ₦60/20 = ₦3 per share

f) The minimum value of the convertible bond is the maximum value between the conversion value and the straight value. Minimum value of bond = Maximum (Conversion Value, Straight Value) = Max (1040,956.71) = ₦1040

g) Convertible bonds have lower ratings as compared to the non-convertible bonds because:

a) Yes, the stock split will affect the conversion ratio which needs to be adjusted. Original conversion ratio = 10:1 Since the stock is split 2:1, the new conversion ratio will be 20:1

b) The conversion price of the convertible bond issued after the stock split will be,

c) The conversion value of the convertible bond after the stock split with its current stock price at ₦52 will be: Conversion value = Conversion ratio × Market price = ₦20 x 52 = ₦1040

d) A straight value of a convertible bond is the price of a straight or non- convertible bond with characteristics similar to those of the convertible bond under consideration. Straight value of bond (equal to present values of an equivalent non- convertible bond).

i) Typically, convertible bonds are classified as subordinated debt, which is junior in ranking to senior or unsubordinated debt as far as principal repayment in the evert of issuer distress or bankruptcy.

ii) Most companies that issue convertible bonds do so because their interest costs are high. By offering investors the option to convert bonds to stocks, the company can pay a lower rate than it does to straight bondholders. But companies with high borrowing costs tend to be lower rated.

h) The lowering of the rating of the convertible bond issue indicates the possibility of default either for interest payment or principal payment or both has increased. In such a scenario, ceteris paribus, any rational investor will expect a higher return from investment due to its increase in risk factor which could be achieved by buying the bond at a lower price. Hence the price of the bond decreases.

Examiner’s report This question tests candidates’ understanding of convertible bonds through eight questions requiring short answers. More than 80% of the candidates attempted this question and performance was good as more than 60% of the candidates scored over 50% of the marks allotted. Those candidates that did not perform well did not understand the issues involved in the issuance of convertible bonds. Candidates at this level of the examination must develop analytical skills that will enable them apply concepts and principles to simple practical situations, as this is the distinction between Skills and Foundation levels of the examination.

MARKING GUIDE Marks 7 a To explain if the stock split of 2:1 would affect the conversion ratio of the company’s convertible bonds issued; if yes, what is the conversion ratio? if no, explain why. 1½ marks b To calculate the conversion price of the convertible bond issued, after the stock split 1½ marks c To calculate the conversion value of the convertible bond, where the stock of ABC (after the split) is currently trading at N52 in the spot market. redemption. 1½ marks d To define and calculate the straight value of the convertible bond, given that another bond trading in the market similar in all characteristics to that of the convertible bond exists yielding 5%. 2½ marks e To define conversion premium of a convertible bond; To determine the conversion premium if it is trading at 110 in the market, for the given convertible bond. 2 marks f To explain the minimum value of a convertible bond; To calculate the minimum value of the given bond. 2 marks g To explain why convertible bonds usually have a lower rating as compared to non-convertible bonds with similar characteristics. 2 marks h To explain what impact the lowering of the rating of the convertible bond by a rating agency after one year of issue have on the issue price of the bond. 2 marks Total 15 marks