Strategic Financial Management · 2014

Governance questions: The May 2014 paper asked in the multiple-choice section which stakeholders governance aims to promote and what is not required in a well governed entity (question 3: board members need not hold the most shares), and asked in the short-answer section to name the processes by which companies are directed and controlled (corporate governance). Read the sections on composition and the role of the board for the points behind those answers.

Short-answer 5: Short-answer question 5 tested interest rate parity. Practise the forward rate formula and the worked examples on IRP and part-year rates.

Short-answer 13: AB Limited (5 million shares at ₦64 and EPS ₦4.00) intends to acquire XY Limited (2 million shares at ₦35 and EPS ₦2.50) through an offer of shares at current market values. The shares to issue are 35 × 2,000,000 ÷ 64 = 1,093,750. Read the section on the purchase consideration and worked example 1.

The 15-mark compulsory question asked for the value of Wazobia Limited by three methods and two limitations of each. The model answer adjusts three years of profit (inventory error, directors’ pay at ₦1,875k and depreciation at ₦3,000k), averages them to ₦4,050k and applies an average peer P/E of 6 for ₦24.3m. Break-up value is ₦29.725m. Dividend yield at an average 10% on ₦2.25m gives ₦22.5m. The examiners said performance was poor because candidates did not understand the valuation methods. Read the sections on asset-based and income-based valuation.

The 15-mark question gave two identical companies that differ in capital structure and asked what an investor holding 4% of the geared company should do to improve income or keep it, and then the effect of a ₦50m loan on the cost of capital under MM with tax. The model answer uses V = V_U + Dt (₦280m + ₦62.5m × 30% = ₦298.75m against a market value of ₦312.5m), sells the overvalued geared shares, borrows personally and buys the other company’s shares. The examiners noted that fewer than 30% attempted it. Read the section on MM and arbitrage.

The May 2014 paper asked (15 marks) why a quoted company would want to know the make-up and objectives of its shareholders, and five advantages to the finance manager. The model answer gives avoiding agency conflict and decisions that follow shareholder preferences, with advantages for dividend policy, risky investment, financing, resisting a takeover, performance measures and the religious beliefs of shareholders. Read the sections on stakeholders and shareholders.

The 15-mark question noted that annual reports are seen as important but that share prices do not react in the short term to their publication. Part (a) asked for the EMH, its forms and the empirical support (5 marks). Part (b) asked for the implications for technical analysis (charting) and for fundamental analysis (5 marks). Part (c) asked for two roles of portfolio managers in an efficient market (5 marks). About 60% of candidates attempted it and performance was fair. Read the sections on the three forms and on the implications.

The May 2014 paper asked (9 marks) how the aim of maximising firm value can be compromised by conflicts between managers and other stakeholders. The expected points are the agency conflicts on this page: effort and reward, little incentive for creative ventures, high salaries and perks, empire-building through mergers, diversification that protects managers, a short-term view and actions that reduce creditors’ wealth. Read the sections on agency conflicts and on reducing the agency problem.

Question 6 included a forward discount calculation, with the dollar at a discount of about 3.7%. Practise the premium and discount rules in the section on forward rates.

The compulsory 30-mark question asked for a project NPV for a cement plant at a project-specific cost of capital of 13%. The model answer lists the cash flows by year, takes tax on operating profit, adds the tax saving on tax depreciation, includes working capital at 10% of revenue as an outflow at the start of each year and a recovery at the end, and leaves out loan repayments, interest, apportioned overheads and sunk survey costs. Worked example 2 and the layout table show the same method on smaller numbers.

The compulsory cement project question gave different growth rates for revenue (5% a year) and variable cost (4%) and fixed overheads (8%), so each item had to be inflated at its own rate and discounted at a money cost of capital. The model answer lists sales revenue, variable cost and fixed cost by year on that basis. Read the sections on money flows and on specific inflation.

The compulsory question asked for a project-specific cost of capital after ungearing and regearing betas, then CAPM for the cost of equity, the after-tax cost of debt (8% × 0.75 = 6%) and a WACC of about 18% on a 100 : 30 equity to debt basis. Read the sections on debt and on WACC.

The compulsory question asked for the cost of capital for a cement project, using a proxy company’s beta, ungearing and regearing and CAPM. The result is about 18% against the company’s 11%, because cement is riskier. Read the section on CAPM and project appraisal.

The 12-mark part asked for the cost of capital for a cement project. The model answer takes the proxy company’s equity beta of 1.82, strips out its 40% drinks division (equity beta 0.8) to find a cement equity beta of 2.5, ungears it using the proxy’s debt to equity ratio of 40% and tax of 25% to about 2.0, regears at the target ratio of 30% to 2.36, uses CAPM for a cost of equity of 21.52%, takes the after-tax cost of debt as 6% and weights them 100 : 30 for a WACC of about 18%. Candidates confused debt to equity with debt to total capital. Read the sections on project-specific rates and betas.

The compulsory cement project question included tax at 25% paid in the year the profit is made, with a tax allowance on plant and equipment claimed evenly over five years with nil scrap value. The model answer takes tax on operating profit and adds a yearly tax saving on the allowance of ₦75m (25% of ₦300m). It leaves out loan repayments and interest. Read the sections on capital allowances and the worked examples.

The compulsory question asked for the NPV (₦404m) and the MIRR of a cement project at 13%, then a recommendation using both. The model answer divides the PV of the return stage (₦2,509m) by the investment at time 0 (₦2,105m), takes the fifth root, multiplies by 1.13 and subtracts 1, giving about 17%, which beats the 13% cost of capital, so the project is accepted. It also marks loan repayments and interest, apportioned overheads and sunk survey costs as irrelevant. Read the sections on the MIRR and on relevant costs.

Chelsy Plc had a profitable Bolts division and a loss-making Nuts division. The board considered closing the company or closing Nuts and selling Bolts to management in a management buyout financed largely by debt. Part (a) asked for the benefits of divesting Bolts through an MBO (4 marks), part (b) for the return to creditors and shareholders if everything were sold (3 marks), part (c) for the extra finance and value of the new company (8 marks), and part (d) for the issues in seeking buyers, negotiating the price and due diligence (5 marks). Read the sections on MBOs and on divestments.

The 20-mark question gave Syntax Plc a target, Synapse Chemical, with five years of forecast revenue, costs and profit, a sale of assets with a tax written down value, capital expenditure, a one-year tax delay, a 22% after-tax WACC and an agreed price of ₦20m. It asked for an appraisal of the acquisition and advice to the board in the form of a report. The cash flow method in this topic is the approach to take: build free cash flows from profit, tax, capital spending and the disposal, then discount. Read the sections on the DCF basis and free cash flow.

Syntax Plc agreed to buy Synapse Chemical for ₦20m. The question asked for an appraisal of the acquisition and advice on whether the price was reasonable, as a report to the board (20 marks). Compare the value of the cash flows with the price, and comment on the assumptions. Read the sections on factors in pricing a bid and valuation methods.

The question asked for a comparison of issuing bonds by private placement and by public offer, the advantages of each and advice on which suits a family-owned drug company seeking a bond in the first quarter of 2015 and shares later. Read the sections on bond markets and the nature of debt finance.

The question asked for four steps to improve the chances and success of an IPO for a family pharmaceutical company that wants to list. Read the sections on public companies and the public offer.

The 4-mark part asked candidates to explain the three forms of the EMH and say which is most likely to apply in practice. Read the sections on the three forms and the evidence.

Question 7 was a foreign exchange question that combined retention money, a money market hedge and forward contracts. Read the section on money market hedges and the worked examples.