Financial Management Question Paper

Financial Management 

Course:Bachelor Of Commerce

Institution: Strathmore University question papers

Exam Year:2011

Bachelor of Commerce
DATE: 23RD MARCH 2011 TIME: 2 Hrs
Answer QUESTION ONE from PART A and ANY TWO Questions from PART B
a) Common/ordinary shares are a common source of capital especially for publicly listed
companies. Discuss five characteristics of this source of funds. (5 marks)
b) Preference shares are considered as hybrid securities. Discuss. (5 marks)
c) Growing Ltd requires Sh.45million to finance a new project. The management has decided to
make a rights issue to raise the capital. They have set an offer price of Sh.9.00 while on
announcement of the rights issue the market price per share is expected to be Sh.9.60. The
current market capitalization of the company is Sh.192million.
i) How many rights are required to buy one new share? (3 marks)
ii) Suppose Ms. Eva holds 1,000 shares in the company and decides to take the following
i. Exercise all her rights and buy new shares. (5 marks)
ii. Exercise half of her rights and buy new shares while she sells the remaining rights.
(5 marks)
iii. Sell all her rights. (3 marks)
iv. Ignore the rights issue. (2 marks)
Evaluate how each of the above actions would affect her wealth.
iii) Explain two reasons why the offer price in a rights issue is usually set lower than the market
price. (2 marks)
(Total: 30 marks)
a) In a discussion between two finance students one was heard to say “Debt is not a favourable
source of funding as it is more expensive than equity.” Do you agree? Discuss. (4 marks)
b) Missile, Inc is considering a Sh.20 million modernisation project in the power systems
division. The project’s after-tax cash flow will be Sh.8 million in perpetuity. Missile’s
Cost of debt is 10% and its cost of equity is 20%. The target debt–equity ratio is 2, and the
firm is in the 34% tax bracket.
What is the weighted average cost of capital and should the firm undertake this project?
(3 marks)
c) State and explain three limitations of using the weighted average cost of capital as a discount
rate. (3 marks)
d) A company has Sh20 million in total assets currently. It plans to increase its production
capacity by Sh.6 million in the coming year and several financing options are available:
• Acquire a loan from a bank at 12% interest p.a.
• Sell 11.5% preference shares at par.
• Utilize funds available internally amounting to Sh.1 million.
• Issue new ordinary shares at Sh.50 each (the company will however incur floatation costs
of 5%).
Over the past few years, dividend yield has been 6% while the firm’s growth rate in
dividends, share price and earnings has been 8%. The tax rate is 34% and the company’s
capital structure considered optimal is given as follows:
Source Amount (Sh.’000)
Debt 8,000
Preference share capital 2,000
Retained Earnings 6,000
Ordinary share capital 4,000
Compute the company’s Marginal cost of capital. (10 marks)
(Total: 20 marks)
a) Define the term optimal capital structure. (1 mark)
b) With the aid of graphs, describe the Traditional view of the optimal capital structure and
compare this view with the Net Operating Income (NOI) and the Net Income (NI) approach.
(12 marks)
c) What role does the finance manager play in dividend decisions? (4 marks)
d) Sate and explain how any three factors affect a firm’s dividend policy. (3 marks)
(Total: 20 marks)
The following information relates to the operations and capital structures of two companies,
Matibabu Limited and Kupona Limited.
Matibabu Limited Kupona Limited
Units sold 80,000 80,000
Sh. Sh.
Revenue 160,000 160,000
Variable costs 64,000 128,000
Fixed costs 76,000 12,000
The capital structures of the companies are as below:
Matibabu Limited Kupona Limited
Sh. Sh.
8% long term debt 150,000 50,000
Common stock (Sh.6.25 par) 50,000 150,000
The corporate tax rate is 50%.
If sales for the two companies increase by 10%, compute and compare:
a) Degree of Operating Leverage (8 marks)
b) Degree of Financial Leverage (8 marks)
c) Degree of Total Leverage (4 marks)
(Total: 20 marks)
Salon Limited’s annual sales amount to Sh.25,000,000 out of which 80% are on credit. Due to
decrease in demand of its products, the firm is considering changing the credit terms from the
current net 30 to 2/10 net 45.
This will lead to an increase in total sales by 20% while credit sales will now be 90% of total
sales. The contribution margin ratio before and after the change in credit policy will remain at
20%.The current level of bad debt is 2% of total credit sales which is expected to increase to 3%
of new total credit sales. The increase in sales will mean extra production using the existing idle
machine capacity therefore additional raw materials amounting to Sh.300,000 would be required.
It is expected that with the introduction of the new credit policy 40% of all credit customers will
take advantage of the discount offered. The credit analysis and administration costs will increase
by Sh.750,000. On average the return on investment in debtors is 15%. Assume 365 days in a
Evaluate whether the firm should adopt the new credit policy. (Total: 20 marks)

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