Professional Documents
Culture Documents
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CORPORATE FINANCIAL
MANAGEMENT
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SUGGESTED ANSWER
FOR THE
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SECTION A
(Compulsory - answer all questions)
Question 1
(a) Agency Problem - The relationship between stockholders and the management
is called the agency relationship. This occurs when the shareholders as
principals hire their agents to act on their behalf. The possibility of conflicts of
interest between them is termed as the agency problem. There are two types of
agency costs, the direct costs originating from compensation and the indirect
ones resulting from monitoring the agent’s performance. Hence, shareholders
should make efforts to affect managerial behaviour in order to minimize agency
cost by practicing a reward system known as executive compensation tied to
performance.
(b) A stockholder owns part of a company and is entitled to income in the form of
dividends. Stockholders also elect directors who run the company. Stakeholders
are groups of people who have an interest in how the firm is run. These include
stockholders, employees, management, creditors and customers among others.
Each group is interested in the firm’s operation and profitability for its own
reasons. All stockholders are stakeholders, but all stakeholders aren’t
stockholders.
(c) The common types (any two) of securities issued the primary market are:
(i) An offer for sale – a situation where a firm sells shares to the public. The
firm is advised by an issuing house (normally a merchant bank), which
endorses the sale. All work involved in managing the issue, including
advertising, publication of prospectus and receiving and dealing with
applications is done by the issuing house.
(ii) Rights issue– additional shares are offered only to existing shareholders on a
pro-rata basis. They are given the pre-emptive right to buy the new shares at
a price lower than the market price. This entitlement means that they can
avoid dilution of ownership and earnings in the future. Alternatively, they
can sell the rights in the market or wait for the issuer to do so and collect any
surplus available.
(iii) A tender offer – involves calling for tenders from prospective subscribers,
after fixing a minimum reserve price for the shares. After receiving all the
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offers, the firm determines the price at which there are sufficient tenders for
it to raise the amount required ( strike price) and issues shares at that price to
all those who offered at least the strike price.
(d) Government securities represents risk free rate of return. This is because
securities issued by a government is guaranteed by the government itself and
carries zero default rate (risk free rate).
The best rating of corporate debt securities that could match the government
securities is AAA, defined as corporate debt securities that have the best quality
and offer the highest safety for timely payment of interest and principle.
(e) Efficient Frontier represents the set of portfolios that has a maximum rate of
return for every given level of risk, or the minimum risk for every level of
return. Every portfolio that lies on the efficient frontier has either a higher rate
of return for equal risk or lower risk for an equal rate of return than some
portfolio beneath the frontier.
(f) The basic idea behind purchasing power parity (PPP) is that a commodity costs
the same regardless of what currency is used to purchase it or where it is selling.
Example: If a burger costs RM2 in Kuala Lumpur, and the exchange rate is
RM3.20 per US dollar, then a burger costs RM2/$3.20 = $0.625 in New York.
In other words, PPP says that $1 will buy you the same number of burger
anywhere in the world.
(g) The four (4) basic motives for capital expenditures are:
(i) Expand - Purchase of additional plant facilities, resulting from a rapid
growth in business operations.
(ii) Replace - When sales slow down or repair becomes more expensive.
(i) Coupon – the annual interest payment promised by the issuer, based on
the par value
(iii) Maturity date – the expiry date, when the principal becomes due
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(v) Current yield – a return measure that indicates the amount of current
income a bond provides relative to its market price
(vi) Callability – the possibility of early retirement of the bond by the issuer
(i) Fixed dividend payout ratio - It is certain percentage of the earnings per
share. When the firm makes more earnings, the dividend paid will be
higher. (Assuming number of shares outstanding is unchanged).
(ii) Fixed dividend payment: The amount of dividend is fixed even if the
firm does not do as well as the previous year, it must pay the agreed
amount.
(iii) Residual dividend - firms pay dividend if there is any "leftover" earnings
after making allocation of the next year's capital budget.
(j) The key factors (any four) distinguishing the finance management of firms
operating within a country from those operating globally. They are:
(ii) Economic and legal ramifications - Each country's unique economic and
legal system can cause significant problems when a MNC attempt to
coordinates its worldwide operations.
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SECTION B
(Answer only THREE questions from this Section)
Question 2
a)
= √ 2 (1000) (26000)
(0.25 x RM4.92)
= EOQ x (P x C)
2
= 6500 x RM1.23 = RM4000
2
= Sales x F
EOQ
= 26000 x RM1000 = RM4000
6500
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i) Just In Time (JIT) - Approach focussed on minimizing the time an inventory is
held. In a production process, the inputs required for stage two is programmed
to arrived just in time. (Immediately after stage one is completed)
iii) LIFO vs. FIFO - The last in first out methods follows that the cost of goods
sold is based on the last unit placed in inventory. The first in first out releases
goods in the order they entered the inventory record.
[Total 20 marks]
Question 3
a) Use IRR to determine the initial capital of both projects as IRR is the rate when
NPV = $0
b) Project A
i. Payback period (Io = 222.58)
50 (Year1) + 80(Year2) + 80(Year3) = 210 + (12.558/90)
= 3.14 years
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Year Cash Flow Discounted Cash
(RM) Flow
(RM)
0 -222.58
1 50 50/ (1.05^1) = 47.62
2 80 80/(1.05^2) = 72.56
3 80 80/(1.05^3) = 69.11
4 90 90/ (1.05^4) = 74.04
Project B
i. Payback period (Io = 120.156)
60 (Year1) + 40 (Year2) = 100 + (20.156/40)
= 2.504 years
c) NPV (Project A)
PV = 47.62 + 72.56 + 69.11 + 74.04 = RM263.33
NPV = 263.33 – 222.58 = RM40.750
NPV (Project B)
PV = 57.14 + 36.28 + 34.55 + 16.45 = RM144.42
NPV= 144.42 – 120.156 = RM24.26
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Question 4
a) MM Proposition 1 (no taxes) states that the value of a levered firm is the same
as the value of unlevered firm (firm value is irrelevant to its capital structure)
while MM Proposition II (no taxes) states that a levered equity has greater
expected return than unlevered equity to compensate for its greater risk.
d) Interest rates appear to have fallen, since the market values of debt and preferred
exceed their original values (book values). Price of debt and preferred is
inversely related to interest rates.
[Total 20 marks]
Question 5
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ii) Price earning ratio (PER)
Price/EPS = RM20/1.75 = 11.43x
(a) Number of shares owned after stock split = (3/2) x 1000 = 1,500 shares
[Total 20 marks]
Question 6
(a)
i) Quick Ratio = (Current Asset – Inventories)/Current Liabilities
= (1,730,112 – 600,000)/740,000
= 1.53x
ii) Debt Ratio = Long Term Debt/Total Asset
= 780,000/3,062,112
= 25.47%
iii) Time Interest Earned Ratio = EBIT / Interest Expenses
= 1,622,000/160,000
= 10.14x
iv) Inventory Turnover Ratio = Sales/Inventory
= 8,000,000/600,000
= 13.33x
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v) Net Profit Margin = Net Profit /Sales
= 1,052,640/8,000,000
= 13.16%
(b)
i) ICP Inventory/(Sales/360)
= 600,000/ (8,000,000/360) 27.00 days
ii) ARCP A/c Receivables/ (Sales/360)
= 400,000/ (8,000,000/360) 18.00 days
iii) APP A/c Payable/ (COGS/360)
= 450,000/ (5,800,000/360) 27.93 days
iv) CCC ICP+ARP-APP 17.07 days
(c) The relative valuation techniques are appropriate to consider under the
following conditions.
(i) You have a good set of comparable entities i.e. comparable companies that
are similar in terms of industry, size and risk
(ii) The aggregate market and the company’s industry are not at a valuation
extreme i.e. they are not either seriously undervalued or overvalued
[Total 20 marks]
-End-
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