ICAN 2022 Strategic Financial Management | Mixed

Vico Tony (VT) is a software design company established six years ago. The company is owned by five directors. Since establishment, the company has developed rapidly. VT finds it difficult to obtain bank finance and relies on a long-term strategy of using internally generated funds to finance expansion. The directors are therefore giving consideration to the possibility of floating the company on the stock market. As a first step, you have been appointed by the directors to advise on the current value of the business under their ownership. The company’s most recent statement of profit or loss and the extracted balances from the latest statement of financial position are as follows: Statement of Profit or loss N’Million Sales 10,000 Cost of sales (6,000) Gross profit 4,000 Other operating costs (3,754) Operating profits 246 Interest on loan (148) Profit before tax 98 Statement of Financial Position N’Million Opening non-current assets 2,400 Additions 132 Non-current assets (at cost) 2,532 Accumulated depreciation (734) Net book value 1,798 Current assets Cash and bank 100 Receivables 520 Inventory 280 900 Total assets 2,698 Non-current liability: Loan 1,980 Current liabilities Payables 182 Tax payables 30 Interest payable 148 360 Total liabilities 2,340 Shareholders Equity 358 During the current year: (i) Depreciation is charged at 10% per annum on the year end non-current assets balance before accumulated depreciation, and is included in other operating costs in the statement of profit or loss. (ii) The investment in net working capital is expected to increase in line with the growth in gross profit. (iii) Other operating costs consisted of: N’Million • Variable component at 15% of sales 1,500 • Fixed costs 2,000 • Depreciation on non-current assets 254 (iv) Sales and variable costs are projected to grow at 9% per annum and fixed costs are projected to grow at 6% per annum. (v) The company pays interest on its outstanding loan of 7.5% per annum and incurs tax on its profits at 30%, payable in the following year. The company does not currently pay dividends. One of your first tasks is to prepare for the directors a forward cash flow projection for three years and to value the firm on the basis of its expected free cash flow to equity. In discussion with them, you note the following: • The company will not dispose of any of its non-current assets but will increase its investment in new non-current assets by 20% per annum. The company’s depreciation policy matches the currently available tax allowable depreciation. This straight-line write off policy is not likely to change; • The directors will not take a dividend for the next three years but will then review the position taking into account the company’s sustainable cash flow at that time; • The level of loan will be maintained at ₦1.98 billion and interest rates are not expected to change; • For estimating the appropriate required return on equity, it is decided to make use of the capital asset pricing model (CAPM). The challenge however, is that since the company is not quoted, an appropriate beta factor does not exist. You have found a listed company, Konputer Limited (KL) that is into software development. KL is also into computer hardware retailing. It has the following financial statistics: Equity beta 1.40 Debt beta 0.20 Debt/Equity ratio 40% Effective tax rate 25%; About 60% of the market value of KL is attributed to software development division while 40% of the value is attributed to computer hardware retailing. The computer hardware retailing division has equity beta of 0.8; Risk-free rate is 4% and the market risk premium is 8%; and VT has maintained a long-term debt/(debt+equity) ratio of 20%.

Effe is a Nigerian company specialising in the provision of information systems solutions to large corporate organisations. It is going through a period of rapid expansion and requires additional funds to finance the long-term working capital needs of the business. Effe has issued one hundred million N1 ordinary shares, which are listed on the stock market at a current market price of N15 with typical increases of 10% per annum expected in the next five years. Dividend payout is kept constant at a level of 10% of post-tax profits. Effe also has N1,000 million of bank borrowings. It is estimated that a further N300 million is required to satisfy the funding requirements of the business for the next five-years beginning July 1, 2021. Two major institutional shareholders have indicated that they are not prepared to invest further in Effe at the present time and so a rights issue is unlikely to succeed. The directors are therefore considering various forms of debt finance. Three alternative structures are under discussion as shown below: • Five-year unsecured bank loan at a fixed interest rate of 7% per annum; • Five-year unsecured bond with a coupon of 5% per annum, redeemable at par and issued at a 6% discount; and • A convertible bond, issued at par, with an annual coupon rate of 4.5% and a conversion option in five years’ time of five shares for each ₦100 nominal of debt. There have been lengthy boardroom discussions on the relative merits of each instrument. Summarised below are the queries of three different directors concerning the instruments. Director A: “The bank loan would seem to be more expensive than the unsecured bond. Is this actually the case?” Director B: “Surely, the convertible bond would be the cheapest form of borrowing with such a low interest rate?” Director C: “If we want to increase our equity base, why use a convertible bond, rather, than a straight equity issue?”

Opeyemi operates in an economy that has almost zero inflation. Management ignores inflation when evaluating investment projects because it is very low and considered insignificant. Opeyemi is evaluating a number of similar, alternative investments. The company uses an after tax cost of capital of 6% and has already completed the evaluation of two investments. The third investment is a new product that would be produced on a just-in-time basis and is expected to have a life of three years. This investment requires an immediate cash outflow of N200,000, which does not qualify for tax depreciation. The expected residual value at the end of the project’s life is N50,000. A draft financial statement showing the values that are specific to this investment for the three years is as follows: Year 1 Year 2 Year 3 N N N Sales 230,000 350,000 270,000 Production costs: Materials 54,000 102,000 66,000 Labour 60,000 80,000 70,000 Other* 80,000 90,000 80,000 Profit 36,000 78,000 54,000 Closing receivables 20,000 30,000 25,000 Closing payables 6,000 9,000 8,000 *Other production costs shown above include depreciation calculated using the straight line method. The company is liable to pay corporate tax at a rate of 30% of its profits. One half of this is payable in the same year as the profit is earned, the remainder is payable in the following year.

The finance director of Keyman Plc. has recently reorganised the finance department following a number of years of growth within the business, which now includes a number of overseas operations. The company has created separate treasury and financial control departments.

The directors of Jindadi Plc. (JP), an Abuja-based entertainment company, are currently considering the appropriate cost of capital to use in appraising capital investments. It is the policy of the company to assess the financial viability of all capital projects using net present value criterion. You have been provided with some financial information of the company. Most recent statement of financial position Nm Nm Equity finance Ordinary shares (N1 nominal value) 200 Reserves 120 320 Non-current liabilities 7% Convertible bonds (N 100 nominal value) 160 5% Preference shares (N 1 nominal value) 80 240 Current liabilities Trade payables 80 Overdraft 120 200 Total liabilities 760 JP has an equity beta of 1.2 and the ex-dividend market value of the company’s equity is N1 billion. The ex-interest market value of the convertible bonds is N168 million and the ex-dividend market value of the preference shares is N50 million. The convertible bonds of JP have a conversion ratio of 19 ordinary shares per bond. The conversion date and redemption date are both on the same date in five years’ time. The current ordinary share price of JP is expected to increase by 4% per year for the foreseeable future. The equity risk premium is 5% per year and the risk-free rate of return is 4% per year. JP pays profit tax at an annual rate of 30% per year.

You have worked with a major oil servicing company in Nigeria, with headquarters in the USA, for the past six years. Recently you completed your ICAN examinations and you have been asked to join the international treasury department in New York City for a two-year attachment. The company is due to pay a UK supplier the sum of ₤5million in three months time. Your team is considering alternative methods of hedging the expected payment against adverse movements in exchange rate. Exchange rate information US$ per ₤1 Spot rate 1.9410 – 1.9531 One – month forward rate 1.9339 – 1.9452 Three – month forward rate 1.9223 – 1.9339 Futures market (contract size of ₤62,500, Quotation: US$ per ₤) 2-month expiry 1.9305 5-month expiry 1.9170 Options market (₤31,250 contracts size, premiums are quoted in cents per ₤1) Call option Put option Exercise 2-month 5-month 2-month 5-month price expiry expiry expiry expiry 1.9000 2.88 3.55 0.15 0.28 1.9200 1.59 2.32 1.00 1.85 1.9400 0.96 1.15 2.05 2.95 You are required to advise the company which of the following hedging strategies should be adopted for the payment due to be made in three months. Show all workings.

You are required to provide a briefing on the following dividend concepts: