ICAN 2025 Strategic Financial Management | Mixed

Kola Plc. is a large listed company involved in two business sectors. Its main business is in the production of food and drink for supermarkets and other large traders. It also owns a chain of restaurants nationwide. Kola’s Board of Directors (BoD) think that the company is undervalued and is of the opinion that it should focus on the rapid innovation taking place in the food and drink production sector. Therefore, Kola’s BoD has decided to unbundle the restaurant business into a company called ZK Ltd and Kola Plc can either spin-off or sell ZK Ltd after the demerger so that Kola Plc can focus on its remaining business of food and drink production. Initially, Kola Plc’s shareholders will own ZK Ltd on the basis of owning one ZK Ltd share for every Kola Plc share owned by them. MK Ltd is a large unlisted company controlled by 20 shareholders who all have a significant stake in the business. MK Ltd owns a number of hotels around the country and is looking to diversify into the restaurant business. MK Ltd has approached Kola Plc about the possibility of purchasing ZK Ltd. MK Ltd will finance the purchase either through a cash-only offer or a share-for-share offer. If ZK Ltd is demerged, it will be listed on the stock exchange as an independent company. Kola Plc is unsure whether to sell ZK Ltd to MK Ltd or demerge it into an independent company. Extracts from Kola Plc’s financial statements are as follows: NM Assets less current liabilities 5,010 Financed by: Share capital (nominal value N0,50 per share) 1,000 Reserves 1,180 Non-current liabilities: Loan notes A (nominal value N100 per loan note) 2,470 Non-current liabilities: Loan notes B (nominal value N100 per loan note) 360 Kola Plc’s shares are trading at 2.45 each and have an equity beta of 1.3. The part of the business which will become ZK Ltd accounts for 24.5% of Kola Plc’s total equity value. Kola Plc’s loan notes A currently have a total market value of 2,100m. Loan notes B currently have a total market value of 400m. The pre-tax cost of debt has been determined at 4.3% for loan notes A and 4.1% for loan notes B. After the unbundling, loan notes B will be serviced by ZK Ltd and loan notes A will remain with Kola Plc. but the pre-tax cost of debt for both will increase by 0.3%. It is expected that ZK Ltd will maintain its capital structure after the unbundling. MK Ltd’s debt to equity ratio is estimated to be 40:60 in equivalent market value terms and it has 1,200 million shares in issue. The restaurant industry is dominated by Yani Plc, a large listed company which owns many restaurants around the country. The average equity beta for the restaurant industry is estimated at 1.38. The average debt equity ratio in the restaurant industry is 20:80. All companies pay corporate tax at a rate of 20% per year and tax is payable in the same year as the profits it is based on. The risk-free rate of return is estimated at 3% and the market risk premium at 7.2%. The following estimated information will be applicable to ZK Ltd if it is demerged. Kola Plc’s sales revenue is 4,500m currently, of which 20% is attributable to ZK Ltd. It is estimated that after ZK Ltd is demerged, its annual sales revenue growth rate will be 6% and the profit margin before interest and tax will be 21% of sales revenue, for each of the next four years. It can be assumed that the current tax allowable depreciation will remain equivalent to the amount of investment needed to maintain the current level of operations, but that ZK Ltd will require an additional investment in assets of 0.25 for every 1 increase in sales revenue. After the initial four years, the annual growth rate of the company’s free cash flow is expected to be 2.5% for the foreseeable future. The following estimated information applies to the acquisition of ZK Ltd by MK Ltd, if ZK Ltd is acquired. The average price earnings (PE) ratio for the hotel industry is 15.61, however, MK Ltd’s PE ratio is estimated to be 10% lower than this. Extracts from the current statements of profit or loss applicable to MK Ltd and ZK Ltd are as follows: MK Ltd ZK Ltd N’M N’M Profit before Interest and tax 305.0 161.2 Interest (91.2) (14.8) Tax (20%) (42.8) (29.3) Profit after tax 171.0 117.1 After the acquisition, it is expected that the PE ratio of the combined company will be midpoint between the two individual companies’ PE ratios. The annual after-tax profits will increase by 62m due to combination of the two companies. MK Ltd has proposed to pay for acquiring ZK Ltd either through a cash offer of 0.66 for a ZK Ltd share, or one MK Ltd share for every three ZK Ltd shares. MK Ltd will borrow the money needed to pay for the acquisition.

An oil company has recently acquired rights in a certain area to conduct surveys and test drillings for oil where it is found in commercially exploitable quantities. The area is already considered to have good potential for finding oil in commercial quantities. At the outset the company has the choice to conduct further geological tests or to carry out a drilling programme immediately. On the known conditions, the company estimates that there is a 70:30 chance of further tests showing a ‘success’. Whether the tests show the possibility of ultimate success or not, or even if no tests are undertaken at all, the company could still pursue its drilling programme, or alternatively consider selling its rights to drill in the area. Thereafter, however, if it carries out the drilling programme, the likelihood of final success or failure is considered dependent on the foregoing. • If ‘successful’ tests have been carried out, the expectation of success in drilling is given as 80:20; • If the tests indicate ‘failure’, then the expectation of success in drilling is given as 20:80; • If no tests have been carried out at all the expectation of success in drilling is given as 55:45. Costs and revenues have been estimated for all possible outcomes and the net present value of each is given below: Outcome Net present value N’m Success: With prior tests 100 Without prior tests 120 Failure: With prior tests -50 Without prior tests -40 Sales of exploitation rights: Prior tests show ‘success’ 65 Prior tests show ‘failure’ 15 Without prior tests 45.

Zeco Plc (ZP) is a listed company in the residential building construction industry. Over the past five years results have been disappointing and consequently the share price has fallen from a high of 3.50 per share five years ago to only 1.05 per share today. This deterioration in performance and share price have been accompanied by an increase in financial gearing to a high level. Zeco Plc capital structure is as follows: ’m Equity: Share capital (0.50 per share nominal value) 40 Retained earnings 35 Long – term liabilities: 6.5% irredeemable loan notes (100 per loan note nominal value) 250 7% bank loan 20 Zeco Plc. loan notes are quoted at 65 per loan note and both the loan notes and the bank loan are secured. Zeco Plc equity beta is 2.3. New venture To improve performance, Zeco Plc. is considering the construction of commercial properties such as office blocks and industrial complexes. This is a new activity for Zeco Plc and it is expected that the risks involved will be different from its current activity. The Finance Director has proposed that a project-specific discount rate should be used to appraise the new venture, but the Commercial Director does not believe this is necessary.

Tolu Ltd (TL) is expecting to receive $24,000,000 on 1 February 2026, which will be invested until it is required for a large project on 1 June 2026. Due to uncertainty in the markets, the company is of the opinion that it is likely that interest rates will fluctuate significantly over the coming months although it is difficult to predict whether they will increase or decrease. TL’s treasury team wants to hedge the company against adverse movements in interest rates using one of the following derivative products: • Forward rate agreements (FRAs) • Interest rate futures • Options on interest rate futures TL can invest funds at the relevant inter-bank rate less 20 basis points. The current inter-bank rate is 4.09%. However, TL is of the opinion that interest rates could increase or decrease by as much as 0.9% over the coming months. The following information and quotes are provided from an appropriate exchange on $ futures and options. Margin requirements can be ignored. Three-month $ futures, $2,000,000 contract size Prices are quoted in basis points at 100 – annual % yield December 2025: 94.80 March 2026: 94.76 June 2026: 94.69 Options on three-month $ futures, $2,000,000 contract size, option premiums are in annual %. Calls Puts June 0.271 0.520 December March June Strike December 0.342 0.432 0.523 94.50 0.090 0.097 0.121 0.289 95.00 0.312 BK Bank has offered the following FRA rates to TL: 1-7: 4.37% 3-4: 4.78% 3-7: 4.82% 4-7: 4.87% March 0.119 0.417 It can be assumed that settlement for the futures and options contracts is at the end of the month and that basis diminishes to zero at contract maturity at a constant rate, based on monthly time intervals. Assume that it is 1 November 2025 now and that there is no basis risk.

Benco Plc (Benco) has recently become a listed company. Prior to its flotation, this previously family-owned private company made dividend decisions each year to suit the requirements at the time of both the company and the small number of family shareholders who held substantially all of the company’s equity. There was no longterm, stable dividend policy, in place. Following flotation, the family is no longer involved in the day-to-day management of the firm but has retained 45% of the equity, which currently represents the largest single block of shares owned. None of the family members is a Director of the firm any longer, but one member has been retained as a non-executive director. The new Board of Directors consists of a group of young professional managers who are all keen in growing the business rapidly. Now that it is a listed company, the question of establishing a more formal dividend policy has arisen and a forthcoming board meeting will address the issue. As the company’s Finance Director you have been approached by two Directors who have made the following observations. Director A The value of the company’s shares is tied to the level of the company’s dividend, so we should pay the maximum dividend possible. If at any time this policy places pressure on finances, then raising further equity will be that much easier, given the policy of maximum dividends the company will have established. Director B What strikes me is the variety of different views on this issue among our shareholders. Some shareholders tell me they want us to maximise the dividends as they depend so much on the income and are not primarily concerned with capital growth. Others say they would prefer the company to retain much of its profits to invest in new projects so as to maximise the share price.

a. Prices of zero-coupon bonds reveal the following pattern of forward rates: Year Forward rates 1 4% 2 6% 3 8% 4 10% A bond with face value of N1,000 pays annual coupon of 7.5% with maturity of three years.

You recently had a conversation with one Director of a client company. He shared: ‘Over the weekend I was reading an article on finance in a Sunday newspaper. It said that as shareholder wealth maximisation is the generally accepted corporate objective, net present value is the most logical approach to investment appraisal’. It then went on to say that “the ‘capital asset pricing model’ is the best way to find the appropriate discount rate to use. This is apparent because you can use the average rate of return from other businesses, also it ignores the specific risk of the investment concerned.” This all seems nonsense to me. These days corporate management needs to be concerned with more than just the shareholders. What about all of the other groups who contribute to the business? They cannot be ignored. Even if shareholders’ wealth were the key issue, I do not see how NPV fits in. Surely internal rate of return is more to the point because it favours investments that get the best returns and cover financing costs. Those investments will make the shareholders richer. As for CAPM, it seems to defy all logic. It cannot be correct to ignore the returns that the investing business seeks and just concentrate on other businesses. In our business we compare weighted average cost of capital with the IRR and this seems more logical than using CAPM.’ The Director went on to say: ‘The article also said that, in theory, it does not make any difference to the shareholders whether new finance is raised from a share issue or a loan stock issue as they both cost the same. We raise all of our new finance from retained earnings, which does not cost anything, but loan finance has a cost.