The managing director (MD) has been in discussions with several research companies about the issue of the proposed use of orange sweet potatoes in...
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The managing director (MD) has been in discussions with several research

companies about the issue of the proposed use of orange sweet potatoes in baking pancakes. The new product would be sold on the basis of having natural sugars and the large amounts of vitamin A - all naturally present in the orange sweet potatoes. The MD is excited about the wonders of the new product and the projected savings on sugar required for baking. Furthermore, the MD is planning to introduce a new health drink called Hibiscus, which he believes shall be quite appealing to health-cautious individuals. However, some senior managers have warned the MD about this proposed diversification and are of the view that they should stick to the confectionery business rather than compete with the likes of Jack and Jerry Uganda Ltd (J & J Ltd), which is even a listed company that has for long been in this beverages sector. The MD is not convinced by the managers and plans to present the two projects anyway to the Board which will be supported by analytical information from the finance department. Based on the currently available information, the price of a kilogram of these pancakes is projected to sell at Shs 2,500 while that of hibiscus is projected to be Shs 2,000 per litre for over a period of four years. The initial investment required is estimated at Shs 1,500 million and Shs 800 million respectively. The total costs associated with the two projects are expected to be stable at 90% for the pancakes and 85% for the Hibiscus of expected revenue. With the coming on board of these new projects, the company shall also be looking for appropriate sources of finance that might be available to KABACO to meet the new financing requirements. Initial consultations by the Board Chairman have suggested euromarkets, the stock market and Islamic financing. The following are extracts from the analysis information provided by the finance department as of May, 2018. KABACO Book value Market value Equity: Shs 'million' Shs 'million' 50 million ordinary shares 141 215 Debt: 10% debentures (May, 2022) 80 85 (J & J Ltd): Book value Market value Equity: Shs 'million' Shs 'million' 60 million ordinary shares 166 231 Debt 65 60 Other relevant information: Beta value of KABACO (asset beta) 1.1 Beta value of J & J Ltd 0.9 Market return 14% Risk-free rate 6% Current inflation rate 4% Corporation tax rate 30% Project sales: Year 1 Year 2 Year 3 Year 4 Vitamin A pancakes (million kg) 2 3 3 4 Hibiscus (million litres ) 1 1.5 1 2


Required:


(a) Determine an appropriate cost of capital that KABACO can use to evaluate the viability of the two projects. (11 marks)
(b) Discuss the appropriateness of the assumptions you may have used in (a) above and any challenges. (7 marks)
(c) Advise the Board of KABACO on which project to undertake based on the following methods of investment appraisal:
(i) Payback period. (5 marks)
(ii) Net present value. (6 marks)
(d) Advise the Board about the sensitivity of the projects to initial investment and state any reservations you may have on this analysis. (6 marks)
(e) Assess the drawbacks and usefulness of the payback period as a method of investment appraisal to be applied by KABACO. (5 marks)
(f) Advise the Chairman of KABACO:
(i) on the usefulness of borrowing from Euromarkets (5 marks)
(ii) as to why he should consider Islamic Financing as a viable option. (5 marks)
(g) Examine the role of a merchant bank in the sourcing of finances from the stock market highlighting the matters that would make its advice attractive to KABACO. (5 marks)


SECTION B


Question 2


The current managers are so concerned about the state of affairs that they plan to hire a consultant to help them in sorting out these problems. During the current year, sales targets have been particularly difficult to achieve and stock levels are quite high. Trade payables have not been settled for the last two years which is worrying the suppliers. After the meeting with the consultants and other stakeholders, the preference shareholders have demanded a scheme of reconstruction or liquidation of the company. The finance committee of the Board has agreed with preference shareholders after several consultations and the following have been agreed upon: 1. The existing 70 million preference shares are to be exchanged for a new issue of 70 million ordinary shares of Shs 1 each. 2. The profit and loss account is to be written off. 3. The bank overdraft is to be repaid. 4. The Committee expects that due to the refinancing, operating profits will be earned at the rate of Shs 550 million per annum after depreciation but before tax, 5. Corporation tax is at 30% Advanced
The following statement of financial position for ROCO Construction Ltd for the year ended 31 December, 2017 has been provided: Shs '000' Shs '000' Non-current assets: Buildings 281,000 Current assets: Inventory 190,939 Current liabilities: Trade payables 205,047 Overdraft 36,713 241,760 Net current liabilities (50,821) 230,179 Ordinary shares Shs 1 each 200,000 5% cumulative preference shares Shs 1 each 70,000 Profit /(loss) (39,821) 230,179 The market values are expected to be based on the recent valuation report. Value of assets: Shs '000' Non-current assets 190,000 Inventory 113,623 Assets available 303,623


Required:


Advise the:
(a) ordinary shareholders and preference shareholders on whether they should support the reconstruction. (11 marks)
(b) management of ROCO Construction Ltd on the types of restructuring that may be available to them. (6 marks)
(c) management of ROCO Construction Ltd on ways in which restructuring can enhance shareholder value.


Questions 3


The directors have just received a report from one of their leading consultants which emphasizes that the returns from existing activities and from the new one-year projects will depend largely on the economic environment that prevails during the coming year. Financial information about the proposed and existing projects with probabilities of the economic environment that may prevail is summarised below. Economic environment A B C Probability: 0.30 0.40 0.30 Returns/ value at year-end: Shs 'billion' Shs 'billion' Shs 'billion' Project Q 12.50 12.50 9.50 Project P 10.00 11.75 13.00 Aggregate returns (value at year-end) from existing portfolio of projects 90.0 120.0 130.0 The company has a current market value of Shs 100 billion. The directors of JAUL believe that the risk and returns per shilling of the market value of existing activities are similar to those of the stock market as a whole, including their dependence on whichever economic environment that prevails. The current rate of interest on short-dated government securities is 10% per annum.


Required:
(a) Evaluate the risks and returns of the two projects, and advise JAUL on the most favourable project to undertake. (15 marks)
(b) Discuss the principles you have used in arriving at your recommendation in (a) above


Question 4


The management of Kampala Knitters Ltd (KKL) is in the process of acquiring new equipment for the manufacture of polo shirts in the medium to long-term. They are, therefore, preparing to hold their money in investments that will store their value securely; and a variety of proposals have been considered and shared with the members of board of directors. The chairman of the board of directors recently attended a meeting where warrants and traded options were extensively discussed. Based on this new information, he suggests that debt instruments accompanied by either attached warrants or traded options might be attractive and also have substantial benefits. However, the finance director is of the view that they should put more time in reviewing KKL's potential to invest in long-term bonds. Currently, there are two bonds (A and B) available on the securities exchange that KKL would need to consider: Security A: The market value of a Shs 100 million per value bond carrying a coupon rate of 14% which is expected to mature in 5 years is Shs 105 million. Security B: A Shs 100 million par value bond bears a coupon rate of 14 %; matures after 5 years; interest is paid semi-annually and the required rate of return is 16%.


Required:


(a) Discuss the viability of the chairman's suggestion in KKL's context. (8 marks)


(b) Estimate the:
(i) yield to maturity of Security A. (7 marks)
(ii) value of Security B. (3 marks)


(c) Advise the management of KKL on the factors they should consider before investing in bonds. (7 marks)


Question 5


The managers of BCL are having a meeting with their bankers in relation to a new opportunity in cardboard manufacturing - especially for the export market. One of the members, who is a retired finance manager, has proposed the use of a mixture of financing by internal funds, a rights issue, convertible loan stock and longterm loans. Another member, however, has a different view, and is proposing issuing new shares and buying them back when the investment yields substantial cash flows instead of paying dividends. Other available information shows that BCL is not sure whether to use the capital asset pricing model (CAPM) or arbitrage pricing theory to determine the cost of capital. However, they all agree to the use of the adjusted present value (APV) technique to evaluate projects when all the relevant information is availed to them. The Ministry of Finance has, on the other hand, pledged a subsidised loan to BCL because of the perceived strategic importance of the new business line; this will cost 2% below the company's normal cost of long-term debt finance.


Required:


Discuss the:
(a) circumstances under which CAPM or arbitrage pricing theory might be better methods of determining the cost of capital for BCL. (8 marks)
(b) main features of share repurchase (buy-back) and why BCL might use it. Include in your discussion comments on the possible effects on the share price of the repurchase in comparison to payment of dividends. (7 marks)
(c) circumstances under which APV might be a better method of evaluating a capital investment than the net present value technique. (4 marks)
(d) key features of a convertible loan stock. (6 marks)

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