MERU UNIVERSITY OF SCIENCE AND TECHNOLOGY

P.O. Box 972-60200 – Meru-Kenya.

Tel: +254 (0)799529958, +254 (0)799529959, +254 (0)712524293
Website: www.must.ac.ke Email: info@must.ac.ke

University Examinations 2020/2021

FOURTH YEAR, FIRST SEMESTER EXAMINATION FOR THE DEGREE OF BACHELOR OF

PURCHASING AND SUPPLIES MANAGEMENT, THIRD YEAR, FIRST SEMESTER
EXAMINATION FOR THE DEGREE OF BUSINESS ADMINISTRATION, THIRD YEAR,
FIRST SEMESTER EXAMINATION FOR THE DEGREE OF BUSINESS INFORMATION
TECHNOLOGY

BFC 3226: INTRODUCTION TO FINANCIAL MANAGEMENT

DATE: AUGUST 2021 TIME: 2 HOURS

INSTRUCTIONS: Answer question one and any other two questions

QUESTION ONE (30 MARKS)

a) Describe how the agency problem arise and hence the various measures that would minimize
agency problems between the owners and the management (10 marks)

b) Explain how Debt financing is cheaper than equity financing (5 marks)

c) You are given the following details about Meru-city Ltd

Percentage contribution of different activities to total turnover

Department stores 30%

Clothing 24%

Building materials 20%

Hotel and catering 16%

Meru University of Science & Technology is ISO 9001:2015 Certified

Foundation of Innovations Page 1
 Electronics 10%

Current share price sh.2.34

Average annual share growth over the past five years 5%

Level of gearing based on market value (debt/debt + equity) 23%

The directors of the company were given share options by its remuneration committee five
years ago. In a year’s time the options will allow each director to purchase 100,000 shares in
the company at a price of sh.2.00. The directors’ average annual salary currently stands at
shs.200,000 on a five year rolling contract basis, while average salaries in the conglomerate
sector are shs.150,000 and tend to be three year rolling contracts.

Required:

Using the above information to illustrate your answer, critically discuss the stent to which
Meru-city ltd can be said to be suffering from agency problem. (5 marks)

d) Mast investment Lt wishes to raise funds amounting to sh. 10 million to finance a project in
the following manner;

Sh.6 million from debt: and

Sh. 4 million from floating new ordinary shares

The present capital structure of the company is made up as follows:

1. 600,000 fully paid ordinary shares of Sh.10 each

2. Retained earnings of Sh. 4 million

3. 200,000, 10% preference shares of Sh.20 each

4. 40,000 6% long term debentures of Sh.150 each

The current market value of the company’s ordinary shares is Sh. 60 per share. The expected
ordinary share dividends in a year’s time are Sh.2.40 per share. The average growth rate in

Meru University of Science & Technology is ISO 9001:2015 Certified

Foundation of Innovations Page 2
 both dividends and earnings has been 10% over the past ten years and this growth rate is
expected to be maintained in the foreseeable future.

The company’s long term debentures currently change hands for Sh.100 each. The
debentures will mature in 100 years. The preference shares were issued four years ago and
still change hands at face value.

Required:

i) Compute the component cost of:

- Ordinary share capital (2 marks)

- Debt capital (2 marks)

- Preference share capital (1 mark)

ii) Compute the company’s current weighted average cost of capital (5 marks)

QUESTION TWO (20 MARKS)

a) When making investment decisions, cash flows are considered to be more important that
accounting profits. Briefly explain why this is the case (4 marks)

b) An investment manager of a quoted company has raised Sh.8, 000,000 through issue of new
shares. He is now evaluating two mutually exclusive projects with unequal economic lives.
Project X has 7 years and project Y has 4 years of economic life. Both projects are expected
to have zero salvage value. These funds can only finance one project. Their expected cash
flows are as follows:

Project A B
Year Cash Flows (Sh.) Cash Flows (Sh.)
1 2,000,000 4,000,000
2 2,200,000 3,000,000
3 2,080,000 4,800,000
4 2,240,000 800,000
5 2,760,000 -
6 3,200,000 -
7 3,600,000 -

Meru University of Science & Technology is ISO 9001:2015 Certified

Foundation of Innovations Page 3
The company expects to pay a dividend per share of Sh.6.50 in one year’s time. The current market
price per share is Sh.50. The future earnings are expected to grow by 7% per annum due to the
undertaking of either of the projects. The firm has no debt capital in its capital structure

Required:

a) The firms cost of equity (4 marks)

b) The net present value of each project (10 marks)

c) Which project should be chosen and why? (2 marks)

QUESTION THREE (20 MARKS)

i) Explain how is the goal of maximization of share-holders wealth a superior goal as compared
to maximization of profit. (8 Marks)

ii) A project is made up of two sub-projects. The first sub-project will require an initial outlay
of sh. 100,000,000 and will generate Sh. 25,600,000 per annum in perpetuity. The second sub-
project will require an initial outlay of sh.300, 000,000 and will generate sh.85, 200,000 per
annum for the 8 years of its useful life. This sub-project does not have a residual value at the end
of the 8 years. Both sub-projects are to commence immediately. The company has a cost of
capital of 16%

Required

Using the net present value (NPV) method, determine which project should be chosen (12 marks)

QUESTION FOUR (20 MARKS)

a) Distinguish between an annuity and a perpetuity (4 marks)

b) Koronya has won a Roton lottery and will receive the following cash inflows:

Year 1 Sh 200,000
Year 2 Sh 500,000

Meru University of Science & Technology is ISO 9001:2015 Certified

Foundation of Innovations Page 4
 Total Sh 700,000
i) If interest rate is 6% compounded annually, what is the present value of the Roton earnings?
(5 marks)

ii) If the interest rate is 6% compounded quarterly, what is the present value of the Roton
earnings? (5 marks)

iii) As a finance manager, briefly explain the factors you would consider when setting a working
capital policy of your company (6 marks)

QUESTION FIVE (20 MARKS)

a) How is dividend decision an important decision for a finance manager? (6 marks)

b) In a company, an agency problem may exist between management and shareholders on one
hand and the debt holders (creditors and lenders) on the other because management and
shareholders who own and control the company have the incentive to enter into transactions
that may transfer wealth from debt holders to shareholders. Hence the need for agreements
by debt holders in lending contracts

Required:

a) State and explain any four actions or transactions by management and shareholders that
could be harmful to the interests of debt holders (sources of conflict) (6 marks)

b) Write short notes on any four restrictive covenants that debt holders may use to protect their
wealth from management and shareholder raids (8 marks)

Meru University of Science & Technology is ISO 9001:2015 Certified

Foundation of Innovations Page 5