A firm that engages in international business transactions faces transaction risk when it has contractual cash flows that are fixed in the foreign currency and the exchange rate might change over the contract period. For instance, transaction risk exists when value of imports and exports are fixed in the foreign currency and there is movement in the exchange rate between the invoice date and settlement date.
Translation risk is when an organisation will suffer exchange losses when the results of its foreign branches and subsidiaries are translated into the home currency.
Economic risk refers to the effect of exchange rate movement on the international competitiveness of an organisation. It refers to the present value of longer-term cash flows. It exists when an organisation faces competition from domestic producers/traders in the foreign country or local importers in the home country.
Analysis of AD Ventures case:
By engaging in the import transaction that will be settled in the future, AD Ventures faces contractual cash flow (here the obligation to pay EUR540,000). Moreover, the contractual cash flow is fixed in the foreign currency, the euro.
Conclusion on risk type:
With respect to the tomato import from Italy, AD Ventures is facing transaction exposure to currency risk.

• Contract size cannot be tailored to the exact requirements the investor. This means that the investor’s underlying exposure may not be covered effectively, resulting in hedge inefficiency.
• Contract maturity date cannot be tailored to synchronise with maturity date of underlying exposure. For instance, AD Ventures’ euro obligation falls due in January 2016 but the available contract matures in February 2016. This results in hedge inefficiency.
• Basis risk is inherent in futures hedge. There is the risk that the futures price may move by a different amount from the price of the underlying asset.
• Unlike options, the investor has an obligation to either trade the underlying asset or take an opposite position to close out. This means that the investor does not have the flexibility to take advantage of favourable price movements in the spot market.
• Unlike forwards, futures requires opening and maintenance of a margin account which involves deposit of cash or cash equivalent.

The appropriate cost of capital for the new oil project is the project’s specific cost of capital. As the company will finance with both equity and debt, this cost of capital should be the project specific WACC.

Where:
E = market value of equity
L = market value of bank loans
B = market value of bonds
V = market value of total capital

After-tax cost of bank loans:   Given as 14.5%
After-tax cost of bonds, Kbt:
Redemption value = GHS100
Conversion value = Number of shares x Value of share on conversion date
Conversion value = 10 shares X =  GHS118.7

Since the conversion value is higher than the redemption value, bondholders will opt for conversion of their bonds.
Therefore, the cost of the bonds is the IRR of the market value, after-tax periodic interests, and the conversion value.

Cost of equity, ke:
Equity beta of Cargo Oil Ltd, βe = 1.8
Ungeared (asset) beta of Cargo Oil Ltd is 1.2:

Market value of Pusher’s equity, Ve = 40m shares x GHS5.5 = GHS220m
Market value of Pusher’s debt, Vd = Value of bank loans + Value of bonds
Market value of Pusher’s debt, Vd = GHS40m + GHS117.72m = GHS157.72m
Value of bonds = Current market price x Units of bond in issue = GHS98.1 x 1.2m = GHS117.72
Units of bond in issue = GHS120m / GHS100 = 1.2m
Therefore the appropriate equity beta that reflects the risk of the new business and capital structure of Pusher Mining Ltd is 1.845:

Conclusion:
The appropriate cost of capital Pusher Mining Ltd should use to appraise the new oil project is 20.1%. This reflects the business risk associated with the new operation in the oil industry and the financial risk associated with Pusher’s financing structure.

• Easier access to funds: Managers prefer sources of finance that are relatively easier to access to those that are relatively difficult to access. Retained earnings, the easiest to access and use, is first choice while new equity offers, the most difficult to access and use, is the last resort.
• Issue costs: Managers prefer sources with lower issue costs to those with higher issue costs. There are no issue costs when retained earnings is used, that is why it is the most preferred. Issue costs relating to debt offers are lower than those relating to equity offers. Therefore, debt offers are preferred to equity offers.
• Investors’ preference for safer securities: As debt stocks offer more secured income streams to investors than equity stocks offer, it is easier for firms to raise funds through debt offers than equity offers.
• Signalling effect: Managers believe debt issue has a better signalling effect than equity offer. Investors may interpret debt issue to mean that managers are confident that the investments will produce profit. Equity offer, on the other hand, may be interpreted by investors as lack of management confidence in the investment producing profits. Thus, managers prefer debt offer to equity offer.

• Business risk: Business risk refers to the risk inherent in business operations in the absence of debt financing. A higher business risk implies a small drop in sales revenue will cause operating profit to drop so low that the company cannot meet its interest obligation. If Moore Plastic Ltd faces high business risk, the new capital structure should have more equity than debt. If business risk is low, a structure of more debt than equity is reasonable.
• Financial risk: Financial risk refers to the additional risk shareholders face as the company uses debt capital. When financial risk is already high, the proportion of equity should be more than that of debt in the new structure.
• Tax position: The tax-benefit from the use of debt financing is high when the company falls into a higher tax bracket. If the company is in a higher tax bracket, a financing structure with more debt than equity would be reasonable.
• Clientele effect: An investor would prefer a particular capital structure to another. So when redesigning capital structure, directors should consider how present and prospective investors will react to the new capital structure.

The average required rate of return on industry listed stocks is 16%. With a marketability risk premium of 7 percentage points, the required rate of return on the equity stock of Papa’s Skin Ltd should be 23%: Appropriate required return on equity = Industry return on equity + Marketability risk premium
Appropriate required return on equity = 16% + 7% = 23%

A. Net assets method:

B. The P/E ratio method:
Using the P/E ratio method, the value per share is estimated as under:
Value per share = Justified P/E ratio x EPS
The earnings per share (EPS) of Papa’s Skin Ltd is GHS4.8:

The P/E ratio for the purpose of valuing an unlisted company could be one-half or two-thirds of the industry average P/E ratio. If we take a figure equal to 50% of the industry P/E ratio for the purpose of valuing Papa’s Skin:
Justified P/E ratio = 10 x 0.5 = 5
Value per share = GHS4.8 x 5 = GHS24

C. Constant growth dividend discount model:
When dividend will grow at a constant rate, the constant growth DDM can be used to estimate the value of equity as under:

Recent dividend per share, DPS0 is GHS0.96:

Required return on equity, Ke = 23% (or the figure candidate obtained in (b) (i) above).
Growth in dividend, g = 5%

Range of suitable considerations:

Fiscal policy involves the use of taxation and government spending mainly to manipulate aggregate demand with a view to influencing the economy in a particular way. Monetary policy involves the manipulation of monetary variables such as money supply and interest rate to achieve certain economic targets such as reduction in inflation.
The distinction between the two is in the variables that are used to achieve the economic target. In the case of fiscal policy, taxation and government spending are manipulated to achieve results whilst economic variables are manipulated to achieve the objectives of monetary policy.

A contractionary fiscal policy involves increasing tax revenue while either maintaining or cutting the level of government spending.
Adverse effects of contractionary fiscal policy on businesses include the following:

• Reduction in sales revenue and consequently, profit: Contractionary fiscal policy involving increases in income tax rate reduces disposable income and thus aggregate demand falls. With other factors of demand remaining the same, the reduction in disposable income will result in reduction in demand for goods and services.
• Reduction in profit that can be reinvested: Increase in income tax rates will take more cash from businesses and thus reduce the amount of cash from operations that would be available for reinvestment. Firms will have to raise funds from external sources with higher costs and risks.
• Restriction on flexibility in taking credit decisions: Higher sales or consumption taxes rate (e.g. VAT rate) reduces businesses’ flexibility in granting credit. As VAT is payable when due regardless of whether payments have been received from customers or not, businesses that grant credit for periods longer than the grace period for payment of consumption taxes over the tax authority will have to pay the amount due from their own resources or with borrowed funds.
• Reduction in profit of firms facing price elastic demand: When rates of indirect taxes such as VAT and excise duty are increased, firms facing price elastic demand will have to either, absorb the additional cost and risk lower profits or pass on the additional cost to consumers in higher price to risk lower demand. In either case, the profit of such businesses will drop.
• Reduction in loanable funds: Contractionary fiscal policy reduces disposable income, and households will have little left to save in banks and/or invest in securities. This reduces the amount of surplus funds from households that can be channelled to businesses. However, if the reduction in aggregate demand results in reduction in inflation, interest rates might drop and cost of capital will be lower.

To conclude whether the company is overtrading or not, candidates are expected to identify the symptoms of overtrading and diagnose the company’s situation from the information given to establish whether those symptoms exist or not. Analysis of financial ratios such as growth in sales revenue, growth in current assets, receivables turnover days, inventory turnover days, debt ratios, and liquidity ratios is relevant to the diagnosis.

Overtrading occurs when a company tries to do too much too quickly with too little long-term capital. Typically, a company that is overtrading would exhibit the following symptoms:

• Rapid growth in sales revenue.
• Rapid growth in current assets, particularly inventory and receivables. Inventory turnover days and receivables turnover days might grow longer.
• There is only small growth in equity capital, which may be through reinvestment of profit and not new equity issue. Much of the growth in assets is financed by credit, particularly, trade payables and bank overdraft.
• Significant increases in debt ratios such as total debt ratio and debt-to-equity ratio.
• Significant decreases in liquidity ratios such as current ratio and quick ratio. There might be net current liabilities.

There has been significant growth in sales revenue (50% in 2013 and 103% in 2014). This is accompanied by significant growth in current assets, particularly receivables and inventory. However, receivables turnover days and inventory turnover days have both shortened from 55 to 53 days and from 138 to 83 days respectively. What is more, the payables turnover days has shortened significantly from 34 days to 25 days due to the increased use of bank overdraft in financing working capital needs. Bank overdraft increased by a whopping 237% in 2014.

The company’s liquidity ratios kept dropping over the three years under review. The current ratio dropped from 2.05:1 in 2012 to just 1.54:1 in 2014 while the quick ratio dropped from 1.03:1 in 2012 to 0.75:1 in 2014. Besides, the ratio of long-term capital to total assets kept reducing over the same periods. Long-term capital that stood at 73% of total assets in 2012 had dropped to 54% of total assets. The decreases in liquidity ratio is due to the significant increase in current liabilities, mainly due to the high increment in bank overdraft financing. The growth in long-term capital is due to reinvestment of profits as stated capital stood the same and medium-term loan was being amortised over the period. These suggest that the company is financing most of the rapid growth in sales with short-term funds rather than long-term capital.

Sales revenue is increasing rapidly, liquidity ratios are falling, long-term capital ratio is falling, and there is significant increase in bank overdraft. On the face of it, one would concluded that the company is overtrading. However, the ratio of long-term capital is not yet too low to permit the conclusion that the company is trying to do too much too quickly with too little long-term capital. If the current trends in long-term capital ratio, sales growth, and liquidity ratios continue in the future, the company might experience overtrading in the near future.

Candidates are expected to match the cost of the early discount policy against the benefit of it. The policy change is worthwhile when the benefit, measured in terms of annual interest savings, exceeds the cost, measured in terms of the cash discount that would be given.

Under current policy:
Current credit sales                    = GHS122 million
Current credit period                 = 40 days
Receivables turnover days        = 53 days
Trade receivables, 2014            = GHS24.210 million
Trade receivables, 2013            = GHS11.210 million

Under discount policy:
Credit sales                             = GHS122 million (assumed to be kept at recent sales level)
Credit period                          = 40 days
Discount period                      = 10 days
Discount rate                          = 1.5%
Early payment probability      =60%

Other relevant data:
Financing cost                       = 15%
Cash discount cost                = Credit sales x Discount rate x Early payment probability
Cash discount cost                = GHS122m x 1.5% x 60% = GHS1.098m
If credit policy remains unchanged, average trade receivables would be GHS17.715m:

If early settlement discount is introduced, average trade receivables would be GHS7.353m:

Funds that would be released every year if the early settlement discount is introduced is GHS11.365m:

𝐹𝑢𝑛𝑑𝑠 𝑡𝑜 𝑏𝑒 𝑟𝑒𝑙𝑒𝑎𝑠𝑒𝑑 = 𝐺𝐻𝑆17.715𝑚 − 𝐺𝐻𝑆7.353𝑚=𝐺𝐻𝑆10.362𝑚
Interest charges that would be saved every year due to the early settlement discount is GHS1.554:

𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑠𝑎𝑣𝑒𝑑=𝐺𝐻𝑆10.362×0.15=𝐺𝐻𝑆1.554𝑚

Summary:
.                                                                                                                                        GHS’m
Benefit of new discount policy: Interest saved every year =                                   1.554
Cost of new discount policy: Cash discount allowed every year =                         1.098
Net benefit of new discount policy =                                                                           0.456

Conclusion:
If the early settlement discount is introduced and 60% of accounts are settled early to take the discount, the company’s profit will increase by GHS0.456m every year. Therefore, management should accept the early settlement discount proposal for implementation.

Switch from financing working capital needs with bank overdraft to financing with trade credit.
If the company continues to finance working capital needs with bank overdraft, the annual financing cost would be 15%.
If the company finances working capital needs with suppliers trade credit the annual financing cost would be 12.3% (assuming simple interest):

Conclusion:
Since the cost of financing with suppliers’ trade credit is lower than the cost of financing with the overdraft facilities, the company should discard its current working capital financing method and finance with trade credit.
Note:
Full credit should be given to candidates who estimate the cost of trade credit based on compound interest:

1) Postpone capital investments.
2) Postpone dividend payments.
3) Accelerate collection from customers by offering incentives for early payment (e.g. early settlement discount, increase in credit limit). This will reduce funds tied up in working capital.
4) Reduce investment in inventory to minimise funds tied up in working capital.
5) Reverse past investment decisions by selling assets previously acquired but are surplus to the company’s needs, or producing negative or lower returns. Even assets that are needed can be sold and leased back.
6) Negotiate with creditors for more favourable payment terms.

When a firm faces capital rationing for a single period and projects are independent and divisible, funds may be allocated to projects based on the profitability index rankings.

That is the company should invest fully in projects PA201, PA203, and PA202; 31.76% in PA204 (27,000/85,000); and nothing in PA205 which is at the bottom of the ranking. The optimum aggregate NPV is GHS279,949.
Workings:
* NPV from PA204 is its NPV multiplied by the proportion of the investment requirement the company will allocate funds to (i.e. GHS95,400 x 31.76%).

Here we consider a combination of the projects and select the combination that will produce the highest combined NPV. Any unused funds may be invested externally (e.g. in securities).

The company should invest in projects PA201, PA202 and PA203 to earn the highest combined NPV of GHS249,650. The unused funds of GHS27,000 should be invested externally.

• Seek joint venture partners with which to share projects investment requirement.
• Use licensing or franchising arrangement with other entities to get the product produced and sold. The firm will earn royalties while avoiding financing of the investment requirements.
• Contract out parts of the project to subcontractors who would finance the project in advance.
• Seek alternative financing such as venture capital and asset securitization.
• Seek grants or aid from government or organizations if the project advances an object the government or such organizations promote or seek to achieve.

NPV can be computed by discounting the real cash flows with the company’s real rate of return. Discounting the project real cash flows with the real rate of return produces an NPV of GHS152,666:

Comment: Since the NPV of the project is positive, the value of the firm will increase when the project is implemented. The project should therefore be accepted for implementation.
Workings:
1. Discount rate
The real rate of return is estimated using the Fisher’s equation as under: 1+𝑖=(1+𝑟)(1+ℎ)
Nominal rate, i = 25%
Inflation rate, h = 15%
Therefore, the real rate of return is 8.7%

2. Discount factor for equal cash flows occurring every year from year 6 to infinity.

The equal annual cash flow of GHS30,000 from year 6 to infinity is first discounted as a perpetuity to obtain the terminal value at end of year 5: Terminal value of constant CF from 6 to infinity= GHS30,000×(1/0.087)
The terminal value is then discounted as a single amount to obtain the PV at time zero:

NB: Some candidates may round the real rate of return to 9% so as to read discount factors from interest factor tables (if provided). In this case, the NPV would be GHS138,715. Full credit should be awarded to candidates who answer the question in this manner.

The sensitivity of the project’s NPV to the discount rate can be estimated as the percentage change in the discount rate needed to reduce NPV to zero.

That is the discount rate will have to increase by 72.4% for the NPV to reduce to zero. The high percentage increase required in the discount rate for the NPV to drop to zero implies Project PA205 is less sensitive to variation in the discount rate.
The IRR is calculated by trial and error as under:

𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛𝑠 (𝑟)=𝑟𝑓+𝛽(𝑟𝑚−𝑟𝑓)
Where 𝑟𝑓 = 𝑅𝑖𝑠𝑘 𝑓𝑟𝑒𝑒 𝑟𝑒𝑡𝑢𝑟𝑛𝑠 ;   𝛽 = 𝐵𝑒𝑡𝑎 𝑓𝑎𝑐𝑡𝑜𝑟 𝑜𝑓 𝑡ℎ𝑒 𝑠ℎ𝑎𝑟𝑒𝑠  ;  𝑟𝑚 = 𝑀𝑎𝑟𝑘𝑒𝑡 𝑟𝑒𝑡𝑢𝑟𝑛
∴ 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛𝑠 (𝑟) = 15%+1.2(20%−15%) = 21%

𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 = 𝐷/𝑟
𝑊ℎ𝑒𝑟𝑒 𝐷=𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑
𝑎𝑛𝑑 𝑟=𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛𝑠
∴ 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 = 10/0.21 = 47.62

• Currency futures is a standardized contract whereas forward contracts are customized contracts.
• Currency futures contracts take place in regulated markets whereas forwards contracts are traded over the counter.
• Currency futures contract are in foreign currency whereas forwards contracts are in local currency.
• Currency futures have flexible closeout dates but forwards have fixed close out dates.
• Underlying transactions for currency futures take place at the spot rate but for forwards the underlying transactions take place at the forward rate.
• Currency futures are cheaper than forward contracts.