Question 1.(a)

1(a)(i). Net present value

Working 1. Determination of cash flows

Year 1

Shs' bn

2

Shs' bn

3

Shs'bn

4

Shs'bn

5

Shs'bn

Profit after tax 38.5 119 140 94.5 98

Add back interest 35 40 55 60 70

Add back depreciation 5 5 5 5 5

Project cash flows 78.5 164 200 159.5 173

Working 2. Working capital

Year 0

Sh'bn

1

Sh'bn

2

Sh'bn

3

Sh'bn

4

Sh'bn

5

Sh'bn

Working

capital

(increasing by

10%)

(20) (2) (2.2) (2.42) (2.662) 29.282

(To be

recouped

in year 5)

Calculation of NPV

Year 0

Sh'bn

1

Sh'bn

2

Sh'bn

3

Sh'bn

4

Sh'bn

5

Sh'bn

Cash flows (W1) - 78.5 164 200 159.5 173

Initial outlay (500) - - - - 10

Working capital (W2) (20) (2) (2.2) (2.42) (2.662) 29.282

Dismantling costs - - - - - (20)

Net cash flows (520) 76.5 161.8 197.58 156.838 192.282

DCF 15% 1 0.870 0.756 0.658 0.572 0.497

PV (520) 66.555 122.321 130.008 89.711 95.564

NPV (15.841)

Note; The exploration costs has been ignored because they are sunk costs.

The project has a negative NPV and therefore it will not increase the value of

shareholders of MUL and should not be undertaken.

1(a)(ii) Discounted payback period (a)(ii)

Year Cash

flows

Sh'billion

DCF

15%

Present

values

Reducing

balances

0 -500 1 -500 -500

1 78.5 0.870 68.295 -431.705

2 164 0.756 123.984 -307.721

3 200 0.658 131.600 -176.121

4 159.5 0.572 91.234 -84.887

5 173 0.497 85.981 -1.094

In discounted terms, the project doesn't recoup the initial outlay and the dismantling

costs. Therefore although nearly project recoups the initial outlay in discounted terms,

the company will have to acquire funds for dismantling outside the project capital

budget. Therefore the project should not be undertaken.

1(b) The three main forms of Agency Relationships.

(i) Between shareholders and managers.

Shareholders act as principals who contract managers as agents to perform

organisation duties and pursue organizational objective on their behalf.

The manager may decide not to maximize shareholders wealth, because less of

this wealth accrues to him. In other words, he may decide to maximize the size

of the organisation since through this objective he increases job security, power,

status, salaries and also create more opportunities for his lower and middle

management.

(ii) Shareholders and government.

Shareholders rely on government services existing in a specific country as they

undertake any form of business.

Government expects owners of organisations to avoid getting involved in

activities that are in conflict with social expectations. In this case the

government acts as the principal and shareholders are agents who are expected

to consider government interests.

(iii) Shareholders and debt holders.

Agency relation exists when one party works as an agent of the principal. The

shareholders through management work as agent for creditors, the principal.

Creditor's interest is to provide credit and get the principal amount and interest

timely for ensuring their credit return, creditors are always concerned with

whether the company is doing business in the right manner or not.

By monitoring the financial performance of the company creditors actually want

to ensure their interests are protected.

On the other hand, you will find the agents doing other wise, for example taking

on big risky projects which may result into losses and the creditors will still

charge the fixed interest agreed upon in the beginning.

In all, shareholders/managers should work closely to see that interest and

principal amounts are paid regularly until the end of the loan period.

(c) Reasons for separation of ownership and management.

Professional managers may be more qualified to run the business because of

their technical expertise, experience and personality traits.

It permits unrestricted change in owners through share transfers without

affecting the operations of the firm. It ensures that the "know how" of the

firm is not impaired despite changes in ownership.

Given economic uncertainties, investors would like to hold diversified portions

of securities. Such diversification is achievable only when ownership and

management are separated.

Most enterprises require large sums of capital to achieve economies of scale.

Hence it becomes necessary to pool capital from thousands or even hundreds

of thousands of owners. It is impractical for many owners to participate

actively in management.

Mitigation of agency problem.

Effective monitoring has to be done to see to it that management is pursuing

the vision and the objective of the firm.

The problem can be avoided by bonding managers. Owners of the business

can sign bonding agreements with Managers to work for a certain period of

time before being allowed to seek for opportunities elsewhere. Within the

bonding period managers will work cautiously avoiding to hurt the interests of

the owners.

Auditing financial statements. Because managers know that their actions will

be checked by an independent external person, they will act in the best

interest of the owners.

Limiting managerial discretion in certain areas and reviewing the actions and

performance of managers periodically. The powers of the managers need to

be restricted. Some decisions need to be taken or approved by owners and

performance and compliancy reviews are undertaken regularly.

Incentives may be offered in the form of cash bonus and rewards that are

linked to certain performance targets. The owners must promise to reward

management when they achieve certain targets. In this way, managers will

act in a way not to hurt the interest of the owners in order to get those

rewards.

Owners should offer share options that grant managers the right to

purchase equity shares at a certain price thereby giving them a stake in

ownership and performance shares when certain goals are achieved.

1(d)(i) Any four transactions by management and shareholders that could be

harmful to the interests of debt holders.

a) Creditors normally lend funds at rates based on the riskiness of existing

assets, expectations concerning riskiness of future assets and the firm's existing

capital structure on the amount of debt financing used and expectations

concerning future capital decisions. Share holders through managers, can

however cause a firm to take on a large new project which is much riskier than

what the creditors planned. The increased risk can raise the required rate of

return on the firm's debt and causes the value of the outstanding debt to fall

hence causing the lenders to share the losses that are likely to come up.

On the other hand, if the project is successful the benefits will go to

shareholders, so the creditors end up losing in both situations.

b) Management can dispose off assets used as collateral in loans and this may

adversely affect creditors.

c) Managers may pay high dividends which reduce the cash available for

investment. Management may decide to declare and pay high dividends to the

shareholders and borrow to finance projects. This means the management will

be using external finance from debt holders and in case of financial distress; it

will be the debt holders to suffer.

d) Firms may also borrow additional debt capital which may take priority in case of

liquidation. Firms after securing debts from one group of debt holders, the can

go ahead and solicit from other groups and this may increase the interest

charges and may be of fixed charge as contrasted to the first one which may be

floating charge.

(ii) Restrictive covenants in debt agreements.

a) Restriction on investments to discourage asset substitution. The debt holders

may require the company to seek consent from the debt holders in case they

want to carry further investment in assets to avoid investment in risky

business that may hurt their interests.

b) Restriction on mergers, since mergers may affect the value of claims. The

debt holders may enter into an agreement restricting it to acquire another or

merge with any company without their consent since the transactions may

change the risk and status of the company.

c) Covenant restricting payments of dividends. The debt holders may enter into

an agreement restricting the payment of dividends or the amount of

dividends to pay to the shareholders. This will force the management to

invest retained earnings.

d) Covenant restricting subsequent financing so as to restrict the issue of

additional debt. The debt holders may enter into an agreement restricting the

additional funds the company can raise from external providers of funds

especially debt. This is to avoid changing the priorities of debt.

e) Restriction on disposal of assets. The debt holders can enter into an

agreement requiring that a firm should not dispose of a substantial proportion

of its assets without the consent of the debt holders.

1(e) Advantages that may accrue to the firm that has ethical behaviours.

Ethical behavior and long run profitability are positively correlated in a way that,

when ethical behaviors are adhered to by the firm in the short run, this becomes

a trigger to profitability in the long run.

Therefore MUL can benefit from adherence to ethical behavior through

Increased profitability. When a firm is operating ethically, everyone would

enjoy dealing with company and hence increased sales and profitability

It helps a firm to avoid fines and legal expenses.

Operating ethically will enhance public trust. When the public trusts the

company, its survival is guaranteed.

Operating ethically increases the loyalty of customers who appreciate its

policies.

Good corporate behavior tends to attract the best talent to work for an

organization.

Question 2

2(a). Determining the value of a Shs 5 m per annum pension in 15 years:

Steps:

I Determine the total number of years; including 5 years when the

Father was getting nothing e.g. 5 + 15 = 20 years.

II Determine the annuity of 10% for 20 years.