SCHOOL OF BUSINESS AND ECONOMICS
		DEPARTMENT OF COMMERCE
END SEMESTER EXAMINATION
SEMESTER: AUGUST – DECEMBER 2011
 CODE: BUS 309X				UNIT – BUSINESS FINANCE
MARKING SCHEME
INSTRUCTIONS
Answer ALL questions
Time 2½ hours
Question one
A.
Five factors that influence the working capital needs of a business. 				(10marks) 
1. The size of the company - a big business is characterized by high levels of assets and sales which call for high levels of working capital to facilitate the operations of the business.

2. Nature of the business - a manufacturing business requires high levels of working capital in the form of raw materials and may hold high levels of cash, stock and debtors than a trading business.

3. Accessibility to money markets - if a business has easy access to financial markets it may not hold too much working capital as it can raise cash easily as and when the need arises.

4. The business credit policy - the level of working capital will be influenced by the firm credit policy in particular the credit terms it offers to its customers. a liberal credit policy means high level of debtors which ties huge amount of capital and thus necessitates high level of working capital and vice versa.

5. Movement in prices - if prices of raw materials change frequently this will compel the business to hold high levels of working capital. 

6. Profitability levels - businesses with high profit margins may not require high levels of operating profits as their activities will be self financing.

7. Growth stage of the business - a business in its early stage of its development requires large amounts of working capital to support heavy investments but these decreases as the business grows to maturity and old age.

B.
a. (3marks)
EOQ 	=	√2CoD
		    Ch

	=	√2 x 185 x 2,500
			25

	=	192 units

b. (2marks)
Number of orders	=	D
				Q

			=	2,500
				  192

			=	13 orders

c. (5marks)
Total cost	=	QCh	+	CoD
			2		  Q

		=	(192 x 25)	+	(185 x 2,500)
			       2				192
		=	sh 4,809

C.
Changes in dividends convey information							
•	Dividends increases								(2½ marks)
•	Management believes it can be sustained
•	Expectation of higher future dividends, increasing present value
•	Signal of a healthy, growing firm
•	Dividends decreases								(2½ marks)
•	Management believes it can no longer sustain the current level of dividends
•	Expectation of lower dividends indefinitely; decreasing present value
•	Signal of a firm that is having financial difficulties

Question two
A.
The investment decision making process that you will use when evaluating the ventures.	(10marks)

The investment decision making process
Capital expenditure is subject to a rigorous process of appraisal and control. A typical model for investment decision making has a number of distinct stages namely;

Origination of proposals
A business entity must set a mechanism that scans the environment for potential opportunities and give an early warning of future problems. It should then come up with a proposal that is consistent with the business overall strategy to achieve its objectives.

Project screening
Each proposal must be subjected to detailed screening so that a qualitative evaluation of a proposal can be made. 

Analysis and acceptance
The analysis can be broken to the following steps;
1.	Complete and submit standard format financial information as a formal investment proposal.
2.	Classify the project by type.
3.	Carry out financial analysis of the project.
4.	Compare the outcome of the financial analysis to predetermined acceptance criteria.
5.	Consider the project in light of the capital budget for the current and future operating periods.
6.	Make the decision whether to adopt the project or not.
7.	Monitor the progress of the project.

B.
Describe the various sources of fixed/long term capital that business entities in Kenya can use, highlighting their advantages and disadvantages.						(15 marks)
1.	leasing
2.	share capital
3.	bonds
4.	debentures
5.	long term loans
6.	retained profits
7.	
Question three
A. 
a.	Using pay back period (PBP) method, which of the two projects should the company invest in? (6marks)
b.	Using the net present value (NPV) method, advise the management accordingly as to which of the two projects would be viable and why.					(9marks)
Payback period method
Project A
PERIOD	CASH FLOW	CUMULATIVE CASH FLOW	
1	300,000	300,000	
2	100,000	400,000	
3	400,000	800,000	
4	500,000	1,300,000	
5	600,000	1,900,000	

Payback period		=	3 years 		+	1,000,000 – 800,000	x	12
										500,000
			=	3 years 5 months
Project 	B
PERIOD	CASH FLOW	CUMULATIVE CASH FLOW	
1	600,000	600,000	
2	500,000	1,100,000	
3	400,000	1,500,000	
4	300,000	1,800,000	
5	100,000	1,900,000	

Payback period		=	3 years 		+	1,000,000 – 800,000	x	12
										500,000
			=	1 year 10 months

Net present value method
Project A
PERIOD	CASH FLOW	PRESENT VALUE FACTOR	PRESENT VALUE
	
1	300,000	.9091	272,730	
2	100,000	.8264	82,640	
3	400,000	.7513	300,520	
4	500,000	.683	341,500	
5	600,000	.6209	372,540	
			1,369,930	

Net present value	=	PV Inflows	-	PV Outflows
			=	1,369,930	-	1,000,000
			=	sh 369,930

Project B
PERIOD	CASH FLOW	PRESENT VALUE FACTOR	PRESENT VALUE
	
1	600,000	.9091	545,460	
2	500,000	.8264	413,200	
3	400,000	.7513	300,520	
4	300,000	.683	204,900	
5	100,000	.6209	62,090	
			1,526,170	

Net present value	=	PV Inflows	-	PV Outflows
			=	1,526,170	-	1,000,000
			=	sh 526,170

b. (5 marks)
E (r)	=	Rf + βi (E (rm) - Rf)

	=	4	+	0.9	(10	-	4)

	=	9.4%
C.
Using appropriate examples, discuss the concept of agency theory.				(5marks)
Agency theory is a concept that explains why behavior or decisions vary when exhibited by members of a group. Specifically, it describes the relationship between one party, called the principal, that delegates work to another, called the agent. It explains their differences in behavior or decisions by noting that the two parties often have different goals and, independent of their respective goals, may have different attitudes toward risk. Agency theory, developed in the 1970s.
Agency theory essentially acknowledges that different parties involved in a given situation with the same given goal will have different motivations, and that these different motivations can manifest in divergent ways. It states that there will always be partial goal conflict among parties, efficiency is inseparable from effectiveness, and information will always be somewhat asymmetric between principal and agent. 
Question four

Gross profit margin (3 marks)
Gross profit margin	=	Gross profit	x	100
				Sales

2010 	=	9,750		-	6,825		x	100
			9,750

	=	30%

2011	=	11,200		-	8,460		x	100
			11,200

The current year gross profit is considerably lower than the previous year. This suggests that there has been a change in the cost of sales and the variance should be investigated.

 Net profit margin (3 marks)
Net profit margin	=	Net profit after tax	x	100
					Sales

2010	=	320	+	60	x	100
			9,750

	=	3.9%

2011	=	465	+	80	x	100
			11,200

	=	4.87%

Net income as a proportion of sales has improved noticeably between the years and is currently marginally ahead of the industrial average. This implies that the business is able to control its overall costs.

Asset turnover (3 marks)
Total assets turnover	=	Annual sales
					Capital employed

2010	=		9,750
		1,730	+	60

	=	4.18x

2011	=		11,200
		2,110	+	800

	=	3.85x

Asset turnover has declined between the periods although the current figure is in line with the industry average. This reduction may indicate that the efficiency with which the assets are used has declined or assets which were acquired in the previous years are yet to fully contribute to the business.

Current ratio (3 marks)
Current ratio		=	Current assets
				Current liabilities

2010	=	1,690
		790

	=	2.1

2011	=	1,950
		890

	=	2.2

The current ratio has improved slightly over the years and is marginally higher than the industrial average. It’s also in line with what is regarded as satisfactory i.e. 2:1

Quick ratio (3 marks)
Quick/acid test ratio		=	Current assets – stock & prepaid expenses
							Current liabilities

2010	=	1,080	+	120
			790

	=	1.52

2011	=	1,230	+	80
			850

	=	1.47

The quick ratio has declined marginally but it’s still better than the industrial average. This suggests that the company has no short term liquidity problems.

Accounts receivable collection period (3 marks)
Accounts receivable collection period	=	Trade receivables	x	365 days
							Credit sales

2010	=	1,080		x	365
		9,750

	=	40 days

2011	=	1,230 		x	365
		11,200

	=	40.4 days

Receivables as a proportion of sales are unchanged and are lower than the industrial average. This implies that the company is doing better than its competititors in debt collection.

Accounts payables payment period (3 marks)
Accounts payables payment period  	= 	Trade payables	x	365 days
						Credit purchases
2010	=	690	x	365
		6,825

	=	37 days

2011	=	750	x	365

	=	32 days

The period of credit taken from suppliers has fallen from 37 days to 32 days and is much lower than the industrial average. The company should negotiate better credit terms with its suppliers.

ROCE (4 marks)
Return on capital employed	=	Net profit before interest and tax		x	100
					Total capital employed

2010	=	320	+	60	x	100
		1,730	+	600

	=	16.3%

2011	=	465	+	80	x	100
		2,110	+	800

	=	18.72%

ROCE has improved considerably between 2010 and 2011 and is higher than the industrial average. This implies that the company can comfortably meet its finance charges.