ADVANCED CREDIT RISK MANAGEMENT AUGUST 2023 PAST PAPER

MONDAY: 21 August 2023. Afternoon Paper. Time Allowed: 3 hours.

Answer ALL questions. Marks allocated to each question are shown at the end of the question. Do NOT write anything on this paper.

QUESTION ONE

MARIDADI FASHIONS

Maridadi Fashions (MF) is located in Mtoni, Coast town. MF was started 14 years ago by Juma Mapesa and Brown Kazungu who had over 25 years of experience with a major government manufacturer. Juma Mapesa is a reserved person and is extremely creative with a real flair for merchandising and trend spotting. Brown Kazungu on the other hand is outgoing, forceful and a good marketer. MF label is synonymous with quality and fashion.

Juma Mapesa is very worried about the liquidity position of the company. His fears emanate from the fact that most of their customers who are in retail business are experiencing financial distress and have spread out their payments which has caused cashflow shortages at MF. Juma Mapesa will be retiring next year due to health related complications.

Considering that they have been partners with Brown Kazungu he is not sure whether Brown Kazungu will be able to manage the affairs of the company after he exits.

Borrowing Concerns
Brown Kazungu’s Maridadi Fashions has no written credit policy in place. Brown Kazungu makes virtually all major operating and financial decisions. Three years ago he made a decision to retire all long-term debts, a move triggered by Kazungu’s fear that MF’s business risk was increasing. He cited the difficulties of seemingly rock-solid retailers like Bidii’s and Malimali to support his claim. Kazungu is also concerned that firms of the size of MF have had difficulty maintaining stable bank relationships. Due to increasingly strict regulations, some banks have called in loans at the slightest technicality, and most are scrutinizing new business loans very carefully. Consequently, Kazungu views bank debt financing as ‘unreliable.

Mapesa is not sure what to make of this argument but he is concerned that this debt avoidance has significantly reduced MF’s financial flexibility because it means that all projects will have to be equity financed. In fact, over the past five years, there has been no dividends because all earnings have been reinvested. Two years ago, each of the partners had to contribute Sh.1.5 million of capital in order to meet the company’s cash needs. Another infusion of capital may be necessary since the firm’s present cash position is low by historical standards. Mapesa is of the opinion that in order to progress, there is an urgent need to monitor the cash conversion cycle of the company. More importantly, however, Mapesa feels that the company is not benefiting from leverage effect of debt financing and that this hurts the profitability of the firms to the two owners.

Working Capital Concerns
Mapesa suspects that MF’s inventory is ‘excessive’ and that capital is unnecessarily tied up in inventory. Kazungu’s position is that a large inventory is necessary to provide speedy delivery to customers. He argues that ‘our customers expect quick service and large inventory helps us to provide it’.
Mapesa is sceptical of this argument and wonders if there is no other efficient way of providing quicker service. He knows that a consultant recommended that MF ‘very seriously’ consider building a state of art distribution center. The proposed facility would allow MF to reduce inventory and also handle big orders from retailers such as Minimart and Prize-Mart. Kazungu rejected the suggestion. Saying that they needed to undertake a number of project evaluation technique like payback period, benefit cost ratio so as to find out whether opening distribution centres will be a viable project.

Kazungu was also concerned that if the company settled on opening distribution centres the company would suffer the following risks; construction risks, start-up phase risks and operational phase risks.

Mapesa also questions Kazungu’s credit standards and collections procedures. Mapesa thinks that Kazungu has been quite generous in granting payment extensions to customers, and at one point nearly 40 percent of the company’s receivables were more than 90 days overdue. Further, Kazungu would continue to accept and ship orders to these retailers even when it was clear that their ability to pay was marginal. Kazungu’s position is that by continuing to extend credit to these customers it was a sure way of not losing sales and that the rough times these retailers face are only temporary.

Mapesa also wonders about the wisdom of passing up trade discounts. MF is frequently offered terms of 1/10, net 30. This company receives a one percent discount if a bill is paid in ten days and in any event full payment is expected within 30 days. Kazungu rarely takes these discounts because he “wants to hold onto cash as long as possible”. He also notes that “the discount is not especially generous and 99 percent of the bill must still be paid.”

Required:

1. State THREE project evaluation techniques that the company could have considered as a guide to opening distribution centres apart from the one mentioned in the case study. (3 marks)

2. Explain the following types of project implementation risks that Maridadi Fashions would suffer as a result of opening distribution centres:

Construction phase risk. (2 marks)

Start-up phase risk. (2 marks)

Operational phase risk. (2 marks)

3. Maridadi Fashions customers who were in retail business were experiencing financial distress.
With reference to the above statement, describe THREE signs that might indicate financial distress in a
company. (6 marks)

4. Examine THREE variables in cash conversion cycle that Maridadi Fashions must pay attention to. (6 marks)

5. Highlight THREE reasons that caused cash flow shortages at Maridadi Fashions. (3 marks)

6. Explain FOUR disadvantages that Maridadi Fashions could have experienced as a result of holding excess inventory. (8 marks)

7. Discuss FOUR benefits that would have accrued to Maridadi Fashions if they had a credit management policy in place. (8 marks)

(Total: 40 marks)

 

QUESTION TWO

1. Differentiate between “fixed capital” and “working capital”. (4 marks)

2. Highlight FIVE benefits of developing a credit loss distribution. (5 marks)

3. Analyse THREE components used in computation of Kenya Bankers Reference Rate (KBRR). (6 marks)

(Total: 15 marks)

 

QUESTION THREE

1. State THREE conditions required for a loan to be reclassified as performing. (3 marks)

2. Describe THREE limitations of providing loan security by a borrower. (6 marks)

3. Discuss THREE elements of portfolio management. (6 marks)

(Total: 15 marks)

 

QUESTION FOUR

1. Enumerate THREE types of trade credit insurance covers. (3 marks)

2. Explain THREE methods of assessing the financial viability of a project. (6 marks)

3. Evaluate THREE features of diversifiable risks. (6 marks)

(Total: 15 marks)

 

QUESTION FIVE

1. Highlight FOUR banks’ functional areas where credit portfolio modelling is applied. (4 marks)

2. Outline FIVE features of capital assessment process under Basel II. (5 marks)

3. Examine THREE signs of a liquidity trap. (6 marks)

(Total: 15 marks)

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