CPA – FINANCIAL MANAGEMENT REVISION KIT (QUESTION AND ANSWER)

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This Revision kit book (Question and answers) contains kasneb past examination past papers and our suggested answers as provided by a team of lecturers who are experts in their area of training. The book is intended to help the learner do enough practice on how to handle exam questions and this makes it easy to pass kasneb exams.

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PAPER NO.8 FINANCIAL MANAGEMENT

 

GENERAL OBJECTIVE

This paper is intended to equip the candidate with knowledge, skills and attitudes that will enable him/her to effectively manage, control and optimize on institutional finances.

 

8.0       LEARNING OUTCOMES

A candidate who passes this paper should be able to:

  • Explain the nature and scope of financial management
  • Describe the nature and functions of financial institutions and markets
  • Analyse the sources of finance for an organisation and evaluate various financing options
  • Evaluate various investment decision scenarios available to an organisation
  • Evaluate the performance of a firm using relevant financial tools
  • Make appropriate capital structure decisions for a firm, Value financial assets and firms
  • Make appropriate liquidity and dividend decisions for a firm
  • Evaluate current developments in the field of finance and their impact on financial decisions

 

CONTENT 

8.1       Overview of financial management

  • Theoretical framework of financial management – The role and responsibilities of a finance manager towards shareholders, employees, society, government and other stakeholders.
  • Goals of a firm and corporate strategy; financial and non-financial objectives, overlaps and conflicts among the objectives
  • Agency theory, stakeholder’s theory and corporate governance
  • Measuring managerial performance, compensation and incentives
  • Ethical issues in financial management

 

8.2       The financing decision

  • Nature and objectives of the financing decision
  • Factors to consider when making financing decisions
  • Sources of finances for enterprises; internally generated funds and the externally generated funds, long term sources (equity, debt, hybrids, lease finance, venture capital, business angel finance, private equity, asset securitisation and sale, Islamic finance and initial coin offerings), medium term sources such as medium term loans and hire purchase financing and short term sources of finance such as overdraft finance, trade credit, issue of commercial papers, accruals, deferred income; characteristics of each source of finance, pros and cons of the various sources of finance.
  • Evaluation of financing options
  • Methods of issuing ordinary shares – Public issue, private placement, bonus issue, employee stock option plans (ESOPS) and rights issues

 

8.3       Financial institutions and markets

  • Overview of a financial system – Financial markets, financial institutions and financial instruments
  • Nature and role of financial markets – primary and secondary securities market, money and the capital markets, over-the counter and organised market, derivatives market, mortgage market, forex market
  • Nairobi securities exchange (NSE, or equivalent entity in other jurisdictions) – The role and functions of the securities exchange, securities exchange terminologies, security exchange listing and cross border listing, share indices, timing of investment at the securities exchange, Central depository system and automated trading system, de-mutualisation
  • Stock market indices
  • Central depository system and automated trading system
  • Timing of investment at the securities exchange – Dow theory and Hatch system of timing
  • The financial institutions and intermediaries: commercial banks, savings and loans associations and co-operative societies, foreign exchange bureaus, unit trusts and mutual funds, insurance companies and pension firms, insurance agencies and brokerage firms, investment companies, investment banks and stock brokerage firms, micro-finance institutions and small and medium enterprises (SMEs)
  • Regulation of financial markets; Central bank of Kenya (CBK, or equivalent entity in other jurisdictions) – The role of the Central bank and the Monetary policy of the central bank; Capital market authority and the Insurance regulatory authority
  • Factors responsible for the rapid development of financial institutions and markets
  • Risks facing financial institutions

 

8.4       Time-value of money

  • Concept of time value of money
  • Relevance of the concept of time value of money in financial management
  • Time value of money versus time preference of money
  • Time line
  • Real versus nominal cash flows
  • Compounding techniques – Compound interest, Future value (FV) of a single cash flow and series of cash flows; Compounding of annuity cash flows
  • Discounting techniques – Present value (PV) of a future cash flow and series of future cash flows and discounting of annuity cash flows
  • Loan amortisation and sinking funds

 

8.5       Business/Financial asset Valuation models

  • Concept of value; book value, going concern value, substitution value, replacement value, conversion value, liquidation value, intrinsic value and market value
  • Reasons for valuing financial assets/business
  • Theories on valuation of financial assets; fundamental theory, technical theory, random walk theory and the efficient market hypothesis
  • Valuation of redeemable, irredeemable and convertible debentures/ corporate bonds
  • Valuation of redeemable, irredeemable and convertible preference shares
  • Valuation of ordinary shares; net asset basis, price-earnings ratio basis, capitalisation of earnings basis, Gordon’s model, finite earnings growth model, Super-profit model, Walter’s model, discounted free cash flow, residual income model, Use of relative measures such as Economic Value added (EVA) and Market Value Added (MVA)
  • Valuation of rights issues
  • Valuation of unit trusts and mutual funds
  • Valuation of private companies: income and market-based approaches

 

8.6       Introduction to capital structure decisions

  • The meaning of capital structure and the factors to be taken into account when making capital structure decision.
  • Cost of capital; Meaning of cost of capital, practical applications of cost of capital, component costs of capital
  • The firm’s overall cost of capital; Weighted average cost of capital (WACC), Weighted marginal cost of capital (WMCC) and factors influencing the firm’s Cost of capital.
  • Leverage and Risk; Operating leverage and Operating risk, financial leverage and financial risk and total leverage and total risk.
  • Analysis of Operating profit (EBIT), Earning per share (EPS) at the point of indifference in the firm’s earnings; Determination of the range of firm’s operating profit (EBIT) within which each financing option will be recommended

 

8.7       Introduction to capital budgeting decisions

  • The nature and importance of capital investment decisions
  • Capital budgeting process
  • Capital investment’s cash flows – initial cash outlay, terminal cash flows and annual net operating cash flows, incremental approach to cash flow estimation
  • Capital investment appraisal techniques
  • Non-discounted cash flow methods – payback period and accounting rate of return
  • Discounted cash flow methods – net-present value, internal rate of return, profitability index, discounted payback period and modified internal rate of return (MIRR)
  • Strengths and weaknesses of the investment appraisal techniques
  • Expected relations among an investment’s NPV, company value and share price
  • Capital investment options – timing option, strategic investment option, replacement option and abandonment option
  • Problems/difficulties encountered when making capital investment decisions in reality

 

8.8       Financial statements analysis and forecasting

  • Scope of financial statement analysis, major financial statements and other information sources, financial statement analysis frame work and users of financial statements and their information needs
  • Financial Statement analysis verses Business analysis
  • Techniques of financial Statement analysis; Cross-Sectional analysis, Time series analysis and a combination of both techniques.
  • Types of financial statement analysis
  • Ratio analysis; nature of financial ratios, classification and calculation of financial ratios and limitation of financial ratios
  • Common size statements – Vertical and horizontal analysis
  • Financial forecasting; cash budgeting and percentage of sales method of forecasting

 

8.9       Working capital management

  • Introduction and concepts of working capital
  • Working capital versus working capital management
  • Factors influencing working capital requirements of a firm
  • Types of working capital
  • Importance and objectives of working capital management
  • Working capital operating cycle; the importance and computation of the working capital operating cycle
  • Working capital financing policies: Aggressive, conservative and matching financing policy
  • Determining the finance mix: basic approaches for determining an appropriate Working Capital finance mix; Hedging or matching approach, conservative approach, aggressive approach.
  • Management of inventory: kinds of inventory, objectives of Inventory Management, Techniques of Inventory Management; stock levels, Economic Order Quantity (EOQ) and Just-In-Time (JIT).
  • Cash Management; Motives of holding cash, techniques of managing cash, cash management models-Baumol model, Miller-Orr model and Orgler’s model
  • Management of accounts receivable and accounts payable; assessing creditworthiness, collecting amounts owing, trade credit

 

8.10    Dividend decision

  • Meaning and significance of dividend policy
  • Factors influencing dividend policy
  • Forms of dividend: script dividend, cash dividend, stock dividend, bond dividend, property dividend
  • Dividend theories; Bird in hand theory, Clientele effect theory, Information signalling theory, Walter’s model, Gordon Model, Tax differential theory, Modigliani and Miller dividend irrelevance theory
  • Types of dividend policy: regular dividend policy, stable dividend policy, irregular dividend policy, zero dividend policy.
  • The impact of dividend payout on share price

 

8.11    Introduction to risk and return

  • Introduction – Risk-return trade off/relationship, Distinction between risk free and risky assets
  • Expected return, Standard deviation of returns and the Relative risk of an individual asset
  • Expected return of a 2 asset-portfolio
  • The Covariance and correlation coefficient of returns of assets.
  • The actual portfolio risk of a 2-asset portfolio using the analytical and mathematical model and its interpretation

 

8.12    Islamic finance

  • Justification for Islamic Finance; history of Islamic finance; capitalism; halal; haram; riba; gharar; usury
  • Benefits and deficiencies of Islamic Finance
  • Principles underlying Islamic finance: principle of not paying or charging interest, principle of not investing in forbidden items; ethical investing; moral purchases
  • The concept of interest (riba) and how returns are made by Islamic financial securities
  • Sources of finance in Islamic financing
  • Types of Islamic financial products:- sharia-compliant products: Islamic investment funds; takaful the Islamic version of insurance Islamic mortgage, murabahah, Leasing – ijara; safekeeping – Wadiah; sukuk – islamic bonds and securitisation; sovereign – sukuk; Islamic investment funds; Joint venture – Musharaka, Islamic banking, Islamic contracts, Islamic treasury products and hedging products, Islamic equity funds; Islamic derivatives
  • 7 International standardisation/regulations of Islamic Finance: case for standardisation using religious and prudential guidance, National regulators, Islamic Financial Services Board

 

8.13    Personal financial management

  • Financial Problems encountered in managing individual financial affairs
  • Savings and investment considerations
  • Personal risk management
  • Cost of credit
  • Financial Alterations – Retirements; Estate and Tax planning and family budgeting

 

8.14    Contemporary issues and emerging trends

  • Globalisation and growth of derivative markets and securitisation
  • Cryptocurrency
  • Block chain technology
  • Cloud funding
  • Digitisation of financial transactions
  • Behavioural finance
  • Big data project finance

SAMPLE WORK

Complete copy of FINANCIAL MANAGEMENT Revision Kit is available in SOFT copy (Reading using our MASOMO MSINGI PUBLISHERS APP) and in HARD copy 

Phone: 0728 776 317

Email: info@masomomsingi.com

 

TOPIC 1

 

OVERVIEW OF FINANCIAL MANAGEMENT

QUESTION 1

August 2023 Question One A

Outline FOUR limitations of profit maximisation as a financial goal of a firm.   (4 marks)

 ANSWER

Limitations of profit maximisation

The profit maximization goal is the idea that a business should make as much profit as possible. This is a common goal for businesses, but it has some limitations. Here are some of the limitations of profit maximization:

  • Definition of Profit – The precise meaning of the profit maximization objective is unclear. The definition of the term profit is ambiguous. Does it mean short or long-term, before or after tax, total or net profit? It is not clear.
  • Time Value of Money – The profit maximization objective does not distinguish between returns received at different times. It does not consider the time value of money; it values benefits received today and benefits received after a period as the same.
  • Profit maximization can also lead to the production of too many of a particular product that is of no use. This will create wastage destroying the raw materials and stuffing the landfills. Therefore, producing efficiently is more acceptable than maximizing the profit only.
  • Profit maximization has also been termed to be vague, and it ignores the risks and returns in a positive manner. The idea of profit maximization is not self-sustaining in nature and it is not built to target a market. That is why it does not consider the risks and returns as commonly as it should.
  • Ignores the Risk – A decision solely based on the profit maximization model would decide in favor of profits. In the pursuit of profits, the risk involved is ignored, which may prove unaffordable at times simply because higher risks directly question the survival of a business. Between projects A and B, project A may be more profitable; however, if it is substantially more riskier, project B may be preferable.
  • Long-Term Sustainable Goals – Profit maximization might be one of the top goals of financial management but this type of practice doesn’t imply that short-term profit increases will help produce long-term sustainable goals for the company. While profit maximization in financial management has the potential to bring in extra money in the short-term, long-term earning could be drastically diminished.
  • Product Quality- Another limitation of profit maximization in financial management is the potential to decrease product quality. Earning higher profits might be one of the goals of financial management but cutting corners, using lower quality materials, and sacrificing company values to earn a higher profit will affect the reputation of the company and potentially lose customers.

 

QUESTION 2

April 2023 Question One A

Management of a limited liability company is appointed to promote and protect shareholders’ interest in the performance of their functions. The aim is to maximise shareholders’ value. The management, however, could have interest that might be in conflict with shareholders’ interest.

Required:

In reference to the above statement:

  • Identify this type of conflict in modern day financial management of a firm. (1 mark)
  • Explain THREE factors that could contribute to the conflict identified in (a) (i) above.    (3 marks)
  • As a financial management professional, explain FOUR strategies that could be used to manage or mitigate this conflict to protect shareholders.    (4 marks)

 

ANSWER

  • Type of conflict in modern day financial management of a firm.

Agency problem   

Factors that could contribute to the conflict identified in (a) (i) above.

  • Managements may use corporate resources for personal use
  • Managements may take holidays and spend huge sum of company money.
  • Creative accounting – involves manipulation of finances
  • Empire building – managers may organize for mergers beneficial to themselves and not shareholders.
  • Failure to declare dividend for no good reason.

 

Strategies that could be used to manage or mitigate conflict to protect shareholders.

  1. Performance based remuneration: This involves remunerating managements for actions they take that maximizes shareholders wealth. Managements could be given bonuses, commission for superior performance in certain periods.
  2. Incurring agency cost: Agency costs are those incurred by shareholders in trying to cut management behaviour and action and therefore minimize agency conflicts. They include: Monitoring cost, boding assurance, opportunity cost, restructuring cost
  3. Direct intervention by shareholders: These may be done in the following ways;
  • Making recommendations to the management on how the firm should be run
  • Threat of firing
  1. Use of corporate governance principles which specify the manner in which organizations are acted and managed. The duties and rights of all stakeholders are outlined.
  2. Threat of hostile takeover (sell the business): This may be arranged by shareholders to lock out managements who aren’t responsible

 

QUESTION 3

December 2022 Question One A

Ethical responsibilities arise not as a result of legal requirements but as a result of moral imperative for companies to operate in an ethical and fair manner.

In light of the above statement, summarise SIX elements of business ethics in management of companies.       (6 marks)

 

ANSWER

Elements of business ethics in management of companies

Business ethics are the principles and values that guide the behavior of individuals and organizations in the business world. There are several elements of business ethics that are important in the management of companies, including:

  1. Honesty: This involves being truthful and transparent in all business dealings.
  2. Integrity: This involves acting with integrity and upholding ethical standards, even when it may be difficult or inconvenient to do so.
  3. Professionalism: This involves exhibiting a professional demeanor and acting in a way that is respectful and responsible.
  4. Responsibility: This involves being accountable for one’s actions and taking responsibility for their impact on others.
  5. Fairness: This involves treating all stakeholders, including employees, customers, and suppliers, fairly and justly.
  6. Respect: This involves treating others with dignity and respect, regardless of their position or status.
  7. Compliance: This involves following laws, regulations, and other rules that govern business operations.
  8. Corporate social responsibility- Companies should strive to be good corporate citizens and strive to create positive social impact through their actions.

 

QUESTION 4

August 2022 Question Two B (i)

Distinguish between the following terms as used in finance:

(i)     “Agency cost” and “agency problem”.     (2 marks)

 

ANSWER

Distinction between “Agency cost” and “agency problem” as used in finance

In finance, the term “agency cost” refers to the cost that a firm incurs as a result of having an agent (e.g., a manager) make decisions on behalf of a principal (e.g., the shareholders). These costs can include the cost of monitoring the agent’s behavior, the cost of aligning the interests of the agent with those of the principal, and the cost of compensating the agent for their services.

The “agency problem” refers to the conflict of interest that can arise between the agent and the principal as a result of the different incentives that each party has. For example, a manager may have an incentive to make decisions that benefit themselves rather than the shareholders, leading to a misalignment of interests. This can result in the agent acting in a way that is not in the best interest of the principal, which can lead to the agency costs mentioned above.

 

QUESTION 5

August 2022 Question Three B

Discuss three causes of conflict between shareholders and managers in relation to agency theory.      (6 marks)

 

ANSWER

Causes of conflict between shareholders and managers in relation to agency theory                                                                                                                   

  • Creative accounting – involves manipulation of finances
  • Empire building – managers may organize for mergers beneficial to themselves and not shareholders.
  • Information asymmetry: Managers often have access to more information about the inner workings of the company than shareholders do, which can make it difficult for shareholders to hold managers accountable for their actions.
  • Short-term versus long-term focus: Shareholders may be more focused on short-term profits, while managers may be more concerned with the long-term stability and growth of the company.
  • Diversification of shareholder interests: If a company has a large and diverse group of shareholders, it can be difficult to reach consensus on important decisions.
  • Managerial entrenchment: Some managers may be resistant to change and unwilling to consider the interests of shareholders.

 

QUESTION 6

April 2022 Question One A

Describe four ways of encouraging managers to achieve stakeholders’ objectives.  (4 marks)

ANSWER

Ways of encouraging managers to achieve stakeholders’ objectives.    

  • Performance based remuneration: This involves remunerating managers for actions they take that maximize shareholders wealth. Management could be given bonuses, commission for superior performance in certain periods.
  • Threat of hostile takeover (sell the business): This may be arranged by shareholders to lock out managements who aren’t responsible.
  • Use of corporate governance principles which specify the manner in which organizations are acted and managed. The duties and rights of all stakeholders are outlined
  • Threat of firing
  • Bonding insurance: Insurance taken for managers who engage in harmful practice
  • Restructuring cost: Are costs incurred in changing an organization structure so as to prevent undesirable management activities.
  • Monitoring costs: Arise as a result of mechanism put in place to ensure interest of shareholders are met. These include; cost of hiring auditors

 

QUESTION 7

December 2021 Question One A

Describe four possible sources of conflict of interest between shareholders and bondholders.    (4 marks)

 

ANSWER

Possible sources of conflict of interest between shareholders and bondholders.

  • Dividend payments to shareholders could be very high
  • Default on interest payment.
  • Shareholders could organize mergers which aren’t beneficial to bondholders.
  • Shareholders could acquire additional debt that increases the financial risk of the firm.
  • Manipulation of the financial statements so as to mislead creditors.
  • Shareholders could dispose assets
  • Shareholders could dispose assets which are security for credit given.
  • Shareholders could invest in very risky projects.

 

QUESTION 8

September 2021 Question One B

Highlight four advantages of the wealth maximisation objective of a firm.          (4 marks)

 

ANSWER

Advantages of the wealth maximisation objective of a firm

  • Considers risks and uncertainties associated with the project.
  • Takes into account the time value of money
  • Consistent with the going concern of the firm
  • Can be useful in case of joint ventures and limited companies
  • The various resources are put to economic and efficient use
  • The employees share in the wealth gets increased

 

 QUESTION 9

November 2019 Question One A

In the context of agency theory:

(i) Explain the “principal-agent” problem.      (2 marks)

(ii) Explore two ways of addressing the principal-agent problem.      (4 marks)

 

ANSWER

a) i) Explanation of Principal-agent problem

This is one conflict in priorities between a person or group and the representative authorized to act on their behalf. An agent may behave in a way that prejudices principal interest.

ii) Ways of addressing the principal-agent problem

  1. Lenders may refuse to lend to the firm or charge higher than normal market interest rates to compensate for increased risk.
  2. They could have covenants related to decision making on financing e.g they could require a representative in annual general meetings or board meetings where credit decisions will made.
  3. Creditors can protect themselves by adopting restrictive covenants in the debt contract to restrict asset disposals, debt financing and company’s divided and remuneration capacity.
  4. Incur agency cost such as :
  • Monitoring expenses such as audit fees, compliance fees.
  • Reorganization costs to structure the organization so that the possibility of undesirable management behavior would be limited.
  • Opportunity cost associated with Loss of profitable opportunities resulting from structure not to permit manager to take action on a timely basis as would be the case if the managers were also owners.
  1. Threat of hostile takeover: under performance will lead to a situation whereby shares become undervalued in the stock market. This highlights the risk of a firm being taken over with the result that firm’s current management will be replaced. The only cure for this is good performance.
  2. Labour market actions whereby only professional managers with a track load of good performance are hired.
  3. Shareholders intervention: hereby the shareholders vote out incompetent directors at the annual general meeting.
  4. Use of corporate governance principles which prescribe how firms should be managed and controlled.
  5. Stock option schemes for managers could be introduced. This forces managers to undertake that enhance shareholders wealth.

 

QUESTION 10

November 2017 Question Four B

Highlight three agency costs that might arise in the principal-agent relationship between shareholders and managers.      (3 marks)

 

ANSWER

Agency costs that might arise in the principal-agent relationship between shareholders and managers

  1. Monitoring expense such as audit fees and compliance fees
  2. Reorganization costs to structure the organization so that the possibility of undesirable management behavior could is limited (cost of internal controls)
  3. Cost of delaying decision

 

QUESTION 11

May 2017 Question Five C

The goal of profit maximisation is considered to be a short-term objective with long-term survival. The firm’s growth cannot be achieved without continuous profitability.

Required:

In relation to the above statement, summarise four arguments-in favour of and four arguments against profit maximisation as a business goal.    (8 marks)

 

ANSWER

Arguments in favour and against profit maximization as a business goal

Against

  1. Ignores risk and uncertainty
  2. Ignores other participants
  3. Does not account for time value of money
  4. Regards profit. Ideally attention should be on cash flows
  5. May lead to exploitation of workers and consumers
  6. Creates immoral practices such as corrupt practices, unfair trade practices etc
  7. It is vague

 

Arguments for

  1. Main aim for business is earning profit
  2. Profit is the parameter of the business operation
  3. Profit reduces risks of the business concern
  4. Profit is the main source of finance
  5. Profitability meets the social needs

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