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Finance 201 Test 1– 2023

SCHOOL OF ACCOUNTING, ECONOMICS AND FINANCE

FINANCE 201
(FINA201)

TEST 1: 24 March 2023 Duration: 90 minutes

INSTRUCTIONS:

1. This test paper consists of 7 numbered pages (including this page).

2. ANSWER BOTH QUESTIONS 1 AND 2.

Answer Question 1 Part A on the MCQ answer sheet provided.
Answer Question 1 Part B, and Question 2 in separate answer
booklets.
Ensure that your student number is written on your MCQ answer
sheet and the cover of both booklets.

3. Appendix A on page 6 contains useful formulae.

4. Appendix B on page 7 contains a financial statement template to

complete. Detach this appendix from the question paper and include
it in your question 2 answer book.

5. Show all workings.

6. Unless specified otherwise, round off all final answers to two

decimal places, and values to the nearest cent.
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Finance 201 Test 1– 2023

Question 1 (50 marks: 45 minutes)

Answer both unrelated parts to this question

Part A (10 marks: 9 minutes)

Indicate your choice for each of questions 1-5 on the MCQ answer sheet provided. There will
be no negative marking.

1. What makes markets efficient?

(a) Competition amongst investors.
(b) Superior price information.
(c) Technical analysis.
(d) Fundamental analysis.
(e) Mispriced shares.

2. The advantage of forming a partnership is that _________.

(a) it has unlimited liability.
(b) it is easy and inexpensive to form.
(c) it allows large amounts of capital to be raised by issuing shares.
(d) partnerships are dissolved when one partner dies.
(e) ownership is not easily transferable.

3. The more liquid a company is, the less likely it is that the firm will experience
___________.
(a) financial distress
(b) a high cash to debt ratio
(c) a high current ratio
(d) agency costs
(e) a high quick ratio

4. In the strong form of the Efficient Market Hypothesis (EMH) which type of
information can be used to beat the market?
(a) Historical information
(b) Insider information
(c) Publicly available information
(d) Empirical evidence
(e) None of the above can be used to beat a strong-form efficient market.

5. A corporation sold a fixed asset for R100 000. This represents:

(a) An investment cash flow and a source of funds.
(b) An operating cash flow and a source of funds.
(c) An operating cash flow and a use of funds.
(d) An investment cash flow and a use of funds.
(e) A financing cash flow and a use of funds.
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Finance 201 Test 1– 2023

Part B (40 marks: 36 minutes)

(a) Essay Question (30 marks: 27 minutes)

“As a company grows and progresses through the different stages of its life cycle, eventually
it will reach a point where stakeholders need to decide whether to stay private or go public...
The decision to remain private or go public is a critical one that many companies will face at
some point. As management teams assess whether or not the time is right to make the call, it
is essential to be mindful of the risks and costs associated with each choice.”- Whyte (2022)

Extract from article on Forbes.com, “Going Public Versus Staying Private: Risks And Benefits Every Business
Leader Should Consider”. Available at:
https://www.forbes.com/sites/forbesfinancecouncil/2022/10/14/going-public-versus-staying-private-risks-and-
benefits-every-business-leader-should-consider/?sh=5411d1b1b968.

Required:
With reference to the above quotation, prepare an essay which must include the following:
 A discussion of the similarities and differences between private and public companies.
 A definition of capital markets. Be sure to explain how these markets fit into the
South African financial system, i.e. explain how the JSE assists in financing
companies in South Africa.
 A discussion of alternative methods available to private companies to raise finance.
(30 marks: 27 minutes)

(b) Explain the Agency Problem, and identify and discuss two solutions to this problem with
the use of examples.
(10 marks: 9 minutes)
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Finance 201 Test 1– 2023

Question 2 (50 marks: 45 minutes)

AWD Ltd is a manufacturer of auto components for the South African motor industry. You
are tasked with analyzing the performance of the firm over the latest two years. A simplified
statement of comprehensive income and statement of financial position are provided below.
Parts A and B relate to AWD Ltd.

AWD Ltd Statement of Comprehensive Income for the year

ended 28 February 2023
2023 2022
Sales 780 000 624 000
Cost of Sales (440 000) (405 600)
Gross Profit 340 000 218 400
Operating Costs (176 880) (149 760)
Operating profit (PBIT) 163 120 68 640
Finance Costs (9 920) (7 200)
Profit before tax 153 200 61 440
Tax (28%) (38 000) (14 000)
Net Profit after Tax (NPAT) 115 200 47 440

AWD Ltd Statement of Financial Position as at 28 February 2023

2023 2022
ASSETS
Net Non-Current Assets 507 700 456 100
Current Assets 268 100 195 900
Inventory 127 600 82 250
Accounts receivables 117 400 92 050
Cash and cash equivalents 23 100 21 600
Total Assets 775 800 652 000
EQUITY AND LIABILITIES
Equity 462 080 376 000
Ordinary Share Capital 150 000 150 000
Retained Profit 312 080 266 000
Liabilities 313 720 276 000
Long term debt 132 000 120 000
Overdraft 34 400 24 000
Accounts payable 147 320 132 000
Total Equity and Liabilities 775 800 652 000

Additional information:
AWD Ltd pays out 60% of its profits as dividends.
Number of shares outstanding (2022 and 2023): 15 000
Market price per share: R15.00 (2022)
R25.80 (2023)
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Finance 201 Test 1– 2023

Part A (36 marks: 32 minutes)

(a) Analyse the profitability and asset management of AWD Ltd for the 2022 and 2023
financial years. Your analysis should include a comparison of relevant ratios in 2022 and
2023. Assume 365 days in a year.
(26 marks: 23 minutes)
(b) Use the three-factor Du Pont identity to analyse the change in AWD Ltd’s Return on
Equity from 2022 to 2023.
(10 marks: 9 minutes)

Part B (14 marks: 13 minutes)

The managing director of AWD Ltd is anticipating a dramatic increase in the demand for
auto components in the 2024 financial year, and is expecting sales to increase to R 1 092 000.
Assume full capacity and a constant dividend payout ratio. All costs are expected to grow at
the same rate as sales.
Use the percentage of sales approach to prepare the pro forma statement of comprehensive
income for AWD to achieve its targeted level of growth in 2024.

Use Appendix B on page 7 of the question paper to complete the pro forma statement of
comprehensive income. Detach this appendix from the question paper and include it in your
question 2 answer book. Please remember to write your student number in the space
provided. Show all your workings in your answer booklet.
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Finance 201 Test 1 Suggested solutions – 2023

QUESTION 1
PART A: MCQ [10 marks]

1. (a)
2. (b)
3. (a)
4. (e)
5. (a)

PART B [40 marks]

(a) Essay

The quote refers to the decision that the stakeholders or management team will have to
make about whether to remain private or go public. Whyte (2022) states that this decision
has to be made whilst being aware of the costs and risks associated with each form of
business organization.

This essay compares the two business forms; private and public companies.
Similarities:
Separation of management from ownership – Generally, in public and private companies,
the shareholders (owners) will elect a board of directors who will then appoint a
management team. A number of directors will usually be involved, as executive directors,
in the daily management of the affairs of the company. The separation of management and
ownership enables the company to raise large amounts of finance. However, this gives rise
to the agency problem.
Separate legal entity - The company (private and public) is a separate legal entity from the
owners and is governed by the Companies Act. This means that a company is legally like
any other person and can buy, sell and transact in its own name. It can enter into contracts
and raise finance, is required to pay tax (separately taxed from the owners) and has the
same rights and responsibilities as a natural person.
Limited liability – means that shareholders are only at risk up to what they have invested in
the company. If a company fails, then the creditors cannot look to the personal assets of the
shareholders. This will encourage investment and enable companies to raise large amounts
of capital and enables shareholders to effectively diversify their investments.
Separate taxation. The company is taxed separately from the owners
Taxation rate – Private and public companies are liable for taxation on “taxable income”.
The corporate tax rate in South Africa is 28%.
Continuous existence - A separate legal identity means that the company can continue
indefinitely and is not subject to the lifespan of the owners. In other words, a company’s
lifespan is not limited by the life-span of its owners. It has continuity of existence unless, of
course the company fails.

Difference:
Transferability and marketability - Ease of ownership transfer, and perpetual succession are
the major advantages of both forms of business organization. It is relatively easy to transfer
share ownership, and investments in the shares of public companies are generally
marketable. In contrast, in a private company, ownership is typically held by a smaller
group of investors/shareholders, and the shares are not publicly traded.
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Finance 201 Test 1 Suggested solutions – 2023

Other differences…. Disclosure requirements and reporting standards can be onerous

requiring a greater investment in information systems, and resulting in an increase in
compliance costs for public companies. There is increased accountability to shareholders
and loss of privacy and flexibility in managing the public company. Private company’s
costs of formation are low because there are no costs of listing on the main board, not
obligated meeting listing requirements and there is limited disclosure of financials.

Financial information about margins and profitability levels of a public company become
available to competitors and potential competitors. Any strategic information shared with
investors will be accessed by competitors. Suppliers and customers become aware of the
financial performance of the company.

One of the biggest advantages of a public company is that capital can be raised directly
from the public through the sale of shares publicly. Thus, the public company form of
organisation is effective for the raising of large sums of capital for the financing of major
projects. Private companies often have restrictions on the transfer of shares and thus,
mechanisms to raise additional financing from the public.

Define capital markets and the role of the JSE

Public companies have the ability to raise large sums of capital in capital markets. The
Capital Market is used mostly for raising long term finance. Capital markets are suitable for
instruments with a life greater than three years. The key capital market securities are bonds
(long-term debt), and both ordinary shares and preferred shares (equity, or ownership).

The JSE Securities Exchange is an example of a capital market in South Africa. Shares of a
company listed on the stock/securities exchange fall into the capital market. Public
companies may have their shares listed on a stock exchange such as the JSE Securities
Exchange and these companies have to comply with the listing requirements of the JSE.
The shares of public companies are freely transferable and if listed, shareholders can freely
buy and sell shares on the JSE. Shares bought and sold as daily transactions on the stock
exchange are an example of dealings in the secondary market. However, an offer of new
equity on the JSE is an example of a primary market transaction. The secondary market is
not a source of finance, but it is nevertheless relevant as it indicates the marketability and
value of the securities. In this way it provides information for the organisation wanting to
raise finance in the primary market.

The role of the JSE: issue shares and raise primary capital to finance business expansion;
ensure there is a secondary market for the trading of shares so that investors can buy and
sell securities; monitor the performance of the company as measured by movements in its
share price (indicates the value of the securities); enhance the public profile of the company
(marketability).

Alternative methods of obtaining finance:

Private companies are limited in their ability to raise financing in capital markets.
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Finance 201 Test 1 Suggested solutions – 2023

Private equity is an alternative investment class and consists of capital that is not listed on a
securities exchange. Private equity is composed of funds and investors that directly invest
in private companies.

Venture capital is a form of private equity financing that is provided by venture capital
firms or funds to startups, early-stage, and emerging companies that have been deemed to
have high growth potential or which have demonstrated high growth.
[30]

(b) Agency problems arise from the separation of management and ownership in a firm. The
separation of ownership and control can lead to a conflict of interests between the principal
(shareholders) and the agent (management).
Solutions to the problem:
Threat of a takeover- The threat of any take-over can motivate management to prioritize
maximizing the share price, making any takeover attempt more costly and potentially
dissuading shareholders from accepting an offer. Companies with underperforming
management are often targeted for takeover and management is typically replaced in such
situations.

Structure management compensation to correspond with firm performance. For example,

management incentives such as share options, which are linked to the share price and
performance bonuses that are linked to variables such as accounting earnings or operating
cash flow. Performance shares and/or cash bonuses are used as compensation under these
plans.

Transparency - Regular and effective communication between managers and shareholders

can be beneficial in mitigating the agency problem. Companies can facilitate this by
providing timely updates on financial performance, strategic plans, and other important
matters, which can help to keep shareholders well-informed and engaged in the decision-
making process. The company could also appoint an independent board of directors who do
not have direct ties to the company.

Increasing corporate governance - The King IV principles aim to address the agency
problem by promoting good corporate governance practices that align the interests of
company directors and executives with those of the shareholders. The King IV report
emphasises the need for ethical leadership, board independence, stakeholder engagement,
and transparent and integrated reporting as a way of building trust and accountability
among stakeholders.
[10]
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Finance 201 Test 1 Suggested solutions – 2023

QUESTION 2

PART A [36 marks]

(a)
Profitability:
2023 2022
Net Profit margin 115 200 / 780 000 = 14.77% 47440 / 624 000 = 7.60%
Gross profit margin 340 000/780 000 = 43.59% 218 400/624 000 = 35%
Return on assets 115 200 / 775 800 =14.85% 47 440 / 652 000 = 7.28%
Return on equity 115 200 / 462 080 =24.93% 47 440 / 376 000 =12.62%

There was an improvement in the profitability ratios in 2023. All measures almost double
of those observed in 2022, indicating that AWD performed better in 2023.

The return on investments in assets and returns to shareholders increased in 2023. These
indicate AWD was efficient in using its assets and shareholder’s equity to generate a profit.

The profit margin ratios (GPM and NPM) increased showing that the firm was more
efficient in managing its operations in 2023. The increasing GPM indicates AWD’s sales
increased at a faster rate than cost of sales. AWD was more efficient at converting sales
into actual profit.

AWD performed better in managing its operations efficiently in 2023 and used its assets
efficiently. Overall profitability has improved, indicating that the firm became more cost-
effective.

Asset management:
2023 2022
Inventory Turnover 440 000 / 127 600 = 3.45 x 405 600 / 82 250 = 4.93 x
Accounts receivable period 117 400 / 780 000 x 365 = 92 050 / 624 000 x 365 =
54.94 days 53.84 days
Accounts payable period 147320/440000 x 365= 132000/405600 x 365=
122.21 days 118.79 days
Total asset turnover (TAT) 780 000 /775 800 = 1.01 x 624 000 / 652 000 = 0.96 x

AWD turned over inventory faster compared to 2022, 3.45 times compared to 4.93 times in
2022. The increased inventory turnover ratio would also indicate that there was no build-up
of damaged or obsolete inventory.

The accounts receivable period is slightly longer (by a day). It took AWD 55 days to
collect from its customers (the credit period extended to customers was higher in 2023).

The accounts payable period is longer in 2023, which indicates that AWD is taking longer
to pay its creditors compared to 2022.

TAT slightly increased in 2023, indicating that AWD was more efficient in using its assets
to generate sales.
[26]
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Finance 201 Test 1 Suggested solutions – 2023

(b)

ROE = NPM x TAT x FLM

2023 2022
NPM 14.77% 7.60%
X TAT 1.01 x 0.96 x
X FLM 775 800 / 462 080 = 1.6789 652 000 / 376 000= 1.73 x
x
= ROE 25.05%(rounding 12.62%
difference)

When we break this down, the Du Pont analysis indicates that the increase in ROE was not
due to changes in asset turnover or financial leverage, but rather it is the impact of a higher
net profit margin on sales, and of generating a greater amount of sales from its assets that
results in a much higher ROE in 2023 than in 2022 OR This is due to an increase in net
profit caused by sales increasing at a faster rate than cost of goods and operating costs.
[10]

PART B [14 marks]

AWD Ltd Pro Forma Statement of

Comprehensive Income for the year ended
28 February 2024
(R) Workings
Sales 1 092 000 Given
Cost of Sales (616 000) (440 000 / 780 000) x 1 092 000
Gross Profit 476 000
Operating Costs (247 632) (176 880 / 780 000) x 1 092 000
Depreciation - No Information provided
Operating profit (PBIT) 228 368
Finance Costs (13 888) (9 920 / 780 000) x 1 092 000
Profit before tax 214 480
Tax (28%) 60 054 214 480 x 0.28
Net Profit after Tax (NPAT) 154 425.6
Less Cash dividend 92 655.36 154 425.6 x 0.6
Addition to Retained 61770.24 154 425.6 – 92 655.36
Earnings OR 154 425.6 x (1- 0.6)