Question no 1

a Dividend policies are the regulations and guidelines that companies develop 5 marks
and implement as the means of arranging to make dividend payments to
shareholders.
Establishing a specific dividend policy is to the advantage of both the
company and the shareholder
The companies have two options with them:
 They can retain these profits within the company
 They can pay these profits in the form of dividends to their
shareholders
b 1. The liquidity position of the firm – just because a firm has income 5 marks
doesn’t mean that it has any cash to pay dividends.
2. Need to repay debt – oftentimes there are negative covenants that
restrict the dividends that can be paid as long as the debt is outstanding.
3. The rate of asset expansion – the greater the rate of expansion of the
firm, the greater the need to retain earnings to finance the expansion.
4. Control of the firm – if dividends are paid out today, equity may have to
be sold in the future causing a dilution of ownership.
5. Legal Considerations:
 Technically, it is illegal to pay a dividend except out of retained
earnings. This is to prevent firms from liquidating themselves
out from underneath the creditors.
 From revenue authority – Improper Accumulation of funds. This
is to prevent individuals from not paying dividends in order to
avoid the personal income taxes on the dividend payments.
C (i) Net income = shs. 7,000,000, amount needed to finance project internally = 5 marks
60% of 10,000,000, hence is 6,000,000. Residual is 1,000,000, therefore shs.
1,000,000 will be used to pay dividend if residual policy is followed;
C (ii) If the company decides to maintain last year's dividend, how much will it 5 marks
pay out in dividends this year?
Distribution = last annual dividend per share * outstanding shares
Distribution = shs. 0.50 *5,000,000 = shs. 2,500,000
Question no. 2
a Given data: (10 marks)
 No of ordinary shares oustanding =100,000
 Price of share ex-dividend shs 6.12
 Cost of new project shs. 100,000
 Growth rate 6%
 Net income (old) 175,000
 Additional income 45,000
 Total expected income shs. 175,000 + 45,000

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 DI
Ke 
PO
where D1 is next year dividend = [(175,000 +45,000)/2]/100,000 = shs
1.1 per share
Po is current share price = 6.12
Ke = is cost of equity = 1.1/6.12 +6% =23.97%
b Ke = 2/40(1-0.05) + 7% = 12.3% 5 marks
Where, g = rb
r =10%
b =70% retained ratio while 30% is payout ratio
c A’s expected return (ke) = Rf + Beta (Rm - Rf) 5 marks
= 8% +1.8(12%-8%) = 15.2%
B’s expected return (ke) =8%+0.8(12%-8%) = 11.2%
Prediction of share prices;
A = 34.04/0.152 =shs. 224
B =34.02/0.112 = shs. 304

Question no. 3

a 14
P/E ratio: because Chwaka ltd is an unquoted company its ratio will be below the
marks
industry of 12 due to the increased risk. However, it has a better profit record than
company with a ratio of 8. Therefore ratio could be in the rage of 8 to 10.

Earnings the average earnings over the last five years are shs. 57,200, over the last
four years (60+63+59+64)/4 = shs. 61,500. The growth pattern of the earnings is
uncertain however; therefore a low estimate of future earning could be shs. 61,500
and higher estimate shs. 64,000 a range could be as:

• With high P/E ratio and high earnings the company can be valued at 10
x shs. 64,000 = shs. 640,000

• With low P/E ratio and low earning company’s valuation is 8 x 61,500 =
shs. 492,000

b Dividend yield is a way to measure how much cash flow you are getting for each 2
(i) shilling invested in an equity position marks

A financial ratio that shows how much a company pays out in dividends each year
relative to its share price. In the absence of any capital gains, the dividend yield is
the return on investment for a stock

dividend per share

mkt price per share
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b The earnings per share by simply dividing the Shilling amount of the earnings a 2
(ii) company reports by the number of shares it currently has outstanding. marks
It measure amount of money that will go to shareholder in the form of cash
dividends

Formula is not useful in investment process but is used as yardstick on how better is
the company in question.

earning available to common stockholders

no. of stockholder ' s shares

b 2
The EPS is to be multiplied by the P/E ratio to arrive at the market price of equity
(iii) share (MPS). marks

MPS = EPS x P/E ratio

The P/E ratio may be derived given the MPS and EPS.

P/E ratio = MPS/EPS

A high P/E multiple is suggested when the investors are confident about the
company's future performance/prospects and have high expectations of future
returns; high P/E ratios reflect optimism.

a low P/E multiple is suggested for shares of firms in which investors have low
confidence as well as expectations of low returns in future years; low P/E ratios
reflect pessimism

Question no 4

a increase in contribution from additional sales(20% x 1.5m x 40%) 120,000 15

increase in bad debts (3.5% x 1.8m)-15,000 -48,000 marks
increase in profit 72,000
present value ratio= 100% -75% x 80%
proposed variable cost of investment in debtors (60% x 1.8m x1/12) 90,000
current variable cost of investment in debtors x 1.5m 1/12) 75,000
additional investment needed 15,000
additional financiing costs at 15% 2,250
Option 1 should be implemented as the increase in the profit from are
greater than the increase in the costs
b On average compay takes 41 days to receive money from customers while takes 50 days to 5
pay their bill to suppliers, hence they have free 9 days of using suppliers money and this is marks
like interes free loan from supplier
2001 2002 2003 2004 2005 average
Creditor’s day 42 53 48 55 55 50
Debtor’s day 38 43 40 45 41 41
I/ free loan 4 10 8 10 14 9
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 Question no. 5
forrecasted ratios
company industry
type of ratio forecast forecast general comment
Quick ratio 0.84 1 Below industry average
Current ratio 2.33 2.7 Below industry average
Inventory turnover 4.8 7 Below industry average
av. Collection period 37.35 days 32 days Above industry average
Fixed Asset turnover 10 times 13 times Below industry average
Total Asset turnover 2.33 times 2.6 times Below industry average
return on total assets 5.90% 9.10% Below industry average
Return on equity 13% 18.2 Below industry average
Debt to equity ratio 48.7% 50% Above industry average
Profit margin on sales 2.50% 3.50% Below industry average
P/E ratio 5 times 6 times Below industry average
marke/ book value ratio 0.7 times 1.09 times Below industry average
Students they are expected to discuss these ratio while compare them with industry. 20 marks
Basically it has to be grouped into:
Liquidity ratio, efficiency ratio, profitability, gearing and market ratio in order to earn
full marks
Marks allocations:
a) Ratio calculations, 12 ratios to be calculated each one mark- 12 marks
b) Interpretation, 2 marks for liquidity, 2 marks for efficiency, 2 marks for
profitability and last 2 marks for marketing analysis- total marks for
interpretation are 8.

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