Project Financing — July 2024

Question 1(a)

Explain five causes of conflict between shareholders and creditors of a project.

(10 marks)

Answer

1. Risk shifting: shareholders may favour riskier investments because they receive much of the upside while creditors bear a greater risk of non-payment.
2. Excessive distributions: large dividends or withdrawals can remove assets that creditors expected to support repayment.
3. Additional borrowing: new debt or stronger security granted to new lenders can weaken existing creditors’ repayment position.
4. Underinvestment: shareholders may reject a worthwhile project if most of its benefits would repay existing debt rather than increase their own return.
5. Different control and information interests: shareholders may resist disclosure, spending restrictions or other covenants that creditors require to protect their funds.

Question 1(b)

Explain five benefits that may accrue to a firm from the use of lease financing to implement its projects.

(10 marks)

Answer

1. It provides access to an asset without requiring the whole purchase price immediately, conserving cash for other project needs.
2. Agreed rental payments spread the financing outflow over time, making budgeting and cash-flow planning easier.
3. A suitable lease term can match the period for which a project needs an asset, avoiding an unnecessary long-term purchase.
4. Some lease agreements include maintenance or support, reducing the lessee’s need to arrange those services separately.
5. Suitable replacement or renewal terms can make it easier to obtain updated equipment and manage obsolescence risk.

Question 2(a)

Explain five challenges that a project manager may encounter when raising finance for an ongoing project.

(10 marks)

Answer

1. Cost overruns or uncertain remaining costs can make it difficult to establish how much additional finance is actually needed.
2. Weak cash flow or delayed project benefits can make lenders doubt the project’s ability to service debt.
3. Existing borrowing and committed collateral can leave little security or borrowing capacity for a new facility.
4. High financing costs or unfavourable market conditions can make the available funding unaffordable.
5. Lengthy appraisal, reporting requirements or restrictive funding conditions can delay the release of funds while work and payments continue.

Question 2(b)

The following information relates to Jumbo Limited as at 31 December 2023:

Calculate the: (i) Gross profit margin; (ii) Net profit margin; (iii) Operating ratio; (iv) Return on total assets; (v) Return on equity.

(10 marks)

Answer

The meaning of “Net Profit” is not specified. Begin with the usual after-tax interpretation, treat paid-up capital as the only equity supplied, and assume no other income. The operating figures reveal an inconsistency, which must not be concealed.

Some texts define return on assets using net income rather than EBIT. With that convention, 1,250,000 ÷ 14,000,000 × 100 = 8.93%; state the numerator used. If the printed KSh 1,250,000 is intended to mean operating profit instead, operating expenses are KSh 250,000 and the operating ratio is 79.17%. Under that different interpretation, after-tax profit would be KSh 600,000 and the corresponding after-tax net margin and return on equity would be 10.00% and 4.00%. These interpretations must not be mixed. A definitive operating ratio requires clarification of the printed profit label and any non-operating income.

Question 3(a)

Explain five advantages of using retained earnings to finance projects of a company.

(10 marks)

Answer

1. It avoids share or debt issue costs such as underwriting, prospectus and arrangement expenses.
2. It does not dilute existing shareholders’ ownership or voting control.
3. It creates no contractual interest payments or principal repayment dates, reducing fixed cash-flow commitments.
4. It provides an internal source that management can allocate without negotiating a new external financing agreement.
5. It strengthens the equity funding base and can preserve borrowing capacity for future needs.

Retained earnings are not economically free: shareholders forgo a distribution and therefore require a return on the funds reinvested.

Question 3(b)

Gama Limited intends to finance a new project by raising capital from the following sources:

Determine the: (i) Specific cost of each of source of capital. (ii) Weighted Average cost of Capital (WACC).

(10 marks)

Answer

The question supplies no equity dividend, growth rate, required return or CAPM inputs. The number and total value of the ordinary shares establish a price of KSh 25 per share, but do not establish the shareholders’ required return. Consequently a unique numerical equity cost or WACC cannot be calculated. Treat the preference and debenture amounts as issued at par, with no issue costs or redemption terms, because no alternatives are given. No corporation-tax rate is supplied for this question.

Here Ke is expressed as a percentage rate. Equivalently, with decimal rates, WACC = 0.500Ke + 0.0575. If a tax rate T were supplied and interest were deductible, the debt term would be 0.375 × 0.12 × (1 − T). The 30% rate in question 5 must not be imported into this unrelated question without an explicit instruction.

Question 4(a)

Outline five limitations of capital budgeting techniques.

(10 marks)

Answer

1. Their results depend on forecasts of future cash flows, which may be inaccurate.
2. Estimating the appropriate discount rate and risk adjustment can be difficult.
3. Important non-financial effects, such as environmental or community consequences, may not be captured adequately by a single financial measure.
4. Simplifying assumptions about timing, project life and reinvestment may differ from actual conditions.
5. Different techniques can give conflicting rankings; for example, payback ignores later cash flows while an unqualified IRR ranking can mislead for projects of different scale.

Question 4(b)

Explain five factors that a project manager may consider when selecting a suitable source of financing.

(10 marks)

Answer

1. Total financing cost: compare interest or required returns, fees and other charges with the project’s expected benefits.
2. Duration and repayment pattern: match the funding period and payment dates to the asset life and expected cash inflows.
3. Availability and eligibility: assess the amount obtainable, approval time and whether the project meets the provider’s conditions.
4. Security and financial risk: consider required collateral, existing debt and the effect of repayment commitments on liquidity.
5. Control and restrictions: assess ownership dilution, voting rights and covenants that may limit project or company decisions.

Question 5(a)

Outline five characteristics of a project.

(10 marks)

Answer

1. It is temporary, with a defined beginning and end.
2. It aims to deliver a specific output, outcome or objective.
3. Its combination of activities and circumstances is unique.
4. It uses limited resources and operates within agreed time, cost and quality constraints.
5. It involves interdependent activities, stakeholders and uncertainty that require coordination.

Question 5(b)

(i) Outline four assumptions underlying the Gordon’s model of asset valuation. (4 marks)

(ii) The following information relates to Agano Limited as at 31 December 2023:

1. Equity shares at a market price of Ksh 25 each, paying a dividend of Ksh 2 per share. The expected dividend growth rate is 5%.
2. A 7%, 10-year redeemable debentures of Ksh 100 each at Ksh 90 each. The corporation tax rate is 30%.

Using the model in (i) above, calculate the after tax cost of each asset. (6 marks)

(10 marks)

Answer

(i) Four assumptions of the Gordon constant-growth model

1. The company is a going concern and the dividend stream continues indefinitely.
2. Dividends grow at a constant sustainable rate g.
3. The required equity return Ke is constant and exceeds g.
4. Dividend and reinvestment policies remain stable enough to support that constant growth; in the retention-growth formulation, retention and return on reinvestment are constant.

(ii) Cost of equity

This treats the stated KSh 2 as the current dividend D0. If it were explicitly the next dividend D1, the result would instead be 2/25 + 5% = 13.00%.

After-tax cost of redeemable debt

The Gordon dividend model values growing equity dividends; it is not the redemption-yield model for a finite-life debenture. Use the coupon, issue price, redemption amount, term and tax rate supplied. Assume redemption at the stated KSh 100 nominal value and annual interest payments.

The exact after-tax yield solves 90 = Σ[4.90/(1 + Kd)^t], for t = 1 to 10, + 100/(1 + Kd)^10. It is approximately 6.2765% (6.28%). The 6.21% figure is the standard average-capital approximation, not an exact yield. The redemption principal is not multiplied by (1 − tax rate).

Question 6(a)

The project manager of Xd Limited is proposing to sell some fixed assets in order to raise finance. Explain five benefits that the company may derive from such a move

(10 marks)

Answer

1. It releases cash tied up in assets, providing funds for the project without waiting for future operating receipts.
2. Selling idle or underused assets reduces avoidable maintenance, storage and insurance costs.
3. It avoids issuing additional shares, preserving existing shareholders’ ownership and voting control.
4. It can reduce the need for new borrowing and the associated interest, security requirements and repayment commitments.
5. It reallocates resources from less useful assets to more productive activities, potentially improving overall asset utilization and returns.

Question 6(b)

Dete Limited intends to invest Ksh 2,000,000 in either project P or project Q. The following are the expected net cash inflows from the projects:

The company’s cost of capital is 12%. (i) Determine the profitability index of each project. (ii) Based on the results in (i) above, advise the management on the project to invest in.

(10 marks)

Answer

The prose calls the alternatives P and Q while the printed table calls them A and B. The calculations follow the printed columns: the first alternative is A (P) and the second B (Q). The supplied initial outlay is KSh 2,000,000 for either project; no additional terminal or working-capital flows are supplied.

(i) Discounted cash-flow working at 12%

(ii) Investment advice

Reject both projects on the stated financial information: each profitability index is below 1 and each NPV is negative at 12%. A ranks above B because 0.9163 exceeds 0.8798, but that ranking does not make A acceptable. If management is explicitly required to choose one regardless of value destruction, A is the less unfavourable alternative; the financially preferable choice is to invest in neither unless the cash flows, costs or other justified benefits change.

Question 7(a)

Explain five factors that may contribute to variability in the cost of an on-going project.

(10 marks)

Answer

1. Inflation and market price changes alter the cost of labour, materials and services compared with the original estimates.
2. Changes in project scope, specifications or approved designs introduce additional work or different resource requirements.
3. Delays, low productivity or repeated work extend labour and equipment usage and increase overhead costs.
4. Exchange-rate changes alter the local-currency cost of imported inputs or foreign-currency contracts.
5. Unexpected site conditions, technical problems or supply disruptions require unplanned work, alternative purchases or emergency transport.

Question 7(b)

One of the areas of focus when carrying out project appraisal for finance is assessing the technical feasibility of the project. Outline five factors that should be considered when carrying out this assessment.

(10 marks)

Answer

1. Availability, suitability and proven performance of the proposed technology and equipment.
2. Availability and required quality of raw materials and other technical inputs.
3. Availability of skilled personnel to install, operate and maintain the system.
4. Suitability of the site and supporting infrastructure, including power, water, access and communications.
5. Whether the proposed process and capacity can meet output, quality, safety and implementation-time requirements.