This section has one compulsory question to be attempted
Mwambu (U) Ltd (MUL) was incorporated in Uganda in 2010 to take advantage of the oil and gas discovered in the Albertine Graben. Mr. Bill Musana, one of the founding members, was appointed as the managing director (MD) to run the company business. His appointment was based on his technical expertise, experience and personality traits. The MD’s main task was to create value for shareholders by developing a trusted brand that would delight customers. His other task was to implement a project in the oil and gas sector that will add value to the shareholders’ wealth. The MD has tasked the finance director to identify a project and determine whether investing in oil and gas will be profitable such that he reports back to the board.
The finance director has identified a project with the following projections:
Year 1
Shs 2
Shs 3
Shs 4
Shs 5
Shs
Sales ‘billion’
205 ‘billion’
400 ‘billion’
700 ‘billion’
1,000 ‘billion’
1,200
Cost of sales (50) (80) (300) (720) (940)
Gross profit
Operating expenses: 155 320 400 280 260
Administrative expenses (50) (80) (100) (70) (40)
Sales & distribution expenses (15) (30) (45) (15) (10)
Profit before interest & tax 90 210 255 195 210
Interest expense (35) (40) (55) (60) (70)
Profit after interest but before tax 55 170 200 135 140
Tax @30%
(16.5) (51) (60) (40.5) (42)
Profit after tax 38.5 119 140 94.5 98
Additional information:
1. Administrative expenses include depreciation Shs 5 billion every year.
2. The project will require an initial outlay Shs 500 billion.
3. The project will also require working capital Shs 20 billion in the current year increasing by 10% every year for four years.
4. The company will incur exploration costs Shs 10 billion.
5. The company will incur dismantling and restoration costs Shs 20 billion at the end of the project life.
6. The assets will have a residual value Shs 10 billion.
7. The minimum required rate of return by the shareholders is 15%
The finance director made his submission to the MD with a request for funds to hire a consultant to evaluate the above information. The MD rejected the request and instead, sacked the finance director accusing him of incompetence.
Without analysing the submitted information, the MD presented it to the Board claiming that the project is viable since the forecasts show profits in all the years.
The board was not convinced by the MD’s presentation. An investigation was instituted and it was discovered that the MD was fronting his natural inclination to pursue his own goals of maximising profitability and welfare of employees. He was aiming at making the employees comfortable, instead of focusing on the vision of the company.
Based on outcomes of investigation, Mr. Bill’s contract was terminated and Mrs. Amongin recruited to replace him.
The new MD, Mrs Amongin, in her inaugural speech said that in some types of organisations, owners are actively involved in management but in most companies, owners are typically not active managers; instead they entrust this responsibility to professional managers who may have little or no equity stake in the firm. There are several reasons for and against the separation of ownership and management, but in all ways, shareholders should always monitor the operations of the business to avoid the agency problems and unethical behaviour.”
Since you were the technical person in the investigation, the board has hired you for advice.
(a) Evaluate the viability of the project using the following methods.
(i) Net present value. (15 marks)
(ii) Discounted payback period. (5 marks)
(b) Explain three main forms of agency relationships existing at MUL.
(3 marks)
(c) Discuss the reasons for separation of ownership and management and give mitigating measures to the agency problem at MUL.
(6 marks)
(d) In a company, an agency problem may arise between management and shareholders on one hand and management and creditors/ lenders on the
other. In performance of their duties, management may have an incentive
to enter into transactions that may transfer wealth from debt holders to shareholders hence the need for agreement by lenders in lending contracts.
(i) Explain any four actions/ transactions by management and shareholders that could be harmful to the interest of debt holders.
(4 marks)
(ii) Discuss any four restrictive covenants that debt holders may use to protect their wealth from managers and shareholders’ raids.
(4 marks)
(e) “Ethical behaviour and long-term profitability are positively correlated”.
In relation to the above statement, explain the advantages that may accrue to firms that operate ethically.
(3 marks) (Total 40 marks)
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