MRP Finance Internship Unit 05

Unit 05 · Practice solutions

Practice solutions

Book Values, Market Values, Inflation, and Currency · Nigeria · ₦ + $

Worked answers to the optional practice questions. The required question is turned in to the TAs, and its answer is not published here.

Practice solutions

5.1

  1. Historical cost is objective and verifiable — two accountants looking at the same invoice produce the same figure, and an auditor can check it. Market value is an estimate that changes daily and on which reasonable people disagree, so financial statements built on it would not be comparable or reliable. The convention trades relevance for verifiability, which is the right trade for reporting and the wrong one for valuation.
  2. Warehouse understated by 280 − 12 = ₦268M. Inventory overstated by 15% × 40 = ₦6M. Assuming cash, receivables and other liabilities are at approximately market value, market equity ≈ 51 + 268 − 6 = ₦313M. The main assumption is that receivables will collect at carrying value, which for a firm selling to contractors deserves testing.
  3. On book values the firm has ₦51M of equity against ₦73M of debt — thinly capitalised, and a lender would either decline or lend only a small amount at a high rate. On market values it has over ₦300M of equity and a warehouse worth ₦280M available as security, which supports a much larger facility at a much better rate. The bank should use market values for the security assessment, because what matters if the firm fails is what the assets fetch, not what they cost twelve years ago — though it should also apply a discount for how long a forced sale would take.

5.2

  1. Open; expect items such as: the consultant roster (specialists attract the patients who generate the highest-margin procedures); accreditation and insurer panel membership (without it, insured patients cannot be treated and a large revenue stream disappears); reputation among referring general practitioners (referrals are the primary patient acquisition channel); and trained nursing staff and clinical protocols (reduce complications, readmissions, and the cost of adverse events). Mark for whether each names a cash flow rather than a virtue.
  2. Annual gross profit = 120 × 35% = ₦42M. Year 1: half the base not yet won, so forgone gross profit = ₦21M. Year 2: fully rebuilt, forgone = ₦0M — though a more careful treatment would phase this, giving perhaps ₦21M and ₦0M as the simple case. Extra selling cost = 2 × ₦5M = ₦10M. Undiscounted replacement cost ≈ ₦31M.
  3. Being well known is not a cash flow, and a valuation requires one — plenty of brands are recognised and worthless. The figure would be defensible if the analyst could show a specific mechanism: a measurable price premium over unbranded competitors, a lower customer-acquisition cost than a new entrant faces, or a higher repeat-purchase rate — each converted into annual gross profit and discounted. Absent that, the ₦200M is an assertion, and replacement cost would at least give an upper bound.

5.3

  1. A loan at a market rate is worth approximately its face value, because the promised payments are being discounted at the rate that was used to set them. It diverges when market interest rates move materially — an existing fixed-rate loan becomes worth less to the lender if rates rise, and more if they fall — and when the borrower's credit quality changes, since the probability of receiving the promised payments has changed.
  2. Defensible version: "The market is pricing this firm as though its Kumasi expansion will fail, but the first two outlets are already at the volumes the plan assumed, which is not reflected in consensus forecasts." What has to be true is a specific, checkable fact about future cash flows that the analyst believes and the market has not priced — not a claim about investor psychology.
  3. Total firm value is roughly unchanged at ₦1,000M, since no operating assets changed. Debt falls from ₦400M to ₦100M and equity rises from ₦600M to about ₦900M — but the new shareholders contributed ₦300M, so the existing shareholders' stake is worth slightly less than before. The remaining debt becomes considerably safer and its market value rises above face; that increase in the lenders' claim comes out of the shareholders. The firm is less risky and the equity holders paid for the reduction.

5.4

  1. Nominal = 1.07 × 1.15 − 1 = 23.05%.
  2. Real approach: PV = 50/1.09 + 50/1.09² + 50/1.09³ + 50/1.09⁴ = 45.87 + 42.08 + 38.61 + 35.42 = ₦161.98M. Nominal: rate = 1.09 × 1.20 − 1 = 30.8%. Cash flows 60.0, 72.0, 86.4, 103.68. PVs = 45.87 + 42.08 + 38.61 + 35.42 = ₦161.98M. Identical.
  3. Flat ₦50M at 30.8%: 38.23 + 29.22 + 22.34 + 17.08 = ₦106.87M. Error = 1 − 106.87/161.98 = 34.0% understatement. It biases decisions toward rejection — firms making this error systematically under-invest, which is a real and observable pattern in high-inflation economies.
  4. Tax is charged on nominal accounting profit, not on purchasing power, so the tax cash flow is naturally a nominal figure. Depreciation allowances are especially important: they are fixed in the historical naira of the original purchase and do not rise with inflation, so their real value erodes every year. In a real-terms model this erosion has to be modelled explicitly and awkwardly, whereas in a nominal model it happens automatically because the allowance simply stays flat while everything else grows.

5.5

  1. (a) transaction; (b) translation; (c) economic; (d) transaction on each scheduled payment, and economic overall — the firm's ability to service the loan from naira earnings is what is really at stake.
  2. The market recognises the loss as an accounting artefact of consolidating foreign subsidiary figures into the reporting currency, with no effect on the cash the group's businesses will generate. Since value is the present value of expected cash flows and none of those changed, the share price should not move.
  3. Open. Strong answers name a specific mechanism, for example: a Kenyan tea or horticulture exporter gains, with economic exposure dominating because dollar revenue rises against largely shilling costs; a Ghanaian pharmaceutical importer loses, with economic exposure dominating because input costs double while patients' ability to pay does not. Mark down answers that assert a direction without naming the currency of revenues and costs.

5.6

  1. Dollar interest = 8% × $80,000 = $6,400. At ₦800 = ₦5.12M; at ₦1,400 = ₦8.96M. Before: total interest = 14 + 5.12 = ₦19.12M, TIE = 34/19.12 = 1.78. After: 14 + 8.96 = ₦22.96M, TIE = 34/22.96 = 1.48.
  2. Approximate naira cost = 1.08 × 1.15 − 1 = 24.2%, against 26% for the naira loan — the dollar loan is marginally cheaper on expectation. A firm might still prefer the naira loan because the 15% depreciation is an average, not a guarantee: the actual path arrives in sudden large moves that can breach covenants or exhaust liquidity in a single month. And because the naira loan's cost is known and smooth, which has real value to a firm whose survival depends on being able to plan its cash.
  3. Dollar-denominated COGS = 380 × 45% = ₦171M, rising 60% to ₦273.6M. Naira COGS = ₦209M. New total COGS = ₦482.6M. New gross profit = 500 − 482.6 = ₦17.4M, down from ₦120M. Original gross margin = 24%. To restore it, revenue must satisfy R − 482.6 = 0.24R, so R = 482.6/0.76 = ₦635M, a price increase of 27%.
  4. Book equity is 48 − 55 = −GH₵7M, so the reported balance sheet says the firm is insolvent. Restating the warehouse at market adds 34 − 12 = GH₵22M, giving market equity of about +GH₵15M, and the distribution agreement — real, valuable, and unrecordable under any accounting standard — makes the true figure higher still. So the owners hold substantial economic value in a firm the accounts describe as gone. The trap is that the covenants, the bank's credit assessment, and the audit opinion are all written against the *book* figures, so the firm can be declared in default on numbers that do not reflect its position. And solvency is not the binding constraint anyway: the warehouse is an asset, not cash, and selling a warehouse takes months. The firm fails on liquidity — unable to pay a supplier next month — while owning more than enough value to have covered the debt, had it been able to convert any of it in time.