Unit: Advanced Financial Management
13 Questions| Year | Project A | Project B | ||
| Cash flows Sh.“000” | Certainty equivalents Sh.“000” | Cash flows Sh.“000” | Certainty equivalents Sh.“000” | |
| 0 | (45,000) | 1.00 | (60,000) | 1.00 |
| 1 | 22,500 | 0.85 | 37,500 | 0.80 |
| 2 | 22,500 | 0.80 | 30,000 | 0.70 |
| 3 | 15,000 | 0.75 | 22,500 | 0.60 |
| 4 | 15,000 | 0.60 | 15,000 | 0.50 |
| 1. | The project will commence on 1 January 2025 with the initial capital of 5 million South Africa Rands (ZAR) which will be used in acquiring agricultural machinery with an estimated useful life of 5 years with a zero salvage value. The straight line method of depreciation will be applied. |
| 2. | To enable the firm pay land rates and other working capital requirements, an additional 2.5 million ZAR will be required and it is expected that this amount will be recouped in full at the end of the project’s useful life. |
| 3. | Annual sales revenue from the project are estimated as follows: | ||
| Year | Revenue (ZAR) | Fixed costs (ZAR) | |
| 2025 | 2,600,000 | 600,000 | |
| 2026 | 3,500,000 | 780,000 | |
| 2027 | 5,000,000 | 905,000 | |
| 2028 | 4,200,000 | 880,000 | |
| 2029 | 2,800,000 | 450,000 | |
| 4. | Variable operating costs are expected to be 20% of the sales and are assumed to accrue evenly. |
| 5. | The exchange rates between the Kenya Shilling and the South Africa Rand are as follows: |
| ZAR/KES | ||
| 1 January 2025 | 8.00 | |
| 31 December 2025 | 8.50 | |
| 31 December 2026 | 9.00 | |
| 31 December 2027 | 9.50 | |
| 31 December 2028 | 10.00 | |
| 31 December 2029 | 10.30 | |
| 6. | All the cash flows are expected to occur at the year end. | |
| 7. | The cost of capital for both South Africa and Kenya is assumed to be 12% per annum. | |
| 8. | Assume that the corporation tax rate in South Africa is 30% and no further taxation will be levied in Kenya. | |
| Required: | ||
| (i) | The net present value (NPV) of the project in Kenya Shillings (KSh.). | |
| (ii) | Based on your results in (c) (i) above, advise the management of Mavuno Bora Ltd. on appropriate course of action. | |
| State of economy | Probability | Forecasted rate of return (%) |
| A | 0.20 | 10 |
| B | 0.30 | 15 |
| C | 0.40 | 7 |
| D | 0.10 | 12 |
| 1. | The company’s portfolio of existing activities are expected to generate an overall return of 18% with a standard deviation of 5%. |
| 2. | The correlation coefficient of returns of the new project and existing portfolio of activities is 0.60 while its correlation with the market portfolio is 0.24. |
| 3. | The forecasted rate of return of the market portfolio and their probability of occurrence in different states of nature are given as follows: |
| State of economy | Probability | Forecasted rate of return (%) | |
| 1 | 0.20 | 20 | |
| 2 | 0.30 | 15 | |
| 3 | 0.40 | 10 | |
| 4 | 0.10 | 5 | |
| 4. | The risk free rate of return is 8%. | ||
| Jaribu Ltd. | Upendo Ltd. | |
| Annual sales (Sh.million) | 1,500 | 180 |
| Net income (Sh.million) | 120 | 15 |
| Ordinary shares outstanding (million) | 30 | 6 |
| Earnings per share (EPS) (Sh.) | 8 | 5 |
| Market price per share (Sh.) | 88 | 40 |
| Percentage (%) of debt (Debt/Debt + Equity) | Likely credit rating | Pre-tax cost of debt (%) |
| 10 | AAA | 6.5 |
| 20 | AA | 7.1 |
| 30 | A | 7.8 |
| 40 | BBB | 8.5 |
| 50 | BB | 10 |
| 60 | B | 12 |
| 70 | C | 15 |
| \(\displaystyle \text{β}_e = \text{β}_a \left[\frac{E + D(1 – t)}{E} \right]\) |
| Where: | \(\text{β}_e\)= Equity beta \(\text{β}_a\)= Asset beta D = Debt E = Equity t = Corporate tax rate |
| (i) | Estimate the value of the option to delay the start of the project for two years using the Black Scholes Option Pricing Model (BSOPM) and comment on your findings. Assume that the government will make its announcement about the potential transport link at the end of the two years. |
| (ii) | On the basis of valuation of the option to delay, estimate the overall value of the project, giving a concise rationale for the valuation method used. |
| (iii) | Explain TWO other types of real options that may be present relating to the Mua Greens Estate housing development. Hint: Value of call option: \(P_s (Nd_1)\) – \(P_e (Nd_2). e^{–rfT}\) Where: \(\displaystyle d_1 = \frac{ln (P_s/P_e) + (rf + 0.5σ^2)T}{σ \sqrt{T}}\) \(d_2 = d_1 – σ \sqrt{T}\) \(P_s\)\(=\)Underlying price \(P_e\) \(=\)Strike price σ \(=\)Volatility rf \(=\) Continuity compounded risk-free interest rate T = Time to expiration |
Want to join the discussion?
Log in to post comments and interact with tutors.
Login to Comment