December 2022

1a

Advanced capital budgeting decision

(i) Explain the term “real option” as used in capital investment appraisal.

(ii) Evaluate THREE types of real options.

1b

Advanced capital budgeting decision

The management of College Publishers Ltd. has estimated the following initial cash outlays and net cash flows and probabilities for a new printing process in each case scenario:

Year	Worst case Sh.“000”	Most probable case Sh.“000”	Best case Sh.“000”
0	(100,000)	(100,000)	(100,000)
1	20,000	30,000	40,000
2	20,000	30,000	40,000
3	20,000	30,000	40,000
4	20,000	30,000	40,000
5	20,000	30,000	40,000
$5^*$	5,000	20,000	30,000
Probability	0.20	0.60	0.20

Year 0 is the initial cost of the new printing process, years 1 – 5 are the operating net cash flows and year 5* is the estimated salvage value. The firm’s cost of capital for a project of average risk is 13% per annum.

Required:

(i) Assuming that the above project has an average risk, compute the expected net present value (ENPV) of the project.

(ii) A sensitivity analysis of the salvage value if this variable changes from the base case value by + (plus or minus) 80%.

(iii) Assume that all cash flows are positive perfectly correlated and that there are only three possible cash flow scenarios over time namely; worst case, most probable case and best case with probabilities of 0.2, 0.6 and 0.2 respectively.

Determine the project’s standard deviation of the net present value (NPV).

2a

Portfolio theory and analysis

The modern portfolio theory (MPT) is a practical method for selecting investments in order to maximise their overall returns within an acceptable level of risk.

Required:

Outline FIVE assumptions of modern portfolio theory (MPT).

2b

Portfolio theory and analysis

The following information is provided on the market, risk free rate and two stocks A and B:

	Expected return %	Correlation with market	%
Treasury bill rate	4.00	0.00	0.00
S & P 500 index	11	1.00	15.00
Stock A	14	0.70	25.00
Stock B	9	0.40	20.00

Required:

(i) Draw the capital market line (CML).

(ii) Calculate the betas of Stock A and Stock B.

(iii) Calculate the Alphas (α) of the Stock A and Stock B.

(iv) Plot the Stocks A and Stock B relative to the CML and comment

2c

Real estate finance

Describe five forms of debt financing in regards to real estate.

3a

Advanced financing decision

Two firms, A Ltd. and B Ltd. operate in the same industry. The two firms are similar in all aspects except for their capital structures.

The following additional information is available:

A Ltd. is financed using Sh.100 million worth of ordinary shares.
B Ltd. is financed using Sh.50 million in ordinary shares and Sh.50 million 7% debentures.
The earnings before interest and tax (EBIT) are Sh.10 million for both firms. These earnings are expected to remain constant indefinitely.
The cost of equity in A Ltd. is 10%.
The corporate tax rate is 30%.

Required:

Using the Modigliani and Miller (MM) model, determine the following:

(i) The market value of A Ltd. and B Ltd.

(ii) The weighted average cost of capital (WACC) of A Ltd. and B. Ltd.

3b

Rema Limited, a United Kingdom (UK) based firm bought goods from a United States (US) supplier and must pay US Dollars 4,000,000 in three months time.

The company is considering three choices in order to hedge the transaction exposure and has collected the following information:

Annual interest rates and exchange rates currently available:
	US Dollar		Sterling Pound (£)
	Deposit rate %	Borrowing rate %	Deposit rate %	Borrowing rate %
1 month	6	9.25	9.75	13.00
3 months	6	9.75	10.00	13.25
			$$/£$ Exchange rate $($ = £1)$
	Spot		1.8625 – 1.8635
	1 month forward		1.8565 – 1.8577
	3 months forward		1.8445 – 1.8460

Required:

Determine the amount payable using the following methods:

(i) Forward exchange contracts.

(ii) Money market borrowing or lending.

(iii) Making a leading payment.

3c

Financial risk management

Advise on the cheapest method based on your results in (b) (i) – (b) (iii) above.

4a

Mergers and acquisitions

Examine FOUR stages that a company might go through during restructuring.

4b

Corporate restructuring and re-organisation

The Altman formula for prediction of bankruptcy is given as follows:

$\text{ Z-score} = 1.2X_1 + 1.4X_2 + 3.3X_3 + 1X_4 + 0.6X_5$

Where:

$X_1$ = Working capital/Total assets.
$X_2$ = Retained earnings/Total assets
$X_3$ = Earnings before interest and tax/Total assets
$X_4$ = Sales/Total assets
$X_5$ = Market value of equity/Book value of debt

You are provided with the following information in respect of three listed companies:

-	Working capital	Retained Earnings	Earnings before interest and tax	Market value of equity	Total assets	Liabilities	Sales
-	Sh.“000”	Sh.“000”	Sh.“000”	Sh.“000”	Sh.“000”	Sh.“000”	Sh.“000”
A Ltd.	4,000	60,000	10,000	20,000	200,000	120,000	200,000
B Ltd.	2,000	20,000	0	5,000	100,000	80,000	120,000
C Ltd.	6,000	20,000	-30,000	48,000	800,000	740,000	900,000

Required

(i) The Z-score for each of the three companies.

(ii) Comment on your results in (b) (i) above.

4c

Advanced financing decision

Kilop Ltd. has decided to instal a new milling machine.

Additional information:

1.	The machine costs Sh.28,000,000 and it would have a useful life of five years with a trade in value of Sh.5,600,000 at the end of year five.
2.	The company has two options: Option A Purchase the machine for cash using a bank facility. The current rate of interest is 15% before tax. Option B Lease the machine under an agreement which would entail payment of Sh.6,720,000 at the end of each year for the next five years.
3.	The corporate rate of tax is 30%.
4.	Capital allowance is given at the rate of 100% in year one if the machine is purchased.
5.	Tax is payable one year in arrears.

Required:

Advise Kilop Ltd. whether to lease or buy the machine.

5a

Financial risk management

Explain FIVE limitations of financial derivatives used in financial risk management.

5b

International financial management

The International Monetary Fund (IMF) has implemented many reforms in recent years designed to strengthen its cooperative nature and improve its ability to serve its membership.

In context of the above statement, propose FOUR main reforms that have been designed by IMF in recent years.

5c

Mergers and acquisitions

Alpha Ltd. and Beta Ltd. are companies operating in the same line of business. In the recent past, Alpha Ltd. has experienced very stiff competition from Beta Ltd. such that Alpha Ltd. is considering acquiring Beta Ltd. in order to consolidate its market share.

The following financial data is available about the two firms:

	Alpha Ltd.	Beta Ltd.
Annual sales (Sh.million)	400	100
Net income (Sh.million)	150	20
Outstanding number of ordinary shares (millions)	50	10
Earnings per share (Sh.)	3.0	2.0
Market price per share (Sh.)	30	15

Both companies are in the 30% income tax bracket.

Required:

(i). Maximum exchange ratio that Alpha Ltd. should agree to if it expects no dilution in its post acquisition Earning Per Share (EPS).

(ii). Alpha Ltd.’s post acquisition earning per share if the companies agree on an offer price of Sh.40.

(iii). Alpha Ltd.’s post acquisition earning per share if for every 200 ordinary shares of Beta Ltd.’s are exchanged for 5 units of 10% debenture of Sh.500 per value each.

(iv). Combined operating profit (EBIT) and post acquisition earning per share at point of indifference between earnings of the firm under the financing plans in (c) (ii) and (c) (iii) above.

December 2022

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