KASNEB Advanced Financial Management - Question 2b

Mapeni Ltd's investment fund comprises four major projects. The details of the projects are as follows: ProjectMarket valueof the fund (%)Expectedreturn ... [Click to view full question and step-by-step solution]

KASNEB Advanced Financial Management - Question 4a

With reference to corporate valuation, describe the importance of enterprise value (EV). ... [Click to view full question and step-by-step solution]

May 2016

1a

Advanced capital budgeting decision

In the context of appraisal of capital investments under conditions of uncertainty, explain four limitations of utility analysis.

1b

Advanced capital budgeting decision

Planet Ltd. is considering undertaking a 20-year project which requires an initial investment of Sh.250 million in a real estate partnership and whose present value (PV) of expected cash flows is Sh.254 million. Planet Ltd. has the option to abandon the project any time in the next five years for Sh.150 million. The variance in the present value (PV) of the cash flows is 0.09 and the 5-year risk-free rate is 7%.

Required:

(i) The net present value (NPV) of the project including the option to abandon the project.

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

Note:

1. The Black-Scholes Option Pricing Model

C = \(P_a\) N(\(d_1\)) - \(P_e\) N(\(d_2\))\(e^{-rt}\)

Where: \({\large d_1 = \frac{ \ln\left( \frac{P_a}{P_e} \right) + \left( r + 0.5s^2 \right)t }{ s\sqrt{t} } }\)

\(d_2 = d_1 - s\sqrt{t}\)

2. The Put-Call Parity Relationship

\(P = C - P_a + P_e e^{-rt}\)

2a

Portfolio theory and analysis

Biashara Ltd. wishes to invest in stocks M and N in two different industries. The following information relates to the two stocks:

	Stock M	Stock N
Expected return (%)	18	16
Standard deviation (%)	8	6
Beta coefficient	1.80	1.50
Amount of money invested (Sh.)	1,200,000	800,000

Required:

(i) The expected portfolio return.

(ii) Explain the effect on the portfolio risk if the returns of stocks M and N were perfectly positively correlated. Include suitable calculations.

2b

Portfolio theory and analysis

Mapeni Ltd's investment fund comprises four major projects. The details of the projects are as follows:

Project	Market value of the fund (%)	Expected return (%)	Standard deviation (%)	Coefficient of correlation with the market
1 2 3 4	28 17 31 14	10 18 15 13	15 20 14 18	0.55 0.75 0.84 0.62

The risk-free rate is 5% and the market return is 14%. The standard deviation of the market return is 13%.

Required:

(i) The beta coefficient of the investment fund.

(ii) By comparing the expected return and the required return, advise whether Mapeni Ltd. should change the composition of its portfolio.

3

Advanced capital budgeting decision

On 1 January 2016, Mavuno Limited was in the process of raising funds to undertake four investment projects. These projects required a total of Sh.30 million.

Given below are details relating to the four investment projects:

Project	Required initial investment Sh. "million"	Internal rate of return (%)
A B C D	8 7 9 6	26 16 20 22

Additional information:

1	The company had Sh.9 million available from retained earnings as at I January 2016. Any extra equity finance would have to be sourced through an issue of new ordinary shares.
2	The market price per ordinary share on 1 January 2016 was Sh.25.60 ex-dividend. Information on earnings per share (EPS) and dividend per share (DPS) over the last 6 years is as follows:

	Year ended 31 December	2010	2011	2012	2013	2014	2015
	EPS (Sh.) DPS (Sh.)	4.5 2.5	4.8 2.8	4.9 2.9	5.2 30	5.5 3.2	6.0 3.5

3	Issue of new ordinary shares would attract a floatation cost of Sh.4.60 per share.
4	9% irredeemable debentures (par value of Sh.1,000 each) could be sold with net proceeds of 95% due to a discount on issue of 2% and a floatation cost of Sh.30 per debenture. The maximum amount available from the issue of the 9% irredeemable debenture would be Sh.4 million after which debt could only be obtained at 12% interest with net proceeds of 90% of par value.
5	10% preference shares can be issued at a par value of Sh.80.
6	The company's capital structure, which is considered optimal, is as Sh. Equity capital 45% Preference share capital 30% Debenture capital 25% 100%
7	The corporate tax rate applicable is 30%.
8	The company has to exhaust internally generated funds before raising extra funds from external sources.

Required:

(a) The levels of total new financing at which breaks occur in the weighted marginal cost of capital (WMCC) curve.

(b) The weighted marginal cost of capital (WMCC) for each of the 3 ranges of levels of total financing as determined in (a) above.

(c) (i) Advise Mavuno Limited on the project(s) to undertake assuming that the projects are divisible.

(ii) Determine the optimal capital budget.

4a

Mergers and acquisitions

With reference to corporate valuation, describe the importance of enterprise value (EV).

4b

Mergers and acquisitions

Huge Ltd. intends to take over Tiny Ltd., another company in the same industry. Tiny Ltd. is expected to post earnings of Sh.86 million next year.

If Huge Ltd. acquires Tiny Ltd., the expected results of Tiny Ltd., for the next three years will be as follows:

	Year after acquisition
	Year 1 Sh. "000"	Year 2 Sh. "000"	Year 3 Sh. "000"
Sales	200,000	280,000	320,000
Cash costs/expenses	120,000	160,000	180,000
Capital allowance	20,000	30,000	40,000
Interest charges	10,000	10,000	10,000
Cash to replace assets and finance growth	25,000	30,000	35,000

From year 4 onwards, it is expected that the annual cash flows from Tiny Ltd. will increase by 4% each year into perpetuity.

Tax is payable at the rate of 30% and this tax is paid in the same year the profits to which it relates are earned.

If Huge Ltd. acquires Tiny Ltd., it estimates that the gearing after the acquisition will be 35% measured as the value of debt as a proportion of the total equity and debt. After the acquisition of Tiny Ltd., Huge Ltd. would have a cost of debt of 7.4% before tax and a beta of 1.60.

The risk-free rate is 6% and the return on the market portfolio is 11%.

Required:

(i) The offer price for Tiny Ltd., if Huge Ltd. were to value Tiny Ltd. on a forward price earnings (P/E) multiple of 8.0 times.

(ii) The weighted average cost of capital (WACC) for Huge Ltd. after the acquisition of Tiny Ltd.

(iii) The offer price for Tiny Ltd. using a discounted cash flow (DCF) based valuation.

5a

Financial risk management

Discuss four techniques that a company might use to hedge against the foreign exchange risk involved in foreign trade.

5b

Financial risk management

Jasper Ltd. is a company based in Nairobi, Kenya which does business with companies based in Tanzania. From such trade, Jasper Ltd. expects the following cash flows in the next six months, in the currencies specified:

Payments due in 3 months	: Ksh.116,000
Receipts due in 3 mont	: Tsh.1,970,000
Payments due in 6 months	: Tsh.4,470,000
Receípts due in 6 months	: Tsh.1,540,000

The exchange rates in the Nairobi market are as follows:


Spot	17.106 - 17.140
Three months forward	0.82 - 0.77 cents premium
Six months forward	1.39 - 1.34 cents premium

	Interest rates
Ksh. Tsh.	Borrowing 12.5% 9%	Lending 9.5% 6%

Required:

The net Kenya shilling receipts/payments that Jasper Ltd. might expect for both its three month and six month transactions if the company hedges foreign exchange risk on the: (i) Forward foreign exchange market.

(ii) Money market.

May 2016

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