November 2016
Unit: Advanced Financial Management
14 Questions
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Questions
1a
Corporate restructuring and re-organisation
Summarise three assumptions of the Grossman-Hart Model (1986).
1b
Advanced capital budgeting decision
SKB Ltd. is considering a proposal to manufacture a new drug named "Millenium". The drug will be manufactured
using a machine which will cost Sh.13 million.
The cash flows and drug life relating to "Millenium" have been estimated as stochastic exogenous variables with the
following distributions:
| Annual after tax cash flow (Sh."000") | Probability | Drug life in years | Probability |
| 1,000 1,500 2,000 2,500 3,000 3,500 4,000 | 0.02 0.03 0.15 0.15 0.30 0.20 0.15 | 3 4 5 6 7 8 9 10 | 0.05 0.10 0.30 0.25 0.15 0.10 0.03 0.02 |
The minimum required rate of return from this investment is 16%.
The company has approached you as a financial management expert to perform an analysis of the above project.
Required:
| (i) | Using the following random numbers, perform 10 simulation runs of the net present value (NPV) of this project. 5397 6699 3081 1909 3167 8170 3875 4883 9033 5852 |
| (ii) | Determine the expected net present value (NPV) of the project. |
2a
Advanced capital budgeting decision
Explain three challenges likely to be encountered in the application of the capital asset pricing model (CAРM).
2b
Portfolio theory and analysis
Moses Mapesa is in the process of evaluating investments in two companies whose percentage returns in the last 10
years are as shown below:
Required:
(i) Correlation coefficient of the companies' returns.
(ii) Portfolio risk assuming equal weighting.
2c
Portfolio theory and analysis
Mary Chege has been investing in the shares of various companies quoted on the securities exchange. Currently, she
holds a portfolio of shares in four companies; W, X, Y and Z.
The following information has been provided:
| Company | Number of shares held | Equity Beta | Market price per share (Sh.) | Expected return on equity |
| W X Y Z | 10,000 15,000 15,000 10,000 | 1.12 0.89 0.70 1.60 | 130 100 90 160 | 18% 23% 11% 17% |
The current market return is 14% per annum and the Treasury Bill's yield is 9% per annum.
Required:
(i) The risk of Mary Chege's portfolio relative to that of the market.
(ii) Determine whether Mary Chege should change the composition of her portfolio.
3a
Advanced financing decision
Explain three assumptions of the traditional theories of capital structure.
3b
Advanced financing decision
Majuu Ltd. is just about to commence operations as an international trading company. The firm will have a book vałue
of assets of Sh.320 million and it expects to earn 16% return on these assets before interest and taxes. However.
because of certain tax arrangements with foreign governments, the company will not pay any taxes.
It is known that the capitalisation rate for an all equity firm in this business is 12%. The company can borrow debt
finance at the rate of 7% per annum. The management is in the process of deciding how to raise the required Sh.10
million debt finance. Assume that the Modigliani and Miller (MM) assumptions apply.
Required:
Using the MM model without taxes, determine:
(i) The current value of the unlevered firm.
(ii) The current value of a levered firm if it uses Sh. 10 million of 7% debt.
(iii) The weighted average cost of capital (WACC) of a levered firm at a debt level of 7%, Sh.10 million.
3c
Advanced financing decision
Assuming that the company in (b) above now pays taxes at the rate of 30%, compute the following in a Modigliani
and Miller (MM) world:
(i) The current value of the firm if it uses no debt.
(ii) The current value of the firm if it uses the debt level of 7%. Sh.10 million.
(iii) The weighted average cost of capital (WACC) at 7% debt level of Sh.10 million.
4a
Corporate restructuring and re-organisation
In relation to corporate restructuring and re-organisation, distinguish between the following terms:
(i) "Boot strapping" and "management buyout".
(ii) "Sell off" and "spin off".
4b
Mergers and acquisitions
Kubwa Ltd., a supermarket chain, is proposing to take-over Small Ltd., a smaller firm in the same industry. In its bid.
Kubwa Ltd. has offered four of its shares for every three shares of Small Ltd.
Additional information:
The following are the latest summarised accounts of the two companies:
| Statements of financial position | ||||
Non-current assets: | Sh."million" | Kubwa Ltd. Sh."million" | Sh."million" | Small Ltd. Sh."million" |
| Land | 966 | 84.6 | ||
| Other non-current assets | 300 | 34 | ||
| 1,266 | 118.6 | |||
| Current assets: | ||||
| Inventory | 656 | 102.8 | ||
| Accounts receivable | 24 | 12.6 | ||
| Cash | 88 | 10.6 | ||
| 768 | 126.0 | |||
| Current liabilities: | ||||
| Trade payables | 894 | 92.2 | ||
| Other accruals | 68 | 8 | ||
| Net current assets | (194) | 25.8 | ||
| Long-term liabilities: | ||||
| 14% loan stock | 400 | - | - | |
| Floating rate loans | 228 | 35 | ||
| (628) | (35) | |||
| Total net assets | 444 | 109.4 | ||
| Shareholders' funds: | ||||
| Ordinary share capital | 150 | 40 | ||
| Reserves | 294 | 69.4 | ||
| Total shareholders' funds | 444 | 109.4 | ||
| Income statement | ||
| Kubwa Ltd. Sh."million" | Small Ltd. Sh."million" | |
| Turnover | 2,260 | 362 |
| Earnings before interest and tax | 230 | 28 |
| Interest | (80) | (4) |
| Profit before tax | 150 | 24 |
| Taxation | (50) | (8) |
| Earnings available to shareholders | 100 | 16 |
| Dividends | (48) | (10) |
| Retained earnings | 52 | 6 |
Additional information:
| 1 | The par value of the shares of Kubwa Ltd. is Sh.0.50 while the par value of Small Ltd's shares is Sh.1.00. |
| 2 | The current share price of Kubwa Ltd. is Sh.4.64 while that of Small Ltd. is Sh.5.90. The current loan stock price of Small Ltd. is Sh. 125. |
| 3 | Recent annual growth trends are as follows: Kubwa Ltd. Small Ltd. Dividends 7% 8% Earnings per share 7% 10% |
| 4 | The following will take place after the acquisition:
|
| 5 | Kubwa Ltd. has an estimated cost of equity of 14.5% and a weighted average cost of capital of 12%. |
| 6 | Small Ltd. has an estimated cost of equity of 13%. |
Required:
(i) Evaluate whether the bid is likely to be viewed favourably by the shareholders of both Kubwa Ltd. and Small Ltd.
(ii) Discuss three factors that are likely to influence the views of the shareholders in the analysis in (b) (i) above.
5a
Financial risk management
Explain how currency swaps could be used to hedge against the foreign exchange operating exposure of a firm.
5b
International financial management
International Bank expects that the Mexican Peso (MXP) will depreciate against the US dollar (USD) from its spot
rate of 0.15to0.14 in ten days. The following interbank lending and borrowing rates exist:
| Annual lending rate | Annual borrowing rate | |
| US dollars (USD) | 8.0% | 8.3% |
| Mexican Peso (MXР) | 8.5% | 8.7% |
Assume that International Bank has a borrowing capacity of either 10 million USD or 70 million MXP in the
interbank market, depending on which currency it wants to borrow. Further, assume that one year has 360 days.
Required:
(i) Demonstrate how International Bank could capitalise on its expectations without using deposited funds.
(ii) Estimate the profits that could be generated from the strategy adopted in (b) (i) above.
5c
International financial management
Assume all the information provided in (b) above with this exception: International Bank expects the MXP to
appreciate from its present spot rate of $0.15 to $0.17 in 30 days.
Required:
(i) Demonstrate how International Bank could capitalise on its expectations without using deposited funds.
(ii) Estimate the profits that could be generated from the strategy adopted in (c) (i) above.
5d
Financial risk management
Highlight two shortcomings of the Black-Scholes option pricing model.
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