KASNEB Advanced Financial Management - Question 1c

Further analysis of the company in (b) above suggests that sales volumes could depend on expected economic state as follows: Economic statePoorNormalGoodProb... [Click to view full question and step-by-step solution]

KASNEB Advanced Financial Management - Question 3a

Summarise five functions of the International Monetary Fund (IMF).... [Click to view full question and step-by-step solution]

November 2019

Q: KASNEB Advanced Financial Management - Question 1a

(i) Distinguish between 'insolvency' and 'bankruptcy' as used in business restructuring. (ii) Highlight four causes of business failure. ... [Click to view full question and step-by-step solution]

1a

Corporate restructuring and re-organisation

(i) Distinguish between "insolvency" and "bankruptcy" as used in business restructuring.

(ii) Highlight four causes of business failure.

1b

Advanced capital budgeting decision

Sunny Technologies Ltd. is' considering investing Sh.50 million in a new machine to manufacture computer micro chips with an expected useful life of 5 years and no salvage value. It is expected that 20 million units of micro chips will be sold each year at Sh.3.00 per unit. Variable production costs are expected to be Sh.1.65 per unit, while incremental fixed costs will be Sh.10 million per annum.

The cost of capital is 12%.

Required:

Evaluate the sensitivity of the project's net present value (NPV) to the following changes:

(i) Sales volume.

(ii) Sales price.

(iii) Variable costs.

1c

Advanced capital budgeting decision

Further analysis of the company in (b) above suggests that sales volumes could depend on expected economic state as follows:

Economic state	Poor	Normal	Good
Probability	0.30	0.60	0.10
Annual sales volume (units)	17,500,000	20,000,000	22,500,000

Required

The expected net present value (NPV) of the project using scenario analysis

2a

Advanced capital budgeting decision

Kanga Limited is considering the design of a new conveyor system. The management must choose among the following three alternative courses of action:

Option 1

The firm could sell the design outright to another corporation with payments over 2 years.

Option 2

The firm could license the design to another manufacturer for a period of 5 years which is likely to be the product life cycle of the conveyor system.

Option 3

The company could manufacture and market the system itself. This alternative will result in 6 years of cash inflows.

Cash flows associated with each alternative are as shown below:

Alternative	Sell	License	Manufacture
Initial investment, I, (Sh.)	400,000	400,000	900,000

Year		Cash inflows (Sh.)
1 2 3 4 5 6	400,000 500,000 - - - -	300,000 200,000 160,000 120,000 80,000 -	400,000 500,000 400,000 400,000 400,000 400,000

The company has a cost of capital of 12%.

Required:

Advise Kanga Limited on the best alternative based on:

(i) Net present value (NPV) approach.

(ii) Annualised net present value (ANPV) approach.

(iii) Compare and contrast your results obtained in (a) (i) and (ii) above.

2b

Advanced financing decision

The finance director of Babito Ltd. wishes to determine the company's optimal capital structure. The cost of debt varies according to the level of gearing of the company as follows:

Percentage debt (%)	Pre-tax cost of debt (%)
10 20 30 40 50 60 70	6.5 7.1 7.8 8.5 10 12 15

Additional information:

1. The company's ungeared equity beta is 0.85.

2 The risk-free interest rate is 6%.

3. The market return is 14%.

4. Corporate tax rate is 30%.

Required:

Advise the company on the optimal weighted average cost of capital (WACC).

3a

International financial management

Summarise five functions of the International Monetary Fund (IMF).

3b

Portfolio theory and analysis

Duncan Kipchumba has an investment capital of Sh.1,000,000. He wishes to invest the fund in two securities, X and Y in the following proportion; Sh.200,000 in security X and Sh.800,000 in security Y.

The return on these two securities depend on the state of the economy, as shown below:

State of economy	Probability	Returns on security X	Returns on security Y
Boom	0.40	18%	24%
Normal	0.50	14%	22%
Recession	0.10	12%	21%

Required:

(i) The expected return on the portfolio.

(ii) The correlation coefficient between security X and security Y.

(iii) The portfolio risk.

(iv) The reduction in risk due to portfolio diversification.

3c

Portfolio theory and analysis

Job Ochieng, an investor, believes that there are three important factors that determine the expected return for a particular common stock. Job uses the following factor betas and factor risk premiums:

Factor	Factor beta	Factor risk premium
1 2 3	0.70 1.20 -0.10	2.5% 5.0% 6.0%

The risk-free rate is 5%.

Required:

(i) The expected return for the stock using the arbitrage pricing theory (APT) model.

(ii) Explain two differences between capital asset pricing model (CAPM) and arbitrage pricing theory (APT) model.

4a

Financial risk management

Distinguish between the following terms as used in the context of derivatives market:

(i) "Currency option" and "currency swap".

(ii)"Interest rate swap" and "interest rate collar".

(iii) "Hedgers" and speculators".

4b

Real estate finance

Property A and property B are categorised under the real estate category. Property A is' all equity financed while property B is financed partly using debt and partly by equity finance.

Both properties generated operating profit (EBIT) of Sh.41,245,900 annually. This is expected to remain constant each year in perpetuity. Unlike property A which is wholly equity financed, property B is financed partly by equity and partly by 10% debt of Sh.215,000,000.

The cost of equity is 12% for both properties and there are no corporation taxes. Each unit of debt is trading at par.

Required:

The current value of each property using the Net Income (NI) approach.

4c

Advanced financing decision

Smoothdrive Ltd., a motor vehicle assembly company issued a 10 year, 16%, Sh.100 million par value bond five years ago. The bond was issued at 2% discount and issuing costs amounted to Sh.2 million.

Due to the decline in Treasury bill rates in the recent past, interest rates in the money market have been falling presenting favourable opportunities for refinancing. A financial analyst engaged by the company to assess the possibility of refinancing the debt reports that a new Sh.100 million par value, 12%, 5-year bond could be issued by the company. Issuing costs for the new bond will be 5% of the par value and a discount of 3% will have to be given to attract investors.

The old bond can be redeemed at 10% premium and in addition, two months interest penalty will have to be paid on redemption. All bond issue expenses (including the interest penalty) are amortised on a straight-line basis over the life of the bond and are allowable for corporate tax purposes.

The applicable corporate tax rate is 40% and the after tax cost of debt to the company is approximately 7%.

Required:

(i) The initial investment required to issue the new bond.

(ii) Annual cash flow savings (if any) expected from the bond refinancing decision.

(iii) The net present value (NPV) of the refinancing decision.

(iv) Advise the company on whether to refinance the bond based on your results in (c) (iii) above.

5a

Mergers and acquisitions

Briefly describe the following types of mergers:

(i) Horizontal.

(ii) Vertical.

(iii) Congeneric.

(iv) Conglomerate.

5b

Mergers and acquisitions

A Ltd. and B Ltd. are companies operating in the same line of business. In the past few years, A Ltd. has experienced stiff competition from B Ltd. to an extent that A Ltd. is now contemplating acquiring B Ltd. in order to consolidate its market share.

The following financial data is available about the two companies:

	A Ltd.	B Ltd.
Annual sales (Sh. million)	400	60
Net income (Sh. million)	40	9
Ordinary shares outstanding (million)	10	3
Earnings per share (EPS)	Sh.4.0	Sh.3.0
Market price per share (MPS)	Sh.60	Sh.30

Both companies are in the 30% income tax bracket.

Required:

(i) The maximum exchange ratio that A Ltd. should agree to assuming that it does not expect dilution in its post acquisition earnings per share (EPS).

(ii) The total premium the shareholders of B Ltd. would agree to receive at the exchange ratio in (b) (i) above.

(iii) A Ltd.'s post acquisition earnings per share (EPS) assuming that the two companies agree on an offer price of Sh.30.

(iv) A Ltd.'s post acquisition earnings per share (EPS) assuming that for every 100 ordinary shares of B Ltd., the shareholders are offered two, 12% debentures of Sh.500 par value.

5c

Advanced financing decision

Twiga Limited has 500,000 ordinary shares trading at Sh.150 each in the Securities Exchange.

Additional information:

1. The dividend payable in one year period is Sh.3 per share.

2. An investment opportunity worth Sh.25 million is to be undertaken. The profit to be earned is Sh.15 million.

3. The cost of capital for the company is 10%.

Required:

Using Modigliani and Miller approach, show that the payment of dividends does not affect the value of the firm.

November 2019

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