Professional Documents
Culture Documents
SECTION FIVE
Capital budgeting
1. Consider a project whose initial investment is 636,000 and the company expects
to generate annual cash flows of 240,000 p.a. for a period of 5 years. The present
cash flows can be re-invested at the rate of 16% pa and the cost of capital is 14%.
Determine the MIRR.
3. Consider a one year project whose initial investment is 100M. The project is
expected to generate sh.125M at the end of the year.
Required: Compute the IRR of the project.
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Compute the expected value and the standard deviation for the 3 markets
Rank the projects according to the coefficient of variation
Question 3
BEP analysis-sensitivity analysis
Consider the following information about project X
The initial investment is sh. 100,000
Annual revenue 200,000.
The operating expenses excluding depreciation is sh. 170,000
The economic life of the project is 5 years and it is being depreciated using straight
line method and the cost of capital is 10%.
The corporate tax rate is 30%
Required:
Carry out the sensitivity analysis in respect of each key variable in isolation. (Initial
investment revenue and operating expenses)
Question 4 (CEC)
Consider a project whose initial investment is sh. 100,000 and it’s expected to generate
the following cash flows.
Year 1 2 3 4 5
Cash flow 35,000 35,000 35,000 35,000 35,000
CEF 0.9 0.8 0.7 0.3 0.2
The cost of capital is 10% and the risk free rate is 8%.
Required; evaluate the project using the equivalent coefficient factor.
QUESTION 5
Simulation
Consider a project whose initial investment is 40M and the cost of capital is 12%. Its
economic life is 5 years and the following costs and revenues are provided.
Revenues Costs
Amount prob Amount prob
40M 0.15 25M 0.10
50M 0.40 30M 0.25
55M 0.30 35M 0.35
60M 0.15 40M 0.30
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Due to the decline in Treasury bill rates in the recent past, interest rates in the money
market have been falling presenting favorable opportunities for the refinancing.
A financial analyst engaged by the company to assess the possibilities of refinancing the
debt reports that a new 100M par value, 12%, 5 years’ bond can be issued by the
company. Issuing cost 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 amortization on a straight line
basis over the life of the bond and are allowable for corporate tax purposes.
The applicable tax rate is 40% and the after tax cost of the debt to the company is
approximately 7%
Required:
a. Cash investment required for the refinancing decision (9 marks)
b. Annual cash benefits (savings) of the refinancing decision (6marks)
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Question two
APM
The shares of XYZ ltd are influenced by the following micro-economic factors as follows.
Factors ER Beta
Inflation 13% 0.95
Industry 10% 1.32
Default premium risk 6% -0.8
The risk free rate is 8%, determine the return of security using APM.
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RIGHT ISSUE.
This is a method of raising equity finance by issuing additional shares to the existing
shareholders at a price below the market price.
Advantages of right issue.
1. It involves less floatation cost since shares are issued to the existing shareholders
who already know the company.
2. It involves less formalities and administration procedures i.e. there is no need for
preparing the prospectus since the shares are sold to the existing shareholders.
3. It increases equity capital and hence reducing the gearing level of the company
4. Ownership and control of the company will not be diluted.
5. It enables the existing shareholders to enjoy the discount offered by the company.
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QUESTION 2
Mhusika ltd is an all equity finance with market capitalization of sh. 720 million. The
company intends to raise sh. 120 million through the right issue to finance a new project.
The current market price per share of the company prior to the announcement of the
right issue is sh.30
The proposed offer price is sh.25. The new project is expected to generate cash-flows of
sh 16.8 million per annum to perpetuity. For the year just ended, the company paid a
dividend per share of sh. 2.83. The project’s cash flows and dividend per share have a
growth rate of 6% per annum.
Required:
(i) The cum-right market price per.
(ii) The number of right.
(iii) The theoretical ex-right MPS
(iv) The value of each right
QUESTION 3
Latex ltd has a paid up ordinary share capital of sh. 4.5 million represented by 6 million
ord shares of sh. 0.75 each. The company has no loan capital. During the last financial
year, EAT were sh. 3.6 million. The P/E ratio is 15 and the company is planning to make a
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The project will generate before tax cash flows of 5M pa ,for the 10 years period .The
residual value at the end of the 10th year is forecasted to be 5 M after tax, as the
investment is in an area that the government wishes to develop , a subsidized loan od 4M
out of the total 9M debt is available. This will cost 2% below the normal cost of long term
debt finance which is 8%.
J ltd equity beta is 0.85 and its financial gearing is 60% equity and 40% debt by market
values.
The average equity beta in the printing industry is 1.2 and the average gearing, 50% equity
and 50% debt by market value.
The risk free rate is 5.5% per annum and the market returns 12% per annum. Issue cost
are estimated to be 1% for the debt financing (excluding the subsidized loan), and 4% for
equity financing. These costs are tax allowable. The tax rate is 30%.
Required.
a. Estimated Adjusted Present Value of the proposed investment (16 marks)
b. State the circumstances which the above method is preferred (4 marks)
COMPANY RESTRUCTURING
QUESTION ONE.
A company has the following for the last 5 years
Period 2010 2011 2012 2013 2014
Dividend per share 5 5.5 6 6.5 7.3
The co has just paid the dividend for the year 2014.The cost of equity is 16%
Required:
Using constant dividend growth model, determine the price of the share as at 31 st Dec
2014.
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INTERNATIONAL ARBITRAGE
Consider the following actual exchange rates.
1 Ksh =0.015 dollars
1 TSH =0.0008 dollars
1 Ksh =TSH 20
Required; Compute the gain from triangular arbitrage to an investor with 200,000 dollars
to invest.
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1. Managerial functions.
2. Routine functions.
1. Managerial function.
They are functions that require technical expertise, knowledge of a finance manager and
they include:
Liquidity and working capital management.
Financing function.
Investment or capital budgeting functions.
Dividend policy decision/ Profit allocation function.
2. Routine functions.
This functions o not requires technical skills and knowledge of the finance manager.
Agency theory
An agency relationship exist where one party known as the principal appoints other
known as the agent and gives him the authority to act on his behalf. There are various
type of agency relationship which include;
(a) Shareholders vs. management.
(b) Creditors vs. shareholders
(c) Government vs. shareholders
(d) Auditors vs. shareholders.
Shareholders VS Management/Shareholders versus Managers
A Limited Liability company is owned by the shareholders but in most cases is managed
by a board of directors appointed by the shareholders. This is because:
a) There are very many shareholders who cannot effectively manage the firm all at
the same time.
b) Shareholders may lack the skills required to manage the firm.
c) Shareholders may lack the required time.
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3. Threat of firing: Shareholders have the power to appoint and dismiss managers
which is exercised at every Annual General Meeting (AGM). The threat offiring
therefore motivates managers to make good decisions.
4. Threat of Acquisition or Takeover: If managers do not make good decisions then
the value of the company would decrease making it easier to be acquired especially
if the predator (acquiring) company beliefs that the firm can be turned round.
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IRR ARR
It is a discounting technique It is a non-discounting technique.
It uses cash flows to evaluate a project. It uses accounting profit to evaluate.
It uses all cash flows to evaluate It uses the average accounting profit.
It gives a decision for accepting or It does not give the decision of either
rejecting a single project accepting or rejecting.
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CAPITAL RATIONING.
This occurs when there is scarcity of the investment fund i.e. the company has no
sufficient money to undertake all viable projects.
There are normally two types of capital rationing.
Where the management may refuse to raise additional funds through issues of
new shares to avoid dilution.
To avoid commitment of large payment of interest or installment of the principle
amount in case the company borrows funds.
Where the management has set a limit on the budget.
Where the project can only be financed by internally generated funds.
2. Hard/externally generated capital rationing.
This occurs due to factors not within the control of the management (external factors).it
occurs as a result of the following:
When the capital market is depressed thereby making it impossible to raise
finances.
Cost of capital of issuing new shares may be too high thereby affecting borrowing.
High demand of investment fund by well established companies.
Lack of security/collateral when borrowing funds.
Due to credit policy of the government thereby restricting financial institution to
lend money.
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1. OPERATING LEVERAGE.
This is the use of the operating costs in order to improve the profitability of the
company
2. FINANCIAL LEVERAGE
This is the use of the financing cost in-order to improve the EPS of the company.
3. COMBINED /TOTAL LEVERAGE.
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SIMULATION ANALYSIS.
Advantages.
1. It is the most suitable method for analyzing long term project where other
techniques may not be applicable.
2. It enables the decision analyst to evaluate various possible combination through
the use of random number.
3. Each key variable factor can be analyzed independently.
Disadvantages.
1. Practically simulation requires the use of computer programme therefore it may
take significant resources.
2. Simulation is not an optimizing technique because it does not give optimal results
of whether to accept or reject a project.
3. It deals with total risk.
4. The probability distribution is usually estimates.
BOND REFINANCING
Is the process of retiring the old bond and issuing a new bond at lower interest rate.
During the period of the declining interest rate, a company might find itself with a fixed
interest security which was issued some years back when the interest rate were very high.
Reasons for bond refinancing
1. Because of declining in the interest rates.
2. Because the company is in better position to repay now compared with the future.
3. Changes in the tax rate leading to change in interest tax shield.
4. Because of less restriction terms and conditions associated with new bond.
5. Because of the capital structure decisions.
Key terms.
1. CALL PREMIUM-this is the penalty for retiring tr bond before maturity period.
2. OVERLAPPING INTEREST CHARGE/EXPENSE-the interest which is paid on the
existing bond after the re-financing but before the amount is received back.is the
interest paid for both bonds.
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FINANCIAL DISTRESS.
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HOSTILE TAKEOVER
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RESTRUCTURING-is the process of changing the capital structure of the company and it’s
carried out as part of corporate restructuring.
Corporate restructuring is categorized into 3 as follows:
1. Financial restructuring.
2. Portfolio restructuring.
3. Organizational restructuring.
FINANCIAL RESTRUCTURING
This is where the capital structure of the company is changed and its normally carried out
by companies that are facing financial problem.
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7. MANAGEMENT BUY-IN.
This is where a group of managers outside the business acquire the business.it takes place
when a business is sold to a team of professionals outside the management team.
ORGNIZATIONAL RESTRUCTURING/RE-ORGANIZATION
It entails the change in the organizational structure of the company so as to change the
following:
I. Management hierarchy.
II. Workforce of the company.
III. Decision making process.
IV. Supply chain.
It’s normally undertaken in order to:
To make the decision making process less complicated.
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WORLD BANK
It was established as a multi-lateral lending agencies focusing on the projects with long-
term implications.
The objective was to promote economic and social progress in developing nations by
helping to raise the productivity so that their people can live better lives. The sources of
finance for the bank include:
1. Equity-this was capital contributed by member countries when joining the
association.
2. Bonds-this was the amount raised from the world financial markets.
3. Private markets-these were finances from investment banks and commercial
banks who were lending money to the institution.
FINANCIAL INNOVATION.
This can be defined as an act of creating and then popularizing new financial instrument
as well as new financial technologies.
Factors that have led to financial innovation/engineering
1. Increased interest rate fluctuations.
2. Frequency of tax and regulation changes.
3. Deregulation of financial service industry.
4. Increased competition within the investment banking.
5. Technological advancement.
6. Accounting benefits.
7. Changes in prices.
8. Opportunities to increase the asset liquidity.
9. Opportunity to reduce risk
10. Transaction cost
Types of financial innovation.
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1. SECURITY INNOVATIONS.
It is the development of the innovation financial instrument for consumer type
applications and the corporate finance application. Examples include.
New bank accounts for customer’s e.g. personal loan, credit cards, savings
account.
Swaps using caps and floors.
2. FINANCIAL PROCESS INNOVATION
This aims at to reflect the effort in reducing the transaction costs and the steps
taken to reduce the idle cash balance and the availability of inexpensive computer
technology to facilitate transaction.
Examples of process innovation include.
Online banking.
Use of ATM’s
3. CREATIVE SOLUTIONS TO CORPORATE FINANCE PROBLEMS.
This involves corporate restructuring, which aim at managing the financial issues.it
involves tax effect cash management strategies. Examples include.
Leases.
Project finance.
Corporate restructuring.
FINANCIAL ENGINEERING.
It is defined as application of technical methods especially from mathematical finance.
FINANCIAL INTERMEDIERIES.
These are institutions which an act as mediators between two parties in a financial
transaction.it normally occurs between borrowers and lenders. Examples of financial
intermediaries will include:
Banks
Insurance companies
Pension funds
Mutual funds
Government saving department
Functions of financial intermediaries.
1. Information
2. Regulation
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CORPORATE VALUATION
Corporate requires regular valuation. This corporate valuations can be possible by use of
several appendicies.the most common methods of corporate valuation are:
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EVA=NOPAT-ROCE.
The following steps are used:
(a) Determine the NOPAT.
(b) Determine the capital employed.
Capital employed=equity=share capital +reserves +retained profit.
(c) Determine the WACC if not provided by either using CAPM or the weighted
average.
(d) Determine the return on capital employed.
(e) Determine EVA.
Advantages of using EVA.
1. It’s a true indicator of the actual wealth created for the shareholders
2. It’s a good measure of performance evaluation.
3. It’s simple to understand and explain to managers.
4. EVA is consistent with the objective of maximizing shareholders wealth.
5. It uses cash flows and hence less easy to be manipulated.
6. It’s widely used to evaluate manager’s performance.
Disadvantages of EVA
1. It’s complex to calculate where large transactions are involved.
2. It’s based on historical information and hence does not consider the future flow.
3. It is not suitable for small enterprises since it doesn’t take into account the size of
the firm.
4. It uses the assumptions of CAPM to determine the required rate of return.
5. It’s not good for comparison since it doesn’t consider the size of the company.
Why EVA has gained prominence.
It’s less easy to manipulate then accounting figures.
It takes into account the cost of capital.
It makes managers accountable.
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SOLUTION.
Minimum amount to sell=PV of the free cash-flows
Free cash flow
Period Year 1 Year 2
Sales 50,000 80,000
Less admin expenses (10,000) (20,000)
Less interest (5,000) (4,000)
PBT 35,000 56,000
Tax 40% (14,000) (22,400)
PAT 21,000 33,600
Less capital expenditure (8,000) (7,000)
Free cash-flows 13,000 26,600
PV factor (1+0.12)-1 0.8929 0.7972
PVCF 11,608 21,205
Minimum amount to accept=11,608+21,205=32,813
4. USE OF VALUATION MODELS.
(a). JAMES WALTER MODEL.
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TYPES OF DERIVATIVES.
They are classified into 4 categories as follows;
Options
Swaps
Future contract
Forward contract
OPTIONS
An option is a contract which gives the buyer/seller the right but not obligation to buy or
sell the specified asset/security at a specified price on or before the specified future date.
The specified price is known as the exercise price.in this case the parties usually are
required to pay a non-refundable fee known as the premium.
Types of options
(a) Call option
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OPTION STYLE
There are 3 basic types of the option based on their settlement date.
1. European option.
This gives the holder of the option to sell/buy the asset on the expiry date only and
therefore it cannot be exercised earlier.
2. American option.
This option gives the holder the right but not obligation to buy/sell on or before
the expiry date.
3. Bermudian option
Under this option, the option can be exercised any time before maturity date but
the date of exercising is normally specified when the contract was signed.
Options categories based on payoffs.
(a) In the money option.
This is when, if the option is exercised today, a profit will be realized.
(b) Out of the money option.
This is when, if the option is exercised today, a loss will be realized.
(c) At the money option.
This is when the option is exercised now, there will be no loss/gain i.e. break even.
ILLUSTRATION.
Suppose a security has an exercise/strike price of sh.30 with a premium of sh.5.determine
the value of both call option and put option as well as profit/ loss assuming the following
prevailing market prices (MPS):
SH (20, 25, 30, 35, 40, 45).
PUT CALL PARITY THEOREM.
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GREEKS.
These are the sophisticated tools used to measure variation in the option premium and
they include:
(a) DELTA
Measures the option sensitizing to change in the price of the asset or security. It’s
therefore the degree to which the option price will change given a change in the
share price or the index price holding other factors constant.
Option delta=change in option value
Change in the share price
(b) GAMMA
The rate at which the delta value of the option increases or decreases due to the
changes in the share price.
Gamma= change in option delta
Change in price of asset
(c) THETA
Measures the change in the option price as the time to expiry increases. The longer
the time to expiry of the option, the greater the value of the delta.
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SWAPS.
This is the arrangement between two parties to exchange the assets or liabilities for the
mutual benefits for each other. It’s therefore an arrangement to exchange a steam of the
future payment concerning the loan and interest.it is flexible private forward contract
between 2 parties to exchange the cash flows.it is classified into as follows:
(a) Interest rate swaps
(b) Currency swaps
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2. CURRENCY SWAPS.
A contract between parties to exchange specific amount of 2 different currencies
exchanged using the market rates.it takes into consideration the transaction between 2
parties in different currencies.
Benefits
1. Enables the company to obtain finances at a cheaper rate
2. It enables the company to hedge its currency exposure for a long period.
3. Enables the company to restructure its debt profile by issuing the bond
4. Enables the company to access international capital market
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FUND MANAGEMENT
This is the process of managing the balance sheet and the off-balance sheet instruments
to maximize and maintain the spread between the interests, carried and paid while
ensuring that the bank has the ability to pay off the liabilities and acquire the assets
earned.
The best way of evaluating the fund management is by undertaking:
a) Operations of the bans.
b) Customer’s behavior.
c) The asset liability composition
d) The economic and competitive environment under which the banks operate.
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