Advanced Financial May

Management 2015
We gratefully acknowledge permission to make use of past examination
papers of KASNEB. We however would want to emphasize that the
solutions given here are not in any way to be construed as obtained
Suggested
from KASNEB but are the suggested solutions by the authors of this solutions
material.

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 Advanced Financial Management

QUESTION ONE
(a) Evaluate four limitations of the Altman’s Z-score model for predicting corporate failure
(8 marks)

(b) Chuma Ltd. is considering replacing a machine. The existing machine was bought 3 years ago at
a price of Sh.50 million. The machine is expected to have a useful life of 5 more years with no
scrap value at the end of its useful life. The machine could be disposed of immediately at Sh.35
million. The new machine will cost Sh.80 million with a useful life of 5 years and an expected
terminal value of Sh.5 million. With the introduction of the new machine, sales are expected to
increase by Sh.25 million per annum over the next five years.

The contribution margin is expected to be 40% and the corporate tax rate is 30%. The operation
of the new machine will also require an immediate investment of Sh.8 million in working capital.
Installation costs of the new machine will amount to Sh.6 million.

Depreciation is to be provided for on a straight line basis. The company’s cost of capital is 12%

Required:
Advise the management of Chuma Ltd.on whether to replace the machine. (12 marks)
(Total: 20 marks)

Suggested solution
(a) Limitations of the Altman’s model
 In common with all correlation models, it relates to the past, without taking into account the
current state of the macro-economic environment, the level of inflation and interest rates.
 The model shares the limitations of the accounting models including the accounting concepts
and conventions on which they are based.
 The publication of accounting data by companies is subject to a delay. Failure might occur
before the data becomes available.
 If the measures incorporated in the models become used as objectives, the model is likely to
become less useful as a predictive tool as the measures will be subject to manipulations.

(b) Chuma Ltd

(i) Initial investment for the replacement decision (incremental analysis)
Sh.‘000’
Cost of new machine (80,000)
Installation cost (6,000)
Total capitalized cost (86,000)

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Disposal proceeds of old machine 35,000

Difference (51,000)
Tax on gain (1,125)
Working capital (8,000)
Net incremental initial outlay (60,125)

(ii) Incremental annual cash flows

Sh.‘000’
Sales increase 25,000
Contribution margin (40%) 10,000
Profits after taxes (70%) 7,000
Add incremental dep tax shield (w1) 2,985
Incremental annual cash flows 9,985
Workings:
W1: incremental depreciation tax shield
New machine depreciation p.a
Sh.86,000 – Sh.5000 ……………Sh.16,200
5 years
Old machine depreciation p.a
Sh.50,000………………………….Sh.6,250
8 years

Incremental depreciation = Sh.9,950

Incremental depreciation tax shield = Sh.2,985 i.e (Sh.9,950 x 30%)

W2 Tax on gain on disposal Sh.’000’ Sh.’000’

Disposal proceedings 35,000
Cost of machine 50,000
Accumulated depreciation (50,000 /8) x 3 18,750 31,250
Gain on disposal 3,750
Tax on gain 30% of 3,750 = 1,125
Current book value

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 Advanced Financial Management

Incremental terminal cash flows Sh.‘000’

Incremental scrap value (5,000 – 0) 5,000
Release of working capital 8,000
Incremental terminal cash flows 13,000
NPV computation
Year cash flows PV factor present value
Sh.‘000’ 12% Sh.‘000’
0 (60,125) 1.000 (60,125)
1-5 9,985 3.6048 35,994
5 13,000 0.5674 7,376
NPV (16,755) negative
The management should not replace the machine since it would result to a negative NPV

QUESTION TWO
(a) “Corporate diversification and conglomerate mergers are an experiment in portfolio theory
applied to corporations”.
Explain the above statement. (4 marks)

(b) Describe how each of the following portfolio performance measures are used:

(i) Treynor’s ratio. (2 marks)

(ii) Jensen’s alpha. (2 marks)

(c) The risk and return characteristics of two assets are as shown below:

Asset A B
Expected return 12% 20%
Risk (standard deviation) 3% 7%

Uchumi Investment Company plans to invest 80% of its available funds in asset A and 20% in asset
B. The board of directors of the company believe that the correlation coefficient between the returns
of these assets is +0.1.

Required:
(i) The expected return from the proposed portfolio of asset A and asset B. (2 marks)

(ii) The risk of the portfolio. (2 marks)

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 Advanced Financial Management

(iii) Comment on your calculations in part (c) (ii) above in the context of the risk-reducing effects
of diversification. (4 marks)

(iv) Suppose the correlation coefficient between the returns of asset A and asset B was -1.0.
Demonstrate how Uchumi Investment Company could invest its funds in order to obtain a
zero-risk portfolio. (4 marks)
(Total: 20 marks)

Suggested solution
(a) Statement
The driving force between conglomerate mergers and corporate diversification has always been
to minimize risk. This can best be achieved especially when the two companies operate in
unrelated lines such that their correlation coefficients are low. To an extent the merger that is
created is able to reduce risk through the diversification effect though in many empirical studies,
individual shareholders can diversify much better than companies.

(b) (i) Treynor’s measure: It is based on the capital asset pricing model (Capm) and it involves
computing the slope of the security market line. The measure is then compared with that
of the market to determine whether a security is either overvalued or undervalued. All
securities with a measure more than that of the market are then recommended since
they also plot above the SML
(ii) Jensen’s alpha: It is also based on the Capm. It involves computing of an alpha index
(the excess returns) of securities. This index reflects the difference between the returns
actually earned on a portfolio and the returns the portfolio is supposed to earn given its
beta as per the capm. A security with a positive alpha index is therefore recommended.

(c) (i) portfolio returns

Rp = (WA,RA) + (WB,RB)
Rp = (0.8 x 12) + (0.2 x 20)
Rp = 13.6%

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(ii) Portfolio risk

Variance of a two asset portfolio
σ p2 = (w2x σ2x) + (w2y σ2y) + (2wx wy cor,xy σx σy)
σ p2 = (0.8 2x 32) + (0.22 x 72) + (2 x 0.8 x 0.2 x 0.1 x 3 x 7)
σ p2 = 8.392

Standard deviation
σ p = √8.392
σ p = √2.9

(iii) The portfolio risk is less than that of the individual projects. The portfolio risk is always
reduced so long as the correlation coefficient is less than +1.0

(iv) Where the correlation coefficient is a perfect negative, The weights of the portfolio that
yields zero risk can be obtained using the formula.

Therefore,

Wx = 0.7 or 70%

QUESTION THREE
(a) In the context of financial management in the public sector, explain four objectives of
performance contracts in Public Sector Entities (PSEs). (8 marks)

(b) Explain the difference between “open-end funds” and “closed-end funds”. (4 marks)

(c) A share is currently selling at Sh.120. There are two possible prices of the share after one year:
Sh.132 or Sh.105. Assume that the risk-free rate of return is 9% per annum.

Required:
The value of a one-year European call option with an exercise price of Sh. 125. (8 marks)
(Total: 20 marks)

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Suggested solution
(a) Objectives of performance contract.
 Improving and refocusing of public entities on realizing their core mandates and
performance.
 Improvements in the performance of the public service particularly through the
introduction of citizen service delivery charters which refocuses on identifying and
delivering weights against service standards;
 Improvements in levels of transparency and accountability and responsiveness in the
public service where obligations of all public agencies are included in the publicly signed
performance contracts
 Evolution of the Performance Contract and Evaluation System to adapt to emerging
issues e.g. expansion of indicators to reflect some of the overarching national concerns
such as corruption;
 Development of a ranking model that avoids ranking in numerical order rather based on
specific performance levels
(b) Differences between open-end funds and closed end funds
Closed-end funds are closed to new capital after it begins operating and its shares trade on stock
exchanges rather than being redeemed directly by the fund as in the case of open-end funds. A
closed-end fund shares can be traded at any time during the market day whereas an open-ended
fund can usually be traded only at the closing price at the end of the market day.
A closed-ended fund usually has a premium or discount whereas an open-ended fund sells at its
NAV (except for sales charges). Closed-ended funds commonly use leverage or gearing to
enhance returns by issuing either preference shares or long-term debt whereas open ended
funds do not.

(c) Binomial valuation of a call using the risk neutrality concept

(prob of price increase x increase in price in %) + (1 – Prob of price increase x decrease in price in
%) = risk free rate
Let the prob of price increase be represented by a
Percentage changes based on the current price of Sh.36
@ Sh.132 a gain of Sh.12 representing 10% increase
@ Sh.105 a loss of Sh.15 representing a decrease of 12.5%

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 Advanced Financial Management

Therefore:
10 a + (1-a) -12.5 = 9
10 a – 12.5 + 12.5 a = 9
22.5 a = 12.5
a = 0.56
Thus:
(0.56 x Sh.7) + (1-0.52) Sh.0 = value of call after one year
3.92 = value of call after one year
3.92 (1.09)-1 = value of call today

3.6 = the value of call today

QUESTION FOUR
(a) Explain the following methods of company restructuring and state the circumstances under which
each is appropriate:

(i) Sell-offs. (2 marks)

(ii) Carve-outs. (2 marks)
(iii) Spin-offs. (2 marks)

(b) Shuka Ltd., a company that manufactures mobile communication gadgets, intends to acquire
Panda Ltd. which is involved in developing communication and networking software.

The following financial information is provided for the two companies:

Shuka Ltd. Panda Ltd.
Current share price Sh.5.80 Sh.2.40
Number of issued shares 210 million 200 million
Equity beta 1.2 1.2
Asset beta 0.9 1.2
Free cash flow to the combined company will be Sh.216 million in current value terms and this
will increase by an annual growth rate of 5% for the next four years before reverting to an annual
growth rate of 2.25% in perpetuity.

The combined operations of the companies will result in cash savings of Sh.20 million per year
for the next four years.

The debt to equity ratio of the combined company will be 4:6 in market value terms and it is
expected that the combined company’s cost of debt will be 4.55%.

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Corporation tax of 30% applies to the company. The current risk-free rate is 2% and the market
risk premium is 7%. It can be assumed that the combined company’s asset beta is the weighted
average of the respective companies’ asset betas.

Required:
Estimate the additional equity value created by combining the two companies based on free cash
flows. (14 marks)
(Total: 20 marks)

Suggested solution
(a) (i) Sell-offs: This is a time of divestment that involves a company selling a part of
its business to a third party. It is most appropriate when the company needs to
concentrate with their core business or rather the sold off divisions are loss
makers. Once sold, the company is able to realize reverse synergy.

(ii) Carve-outs: This is a method of divestiture involving a company selling some

equity while still maintaining a proportion to itself. More appropriate where the
company needs to finally sell-off but is unable to locate one buyer of the shares
or rather, where the company needs to continue enjoying an interest but still
needs to sell of the division.

(iii) Spin-off: Where the company creates a new company from the existing single
entity, its called spin-off. The spin off company would be usually created as a
subsidiary. Hence, there is no change in ownership.

(b) Shuka Ltd and Panda Ltd

Step 1
Computation of the combined company asset beta
Equity value of Shuka Ltd (210 m x 5.80) 1,218 m……71.7%
Equity value of Panda Ltd (200 m x 2.40) 480 m……..28.3%
Total combined value 1,698 m …..100%

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Weighted average asset beta

(0.717 x 0.9) + (0.283 x 1.2) = 0.985
Step 2
Computation of the combined company’s Geared beta

Beg = Bug 1  (1  T ) D 

 E

Beg =0.985 x 1+ 0.7 x 4 /6

Beg = 1.44

Step 3
Computation of combined company’s cost of equity

Ke = Rf + Be (Rm –Rf)

Ke = 2 + 1.44 (7)

Ke = 12.1%

Step 4
Computation of the combined company’s WACC

Wacc = 9.08 approx 9%

Step 5
Valuation of Pand Ltd using the Wacc obtained

(i) Free cash flows

Year Cash flows PVIF @9% P values
1 226.8 0.9174 208.07
2 238.14 0.8417 200.44
3 250 0.7722 193.05
4 262.55 0.7084 186.00
Totals 787.55

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Value after 4 years

Pv = 3,977.2

Discounting the value at 9% 4 years

3,977.2 x 0.7084 = 2,817.44

Total value of free cash flows

2,817.44 + 787.55 = 3,605

(ii) Cash savings

20 x PVAF9% 4 years

20 x 3.2397 = 64.8

(iii) Total value based on (i) and (ii) above

Sh.3,605 + Sh.64.8 = Sh.3,670

Therefore,
The additional equity value created equals.

Sh.3,670 m – Sh.1,698 m = Sh.1,972 m

QUESTION FIVE
(a) Explain how inflation rates could be used to forecast exchange rates. (6 marks)

(b) Assume that the spot exchange rate equals 100 Japanese Yen (¥) to one US dollar ($) and the six-
month forward rate equals 101 Japanese Yen (¥)) to one US dollar ($). An investor can purchase
a Treasury Bill in the United States that matures in six months time and earn an annual rate of
return of 3%.

Required:
The annual rate of return on a similar investment in Japan. (4 marks)

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(c) You have been provided with the following series of exchange rates for the United States (U.S.)
dollar ($), the Canadian dollar (C$) and the British pound (£).

$0.6000/C$ (C$1 .6667/$)

$l.2500 /£ (£0.8000/$)
C$2.500/£ (£0.4000/C$)

Assume that you have $1,000,000 in cash.

Required:
Demonstrate how you could take advantage of these exchange rates to obtain an arbitrage profit
(10 marks)
(Total: 20 marks)

Suggested solution
(a) How inflation rates can be used to forecast exchange rates.
This can be explained by applying the purchasing power parity theory which attempts to
explain changes in the exchange rate exclusively by the rate of inflation in different
countries. The theory predicts that exchange value of a foreign currency depends on the
relative purchasing power of each currency in its own country and that spot exchange
rates will vary over time according to the relative price changes.
i.e St = So x 1 + if
1 + ik
Where:
St = expected spot rate at time t
So = current lower foreign currency spot rate
if = the expected inflation in the foreign country to time t (expressed as a decimal)
ik = the expected inflation in the home country to time t (expressed as a decimal)
Where the rate of inflation is higher in one country than in another, the value of its
currency will tend to weaken against the other country’s currency. In the real world,
exchange rates moves towards purchasing power parity over a long period.

(b) Annual rate of return

R¥………..?
R$...............3/2 …….1.5% (for six months)
F¥ / $........Forward rate

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S¥ / $........Spot rate

Interest rate parity

1+R¥ = 1.02515

Therefore,
R¥ = 2.515%

(c) Triangular arbitrage

First convert the (dollars) $1,000,000 to (Pounds) at the exchange rate of ($1.2500) this
transaction will yield £800,000 i.e (1,000,000 /1.2500). Then converts the Pounds obtained to
Canadian Dollars C$ (exchange rate of C$2.500) i.e (800,000 x 2.500) which yields C$2,000,000.
Finally convert the Canadian Dollars back again into US Dollars to obtain $1,200,000.
$1,000,000 £800,000 C$2,000,000 $1,200,000

Arbitrage profit = $1,200,000 - $1,000,000 = $200,000

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