Advanced Financial May

Management 2016
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) In the context of appraisal of capital investments under conditions of uncertainty, explain
four limitations of utility analysis. (8 marks)

(b) 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 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 five year risk-free rate is 7%.

Required:
(i) The net present value (NPV) of the project including the option to abandon the
project. (10 marks)

(ii) Comment on the results of your analysis in (b) (i) above. (2 marks)

Note:
1. The black-Scholes Option Pricing Model

C = Pa N(d1) – Pe N(d2)e-rf

Where:

[ ]
√

√
2. The put-call parity relationship

P= C – Pa + Pe e -rf

(Total: 20 marks)

Suggested solution
(a) Limitations of utility analysis.
 The analysis applies at a specific one point in time only. Where circumstances keep changing, it
fails.
 Where it involves a group of investors having different risk attitudes, it is difficult to determine a
utility function.
 Where there are expected conflicts of interests between shareholders and management, it
becomes impossible to develop a collective utility function.

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 Advanced Financial Management

 It suffers the problem of measurement especially since it is much attached to qualitative factors.
Its difficult to perfectly determine the utility relating to an individual.

(b) Planet Ltd

Pa = Sh.254 m
Pe = Sh.150 m
rf = 0.07 or 7%
t = 5 years
σ = √0.09 or 0.3

[ ]
√

[ ]
√

d1= 0.5267 + 0.575

0.67082

d1= 1.64

d2 = 1.64 – 0.67082
d2 = 0.97

Using the normal distribution tables

Nd1 = 0.5 + 0.4495
Nd1 =0.9495
Nd2 = 0.5 + 0.3340
Nd2 = 0.8340
C = Pa N(d1) – Pe N(d2)e-rf

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 Advanced Financial Management

C = (254 x 0.9495) – (150 x 0.8340 x 2.7183(-0.07x5) )

C = 241.173 – 88.156
C = 153 m

P= C – Pa + Pe e -rf
P= 153 – 254 + 150 x 2.7183-0.07x5
P = 4.7 m

Therefore,
Basic NPV (254m – 250m) Sh.4 m
Value of abandonment option Sh.4.7 m
Strategic NPV Sh.8.7 m

(ii) Planet Ltd should invest in this project and exercise the option to abandon it after 5 years
to enhance the NPV.

QUESTION TWO
(a) 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. (4 marks)

(ii) Explain the effect on the portfolio risk if the returns of stocks M and N were
perfectly positively correlated. Include suitable calculations. (6 marks)

(b) Mapeni Ltd.’s investment fund comprises four major projects. The details of the projects
are as follows:

Project Market value Expected Standard Coefficient of correlation

Of the fund (%) return (%) deviation (%) with the market
1 28 10 15 0.55
2. 17 18 20 0.75

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3. 31 15 14 0.84
4 24 13 18 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. (4 marks)

(ii) By comparing the expected return and the required return, advise whether Mapeni
Ltd. should change the composition of its portfolio. (6 marks)
(Total: 20 marks)

Suggested solution
(a) Biashara Ltd
(i) Expected portfolio return
Rp =(WmRm) +(WnRn)

Wm =1,200,000 / 2,000,000
Wm = 0.6 0r 60%

Wn = (1-W
Wn = 0.4 0r 40%

Rp = (0.6x18) +(0.4x16)
Rp = 17.2%

(ii) So long as the correlation coefficient between two securities is perfectly positive, there
can never be any risk reduction through portfolio formation. Portfolio risk remains to be
the average risk of the securities.
Variance of the portfolio =
Portfolio variance = 51.84
Portfolio std deviation =√51.84 = 7.2

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The weighted average std deviation

σp =Wmσm +Wnσn
σp = (0.6 x 8)+(0.4 x 6)
σp =7.2

This proves that the risk will remain the weighted average risk

(b) Mapeni Investment fund

(i) Beta of the fund
Steps:
1. Compute the beta for each project
2. Using the weights provided determine the weighted average
Beta
Bj=Corjm σj
Weights (wi) σm WiBi
1 0.28 0.635 0.18
2 0.17 1.154 0.20
3 0.31 0.905 0.28
4 0.24 0.858 0.21
0.86
(ii) Advise

Expected returns Required returns (%)

Bj Erj (%) Rj=Rf+Bj(Rm-Rf) Decision
1 0.635 10 10.71 Reject
2 1.154 18 15.38 Accept
3 0.905 15 13.14 Accept
4 0.858 13 12.73 Accept

Mapeni Ltd should therefore maintain projects 2,3 and 4 in their portfolio and sell
asset 1

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QUESTION THREE
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 Internal rate

Investment of return (%)
Sh. “million”
A 8 26
B 7 16
C 9 20
D 6 22

Additional information:
1. The company had Sh.9 million available from retained earnings as at 1 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.) 4.5 4.8 4.9 5.2 5.5 6.0
DPS (Sh.) 2.5 2.8 2.9 3.0 3.2 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 follows:
(%)
Equity capital 45
Preference share capital 30
Debenture capital 25
100
7. The corporation 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. (2 marks)

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(b) The weighted marginal cost of capital (WMCC) for each of the 3 ranges of levels of total
financing as determined in (a) above. (10 marks)

(c) (i) Advise Mavuno Ltd on the project(s) to undertake assuming that the projects are
divisible. (6 marks)

(ii) Determine the optimal capital budget. (2 marks)

(Total: 20 marks)

Suggested solution
(a) The levels of total new financing at which breaks occur in the weighted marginal cost of
capital (WMCC) curve.
Break point due to exhaustion of debt up-to Sh.4,000,000.
Sh.4,000,000 / 25% = Sh.16,000,000……..Break-point 1

Break point due to exhaustion of retained earnings up-to Sh.9,000,000.

Sh.9,000,000 / 45% = Sh.20,000,000……. Break-point 2

(b) The weighted marginal cost of capital (WMCC) for each of the 3 ranges of levels of total
financing as determined in (a) above.
Component costs
Equity (derived from the dividend valuation model)
Cost of retained earnings Kre = Do (1 + g) +g
Po
Cost of ordinary shares Ke = Do (1 + g) +g
Po -f

Note: where:
Do = Sh.3.50 f = floatation costs

√ g = growth rate in dividends

g = 7% (approx.) Po = current value of a share

Po = Sh.25.60 Do =dividends paid/ declared in the current
F = Sh.4.60 year

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Kre = 3.50 (1.07) + 0.07 = 0.2163 or 21.63%...........retained earnings

25.60

Ke = 3.50 (1.07) + 0.07 = 0.2483 or 24.83%...........ordinary shares

25.60-4.60

Cost of Debt

For debts up to 4m
Int = 9% of Sh.1,000 = Sh.90
Bo = 95% of Sh.1,000 = Sh.950
Kd = (90 / 950) x 100
Kd = 9.47%
9.47% (1-0.3) = 6.63%

For debts above 4m

Int = 12% of Sh.1,000 = Sh.120
Bo = 90% of Sh.1,000 = Sh.900
Kd = (120 / 900) x 100
Kd = 13.33%
13.33% (1-0.3) = 9.33%

Cost of preference shares

P div = 10% of Sh.80 = Sh.8

Po = Sh.80
Kp = (8 / 80) x 100
Kp = 10%

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Mcc computation
Mcc = (keWe) + (KpWp) +(KdWd)
Up to total financing of Sh.16 m
Mcc = (21.63% x 0.45) + (10% x 0.3) + (6.63% x 0.25)…………………………14.4%

for financing of between 16m and 20m

Mcc = (21.63% x 0.45) + (10% x 0.3) + (9.33% x 0.25)…………………………15.1%

For financing above Sh.20 m

Mcc = (24.83% x 0.45) + (10% x 0.3) + (9.33% x 0.25)…………………………16.5%

(c) (i) Advise to Mavuno Ltd on the project(s) to undertake.

Invest in projects A,D and C since they all plot above the Mcc curve

(ii) Capital budget.

Project cost
A 8m
D 6m
C 9m
Total 23m

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 Advanced Financial Management

QUESTION FOUR
(a) With reference to corporate valuation, describe the importance of enterprise value (EV)
(6 marks)
(b) 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.

Year after acquisition

Year 1 Year 2 Year 3
Sh. “000” Sh. “000” 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. (2 marks)

(ii) The weighted average cost of capital (WACC) for Huge Ltd. after the acquisition
of Tiny Ltd. (2 marks)

(iii) The offer price for Tiny Ltd. using a discounted cash flow (DCF) based valuation.
(10 marks)
(Total: 20 marks)

Suggested solution
(a) Importance of enterprise value (EV)
Investors invest in a firm only when they know its true value. The highest investment comes in
those companies that generate higher cash flows along with high enterprise value. Enterprise

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Value is very critical for the value investors who consider the value of a company beyond the
outstanding equity. Debt and cash have a huge impact in finding the correct valuation of a
company. Both the components do not form part of market capitalization to find the true value
of the company. Enterprise Value acknowledges such aspect and helps in finding the actual
valuations of the enterprise. To sum up, Enterprise Value helps the investors to know the
accurate value of the company and determine whether it is undervalued or not and helps in
comparison of companies having different capital structures. Thus, the actual value of the
company comprises of not only market capitalization but also the other components.

(b) (i) Huge Ltd and Tiny Ltd

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.

……………………………based on one share

………based on entire company’s shares

Making “Value of the firm” to be the subject

Value of the firm =P/E ratio x post tax earnings
Value of the firm = 8 x 86m
Value of the firm = Sh.688 m

(ii) WACC for Huge Ltd.

Ke = Rf +Be(Rm-Rf)
Ke = 6%+1.60(11% - 6%)
Ke = 14%

Kd(after tax) = 7.4(1-0.3)

Kd =5.18%

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Wacc = (kewe) + (Kdwd)

Wacc =(14 x 0.65) + (5.18 x 0.35)
Wacc = 10.913%

(iii) Using a discounted cash flow (DCF) based valuation.

Steps:
1. Compute free cash flows
2. Compute present value of these cash flows for the three years using the Wacc as
discount rate.
3. Using Gordon’s normal valuation method determine the PV of all future cash
flows (year 4 to infinite) at the end of three years subject to a growth rate of 4%
4. Discount further the value obtained in step 3 above to determine the PV of all
cash flows expected after year three.
5. Add the values obtained in step 2 and step 4 above.

Free cash flows

1 2 3
Sales "000" 200,000 280,000 320,000
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 (25,000) (30,000) (35,000)
Free cash flows 25,000 50,000 55,000

Free PVIF
Year cash flows @ 10.91% P values
1 25,000 0.9016 22,540.80
2 50,000 0.8129 40,647.01
3 55,000 0.7330 40,313.51
103,501.31

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= Sh.827,785.82

PV 0 years = Sh.827,78582 x 0.7330

PV 0 years = Sh.606,744.52
Value of the firm = 103,501.32 + 606,744.52
= 710,245.84 or 710.245 m

QUESTION FIVE
(a) Discuss four techniques that a company might use to hedge against the foreign exchange
risk involved in foreign trade. (8 marks)

(b) 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 months : Tsh.1,970,000
Payments due in 6 months : Tsh.4,470,000
Receipts due in 6 months : Tsh.1,540,000

The exchange rates in the Nairobi market are as follows:

Tsh./Ksh.
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
Borrowing Lending
Ksh. 12.5% 9.5%
Tsh. 9% 6%

Required:
The net Kenya shillings 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. (6 marks)

(ii) Money market. (6 marks)

(Total: 20 marks)

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Suggested solution
(a) Techniques that a company might use to hedge against the foreign exchange risk involved in
foreign trade.
Matching assets and liabilities. A company which expects to receive a substantial amount of
income in a foreign currency will be concerned that this currency may weaken. it can hedge
against this possibility by borrowing in the foreign currency and using the foreign currency
receipts to repay the loan
Forward exchange contracts: In this case the importer or exporter arranges for a bank to sell or
buy a quantity of foreign currency at a future date, at a rate of exchange determined when the
forward contract is made. The forward contract allows a trader who knows that e will have to
buy or sell foreign currency at a date in future, to make the purchase or sale at a predetermined
rate of exchange.
Leading and lagging: this involve lead payments (payments in advance) or lagged payments
(delayed payments beyond their due date) in order to take advantage of foreign exchange rate
movements.
Matching receipts and payments: wherever possible, a company that expects to make payments
and have receipts in the same foreign currency should plan to offset its payments against its
receipts in the currency. this way, the company will not be concerned whether the currency
strengthens or weakens.
Futures and currency risk: standardized contract covering the sale or purchase at a set future
date of a set quantity of a commodity, financial investment or cash. a currency future is a future
contract to buy or sell currency.
Currency options: this is an agreement involving a right but not an obligation to buy or to sell a
certain amount of currency at a stated rate of exchange (the exercise price) at some time in the
future. the agreement therefore is not like a forward or a future contract which are binding to
both parties.

(b) Jasper Ltd

Steps:
1. Compute the forward rates by adding the premium to the spot rates
2 Compute the interest rates for 3 months and for 6 months

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Buy sell
Spot rate 17.106 17.140
3 month premium -0.0082 -0.0077
3 month forward 17.0978 17.1323

Buy sell
Spot rate 17.106 17.140
6 month premium -0.0139 -0.0134
6 month forward 17.0921 17.1266

Interst in 3 months Borrowing Lending

Ksh 3.13% 2.38%
Tsh 2.25% 1.50%

Interst in 6 months Borrowing Lending

Ksh 6.25% 4.75%
Tsh 4.50% 3.00%

(i) Using forward market

(a) 3 months
Payment Ksh.116,000 Ksh.116,000
Receipt Tsh.1,970,000 / 17.91 Ksh.114,987.48
Net payment Ksh.1,012.52
(b) 6 months
Payment Tsh.4,470,000 / 17.0921 Ksh.261,524.33
Receipt Tsh. 1,540,000 / 17.1266 Ksh.89,918.61
Net payment Ksh.171,605.72

(ii) Using the money market

(a) 3 months
Payment of Ksh.116,000 Ksh.116,000
Receipt of Tsh.1,970,000

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Borrow (Tsh.1,970,000 / 1.0225) =Tsh.1,926,650.37

Convert immediately to Ksh.112,406.67. i.e (Tsh.1,926,650.37 / 17.140)
Invest Ksh.112,406.67 in Kenya for 3 months at 2.375% to get Ksh.115,076.33
Net payment = Ksh.115,076.33 – Ksh.116,000 = (Ksh.923.67)
i

(b) 6 months
Payment of Tsh.4,470,000
Borrow (Tsh.4,339,805.83 / 17.140) =Ksh.253,197.54 in Kenya today
Note: The Tsh.4,339,805.83 is the amount required to be invested in Tanzania
today at the rate of 3% for 6 months to earn Tsh.4,470,000 needed in 6 months.
Convert immediately to Tsh.4,339,805.83. i.e (Ksh.253.197.54 x 17.140)
Invest Tsh.4,339,805.83 in Tanzania for 6 months at 3% to get Ksh.4,470,000
and pay.
Note: The Kenyan loan will mature to Ksh.269,022.39 i.e (253,197.54 x 1.0475)
Receipt of Tsh.1,540,000
Borrow (Tsh.1,540,000 / 1.045) =Tsh.1,473,684.21
Convert immediately to Ksh.85,979.24. i.e (Tsh.1,473,684.21 / 17.140)
Invest Ksh.85,979.24 in Kenya for 6 months at 4.75% to get Ksh.90,063.26
Net payment = Ksh.269,022.39 – Ksh.90,063.27 = (Ksh.178,959.13)
Note: There is no mention that the company can first hedge using the netting (Cancelling
foreign receipts against foreign payments) approach. This explains why we dealt with
each transaction independently

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