ADVANCED FINANCIAL MANAGEMENT
CPA ADVANCED LEVEL
TUESDAY: 23 April 2024. Morning Paper. Time Allowed: 3 hours.
Answer ALL questions. Marks allocated to each question are shown at the end of the question. Show ALL your workings. Do NOT write anything on this paper.
QUESTION ONE
(a) Summarise FOUR causes of hard capital rationing as used in capital budgeting. (4 marks)
(b) Outline FOUR limitations of Treynor’s measure of portfolio performance. (4 marks)
(c) Kangaro Youth Sports Ltd. wishes to design a new sports bicycle. The company will have to invest Sh.100 million at the beginning of the first year for the design and model testing of the new bicycle.
The firm’s managers believe that there is an 80% probability that this phase will be successful and the project will continue.
If Phase 1 is not successful, the project will be abandoned with zero salvage value.
The next phase, if undertaken, would consist of making the molds and producing twenty prototype bicycles. This would cost Sh.400 million at the end of the first year. If this phase is successful, the firm would go into full scale production. If the phase is not successful, the molds and prototypes could be sold for Sh.150 million. The managers estimate that the probability that the bicycles will pass the test is 90% and that Phase 3 will be undertaken.
Phase 3 consists of changing over current production line to produce the new design. This would cost Sh.1,100 million in year 2.
If the economy is strong at this point, the net value of cash flows would be Sh.3,500 million, while if the economy is weak the net value of cash inflows would be Sh.2,600 million. Both net values of cash inflows will be realised at the end of year 3 and both states of the economy are equally likely.
The company’s cost of capital is 13%.
Required:
(i) Using a decision tree, determine the project’s expected net present value (ENPV). (5 marks)
(ii) Calculate the project’s standard deviation of expected net present value and comment on the result.
(4 marks)
(iii) Using the normal probability distribution, compute the probability that the project’s net present value will be at least Sh.80 million. (3 marks)
(Total: 20 marks)
QUESTION TWO
(a) Two assets, A and B are known to lie on the security market line (SML). Asset A has a beta of 0.5 and a risk premium of 4%. Asset B has an expected rate of return of 20% and a beta of 1.75.
You are considering the following securities which are available in the market:
Security Expected return (%) Beta
A 20 2.00
B 14 0.75
C 15 1.25
D 12 –0.25
E 31 3.25
(i) Determine the risk free rate of return. (2 marks)
(ii) Calculate the required rate of return of each security. (4 marks)
(iii) Identify which security is undervalued, overvalued or correctly valued. (2 marks)
(b) Cosmos Operators Ltd. have an optimal capital structure given as follows:
Sh.“000”
Ordinary share capital (Sh.20 par value each) 80,000
Reserves 20,000
16% debt (Sh.100 par value each) 40,000
10% preference share capital (Sh.30 per value each) 60,000
Additional information: 200,000
1. The firm is considering raising Sh.20 million for an expansion programme of which Sh.2,000,000 is expected to be raised from internal sources.
2. New ordinary shares will be issued at Sh.35 each. A floatation cost of Sh.5 per share issued will be incurred.
3. The firm’s most recent earnings per share (EPS) is Sh.3. The firm adopts 50% pay out ratio as its dividend policy. Dividends are expected to grow at a rate of 5% each year in a perpetuity.
4. New 10% irredeemable debentures will be issued at Sh.110 each. A floatation cost of Sh.10 per debenture will be incurred.
5. New 10% irredeemable preference shares will be issued at Sh.40 each.
6. Corporation tax rate is 30%.
Required:
(i) The retained earnings break point. (2 marks)
(ii) The number of new ordinary shares to be issued to raise the desired external equity. (2 marks)
(iii) The weighted marginal cost of capital (WMCC) in each of the intervals between the breakpoints.
(8 marks)
(Total: 20 marks)
QUESTION THREE
(a) Explain the following option trading strategies:
(i) Bull spread. (2 marks)
(ii) Bear spread. (2 marks)
(iii) Covered call. (2 marks)
(b) Duet Ltd. is considering a takeover bid for Small Ltd., another company in the same industry. Small Ltd. is expected to have earnings next year of Sh.129,000,000.
If Duet Ltd. acquires Small Ltd., the expected results from Small Ltd. will be as follows:
Year after acquisition
Year Year 1 Year 2 Year 3
Sh.“000” Sh.“000” Sh.“000”
Sales 300,000 420,000 480,000
Cash costs/expenses 180,000 240,000 270,000
Capital allowances 30,000 45,000 60,000
Interest charges 15,000 15,000 15,000
Cash flows to replace assets and finance growth
Additional information: 37,500 45,000 52,500
1. From year 4 onwards, it is expected that the annual cash flows from Small Ltd. will increase by 4% each year in perpetuity.
2. Tax is payable at the rate of 30%. Tax is paid in the same year it falls due.
3. If Duet Ltd. acquires Small Ltd., it estimates that gearing after the acquisition will be 35% (measured as the value of its debt capital as proportion of total equity plus debt).
4. The cost of debt is 7.4% before tax. Duet Ltd. has an equity beta of 1.60.
5. The risk free rate of return is 6% and the return on the market portfolio is 11%.
(i) The offer price for Small Ltd. assuming Duet Ltd. chooses to value Small Ltd. on a forward price earnings (P/E) multiple of 8 times. (2 marks)
(ii) The cost of capital of Duet Ltd. (4 marks)
(iii) Determine the offer price for Small Ltd. using discounted free cash flow (DCF) valuation method.
(8 marks)
(Total: 20 marks)
QUESTION FOUR
(a) Explain FOUR advantages of real estate investments. (4 marks)
(b) Jacob Ouma, a financial analyst, gathered the following financial information from the banking industry in Kenya. The interest rate on a one year Kenyan bank is 16%.
The interest rate on a one year foreign bank deposit is 22%.
Required:
(i) Compute the percentage change in the value of the foreign currency according to International Fisher Effect. (3 marks)
(ii) Given a spot rate of Tsh1 = Ksh. 6.06, calculate the forward rate of Tsh after one year. (2 marks)
(c) The following are the financial statements of Bobi Ltd. for the year ended 31 December 2023:
Bobi Limited
Statement of profit or loss for the year ended 31 December 2023:
Sh.“000”
Revenue 60,000
Cost of sales (35,000)
Gross profit 25,000
Operating expenses (10,000)
Operating profit 15,000
Finance cost (11,000)
Earnings before tax 4,000
Income tax expense (1,200)
Profit for the year 2,800
Bobi Limited
Statement of financial position as at 31 December 2023:
Sh. “000” Sh.“000”
Net tangible assets 126,000
Intangible assets 42,000
168,000
Current assets:
Inventory 48,000
Trade receivables 36,000
Bank balance 4,800 88,800
256,800
Financed by:
Equities and liabilities:
Equity:
480,000 preference shares (Sh.25 each) 12,000
500,000 ordinary shares (Sh.24 each) 12,000
Share premium 24,000
Retained earnings 16,800
64,800
Non-current liabilities:
Mortgage (20 years) 48,000
8% debentures 72,000 120,000
Total equity and reserve 184,800
Current liabilities:
Trade payables 12,000
Notes payable 60,000 72,000
Total liabilities and equity 256,800
Additional information:
1. The Z-score is to be calculated using the following formula: Z-score = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5
Where:
X1 = Working capital/Total assets X2 = Retained earnings/Total assets
X3 = Earnings before interest and tax/Total assets X4 = Market value of equity/Book value of debt X5 = Sales/Total assets
2. The current market price per share is Sh.42.
Required:
(i) The Z-score of Bobi Ltd. for the year ended 31 December 2023. (6 marks)
(ii) Interpret the meaning of Z-score obtained in (c) (i) above. (2 marks)
(iii) Outline THREE limitations of Z-score model. (3 marks)
(Total: 20 marks)
QUESTION FIVE
(a) Discuss THREE factors that distinguish between the cost of capital of a multinational corporation and the cost of capital of a domestic firm. (6 marks)
(b) In relation to financial risk management, explain FOUR advantages of plain vanilla currency swaps with monthly delivery compared with a strip of forward contracts. (4 marks)
(c) Kawaida Ltd. has Sh.3,000,000 in equity capital and Sh.1,000,000 in debt capital (at market values). The beta value of the equity is 1.126 and the beta of the debt capital is 0.
The risk free cost of capital is 5% and the market portfolio return is 11%. The tax rate is 30%.
Required:
(i) Calculate the current weighted average cost of capital (WACC). (3 marks)
(ii) Compute the asset beta for the company and explain what this means. (3 marks)
(iii) Calculate the equity beta, the cost of equity and the WACC would be if the company consisted of 60% equity and 40% debt. (4 marks)
(Total: 20 marks)
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