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CPA
Advanced Leval
Advanced Financial Management May 2016
Suggested solutions

Advanced Financial Management
Revision Kit

QUESTION 1(a)

Q In the context of appraisal of capital investments under conditions of uncertainty, explain four limitations of utility analysis
A

Solution


➫ The utility function is constrained to a single point in time, as the investor's preferences and satisfaction levels are subject to continual change.

➫ Defining a utility function for a group of individuals with diverse risk attitudes poses a challenge due to the inherent difficulty in capturing varied preferences within a cohesive numerical framework.

➫ In practical terms, utility is not easily quantifiable in numerical terms, deviating from the assumptions made by utility theory.

➫ Specifying utility functions becomes particularly challenging due to conflicts of interest between shareholders and managers, who often harbor distinct risk attitudes.

➫ The dynamic nature of investor preferences introduces complexity, as utility is subject to constant fluctuations over time.

➫ The intricacies of diverse risk attitudes among individuals within a group further complicate the accurate specification of utility functions.

➫ Utility, being inherently challenging to measure numerically, raises questions about the applicability of traditional utility theory in real-world scenarios.

➫ The conflict of interest between shareholders and managers, stemming from disparate risk attitudes, adds an additional layer of complexity to utility function specification.

➫ The assumption of numerical measurability of utility may oversimplify the multifaceted nature of individual preferences and satisfaction.

➫ In the context of utility theory, the challenge of specifying utility functions is compounded by the need to reconcile conflicting risk attitudes among stakeholders.

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QUESTION 1(b)(i)

Q The net present value (NPV) of the project including the option to abandon the project
A

Solution




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QUESTION 2(a)(i)

Q The expected portfolio return.
A

Solution


Weight
=
Amount invested in security
Total amount invested


Weight M
=
1,200,000
1,200,00 + 800,000
=
1,200,000
2,000,000


= 0.6

Weight N
=
800,000
2000,000
= 0.4


Portfolio return = 0.6 x 18 + 0.4 x 16

10.8 + 6.40

17.2%

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QUESTION 2(a)(ii)

Q Explain the effect on the portfolio risk if the returns of stocks M and N were perfectly positively correlated. Include suitable calculations.
A

Solution


Weighted portfolio risk = σwWw + σ NWN

(0.6 × 8) + (0.4 × 6)

4.8 + 2.4

7.2%

Actual portfolio risk = √w 2mσ 2m + w 2nσ 2n + 2w mw ncov m&n

√0.62 x 0.082 + 0.42 x 0.062 + 2 x 0.6 x 0.4 x 0.08 x 0.06 x 1

√0.002304 + 0.000576 + 0.002304 = 7.2%

Percentage risk reduction

=
Weight portfolio Risk - Actual portfolio Risk
Weighted portfolio Risk
x 100%


=
7.2 - 7.2
7.2
x 100% = 0%


There is no diversification for investing in stock m and stock n


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QUESTION 2b(i)

Q The beta coefficient of the investment fund.
A

Solution


Beta coefficient
=
Standard Deviation Security x Coefficient Correlation
Standard Deviation Market


Beta 1 = 15/13 x 0.55 = 0.63
Beta 2 = 20/13 x 0.75 = 1.15
Beta 3 = 14/13 x 0.84 = 0.90
Beta 4 = 18/13 x 0.62 = 0.86

Project Weight Beta Weight beta
1 0.28 0.63 0.1764
2 0.17 1.15 0.1955
3 0.31 0.90 0.2790
4 0.26 0.86 0.2064
Beta of investment fund 0.8573


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QUESTION 2(b)(ii)

Q By comparing the expected return and the required return, advise whether Mapeni Ltd. should change the composition of its portfolio.
A

Solution


Project Weight Beta Alpha Comment
1 10 5 + 0.63 x 9 = 10.67 -0.67 Overvalued
2 18 5 + 1.15 x 9 = 15.35 2.65 Undervalued
3 15 5 + 0.90 x 9 = 13.10 1.90 Undervalued
4 13 5 + 0.86 x 9 = 12.74 0.26 Undervalued


CAPM = Risk free rate + Beta(market risk premium)

Market risk premium = market return - risk free rate

14% - 5% = 9%

Mapeni Ltd should change the composition of portfolio. Mapeni should invest more in project 2, 3 and 4 .he should dispose off assets in project 1


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QUESTION 3(a)

Q The levels of total new financing at which breaks occur in the weighted marginal cost of capital (WMCC) curve.
A

Solution


Break point
=
Amount of financing
Proportion capital structure


Break point retained earnings = 9 million/0.45

Shs. 20 million.

Breakpoint first 4,000,000 debenture capital

4 million / 0.25

16 Million

Breakpoint of debenture amount above 4 million

∞ / 0.25 = ∞

Breakpoint of unlimited preference Share capital = ∞ / 0.30 = ∞

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QUESTION 3(b)

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

Solution


i) Cost of retained earnings(K r )

K r
=
Do(1 + g)
P o
+ g x 100%


g
=
[(
Newest dividend
Oldest dividend
)1/n - 1]
x 100%


[(3.5 / 2.5)⅕ - 1 ] x 100% = 6.96%

Cost of retained earnings

3.5(1.0696) / 25.6 + 0.0696 x 100%

21.58%

ii) Cost of new ordinary shares issued

Ke
=
Do(1+ g)
Po - F
+ g x 100%


=
3.5(1.0696)
25.60 - 4.60
+ 0.0696 x 100% = 24.79%


iii) Cost of preference share capital is 10% since issued at bar

iv) Cost of 9% irredeemable debenture

k d = I(1 - g) / Po x 100%

90(1 - 0.3) / 950 x 100% = 6.63%

v) Cost of 12% irredeemable debenture

k d = 120(1 - 0.3) / 900 x 100% = 9.33%

Range
"Millions"		 Cost of equity % Cost of preference
shares %		 Cost debt % Weighted Cost %
0 - 16 0.45 x 21.58 = 9.71 0.30 x 10 = 3 0.25 x 6.63 = 1.66 14.37
16 - 20 0.45 x 21.58 = 9.71 0.30 x 10 = 3 0.25 x 9.33 = 2.33 15.04
Over 20 0.45 x 24.79 = 11.16 0.30 x 10 = 3 0.25 x 9.33 = 2.33 16.49


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QUESTION 3(c)(i)

Q Advise Mavuno Limited on the project(s) to undertake assuming that the projects are divisible.
A

Solution


Given that the weighted marginal cost is highest at 16.49%, our criterion for project selection is to exclusively pursue projects with an internal rate of return surpassing this threshold. Consequently, we have chosen to embark on projects A, C, and D.

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QUESTION 3(c)(ii)

Q Determine the optimal capital budget.
A

Solution


Project Initial outlay million
A 8
C 9
D 6
23million

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QUESTION 4(a)

Q With reference to corporate valuation, describe the importance of enterprise value (EV).
A

Solution


In the scope of corporate valuation, the significance of enterprise value (EV) lies in its holistic representation of a company's overall worth. Unlike market capitalization, which focuses solely on equity, enterprise value encapsulates the entire company, incorporating not only equity but also the impact of debt, and adjustments for minority interests and associates. This makes EV a versatile metric, particularly beneficial for deriving ratios above the income statement interest line, such as EV/Sales, EV/EBITDA, and EV/EBIT.

The computation of enterprise value involves a comprehensive formula:


.

EV = Market Capitalization (all share classes) + Net Debt (and other liabilities, e.g., pension deficits) + Minority Interest − Associates (both fair value).


Enterprise value manifests in three distinct types:


➫ Total Enterprise Value: Reflecting the comprehensive value of all business activities.


➫ Operating Enterprise Value: Derived by subtracting the value of non-operating assets at market value from the total enterprise value.


➫ Core Enterprise Value: Computed by subtracting non-core assets from the total enterprise value, rendering core EV a more nuanced and subjective measure.


The multifaceted nature of enterprise value enhances its utility in evaluating a company's true financial standing and facilitates a more nuanced analysis beyond the limitations of market capitalization. This comprehensive approach, encompassing debt and adjustments for various interests, allows for a more accurate assessment of a company's valuation and financial health.

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QUESTION 4(b)(i)

Q 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.
A

Solution


Value = P/E multiple x Combined earnings
8 x 86 = Shs. 688 Million

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QUESTION 4(b)(ii)

Q The weighted average cost of capital (WACC) for Huge Ltd. after the acquisition of Tiny Ltd.
A

Solution


Cost of equity using capital asset pricing model

K e = R ƒ + B(R m - R ƒ)

6 + 1.6(11 - 6) = 14%

Kd =I(1 - t) = 7.4 (1 - 0.3) = 5.18%

Weighted average cost of capital

Ke - ( Ke- Kd)D / V

14 - (14 - 5.18)0.35

14 - 3.087 = 10.913%

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QUESTION 4(b)(iii)

Q The offer price for Tiny Ltd. using a discounted cash flow (DCF) based valuation.
A

Solution


Year 1
Sh."000" 		Year 2
Sh."000"		 Year 3
Sh."000"		 Year 4 to ∞
Sh."000"
Sales 200,000 280,000 320,000
Expenses (120,000) (160,000) (180,000)
Capital allowance (20,000) (30,000) (40,000)
Interest (10,000) (10,000) (10,000)
PBT 50,000 80,000 90,000
Less Tax(30%) (15,000) (24,000) (27,000)
PAT 35,000 56,000 63,000
Less:Retention (25,000) (30,000) (35,000)
Cash flows 10,000 26,000 28,000


Terminal cash flows
=
28,000(1.04)
0.10913 - 0.04
= 421,235.354


Offer price tiny limited

= (10,000,000 × 1.10913 -1 ) + (26,000,000 x 1.10913-2) + ((421,235.354 + 28,000) x 1.10913-3)

Sh.359,401,972.90


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QUESTION 5(a)

Q Discuss four techniques that a company might use to hedge against the foreign exchange risk involved in foreign trade.
A

Solution


Companies engaged in foreign trade often face foreign exchange (forex) risk due to fluctuations in currency values. To mitigate this risk, various hedging techniques can be employed. Here are some common strategies:

1. Forward Contracts:


A forward contract is an agreement to buy or sell a specific amount of currency at a future date at a predetermined exchange rate.
Helps companies lock in a future exchange rate, providing certainty about the cost or revenue in their base currency.


2. Futures Contracts:


Similar to forward contracts, futures contracts involve an agreement to buy or sell a specific currency at a predetermined price on a specified future date.
Traded on organized exchanges, futures contracts offer standardized terms and can be used for speculation or hedging.


3. Currency Options:


Currency options provide the right, but not the obligation, to buy or sell a specific amount of currency at a predetermined price within a specified time frame.
Offers flexibility; companies can choose whether to exercise the option based on market conditions.


4. Money Market Hedge:


Involves borrowing or lending in a foreign currency in the money markets to offset the impact of exchange rate movements.
Helps eliminate forex risk by creating an offsetting position in the money market.


5. Natural Hedging:


Adjusting the company's operating practices or structure to offset the impact of currency fluctuations.
Companies might match currency revenues with currency expenses or establish production facilities in the same currency zone as their major customers.


6. Netting:

Consolidating payables and receivables in each currency to reduce exposure.
By offsetting payable and receivable amounts in the same currency, companies can reduce the need for external hedging instruments.


7. Leading and Lagging:


Timing the payment or receipt of foreign currency invoices to capitalize on expected currency movements.
If a currency is expected to strengthen, a company might delay payments in that currency; if it's expected to weaken, the company might accelerate payments.


8. Cross-Currency Swaps:


Involves swapping cash flows in different currencies to manage exchange rate risk.
Companies can use swaps to convert debt payments or interest payments from one currency to another, aligning cash flows with their risk tolerance.


9. Risk Sharing with Counterparties:

Entering into agreements with suppliers or customers to share or absorb the impact of currency fluctuations.
Agreements can include pricing adjustments, cost-sharing mechanisms, or currency clauses to distribute risk.


10. Diversification:


Operating in multiple currencies or markets to spread and reduce risk.
By diversifying operations, a company can minimize the impact of adverse currency movements in one region.

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QUESTION 5(b)(i)

Q Forward foreign exchange market.
A

Solution


A) Hedging Tsh 1,970,000 3 months receipt

3 months forward rate = 17.140 -0.0077 = 17.1323

Tshs 17.1323 = 1 Kshs
Tshs 1,970,000 = ?

1,970,000 x 1 / 17.1323

Ksh. 114,987.4798

Net payment 3 months

=116,000 - 114,987.4748

Shs. 1,012.5252

b) Hedging net payment (4,470,000 - 1,540,000) =Tsh. 2,930,000

6 Month forward rate = 17.106 - 0.1139 = 17.0921

Tsh 17.0921 = 1 Ksh
Tshs.2,930,000 = ?

∴ 2,930,000 x 1 / 17.0921 = Sh. 171,424.2252

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QUESTION 5(d)

Q Money market.
A

Solution


A. 3 months Ths 1,970,000 receivable.

(i). Borrow present value of 1970 in interbank market

Tshs 1,970,000 [1 + (0.09 x 3 / 12)]-1

Tshs. 1,926,650.367

(ii). Convert borrowed amount to Ksh at prevailing sport rate

Tsh. 17.140 = 1 Ksh
Tshs.1926 650.367 = ?

1,926,650.367 x 1 / 17.140 = Kshs 112,406.6725

(iii). Invest above amount at 9.5% a Dover a 3 month period

112,406.6725 [1+ (0.095 × 3 / 12)]

Kshs. 112,406.6725 x 1.02375

Ksh. 115,076.331

B. Money market hedge Tsh.2,930,000 6 month payment

(i). invest present value of Tsh. 2,930,000 in Tanzania where the payment is to be made

Tsh 2,930,000 [1 + (0.06 x 6 / 12)]-1

Tshs. 2,930,000 × 0.9709 = Tsh. 2,844,660.194

(ii). Determination of amount you need to convert to above amount in Kshs.

Ths 17.106 = 1Kshs
Ths 2,844,660.194 = ?

2,844,660.194 x 1 / 17.106

ksh. 166,296.0478

(iii). Future amount of amount in step (ii) at 12.59% annualized over a 6 month period.

= 166,296.0478 [1 + (0.125 × 6 / 12)] =

= 166,296.0478 x 1.0625

= Kshs. 176,689.5508

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