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CPA
Advanced Leval
Advanced Financial Management May 2017
Suggested solutions

Advanced Financial Management
Revision Kit

QUESTION 1(a)

Q ➢ Ways in which corporate social responsibility (CSR) activities might enhance the value of a firm
A

Solution


➧ Enhanced Brand Reputation:

Engaging in CSR activities helps build a positive brand image and reputation. When a company is perceived as socially responsible and committed to making a positive impact, it can attract customers, investors, and other stakeholders who value ethical and responsible business practices. This can lead to increased brand loyalty and preference, ultimately translating into higher sales and market share.

➧ Stakeholder Engagement and Relationships:

CSR activities demonstrate a company's commitment to its stakeholders, including employees, customers, suppliers, and local communities. By addressing social and environmental concerns, companies can foster stronger relationships with these stakeholders. This can lead to increased employee satisfaction, customer loyalty, and supplier partnerships, creating a supportive ecosystem that enhances the firm's value.

➧ Risk Management and Mitigation:

CSR activities can help manage and mitigate risks. By proactively addressing environmental, social, and governance (ESG) issues, companies can reduce the likelihood of negative incidents, regulatory compliance issues, and reputational damage. Effective risk management improves long-term stability, resilience, and value creation.

➧ Access to Capital and Investment Opportunities:

Investors are increasingly considering ESG factors when making investment decisions. Engaging in CSR activities can attract socially responsible investors who prioritize companies with strong ESG performance. This can provide access to a wider pool of capital and investment opportunities, potentially resulting in lower financing costs and increased financial performance.

➧ Innovation and Operational Efficiency:

CSR initiatives often drive innovation and operational efficiency. For example, companies investing in sustainable technologies or energy-efficient practices can reduce costs, enhance productivity, and gain a competitive advantage. Embracing CSR as part of the company's culture can foster a culture of innovation, attracting talent and enabling continuous improvement.

➧ Employee Attraction and Retention:

Companies that demonstrate a commitment to CSR can attract and retain top talent. Employees, particularly millennials and Gen Z, often seek purposeful work and want to be part of organizations that make a positive impact. CSR initiatives provide employees with a sense of purpose, leading to higher job satisfaction, improved productivity, and lower turnover rates.

➧ License to Operate:

CSR activities can help secure the social license to operate, especially in industries that have significant environmental or social impacts. By addressing stakeholder concerns and engaging in dialogue with local communities, companies can build trust, mitigate opposition, and maintain a positive relationship with key stakeholders. This can support long-term business continuity and value creation

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QUESTION 1(b)(i)

Q The amounts in shillings at which breaks in the marginal cost of capital (MCC) schedule occur.
A

Solution


Retained earnings:

40/100 X 2,500,000

= 1,000,000.

Breakpoint retained earnings:

1,000,000 / 0.55

= 1,818,181.82

Breakpoint loans

Breakpoint 0 - 500,000 = 500,000 / 0.45

= 1,111,111.11

Breakpoint loans = 500,000 - 900,000

900,000 / 0.45

2,000,000

Breakpoint loans greater than 900,000

∞ / 0.45 = ∞

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QUESTION 1(b)(ii)

Q The weighted marginal cost of capital (WMCC) in each of the intervals between the breaks in the MCC schedule.
A

Solution


Cost of retained earnings(Kr )
Kr
=
Do(1 + g)
Po
+
g x 100%


2.2(1.05) / 22 + 0.05 x 100% = 15.5%

Cost of ordinary shares(Ke)

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


Ke
=
2.2(1.05)
22 - (10 / 100 x 22)
+
0.05 x 100%


16.67%

Cost of loans()

= I(1 - T)

Cost of loans 0 - 500,000
= 9% (1 - 0.3) = 6.3%
Cost of loans 500,000 - 9000,000
= 11% (1 - 0.3) = 7.7%
Cost of loans 900,000 and above

13%(1 - 0.3) = 9.1%

Range Equity
55%		 Debt
45%		 Weighed marginal cost of capital
0 - 1,111,111.11 15.5% 6.3% (0.55 x 15.5) + (0.45 x 6.3) = 11.36%
1,111,111.11 - 1,818,181.82 15.5% 7.7% (0.55 x 15.5) + (0.45 x 7.7) = 11.99%
1,818,181.82 - 2,000,000 16.67 7.7% (0.55 x 16.67) + (0.45 x 7.7) = 12.63%
2,000,000 & above 16.67 9.1% (0.55 x 16.67) + (0.45 x 9.1) = 13.26


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QUESTION 1(b)(iii)

Q The internal rate of return (IRR) for project A and project C.
A

Solution


Discount rate estimate project A

675,000 / 155,401 = 4.3436

Anmunity factor of 4.3436 for 8 years discount rate 16%. So internal rate of return for project A is 16%

Discount rate estimate project C

375,000 / 161,524 = 2.316
Present value interest factor annuity of 2.3216 for 3 years discount rate 14%. So internal rate of return for project c is 14%


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QUESTION 1(b)(iv)

Q Using the investment opportunities schedule (IOS), advise on which project(s) should be accepted.
A

Solution


Projects A, B, and C should be accepted since their internal rate of return exceeds the highest weighted marginal cost of capital, which is 13.26%.

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QUESTION 2(a)

Q ➢ Factors responsible for financial distress in a firm
A

Solution




➧ Poor Financial Management:

Inadequate financial management practices, such as inefficient budgeting, lack of cost control, or improper cash flow management, can lead to financial difficulties over time.

➧ High Debt Levels:

Excessive debt or leveraging can strain a firm's financial health, especially if the company is unable to generate sufficient cash flows to service the debt obligations. This can lead to increased interest payments, potential defaults, or credit rating downgrades.

➧ Declining Revenue and Profitability:

A sustained decline in revenue and profitability can erode a firm's financial stability. Factors such as market downturns, competitive pressures, changing consumer preferences, or ineffective business strategies can contribute to a decline in financial performance.

➧ Ineffective Cost Structure:

Inefficient cost structures, including high operating expenses, inefficient production processes, or poor supply chain management, can lead to reduced margins and financial strain.

➧ Inadequate Risk Management:

Firms that fail to identify and manage financial risks effectively may face unexpected events, such as economic downturns, fluctuations in interest or exchange rates, commodity price volatility, or natural disasters, which can impact their financial stability.

➧ Industry and Market Factors:

Adverse conditions specific to an industry or market, such as increased competition, regulatory changes, disruptive technologies, or shifts in consumer demand, can significantly impact a firm's financial position.

➧ Poor Corporate Governance:

Weak corporate governance practices, lack of transparency, unethical behavior, or mismanagement can erode investor confidence, leading to a loss of financing opportunities and difficulty in attracting and retaining key stakeholders.

➧ Legal and Regulatory Issues:

Legal disputes, regulatory non-compliance, fines, penalties, or litigation expenses can impose financial burdens on a company, affecting its financial health and reputation.

➧ Macro-Economic Factors:

Broader economic conditions, such as recessions, inflation, interest rate fluctuations, or geopolitical events, can influence a firm's financial stability and ability to generate revenues and profits.

➧ External Financing Challenges:

Difficulty in accessing capital markets, tight credit conditions, or limited availability of external financing options can restrict a firm's ability to fund operations, investments, or debt obligations, leading to financial distress.

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QUESTION 2b(i)

Q Sharpe's method.
A

Solution


Sharpes Method
=
Return on security - Risk free rate
Standard deviation


Portfolio P
=
18.6 - 9
27
= 0.36


Portfolio Q
=
14.8 - 9
18
= 0.32


Portfolio R
=
15.1 - 9
8
= 0.76


Portfolio S
=
22 - 9
21.2
= 0.61


Portfolio T
=
-9 - 9
4
= -4.5


Portfolio U
=
26.5 - 9
19.3
= 0.91


Portfolio Sharpes Ratio Rank
P 0.36 3
Q 0.32 4
R 0.76 1
S 0.61 2
U -4.50 5


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QUESTION 2(b)(ii)

Q Treynor's method.
A

Solution


Beta coefficient
=
Standard deviation x Cprrelation with marks return
Standard deviation market


Project P = 27 / 12 x 0.81 = 1.82
Project Q = 18 / 12 × 0.65 = 0.98
Project R = 8 / 12 x 0.98 = 0.65
Project S = 21.2 / 12 x 0.75 = 1.33
Project T = 4 / 12 x 0.45 = 0.15
Project U = 19.3 / 12 x 0.63 = 1.01


Treynors Ratio
=
Return on security - Risk free rate
Beta coefficient


Rank
Portfolio P
=
18.6 - 9
1.82
= 5.27
 5
Portfolio Q
=
14.8 - 9
0.98
= 5.92
 4
Portfolio R
=
15.1 - 9
0.65
= 9.38
 3
Portfolio S
=
22 - 9
1.33
= 9.77
 2
Portfolio T
=
-9 - 9
0.15
= -120
 6
Portfolio U
=
26.5 - 9
1.01
=17.33
 1


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QUESTION 2(c)

Q Compare the rankings using the two methods in (b) above and explain two reasons behind the differences.
A

Solution


➢ The Sharpe measure incorporates the overall risk of an investment, represented by the standard deviation, while the Treynor measure focuses on the systematic risk, represented by the beta coefficient.

➢ Portfolio R being surpassed by portfolio S in Treynor's ranking is attributed to the impact of correlation between assets.

➢ Treynor's measure tends to decrease with higher correlation coefficients.

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QUESTION 3a

Q ➢ Defensive strategies in a hostile take over
A

Solution


1. Stock repurchase

A stock repurchase, also known as a self-tender offer, refers to the act of a company purchasing its own shares from its shareholders. This strategy has proven to be an effective defense mechanism and has been successfully utilized in notable antitakeover defense cases such as Unocal Corp. v. Mesa Petroleum Co.

2. Poison pill

A poison pill, also known as a shareholder rights plan, involves the distribution of rights to the target's shareholders, enabling them to purchase shares of the target or the acquiring company at a significantly reduced price. The activation of these rights is triggered when an acquiring entity reaches a certain percentage of the target's shareholding. If exercised, these rights can greatly dilute the acquiring entity's shareholding, acting as a deterrent to a hostile takeover. The poison pill is considered one of the most potent defenses against such takeovers.

There are different types of poison pills, including flip-in, flip-over, dead hand, and slow/no hand pills. A flip-in poison pill can be "chewable," meaning that shareholders have the ability to vote for pill redemption within a specified timeframe if the tender offer involves an all-cash offer for all of the target's shares. The poison pill may also include a window of redemption, which determines the period during which management can redeem the pill.

A "dead hand" pill establishes a group of continuing directors, who are the only ones authorized to redeem the pill if an acquirer threatens to acquire the target. While earlier court decisions limited the use of dead hand and no hand pills, more recent rulings have upheld their validity.

A "no hand" (or "slow hand") pill prohibits the redemption of the pill for a specific period, such as six months.

3. Staggered board

A staggered board is a type of hostile takeover defense strategy employed by a company. It involves dividing the board of directors into different classes, each serving different term lengths. As a result, only a portion of the board stands for election each year. This staggered board structure makes it more difficult for hostile acquirers to gain control of the board in a single proxy contest. By extending the timeline required to gain full control, a staggered board can act as a deterrent against hostile takeovers.

4. Shark repellants

Shark repellants refer to specific provisions within a target company's charter or bylaws that discourage the attractiveness of a hostile takeover. This defense mechanism often entails the imposition of a supermajority vote requirement for a merger between the target company and its majority shareholder. Additionally, this defense includes other provisions within the target's certificate of incorporation or bylaws that serve as deterrents against takeovers.

5. Golden parachutes

Golden parachutes are a type of defense mechanism employed by a target company in response to a hostile takeover attempt. They involve offering lucrative financial benefits and compensation packages to top executives and key management personnel in the event of their termination or change in control resulting from a successful acquisition. By providing these attractive severance packages, golden parachutes aim to incentivize management to resist the hostile takeover and potentially negotiate for a higher price or more favorable terms. Golden parachutes can act as a deterrent by increasing the cost and complexity of the acquisition, potentially dissuading hostile acquirers from pursuing the takeover or encouraging them to negotiate with the target company's management.

6. Greenmail

Greenmail is a defensive strategy utilized by a target company to ward off a hostile takeover attempt. It involves the target company repurchasing its own shares from the hostile acquirer at a premium price above the prevailing market value. By buying back these shares at an inflated price, the target company aims to dissuade the acquirer from continuing with the takeover and instead convinces them to abandon their pursuit of control. The payment of greenmail essentially serves as a financial incentive to persuade the hostile acquirer to sell their stake back to the target company. This defense mechanism increases the cost of the takeover and can deter hostile acquirers by making the acquisition financially less attractive or unfeasible.

7. Standstill agreement

Standstill agreement is an undertaking by the acquirer not to acquire any more shares of the target within certain period of time. A standstill agreement is an additional defense that usually accompanies the greenmail described above.

8. Leveraged recapitalization

Leveraged recapitalization (aka corporate restructuring) is a series of transactions designed to affect the equity and debt structure of a corporation. Recapitalization usually involves such transactions as :

(i) sale of assets,
(ii) issuance of debt, and
(iii) distribution of dividends.


9. Leveraged buyout

Leveraged buyout is a purchase of the target by the management with the use of debt financing. This defense burdens the target with the debt. In such a case, the management becomes a bidder and competes with a hostile acquirer for control over the target.

10. Crown jewels

Crown jewels, in the context of a hostile takeover defense, refers to the strategic assets or valuable components of a target company that are safeguarded to make an acquisition less desirable or challenging for the hostile acquirer. This defense strategy involves identifying and protecting the most valuable and critical assets of the target company to prevent their acquisition or control by the hostile party.

The crown jewels defense can take various forms, such as placing these key assets in separate entities, implementing legal barriers or restrictions on their transfer, or making them subject to complex licensing or contractual arrangements. By protecting the crown jewels, the target company aims to deter the hostile acquirer, as the loss or control of these valuable assets could significantly diminish the value or potential of the acquisition.

This defense strategy can make the acquisition more complex, costly, or less appealing to the hostile acquirer. It signals to potential acquirers that key assets are off-limits or that acquiring them would require significant negotiations and concessions. The crown jewels defense is intended to protect the long-term interests and value of the target company and its shareholders.

11. Scorched earth

Scorched earth is a defensive strategy employed by a target company to deter a hostile takeover attempt. It involves implementing aggressive tactics that significantly devalue the target company or make it less desirable to the acquiring party. The purpose of scorched earth tactics is to make the acquisition financially unattractive or operationally difficult for the hostile acquirer.

Examples of scorched earth defenses include selling off valuable assets, incurring excessive debt, implementing aggressive cost-cutting measures, initiating lawsuits, or making long-term commitments that bind the target company even after a potential acquisition. These actions can diminish the target company's value, increase its liabilities, create legal complications, or hinder its future prospects.

The scorched earth strategy aims to discourage the hostile acquirer by making the takeover less advantageous or more challenging. However, it should be noted that scorched earth tactics can also negatively impact the target company's shareholders and overall business stability in the long term.

12. Lockups

Lockups are defensive mechanisms in friendly mergers and acquisitions designed to deter hostile bids.
The lockups include:

(i) no-shop covenant,
(ii) termination/bust-up fee,
(iii) option to buy a subsidiary,
(iv) expense reimbursement etc.


13. Pacman

Pacman, also known as a "defensive Pacman," is a defensive tactic employed by a target company to counter a hostile takeover attempt. It involves the target company turning the tables on the acquirer by launching a counter-bid to acquire the would-be acquirer. In essence, the target company attempts to "eat" or acquire the hostile acquirer.

The Pacman defense is a proactive strategy that seeks to disrupt the hostile takeover by shifting the balance of power and control. By launching a counter-bid, the target company forces the hostile acquirer to defend itself and potentially reconsider its takeover plans.

The Pacman defense can create uncertainty and complicate the acquisition process, making it more challenging and costly for the hostile acquirer. It also sends a message to the market that the target company is willing to fight back and maintain its independence.

However, it's important to note that the Pacman defense can involve significant financial resources and may not always be feasible or successful in deterring the hostile takeover. It is just one of several defensive tactics that target companies may employ in their efforts to resist an unwelcome acquisition.

14. White knight

A white knight refers to a strategic merger that occurs without a change of control, relieving the management of the target company from the obligation to seek the highest available price. A notable example of this strategy can be seen in the case of Paramount Communications, Inc. v. Time Inc..

15. White squire

A white squire refers to the act of the target company granting a friendly party a certain ownership stake in the company. This defense mechanism proves effective in preventing the hostile party from gaining complete control over the target company and potentially "freezing out" minority shareholders.

16. Change of control provisions

Change of control provisions is target’s contractual arrangements with third parties that burden the target in the case of a change in its control.

17. “Just say no”

The "just say no" approach involves the board of directors formulating and executing a long-term corporate strategy that allows them to outright reject any proposal from a potential acquirer unless the acquirer can demonstrate that their acquisition strategy aligns with that of the target company.

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QUESTION 3(b)(i)

Q The weighted average cost of capital (WACC) of both J Ltd. and V Ltd.
A

Solution


Cost of equity (Ke) = Risk free rate + Global equity risk premium x Beta

Kev = 3 + 1.85 x 4 = 10.4%
Kel= = 3 + 0.95 x 4 = 6.8%
Cost of debt = Default risk premium + Risk free rate

Κdν = 3 + 1.6 = 4.6%

Kdj = 3 + 3.0 = 6.0%

After tax cost of debt = I(1 - t)
Kdv = 4.6(1 - 0.3) = 3.22%
Kdj = 6(1 - 0.3)= 4.20%
Value of firm (V) = E + D
Vv = 6.60 + 19.80 = 26.4 billion

V₁ = 11.60 + 13.40 = 25 billion

Weighted average cost of capital

WACC = ke - (Ke - Kd)D / E

WACCv = 10.4 - (10.4 - 3.22)6.6 / 26.4

= 10.4 - 1.795 = 8.605%

WACCj = 6.8 - (6.8 - 4.2)11.60 / 25.00

6.8 - 1.2064 = 5.5936%


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QUESTION 3b(ii)

Q The current value of both J Ltd. and V Ltd.
A

Solution


Share options exercisable at end of 3 years for V ltd

50.80 milion x (1 - 0.05)3 x (1 - 0.2)

34.84372 million shares option.

Total value options = (Intrinsic value + time value) x no of options

Intrinsic value = (Actual price - exercise price)

Actual price = Market value equity/Shares issued

19,800 / 680 = Shs. 29.12

Intrinsic value = 29.12 - 22

Sh. 7.12 per option

Total option value = (7.12 + 7.31) 34.84372

502.794796 Million

Value of V
=
Freecash flows (1 + g)
r - g
-
Total option value


=
900(1.05)
0.8605 - 0.05
-
502.7948796


26,213.59 - 502.79

Sh. 25,710.80 million.

Value of J
=
Freecash flows (1 + g)
r - g
-
Total option Value


Value of J
=
410(1.04)
0.055936 - 0.04
-
860 million


26,757.03 million - 860 million = Sh 25,897.03 million


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QUESTION 4(a)

Q Functions of the African Development Bank
A

Solution


The African Development Bank (AfDB) is a regional development bank that aims to promote sustainable economic growth and poverty reduction in Africa.

The bank has several key functions, including:

➧ Financial Intermediation: The AfDB provides financial resources to its member countries in the form of loans, grants, and equity investments. It mobilizes funds from various sources, including capital markets, donor countries, and other financial institutions, to support development projects and programs in Africa.

➧ Project Financing: The bank supports infrastructure development, such as transportation, energy, water supply, and telecommunications, by financing specific projects. It provides loans and technical assistance to governments and private sector entities to help fund and implement these projects.

➧ Policy Advice and Technical Assistance: The AfDB offers policy advice and technical assistance to member countries to help them develop and implement effective development strategies. This can include support in areas such as economic policy formulation, institutional capacity building, governance reforms, and project preparation.

➧ Regional Integration: The AfDB plays a crucial role in promoting regional integration within Africa. It supports initiatives aimed at enhancing trade, investment, and cooperation among African countries. The bank provides financing for regional infrastructure projects, such as cross-border transportation networks, energy interconnections, and regional trade facilitation programs.

➧ Private Sector Development: Recognizing the importance of the private sector in driving economic growth, the AfDB actively promotes private sector development in Africa. It provides financing and advisory services to private enterprises, including small and medium-sized enterprises (SMEs), to stimulate investment, entrepreneurship, and job creation.

➧ Knowledge Generation and Dissemination: The AfDB generates and disseminates knowledge on development issues in Africa. It conducts research, produces reports, and organizes conferences and seminars to share best practices, promote innovation, and build capacity among policymakers, practitioners, and other stakeholders.

➧ Partnership and Collaboration: The AfDB collaborates with various stakeholders, including other regional and international organizations, governments, civil society, and the private sector, to leverage resources and expertise for development in Africa. It actively seeks partnerships to enhance the effectiveness and impact of its interventions.

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QUESTION 4(b)(i)

Q Using the interest rate parity relationship, compute the expected 5-month forward exchange rate as at 31 May 2017.
A

Solution


12 months Kenya lending rate = 18%
5 months Kenya lending rate = ?

5 / 12 × 18% = 7.5%

12 months borrowing rate USA = 15%

5 months borrowing rate USA = ?

5 / 12 x 15% = 6.25%

Forward rate spotrate =
x
1 + interest home country
1 + interest foreign country
100 x 1.075 / 1.0625

100 × 1.0118

Shs. 101.18


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QUESTION 4(b)(ii)

Q Advise Biashara Ltd. on which is the better hedging strategy between a forward contract and a money market hedge.
A

Solution


Forward contract hedge

$1 = Kshs. 101.18
$140,000 = Kshs?

140,000 / 1 x 101.18

Shs. 14,165,200

Money market hedge

Borrow an amount equal the present value of $ 140,000 from USA

PV = $140,000 × (1 + 0.00625)-1
$140,000 x (1.0625)-1
$ 131,764.71

Convert amount borrowed to Kenyan shillings at the prevailing sport rate

$1 = Ksh 100
$ 131,764.718 = kshs?

131,764.71 × 100

Kshs. 13,176,471

Invest amount converted at prevailing spot rate amount will then grow to

13,176,471(1.075)

Kshs. 14,164,706.33

Since amount received under forward contract hedge is more than amount received under money market hedge, then forward contract hedge is the best option for Biashara limited.

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QUESTION 5(a)(i)

Q The maximum exchange ratio that A Ltd. should agree to if it expects no dilution in earnings per share.
A

Solution


Non diluting offer price

P / E predator x EPS target

40 / 3.5 x 1.5 = Shs.17.14

Maximum exchange ratio

Non-diluting offer price/Market price per share predator

17.14 / 40 = 0.4285

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QUESTION 5(a)(ii)

Q Total premium that the shareholders of B Ltd. would receive at the exchange ratio calculated in (a) (i) above..
A

Solution


New shares issued = Exchange ratio x Number of shares target

0.4285 x 2,000,000

857,143 shares

Total premium = (non diluting offer price - market price target) New shares issued .

(17.14 - 15) 857,143 = Shs. 1,834,286

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QUESTION 5(a)(iii)

Q A Ltd.'s post acquisition earnings per share, if the two companies settle on a price of Sh.20 per share.
A

Solution


Exchange ratio:= Offer price/ Market price per share Predator

20 / 40 = 0.5

New shares issued = Exchange ratio x number of shares target

= 0.5 × 2,000,000 = 1,000,000 shares

Post acquisition EPS A

(Earnings A + Earnings B) / (Number of shares A + new shares issued)

(35,000,000 + 3,000,000) / (10,000,000 + 1,000,000)

= Shs. 3.45

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QUESTION 5(a)(iv)

Q A Ltd.'s post-acquisition earnings per share if every 50 ordinary shares of B Ltd. were exchanged for one 8% debenture of a par value of Sh.1,000 each.
A

Solution


50 Ordinary shares B = 1 debenture A
2,000,000 ordinary shares B = ?

2,000,000 / 50 x 1 = 40,000 Debentures

Value of debentures

40,000 x 1,000 = 40,000,000

Debenture interest annually

8 / 100 x 40,000,000 = Shs. 3,200,00

After tax debenture interest

70 / 100 × 3,200,000 = Shs. 2,240,000

Post acquisition earnings per share A

(Combined earnings - After tax interest) / Number of shares predator

(35,000,000 + 3,000,000 - 2,240,000) / 10,000,000 = Sh.3.576

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QUESTION 5(b)

Q Advice to management of Chuma Ltd. on how frequently the machine should be replaced
A

Solution





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