Guaranteed

95.5% Pass Rate

CPA
Advanced Leval
Advanced Financial Management May 2018
Suggested solutions

Advanced Financial Management
Revision Kit

QUESTION 1a

Q Core attributes of an effective corporate governance system are:
A

Solution


Corporate governance

➦ Corporate governance is the set of regulations and guidelines that control a company's behavior, decision - making, and practice. This infrastructure is founded on four fundamental principles: accountability, fairness, transparency, and responsibility.

Accountability
➫ Accountability goes beyond right and wrongdoing or assigning blame. Businesses must be able to account for and explain every action and decision they make, and they must accept responsibility for the risks they face. This fosters trust among businesses, stakeholders, and shareholders, which is critical for retaining confidence and attracting investment.

Transparency
➫ The board should present shareholders and other stakeholders with timely, accurate, and clear information regarding financial performance, conflicts of interest, and hazards.

Fairness
➫ Fair and equal treatment in all dealings between managers, directors, and shareholders.

Responsibility
➫ The board is in charge of overseeing corporate affairs and management actions. It must be aware of, and support, the company's continued success.As the authoritative voice in charge of so many aspects of company, the board must handle their influence properly. Directors must always act ethically and in the best interests of all persons impacted by the business.

More info

QUESTION 1(b)

Q Limitations of sensitivity analysis:
A

Solution


Sensitivity analysis

➦ Sensitivity analysis is a technique for determining how changes in one or more input variables influence the output of a model or system. For instance, if you are evaluating a project's net present value (NPV), you can use sensitivity analysis to see how the NPV varies when the discount rate, initial investment,period, operating costs, or cashflows are changed.

Limitations of sensitivity analysis:

Unrealistic assumptions
➫ Sensitivity analysis assumes that only one variable changes at a time, with the values of all other variables held constant, which is not feasible in practice. In reality, the values of decision variables can vary at the same time.

Complex and time-consuming
➫ When there are several input variables and a large range of values to consider it might get complex and consume alot of time.

Does not provide probability of occurrence of key variables
➫ Unlike scenario analysis, which offers the chance of certain key variables occurring, sensitivity analysis does not provide the probability of certain important variables occurring.Sensitivity analysis excludes cashflow uncertainty and only evaluates the impact of a change in the value of one variable on the project's profitability.

The analysis is narrow
➫ The sensitivity analysis is limited in scope and presumes that the variables are independent, however, in reality, decision variables are interrelated..

More info

QUESTION 1(c)

Q (i) Decision tree for the investment to show pay offs, probabilities and net present value (NPV) for each alternative

(ii) The expected NPV of the project

(iii) Probability that Taby Ltd will avoid wild takeover
A

Solution



(ii) The expected NPV of the project

(iii) Probability that Taby Ltd will avoid wild takeover

Z score = (5 – 50.164) / √1861.47 = 1.05



More info

QUESTION 2(a)

Q Limitations of the capital assets pricing model(CAPM):
A

Solution


Capital asset pricing model (CAPM)

➦ The capital asset pricing model (CAPM) is a financial model that assesses the expected rate of return on an asset or investment. CAPM does this by utilizing the projected return on both the market and a risk-free asset, as well as the asset's correlation or sensitivity to the market (beta).

Limitations of the capital assets pricing model(CAPM)

The CAPM is apoor predictor of returns
➫ If the CAPM is a good model, its asset return estimates should be closely related to realized returns.However, empirical support for the CAPM is lacking; in other words, CAMP tests reveal that asset returns are not solely influenced by systemic risk.Because return generating models are used to estimate future returns, poor predictability of returns while utilizing CAPM is a severe issue.

Market Portfolio:
➫ According to CAPM, the true market portfolio contains all assets, both financial and non-financial, which means it includes many assets that are not investable, such as human capital and assets in closed economies.The genuine market portfolio is unobservable, which is one of the reasons CAPM is not testable.

Homogeneity in investor expectations
➫ CAPM assumes that investor expectations are homogeneous in order for the model to generate a single optimal risky portfolio (the market) and a single securities market line.There will be various optimal risky portfolios and numerous security marketlines if this assumption is not made.Clearly, investors can evaluate the same information rationally and arrive at various optimal risky portfolios.

Proxy for market portfolio
➫ Market players typically employ proxies in the absence of a true market portfolio.However, these proxies differ among analysts, the country of the investor, and other factors, resulting in varying return projections for the same asset, which is not permitted in CAPM. A three to five-year return history is required to determine beta risk.However, the company's previous status may not be an accurate indication of the company's current or future situation.In general, the CAPM is an ex ante model, however it is typically implemented using ex post data.
Furthermore, using different times for estimation yields different beta estimates.As a result, depending on the beta estimate employed in the model, different returns for the same asset are likely.

More info

QUESTION 2b

Q (i) The proportion invested in Security 1, if the portfolio of the two securities has an expected return of 15%. (1 mark).
(ii) The expected standard deviation of an equal-weighted portfolio, if the correlation of returns between the two securities is -0.15.(2 marks).
(iii) The expected standard deviation of an equal-weighted portfolio, if the returns of the two securities are uncorrelated. (2 marks)
A

Solution


Using a trial and error approach 75% of funds should be invested in security and the remaining 25% to be invested in security 2 to get a portfolio return of 15%.

(ii) The expected standard deviation of an equal-weighted portfolio, if the correlation of returns between the two securities is-0.15.

δ = √w21 δ21+ W22 δ22 +2W1 W2COV1&2

√ 0.5 2 x 202 + 0.52 x 202 + 2 x 0.5 x 0.5 x 20 x 20 x 0.15

√170. = 13.04%.

(iii) The expected standard deviation of an equal-weighted portfolio, if the returns of the two securities are uncorrelated.

= √0.52 x 202 + 0.52 x 202 + 2 x 0.5 x 0.5 x 20 x 20 x 0

= √200.

= 14.14%


More info

QUESTION 2c(i)

Q (i) The estimated equation of the security market line (SML). (3 marks).

(ii) The fund's required rate of return for the next period.

(iii) Using the capital asset pricing model (CAPM), advise Anthony Muli on whether to invest in the new company's shares. (7 marks)
A

Solution


(i) The estimated equation of the security market line (SML).

Weight alpha = 140 / 500 = 0.28.
Weight Beta = 80 / 500 = 0.16
Weight chatter ltd = 20 / 500 = 0.04
Weight Dinner Ltd = 100 / 500 = 0.20
Weight Eastern Ltd = 60 / 500 = 0.12

Portfolio Beta = (0.28 x 0.8) + (1.5 x 0.16) + (0.04 x 3) + (0.2 x 1) + (2.5 x 0.12)

0.224 + 0.24 + 0.12 + 0.2 + 0.3 = 1.084.

Expected market return

(0.1 x 7) + (0.2 x 9) + (0.4 x 11) + (0.2 x 13) + (0.1 x 15)

0.7 + 1.8 + 4.4 + 2.6 + 1.5 = 11%

Estimated security market line.

Riskfree rate + Beta(market return - risk free rate)

Alpha Ltd = 8 + 0.8(11 - 8) = 10.4%
Beta Ltd = 8 + 1.5(11 - 8) = 12.5%
Chatter ltd = 8 + 3(11 - 8) = 17.0%
Dinner ltd = 8 + 1(11 - 8) = 11.0%
Eastern Ltd = 8 + 2.5(11 - 8) = 15.5%

(ii) The fund's required rate of return for the next period.

8% + 1.084(11 - 8) = 8% + 3.252% = 11.25%

(iii) Using the capital asset pricing model (CAPM), advise Anthony Muli on whether to invest in the new company's shares.

Expected return from project = 0.1 x 10 + 0.2 x 15 + 0.4 x 20 + 0.2 x 10 x 0.1 x 15

1 + 3 + 8 + 2 + 1.5 = 15.5%

Alpha value = Expected return - Required return

15.5% - 11.25% = 4.25%

The positive alpha indicates the return from Anthony Muli should invest in the new project

More info

QUESTION 3(a)

Q Describe the following pre-offer takeover defensive mechanisms:

(i) Poison pills.
(ii) Golden parachutes.
(iii) Fair price amendments.
(iv) Supermajority voting provisions.
(v) Restricted voting rights.
A

Solution


Pre-offer takeover defensive mechanisms:

➦ A "pre-offer defense mechanism" is a collection of defensive techniques used during a hostile takeover. To protect itself from a potential acquirer in a hostile takeover, a company implements pre-offer defense mechanisms.

(i). Poison pills:
➫ This is a pre-offer takeover defensive mechanism that makes acquiring control of a target company without the prior approval of the target's board of directors unreasonably expensive.

(ii). Golden parachutes:
➫ These are compensation agreements between the target firm and senior management. These employment contracts allow executives to obtain hefty settlements, generally several years' salary, if they quit the target company due to a change in corporate ownership.

(iii). Fair price amendments:
➫ Fair pricing amendments are adjustments to the corporate charter and bylaws that prohibit mergers if the offer falls below a certain threshold.By establishing a floor value bid, this protects targets from momentary drops in their share prices.

(iv). Superior majority voting provisions:
➫ Many target companies amend their charters and bylaws to seek a higher proportion of shareholder approval for mergers than is ordinarily required.
As a result, even if an acquirer is able to acquire a significant amount of the target's share, it may have a more difficult time amassing enough votes to approve a merger.

(v). Restricted voting rights:
➫ Requires alarge share holder to obtain board permission to vote once acertain ownership threshold has been crossed

More info

QUESTION 3(b)

Q Factors that multinational corporations(MNCs) should consider when making long-run investment decisions:
A

Solution


Vertical integration:
➫ MNCs make foreign investments in countries where inputs are available in order to assure a stable supply of inputs.This is a business model in which a corporation owns its supply chain. In other words, it occurs when a corporation controls more than one level of the supply chain.MNCs make foreign investments in countries where inputs are available in order to assure a steady supply of these commodities at a reasonable price. If MNCs have monopolistic/oligopolistic control over the input market, it might act as a barrier to entrance into the industry.

Trade barriers:
➫ Acts of government frequently make international marketplaces for goods and services less than ideal.Tariffs/quotas and other restrictions on exports and imports of goods and services may be imposed by governments, obstructing the free flow of these products across national borders. Government regulation to increase revenue or safeguard domestic businesses is also a trade barrier.

Intangible assets:
➫ MNCs always have a competitive advantage because of unique intangible assets, including superior research and development capabilities, managerial/marketing know-how, technology, and brand identities.These intangible assets are typically difficult to package and sell to outsiders.Furthermore, property rights in intangible goods are difficult to establish and maintain, particularly in foreign nations where legal remedy may not be readily available.As a result, MNCs may find it economical to form subsidiaries and collect returns directly by internalizing transactions in these assets.

Imperfect labour market:
➫ Severe labor-market flaws may result in enduring wage disparities between countries.When workers are unable to move owing to immigration constraints, MNCs should relocate to the workers in order to profit from low-cost labor services.This is one of the reasons multinational corporations (MNCs) invest in developing countries such as Africa, Asia, and the Middle East.

Shareholder diversification services:
➫ If investors are unable to successfully diversify their portfolio holdings abroad due to impediments to cross-border capital movements, corporations may be able to provide direct diversification services in foreign nations to their shareholders.

Product lifecycle:
➫ Foreign investment occurs when the product reaches maturity and cost becomes a factor.Thus, foreign investment might be understood as a defensive strategy to keep the company competitive against both home and foreign competitors.When a firm introduces new products and keeps production facilities at home, close to clients, demand grows worldwide, exports increase, and the company and other MNCs are persuaded to invest in international markets.

More info

QUESTION 3(c)

Q Determine the combined operating profit of the two firms and the post acquisition earnings per share (EPS) at the point of indifference in the firm's earnings under financing options (1) and (2) above. (10 marks)
A

Solution


New shares issued = 1/2 x 6,000,000 = 3,000,000.

Option 1.

Basic EPS
=
EBIT(1-T)
Number of Shares


Basic EPS
=
EBIT(1-0.3)
20 + 3


Basic EPS
=
0.7 EBIT
23


Ottion 2.

Value of debentures = 2 x 6 / 100 x 100 = 12 million.

Debenture interest = 10% x 12 = 1.2 million.

EPS
=
EBIT - Interest(1 - T)
Number of shares


EPS
=
(EBIT - 1.2)(1 - 0.3)
20


=
0.7EBIT - 0.84
20


0.7EBIT
23
=
0.7EBIT - 0.84
20


20 x 0.7EBIT = 23(0.7EBIT - 0.84).

14EBIT = 16.1EBIT - 19.32.

16.1EBIT - 14EBIT = 19.32.
2.1EBIT/ 2.1 = 19.32 / 2.1.

EBIT 9.2 Million.

Therefore earning per share at indifferent point.

(0.7 x 9.2) / 23 = Sh 0.28


More info

QUESTION 4(a)

Q (i) Similarities Between Forward and Futures Contracts

(ii) difference between a strangle and straddle

(iii) Methods of Swap Contract Termination
A

Solution


(i) Similarities Between Forward and Futures Contracts

➦ Forward contracts and futures contracts are derivatives arrangements in which two parties agree to acquire or sell a specified asset at a predetermined price at a future date. Buyers and sellers can reduce the risks associated with future price swings by locking in the purchase/sale price in advance.

Similarities
➫ Both are financial instruments.
➫ Both involve the agreement between two parties to buy and sell an asset at a specified price by a certain date.
➫ Allowing both sides of the trade to lock down the prices.
➫ They Both help to mitigate the risk and losses of price fluctuation

(ii) difference between a strangle and straddle

A straddle is an option strategy in which a call and put with the same strike price and expiration date is bought.
A strangle is an option strategy in which a call and put with the same expiration date but different strikes is bought.

(iii) Methods of Swap Contract Termination

➦ A swap is an agreement between two parties to exchange cash flows on various assets over a specific time period.

By Mutual Agreement or as per Contract Details.
➫ When a swap contract is initiated it has zero value

By Entering into an Offsetting Swap.
➫ A swap can also be terminated indirectly by entering into a similar swap agreement that offsets the original contract.

By Selling the Swap.
➫ A swap can also be canceled by selling it to a different counterparty.

By Using a Swaption.
➫ Swaptions can also be used to end the swap. A swaption gives an option holder the choice to enter into a swap. A swaption allows a party to engage in an offsetting swap.

More info

QUESTION 4(b)

Q (i) Using the Modigliani-Miller (M-M) information provided above, analyse implications the change capital structure of Lagdara Ltd. (9 marks).

(ii) Justifying your answer, advise management of Lagdara Ltd on whether to chacge its capital structure(2 marks)
A

Solution


Number of ordinary shares ord Number of ordinary shares ordinary share capital + par value.

120,000,000 / 50 = 2,400,000.

Market value = 2,400,000 x 200 = 480,000,000.

Sh."000"
Operating profit 60,000
Less: interest 0
Profit before tax 60,000
Less:tax 30% (18,000)
Profit after tax 42,000


Cost of equity = Profit after tax / Market value equity x 100%.

42,000,000 / 480,000,000 x 100% = 8.75%

The above cost of equity will be also be weighted average cost of capital. Impact of borrowing Sh. 40 million.

Sh."000"
Operating profit 60,000
Less: interest 4,000
Profit before tax 56,000
Less: tax 30% (16,800)
Profit after tax 39.200


Value of levered firm.
value unlevered firm + value of debt Multipled by tax.

480,000,000 + 40,000,000 x 0.3 = Sh. 492,000,000.

Thereofore value of equity levered firm.

492,000,000 - 40,000,000 = Shs. 452,000,000.

Cost of equity levered company.

39,200,000 / 452,000,000 × 100% = 8.67%.

After tax cost of Debt (Kd ).

Kd = I(1 - T).

10(1 - 0.3) = 7%

Weighted average cost of capital.

Ko = KeL - (KeL - Kd)D / V.

8.67 - (8.67 - 7)40,000,000 / 492,000,000 = 8.53%.

(ii) advise to the management Lagdara Ltd. whether to change its structure.

The management should change capital structure as it will weighted average cost of capital from 8.75% to 8.53% and increase firm value from Shs. 480 million to Shs.492 million

More info

QUESTION 5(a)

Q Limitations of applying free cashflow (FCF)approach using weighted average cost of capital (WACC)as a discount rate when evaluating projects with different risks or debt capacity:
A

Solution


Free Cash Flow (FCF)
➦ This is the cash generated by a corporation after accounting for financial outflows to sustain operations and maintain capital assets

Limitations

Busines srisk:
➫ The WACC application assumes that the project under consideration has the same business risk as the firm's existing assets.This could be a reasonable assumption for replacement and/or growth projects in the same industry.However, if the project has a different business risk profile, the project evaluation will be biased.

Cashflowpatterns:
➫ In practice, we rarely see projects with perpetual cashflows because the original version of WACC presupposes that FCFs are level and perpetual.

Finance Assets:
➫ WACC accounts for debt financing interest tax shields.However, WACC is unable to account for various other financial implications.To analyze projects that do not have a constant debt ratio, have diverse cashflow patterns, and have multiple financing implications, we need approaches other than the WACC approach.

Debt capacity:
➫ The use of the firm's WACC as a discount rate requires that the project under consideration adds debt capacity equal to the firm's debt capacity and that the firm has a stable capital structure (debt ratio).Except for a few ordinary projects, this may not be true for all projects.Projects have a finite life, and corporations can raise funding from financial institutions or the general public that are attached to specific projects.

Issue costs:
➫ WACC is not a valid basis for calculating the cost of issuing securities. These are one-time costs that cannot be changed in the computation of WACC, which is used as a discount rate for FCFs that occur over time.

More info

QUESTION 5(b)

Q Objectives of transfer pricing other than reducing tax liability:
A

Solution


Transfer pricing
Refers to the pricing of transactions involving the transfer of goods or services between related firms that are part of an multinational corperation(MNC).

Objectives

➢ Reducing exchange exposure and avoiding exchange controls, as well as limiting profit repatriation to maximize transfers from affiliates to the parent.
➢ Fund placement in areas that are suite with business working capital policies
➢ Window dressing to improve an affiliate's perceived financial status so that its credit rating can be improved.
➢ Reducing customs duty payments and overcoming quota restrictions on imports.
➢ Getting around import quotas (in value terms).

More info

QUESTION 5(c)

Q Evaluate whether the money market hedge or a forward hedge would be preferred. (7 marks)
A

Solution


1. Borrow an amount equivalent to the present value of 750,000,000 euros at annualized rate of 8% over a 6 month period.

PV = Euros 750,000 [1 + (6/12×0.08)] -1 = euros 721,153.85.

2. Convert above amount to US dollard at the prevailing spot rate.

1 Usd = Euros 2.3949.
? = Euros 721,153.85.

∴ 721,153.85 / 2.349 × 1 = USD 307,004.62.

3. Invest USD 307.004 62 at annualized rate of 2% over a 6 month period. The future value of above amount.

USD 307,004.62 [1 + (6 / 12 × 0.04)].
USD 307.004.62 x 1.02 = 313,144.71.

Forward contract hedge

Forward rate 1 USD = euros 2.412.
? = Euros 750,000.

∴ 750,000 / 2.412 x 1 = USD 310,945.2736.

Advice.

Most preferred option will be money market hedge since kikuma will receive the highest amount of cash there.

More info

QUESTION 5(d)

Q Compute the value of Kisima Ltd. (5 marks)
A

Solution


The value of unlevered firm (Vu): = 7.36M / (12% - 4%) = Sh.92 M.

Year 1 Interest tax shield, (DT) is given by:

(DT): = 0.4 × 5% x 30million = Sh.600,000.

PVDT = 600,000 / 0.05 = Sh.12,000,000.

Therefore, the value of the levered firm:

VL = Vu+ PVDT = 92 million + 12 million = Sh. 104million.

Value of Kisima Ltd. Sh.104 million.

Alternatively:

VL = Vu+ BT.

= 92 million + (40% x 30 million).
= 92 million + 12 million = Sh. 104 million

More info
New Unlock your potential with focused revision and soar towards success
Pass Kasneb Certification Exams Easily

Comments on:

CPA past papers with answers