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Advanced Leval
Advanced Financial Management May 2019
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Advanced Financial Management
Revision Kit

QUESTION 1a

Q Applications of capital asset pricing model(CAPM)
A

Solution


Pricing of securities

CAPM is used to determine whether financial assets are over-valued, under-valued, or correctly priced by the market forces.This is the basis upon which to decide whether to buy or sell securities at prevailing market forces.

Investment decisions

CAPM is applied to determine the discounting rate used to evaluate capital investments. It is also used to determine the risk-adjusted discounting rate.

Cost of capital

CAPM is used to determine the cost of capital,which is made up of the cost of equity capital,debt capital, and the firm’s overall cost of capital.

Evaluate portfolios

CAPM is used to evaluate portfolios to establish whether portfolios are profitable or not. It is thus applied to evaluate whether to change the composition of a portfolio or not.

Efficiency of portfolio

CAPM is used to determine which portfolios are super-efficient,inefficient, or efficient.

Evaluate performance of portfolios

CAPM is applied to evaluate the performance of portfolios. The Trenor’s measure of Portfolio performance is based on the background of CAPM.

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QUESTION 1b(i)

Q (i) Earnings before interest and tax (EBIT) at the point of indifference in companv's earnings for each financing option. (8 marks')
A

Solution


Let EBIT at point of indifference be x.

At this point both eps are equal.

EPS1 = EPS2

Eps = ((EBIT - 1)(1 - T)- Dp ) / So.

Where;

So = Total number of shares.

Financing plan 1.

EPS1 = (( X - 2,800)(1 - 0.3) - 1,000) / (2,500 + 10,000 / 20).

EPS1 = (0.7X - 2,960) / 3,000.

Financial plan 2.

EPS2 = (x - [(14% x 20,000) + (12% x 5,000)](1 - 0.3) - 1,000) / (2,500 + 5,000 / 20).

EPS2 = (0.7X - 3,380) / 2,750.

At indifference point.

EPS1= EPS2

(0.7X -2,960) / 3,000 = (0.7X - 3,380) / 2,750.

2,750 (0.7X - 2,960) = 3000 (0.7X - 3,380).

1,925X - 8,140,000 = 2,100X - 10,140,000.

2,100X - 1,925X = -8,140,000 + 10,140,000.

175X = 2,000,000.

x = 11,428.57143.

Earnings before interest and tax (EBIT) at the point of indifference .

Sh. 11,428,571.43


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QUESTION 1b(ii)

Q Earnings per share (EPS) at the point of indifference in (b) (i) above. (4 marks)
A

Solution


Using EPS1.

EPS1 = (0.7X - 2,960)/3,000.

X = 11,428.57143.

EPS1 = ((0.7 x 11,428.57143) - 2,960) / 3,000

EPS1 = (8,000 - 2,960) / 3,000.

5,040 / 3,000

EPS = Sh 1.68


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QUESTION 2a

Q Roles of the unclaimed financial Assets Authority(UFAA)
A

Solution


i. Receiving, protecting, investing, and distributing unclaimed financial assets

ii. Make sure the owners of unclaimed money either reunite with them or give them to the appropriate party.

iii. Receive all payments required by the Act to be made to the fund.

iv. Assume custody of the rights of unclaimed financial assets holder.

v. Make payments out of the Fund to the rightful owners

vi. Carry out inspection of unclaimed financial assets to ensure accurate reporting

vii. Locate and notify owners of the unclaimed financial assets

viii. Ensure that all relevant information on unclaimed financial assets is submitted to the Authority and maintained safely in the database.

ix. Manage and invest the funds

x. Implementation of unclaimed financial assets policies and procedures

xi. Act as the Trusteee to the fund in accordance with unclaimed financial assets act.

xii. Implement all government policies relating to it and perform such other functions as are conferred on it by the unclaimed financial Assets Act.

xiii. Advise the Cabinet Secretary on the national policy to be followed with regard to unclaimed assets

xiv. Enforce and generally administer the provisions of the unclaimed financial assets act

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QUESTION 2b

Q The intrinsic value of the share. (4 marks)
A

Solution


Year Dividend per share DF 16% PV
1 1.5 x 1.121 = 1.68 0.8621 1.45
2 1.5 x 1.122 = 1.88 0.7432 1.4
3 1.88 x 1.11 = 2.07 0.6407 1.33
4 1.88 x 1.12 = 2.27 0.5523 1.26
5 to 2.27(1.08) / (0.16 - 0.08) = 30.65 0.5523 16.93
Intrinsic Value 22.36


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QUESTION 2c(i)

Q The price of the ordinary shares at the end of the year, assuming a dividend is not declared. (2 marks)
A

Solution


Po
=
Di + Pi
1 + (ks )1


Where;

Di = Dividend Payable at the end year.

Pi = Price of a share at the year end.

Ks = Cost of equity.

Po
=
0 + Pi
1 + 10%


50
=
Pi
1.1


Pi = Sh.55


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QUESTION 2c(ii)

Q (ii) The price of the ordinary shares at the end of the year, assuming a dividend is declared. (2 marks)
A

Solution


Po
=
Di + Pi
1 + (ks )1


50
=
3 + Pi
1 + 10%


Pi = (50 x 1.1) - 3 .

Sh.52


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QUESTION 2c(iii)

Q Show that under the Modigl iani and Miller's assumption, payment or non-payment of dividends has no effect on the company's value. (6 marks)
A

Solution


New financing required.

(200,000 x 3) + 4,000,000 - 2,000,000 = Sh.2,600,000.

Value of dividend paying firm.

New shares to be issued(N) = 2,600,000/52 = 50,000 shares.

Value of the firm
=
(N + M)Pi - I + E
1 + r


(200,000 + 50,000)52 - 4,000,000 + 2,000,000
1.1


Sh.10,000,000


Value of non paying dividend firm.

Additional financing = investments + dividends paid - Earnings.

4,000,000 + 0 - 2,000,000.

2,000,000.

New shares to be issed (N) = Additional financing ÷ P1.

2,000,000 ÷ 55.

36,364 shares.

Value of the firm
=
(N + M)Pi - I + E
1 + r


Value of the firm
=
(36,364 + 200,000)55 - 4,000,000 + 2,000,000
1.1


Sh.10,000,018.18

Therefore payment dividend nonpayment of dividend does not affect current value of firm.
Therefore dividend decision irrelevant


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QUESTION 3a

Q Types of risks associated with investment in real estate investment trust(REITs)Securities:-
A

Solution


(i)Real estate portfolio risk

REIs manage assets related to real estate as well as income-producing properties. A REIT's performance is determined by the performance of the properties it owns. Diverse risks can have an impact on the value and income that REITs create. Changes in the general economy, current interest rates, tenant competition, decreased occupancy rates, space supply or lower demand, tenant defaults, maintenance and improvement costs, and changes in the overall economy all have an impact on REIT.

(ii)General Economic Risk

Real estate valuations, occupancy rates, and property income are all impacted by the economy. This will have an effect on the earnings and financial health of a REIT.

(iii)Market and Liquidity Risk

Market risk can affect the price of REIT securities. Many variables, both inside and outside the REITs contract, may cause these prices to change.

(iv)Interest Rate Risk

Since REITs borrow money to fund their investments, increases in the prevailing market rate will have a negative impact on their net income.

(v)Leverage Risk

In order to finance and manage real estate investments, REITs take out significant loans. A REIT may reduce the chance that its cashflows won't be enough to cover necessary principle and interest payments by using a lot of leverage.

(vi)Dividend Risk

The amount of cash available for distribution by a REIT will fluctuate based on the performance of its income-producing assets, which may prevent the REIT from being able to maintain or increase dividend level in the future. REITs are required to distribute annual dividends or their investment income.

(vii) Other General Risks

Capital market risk, growth risk, counter party risk, conflict of interest risk, key personnel risk, structural and regulatory risk are some other broad concerns.

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QUESTION 3b(i)

Q The firm's return on equity (ROE) using Gordon's growth approximation method. (3 marks)
A

Solution


Source Weight
OSC = 80,000 / 130,000 x 100% 61.54%
10% irredeemable debentures = 30,000 / 130,000 x 100% 23.08%
8% preference shares = 20,000 / 130,000 x 100% 15.38%


g + [(4.8/4)⅓ - 1 ] x 100% = 6.27%.

g = Return on equity x retention ratio.

6.27% = ROE(1 - 0.6) .

0.0627 = 0.4ROE.

ROE = 15.675%


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QUESTION 3b(ii)

Q The firm's existing weighted average cost of capital ( WACC). (6 marks)
A

Solution


Cost of debentures.

I(I - T)/Po x 100%.

10(1 - 0.3) / 100 x 100% = 7%.

Cost of preference shares.

Kp = D p/P o x 100%.

D o = Dividend per share.

8/100 x 20 = 1.6.

K p = 1.6 / 25 x 100% = 6.4%.

Cost of equity.

Ke = D o(1 + g) / Po + g x 100%.

K e
=
4.8(1.0627)
34.8 - 4.8
+ 0.0627 x 100%


23.27%.

Number of ordinary shares = Ordinary Share Capital / Par Value.

= 80,000 ÷ 10 = 8,000.

Market value of ordinary shares.

= 8,000 × 30 = sh. 240,000.

Number of 8% preference shares = preference share capital par value.

= 20,000 / 20 = 1,000.

Market value = 1,000 x 25 = Sh 25,000.

Total amount = 240,000 + 25,000 + 30,000 = 295,000.

Weighted average cost of capital (WACC).

= 23.27 x 240 / 295 + 6.4 x 25 / 240 + 7 x 30 / 240 .

= 18.93 + 0.67 + 0.88.
= 20.48%

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QUESTION 3b(iii)

Q The project's risk adjusted discounting rate (RADR). (3 marks)
A

Solution


RADR = RF + B(Rm — Rƒ).

10 + 1.5(18 - 10).

10 + 12.

22%

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QUESTION 4a

Q (i) Forward contract hedge. (2 marks)

(ii) Monev market hed oe. (6 marks)

(iii) Using the results obtained in (a) (i) and (a) (ii) above. advise the management of Kadzenga Limited on the besi hedging strategy, (2 marks)
A

Solution


(i) Forward contract hedge

$1 = kshs 102.

$60,000 Kshs?.

60,000 x 102 = Shs6,120,000.

(ii) Money market hedge

1. Borrow from USA.

13% = 12 months .

? = 3 months .

3 / 12 x 13% = 3.25%.

Amount to borrow = 60,000 (1.0325)-1.

$58,111.38.

2. Convert to Kshs at current prevailing rate is.

$1 = Kshs 105.

$ 58,111.38 = Kshs?.

$ 58,111.38 / $1 x 105 = Kshs 6,101,694.915.

3. Invest in Kenya.

13% = 12 months.

?= 3 months.

3 / 12 x 13% = 3.25%.
Amount = ksh. 6,101,694.915 x 1.0325.

= Kshs 6,300,000

(iii) Advise the management

The best hedging strategy is money market hedge since Kshs.6,300,000 made exceeds Kshs.6,120,000 received under forward contract hedge.

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QUESTION 4b

Q (i). The cost of equity before and after issue of the long-term debt.

(ii). The weighted average cost of capital (WACC) before and after issue of the debt

(iii). The current market value of the firm before and after issue of the debt.

(iv). Advise the management of Ziani Limited on whether to change its capital structure.
A

Solution


(i) Cost of equity

K e = D o/P o x 100%.

4/20 x 100% = 20%.

Cost of equity Levered firm (Kel ).

Kel = Keu + [Keu - Kd(1 − T)]D/E

Where:

K eu = 20%

Kd = 12%(1 - 0.3) = 8.4%.

D = 50M.

E = 20 x 10,000,000 = 200,000,000.

Kel = 20 + (20 - 8.4)50 / 200.

20 + 2.9 = 22.9%

(ii) WACC

K o = K eu - (K eu - K d)D/V.

20% - (20% - 0)0 / 200 = 20%.

WACC after issue of long term debt.

Ko = 22.9 - (22.9 - 8.4)50 / 250 = 20%.

or.

WACC = Ke(E / V) + Kd(D / v).

22.9 x 200 / 250 + 8.4 x 50 / 250 = 20%

(iii) The current market value of the firm before and after issue of the debt.

Number of ordinary shares x Market price per share.

= 10,000,000 x 20.

Shs. 200,000,000.

The Current market Value of firm after debt issue.

Value of firm = Value of equity + Value of debt

V₁ = V u + D r

50,000,000 x 0.3 + 200,000,000.

Sh. 215,000,000

(iv) Advise the management

Management of ziani limited should change the capital structure as it will lead to an increase in the value of the firm with no corresponding change in the cost of capital

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QUESTION 5a

Q (i). The expected net present value of the project
A

Solution






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QUESTION 5b

Q Determine the maximum price payable to acquire Best Ltd. using the discounted free cash flow basis. (10 marks)
A

Solution


Year 1M 2M 3M 4M 5M
Sales 50 60 75 70 65
Less:Variables (30) (36) (45) (42) (26)
Contribution 20 24 30 28 39
Operating cost (5) (10) (15) (15) (12)
Selling and admin cost (10) (10) (8) (9) (11)
Interest (2) (2) (2) (2) (2)
Profit before tax 3 2 5 2 14
Less tax (0.6) (0.4) (1) (0.4) (2.8)
Profit after tax 2.4 1.6 4 1.6 11.2
Less acceptable costs (0.5) (0.7) (1.6) (1.2) (0.2)
Add terminal cash flows 310.11
Cash flows 1.9 0.9 3.4 0.4 321.11


Terminal cash flows 11(1.06) / (0.0976 - 0.6).

310.11 million.

Cost of equity = R𝑓 + β (R m - R𝑓).

8 + 0.8(13 - 8).

12%.

Cost of debt = K d (1 - t).

8%(1 - 0.2) = 6.4%.

WACC = (0.4 x 6.4) + (0.6 × 12%).

2.56 + 7.2% = 9.76%

Year Cash flows.
Million 		DF 9.76% PV(M)
1 1.9 0.9111 1.73109
2 0.9 0.8301 0.74709
3 3.4 0.7563 2.57142
4 0.4 0.6890 0.2756
5 321.111 0.6277 201.56
206.89


Maximum to pay to acquire best ltd 206.89 million


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CPA past papers with answers