ADVANCED FINANCIAL MANAGEMENT NOVEMBER 2016 - CPA SOLUTION|REVISION KITS|KASNEB

QUESTION 1(a)

Q Summarise the assumptions of the Grossman-hartModel(1986):

A

Solution

➧ Ownership and control are considered to be synonymous. Ownership implies the ability to exercise control over an asset or entity.

➧ The model does not differentiate between employees and outside contractors when the firm provides all the tools and assets used by the contractor. The focus is on the allocation of property rights in such cases.

➧ The relationship between firms, whether vertical or lateral, is assumed to span two periods. In the first period, managers of each firm make relationship-specific investments. In the second period, further production decisions are made, and the benefits from the relationship are realized.

➧ The investment decisions made by managers of different firms are chosen independently and without cooperation.

➧ At date 0, there is a competitive market with identical potential trading partners available.

➧ All variables involved in the model are not contractible in advance.

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QUESTION 1(b)(i)

Q Perform 10 simulation runs of the net present value (NPV) of this project.

A

Solution

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QUESTION 1(b)(ii)

Q The expected Net Present Value (NPV) Of the project

A

Solution

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QUESTION 2(a)

Q Challenges in the application of the CAPM in practice

A

Solution

➧ Assumptions: The CAPM relies on a set of assumptions that may not hold in the real world. For example, it assumes that investors have homogeneous expectations, markets are perfectly efficient, and there are no transaction costs or taxes. These assumptions can limit the accuracy of the model's predictions.

➧ Market Efficiency: The CAPM assumes that markets are efficient, meaning that asset prices fully reflect all available information. However, in reality, markets can be inefficient, and asset prices may deviate from their fundamental values. This can lead to discrepancies between the expected returns predicted by the CAPM and the actual returns observed in the market.

➧ Beta Estimation: The CAPM relies on the estimation of an asset's beta, which measures its sensitivity to market movements. However, estimating beta accurately can be challenging, as it requires historical data and assumes that the relationship between an asset and the market is stable over time. In practice, estimating beta can be subject to errors and may not capture the true risk characteristics of an asset.

➧ Non-Diversifiable Risk: The CAPM assumes that investors can eliminate all non-diversifiable risk through a well-diversified portfolio. However, in reality, there may be factors or risks that are not adequately captured by the CAPM's single-factor beta. This can lead to mispricing and suboptimal portfolio allocations.

➧ Market Risk Premium: The CAPM relies on the estimation of the market risk premium, which represents the additional return that investors demand for bearing systematic risk. However, determining an appropriate market risk premium is subjective and can vary depending on the chosen methodology or time period used for estimation. This can introduce uncertainty and affect the accuracy of the CAPM's expected return estimates.

➧ Behavioral Factors: The CAPM assumes that investors are rational and make decisions based solely on expected returns and risks. However, in practice, investors' behavior can be influenced by psychological biases, market sentiment, and other non-rational factors. These behavioral aspects can impact asset pricing and introduce deviations from the predictions of the CAPM.

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QUESTION 2b(i)

Q Correlation coefficient of the companies returns.

A

Solution

x	x-x	(x-x)²	y	y-y	(y-y)²	(x-x)(y-y)
37	22	484	32	17	289	374
24	9	81	29	14	196	126
-7	-22	484	-12	-27	729	594
6	-9	81	1	-14	196	126
18	3	9	15	0	0	0
32	17	289	30	15	225	225
-5	-20	400	0	-15	225	300
21	6	36	18	3	9	18
18	3	9	27	12	144	36
6	-9	81	10	-5	25	45
150		1,954	150		2,038	1,874

X̄ = 150/10 = 15
Ȳ = 150/10 = 15
Covariance X&Y = 1,874/10 = 187.4

standard deviation X = √ 1,954/9 = 14.73

standard deviation Y = √ 2,038/9 = 15.05

Correlation coefficient

=

Covariance X&Y

σ _x σ _y

187.4

14.73 x 15.05

0.8453

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QUESTION 2(b)(ii)

Q Portfolio risk assuming equal weighting.

A

Solution

Actual portfolio risk = √w ²_xσ ²_x + w ²_yσ ²_y + 2w _xw _ycov _x&y

√0.5² x 14.73² + 0.5² x 15.05² + 2 x 0.5 x 0.5 x 187.4

√54.24 + 56.63 + 93.7 = 14.2%

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QUESTION 2(c)(i)

Q The risk of Mary Chege's portfolio relative to that of the market.

A

Solution

Company	Market capitalization "000"	Weight	Beta	Weight Beta
W	10 x 130 = 1,300	1,300 / 5,750 = 0.22	1.12	0.25
X	15 x 100 = 1,500	1,500 / 5,750 = 0.26	0.89	0.23
Y	15 x 90 = 1,350	1,350 / 5750 = 0.23	0.70	0.16
Z	10 x 160 = 1,600	1,600 / 5,750 = 0.28	1.60	0.45
	5,750			1.09

Since Mary Chege's portfolio beta of 1.09 is greater than market portfolio beta of 1 then Mary Chege portfolio is riskier as compared to that of the market.

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QUESTION 2(c)(ii)

Q Determine whether Mary Chege should change the composition of her portfolio.

A

Solution

Company	Actualization	RR(CAPM)	Alpha	Comment
W	18%	9 x 1.12 x 5 = 14.6%	3.4	Suppereffecient company
X	23%	9 + 0.89 x 5 = 13.45%	9.55	Supperefficient asset
Y	11%	9 + 0.75 x 5 = 12.75%	-1.75	Inefficient asset
Z	17%	9 + 1.6 x 5 = 17	0	Efficient asset

Market risk premium = Return on market-Risk free

= 14% - 9% = 5%

CAPM = Risk free rate + Beta x Market risk premium

Mary Chege should change the composition of her portfolio. She should buy more shares of super efficient assets and sell shares of inefficient company /asset.

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QUESTION 3a

Q Assumptions of the traditional theories of capital structure:

A

Solution

➧ Perfect capital markets: The traditional theories assume the existence of perfect capital markets, where all investors and firms have equal access to information, can trade securities at no cost, and face the same borrowing and lending rates. This assumption ensures that there are no barriers to capital flows and all relevant information is available to market participants.

➧ No taxes: The theories assume a world without taxes, where there are no corporate taxes, personal taxes on dividends or interest income, or any other tax-related considerations. This assumption simplifies the analysis by removing the impact of tax shields and the potential tax advantages of debt financing.

➧ No transaction costs: The theories assume that there are no transaction costs associated with issuing securities or changing the firm's capital structure. This assumption allows for frictionless adjustments between debt and equity and simplifies the analysis of optimal capital structure decisions.

➧ Rational behavior: The theories assume that all market participants, including firms and investors, are rational and act in their own self-interest to maximize their wealth or value. This assumption implies that managers and investors make decisions based on a careful evaluation of costs and benefits, without being influenced by behavioral biases or other non-rational factors.

➧ Homogeneous expectations: The theories assume that all market participants have the same expectations about future cash flows, risks, and other relevant variables. This assumption ensures that there is a consensus view of the firm's prospects and eliminates any potential disagreements or information asymmetry among market participants.

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QUESTION 3(b)

Q (i) The current value of the unlevered firm.
(ii) The current value of a levered firm if it uses Sh. 10 million or 7% debt.
(iii) The weighted average cost of capital (WACC) of a levered firm at a debt level of 70 Sh. 10 million.

A

Solution

(i) The current value of the unlevered firm.

Operating Profit = 16 / 100 x 320 Million = Sh 51.2 Million

Value of unlevered firm = operating profit / cost of equity

51.2 + 0.12

Sh.426.67 Million

(ii) The current value of a levered firm if it uses Sh. 10 million or 7% debt.

Value of levered firm is equal to value of unlevered firm. So the value of levered firm is Shs. 426.67 million.

(iii) The weighted average cost of capital (WACC) of a levered firm at a debt level of 70 Sh. 10 million.

Cost of equity Levered firm = Cost of equity unlevered firm + (K _eu - K _d )D/E 12 + (12 - 7)10 / 416.67 = 12.12%

WACC = 12.12 - (12.2 - 7)10 / 426.67 = 12.12 - 0.12 = 12%

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QUESTION 3(b)

Q ( i) The current value of the firm if it uses no debt.
( ii) The current value of the firm if it uses the debt level or 70/0, Sh.10 million.
( iii ) The weighted average cost of capital (WACC) at 7% debt level of Sh.10 million

A

Solution

(i) The current value of firm if it uses no debt.

Value of unlevered firm = EBIT(1 - T) / K _e

51.2(1 - 0.3) / 0.12 = Sh.298.67

( ii) The current value of the firm if it uses the debt level or 7%, Sh.10 million.

Value of levered firm = Value of unlevered firm + DT

=298.67 + 3
=Shs.301.67

( iii ) The weighted average cost of capital (WACC) at 7% debt level of Sh.10 million

K _d = I(1 - t)
7(1 - 0.3)
4.9%
Cost of equity levered firm

K _el = K_eu + (K_eu - K_d)D / E

= 12 + (12 - 4.9)10 / 291.67

12.24%

Weighted average cost of capital

12.24 - (12.24 - 4.9)10 / 301.67 = 12.00%

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QUESTION 4(a)(i)

Q Distinction between the following terms in relation to corporate restructuring and re-organization

A

Solution

(i) Bootstrapping and management buy-out:

Bootstrapping refers to a strategy where a company relies on its internal resources, such as retained earnings or cash flow, to finance its growth or operations. It involves minimizing external financing and using available resources effectively to fund the company's activities.

A management buy-out (MBO), on the other hand, is a type of corporate restructuring where the existing management team or a group of managers acquires a controlling stake or complete ownership of the company they currently work for. In an MBO, the management team typically obtains financing from external sources, such as private equity firms or banks, to facilitate the purchase of the company.

The key distinction between bootstrapping and an MBO is that bootstrapping focuses on using internal resources to fund company activities, while an MBO involves the management team purchasing the company with external financing.

(ii) Sell-off and spin-off:

A sell-off, also known as divestment or asset sale, occurs when a company sells off a portion or all of its assets or business divisions. The goal of a sell-off is to streamline operations, reduce debt, or refocus the company's activities on its core business. The proceeds from the sale can be used to strengthen the company's financial position or invest in other strategic initiatives.

A spin-off, on the other hand, involves creating a new, independent company by separating a business division or subsidiary from the parent company. The shares of the newly formed company are distributed to the existing shareholders of the parent company. The spin-off allows the parent company to focus on its core operations while providing the spun-off entity with its own identity and strategic direction.

The main distinction between a sell-off and a spin-off is that a sell-off involves selling assets or business divisions to external parties, while a spin-off creates a separate, independent entity by distributing shares to existing shareholders.

Summary

Bootstrapping involves using internal resources to fund a company's activities, while a management buy-out refers to the acquisition of a company by its existing management team with external financing. A sell-off entails selling assets or business divisions to external parties, whereas a spin-off involves creating a new, independent entity by distributing shares to existing shareholders.

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QUESTION 4(b)

Q ( i) Evaluate whether the bid is likely to be viewed favourably by the shareholders of both Kubwa Ltd. and Small Ltd.
(ii) Discuss three factors that are likely to influence the views of the shareholders in the analysis in (b) (i) abose.

A

Solution

( i) Evaluate whether the bid is likely to be viewed favourably by the shareholders of both Kubwa Ltd. and Small Ltd.

Exchange ratio = 4 / 3 x 1 = 4 / 3

Offer price = Exchange ration x Market price per share predator

4 / 3 x 464 = Sh.6.19

Since offer price is greater than existing market per price per share small ltd (Sh 5.90) then shareholders of small Ltd will be in support of acquisition
Number of share Kubwa ordinary share capital / per value

150 / 0.5 = 300 Million

Number of shares small = 40 / 1 = 40 Million

40χ4 / 3 = 53⅓ million shares

Post merger market value kbwa

=

Premerger market value kubwa + Post merger market value small

Number of shares Kubwa = New shares issued

=

(300 x 4.64) + (5.9 x 40)

300 + 53⅓

= 4.61

Then Merger will be unacceptable to shareholders of kubis limited since it will result o a lower post mirger market value of kubwa limited.

Total value of synergistic benefits and costs post merger

	Sh.Million
Proceed from disposal warehouse	13.6
Redundancy of employees	(18.0)
Present calue of employee savings (5.4 x 3.6048)	19.47
	15.06592 million

Value of synergistic benefits per share

15.06592m / 353⅓ Million = 0.04

When considering synergistic benefit post merge market price per share Kubwa limited

= (4.61 + 0.04) = Sh.4.65

If we consider value of synergistic benefits post merger, then shareholders of Kubwa ltd will accept the merger.

(ii) Discuss three factors that are likely to influence the views of the shareholders in the analysis in (b) (i) abose.

1. Dividend cover

Dividend cover

=

Earnings available shareholders

Dividends

Kubwa ltd = 100 / 48 = 2.08
Small Ltd = 16 / 10 = 1.60

Incase shareholders of Kubwa limited care about dividends they will prefer not to own shares of small-ltd.

2. The intrinsic value of small limited shares using Gordon Dividend valuation model

Value per share

=

D_o(1 + g)

K_e - g

Where:

D _o Dividend per share small = 10 / 40 = 0.025

Value per share

=

0.25(1 + 0.08)

0.13 - 0.08

=Shs. 5.40 Given the current situation where shares of Small Ltd are considered overvalued, shareholders of Small Ltd would be inclined to divest their holdings.

3. Solvency levels of two companies.

Longterm debt to equity ratio= Longterm debt/Equity × 100%

Small ltd: = 35 / 109.4 x 100% = 31.99%

Kubwa Ltd:= 628 / 444 x 100% = 141.44%

If leverage is a concern for shareholders of Kubwa Ltd, they would be more inclined to possess shares in Small Ltd. Conversely, shareholders of Small Ltd, who prioritize leverage, might hesitate to acquire shares in Kubwa Ltd.

4. Growth in earning per share and dividend per share

Due to its sluggish growth in earnings per share and dividend per share, Small Ltd is currently surpassing Kubwa Ltd in these aspects. As a result, potential investors may hesitate to acquire shares in Kubwa Ltd due to its unfavorable growth prospects.

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QUESTION 5(a)

Q How currecy swap can be used to hedge against foreign exchange operating exposure of a firm

A

Solution

➧ Identifying the Exposure: The firm assesses its operating exposure by identifying the specific currencies in which it has cash flow exposure. For example, if a company operates in multiple countries and generates revenues or incurs expenses in different currencies, it may face operating exposure to those currencies.

➧ Designing the Currency Swap: The firm then enters into a currency swap agreement with a counterparty. In a currency swap, two parties agree to exchange a specified amount of principal and interest payments denominated in different currencies. The terms of the swap, such as the notional amount, currencies, and maturity, are determined based on the firm's exposure and risk management objectives.

➧ Hedging Cash Flows: Through the currency swap, the firm can effectively hedge its operating exposure. For instance, if the firm has cash flow exposure to a foreign currency, it can enter into a swap agreement to exchange the foreign currency cash flows for the domestic currency equivalent. By doing so, the firm locks in a fixed exchange rate, reducing the uncertainty and potential impact of exchange rate fluctuations on its cash flows.

➧ Mitigating Exchange Rate Risk: The currency swap allows the firm to convert its foreign currency cash flows into its domestic currency at a predetermined exchange rate. This helps in mitigating the exchange rate risk associated with the operating exposure. Regardless of the actual exchange rate movements, the firm's cash flows are protected by the terms of the swap.

➧ Monitoring and Managing the Swap: Throughout the duration of the swap, the firm needs to actively monitor and manage its exposure. This may involve periodically reviewing and adjusting the hedge position based on changes in the operating exposure, market conditions, or the firm's risk management strategy.

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QUESTION 5(b)

Q (i) Demonstrate how International Bank could capitalise on its expectations without using deposited funds.
( ii) Estimate the profits that could be generated from the strategy adopted in (b) (i) above.

A

Solution

(i) Demonstrate how International Bank could capitalise on its expectations without using deposited funds.

1. Borrow MXP 70 million

2. Convert borrowed million MXP to US dollars at prevailing rates

1 mxp = $0.15
70,000,000 MXP = $?

70,000,000 × 0.15 = $10,500,000

3. Lend borrowed amount at 8% annalised over a 10 day period future value of amount

= $10,500,000[1 + (0.08 x 10 / 360)]

= $10,523,333.33

4. Repay borrowed MXP amount at 8.7% annualized over a 10 day period. Future value of amount

= MXP 70,000,000 [1 + (0.087 x 10 / 360)]

= MXP 70,169,166.67

5. Amount to get in MXP after converting $ 10,523,333.33 to MXP

1 MXP = $0.14
? MXP = $10,523,333.33

10,523,333.33 / 0.14 x 1

MXP = 75,166,666.64

(ii) Estimating the profits that could be p erated from the strategy adopted in (b) above

Arbitrage profit = 75,166,666.64 - 70,169,166.67

MXP 4,997,499.973

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QUESTION 5(c)

Q (i) Demonstrate how International Bank could capitalise on its expectations without using deposited funds.
( ii) Estimate the profits that could be generated from the strategy adopted in (c) (i) above.

A

Solution

(i) Demonstrate how International Bank could capitalise on its expectations without using deposited funds.

i. Borrow US Dollard 10 million

ii. Convert them into Mexican pesos at prevailing spot rate

1 MXP = $0.15
?= $ 10,000,000

MXP = 10,000,000 / 0.15 x 1 = MXP 66,666,666.67

iii. Lend USD 10 million in the interbank market at 8.5 % annualized over a 30 day period

MXP 66,666,666.67 x [1 + (0.085 x 30 / 365)]

MXP 67,132,420.09

iv. Convert back to us dollars at rate prevailing at end of 30 days period

1 MXP = $0.17
67,132,420.0.9 = $?

67,132,420.09 x 0.17 / 1 = $11,412,511.42

v. Amount to pay back in Us Dollars after 30 days

$10,000,000 [1 + (0.083 x 30 / 360)] = $ 10,069,166.67

(ii) Estimating the profits that could be generated from the strategy adopted in (c) (i) above

Arbitage gain = 11,412,511.42 - 10,069,166.67 = $1,343,344.753

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QUESTION 5(d)

Q Short comings of the Black-Scholes Option pricing Model:

A

Solution

The Black-Scholes option pricing model is a mathematical formula used to calculate the theoretical value of European-style options. It was developed by economists Fischer Black and Myron Scholes in 1973. The model is based on the concept of risk-neutral valuation

Short comings of the Black-Scholes Option pricing Model:

➧ Assumptions may not hold: The model relies on several assumptions that may not fully capture the complexities of real-world markets. These assumptions include constant volatility, continuous trading, risk-free interest rates, no transaction costs, and efficient markets. In reality, these assumptions may not hold, and deviations from these assumptions can affect the accuracy of the model's predictions.

➧ Limited applicability: The Black-Scholes model is primarily designed for European-style options, which can only be exercised at expiration. It does not account for American-style options, which can be exercised at any time before expiration. The model's assumptions are better suited for European options on non-dividend-paying stocks, and its applicability to other types of options, such as those on dividend-paying stocks or with complex features, may be limited.

➧ Volatility estimation: The model assumes that volatility is constant over the option's life, which may not reflect the actual dynamics of volatility in the market. Estimating volatility accurately can be challenging, and changes in volatility can significantly impact option prices. The model's sensitivity to volatility assumptions is known as the volatility risk or the volatility smile problem.

➧ Non-normal distribution of returns: The Black-Scholes model assumes that stock returns follow a log-normal distribution. However, empirical evidence suggests that stock returns have fat tails and exhibit skewness, meaning that extreme events occur more frequently than what the normal distribution assumes. This can lead to underestimating the likelihood of large price movements and, consequently, mispricing options.

➧ No consideration of market frictions: The Black-Scholes model does not incorporate market frictions, such as transaction costs, liquidity constraints, or market impact. These frictions can impact the actual execution and trading of options, deviating from the idealized assumptions of the model.

➧ Limited flexibility for real-world complexities: The Black-Scholes model assumes a constant risk-free interest rate, whereas interest rates can vary over time. Additionally, it does not account for factors such as taxes, dividends, or early exercise provisions. These complexities may require modifications or extensions to the model to capture the real-world dynamics accurately.

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CPA
Advanced Leval
Advanced Financial Management November 2016
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Comments on CPA past papers with answers:

Advanced Public Finance

Advanced Financial reporting & analysis

Advanced Auditing & Assurance

Advanced Management Accounting

Advanced taxation

Comments on:

CPA
Advanced Leval
Advanced Financial Management November 2016
Suggested solutions