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CPA
Advanced Leval
Advanced Financial Management November 2018
Suggested solutions

Advanced Financial Management
Revision Kit

QUESTION 1(a)

Q (i) Leveraged Buyout and Management Buyout:

(ii) Divestiture and spin-off:

(iii) Unbundling and Sell off:
A

Solution


(i). Leveraged Buyout and Management Buyout

Leveraged Buyout is a tactic that involves purchasing a publicly traded company utilizing a sizable number of bonds or loans to cover the cost of acquisition.

Management Buyout a deal in which the management team of a corporation buys the assets and operations of the company they oversee. MBOs typically take place when a company is taken private in an effort to improve profitability and streamline operations.

➪ In a leveraged buyout the business is sold to private investors where as in a management buy out the business is sold to the managers of the business unit,division or subsidiary.

(ii).Divestiture and spin-off:

Divestment – It refers to selling a stake in or ownership of particular investments, business units associated with production lines, divisions, or workforces.This can be done to free up money that can be spent more wisely in other business areas.Additionally, it might be done strategically or in order to focus on the essential functions of the company.

Spin-off – includes separating the existing company into one or more completely separate businesses without giving outside investors control.This means that through different corporate reorganization processes, the old firm is turned into a new company, and the shareholders of the original company become the shareholders of one or more of the newly established companies.

(iii). Unbundling and Sell-off:

Unbundling – is a portfolio reconstruction strategy whereby a company will sell off its assets, business units, production lines, operating divisions, subsidiaries, and other units in order to improve the performance of the parent company or the newly formed units. Unbundling may be performed voluntarily or under duress.

Sell-off – occurs when a lot of securities are sold quickly, bringing in a series of steep price drops for the securities. When there are more shares available than there are willing buyers, the price may fall faster as market sentiment becomes negative.

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QUESTION 1(b)

Q Evaluate the impact of financial reconstruction on Mayueni Ltd's weighted average cost of capital (WACC).
A

Solution


Geared Beta(Βe ) = Βα[1 + D / E(1 - T)].

Where:

α = Asset Beta = 0.3.

D / E = Debt Equity ratio = 0.8.

Therefore geared beta before financial reconstruction.

0.3 [1 + 0.8 (1 - 0.3)] = 0.468

Cost of equity before financial reconstruction using CAPM formula.

8% + 0.468(14% - 8%) = 10.81 %.

After tax cost of debt before financial reconstruction.

Kd = 1(1 - t).

8(1 - 0.3) = 5.6% .

Weighted average cost of capital reconstruction.

WACC = WeKe + WdKd.

(10.81 x 1/1.8) + (5.6 x 0.8 / 1.8) = 8.49%

Geared Beta (Be) after financial reconstruction.

Be = Bα[1 + D / E(1 - T)].

0.3(1 + 1.2(1 - 0.3)] = 0.552.

Cost of equity after reconstruction.

Ke= 8 + 0.552(14 - 8) = 11.312%.

Weighted average cost of capital after reconstruction.

WACC = (11.312 x 1 / 2.2) + (5.6 x 1.2 / 2.2) = 8.196%

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QUESTION 1(c)

Q The proportion of each security to be invested in the portfolio in order to attain a zero portfolio risk (6 marks)
A

Solution


Pi(A-Ā)(B-B̄) Pi A Ā=PiA A-Ā P(A-Ā) 2 B B̄ B-B̄ P(B-B̄)2
-2.25 0.1 -5 -0.5 -18 32.4 10 1 1.25 0.15625
-4.6875 0.25 10 2.5 -3 2.25 15 3.75 6.25 9.765625
1 0.4 15 6 2 1.6 10 4 1.25 0.625
-15.3125 0.25 20 5 7 12.25 0 0 -8.75 19.140625
∑ = -21.25 ∑ ̄ = 13 ∑ = 48.5 ∑ = 8.75 ∑ = 29.6875


Standard deviation security A.

=√48.50 = 6.96.

Standard deviation security B.

=√29.6875 = 5.45

Covariance of security A and B

∑Pi(A-Ā)(B-B̄) = -21.25.

Proportion of investment in security A to Obtain a Zero risk portfolio.

Weight A
=
δB2 - COVA&B
δA2 + δB2 - 2COVA&B


Weight A
=
29.6875 - (-21.25)
48.5 + 29.6875 - (2 x -21.25)


50.9375 / 120.6875 = 0.4221

Weight B = 1 - 0.4221.

0.5779.

Therefore to obtain a zero risk portfolio, invest 42.21% of the funds in security A and remaining 57.7990 of the funds in security B.


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QUESTION 2(a)

Q Practical challenges encountered when making capital investment decisions:
A

Solution


(i). Uncertainty of values of decision variables

The value of a capital investment's decision variables, such as the asset's useful life, scrap value, annual sales revenue, annual variable costs, additional working capital investments, changes in tax rates, changes in discounting rates, etc., cannot be predicted with certainty because the future is uncertain.

(ii). Conflict in the ranking of projects

Internal rate of return (IRR) and net present value (NPV) approaches may evaluate mutually exclusive projects in different ways, making it challenging to make an investment decision.when this is the situation.IRR results are superseded by NPV technique results.

(iii). Capital rationing

This happens if there aren't enough money to carry out all feasible capital investments through to completion.There are several different types of capital rationing, including single period, multi period, soft capital, and hard capital rationing.



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QUESTION 2b(i)

Q Expected net present value (NPV) of the new product.
A

Solution


Depreciation annually
=
initial outlay - scrap value
Useful Life
280,000,000 - 0
5
= Sh 56,000,000


Expected selling price
0.30 x 35 + 0.4 x 30 + 0.30 x 50 = Sh.37.50
Expected unit variable cost
0.2 x 15 + 0.5 x 10 + 0.3 x 25 = 15.50

Expected contribution per unit
Expected selling price per unit - Expected variable cost per unit
37.50 - 15.50 = Sh 22

Expected sales volume
0.1 x 4 + 0.6 x 7 + 9 x 0.3 = 7.3

Expected contribution 7,300,000 x 22
Less: Fixed operating costs
Profit before Depreciation & tax
Less: tax 30%
Profit after tax
Add: Depreciation Tax Shield((280 - 0)/5) x 30%
Annual cash inflows		 160,600,000
(30,000,000)
(130,600,000)
(39,180,000)
91,420,000
16,800,000
108,220,000


Expected net present value
(108,220,000 x 3.1993) - 280,000,000 = Sh. 66,228,246.


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QUESTION 2b(ii)

Q Simulating the net present values (NPV) using the following random numbers:

(802560 638351 057530 150353 603785 553525 245239 369948 160252 857015)

and computing the expected net present value of the project.
A

Solution


Step 1
Construct probability distribution table

Unit selling price probability Cumulative Probability Random number
35
30
50		 0.30
0.40
0.30		 0.30
0.70
1.00		 00-29
30-69
70-99


Unit variable cost probability Cumulative Probability Random number
15
10
25		 0.20
0.50
0.30		 0.20
0.70
1.00		 00-19
20-69
70-99


Annual sales volume
(Sh.Million)		 probability Cumulative Probability Random number
4
7
9		 0.10
0.60
0.30		 0.10
0.70
1.00		 00-09
10-69
70-99


Step 2
Determine the number of runs
Number of runs = No. random no.s based on digits in the probability list / No. of Variables
30 / 3 = 10 runs

Step 3
Construct simulation worksheet

S.p = Selling Price
V.c = Variable cost
S.v = Sales volume
C = Contribution
F.c = Fixed cost
PBDT = Profit Before Depreciation and Tax
D.T.S = Depreciation Tax Shield

Run Rn1 S.p Rn2 V.c Rn3 S.v C F.c PBDT
1
2
3
4
5
6
7
8
9
10		 80
63
05
15
60
55
24
36
16
85		 50
30
35
35
30
30
35
30
35
50		 25
83
75
03
37
35
52
99
02
70		 10
25
25
15
10
10
10
25
15
25		 60
51
30
53
85
25
39
48
52
15		 7
7
7
7
9
7
7
7
7
7		 280
35
70
140
180
140
175
35
140
175		 30
30
30
30
30
30
30
30
30
30		 250
5
40
110
150
110
145
5
110
145


PBDT Tax P.A.T D.T.S Annual Cashflows PVAF17%,5yrs P.V Initial Outlay NPV
250
5
40
110
150
110
145
5
110
145		 75
1.5
12
33
45
33
43.5
1.5
33
43.5		 175
3.5
28
77
105
77
101.5
3.5
77
101.5		 16.8
16.8
16.8
16.8
16.8
16.8
16.8
16.8
16.8
16.8		 191.8
20.3
44.8
93.8
121.8
93.8
118.3
20.3
93.8
118.3		 3.1993
3.1993
3.1993
3.1993
3.1993
3.1993
3.1993
3.1993
3.1993
3.1993		 613.626
64.946
143.329
300.094
389.675
300.094
378.477
64.946
300.094
378.447		 280
280
280
280
280
280
280
280
280
280		 333.626
(215.054)
(136.671)
20.094
109.675
20.094
98.477
(215.054)
20.094
98.477
133.758


Expected NPV = 133.758 / 10 x 1,000,000 = 13,375,800


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QUESTION 3a

Q (i). Evaluate whether Dzikunze Ltd's share is currently overvalued or undervalued by the market forces. (8 marks)

(ii). Advise a prospective investor whether to buy the ordinary shares of Dzikunze Limited. (2 marks)
A

Solution


Overall cost of capital using CAPM Formula.

Cost of capital = Risk free Rate + Overall Beta (Return market - Risk free rate).

12 + 0.8(28 - 12).

24.8%.

Number of shares Dzikunze limited.

Ordinary share capital/par value.

30,000 / 20 = 1,500.

Dividend per share 2017.

3,000 / 1,500 = Sh. 2 per share.

Dividend growth rate in perpetuity.

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

g = [(3,000 / 2,100)1/2 - 1] x 100% = 19.52%.

Value of share using Gordon model.

Year Dividend per share Discount factor(24.8*) PV
1 2 x 1.25 1 = 2.5 0.8013 2.00325
2 2 x 1.25 2 = 3.125 0.6421 2.00656
3 2 x 1.25 3 = 3.906 0.5145 2.00064
4 to
3.906(1.1952)
0.248 - 0.1952
=
88.418
 0.5145 45.4909
Fair value of share 51.5103


Ex dividend price = cum dividend price - Dividend per share.

67.7 - 2 = Sh.65.70.

Since fair value of 51.5103 is below current ex dividend price of 65.70 then Dzikuze limited share is overvalued.

(ii). Advice

A prospective should not buy shares of Dzikunze since they are overvalued


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QUESTION 3b

Q (i) Determine whether forward market hedge, money market hedge or currency option hedge would be the most appropriate hedging strategy for the company

(ii). Advise a prospective investor, the most appropriate hedging strategy if no hedging takes place
A

Solution


(i). Forward market hedge.

Expected forward rate.

0.2 × 61 + 0.5 x 63 + 0.3 x 67.

12.20 + 31.50 + 20.1.

63.80.


Forward rate

1$ - Kes 63.80.
$ 800,000 = Kes?.

800,000 × 63.80. = Ksh. 51,040,000.

(ii) Currency option hedge.
]br Effective put option = Exercise - Premium price.

63 - 4 = Sh.59.

Therefore;

$1 = Sh.59.
$ 800,000 = Sh?.
800,000 × 59 = Shs. 47,200,000.

(iii) Money market hedge.

(a) Borrow amount from USA present.

Value of borrowed amount.

PV = Amount borrowed / (1 + foreign borrowing rate) = $800,000/ 1.12.

$714,285.71.

b) Convert amount borrowed above at prevailing spot rate.

$1 = Sh. 60,

$714,285.71 = Sh?.

714,285.71 x 60. = Sh. 42,857,142.86.

(c) Invest amount in Kenya immediately.

Future value (FV) = PV (1 + r).

42,857,142.86(1.09)¹ = Sh. 46,714,285.71.

Advice.

The forward contract hedge is the most suitable hedging method because Chigiri Investment Limited will profit most from it.

(ii) Advise a prospective investor, the most appropriate hedging strategy if no hedging takes place

If no hedging takes place then.

$1 Kshs = 62.
800,000$ = Kshs?.

800,000 × 62 = Sh. 49,600,000.


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QUESTION 4(a)

Q The value of call option using the Black Scholes Model
A

Solution


d1
=
In
[
S
X
]
+
(
r +
(
δ
2
)
2
)
t
δ
√ t 


Where:

s = price of stock = Shs. 35.
x = strike price = Shs. 30.
r = risk free rate = 10%.
t = time in years 9/12 = 0.75 .
δ = volatility of returns = 0.3.

d1
=
In
[
35
30
]
+
(
0.1 +
(
0.3
2
)
2
)
0.75
0.3
√ 0.75 


(0.1542 + 0.10875) / 0.2598 = 1.01

d₂ = d₁ - δ√t.

1.01 - 0.2598 = 0.7502.

N(d1 ) = 0.5 + 0.3438 = 0.8438.

N(d2 ) = 0.5 + 0.2734 = 0.7734.

Value of call option.

C = SN(d₁) 1 - Xe-rt N(d2)

(35 x 0.8438) - 30 x e-0.1 x 0.75 × 0.7734.

29.533 - 21.526 = Sh.8.007

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QUESTION 4(b)

Q (i) The Beta coefficient of securities A and B.

(ii) Using capital asset pricing model (CAPM) to determine the minimum required rate of returns for securities A and B.
A

Solution


P A ∑PiA A-Ā ∑Pi(A-Ā)2 M ∑PiM M-M̄ ∑Pi(M-M̄)2 Pi(A-Ā)(M-M̄)
0.2 15 3 4.6 4.232 16 3.2 4.7 4.418 4.324
0.5 10 5 -0.4 0.080 12 6 0.7 0.245 -0.14
0.3 8 2.4 -2.4 1.728 7 2.1 -4.3 5.547 3.096
A=10.4 6.04 11.3 10.21 7.28


Standard deviation security A = √6.04 = 2.46.

Standard deviation market = √10.21 = 3.20.

Beta coefficient security A.

Covariance A&M
δM2


7.28 / 10.21. = 0.713.

P B ∑PiB B-B̄ ∑Pi(B-B̄)2 M ∑PiM M-M̄ ∑Pi (M-M̄)2 Pi(B-B̄)(M-M̄)
0.2 12 2.4 -0.9 0.162 16 3.2 4.7 4.418 -0.846
0.5 15 7.5 2.1 2.205 12 6 0.7 0.245 0.735
0.3 10 3.0 -2.9 2.523 7 2.1 -4.3 5.547 3.741
12.9 4.89 11.3 10.21 36.30


Standard deviation security B.

√4.89 = 2.211.

Beta coefficient security B.

3.63 / 10.21 = 0.356.

(ii) Using capital asset pricing model (CAPM) to determine the minimum required rate of returns for securities A and B.

CAPM = Rƒ + Β(Rm - R ƒ )

Minimum required return A = 8 + 0.713(11.3 - 8) = 10.35%.

Minimum required return B = 8 + 0.0356(11.3 - 8) = 9.17%


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QUESTION 4(c)

Q (i) The relevant offer price range.(4 marks)

(ii) If Roka Ltd's shareholders accept an offer by Chilulu Ltd, of Sh 40 per share in a share for share exchange Determine the post-merger earnings per share (EPS). (4 marks)

(iii) Using the results obtained in (c) (i) above and assuming that Chilulu Ltd's price-earning (P/E) ratio will remain unchanged after the merger, determine the post acquisition market price of a share of Chilulu Limited (2 marks)
A

Solution


(i) The relevant offer price range.

Non-diluting offer price(maximum price).

P/E Predator x EPS target.

50/5 x 6 = Sh.60.

Minimum price = 25/100 x 40 = Sh.10.

Relevant offer price range Sh.10 to Sh.60

(ii) If Roka Ltd's shareholders accept an offer by Chilulu Ltd, of Sh 40 per share in a share for share exchange Determine the post-merger earnings per share (EPS).

Exchange ratio
=
Offer price
MPS Predator
=
40 / 50 = 0.8.


New shares issued = Exchange Ratio x Number of shares target.

0.8 x 2 = 1.6 million.

Post merger EPS chillum ltd.

Earnings target + Earnings predator
Shares predator + new shares issued


(30+12)
(6+1.6)


Shs. 5.53.

Post merger EPS target.

Post merger Predator x Echange ratio.

5.53 × 0.8 = Sh. 4.42.

(iii) Using the results obtained in (c) (i) above and assuming that Chilulu Ltd's price-earning (P/E) ratio will remain unchanged after the merger, determine the post acquisition market price of a share of Chilulu Limited

Post merger market price = premerger + premerger Per share chilulu market value of old Shares + new shared issued.

(6 x 50)/6 + (2 x 40)/1.6 = 50 + 50 = Sh.100

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QUESTION 5(a)

Q Assumptions of the income approach of valuing real estate firms/business
A

Solution


➪ Value is a function of income – People buy real estate that generates money in order to profit from their investments. As a result, the estimated value of a property is determined by the potential income it could generate. Therefore, the type of property being assessed must be one that is frequently purchased or sold based on its source of income..

➪ Investors will Estimate the Duration, Quantity, and Quality of the Future Income - Knowing how much income investors will receive, how long they will receive it, and the dangers involved in doing so will help determine a property's price. This strategy makes the assumption that a real estate investor will calculate the risk and duration of a revenue stream.

➪ Future income is less valued thanpresent income. – In this strategy, the idea of present value is crucial.It stipulates that the total present value of all future income payments will never equal the total amount of those payments when they have not been discounted.In addition, investors favor current rewards above future returns.They discount future returns when an alyzing investments.

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QUESTION 5(b)

Q Using purchasing power parity model,recomend the tender priced to be used (7 marks)
A

Solution


Forward rate =
Spot rate x
(
1 + Inflation home country
1 + Inflation foreign country
)


8.125 x
1.082
1.062

8.434.

Foward rate 2yrs time 1 ZAR = Ksh 8.434.

Tender price in Ksh = 120 / 100 x 2,000,000.

Ksh.2,400,000

Ksh.8.434 = 1 ZAR
Ksh.2,400,000 = ?.
2,400,000 / 8.434 = ZAR 284,562.4852

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QUESTION 5(c)

Q (i) The Optimal capital structure of embakasi investment ltd. (6 marks)

(ii) The optimal weighted average cost of capital of embakasi investment ltd
A

Solution


Geared Beta equity can be estimated by.

Be = Bα [1 + D / E(1-T)].

Where:

Bα Asset Beta = 1.2.
T = tax rate = 30% or 0.3.

Cost of equity (K) will be estimated using capital asset pricing model.

After tax cost of debt (Kd) will equal to:

K d = I(1-T).

Debt Equity D/E Be Ke Kd WACC
0.00 1.00 0.00 1.2 14.60% 0.00% 14.6%
0.2 0.8 0.25 1.41 16.28% 5.95% 14.21%
0.375 0.625 0.6 1.704 18.63% 7.00% 14.277%
0.621 0.37 1.70 2.628 26.02% 9.80% 15.80%
0.711 0.286 2.50 3.3 31.40% 11.20% 16.98%


Optimal capital structure of embakasi investment ltd is to use 20% debt and 80% equity because it has the lowest WACC

(ii) The optimal weighted average cost of capital of embakasi investment ltd

The optimal weighted average cost of capital is 14.21%

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