ADVANCED FINANCIAL MANAGEMENT NOVEMBER 2018 - CPA SOLUTION|REVISION KITS|KASNEB

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(Β_e ) = Β_α[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.

K_d = 1(1 - t).

8(1 - 0.3) = 5.6% .

Weighted average cost of capital reconstruction.

WACC = W_eK_e + W_dK_d.

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

Geared Beta (B_e) after financial reconstruction.

B_e = B_α[1 + D / E(1 - T)].

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

Cost of equity after reconstruction.

K_e= 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

P_i(A-Ā)(B-B̄)	P_i	A	Ā=P_iA	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

∑P_i(A-Ā)(B-B̄) = -21.25.

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

Weight A

=

δ_B² - COV_A&B

δ_A² + δ_B² - 2COV_A&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	PVAF_17%,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	∑P_iA	A-Ā	∑P_i(A-Ā)²	M	∑P_iM	M-M̄	∑P_i(M-M̄)²	P_i(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

δ_M²

7.28 / 10.21. = 0.713.

P	B	∑P_iB	B-B̄	∑P_i(B-B̄)²	M	∑P_iM	M-M̄	∑P_i (M-M̄)²	P_i(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 = R_ƒ + Β(R_m - 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.

B_e = B_α [1 + D / E(1-T)].

Where:

B_α 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 (K_d) will equal to:

K _d = I(1-T).

Debt	Equity	D/E	B_e	K_e	K_d	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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CPA
Advanced Leval
Advanced Financial Management November 2018
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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 2018
Suggested solutions