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Advanced Leval
Advanced Financial Management November 2019
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Advanced Financial Management
Revision Kit

QUESTION 1a(i)

Q (a) Distinguish between "insolvency" and "bankruptcy" as used in business restructuring. (2 marks)
A

Solution


(i) Distinction between "insolvency" and "bankruptcy" as used in business restructuring.

➫ Bankruptcy can help those who can no longer pay their debts start over by liquidating assets to pay off their debts or creating a repayment plan. Bankruptcy laws also protect companies in financial difficulty where as
➫ insolvency is a financial situation in which a person's or a company's debts exceed its assets.

➢ Insolvency is a pre- requisite for bankruptcy but not every person insolvent is bankrupt.

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QUESTION 1a(ii)

Q (ii) Highlight four causes of business failure. (4 marks)
A

Solution


(ii) Causes of business failure.

➢ Over-investment in fixed assets.

➢ High interest rates.

➢ Lack of experience.

➢ Inability to compete with other similar businesses

➢ Inability to recover from a major business interruption.

➢ Excessive regulations.

➢ Lack of patience

➢ Poor management decisions.

➢ Poor business location.

➢ Business finance mismanagement.

➢ Recessions.

➢ Engaging in the wrong business niche.

➢ High taxation.

➢ Insufficient capital.

➢ Insufficient marketing.

➢ Poor inventory management.

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QUESTION 1b(i)

Q Sales volume
A

Solution




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QUESTION 1b(ii)

Q Sales Price
A

Solution




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QUESTION 1b(iii)

Q Variable Cost
A

Solution




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QUESTION 1c

Q The expected net present value (NPV) of the project using scenario analysis.
A

Solution




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QUESTION 2a(i)

Q Advise to Kanga Limited on the best alternative based on Net present value (NPV) approach
A

Solution



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QUESTION 2a(ii-iii)

Q (ii) Advise to Kanga Limited on the best alternative based on Annualized net present value (ANPV) approach.
(iii) Compare and contrast your results obtained in (a) (i) and (ii) above. (2 marks)
A

Solution


(ii) The best alternative based on Annualized net present value (ANPV) approach.


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QUESTION 2b

Q Advise the company on the optimal weighted average cost of capital (WACC). (12 marks)
A

Solution


Cost of equity (Ke) = Risk rate + Geared beta (RM - RF).

Geared beta = Asset beta = (1 + D/E(1-T)).

After tax debt cost (Kd) = I (1-T).

WACC = WeKe + WdKd

%debt %equity D/E Geared Beta Cost of Equity Kd WACC
0.1 0.9 0.11 1 + 0.11 x 0.7 = 1.077 14.616 4.55 13.62
0.2 0.8 0.25 1 + 0.25 x 0.7 = 1.175 15.4 4.97 13.31
0.3 0.7 0.43 1 + 0.43 x 0.7 = 1.301 16.408 5.46 13.12
0.4 0.6 0.67 1 + 0.67 x 0.7 =1.469 17.752 5.95 13.02
0.5 0.5 1.00 1 + 1 x 0.7 = 1.7 19.6 7.00 13.30
0.6 0.4 1.50 1 + 1.5 x 0.7 = 1.05 14.4 8.40 10.80
0.7 0.3 2.33 1 + 2.33 x 0.7 = 2.631 27.048 10.5 15.47


Optimal weight avarage cost of capital is 10.80% which is the lowest

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QUESTION 3a

Q Summarise five functions of the International Monetary Fund (IMF). (5 marks)
A

Solution


Functions of international monitory fund(IMF).

➫ Stabilize economies

➫ Exchange stability.

➫ Eliminating balance of payment disequilibrium.

➫ Determination of par values.

➫ Reducing tariffs.

➫ Mantain balances between demand and supply of currencies

➫ liquidity Maintenance.

➫ Technical assistance.

➫ Credit facilities.

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QUESTION 3b

Q (i) The expected return on the portfolio. (3 marks)

(ii) The correlation coefficient between security X and security Y. (4 marks)

(iii) The portfolio risk. (2 marks)

(iv) The reduction in risk due to portfolio diversification. (2 marks)
A

Solution



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QUESTION 3c(i)

Q (i) The expected return for the stock using the arbitrage pricing theory (APT) model. (2 marks)
A

Solution


5 + (0.7 x 2.5) + (1.2 x 5) – (0.1 x 6)

5 + 1.75 + 6 - 0.6

12.15%

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QUESTION 3c(ii)

Q Explain two differences between capital asset pricing model (CAPM) and arbitrage pricing theory (APT) model. (2 marks)
A

Solution


Differences between capital asset pricing model (CAPM) and arbitrage pricing theory (APT) model.

1. CAPM assumes the existence of a well-diversified portfolio, while APT ignores the assumption of a well-diversified portfolio.

2. CAPM assumes normal distribution of return whereas APT assumes return are generated through trading..

3. APT is a multifactor model whereas CAPM is a single factor model.

4. CAPM uses indifference curves to determine investor utility, while APT does not use indifference curves to determine utility.

5. APT is a multi-period model while CAPM is a single period model

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QUESTION 4a

Q (i) "Currency option" and ''currency swap' (2 marks)

(ii) "Interest rate swap" and "interest rate collar". (2 marks)

(iii) "Hedgers" and speculators". (2 marks)
A

Solution


(i) Difference between "currency option" and "Currency swap" .

➫ Currency swap consists of exchanging a certain amount of money in one currency for an equivalent amount in another currency.
By agreeing to a swap,two companies are able to obtain low-cost loans and hedge against volatility.
➫ Currency options are contracts that give the buyer the right, but not the obligation, to buy or sell a currency at a specified exchange rate on or before a specified date.
Major difference of currency swap and currency option is that there is no exchanging of currencies.

(ii) Difference between "interest rate swap" and interest rate collar".

➫ An interest rate swap is a forward contract in which one stream of future interest payments is exchanged for another based on a specified principal amount.
➫ An interest rate collar is an investment strategy that uses derivatives to hedge an investor's risk against interest rate fluctuations. An interest rate collar protects borrowers against rising rates, while settling a floor that protects against falling rates.

(iii) Difference between hedgers and speculators.

➫ Speculators are investors who attempt to make a profit from a security price change while;
➫ Hedgers reduce amount of risk associated with a security's price change

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QUESTION 4b

Q The current value of each property using the Net Income (NI) approach. (4 marks)
A

Solution


Value of property A = 41,245,900/0.12 = 343,715,833.3

Value of property B .

WACC of B = (0.5 x 10) + (0.5 x 12) = 11%

Sh.
Operating profit 41,245,900
Interest (21,500,000)
19,745,900


Value of equity = 19,745,900/0.11 = Sh.179,508,181.8

Value of property B = Debt value + equity value.

179,508,181.8 + 215,000,000 = Sh.394,508,181.8

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QUESTION 4c

Q (i) The initial investment required to issue the new bond, (4 marks)

(ii) Annual cash flow savings (if any) expected from the bond refinancing decision. (4 marks)

(iii) The net present value (NPV) of the refinancing decision. (l mark).

(iv) Advise the company on whether to refinance the bond based on your results in (c) (iii) above. (l mark)
A

Solution


(i) The initial investment required to issue the new bond

Sh
"million"		 Sh
"million"
Call premium(0.1 x 100) 10
Overlapping interest(2/12 x 16/100 x 100 2.67
Discount new bond(5/100 x 100 5.0
Floatation cost new bond(3/100 x 100) 3.0
Gross cash outlay 20.67
Less:tax shield benefit
Call premium 10.00
Overlapping interest 2.67
Un amortised discount old brand (0.02 x 100)/10 x 5 1.00
Unamortised issue cost old bond(2/5 x 5) 1.00
14.67 x 0.4 (5.868)
14.802


(ii) Annual cash flow savings (if any) expected from the bond refinancing decision.

Sh."million" Sh."million"
Interest old bond(0.16 x 100) 16
Less:tax shield benefit 16
Amortised discount 0.2
amortised issue cost 0.2
16.4 x 0.4 (6.56)
Annual cost savings 9.44


Annual cash flow due to issue of new bonds.

Sh."million" Sh."million"
Interest old bond(0.12 x 100) 12
Less tax shield benefit 12
Amortised discount 1
Amortised issue cost 0.6
13.6 x 0.4 (5.44)
Annual cost savings 6.56


Annual cash savings = 9.44 - 6.56 = Sh.2.88 million

(iii) The net present value (NPV) of the refinancing decision.

=(2,880,000 × 4.1002) - 14,802,000.

= Sh. 11,808,576 - 14,802,000 = (Sh.2,993,424).

(iv) Advise the company on whether to refinance the bond based on your results in (c) (iii) above.

We should not refinance the bond as it will result to a negative net present value.


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QUESTION 5a

Q (i) Horizontal.(l mark).
(ii) Vertical.(l mark).
(iii) Congeneric.(l mark).
(iv) Conglomerate.(l mark)
A

Solution


(i) Horizontal type of merger.

Is one in which one company acquires another company in the same line of business. A horizontal merger happens between firms who produce products that are considered substitutes and compete with each other. The main benefit of horizontal merges is to reduce competition in the market in which the firms operate. These firms are also likely to purchase the same or substitute products in the input market.Horizontal mergers mostly lead to horizontal integration.

(ii) Vertical type of merger.

A vertical merger is a merger between companies operating at different stages of production or producing complementary products, such as a leather shoe manufacturer acquiring a leather tanning company. Vertical integration is considered backward when a company merges with a supplier and forward when a company merges with a customer.

(iii) congeneric type of merger.

A Congeneric merger is a merger in which two companies are in the same industry or market, but do not offer the same products in a congeneric merger. The two companies may share similar distribution channels, which provides synergies to the merger.
A congeneric merger allows the target firm and its acquirer to exploit overlapping technologies or production processes to expand its product line or increase its market share.

(iv) Conglomerate type of merger.

These mergers are neither vertical nor horizontal. In a conglomerate merger, a company acquires another company in an unrelated industry, such as a telco company acquiring a printing company.

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QUESTION 5b

Q (i) The maximum exchange ratio that A Ltd. should agree to assuming that it does not expect dilution in its post acquisition earnings per share (EPS). (2 marks)

(ii) The total premium the shareholders of B Ltd. would agree to receive at the exchange ratio in (b) (i) above. (2 marks)

(iii) A Ltd. 's post acquisition earnings per share (EPS) assuming that the two companies agree on an offer price of Sh.30.(2 marks)

(iv) A Ltd.'s post acquisition earnings per share (EPS) assuming that for every 100 ordinary shares of B Ltd.. the shareholders are offered two, 12 % debentures of Sh.500 par value. (3 marks)
A

Solution


(i) Non diluting offer price = P/E Predator X EPS target.

60/4 X 3= Shs. 45.

Maximum exchange ratio = Non diluting offer price/Market price predator.

= 45 ÷ 60 = 0.75

(ii) New shares issued = Exchange ration x no of shares target.

= 3,000,000 × 0.75.

= 2,250,000 shares.

Total premium (Offer price target - MPS target) new shares issued.

= (45 - 30) x 2,250,000 shares = Sh. 33,750,000

(iii) Exchange ratio = Offer price/Mps predator .

30/60 = 0.5.

New shares issued = exchange ratio x shares target.

3,000,000 x 0.5 = 1,500,000. shares

Post acquisition EPS A = (Combined earnings)/(shares A + new shares issued).

(40,000,000 + 9,000,000)/(10,000,000 + 1,500,000) = Sh.4.26

(iv) 100 shares B = 2 bentures A.

3,000,000 shares B = ?

(3,000,000/100 x 2) = 60,000 debentures.

Value of debentures = 500 x 60,000 = Sh.30,000,000

Pre-tax debenture interest = 12/100 x 30,000,000 = 3,600,000.

Post-tax debenture interest = 70/100 x 3,600,000= 2,520,000.

Post acquisition EPS A = (40,000,000 + 9,000,000 - 2,520,000)/10,000,000 = Sh.4.648

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QUESTION 5c

Q Using Modigliani and Miller approach, show that the payment of dividends does not affect the value of the firm. (7 marks)
A

Solution


P₁ = P(1+K)-D o
Where:

P → price at year end.

Po → Price at year begininning = 150.

K → cost of capital = 10% .

D → Divident per share = 3.

P1 =150 (1+0.1)-3 = shs. 162.

Amount to be raised from additional share Issues.

investment + dividends to pay - profit.

25,000,000+ (500,000 x 3) - 15,000,000 = Sh 11,500,000.

New shares issued(M) = Additional financing/P1

11,500,000/162 = 70,987.6543.

Value firm = ((M+N)P 1 + Earnings - Investment)/cost of capital.

Where:

M = Original number shares = 500.000.

N = New shares = 70987.6543

P₁ = at year end = Sh.162.

((500,000+ 70,987.6543)162+15,000,000 - 25,000,000) / 0.1.

Sh.825,000,000

Value of non-dividend firm P₁= Po(1+K) - Do.

= 150(1.1)-0 = 165.

Additional financing to raise from share issue = Investment + dividends - profits.

= 250,000,000 + 15,000,000 = Sh 10,000,000.

New shares issued = Additional Financing/ P₁.

= 10,000 ÷ 165 = 60,606.06061.

Value of firm = ((M+N)P₁ + E-I)/k.

Where :

R M → original shares on issue = 500,000.

N → New shares issued = 60,606.06061.

P₁ → Price at year end = Shs. 165.

E → Earnings = 15,000,000.

I → investment = Sh 25,000,000.

((500,000 + 60,606.060610)165 + 15,000,000 - 25,000,000)/ 0.1 = Shs. 825,000,000

Conclusion:

Therefore whether the firms pays or does not pay dividend, the value remains at Shs. 825 Million.

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CPA past papers with answers