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CPA
Advanced Leval
Advanced Financial Management November 2020
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Advanced Financial Management
Revision Kit

QUESTION 1a

Q Discuss four reasons for restructuring and reorganising an organisatione (8 marks)
A

Solution


Reasons for restructuring and reorganizing.

➢ Emerging Technologies:- Technological innovations that impact your business can require organizational transformation to keep up with the times..... Changes due to the introduction of new technologies are common in most organizations. Harnessing the power of IT may first require a complete overhaul of your current systems and practices. However, new technologies are more efficient and provide economical ways to get the job done.

➢ Management Style:- Organizational transformation allows companies to adapt to changing business conditions. The vertical management hierarchy has been replaced by a simpler, horizontal organizational structure. Adopting an agile, immutable and open operating model requires an innovative approach that facilitates cross-functional collaboration in a truly integrated way.

➢ Downsizing:- As companies adopt new strategies or change their product mix,some employees are laid off by away of restructuring. During this process, job descriptions are reviewed and terms revised so that the rest of the workforce can complete the required tasks without being overwhelmed.

➢ Mergers and acquisitions:- Mergers and acquisitions are common in today's corporate world where growth expectations are paramount. Every merger or acquisition requires constant reorganization to eliminate redundant work systems , accommodate new manager preferences, and ensure consistent procedures and policies.

➢ External pressure:- External pressures can come from many different areas, including customers, competitors, changing government regulations, and other environmental factors.Sometimes, this pressure can force organizational change to meet some statutory or regulatory demands.

➢ Performance Gaps:- When business goals and objectives are not being met, change is required to close those gaps. Once the gap has been identified, the next step is to investigate possible causes. Gaps often result from internal inefficiencies. For example, lack of communication and coordination between departments. Problems of this kind can be resolved by reviewing and adjusting internal procedures.

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QUESTION 1b(i-ii)

Q (i) The Z score for Alpha Limited. (5 marks).
(ii) Comment on the results obtained in (b) (i) above. (1 mark)
A

Solution


(i) The Z score for Alpha Limited.

X 1 = Net working capital/Total assets = (100,000 - 20,000)/400,000 = 0.2

X 2 = Retained earnings/Total assets.... = 120,000/400,000 = 0.3.

X 3 = Operating profit/Total assets = 40,000/400,000 = 0.1 .

X 4 = Market value of equity shares / Book value of debt including preference share capital .

No. Of ordinary shares = 100,000/10 = 10,000 shares.

Market value of ordinary shares = 15 x 10,000 = Sh. 150,000.

X 4 = 150,000/(20,000 + 40,000 + 80,000) = 1.07

X 5 = sales/Total assets = 400,000/400,000 = 1

Z = 1.2X 1 + 1.4X 2 + 3.3X 3 + 0.6X 4 + 0.999X 5 .

(1.2 x 0.2) + (1.4 x 0.3) + (3.3 x 0.1) + (0.6 x 1.07) + (0.999 x 1) = 2.631 .

(ii) Comment on the results obtained in (b) (i) above.

The above Z score shows that Alpha Ltd is no danger of failure

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QUESTION 1c(i-ii)

Q (i) Advise the management of Chanzu Limited on whether to undertake the project' (4 marks).
(ii) Comment on the impact of inflation in Cc) (i) above, (2 marks)
A

Solution


i) Whether to undertake the project.

Money rate of return.

(1+i)=(1+r)(1 + h).

Where: i = money rate.

r = Real rate.

h = inflation rate

[(1+0.16) (1.075) - 1] × 100%

(1.247-1) x 100%.

24.7%

Year Fixed income Savings Total
1 2,500,000 500,000 x 1.05 1 = 525,000 3,025,000
2 2,500,000 500,000 x 1.05 2 = 551,250 3,051,250
3 2,500,000 500,000 x 1.05 3 = 578,812.5 3,078,812.5
4 2,500,000 500,000 x 1.05 4 = 607,753.125 3,107,753.125


Year Total Running costs Net cash flows
1 3,025,000 1,000,000 x 1.1 1 = 1,100,000 1,925,000
2 3,051,250 1,000,000 x 1.1 2 = 1,210,000 1,841,250
3 3,078,812.5 1,000,000 x 1.1 3 = 1,331,000 1,747,812.500
4 3,107,753.125 1,000,000 x 1.1 4 = 1,464,100 1,643,653.125


Year Cash flows D.F 24.7% PV
1 1,925,000 0.8010 1,543,657.5
2 1,841,250 0.6431 1,184,107.875
3 1,747,812.5 0.5157 901,346.906
4 1,643,653.125 0.4136 679,814.933


PV of cash flows 4,308,927.214
Less initial outlay 5,000,000
(691,072.786)



(ii) Comment o the impact of inflation.

Inflation leads to increase in cash flows.
Inflation leads to the increase in cost of capital


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QUESTION 2a(i-iii)

Q (i) Jensen's alpha.(2 marks).
(ii) Treynor's alpha.(2 marks).
(iii) Sharpe index for the funds and the market, (3 marks)
A

Solution


(i) Jensen's alpha.

α Omega = 13 - {8 + 1.0(12-8)} = 1%....
α Beta = 18-{8 + 2(12-8)} = 2%

(ii) Treynor's alpha.

Treynor's ratio = (Realised return - Risk free rate)/Beta .

Treynor's alpha omega = (0.13 - 0.08)/1.0 = 0.05.

Treynor's alpha Beta =(0.18 - 0.08)/2 = 0.05. .


(iii) Sharpe index for the funds and the market.

Sharpes ratio = (rp - rf)/ δp

Where:
rp = return on portfolio .
rf = risk free rate.
δp = standard diviation of portfolio .

Sharpe's ratio omega = (13-8)/19 = 0.26.

Sharpe's ratio Beta = (18 - 8)/15 = 0.67



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QUESTION 2b(i-ii)

Q The required rate using the Fama-French model. (3 marks).
The required rate of return using the Pastor-Stambaugh model (PSM). (3 marks)
A

Solution


The required rate using the Fama-French model.

Expected rate of return = Risk free rate + Market risk premium + size factor premium + value.... factor premium.

5 + (1.05 x 5) - (0.65 x 2.5) - (0.2 x 4.5) = 7.725%.

The required rate of return using the Pastor-Stambaugh model (PSM).

r = R𝑓 + market risk premium + size factor premium + value factor premium + liquidity premium.

5 + (1.05 x 5) - (0.65 x 2.5) - (0.2 x 4.5) + (0.2 X 4.5) = 8.625%

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QUESTION 2c(i)

Q Determine whether the interest rate parity (IRP) is currently holding. (2 marks)
A

Solution


F/S = (1 + ih)/(1 + i𝑓).

Where:....

F = Forward rate.

S = Spot rate = 100 .

ih = Interest home country = 3/12 x 8 = 2%.

i𝑓 = Interest foreign country = 3/12 x 5.8 = 1.45 .

F = ((1 + ih)/(1 + i𝑓))S

((1 + 0.02)/1.0145) x 100 = 100.54.

The interest rate parity clearly is not holding

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QUESTION 2c(ii-iii)

Q (ii) Demonstrate how you could undertake a covered interest arbitrage assuming that IRP is not holding. (4 marks).
(iii) Determine the arbitrage profit. (l mark)
A

Solution


(ii) Demonstrate how you could undertake a covered interest arbitrage assuming that IRP is not holding.

a) Borrow KES 1,000,000.....

Amount of interest to pay = 2/100 x 1,000,000 = Sh. 20,000.
Total amount to repay after 3 months = 20,000 + 1,000,000 = 1,020,000
b) Convert the borrowed amount to US dollars at prevailing spot rate.

1 USD = KES 100.
? USD KES 1,000,000.
1,000,000/100 x 1= USD 10,000.

c) Invest the amount in the US for three months. Amount in US dollars at the end of the 3 months.

= 1,000,000 + 1.45/100 x 10,000.
= 10,000+ 145 = USD 10,145.

d) Convert back to KES at the forward exchange rate of 105.

1 USD = KES 105.
10,145 USD = KES?.

(10,145 x 105)/ 1 = 1,065,225.


(iii) Arbitrage profit.

1,065,225 - 1,020,000.
= Sh. 45,225

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QUESTION 3a(i-iii)

Q (i) "Primary mortgage market" and "secondary mortgage market" (2 marks) .
(ii) "Fixed-rate mortgage" and "adjustable-rate mortgage"(2 marks).
(iii) "Lien" and "recourse".(2 marks)
A

Solution


i) Primary mortgage market secondary mortgage - Primary mortgage market, is where mortgage.... loans are created for the first time. secondary mortgage,is where lenders sell already issued mortgages to interested parties

ii) Fixed rate mortgage, interest remains unchanged throughout the of mortgage period whereas for adjustable ,rate will keep varying in tandem with prevailing situations in the economy.
iii) Lien and recourse - A lien is the right to retain another person's property until the debt owed by that person is paid. Recourse is the lender's legal right to recover collateral posted by the borrower in the event of default by the borrower..

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QUESTION 3b(i-ii)

Q (i) For 'each possible project pair combination, calculate the expected return, correlation coefficient and standard deviation. (12 marks).

(ii) Advise the shareholders of Mali Investment Holdings on the optimal project pair based on the mean variance criterion. (2 marks)
A

Solution




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QUESTION 4a

Q (i). Interest rate parity.(2 marks).
(ii). Purchase power parity. (2 marks).
(iii). International fisher effect
A

Solution


International parity conditions.

i) Interest rate parity.
This theory is that the difference between interest rates in two countries is equal to the difference calculated using the forward exchange rate and the spot rate.....

F/S = (1+ ih) / (1 + i𝑓 ).

Where:

F= Forward exchange rate.
S= Prevailing spot exchange rate .
ih = Interest rate in foreign country.
i𝑓 = Interest rate in foreign country .


ii) Purchasing power parity.

This theory states that the difference between the inflation rates of the two countries is equal to the calculated difference between the forward exchange rate and the spot rate.

F/S = (1+ ih) / (1 + i𝑓 ).

F = Forward exchange rate.
S= Prevailing spot exchange rate.
ih = Interest rate in home country.
i𝑓 = Interest rate in foreign country.


iii) International Fisher effect.

The international Fisher effect is an economic theory that the expected difference in the exchange rates of two countries is approximately equal to the difference in their nominal interest rates. According to the international Fisher effect, countries with higher nominal interest rates experience higher inflation and depreciate their currencies relative to other countries.

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QUESTION 4b(i)

Q (i) Determine the options value based on each of the above market prices. (3 marks)
A

Solution


i) Option value.

Option value = market price - exercise price.....

Market price Exercise price Value
114 100 14
112 100 12
110 100 10
108 100 8
106 100 6
105 100 5
104 100 4
102 100 2
100 100 0
98 100 0
96 100 0
94 100 0


At market price below Sh. 100 you should not exercise call option .

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QUESTION 4b(ii)

Q (ⅱ) Determine the profit or loss associated with the option on the basis of each of the possible market prices. (3 marks)
A

Solution


Mps Call option value Premium Profit or loss
114 14 5 9
112 12 5 7
110 10 5 5
108 8 5 3
106 6 5 1
105 5 5 0
104 4 5 -1
102 2 5 -3
100 0 5 -5
98 0 5 -5
96 0 5 -5
94 0 5 -5


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QUESTION 4b(iii-iv)

Q (i) Represent the information in (b) (ii) above in a diagram where the x-axis represents market price and y axis represents profit or loss for the option buyer. (3 marks).

(iv) Interpret the graph in (b) (iii) above.
A

Solution


(i) Represent the information in (b) (ii) above in a diagram where the x-axis represents market price and y axis represents profit or loss for the option buyer....



iv) Interpretation

For market prices above Sh.106, it is profitable to exercise the option. Exercising options on markets below 104 is not recommended.

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QUESTION 4c

Q Describe four types of real options available to the management while making strategic capital budgeting decisions of a firm. (4 marks)
A

Solution


The types of real options available to management when making strategic capital budgeting decisions.

Strategic investment option: A project can move forward because it leads to new opportunities, but not because the NPV is positive. Managers should articulate their reasons for undertaking a particular project. This option is frequently used in development projects such as.... institutions,hospitals.
Timing/Postpone option: These are options that allow management to delay investment in capital projects if they feel the need to gather sufficient information about the project that will lead to its success.
Abandonment option: Abandonment is a situation in which a company liquidates the same project after running it for several years..

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QUESTION 5a

Q (a) Explain six reasons why mergers and acquisition deals fail despite good planning, (6 marks)
A

Solution


Reasons why mergers and acquisition deals fail despite good planning.

➢ Window dressing: This calls for acquisitions to disguise the underlying company's financial performance.....
➢ Hubris hypothesis: This involves paying an inflated premium to the target company.
➢ Inadequate integration:Conducting an acquisition can be a stressful and time-consuming process for all involved. Usually after the completion of the acquisition,people are busy with their regular jobs, and post-completion merger synergies aren't implemented fast enough. If follow-up and accountability for the integration plan are not put in place, it may lead to poor integration later.
➢ Human Resources and HR Matters: People are generally the key gear in any business. Important human factors such as attachment, cultural differences, and job security are overlooked in the merger process.
➢ External factors: External factors such as economic collapse and other environmental factors affect business performance.
➢ Board Split: When a merger is being considered, it is important to assess board composition and director compatibility. Managers and directors who are suddenly stripped of power can be particularly resentful. Certain personality conflicts between executives of both companies are also common. ➢ Misleading Investment Value: Investing in assets may look good on paper, but in reality, once the deal is closed, they may not be profitable areas.
➢ Inconsistent Strategies: Successful mergers and acquisitions are based on sound business strategy. Companies that fail to understand the strategic benefits of mergers face failure.

➢Regulatory Issues: Legal approval is required for the entire merger process. If one of her stakeholders does not approve the merger, it could create legal roadblocks and slow down the whole process. This leads to regulatory delays and increases the risk of business deterioration.



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QUESTION 5b(i)

Q (i) The current cost of equity and weighted average cost of capital (WACC). (2 marks)
A

Solution


Ke = R𝑓 + B(Rm - R𝑓) = 8 + 0.6(15 - 8).... = 12.2%.

Since its ungeared, cost of equity and weighted average cost of capital is the same.

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QUESTION 5b(ii)

Q (ii) The firm's optimal level of debt using the "pure" Modigliani and Miller with corporation tax model. (4 marks)
A

Solution


Value of levered firm (VL) = Value unlevered firm + DT - Financial distress.....

Value unlevered firm
(million)		 DT
(million) 		FD
(million) 		VL
(million)
80 2.5 x 0.3 = 0.75 0 x 8 = 0.00 80.75
80 5 x 0.3 = 1.50 0.0125 x 8 = 0.10 81.40
80 7.5 x 0.3 = 2.25 0.025 x 8 = 0.20 82.05
80 10 x 0.3 = 3.00 0.0625 x 8 = 0.50 82.50
80 12.5 x 0.3 = 3.75 0.125 x 8 = 1.00 82.75
80 15 x 0.3 = 4.50 0.3125 x 8 = 2.50 82.00
80 20 x 0.3 = 6.00 0.75 x 8 = 6.00 80.00


The firm optimal leval of debt is Sh.12.5 million because it maximizes the value of the firm.

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QUESTION 5b(iii)

Q (iii) The firm's optimal weighted average cost of capital (WACC) and hence its optimal capital structure proportions. (8 marks)
A

Solution


D E D/E Geared Beta Cost of Equity Kd WACC
2.5 80 0.03 0.6(1 + 0.03 x 0.7) = 0.61 12.29% 4.2% 12.04%
5.0 80 0.06 0.63 12.38% 5.25% 11.96%
7.5 80 0.09 0.64 12.46% 6.3% 11.93%
10 80 0.13 0.65 12.55% 7.0% 11.93%
12.5 80 0.16 0.67 12.67% 8.05% 12.05%
15.0 80 0.19 0.68 12.76% 8.75% 12.13%
20.0 80 0.25 0.71 12.94% 9.80% 12.31%


Geared Beta Be = Ba[1 + D/E(1-T)].

After tax cost of debt Kd

Kd = I(1-T).

Optimal weighted average cost of capital is 11.93%. The optimal promotion of debt is 8.57% and equity 91.43%(80/87.5 x 100)


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