August 2024 Advanced Financial Management Answers

Description

CPA ADVANCED LEVEL ADVANCED FINANCIAL MANAGEMENT
TUESDAY: 20 August 2024. Morning Paper. Time Allowed: 3 hours.
Answer ALL questions. Marks allocated to each question are shown at the end of the question. Show ALL your workings. Do NOT write anything on this paper.
QUESTION ONE
(a) In relation to real estate finance, highlight FOUR differences between a “residential property” and a “commercial property”. (4 marks)
(b) A company is considering two mutually exclusive projects namely; project A and project B. The company uses the certainty equivalent approach to evaluate capital projects. The estimated cash flows and certainty equivalents for each project are as follows:

Year Project A Project B
Cash flows Certainty equivalents Cash flows Certainty equivalents
Sh.“000” Sh.“000” Sh.“000” Sh.“000”
0 (45,000) 1.00 (60,000) 1.00
1 22,500 0.85 37,500 0.80
2 22,500 0.80 30,000 0.70
3 15,000 0.75 22,500 0.60
4 15,000 0.60 15,000 0.50
The risk free rate is 5%.
Required:
Advise the company on which project to undertake using the certainty equivalent method. (6 marks)
(c) Mavuno Bora Ltd. is an agro-based company incorporated in Kenya. The company intends to invest in a capital project which will be based in Cape Town, South Africa.
Additional information:
1. The project will commence on 1 January 2025 with the initial capital of 5 million South Africa Rands (ZAR) which will be used in acquiring agricultural machinery with an estimated useful life of 5 years with a zero salvage value. The straight line method of depreciation will be applied.
2. To enable the firm pay land rates and other working capital requirements, an additional 2.5 million ZAR will be required and it is expected that this amount will be recouped in full at the end of the project’s useful life.
3. Annual sales revenue from the project are estimated as follows:

Year Revenue (ZAR) Fixed costs (ZAR)
2025 2,600,000 600,000
2026 3,500,000 780,000
2027 5,000,000 905,000
2028 4,200,000 880,000
2029 2,800,000 450,000
4. Variable operating costs are expected to be 20% of the sales and are assumed to accrue evenly.
5. The exchange rates between the Kenya Shilling and the South Africa Rand are as follows:

ZAR/KES
1 January 2025 8.00
31 December 2025 8.50
31 December 2026 9.00
31 December 2027 9.50
31 December 2028 10.00
31 December 2029 10.30
6. All the cash flows are expected to occur at the year end.

7. The cost of capital for both South Africa and Kenya is assumed to be 12% per annum.
8. Assume that the corporation tax rate in South Africa is 30% and no further taxation will be levied in Kenya.
Required:
(i) The net present value (NPV) of the project in Kenya Shillings (KSh.). (8 marks)
(ii) Based on your results in (c) (i) above, advise the management of Mavuno Bora Ltd. on appropriate course of action. (2 marks)
(Total: 20 marks)
QUESTION TWO
(a) Examine THREE methods that could be used by multinational corporations to finance international trade.
(6 marks)
(b) Kiwanda Ltd., an all equity financed company is contemplating setting up a manufacturing plant overseas.
The expected pay-off from the project would depend on the future state of the economy that might prevail as shown below:

State of economy Probability Forecasted rate of return (%)
A 0.20 10
B 0.30 15
C 0.40 7
D 0.10 12
Additional information:
1. The company’s portfolio of existing activities are expected to generate an overall return of 18% with a standard deviation of 5%.
2. The correlation coefficient of returns of the new project and existing portfolio of activities is 0.60 while its correlation with the market portfolio is 0.24.
3. The forecasted rate of return of the market portfolio and their probability of occurrence in different states of nature are given as follows:

State of economy Probability Forecasted rate of return (%)
1 0.20 20
2 0.30 15
3 0.40 10
4 0.10 5
4. The risk free rate of return is 8%.
Required:
(i) Compute the covariance of returns of the new project and existing portfolio returns. (4 marks)
(ii) Advise the management of Kiwanda Ltd. on whether to accept the proposed project using the capital market line (CML) analysis. (5 marks)
(iii) Determine whether the project is acceptable using the Capital Asset Pricing Model (CAPM). (5 marks)
(Total: 20 marks)
QUESTION THREE
(a) Highlight FOUR reasons why firms make bond refinancing decisions. (4 marks)
(b) Palm Limited has Sh.12.5 billion of equity capital and Sh.2.5 billion of debt capital, all at current market value. The cost of equity is 14% and the cost of debt is 8%. The company is planning to raise Sh.2.5 billion by issuing new ordinary shares. It will use the money to redeem all the debt capital.
Required:
Using the Modigliani and Miller (MM) proposition, determine the cost of equity of the company after the debt has been redeemed. Assume that there is no corporate tax if the company issues new equity. (4 marks)
(c) Jaribu Ltd. is considering acquiring Upendo Ltd. Selected financial data for the two companies is provided:
Jaribu Ltd. Upendo Ltd.
Annual sales (Sh.million) 1,500 180
Net income (Sh.million) 120 15
Ordinary shares outstanding (million) 30 6
Earnings per share (EPS) (Sh.) 8 5
Market price per share (Sh.) 88 40
Both companies are in the 30% tax bracket.

Required:
(i) The maximum exchange ratio that Jaribu Ltd. should agree to if it expects no dilution in earnings per share (EPS). (3 marks)
(ii) Post merger EPS of Jaribu Ltd. and Upendo Ltd. if the two companies settle on a price of Sh.48.40 per share. (4 marks)
(iii) Jaribu Ltd.’s EPS if Upendo Ltd.’s shareholders accept one (1) 12% convertible preference share with a par value of Sh.100 for every 5 ordinary shares they own. (3 marks)
(iv) Explain the term “bootstrapping earnings” as used in mergers and acquisition. (2 marks)
(Total: 20 marks)

QUESTION FOUR
(a) Summarise FOUR financial difficulties a company may experience during financial distress. (4 marks)
(b) Kilop Ltd. is considering a financial restructuring plan that involves converting a portion of its debt into equity. Currently, the company has 1 million ordinary shares outstanding with a current market value of Sh.20 per share. The total debt to be converted into equity amounts to Sh.5 million.

Required:
Assuming the conversion is successful, evaluate the impact of financial restructuring on the share price of Kilop Ltd. (6 marks)
(c) The finance director of Dambo Ltd. wishes to find the company’s optimal capital structure. The cost of debt varies according to the company’s credit rating, which itself depends, amongst other factors, the level of gearing of the company as shown below:

Percentage (%) of debt (Debt/Debt + Equity) Likely credit rating Pre-tax cost of debt (%)
10 AAA 6.5
20 AA 7.1
30 A 7.8
40 BBB 8.5
50 BB 10
60 B 12
70 C 15

Additional information:
1. The company’s ungeared equity beta (asset beta) is 0.85.
2. The risk free rate is 6% per annum.
3. The market return is 14% per annum.
4. The corporate tax rate is 30%.

Required:
(i) The optimal weighted average cost of capital (WACC) for the company. (9 marks)

(ii) Interpret your results in (c) (i) above. (1 mark)
Hint: Formula for computing equity beta
βe = βa

Where: βe
βa =
= Equity beta Asset beta
D = Debt
E = Equity
t = Corporate tax rate
(Total: 20 marks)

QUESTION FIVE
(a) Discuss THREE types of crowdfunding. (6 marks)
(b) Ujezi Ltd., a property development company, has gained planning permission for the development of a housing complex at Mua Greens Estate which will be developed over a three-year period.

The resulting property sales less building costs have an expected net present value of Sh.4,000,000 with a cost of capital of 10% per annum. Ujezi Ltd. has an option to acquire land in Mua Greens Estate at an agreed price of Sh.24,000,000 which must be exercised within the next two years.
Immediate building of the housing complex would be risky as the project has a volatility attaching to its net present value of 25%.

One source of risk is the potential for development of Mua Greens Estate as a regional commercial centre for the large number of firms leaving the capital, because of high rents and local business taxes. Within the next two years, an announcement by the government will be made about the development of transport links into Mua Greens Estate from the outlying areas including the area where Ujezi Ltd. hold the land option.

The risk free rate of interest is 5% per annum.

Required:
(i) Estimate the value of the option to delay the start of the project for two years using the Black Scholes Option Pricing Model (BSOPM) and comment on your findings.
Assume that the government will make its announcement about the potential transport link at the end of the two years. (10 marks)
(ii) On the basis of valuation of the option to delay, estimate the overall value of the project, giving a concise rationale for the valuation method used. (2 marks)

(iii) Explain TWO other types of real options that may be present relating to the Mua Greens Estate housing development. (2 marks)

Hint:
Value of call option: Ps (Nd1) – Pe (Nd2). e–rfT
Where: d1 = ln (Ps/Pe) + (rf + 0.5σ2)T

σ  T d2 = d1 – σ T
Ps = Underlying price
Pe = Strike price σ = Volatility
rf = Continuity compounded risk-free interest rate T = Time to expiration

………………………………………………………………………………………………..

(Total: 20 marks)