- December 2025 Advanced Financial Management Answers

Description

CERTIFIED PUBLIC ACCOUNTANTS (CPA) ADVANCED LEVEL
ADVANCED FINANCIAL MANAGEMENT

TUESDAY: 2 December 2025. Morning Paper. Time Allowed: 3 hours.
This paper consists of five (5) questions. 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) Describe THREE characteristics of real options as used in capital budgeting. (6 marks)

(b) Evaluate THREE investment characteristics of real estate investment trusts (REITS). (6 marks)

(c) Web Limited is negotiating the purchase of a new piece of construction equipment for its current operations. The following information is provided:

1. The equipment would replace an existing equipment which has a current market value of Sh.2,200,000. The old equipment will be sold if the new one is bought.
2. Purchase of the new equipment would not affect revenues but the before tax operating costs could be reduced by Sh.1,000,000 per annum for five years. The savings would occur at the end of each year.
3. The old equipment is now three years old. It is expected to last for another five years and it is expected to have a resale value of Sh.500,000 at the end of those five years. It was purchased for Sh.4,000,000 and is being depreciated on a straight line basis.
4. The new equipment will also be depreciated on a straight line basis over a period of five years. Web Limited expects to sell the equipment for Sh.1,000,000 at the end of the five years.
5. Corporation tax rate is 30%.
6. Web Limited has profitable ongoing operations.
7. The appropriate discounting rate is 14%.

Required:
Determine the price that Web Limited should offer for the new equipment. (8 marks)
(Total: 20 marks)

QUESTION TWO
(a) Explain the following terms as used in international financial management:
(i) Purchasing power parity. (1 mark)

(ii) Interest rate parity theory. (1 mark)

(iii) The Fisher effect. (1 mark)
(iv) Arbitrage operations. (1 mark)

(b) Haraka Company Limited has the following four short term portfolio of investments made from the accumulated retained earnings over the years:

Company Number of
shares Beta equity
coefficient Market price per
share (Sh.) Dividend yield
in 2024 (%) Expected return
on equity in 2025 (%)
W 120,000 1.2 42.9 6.1 9.5
X 160,000 2.3 29.2 3.4 15.5
Y 200,000 0.85 21.7 5.7 12.5
Z 250,000 1.28 31.4 3.3 7.3

Additional information:
1. The current market return is 19% per annum.
2. The risk free rate is 12% per annum.

Required:
(i) Calculate the risk of the company’s short term investment portfolio relative to that of the market.
(4 marks)
(ii) Recommend, with reasons, whether Haraka Company Limited should change the composition of its portfolio. (4 marks)

(c) Zigma Limited is a mutual fund investment company and has invested in the following three schemes:

Scheme Dividends distributed Capital appreciation Opening net asset value
(Sh.“million”) (Sh.“million”) (Sh.“million”) Beta
X 17.5 29.7 320 1.3
Y 0 35.3 271.5 0.90
Z 13 19.9 235 1.4

Additional information:
1. The treasury bill rate, which is considered risk free, is 7.84%.
2. The market portfolio is 13%.

Required:
(i) Compute Jensen’s alpha of each of the schemes. (6 marks)
(ii) Recommended to Zigma Limited the scheme(s) to continue to invest in based on the scheme’s performance. (2 marks)
(Total: 20 marks)

QUESTION THREE
(a) Summarise FOUR advantages of raising funds in the international capital markets as opposed to relying solely on domestic capital markets. (4 marks)

(b) A bond with a five year to maturity has a current value of Sh.462.05, coupon rate of 8% per annum and a current market yield of 10% per annum.
The bond will be redeemed at par value of Sh.500.

Required:
The Macaulay duration of the bond. (5 marks)
(c) Maridadi Limited, a garment manufacturing firm, is considering a strategic restructuring by diversifying into the electronics business. The anticipated return from the new venture is 18%. To guide its decision, the company intends to apply the Capital Asset Pricing Model (CAPM).

Three potential electronics companies; A Ltd., B Ltd. and C Ltd. have been identified as possible acquisition targets. The following information relates to these firms:
• A Ltd.: Equity beta of 1.5; capital structure consists of 50% debt and 50% equity.
• B Ltd.: Equity beta of 1.4; has recently undertaken an unrelated project representing 20% of its total value, with an asset beta of 1.4. The company is financed by 40% debt and 60% equity.
• C Ltd.: Equity beta of 1.05; capital structure consists of 35% debt and 65% equity.
Additional information:
1. Corporation tax rate is 30%.
2. Maridadi Limited’s debt to equity ratio is 0.70 : 0.30.
3. The expected market return is 15%.
4. Risk-free rate is 12%.
Required:
Using appropriate computations, advise Maridadi Limited on whether it should proceed with the proposed restructuring into the electronics business. (11 marks)
(Total: 20 marks)

QUESTION FOUR
(a) Foreign Direct Investment (FDI) plays a critical role in a country’s balance of payments and can drive economic growth by bringing in capital, technology and skills.
Required:
Discuss FOUR factors that encourage the growth of FDI in a country. (4 marks)

(b) Baobab Limited shares has a market value of Sh.28 per share with a standard deviation of 40%. The risk free rate is 5% compounded continuously.
Required:
Using Black-Scholes Option Pricing Model (BSOPM), determine the value of the call option on Baobab Limited shares expiring in nine months with an exercise price of Sh.30.
(6 marks)

Note:

1. The Black-Scholes Option Pricing Model

                           Where:

Where: So = Current share price
K = Exercise (strike price)
T = Time to expiry
R
 =
= Risk free rate
Volatility (standard deviation)

(c) The following data relate to two companies, Sigma Ltd. and Delta Ltd., which belong to the same risk class:

Sigma Ltd. Delta Ltd.
Number of ordinary shares 80,000,000 120,000,000
Market price per share (MPS) Sh.20 Sh.12
Profit before interest and tax (EBIT) Sh.16,000,000 Sh.16,000,000
8% debentures (market value) Sh.50,000,000 Sh.0
All profits after debenture interest are distributed as dividends.
Required:
(i) Using suitable computations, demonstrate how under Modigliani and Miller (MM) approach (without taxes) an investor holding 10% of Sigma Ltd. will be better off by switching his holding to Delta Ltd.
(8 marks)
(ii) Explain when according to Modigliani and Miller (without taxes), the process described in (c) (i) above would come to an end. (2 marks)
(Total: 20 marks)

QUESTION FIVE
(a) Examine FOUR potential threats of using digital financial services in your country. (4 marks)

(b) Haz Millers Ltd. is at an advanced stage of acquiring Baraka Wheat Growing Company Limited. The projected post-merger information for the next five years of Baraka Wheat Growing Company is provided below:

2026 2027 2028 2029 2030
Sh. Sh. Sh. Sh. Sh.
Turnover 2,000,000 2,500,000 2,750,000 2,920,000 3,040,000
Cost of sales (800,000) (1,000,000) (1,100,000) (1,168,000) (1,216,000)
Gross profit 1,200,000 1,500,000 1,650,000 1,752,000 1,824,000
Operating expenses (400,000) (500,000) (550,000) (584,000) (608,000)
Profit before interest and taxes 800,000 1,000,000 1,100,000 1,168,000 1,216,000
Interest expense (80,000) (100,000) (110,000) (116,000) (121,600)
Profit before taxes 720,000 900,000 990,000 1,051,200 1,094,400

Additional information:
1. After the fifth-year, cash flows available to Haz Millers Ltd. from Baraka Wheat Growing Company will grow by 15% per annum to infinite period.
2. An amount of Sh.125,000 will be retained annually by Baraka Wheat Growing Company for expansion.
3. The cost of capital is provided at 16%.
4. The corporation tax rate is 30%.

Required:
(i) Determine the annual cash flows after considering the terminal value(s). (4 marks)

(ii) With appropriate justification, advise Haz Millers Ltd. the maximum amount to pay to acquire Baraka Wheat Growing Company. (4 marks)
(c) Zipron Limited is a United Kingdom (UK) based company which has the following expected transactions: One month : Expected receipt of $720,000
One month : Expected payment of $420,000 Three months : Expected receipts of $900,000

The finance manager has collected the following information:
Spot rate ($ per ₤) : 1.7820 + 0.0002 One month forward rate ($ per ₤) : 1.7829 + 0.0003 Three month forward rate ($ per ₤) : 1.7846 + 0.0004

Money market rates for Zipron Limited: Borrowing Deposits
One year sterling interest rates 4.9% 4.6%
One year dollar interest rate

Assume that its now 1 October 2025.
Required: 5.4% 5.1%
(i) Calculate the expected sterling receipts in one and in three months using the forward market. (4 marks)

(ii) Calculate the expected sterling receipts in three months using a money market hedge and recommend whether a forward market hedge or a money market hedge should be used. (4 marks)

(Total: 20 marks)
………………………………………………………………………..