CPA ADVANCED LEVEL

ADVANCED FINANCIAL MANAGEMENT

TUESDAY: 6 December 2022. 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) (i) Explain the term “real option” as used in capital investment appraisal. (2 marks)

(ii) Evaluate THREE types of real options. (6 marks)

(b) The management of College Publishers Ltd. has estimated the following initial cash outlays and net cash flows
and probabilities for a new printing process in each case scenario:

Year Worst case Most probable case Best case

Sh.“000” Sh.“000” Sh.“000”
0 (100,000) (100,000) (100,000)
1 20,000 30,000 40,000
2 20,000 30,000 40,000
3 20,000 30,000 40,000
4 20,000 30,000 40,000
5 20,000 30,000 40,000
5* 5,000 20,000 30,000

Probability 0.20 0.60 0.20

Year 0 is the initial cost of the new printing process, years 1 – 5 are the operating net cash flows and year 5* is the
estimated salvage value. The firm’s cost of capital for a project of average risk is 13% per annum.

Required:
(i) Assuming that the above project has an average risk, compute the expected net present value (ENPV) of
the project. (4 marks)

(ii) A sensitivity analysis of the salvage value if this variable changes from the base case value by + (plus or
minus) 80%. (4 marks)

(iii) Assume that all cash flows are positive perfectly correlated and that there are only three possible cash
flow scenarios over time namely; worst case, most probable case and best case with probabilities of 0.2,
0.6 and 0.2 respectively.

Determine the project’s standard deviation of the net present value (NPV). (4 marks)
(Total: 20 marks)
QUESTION TWO
(a) The modern portfolio theory (MPT) is a practical method for selecting investments in order to maximise their
overall returns within an acceptable level of risk.

Required:
Outline FIVE assumptions of modern portfolio theory (MPT). (5 marks)
(b) The following information is provided on the market, risk free rate and two stocks A and B:
Expected return Correlation with market Standard deviation
% %
Treasury bill rate 4 0.00 0.00
S & P 500 index 11 1.00 15.00
Stock A 14 0.70 25.00
Stock B 9 0.40 20.00
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 Required:
(i) Draw the capital market line (CML). (3 marks)

(ii) Calculate the betas of Stock A and Stock B. (2 marks)

(iii) Calculate the Alphas (α) of the Stock A and Stock B. (2 marks)

(iv) Plot the Stocks A and Stock B relative to the CML and comment. (3 marks)

(c) Describe five forms of debt financing in regards to real estate. (5 marks)
(Total: 20 marks)

QUESTION THREE
(a) Two firms, A Ltd. and B Ltd. operate in the same industry. The two firms are similar in all aspects except for their
capital structures.

The following additional information is available:

1. A Ltd. is financed using Sh.100 million worth of ordinary shares.

2. B Ltd. is financed using Sh.50 million in ordinary shares and Sh.50 million 7% debentures.
3. The earnings before interest and tax (EBIT) are Sh.10 million for both firms. These earnings are
expected to remain constant indefinitely.
4. The cost of equity in A Ltd. is 10%.
5. The corporate tax rate is 30%.

Required:
Using the Modigliani and Miller (MM) model, determine the following:

(i) The market value of A Ltd. and B Ltd. (4 marks)

(ii) The weighted average cost of capital (WACC) of A Ltd. and B. Ltd. (4 marks)

(b) Rema Limited, a United Kingdom (UK) based firm bought goods from a United States (US) supplier and must
pay US Dollars 4,000,000 in three months time.

The company is considering three choices in order to hedge the transaction exposure and has collected the
following information:

Annual interest rates and exchange rates currently available:

US Dollar Sterling Pound (£)

Deposit rate Borrowing rate Deposit rate Borrowing rate
% % % %
1 month 6 9.25 9.75 13.00
3 months 6 9.75 10.00 13.25

$/£ Exchange rate ($ = £1)

Spot 1.8625 – 1.8635
1 month forward 1.8565 – 1.8577
3 months forward 1.8445 – 1.8460

Required:
Determine the amount payable using the following methods:

(i) Forward exchange contracts. (4 marks)

(ii) Money market borrowing or lending. (4 marks)

(iii) Making a leading payment. (2 marks)

(c) Advise on the cheapest method based on your results in (b) (i) – (b) (iii) above. (2 marks)
(Total: 20 marks)

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QUESTION FOUR
(a) Examine FOUR stages that a company might go through during restructuring. (4 marks)

(b) The Altman formula for prediction of bankruptcy is given as follows:

Z-score = 1.2X1 + 1.4X2 + 3.3X3 + 1X4 + 0.6X5

Where:
X1 = Working capital/Total assets.
X2 = Retained earnings/Total assets
X3 = Earnings before interest and tax/Total assets
X4 = Sales/Total assets
X5 = Market value of equity/Book value of debt

You are provided with the following information in respect of three listed companies:
Working Retained Earnings before Market value Total Liabilities Sales
capital Earnings interest and tax of equity assets
Sh.“000” Sh.“000” Sh.“000” Sh.“000” Sh.“000” Sh.“000” Sh.“000”
A Ltd. 4,000 60,000 10,000 20,000 200,000 120,000 200,000
B Ltd. 2,000 20,000 0 5,000 100,000 80,000 120,000
C Ltd. 6,000 20,000 –30,000 48,000 800,000 740,000 900,000

Required
(i) The Z-score for each of the three companies. (6 marks)

(ii) Comment on your results in (b) (i) above. (2 marks)

(c) Kilop Ltd. has decided to instal a new milling machine.

Additional information:
1. The machine costs Sh.28,000,000 and it would have a useful life of five years with a trade in value of
Sh.5,600,000 at the end of year five.
2. The company has two options:

Option A
Purchase the machine for cash using a bank facility. The current rate of interest is 15% before tax.

Option B
Lease the machine under an agreement which would entail payment of Sh.6,720,000 at the end of each
year for the next five years.
3. The corporate rate of tax is 30%.
4. Capital allowance is given at the rate of 100% in year one if the machine is purchased.
5. Tax is payable one year in arrears.
Required:
Advise Kilop Ltd. whether to lease or buy the machine. (8 marks)
(Total: 20 marks)
QUESTION FIVE
(a) Explain FIVE limitations of financial derivatives used in financial risk management. (5 marks)

(b) The International Monetary Fund (IMF) has implemented many reforms in recent years designed to strengthen its
cooperative nature and improve its ability to serve its membership.

In context of the above statement, propose FOUR main reforms that have been designed by IMF in recent years.
(4 marks)

(c) Alpha Ltd. and Beta Ltd. are companies operating in the same line of business. In the recent past, Alpha Ltd. has
experienced very stiff competition from Beta Ltd. such that Alpha Ltd. is considering acquiring Beta Ltd. in order
to consolidate its market share.
The following financial data is available about the two firms:
Alpha Ltd. Beta Ltd.
Annual sales (Sh.million) 400 100
Net income (Sh.million) 150 20
Outstanding number of ordinary shares (millions) 50 10
Earnings per share (Sh.) 3.0 2.0
Market price per share (Sh.) 30 15
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Both companies are in the 30% income tax bracket.

Required:
(i) Maximum exchange ratio that Alpha Ltd. should agree to if it expects no dilution in its post acquisition
Earning Per Share (EPS). (2 marks)

(ii) Alpha Ltd.’s post acquisition earning per share if the companies agree on an offer price of Sh.40.
(2 marks)

(iii) Alpha Ltd.’s post acquisition earning per share if for every 200 ordinary shares of Beta Ltd.’s are
exchanged for 5 units of 10% debenture of Sh.500 per value each. (3 marks)

(iv) Combined operating profit (EBIT) and post acquisition earning per share at point of indifference between
earnings of the firm under the financing plans in (c) (ii) and (c) (iii) above. (4 marks)
(Total: 20 marks)
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