Advanced Financial Management December 2023 Past Paper

TUESDAY: 5 December 2023. 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.
(a) The management of Kapricon Ltd. are in the process of estimating utile and establishing the categories of investors. The management has approached CPA Samuel Okeyo, a financial management consultant and provided him with the following cases:
Case 1: There is 0.50 chance of receiving Sh.30 million and 0.50 chance of receiving Sh.100 million. The investor is willing to pay a maximum of Sh.60 million.

Case 2: There is 0.40 chance of receiving Sh.55 million and 0.60 chance of receiving Sh.100 million. The investor is willing to pay a maximum of Sh.82 million.
Case 3: There is 0.30 chance of receiving Sh.30 million and 0.70 chance of receiving Sh.60 million. The investor is willing to pay a maximum of Sh.45 million.

Assume that utile values of 0 and 1 are assigned to a pair of wealth representing the two extremes Sh.0 and Sh.100 million respectively.

(i) Using the expected monetary value (EMV) technique, determine the category of investor in case 1, case 2 and case 3 above. (6 marks)
(ii) Compute the utile value for case 1, case 2 and case 3 respectively. (3 marks)
(b) In a study carried out by a financial analyst, the earnings before interest and tax (EBIT) of Papa Ltd. and Kaka Ltd. was found to be Sh.10 million.

Papa Ltd. is fully equity financed while Kaka Ltd. is financed partly using equity and debt. The capital structures of both firms are given as follows:

Papa Ltd.
Sh.“million” Kaka Ltd.
Equity (market value) 100 70
5% debt (trading at par)

Additional information: – 50
1. Both firms adopt a 100% pay out ratio as their dividend policy.
2. The cost of equity of Papa Ltd. is 10%.

Using Modigliani and Miller’s proposition in the absence of taxes:
(i) Determine the cost of equity of Kaka Ltd. (3 marks)

(ii) Comment on the equilibrium position on the value of both firms and hence show that the capital structure decision will have no effect on both value of the firms and their weighted average cost of (WACC).
(4 marks)

(iii) Calculate the arbitrage profit (if any) for a shareholder holding 10% of the shares of Kaka Ltd. (4 marks)
(Total: 20 marks)

(a) Economic and Monetary Union (EMU) was formulated by European leaders. On 1 January 1999, the new European currency, the Euro, came into being. From that date, there was to be no change in the exchange rates of the member countries.
Euro notes and coins were introduced into circulation on 1 January 2002. Dual circulation of the Euro and the legacy currencies of each country continued for a short period of time. Thereafter, participating countries have only used Euro notes and coins.

In regards to the above statements, explain SIX arguments in favour of Economic and Monetary Union (EMU).
(6 marks)

(b) Daniel Wekesa, an investment specialist has been entrusted with Sh.5,000,000 by an investment club and instructed to invest the money optimally over a 1-year period.
Part of the instructions are given as follows:

1. The funds be invested in one or more of the three specified projects and in the money market.
2. The three projects are not divisible and cannot be postponed.
3. The investment club requires a return of 14% per annum.
4. The following details relate to the projects and money market:

Initial cash outlay Sh. “000″ Forecasted rate of return (%) Expected standard deviation of return (%)
Project 1(P1) 3,000 16 8
Project 2(P2) 2,000 15 6
Project 3 (P3) 2,000 22 10
Money market (MM) 3,000 12 4

5. The correlation coefficients of returns of the above combination of projects are as follows:

Between projects Between projects and market portfolio (MP) Between projects and money market (MM) Between money market (MM) and market portfolio (MP)
P1 and P2 = 0.90 P1 and MP = 0.80 P1 and MM = 0.30 MM and MP = 0.40
P1 and P3 = 0.50 P2 and MP = 0.10 P2 and MM = 0.75
P2 and P3 = 0.20 P3 and MP = 0.65 P3 and MM = 0.15

Additional information:
1. The risk free rate of return is 12%.
2. Expected return of the market portfolio is a weighted average return. Given below are forecasted rate of returns from a market portfolio and their probability of occurrence in different states of nature:

State of nature Probability Forecasted rate of return (%)
Recession 0.30 10
Average 0.40 15
Boom 0.30 20

Evaluate how Daniel Wekesa should invest the Sh.5 million using:

(i) Capital market line (CML) analysis in portfolio theory. (7 marks)
(ii) Capital asset pricing model (CAPM). (7 marks)
(Total: 20 marks)

(a) Highlight SIX economic and financial justifications advanced for mergers and acquisitions. (6 marks)
(b) Kubwa Ltd. is considering acquisition of Ndogo Ltd., a firm in an unrelated line of business in order to diversify their risks.

Selected financial data for both firms are provided as follows:

Kubwa Ltd. Ndogo Ltd.
Sales (Sh.million) 100 50
Cost of sales (Sh.million) 30 10
Operating costs (Sh.million) 10 5
Finance cost (Sh.million) 5 2
Number of issued shares (million) 10 7
Market price per share (Sh.) 40 20
Additional information:
1. Kubwa Ltd. is considering financing the acquisition of Ndogo Ltd. using a share for share exchange or share debenture exchange.
2. Corporation tax rate applicable is 30%.

(i) Non-diluting maximum exchange ratio. (3 marks)
(ii) The post acquisition earning per share (EPS) assuming an offer price is set at Sh.30 per share. (2 marks)
(iii) The post acquisition EPS assuming 1,000 ordinary shares are exchanged for 10 units of 15% debenture with par value of Sh.100 each. (3 marks)
(iv) Considering your results in (b) (ii) above and (b) (iii) above, advise on the best financing plan. (1 mark)
(c) A bond with a five year to maturity has a current value of Sh.92.41, a coupon rate of 8% per annum and a current market yield of 10% per annum.
The bond will be redeemed at a par value of Sh.100.
Using the Macaulay duration method, compute the bond’s duration. (5 marks)
(Total: 20 marks)
(a) Discuss FOUR real estate financing options available to real estate investors in your country. (8 marks)
(b) Highspeed Electronics Ltd. has taken delivery of 50,000 electronic devices from an American company. The seller is in a strong bargaining position and has priced the devices in American dollars at $ 12.00 each.
Highspeed Electronics Ltd. has been granted three months credit. Assume that interest rates in America are 3% per quarter. Highspeed Electronics Ltd. has all its money held up in its operations but it could borrow in United States dollars at an interest rate of 3% per quarter if necessary.
Additional information:
1. The following foreign exchange rates are applicable: United State Dollar (US$)/Kenya Shilling (KES) Spot rate 0.013
Three month forward rate 0.0154
2. A three month dollar call option for US $ 600,000 is available at a premium of US $ 15,000.
Determine the amount payable by Highspeed Electronics Ltd. using the following hedging strategies:
(i) Forward contract. (2 marks)
(ii) Leading. (2 marks)
(iii) Money market hedge. (2 marks)
(iv) Use of options. (2 marks)
(v) Distinguish between a “currency option” and a “currency swap”. (4 marks)
(Total: 20 marks)

(a) Explain the following terms as used in behavioural finance:
(i) Market paradox. (2 marks)
(ii) Herd mentality bias. (2 marks)
(iii) Loss aversion bias. (2 marks)

(b) One of the most notable qualitative model of predicting corporate failure is Argenti’s A model score. Argenti suggested that the failure process follows a predictable sequence.

Examine the THREE failure sequence processes as predicted by Argenti’s model score. (6 marks)

(c) The current share price of Nonop Ltd. is Sh.7.00.

Additional information:
1. The continuously compounded risk free rate of interest is 8% per annum.
2. The variance of the rate of return on the share has been 12% per annum.

Using the Black-Scholes option pricing model, estimate the value of a European call option on the shares of the company that has an exercise price of Sh.6.60 and has 3 months to run before it expires.
Note: The Black-Scholes formula is given as follows: Pc = PS N(d1) – Xe –rTN(d2)
N(d) = Cumulative distribution function d1 =


+ 0.5T

d2 = d1 – T
Ps = Share price
e = The exponential constant 2.7183
X = Exercise price of option
r = Annual (continuously compounded) risk free rate of return
T = Time of expiry of option in years
 = Share price volatility, the standard deviation of the rate of return on shares.
N(dx) = Delta, the probability that a deviation of loss than dx will occur in a normal distribution with a
mean of zero and a standard deviation of one
ln = Natural log


(8 marks)
(Total: 20 marks)

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