CPA ADVANCED LEVEL

ADVANCED FINANCIAL MANAGEMENT

TUESDAY: 23 April 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

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(a) Summarise FOUR causes of hard capital rationing as used in capital budgeting. (4 marks)

Ap
(b) Outline FOUR limitations of Treynor’s measure of portfolio performance. (4 marks)

(c) om
Kangaro Youth Sports Ltd. wishes to design a new sports bicycle. The company will have to invest Sh.100
million at the beginning of the first year for the design and model testing of the new bicycle.
.c

The firm’s managers believe that there is an 80% probability that this phase will be successful and the project will
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continue.
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If Phase 1 is not successful, the project will be abandoned with zero salvage value.
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The next phase, if undertaken, would consist of making the molds and producing twenty prototype bicycles. This
would cost Sh.400 million at the end of the first year. If this phase is successful, the firm would go into full scale
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production. If the phase is not successful, the molds and prototypes could be sold for Sh.150 million. The
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managers estimate that the probability that the bicycles will pass the test is 90% and that Phase 3 will be
undertaken.

Phase 3 consists of changing over current production line to produce the new design. This would cost Sh.1,100
million in year 2.

If the economy is strong at this point, the net value of cash flows would be Sh.3,500 million, while if the economy
is weak the net value of cash inflows would be Sh.2,600 million. Both net values of cash inflows will be realised
at the end of year 3 and both states of the economy are equally likely.

The company’s cost of capital is 13%.

Required:
(i) Using a decision tree, determine the project’s expected net present value (ENPV). (5 marks)

(ii) Calculate the project’s standard deviation of expected net present value and comment on the result.
(4 marks)

(iii) Using the normal probability distribution, compute the probability that the project’s net present value
will be at least Sh.80 million. (3 marks)
(Total: 20 marks)

QUESTION TWO
(a) Two assets, A and B are known to lie on the security market line (SML). Asset A has a beta of 0.5 and a risk
premium of 4%. Asset B has an expected rate of return of 20% and a beta of 1.75.

You are considering the following securities which are available in the market:

Security Expected return (%) Beta

A 20 2.00
B 14 0.75
C 15 1.25
D 12 –0.25
E 31 3.25

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 Required:
(i) Determine the risk free rate of return. (2 marks)

(ii) Calculate the required rate of return of each security. (4 marks)

(iii) Identify which security is undervalued, overvalued or correctly valued. (2 marks)

(b) Cosmos Operators Ltd. have an optimal capital structure given as follows:

Sh.“000”
Ordinary share capital (Sh.20 par value each) 80,000
Reserves 20,000
16% debt (Sh.100 par value each) 40,000
10% preference share capital (Sh.30 per value each) 60,000
200,000

Additional information:
1. The firm is considering raising Sh.20 million for an expansion programme of which Sh.2,000,000 is
expected to be raised from internal sources.

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2. New ordinary shares will be issued at Sh.35 each. A floatation cost of Sh.5 per share issued will be

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incurred.
3. The firm’s most recent earnings per share (EPS) is Sh.3. The firm adopts 50% pay out ratio as its
dividend policy. Dividends are expected to grow at a rate of 5% each year in a perpetuity.
4. om
New 10% irredeemable debentures will be issued at Sh.110 each. A floatation cost of Sh.10 per
debenture will be incurred.
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5. New 10% irredeemable preference shares will be issued at Sh.40 each.
6. Corporation tax rate is 30%.
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Required:
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(i) The retained earnings break point. (2 marks)

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(ii) The number of new ordinary shares to be issued to raise the desired external equity. (2 marks)
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(iii) The weighted marginal cost of capital (WMCC) in each of the intervals between the breakpoints.
(8 marks)
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(Total: 20 marks)

QUESTION THREE
(a) Explain the following option trading strategies:

(i) Bull spread. (2 marks)

(ii) Bear spread. (2 marks)

(iii) Covered call. (2 marks)

(b) Duet Ltd. is considering a takeover bid for Small Ltd., another company in the same industry. Small Ltd. is
expected to have earnings next year of Sh.129,000,000.

If Duet Ltd. acquires Small Ltd., the expected results from Small Ltd. will be as follows:

Year after acquisition

Year Year 1 Year 2 Year 3
Sh.“000” Sh.“000” Sh.“000”
Sales 300,000 420,000 480,000
Cash costs/expenses 180,000 240,000 270,000
Capital allowances 30,000 45,000 60,000
Interest charges 15,000 15,000 15,000
Cash flows to replace assets and finance growth 37,500 45,000 52,500

Additional information:
1. From year 4 onwards, it is expected that the annual cash flows from Small Ltd. will increase by 4% each
year in perpetuity.
2. Tax is payable at the rate of 30%. Tax is paid in the same year it falls due.
3. If Duet Ltd. acquires Small Ltd., it estimates that gearing after the acquisition will be 35% (measured as
the value of its debt capital as proportion of total equity plus debt).
4. The cost of debt is 7.4% before tax. Duet Ltd. has an equity beta of 1.60.
5. The risk free rate of return is 6% and the return on the market portfolio is 11%.

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 Required:
(i) The offer price for Small Ltd. assuming Duet Ltd. chooses to value Small Ltd. on a forward price
earnings (P/E) multiple of 8 times. (2 marks)

(ii) The cost of capital of Duet Ltd. (4 marks)

(iii) Determine the offer price for Small Ltd. using discounted free cash flow (DCF) valuation method.
(8 marks)
(Total: 20 marks)

QUESTION FOUR
(a) Explain FOUR advantages of real estate investments. (4 marks)

(b) Jacob Ouma, a financial analyst, gathered the following financial information from the banking industry in Kenya.
The interest rate on a one year Kenyan bank is 16%.

The interest rate on a one year foreign bank deposit is 22%.

p
Required:

Ap
(i) Compute the percentage change in the value of the foreign currency according to International Fisher
Effect. (3 marks)

(ii) om
Given a spot rate of Tsh1 = Ksh. 6.06, calculate the forward rate of Tsh after one year. (2 marks)
.c
(c) The following are the financial statements of Bobi Ltd. for the year ended 31 December 2023:
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Bobi Limited
Statement of profit or loss for the year ended 31 December 2023:
en

Sh.“000”
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Revenue 60,000
Cost of sales (35,000)
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Gross profit 25,000

Operating expenses (10,000)
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Operating profit 15,000

Finance cost (11,000)
Earnings before tax 4,000
Income tax expense (1,200)
Profit for the year 2,800

Bobi Limited
Statement of financial position as at 31 December 2023:
Sh. “000” Sh.“000”
Net tangible assets 126,000
Intangible assets 42,000
168,000
Current assets:
Inventory 48,000
Trade receivables 36,000
Bank balance 4,800 88,800
256,800
Financed by:
Equities and liabilities:
Equity:
480,000 preference shares (Sh.25 each) 12,000
500,000 ordinary shares (Sh.24 each) 12,000
Share premium 24,000
Retained earnings 16,800
64,800
Non-current liabilities:
Mortgage (20 years) 48,000
8% debentures 72,000 120,000
Total equity and reserve 184,800
Current liabilities:
Trade payables 12,000
Notes payable 60,000 72,000
Total liabilities and equity 256,800
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 Additional information:
1. The Z-score is to be calculated using the following formula:
Z-score = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5

Where:
X1 = Working capital/Total assets
X2 = Retained earnings/Total assets
X3 = Earnings before interest and tax/Total assets
X4 = Market value of equity/Book value of debt
X5 = Sales/Total assets
2. The current market price per share is Sh.42.

Required:
(i) The Z-score of Bobi Ltd. for the year ended 31 December 2023. (6 marks)

(ii) Interpret the meaning of Z-score obtained in (c) (i) above. (2 marks)

(iii) Outline THREE limitations of Z-score model. (3 marks)

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(Total: 20 marks)

Ap
QUESTION FIVE
(a) Discuss THREE factors that distinguish between the cost of capital of a multinational corporation and the cost of
capital of a domestic firm. om (6 marks)
.c
(b) In relation to financial risk management, explain FOUR advantages of plain vanilla currency swaps with monthly
delivery compared with a strip of forward contracts. (4 marks)
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(c) Kawaida Ltd. has Sh.3,000,000 in equity capital and Sh.1,000,000 in debt capital (at market values). The beta
en

value of the equity is 1.126 and the beta of the debt capital is 0.
ak

The risk free cost of capital is 5% and the market portfolio return is 11%.
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The tax rate is 30%.

So

Required:
(i) Calculate the current weighted average cost of capital (WACC). (3 marks)

(ii) Compute the asset beta for the company and explain what this means. (3 marks)

(iii) Calculate the equity beta, the cost of equity and the WACC would be if the company consisted of 60%
equity and 40% debt. (4 marks)
(Total: 20 marks)
..............................................................................................................

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 CPA ADVANCED LEVEL

ADVANCED FINANCIAL MANAGEMENT

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.

QUESTION ONE
(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

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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
.c
is willing to pay a maximum of Sh.45 million.
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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.
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Required:
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(i) Using the expected monetary value (EMV) technique, determine the category of investor in case 1, case
2 and case 3 above. (6 marks)
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(ii) Compute the utile value for case 1, case 2 and case 3 respectively. (3 marks)
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(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.
So

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. Kaka Ltd.

Sh.“million” Sh.“million”
Equity (market value) 100 70
5% debt (trading at par) - 50

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

Required:
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)
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 QUESTION TWO
(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.

Required:
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 Forecasted rate of return Expected standard

outlay Sh. “000" (%) deviation of return (%)

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Project 1(P1) 3,000 16 8
Project 2(P2) 2,000 .c 15 6
Project 3 (P3) 2,000 22 10
Money market (MM) 3,000 12 4
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5. The correlation coefficients of returns of the above combination of projects are as follows:
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Between projects Between projects and Between projects and Between money market
market portfolio (MP) money market (MM) (MM) and market
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portfolio (MP)
P1 and P2 = 0.90 P1 and MP = 0.80 P1 and MM = 0.30 MM and MP = 0.40
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P1 and P3 = 0.50 P2 and MP = 0.10 P2 and MM = 0.75

So

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

Required:
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)

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 QUESTION THREE
(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 ([Link]) 100 50
Cost of sales ([Link]) 30 10
Operating costs ([Link]) 10 5
Finance cost ([Link]) 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%.

Required:
(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

om
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.
.c (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.
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The bond will be redeemed at a par value of Sh.100.

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Required:
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Using the Macaulay duration method, compute the bond’s duration. (5 marks)
(Total: 20 marks)
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QUESTION FOUR
(a) Discuss FOUR real estate financing options available to real estate investors in your country. (8 marks)
m

(b) Highspeed Electronics Ltd. has taken delivery of 50,000 electronic devices from an American company. The
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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.

Required:
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)

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 QUESTION FIVE
(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.

Required:
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.

Required:
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:

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Pc = PS N(d1) – Xe –rTN(d2)

Where:
.c
N(d) = Cumulative distribution function
d1 = ln Ps + rT
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x + 0.5δT
δ√T
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d2 = d1 - δ√T
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Ps = Share price
e = The exponential constant 2.7183
X = Exercise price of option
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r = Annual (continuously compounded) risk free rate of return

T = Time of expiry of option in years
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δ = 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
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mean of zero and a standard deviation of one

ln = Natural log
(8 marks)
(Total: 20 marks)
..............................................................................................................

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 CPA ADVANCED LEVEL

ADVANCED FINANCIAL MANAGEMENT

TUESDAY: 25 April 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.

QUESTION ONE
(a) (i) Explain the term “static trade off theory of capital structure”. (2 marks)

(ii) Selected financial information for Tembo Ltd. is shown below:

• Yield to maturity on debt 8%

• Market value of debt Sh.100 million
• Number of ordinary shares 10 million
• Market price per ordinary share Sh.30
• Cost of capital if all equity financed 10.3%
• Marginal tax rate
om 30%
.c
Additional information:
1. Johnson Njogu, a financial analyst expects that an increase in Tembo Ltd’s financial leverage will
ya

increase its costs of debt and equity.

2. Based on an examination of similar companies in Tembo Ltd. industry, Johnson Njogu estimates that the
company’s cost of debt and cost of equity at various debt to total capital ratios are as shown below:
en

Estimates of Tembo Ltd. before tax costs of debt and equity:

ak

Debt to total capital ratio (%) Cost of debt (%) Cost of equity (%)
me

20 7.7 12.5
30 8.4 13.0
So

40 9.3 14.0
50 10.4 16.0

Required
Determine the debt to total capital ratio that would minimise Tembo Ltd.’s weighted average cost of capital
(WACC). (5 marks)

(b) Adept Consultants is a research firm that provides market related data for use by market participants. Michael
Aloo is a financial manager at Adept Consultants tasked with estimating stock beta.

Required:
Explain THREE practical considerations that Adept Consultants should take when forecasting beta of an asset.
(3 marks)

(c) XYZ Limited is considering six investment projects with the following details:

Project Initial outlay Net present value

Sh. “000” Sh. “000”
1 1,000 390
2 750 325
3 1,125 590
4 1,850 840
5 1,300 635
6 1,500

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 Additional information:
1. Project 6 is expected to generate the following annual cash flows:
Year 1 2 3 4
Sh. “000” Sh. “000” Sh. “000” Sh. “000”
Sales 725 765 885 612
Cost 145 168 202 94
Project 6 cash flows are exclusive of inflation at the rate of 4% per year for sales income and 5% per year
for costs.
2. The cost of capital is 10%.
3. Due to management reluctance to raise additional finance, the capital for investment is currently
restricted to Sh.5,000,000.
4. Project 1, 3, 5 and 6 are all independent but project 2 and 4 are mutually exclusive.
5. All of the above projects are divisible and none can be delayed or repeated.

Required:
(i) The net present value (NPV) for project 6. (3 marks)

(ii) The optimum investment combination given the capital constraint. (6 marks)

(iii) The resulting net present value (NPV) in (c) (ii) above. (1 mark)
(Total: 20 marks)

QUESTION TWO
(a) (i) Differentiate between “white knight” and “white squire” in relation to mergers and acquisitions.
(4 marks)

(ii) Felix Bodo has collected the following information relating to the pro-forma financial statements of ABC
Ltd., a company that is a target of its competitors.
om
Pro forma statement of profit or loss:
.c
Year
2022 2023 2024 2025 2026
ya

Sh.“000” Sh.“000” Sh.“000” Sh.“000” Sh.“000”

Revenue 15,752 17,327 19,060 20,966 23,023
en

Cost of goods sold 8,664 9,530 10,483 11,531 12,685

Gross profit 7,088 7,797 8,577 9,435 10,378
ak

Selling, general expenses 2,363 2,599 2,859 3,145 3,459

Depreciation 551 606 667 734 807
me

Earning before interest and taxes 4,174 4,592 5,051 5,556 6,112
Net interest expense 642 616 583 543 495
So

Earning before taxes 3,532 3,976 4,468 5,013 5,617

Income tax 1,236 1,392 1,564 1,755 1,966
Net income 2,296 2,584 2,904 3,258 3,651

Selected pro forma statement of financial position:

Year
2022 2023 2024 2025 2026
Sh.“000” Sh.“000” Sh.“000” Sh.“000” Sh.“000”
Change in deferred income tax 19 21 23 26 28

Selected pro forma cash flow statement:

Year
2022 2023 2024 2025 2026
Sh.“000” Sh.“000” Sh.“000” Sh.“000” Sh.“000”
Change in networking capital 455 551 607 667 734
Capital expenditures 1,461 1,709 1,880 2,068 2,275

Additional information:
1. ABC Ltd. has a corporate tax rate of 30%.
2. The weighted average cost of capital is 10%.
3. The terminal growth rate is 6%.

Required:
Determine using the discounted free cash flow analysis the value of ABC Ltd. (10 marks)

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 (b) Consider a two-period binomial model in which a share currently trades at a price of Sh.65. The share price can
go up 20% or down 17% each period. The risk free rate is 5%.

Required:
The price of a put option expiring in two periods with an exercise price of Sh.60. (6 marks)
(Total: 20 marks)

QUESTION THREE
(a) In regards to restructuring in the public sector, the ministry of finance or an equivalent body can use performance
results to motivate agencies to improve performance.

Required:
Examine THREE broad categories of potential mechanisms available to the Ministry of Finance to motivate
performance including the rewards and sanctions in each category line. (6 marks)

(b) One of the instruments of real estate financing is mortgages.

Highlight FOUR methods by which the interest on a mortgage may be charged. (4 marks)

(c) You have been appointed as a finance manager of Mamba Ltd. After evaluating the investment portfolio of the
company, you have divided the market into four portfolios following two dimensions; value/growth and
small/large.

The weight of each portfolio in the index is given below:

Portfolio Weight Sensitivity to factor 1 Sensitivity to factor 2 Sensitivity to factor 3

(%) (Market beta) (Price/book) Average capitalisation
Small value 10 0.87 0.83 2
Small growth
Large value
10
30
0.97
0.92
om 0.33
5
2
20
.c
Large growth 50 1.12 6 22
Risk premium 8% –3% 0.40%
ya

The risk free rate is 3%.

en

Required:
ak

(i) Using the arbitrage pricing theory (APT), determine the portfolio that has the highest expected return.
(4 marks)
me

(ii) The portfolio that would maximise your return if you decide to use capital asset pricing model (CAPM).
So

(4 marks)

(iii) In order to diversify his perceived risk, a competitor wants to combine the small value and large growth
portfolios. The new portfolio should have an overall sensitivity to factor 1 (market beta) of 1.

Determine the proportion to be invested in the small value and large growth. (2 marks)
(Total: 20 marks)

QUESTION FOUR
(a) Explain THREE differences between “futures contracts” and “forward contracts”. (6 marks)

(b) Pine Ltd. is considering an investment in one of two corporate bonds namely A and B. Both bonds have a par
value of Sh.1,000 and pay coupon interest on an annual basis.

The market price of bond A is Sh.1,079.60 with a coupon rate of 6% and is due to be redeemed at par in five
years. Bond B is about to be issued with a coupon rate of 4% and will also be redeemable at par in five years.

Additional information:
1. Both bonds are expected to have the same gross redemption yield (yield to maturity).
2. The yield to maturity of a company bond is determined by its credit rating.
Pine Ltd. considers duration of the bond to be a key factor when making decisions on which bond to invest in.

Required:
(i) The Macaulay duration for bond A and bond B. (10 marks)

(ii) Discuss TWO limitations of duration as a measure of a bond price to changes in interest rates. (4 marks)
(Total: 20 marks)
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 QUESTION FIVE
(a) Globalisation has resulted in several organisations engaging in corporate alliances and the establishment of
trading blocks. The advent of e-commerce has enabled companies to greatly expand their market.

Required:
Elaborate on FOUR factors that complicate financial management in multinational firms. (8 marks)

(b) Explain THREE divestment strategies available to a company undertaking restructuring. (6 marks)

(c) A group of companies controlled from the United States has subsidiaries in the United Kingdom (UK), South
Africa (SA) and France (FR).

As at 30 November 2022, intercompany indebtness were as follows:

Debtors Creditors Amount Currency

UK SA 1,236,000 SA Rand
UK FR 494,400 Euro
FR SA 824,000 SA Rand
SA UK 76,220 Sterling Pound
SA FR 386,250 Euro

Additional information:
1. It is the company’s policy to net off inter-company balances to the greatest extent possible.
2. The central treasury is to use the following exchange rates for netting off purposes:

US$ = SA Rand 6.4323/£0.7140/Euro 6.1740

Required:
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Calculate the net payment to be made between the subsidiaries after netting of inter-company balances. (6 marks)
(Total: 20 marks)
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..............................................................................................................
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 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

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and probabilities for a new printing process in each case scenario:
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Year Worst case Most probable case Best case
a.
Sh.“000” Sh.“000” Sh.“000”
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0 (100,000) (100,000) (100,000)

1 20,000 30,000 40,000
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2 20,000 30,000 40,000

3 20,000 30,000 40,000
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4 20,000 30,000 40,000

5 20,000 30,000 40,000
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5* 5,000 20,000 30,000

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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%.

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5. The corporate tax rate is 30%.
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a.
Required:
Using the Modigliani and Miller (MM) model, determine the following:
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(i) The market value of A Ltd. and B Ltd. (4 marks)

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

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Required
(i) co
The Z-score for each of the three companies. (6 marks)
a.
(ii) Comment on your results in (b) (i) above. (2 marks)
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(c) Kilop Ltd. has decided to instal a new milling machine.

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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
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Sh.5,600,000 at the end of year five.

2. The company has two options:
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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 ([Link]) 400 100
Net income ([Link]) 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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 CPA ADVANCED LEVEL

ADVANCED FINANCIAL MANAGEMENT

TUESDAY: 2 August 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) A project requires an initial investment of Sh.500,000. It is expected to generate cash inflows of Sh.200,000 per
annum for the next 5 years.

Additional information:
1. The firm is indifferent between a certain amount of Sh.181,347 at the end of the first year and the
expected amount of Sh.200,000.
2. The risk free rate of return is 5% per annum. om
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Required:
(i) The net present value (NPV) of the project incorporating certainty equivalent coefficient (CEC).(5 marks)
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(ii) Advise the management on whether the project is worthwhile. (1 mark)

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(b) An investor has decided to invest Sh.2,000,000 in the shares of two companies namely Dela Ltd. and Alpha Ltd.
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The projections of returns from the shares of the two companies along with their associated probabilities are as
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follows:

Probability Returns %
Dela Ltd. Alpha Ltd.
0.20 6 8
0.25 7 5
0.25 –3.5 14
0.30 14 –1

Required:
(i) Determine the proportion of each of the above shares required to formulate a minimum risk portfolio.
(8 marks)
(ii) The amount (in shillings) that should be invested in each share using the proportions determined in (b) (i)
above. (2 marks)

(c) Describe four factors that could significantly impact on the price of cryptocurrencies. (4 marks)
(Total: 20 marks)

QUESTION TWO
(a) Libe Ltd. debt-equity ratio, by market value is 2:5. The corporate debt, which is assumed to yield a return similar
to treasury bills have a rate of 10% before tax.

The beta value of the company’s equity is currently 1.1. The average returns on stock market equity are 15%.

The company is now proposing to invest in a project which would involve diversification into a new industry.

The following information is available relating to this industry:

1. Average beta coefficient of equity capital is 1.60.
2. Average debt-equity ratio in the industry is 1:2 (by market value).
3. The corporation rate of tax is 30%.

Required:
Determine the suitable cost of capital to apply to the project. (6 marks)
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 (b) Rona Hotel Ltd. is currently evaluating a proposal to take over Duet Restaurant Ltd. The Board of directors of
Rona Ltd. is in the process of making a proposal for acquisition of Duet Restaurant Ltd. but first needs to place a
value on the company.

Rona Ltd. has gathered the following financial data:

Rona Hotel Ltd.:

1. Weighted average cost of capital 12%
2. Price to earnings (P/E) ratio 12 times
3. Shareholders required rate of return 15%

Duet Restaurant Ltd.:

1. Current dividend payment per share (DPS) Sh.2.7
2. Past five years dividend payment:
Year 2017 2018 2019 2020 2021
Dividend per share (DPS) (Sh.) 1.5 1.7 1.8 2.1 2.3
3. The current Earnings Per Share (EPS) is Sh.3.7
4. The number of issued ordinary shares are 5 million shares.

Additional information:
1. It is estimated that the shareholders of Duet Restaurant Ltd. require a rate of return of 10% higher than
that of Rona Ltd. owing to the higher level of risk associated with Duet Restaurant Ltd.’s operations.
2. Rona Restaurant Ltd. estimates that the free cash flows from Duet Restaurant Ltd. at the end of the first
year will be Sh.2.5 million and these will grow at an annual rate of 5% for the first 4 years after which
the growth rate will revert to the historical earnings/dividend growth rate in perpetuity.
3. Rona Ltd. expects to raise Sh.5 million at the end of year 2 by selling off hotels of Duet Ltd. that are
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surplus of its needs.
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Required:
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Estimate values of Duet Restaurant Ltd. using the following valuation approaches:
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(i) Price/earnings ratio model. (2 marks)

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(ii) Dividend growth model. (3 marks)

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(iii) Discounted free cash flow basis. (5 marks)

(c) Discuss Modigliani and Miller’s proposition in a real estate finance context clearly stating the assumptions of the
theory. (4 marks)
(Total: 20 marks)
QUESTION THREE
(a) Evaluate five benefits of a currency swap. (5 marks)

(b) A United States (US) company buys goods worth 1,440,000 Euros (€) from a German company payable in 30
days. The US company wants to hedge against the Euro (€) strengthening against the United States dollar ($).

The following exchange rates are provided:

Current spot rate: $/€ 0.9215 – 0.9221

Futures exchange rate: $/€ 0.9245.

The standard size of a 3 month € futures contract is €125,000. In 30 days time, the spot rate is 0.9345 – 0.9351
$/€ and closing futures price will be 0.9367 $/€.

Required:
Determine the net outcome of the futures currency hedge. (5 marks)

(c) Bezo Construction Company Ltd. made a Sh.20 million bond issue 5 years ago when interest rates were
substantially high. The interest rates have now fallen and the firm wishes to retire this old debt and replace it with
a new and cheaper one. Given below are details about the two bond issue:

Old Bond: The outstanding Sh.20 million bond has a nominal value of Sh.1,000 and a coupon rate of 20%. They
were issued 5 years ago with a 25-year maturity. They were initially sold at 5% discount to attract investors and
the firm incurred a floatation cost of Sh.450,000. The bond is callable at Sh.1,150 per unit.
New Bond: The new bond issue of Sh.20 million would have Sh.1,000 nominal value per unit and 18% coupon
rate. They would have a 20-year maturity and will be sold at 10% discount to attract investors. Floatation cost on
the new bond are estimated at Sh.550,000.
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 Assume two months overlapping period and corporation tax rate of 30%.

Required:
(i) Determine the incremental initial cash outlay required to issue the new bond. (4 marks)

(ii) Calculate the annual cash flow saving (if any), expected from the bond refinancing. (3 marks)

(iii) Determine the net present value (NPV) of the bond refinancing and hence advise the company
accordingly. (3 marks)
(Total: 20 marks)
QUESTION FOUR
(a) Assess four circumstances under which a company would consider reorganising its operations rather than
liquidating. (4 marks)

(b) In relation to corporate restructuring and reorganisation, discuss the potential advantages for a company
undertaking the divestment of one of its division by means of:

(i) A sell off. (2 marks)

(ii) A demerger. (2 marks)

(iii) A divestment. (2 marks)

(c) Ngao Ltd. is considering investing in two capital investment projects; X and Y. The projects cash flows are
provided as shown below: om
Project
Year X Y
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Cash flow Sh.“000” Cash flow Sh.“000”

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0 (40,000) (80,000)
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1 (80,000) (40,000)
2 (120,000) -
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3 400,000 240,000
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The funds available for investment in both projects are restricted as follows:
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Year Amount Sh.“000”

0 100,000
1 80,000
2 60,000

Additional information:
1. None of the projects will delay, that is, both investments will start in year 0.
2. The funds not utilised in one year shall not be available for investment in the subsequent years.
3. Both projects are divisible, that is, a project can be undertaken in part or in whole.
4. The cost of capital is 13%.

Required:
(i) Formulate a linear programming model to solve the problem. (4 marks)

(ii) Using the graphical approach, solve the linear programming model and hence determine the proportion
of each project to be undertaken to maximise net present value (NPV). (6 marks)
(Total: 20 marks)
QUESTION FIVE
(a) Summarise four objectives of the International Monetary Fund (IMF). (4 marks)

(b) Discuss four advantages of Foreign Direct Investment (FDI). (8 marks)

(c) The following information relates to the performance of three portfolios; A, B and C during the year ended
30 June 2022:

Portfolio Average return (%) Standard deviation (%) Covariance of portfolio

return with market returns
A 17.55 30 0.0088
B 13.26 34 0.0750
C 9.34 28 0.0021

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 Additional information:
1. The market return and the risk-free rate averaged 14% and 7% respectively during the year ended
30 June 2022.
2. The standard deviation of the market is 10%.

Required:
Evaluate the performance of the three portfolios using:

(i) Sharpe’s performance measure. (4 marks)

(ii) Treynor’s performance measure. (4 marks)

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

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 CPA ADVANCED LEVEL

PILOT PAPER

ADVANCED FINANCIAL MANAGEMENT

December 2021. Time Allowed: 3 hours.

Answer ALL questions. Marks allocated to each question are shown at the end of the question. Show ALL your workings.

QUESTION ONE
(a) GLD Building Group is contemplating a takeover of Diarim Enterprise Ltd., a manufacturer of earthmoving
equipment.
The following information is available about the two companies.
GLD Diarim
Number of shares in issue 6,000,000 4,000,000
Dividend per share Sh.0.30 Sh.0.09
Price per price Sh.8.91 Sh.3.20
Additional information.
1. The cost of equity capital for both firms is 10%.
2. From a level of Sh.0.06 per share 6 years ago, GLD’s dividends has grown to the current level of Sh. 0.09 per share.
3. GLD’S management is confident that managerial synergies arising as a result of proposed takeover will enable them
to increase Diarim Ltd’s past dividends growth rate by a further 1%.
4. The merger will involve transactions cost of Sh.500000.
Required:
Based on the approximate dividend growth rate, estimate the post-acquisition value of Diarims Ltd. using the dividend growth
model, and evaluate the value gain arising as a result of the takeover. (7 marks)
(b) (i) Discuss the main economic and financial justification advanced for mergers and acquisitions. (4 marks)

(ii) According to evidence, to what extent do the shareholders of the companies tend to benefit from such an
activity? (2 marks)
(iii) According to the evidence, to what extent do the managers of companies tend to benefit from such activity?
(2 marks)
(iv) Explain what are referred to as “managerial” motives for mergers and acquisitions (M&A). (5 marks)
(Total: 20 marks)
QUESTION TWO
Arkard, an investment specialist has been entrusted with Sh.10 million by a collective investment scheme (unit trust) and
instructed to invest the money optimally over a two-year period.
Parts of the instruction are that:
1. The funds be invested in one or more of four specified projects and the money market.
2. The four projects are not divisible and cannot be postponed.
3. The unit requires a return of 24% over the two years. The following are details of the investment in the projects and
the money market.

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 Initial Cost Return over Expected Standard deviation
two years of returns over the two years
Sh.”000” % %
Project 1(p1) 6,000 22 7
Project 2(p2) 4,000 26 9
Project 3(p3) 6,000 28 15
Project 4(p4) 6,000 34 13
Money market (MM) 1,000 (minimum) 18 5

The correlation coefficients of returns over the two years are as follows:
Between Between projects Between projects Between money
Projects &market portfolio and the money market and market
(MP) market (mm) portfolio
P1&p2=0.70 p1&mp=0.68 p1&mm=0.40 MM&MP=0.4
P2&p3=0.0 p2&mp=0.65 p2&mm=0.45
P1&p3=0.62 p3&mp=0.75 p3&mm=0.55
P1&p4=0.56 p4&mp=0.88
P2&p4=0.57
P3&p4=0

Over the two year period, the risk free rate is estimated to be 16%, the market portfolio return is 27% and the variance of the
return on the market 100%.
By analyzing the two assets portfolios:
(a) Use the mean variance dominance rule to evaluate how Arkard should invest the Sh.10 million. (8 marks)

(b) Determine the betas and required rates of return for the portfolios then use the capital assets pricing model to evaluate
how Arkard should invest the Sh.10 million. (8 marks)

(c) Examine four criticisms of the Modigliani and Miller (MM) hypothesis without taxes. (4 marks)
(Total: 20 marks)
QUESTION THREE
An investor is considering introducing a new product code named super pad into the market. This would involve purchasing
a plant costing Sh.300 million.
Additional information:
1. The plant has a useful life of five years and is to be depreciated on a straight line basis.
2. The salvage value is nil.
3. Due to market uncertainties, the sale price, variable cost and sales volume of the super pad have been
estimated stochastically as follows:
Selling price Variable Cost Sales Volume
Value Probability Value Probability Value Probability
Sh. Sh. units
30 0.20 10 0.20 4 million 0.20
40 0.60 20 0.50 6 million 0.50
50 0.20 30 0.30 8 million 0.30

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 4. The company’s cost of capital is 12% and the corporate tax rate is 30%.
Required:
(a) The expected net present value (NPV) of the new product using expected values for each variable. (4 marks)

(b) The expected NPV by performing ten runs using the following random numbers for each variable.
Selling price: 76 64 02 53 16 16 55 54 23 36
Variable cost: 20 82 74 08 01 69 36 35 52 99
Sales volume: 55 50 29 58 51 14 86 24 39 47
Required:
Determine the expected NPV as simulated. (10 marks)

(c) The probability that this product will be a success. (1 mark)

(d) Discuss the advantage (merits) and disadvantages (limitations) of simulation analysis. (5 marks)
(Total: 20 marks)
QUESTION FOUR
(a) Unbundling is the process of selling off incidental non-core businesses to release funds, to reduce gearing in order
to allow management to concentrate on their chosen core business.
In relation to corporate restructuring and reorganization, briefly explain the following forms of unbundling:
(i) Management buyout (MBO). (2 marks)

(ii) Management buy in (MBI). (2 marks)

(iii) Spin off or demerger. (2 marks)

(iv) Sell off or divestment. (2 marks)

(b) Rhinox LTD is planning to invest in an expansion plan. The company has estimated Sh.20 million as the initial
investment for the expansion.
The plan is expected to generate Sh.5 million annual after tax cash inflow for the next 5 years. Cost of capital is
10%.
Required:
(i) The NPV of the project. (2 marks)

(i) The value of the call option to delay if the risk free rate of return is 7% and standard deviation of returns is
30%.
(6 marks)
(c) In relation to financial risk management, briefly explain four advantages of financial derivatives. (4 marks)
(Total: 20 marks)

QUESTION FIVE
(a) Alpha will receive US dollars 400,000 in 3 month’s time. The company treasurer has determined the following:
Spot rate Dollars 1.8250-Dollars 1.8361
3 months forward Dollars 1.8338-Dollars 1.8452

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 Money market rates Borrowing Deposit
US Dollars 5.1% 4.2%
Sterling 5.75% 4.5%
The money market rates are annual rates.
Required:
Determine whether a forward contract hedge or a money market hedge should be undertaken. (8 marks)

(b) Explain four advantages of investing in Real Estate Investment Trusts. (8 marks)

(c) Explain the meaning of the term crypto currency and give an example. (4 marks)

(Total: 20 marks)

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