Corporate Finance Question Paper
Corporate Finance
Course:B.Com
Institution: Kabarak University question papers
Exam Year:2008
KABARAK
UNIVERSITY
UNIVERSITY EXAMINATIONS
2008/2009 ACADEMIC YEAR
FOR THE DEGREE OF BACHELOR OF COMMERCE
COURSE CODE: FNCE 310
COURSE TITLE: CORPORATE FINANCE
STREAM: Y3S1
DAY: MONDAY
TIME:
8.30
–
10.30
A.M.
DATE: 11/8/2008
INSTRUCTIONS:
1. Answer Question ONE and any other two questions only.
2.
All necessary workings must be carefully shown
3.
Marks allocated are shown at the end of each question.
PLEASE TURN OVER
Page 1 of 5
QUESTION ONE (COMPULSORY)
(a)
For each of the companies described below, explain which one you would expect
to have a medium, high or a low dividend payout ratio:
(i)
A Company with a large proportion of inside ownership, all of whom are
high
income
individuals.
(1½mks)
(ii)
A growth company with an abundance of good investment opportunities.
(1½mks)
(iii) A Company experiencing ordinary growth, has high liquidity and much
unused
borrowing
capacity.
(1½mks)
(iv) A dividend-paying company that experiences an unexpected drop in
earnings
from
the
trend.
(1½mks)
(v)
A Company with volatile earnings and high business risk
(1½mks)
(b)
Pesa Yote Ltd Finance Manager is considering buying stocks X and Y being sold
in
Nairobi
Stock
Exchange.
The stocks have the following distribution of returns:
State
of
Economy Probability Stock
X
Stock
Y
(%)
(%
)
A 0.1
-8 14
B 0.2 10 -4
C
0.4
8
6
D 0.2
5 15
E 0.1
-4 20
Required:
(i)
Calculate
the
expected
returns
and
risk
of
each
stock.
(6mks)
(ii) Calculate
the
covariance
and
correlation
coefficient
between
the
two
stocks.
(4mks)
(iii) What is the expected returns and risk of a portfolio with equal
weighs
in
each
asset?
(5mks)
(iv) Explain the two main types of risks giving examples of each.
(3mks)
(d)
(i)
What is the objective of capital structure management?
(1½mks)
(ii)
Identify and briefly explain four factors that need to be considered in
making
capital
structure
decisions.
(4mks)
(TOTAL: 20 MARKS)
Page 2 of 5
QUESTION TWO
(a)
In the context of portfolio, theory explains the general relationships between the
gains from diversification and correlation among security returns. (8mks)
(b)
Kabu Ltd is considering two Investment projects, A and B for which the
following information has been calculated:
Investment
A
Investment
B
Shs
Shs.
Investment
outlay 2,000,000 2,000,000
Expected
return 0.20 0.20
Standard
deviation
of
returns
0.40
0.60
Data
of
returns
1.80 1.80
The finance Manager has formulated a risk adjustment relationship based on the
coefficient of variance as follows:
Required return on a project = Risk free return + 0.04 C.V.
He also takes into consideration the security market line (SML) relationships
using 6% as the estimate of the risk free return and 5% as the market risk
premium.
Required:
(i)
Calculate the required return on each project, using separately the two
alternative
methods
of
calculating
the
risk
adjustment
factor.
(6mks)
(ii)
Advise the company on which project(s) should be accepted first by
assuming that the projects are independent and second assuming that they
are
mutually
exclusive.
(6mks)
(TOTAL: 20 MARKS)
QUESTION THREE
(a)
Define the term “Sensitivity analysis” in the context of capital investment
appraisal.
(2mks)
(b)
Explain how sensitivity analysis can be used in appraising risky capital
investments.
(4mks)
(c)
The management of Tayari Ltd is considering undertaking a project with the
following
characteristics:
Page 3 of 5
Characteristics
Detail Amount
A
Initial
outlay Sh.7,360,000
B
Expected
useful
life
5
years
C
Sales
volume 1,200,000
units
D
Selling
price Ksh.15
per
Unit
E
Variable
cost
per
unit
Ksh
10
per
unit
F
Fixed
cost Ksh.2,000,000.
The company’s cost of capital is 16% and corporate tax is 30%. Assume straight
line
method
of
depreciation.
Required:
(i)
Calculate
the projects net present value
(NPV)
(4mks)
(ii)
Calculate the project’s net present value and its percentage change
assuming each of the characteristics A, C, D and E vary adversely by 10%
(10mks)
(TOTAL: 20 MARKS)
QUESTION FOUR
Mr Upendo, a director of Yote Limited met Mr. Mapenzi, a Director of Toa Ltd during a
conference in Kabarak University. They had some discussions about their various
companies. After flying back to Nairobi, Mr. Upendo proposed to his board of Directors
acquisition of Toa Ltd.
During his presentation to the board, he stated that as a result of this take over we will
diversify our operations and earnings per share will rise by 13%, bringing great benefits
to our shareholders.
No bid has yet been made and Yote Ltd currently owns only 2% of Toa Ltd.
A bid would be based on an exchange of shares between the two companies which would
be one Yote share for every Toa shares.
Financial data for the two companies include the following:
Yote
Limited
Toa
Limited
Sh
(Million) Sh
(Million)
Turnover 56 42
Profit
before
Tax
12
10
Profit available to ordinary
shareholders 7.8 6.5
Issued
ordinary
shares 20
15
Market
price
per
share
sh3.2
sh0.45
Par
value
per
share
sh0.5
sh0.10
Page 4 of 5
Required:
(a)
Explain whether you agree with Mr. Upendo when he says that the takeover
would bring great benefits to our shareholders. Support your explanation with
relevant calculations.
State clearly any assumptions made.
(12mks)
(b)
On the basis of information provided, calculate the likely post price of a share of
Yote Ltd if a bid is successful.
(4mks)
(c)
What alternative forms of payment are available in a bid?
(4mks)
(TOTAL: 20 MARKS)
QUESTION FIVE
(a)
Briefly explain the following capital structure theories:
(i) Traditional
theory
(4mks)
(ii) Madigliani and Miller (MM) with taxes theory
(4mks)
(b)
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 Shs. 100 million worth of ordinary shares.
2.
B Ltd is financed using Shs 50 million in ordinary shares and Shs 50
million
in
7%
debentures.
3.
The annual earnings before interest and Tax are Shs 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
(6mks)
(ii) The weighted average cost of capital of A Ltd and B Ltd.
(4mks)
(TOTAL: 20 MARKS)
Page 5 of 5
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