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Fnce 310: Corporate Finance Semester 1 Question Paper
Fnce 310: Corporate Finance Semester 1
Course:Bachelor Of Commerce
Institution: Kabarak University question papers
Exam Year:2010
COURSE CODE: FNCE 310
COURSE TITLE: CORPORATE FINANCE
STREAM: Y3S1
DAY: WEDNESDAY
TIME: 9:00 – 11:00A.M.
DATE: 24/03/2010
INSTRUCTIONS:
1. Answer questions ONE and any other TWO questions only.
2. ALL necessary workings must be carefully shown.
QUESTION ONE (COMPULSORY)
(a) Although profit maximization has long been considered as the main goal of a firm,
shareholder wealth Maximization is gaining acceptance amongst most companies as key goal
of a firm.
Required:
i. Distinguish between the goals of profit maximization and shareholder wealth
maximization (4 marks)
ii. Explain limitations of the goal of profit maximization (4 marks)
(b) “Since debt capital is cheaper than equity, companies should resort to 100% use of debt to
finance their investments”. Explain the limitations of the above financing policy
(6 marks)
(c) An investor expects a risk-free rate of return of 4.5% p.a and a market rate of return of
14.5% p.a. Two stocks A and B have the following betas and estimated returns:
Stock A Beta Estimated return
A 1.2 16%
B 0.8 14%
Required:
(i) Using capital asset pricing model(CAPM),use a graph to indicate the points where
the stocks would be plotted on the security market line(SML). (4 marks)
(ii) State whether stock A and stock B are undervalued or overvalued. (2 marks)
d) The capital structure of Maji Mazuri Ltd is as shown below:
Sh.
Equity (including retained earnings of Sh.3,000,000) 30,000,000
10.5% preferred stock 6,000,000
10% debt 24,000,000
The management of the company considers the above capital structure to be optimal. The
company is Undertaking a major expansion project which will require additional finance
amounting to Sh.3,000,000
Additional information:
1. The ordinary shares are currently trading at Sh. 30 per share. Flotation costs
amount to sh.3 per share
2. The dividend per share for the current year has been fixed at Sh.1.20.
Dividends are expected to grow at an annual rate of 8%
3. The corporation tax rate 30%
Required:
(i) The amount of additional capital that should that should come from equity if the company
is to maintain the existing capital structure, (2 marks)
(ii) The amount of equity that should be financed through an external issue of shares,
(2 marks)
(iii)The cost of additional share capital, (3 marks)
(iv) The cost of retained earnings (3 marks)
(Total: 30 marks)
QUESTION TWO
a) A Company earned an expected return of 12% on its existing operations subject to a
standard deviation of 20%. The company is evaluating a new investment which has an
expected returned of 16%, a standard deviation of 32% and correlation coefficient of
0.25 with the company’s existing operations. The new investment will account for
25% of the company’s operations. The company uses a measure of Utility to choose
between risky project and the measure is as follows:
Uj= 100rj-a2 where
uj is utility earned on project/portfolio
rj is expected return on the project/portfolio
aj is the standard deviation of returns
Required:
Using portfolio theory evaluate whether the new investment is acceptable (5marks)
b) Scenic systems designs and manufactures special bathroom fittings. The company’s
management is considering a proposal to manufacture and market a new shower systems
product. The project would require an investment in plant and equipment of sh. 1.5m. The
marketing manager estimates sales of the new unit at 80,000 at selling price of sh.26 per unit.
Relevant cash operating costs are estimated at 75% of the sales value. Assume a cost of
capital of 15% and an economic project life of 10 years.
Required:
a) Compute the projects NPV (3marks)
b) Test the sensitivity of project NPV to changes in:
i. Selling price (4marks)
ii. Cost of capital (4marks)
iii. Project life (4marks)
[Total: 20 marks]
QUESTION THREE
a) Explain the relevance of decision trees in the evaluation of capital investments.
(4mks)
b) The directors of Kabu Ltd wish to expand the company’s operations. The project
manager has identified a three-year project whose cash inflows and probabilities are
estimated as follows:-
Year cash Inflows (sh) Probability
1 4,000,000 0.5
5,000,000 0.4
6,000,000 0.1
2. 8,000,000 0.2
7,000,000 0.3
6,000,000 0.5
3 12,000,000 0.1
9,000,000 0.6
10,000,000 0.3
Additional information:
1. All the cash inflows are expected to occur at the year end.
2. The initial investment costs sh.20 million.
3. The cost of capital is 10%.
Required:
i) Prepare a decision tree of the project
(5mks)
ii) The net present value of the project (NPV)
(6mks)
iii) Determine the standard deviation of the project’s cash inflows
(5mks)
QUESTION FOUR
Mr.Smart, a director of Kabu Ltd Ltd met a director of Tazama Ltd during a conference held
in Kabarak University.They had some discussion about their companies. After flying back to
Nairobi, Mr.Smart proposed to his board of directors acquisition of Tazama Ltd. During his
presentation to the board he stated that “as a result of this takeover we will diversify our
operations and earnings per share will rise by 13%”. A bid would be based on an exchange of
shares between the two companies which would be one Kabu share for every six Tazama
shares.
Kabu Ltd. Tazama Ltd.
(Shs. Million) (Shs Million)
Profit before tax 12 10
Profit available to ordinary shareholders 7.8 6.5
Issued ordinary shares in value 20 15
Par value per share sh. 0.5 0.1
Market price per share sh. 3.2 0.45
Required:
(i) Explain five reasons why a company seeking to maximize the wealth of its shareholders
may wish to take over another company. (5marks)
(ii) Compute the maximum price payable per share of Tazama Ltd. (4marks)
(iii)Explain whether you agree with Mr. Smart when he says that earnings per share will rise
by 13%. (Give relevant calculations). (7marks)
(iv) Compute the likely post acquisition price of a share (MPS) of Kabu Ltd if the bid is
successful. (4marks)
(Total:20 marks)
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