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Hbc2206:Financial Management Question Paper
Hbc2206:Financial Management
Course:Bachelor Of Commerce
Institution: Meru University Of Science And Technology question papers
Exam Year:2011
QUESTION ONE
(a) Explain the methods that may be used by a company to resolve the agency conflicts between managers and shareholders. (6Marks)
(b) An investor has two securities, A and B with the following return characteristics:
State of economy
Probability Returns Security A (%)
Returns Security B (%)
Recession 0.3 12 6
Stable 0.4 15 7.5
Boom 0.3 10 5
Required:
Assess the riskiness of securities A and B.
2
(c) Kiraithe limited has set a minimum cash account balance of Sh. 75,000. The average cost to the company of making deposits or selling investments is Sh. 180 per transaction and the standard deviation of its cash flows was Sh. 10,000 per day during the last year. The average points for the cash account of Kiraithe limited using the Miller-Orr model and explain the relevance of these values for the cash management of the company. (6Marks)
(d) AN investor holds 500 shares in County Ltd, a quoted company. Country Ltd has been paying average dividends of Sh. 2 per share per annum in recent years. The dividends are expected to grow at a rate of 15 percent per annum over the coming three years, then at a rate of 10 percent over the next three years and finally at a rate of 5 percent per annum to perpetuity. The required rate of return is 9 percent.
Required:
The value of 500 shares in county Ltd, using the dividend growth model. (7Marks)
(e) A project under consideration has the following projected cash flows which are in current terms:
Time T0 T1 T2 T3-T10
Cash Flows
(1,700) 100 200 300
The rate of inflation which will affect all cash flows equally is 3% and the firms required nominal return is 10%.
Required:
Calculate the NPV of the project and determine whether the project is acceptable. (5Marks)
QUESTION TWO
(a) Explain the limitations of the following methods of dealing with risk in Capital budgeting;
(i) Simulation analysis (3Marks)
(ii) Sensitivity analysis (3Marks)
3
(b) Bora limited is evaluating a new technology for its reproduction equipment. The technology will have three- flows is subject to risk.
In the first year, management estimates that there is an equal chance that technology will either succeed and save the company Sh. 800,000 or fail saving it nothing at all. If technology fails in the first year, savings in the last two years will be zero. Even worse, there is a 40% chance that additional Sh. 240,000 may be required in the second year to convert back to the original process.
If the technology succeed in the first year, the second year cash flows may be Sh. 1,440,000, Sh. 1,120,000 or Sh. 800,000 with probabilities of 0.20, 0.60 or 0.20 respectively. Third year cash flows are expected to be Sh. 160,000 greater or Sh. 160,000 less than cash flows in the second year with equal chance of each occurring. All cash flows are after taxes.
Required:
(i) A probability tree depicting the above cash flow possibilities (5Marks)
(ii) Net present value for each possibility using a risk-free rate of 5% (5Marks)
(iii)The expected net present value of the technology using a risk free rate of 5%. (4Marks)
QUESTION THREE
(a) Distinguish Financial leverage from operating leverage. (2Marks)
(b) Name and explain the approaches that could be used by a company to finance its working capital requirements. (6Marks)
(c) A proforma cost sheet of a company provides the following data;
Cost (per unit) Kshs. Raw materials 52.0 Direct labour 91.5 Overheads 39.0 Total cost (per unit) 110.5 Profit 19.5 Selling Price 130.0
4
The following additional information is provided; Average raw material in stock: once month; average materials in process: half a month. Credit allowed by suppliers: one month; Credit allowed to debtors: two months. Time lag in payment of wages: one and half weeks. Overheads: one month. One-fourth of sales are on a cash basis. Cash balance is expected to be Kshs. 1,200,000.
Required:
Prepare a statement showing the working capital needed to finance a level of activity of 70,000 units of output assuming that production is carried on evenly throughout the year and wages and overheads accrue similarly. (Assume 360 – day year). (12Marks)
QUESTION FOUR
(a) Explain the factors that should be considered by a company in determining its capital structure. (4Marks)
(b) The following extract of the statement of financial position of Upendo limited shows the capital structure of the company as at 31st December, 2011.
Ordinary share capital (per value) Sh. 125) 62,500
Reserves 121,500
Share holders equity 184,000
Long-term Liability:
14% debentures stock (per value Sh. 500) 118,500
Capital employed 302,500
The management of the company considers the above capital structure to be optimal. Additional information:
1. per annum. These earnings are expected to be maintained in the foreseeable future.
2. The ordinary shares are currently trading at Sh. 40 per debenture.
3. The corporate rate of tax is 30%.
5
Required:
(i) Cost of equity (4Marks)
(ii) After tax cost of debt (market-value weighted) (3Marks)
(iii) Market-weighted cost of capital (3Marks)
(c) A limited and B limited are identical in all aspects except that A limited is unlevered while B limited has issued Sh. 10 Million 5% corporate bond.
The earnings before interest and tax (EBIT) for the two companies are Sh. 2 Million per annum and the cost of equity of A limited is 10%.
Required: Using Modigliani and Miller (MM) without taxes model, answer the following:
(i) Determine the value of each company. (2Marks)
(ii) Determine the cost of equity of B limited. (2Marks)
(iii)Determine the weighted average cost of capital of each company. (2Marks)
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