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(i)Forward rate of agreement (FRA)
This is a contract between a bank and a company to lend or borrow a given amount of money at an agreed
future interest rate.
IA case of borrowing the Bank will loose if leading rate at the time of borrowing by the borrower is
higher than the agreed interest rate
FRA involve one year borrowing and the borrowing is in batches of UK ƒ500,000
(ii) Interest rate futures
This is a contract to borrow or lend a fixed amount of money at a given rate and within a
specified future period typically 3 months
Futures are closed out and people can buy or ell the futures e.g. the purchase of a interest rate
futures entitle the buyer to receive interest which the sale of futures involve obligations to pay
interest charges
Interest rate futures are closed out by reversing earlier e.g if one sold the contract today, he will
buy it at a future date. Initial deposits called margins are required
The contracts must be in whole
(iii) Interest rate options
This are also called interest rate Guarantee (IRG) and involve the right to borrow or lend at a
guaranteed interest rate at a fixed future date.
If on exercise date the interest rate guarantee turns out to be unfavourable, the
borrower/depositor will allow the option to lapse
A cost called premium is paid to buy options
(iv) Interest rate Swaps
an agreement to exchange interest rate obligations between two parties where one party has a fixed
interest rate bond but anticipate decline in interest rate while another has floating interest bond but
anticipate increase in interest rate. Both parties would swap the interest obligations to take advantage of
anticipated charges in interest rates. It does not involve actual cash flow of the principal loan
The loan, interest rate and period of loans must be equal
Kavungya answered the question on April 19, 2021 at 13:54
- As a firm operating in a mature industry, Orchard Farms is expected to maintain a constant dividend
pay out ratio and constant growth rate of earnings...(Solved)
As a firm operating in a mature industry, Orchard Farms is expected to maintain a constant dividend
pay out ratio and constant growth rate of earnings for the foreseeable future. Earnings were Sh. 4.50
per share in the recently completed fiscal year. The dividend pay out ratio has been a constant 55%
in recent years and is expected to remain so. Orchard Farms' return on equity (ROE) is
expected to remain at 10% in the future, and you require an 11% return on the stock.
Required:
(i) Using the constant dividend growth model, calculate the current value of Orchard Farms‟ share.
(ii) After aggressive acquisition and marketing programme, it now appears that Orchard
Farms‟ earnings per share and ROE will grow rapidly over the next two years. Assuming
the Orchard Farms‟dividend will grow at a rate of 15% for the next two years, returning in the
third year, to the historical growth and continuing at the historical rate of the foreseeable future.
Calculate Orchard Farms‟ current market rate.
Date posted: April 19, 2021. Answers (1)
- The Better Shoe Company is considering a major investment in a new product area, novelty
umbrellas. It hopes that this product will become a fashion icon....(Solved)
The Better Shoe Company is considering a major investment in a new product area, novelty
umbrellas. It hopes that this product will become a fashion icon. The following information has
been collected:
1. The project will have a limited life of 11 years.
2. The initial investment in plant and machinery will be Sh. 10 million and a marketing budget
of Sh. 2 million will be allocated to the first year.
3. The net cash flows before depreciation of plant and machinery and before
marketing expenditure for each umbrella will be Sh. 100.
4. The products will be introduced both in Kenya and Uganda.
5. The marketing costs in years 2 to 11 will be Sh. 5 million per annum.
6. If the product catches the imagination of the customers in both countries, then sales in the
first year are anticipated at 1 million umbrellas.
7. If the fashion press ignores the new products in one country but become enthusiastic in
the other, sales ill be 700,000 umbrellas in year 1.
8. If the marketing launch is unsuccessful in both countries, first year sales will be 200,000
umbrellas.
The probability of each of these events occurring is:
1 million sales = 0.3
0.7 million sales = 0.4
0.2 million sales = 0.3
9. If the first year is successful in both countries then two possibilities are envisages.
Sales levels are maintained at 1 million units per annum for the next 10 years – probability of 0.3.
The product is seen as a temporary fad and sales fall to 100,000 units for the remaining 10 years
– probability of 0.7.
10. If success is achieved in only one country in the first year, then for the remaining 10 years
there is:
A 0.4 probability of maintaining the annual sales at 700,000 units and
A 0.6 probability of sales immediately falling to 50,000 units per year.
If the marketing launch is unsuccessful in both countries, the production will cease and the
project will be scraped with zero value. The annual cash flows and marketing costs will be payable
at each year end.
Assume:
Cost of capital is 10 per cent per annum.
No inflation or taxation.
No exchange rate charges.
Required:
(i) Calculate the expected net present value for the project.
(ii) Calculate the standard deviation for the project.
(iii) If the project produces a net present value of less that Sh. 10 million, the directors fear that the
company will be vulnerable to a hostile takeover. Calculate the probability of the firm avoiding a
hostile takeover. Assume normal distribution.
Date posted: April 19, 2021. Answers (1)
- Bara Ltd. is contemplating a bid for the share capital of Pwani Ltd. with an intention of buying the whole company. The following data for...(Solved)
Bara Ltd. is contemplating a bid for the share capital of Pwani Ltd. with an intention of buying the whole company. The following data for the two companies have been provided.
After acquisition, Bara Ltd. intends to sell a division of Pwani Ltd. which accounts for Sh.20 million
annually in equity earnings. The division does not form part of the core business of the intended group. The
division has a current market price of Sh. 50 million.
Bara Ltd.'s management believes that by introducing better management, earnings of Pwani Ltd. could
be permanently increased by 25% although the price/earnings multiple will remain the same. To avoid duplication,
some of Bara Ltd.'s own property could be disposed of at an estimated price of Sh. 130 million.
Rationalization costs are estimated at Sh. 100 million, these comprise retrenchment and legal costs
among others.
Required:
(a) Highlight the advantages of growth by acquisition.
(b) Calculate the effect on the current share price of each company, all other things being equal, of a two for
ten share offer by Bara Ltd., assuming that Bara Ltd.'s estimates are in line with those of the market.
(c) Assume that Bara Ltd. is proposing to offer Pwani Ltd.'s shareholders the choice of a two for ten
share exchange or a cash alternative. Giving reasons, advise Bara Ltd. whether the cash alternative
should be more or less that the current value of the share exchange.
Date posted: April 19, 2021. Answers (1)
- The Minister for Finance has stated that he wants to put a limit to the Public Sector Borrowing
Requirements. What difficulties and economic problems are likely...(Solved)
The Minister for Finance has stated that he wants to put a limit to the Public Sector Borrowing
Requirements. What difficulties and economic problems are likely to arise due to this?
Date posted: April 19, 2021. Answers (1)
- You have just finished reading the budget speech by the Minister of Finance where you came
across the term “Public Sector Borrowing Requirements.” What is meant...(Solved)
You have just finished reading the budget speech by the Minister of Finance where you came
across the term “Public Sector Borrowing Requirements.” What is meant by this term?
Date posted: April 19, 2021. Answers (1)
- The management of Wambu Limited wants to make a decision whether to change its policy
of purchasing raw material stocks.
The current policy is to purchase raw...(Solved)
The management of Wambu Limited wants to make a decision whether to change its policy
of purchasing raw material stocks.
The current policy is to purchase raw materials monthly, on the last day of each month, for
consumption in the following month. Suppliers are paid at the end of the following month –
purchases at the end of January would be paid for at the end of February.
The proposed policy is to purchase raw materials every 3 months; suppliers would then allow an extra 2
months‟ credit. The extra cost of stock holding under the proposed policy would be
Sh.600,000 per annum.
The decision about which policy to adopt will be made in time to affect purchases at the end
of December 2004, when the cost of materials for January 2005 would be Sh. 20,000,000.
A growth rate of 0.75% per month is expected in purchases into the indefinite future from
January 2005 onwards.
The cost of capital is 1% per month compound.
Required:
Which policy should be preferred? (ignore taxation)
Date posted: April 19, 2021. Answers (1)
- On the basis of a one-factor model, Mwangi assumes that the risk free rate is 6% and the expected return on a portfolio work unit...(Solved)
On the basis of a one-factor model, Mwangi assumes that the risk free rate is 6% and the expected return on a portfolio work unit sensitivity to the factor is 8.5%. Consider a portfolio of two securities with the following characteristics:
According to the arbitrage pricing theory, what is the portfolio‟s equilibrium expected return?
Date posted: April 19, 2021. Answers (1)
- As a senior financial analyst of an investment bank, you are charged with the responsibility of
estimating the expected returns of various securities. One o the...(Solved)
As a senior financial analyst of an investment bank, you are charged with the responsibility of
estimating the expected returns of various securities. One o the securities you want to estimate is
expected return in Alpha Steel works Ltd.
You have decided to use arbitrage pricing model and you have derived the following estimates
for the factor betas and risk premiums.
Required:
(i) Identify the risk factor for Alpha Steel Works Ltd.
(ii) If the risk free rate is 5%, estimate the expected return on Alpha Steel Works Ltd.
Date posted: April 19, 2021. Answers (1)
- The Moon Company Ltd. has issued 10,000,000, Sh. 10 par equity shares which are at present selling for
Sh. 30 per share. It has also issued...(Solved)
The Moon Company Ltd. has issued 10,000,000, Sh. 10 par equity shares which are at present selling for
Sh. 30 per share. It has also issued 5,000,000 warrants, each entitling the holder to buy one equity share.
The warrants are protected against dilution.
(a) The company has plans to issue rights to purchase one new equity share at a price of Sh. 20 per
share for every four shares held.
Required:
(i) Calculate the theoretical ex-rights price of Moon Company Ltd.'s equity shares.
(ii) The theoretical value of a right of the Moon Company Ltd. before the shares sell ex rights.
(b) The chairman of the company receives a phone call from an angry shareholder who owns 100,000
shares. The shareholder argues that he will suffer a loss in his personal wealth due to this rights issue,
because the new shares are being offered at a price lower than the current market value.
The chairman assures him that his wealth will not be reduced because of the rights issue, as long
as the shareholder takes appropriate action.
Required:
(i) Explain whether the chairman is correct. What should the shareholder do?
(ii) A statement showing the effect of the rights issue on this particular
shareholder's wealth, assuming:
He sells all the rights.
He exercises one half of the rights and sells the other half.
He does nothing at all.
(iii) Are there any real circumstances which might lend support to the shareholder's claim?
Date posted: April 19, 2021. Answers (1)
- The following data currently exist for the ordinary shares of four companies quoted on a stock exchange for the period between 1 July 1998 to...(Solved)
The following data currently exist for the ordinary shares of four companies quoted on a stock exchange for the period between 1 July 1998 to 1 July 2003.
During the same time period (1 July 1998 to 1 July 2003), the four companies:
Issued no additional shares
Had no stock dividends or split
Paid no cash dividend.
Required:
(i) A four-stock index that is value-weighted.
(ii) A four-stock index that is price-weighted.
(iii) A four-stock index that is equally weighted.
Date posted: April 19, 2021. Answers (1)
- Highlight the limitations of the following methods of dealing with risk in capital budgeting:
(i) Simulation analysis.
(ii) Sensitivity analysis.(Solved)
Highlight the limitations of the following methods of dealing with risk in capital budgeting:
(i) Simulation analysis.
(ii) Sensitivity analysis.
Date posted: April 19, 2021. Answers (1)
- 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...(Solved)
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.
(ii) A growth company with an abundance of good investment opportunities.
(iii) A company experiencing ordinary growth, has high liquidity and much unused borrowing capacity.
(iv) A dividend-paying company that experiences an unexpected drop in earnings from the trend.
(v) A company with volatile earnings and high business risk.
Date posted: April 19, 2021. Answers (1)
- Rugongo Ltd. is an ungeared company operating in the processed food industry. The company is planning to take over Sauce Ltd. but is unsure on...(Solved)
Rugongo Ltd. is an ungeared company operating in the processed food industry. The company is planning to take over Sauce Ltd. but is unsure on how to value its net assets. Rugongo Ltd.‟s analysts have assembled the following information:
Sauce Ltd.‟s balance sheet as at 30 September 2003
In its most recent trading period ended 30 September 2003, Sauce Ltd.‟s sales were
Sh.500,000,000, but after operating costs and other expenses including a depreciation charge of
Sh.20,000,000, its profit after tax was Sh.20,000,000. This figure includes an extraordinary item (sale of
property) of Sh.5,000,000. The full years dividend was Sh.5,000,000.
Sauce Ltd. has recently followed a policy of increasing dividends by 12% per annum. Its shareholders require
a return of 17%.
The price earnings ratio of Rugongo Ltd. is 14 times and that of Sauce Ltd. is 8 times.
More efficient utilization of Sauce Ltd.‟s assets could generate operating savings of Sh.5,000,000
per annum after tax.
Required:
(i) Current market value of Sauce Ltd.'s share.
(ii) Explain why the market value might differ from the book value.
(iii) A company experiencing ordinary growth, has high liquidity and much unused borrowing capacity.
(iv) The value of Sauce Ltd. using the discounted cash flow method.
Date posted: April 19, 2021. Answers (1)
- Pwani Limited is planning advertising campaigns in three different market areas. The estimates of
probability of success and associated additional profits in each of the three...(Solved)
Pwani Limited is planning advertising campaigns in three different market areas. The estimates of
probability of success and associated additional profits in each of the three markets are provided
below:
Required:
(i) Compute the expected value and standard deviation of profits resulting from advertising campaigns
in each of the market areas.
(ii) Rank the three markets according to riskiness using the coefficient of variation.
Date posted: April 18, 2021. Answers (1)
- Goldstar Manufacturing Limited is evaluating an investment opportunity that would require an
outlay of sh.100 million. The annual net cash inflows are estimated to vary according...(Solved)
Goldstar Manufacturing Limited is evaluating an investment opportunity that would require an
outlay of sh.100 million. The annual net cash inflows are estimated to vary according to economic
conditions.
The firm's required rate of return is 14 percent. The project has an expected life of six years.
Required:
Compute the expected net present value (NPV) of the proposed investment.
Date posted: April 18, 2021. Answers (1)
- The finance director of Benga Ltd. wishes to find the company's optimal capital structure. The
cost of debt varies according to the level of gearing of...(Solved)
The finance director of Benga Ltd. wishes to find the company's optimal capital structure. The
cost of debt varies according to the level of gearing of the company as follows:
The company's ungeared equity beta (asset beta) is 0.85. The risk free rate is 6% per annum
and the market return is 14% per annum. Corporate taxation is at the rate of 30% per year.
Required:
(a) Estimate the company's optimal weighted average cost of capital.
(b) Recommend whether or not the company should adopt the optimal capital structure identified in (a)
above explain the factors that might influence the capital structure decision.
Date posted: April 17, 2021. Answers (1)
- Your company is proposing to erect a new factory in a foreign country at a cost of 20 million local
currency units. Return cash flows will...(Solved)
Your company is proposing to erect a new factory in a foreign country at a cost of 20 million local
currency units. Return cash flows will amount to 27 million local currency units per annum and will
be spread over five years.
What actions would you take to preserve the profitability of this venture in terms of your
home currency?
Date posted: April 17, 2021. Answers (1)
- The purpose of long-term foreign exchange management is not to cover a given foreign
exchange exposure by dealings on the forward markets, but to minimize and,...(Solved)
The purpose of long-term foreign exchange management is not to cover a given foreign
exchange exposure by dealings on the forward markets, but to minimize and, if possible,
eliminate such exposures before they become critical and therefore costly to cover. (Source:
Havard Business Review – March/April 1977)
Comment on the above statement and suggest what actions the financial manager should take
in both the long and short term in order to reduce risks from foreign currency transactions.
Date posted: April 17, 2021. Answers (1)
- The new credit manager of Kay's Departmental Store plans to liberalize the firm's credit
policy. The firm currently generates credit sales of Sh.575,000,000 annually. The more...(Solved)
The new credit manager of Kay's Departmental Store plans to liberalize the firm's credit
policy. The firm currently generates credit sales of Sh.575,000,000 annually. The more lenient credit
policy is expected to produce credit sales of Sh.750,000,000. the bad debt losses on additional sales
are projected to be 5 per cent despite an additional Sh.15,000,000 collection expenditure. The new
credit manager anticipates production and selling costs other than additional bad debt and collection
expenses will remain at the 85 per cent level. The firm is paying tax at 30% tax bracket, after
deductible allowances.
Required:
If the firm maintains a debtors turnover of 10 times, by how much will the debtors balance increase?
What would be the firm's incremental return on investment?
Assuming additional stocks of Sh.35,000,000 are required to support the additional sales, compute the
after tax return on investment.
Date posted: April 17, 2021. Answers (1)
- In an effort to lower its debtor balances, Zen Manufacturing Ltd. is considering switching from its no
discount policy to a 2% discount for payment by...(Solved)
In an effort to lower its debtor balances, Zen Manufacturing Ltd. is considering switching from its no
discount policy to a 2% discount for payment by the fifteenth day. It is estimated that 60% of
Zen's customers would take the discount and the average collection period is expected to
decline from 60 days. Company officials project a 20,000 unit increase in annual sales to 220,000
units at the existing price of Sh.2,500 per unit. The variable cost per unit is Sh.2,100 and the average
cost per unit is Sh.2,300.
If the firm requires a 15% return on investment, should the discount be offered?
Date posted: April 17, 2021. Answers (1)