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Cfm 200: Financial Management Question Paper

Cfm 200: Financial Management

Course:Bachelor Of Commerce

Institution: Kca University question papers

Exam Year:2009

1
UNIVERSITY EXAMINATIONS: 2008/2009
THIRD YEAR STAGE 1 EXAMINATION FOR THE DEGREE OF
BACHELOR OF COMMERCE
CFM 200: FINANCIAL MANAGEMENT
DATE: APRIL 2009 TIME: 2 HOURS
INSTRUCTIONS: Answer question ONE and any other TWO questions
QUESTION ONE
a) Briefly explain the pecking order theory of capital structure. [3 marks]
b) Highlight the limitations of sensitivity analysis method of dealing with risk in capital
budgeting. [3 marks]
c) Calculate the degree of operating leverage for a company with the following characteristics.
i) Quantity in units is 800
ii) Selling price per unit is shs 15 while the variable cost per unit is sh.10
iii) The fixed cost is sh 1000. [2 marks]
d) Highlight the various measures that would minimize agency problems between the owners and
the management. [6 marks]
e) Consider firm A and B which have the following characteristics.
A B
Equity 10m 8m
7.5% debt 0 2m
10m
===
10m
===
Ke 10% 11%
2
Assuming the companies are identical operating in the same industry and the return on their
investment is 10%, use the net income approach to determine the value of the 2 firms and the
weighted average cost of capital for the firms. [6 marks]
f) A company is considering undertaking a project whose initial cash outlay is sh.100,000. Its
annual cash inflow is summarized below.
Year Annual Cash
inflows
Certainty equivalent
coefficient
1 35000 0.9
2 35000 0.8
3 35000 0.7
4 35000 0.3
5 35000 0.2
The cost of capital is 10% and the risk free rate is 7.5%
Required
i) Determine the project’s NPV without adjusting for the inherent risk in the respective
year cash flows. [3 marks]
ii) Calculate the projects NPV after adjusting for the inherent risk in each year’s cash
flows. [3 marks]
g) The moon company Ltd has issued 10,000,000 shs. 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.
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.
3
Required
i) Calculate the theoretical ex-rights price of moon company Ltd’s equity shares. [2 marks]
ii) The theoretical value of a right of the moon company Ltd before the shares sell ex-rights.
[2 marks]
QUESTION TWO
a) Discuss the Modigliani and Miller’s (MM) dividend irrelevancy proposition. [10 marks]
b) Explain 5 factors that a company may consider before paying dividends. [10 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:
• A Ltd is financed using sh. 100 million worth of ordinary shares.
• B Ltd is financed using sh. 50 million in ordinary shares and sh. 50 million in 7%
debentures.
• The annual earnings before interest and tax are sh. 10 million for both firms. These
earnings are expected to remain constant indefinitely.
• The cost of equity in A Ltd is 10%
• The corporate tax rate is 30 %
Using the Modigliani and Miler (MM) Model, determine the following.
(i) The market value for A Ltd and B Ltd. [6 marks]
(ii) The weighted average cost of capital of A Ltd and B Ltd. [ 4 marks]
b) Outline FIVE factors that might influence the capital structure decision. [10 marks]
4
QUESTION FOUR
a) Gome Drug products Ltd (GDPL) is faced with several possible investment projects. For
each, the total cash outflows required will occur in the initial period. The cash outflows,
expected net present values and standard deviations are as follows.
Project Cost
sh.’000’
Net present value Standard deviations
A 10,000 1,000 2,000
B 5,000 1,000 3,000
C 20,000 2,500 1,000
D 1,000 500 1,000
E 50,000 7,500 7,500
All projects have been discounted at a risk free rate of 8% and it is assumed that the distribution of
their possible net present values are normal.
i. Construct a risk profile for each of these projects in terms of the profitability index.
[5 marks]
ii. Ignoring size problems, do you find some projects clearly dominated by others? [5 marks]
b) Identify and explain 5 methods of handling risks in capital budgeting. [10 marks]
QUESTION FIVE
a) A company makes payments of sh. 16,000 per week. The applicable interest rate on
marketable securities 12% p.a and every security costs shs. 30.
i) Determine the optimal amount of the security to be converted into cash. [4 marks]
ii) Determine the total number of transfers required per year. [2 marks]
iv) Determine the total cost of maintaining the cash balances per year (assume there are
50 weeks per year) [4 marks]
5
b) XYZ Ltd a debt collection agent has estimated that the standard deviation of its daily net
cashflows is shs. 22,750, the company pays shs 120 in transactions cost every time it transfers
found into and out of the money market. The rate of interest rate in the money market is
9.46%. The company uses Miller-Orr model to set its target cash balance. The minimum cash
balance has been set at sh. 87,500.
Required
i) The target cash balance. [2 marks]
ii) The upper cash limited. [2 marks]
iii) The company’s decision rule [6 marks]

Cfm 200: Financial Management Question Paper

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