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Corporate Finance Question Paper
Corporate Finance
Course:Bachelor Of Commerce
Institution: Kabarak University question papers
Exam Year:2009
COURSE CODE: FNCE 310
COURSE TITLE: CORPORATE FINANCE
STREAM: Y3S1
DAY: MONDAY
TIME: 2:00A.M – 4:00P.M.
DATE: 7/12/2009
Instructions
1. Answer question ONE and any other TWO questions.
2. Marks allocated to each question are shown at the end.
3. Show ALL your workings
QUESTION ONE
a) For what basic reasons is profit maximization as goal of corporate firm inconsistent
with wealth maximization? (3mks)
b) Respond to the following comments:
(i) Profits are the same as cash flows (2mks)
(ii) Capital structure is the same as financial risk (2mks)
(iii) Business risk is the same as financial risk (2mks)
(iv) Systematic risk and diversifiable risk are the same (2mks)
c) Creation of shareholder value has become a generally acceptable corporate objective,
to facilitate the realization of this objective value based management systems
(VBMS) have been developed.
Required: Highlight the factors that have stimulated the increased interest by
companies in value based management system. (5mks)
d) An invest has the opportunity to invest in the shares of KENGEN Ltd with an
expected return of 25% but subject to standard deviation of 10%.
The investor can also invest in KENGEN Bonds with annual risk free rate of 12%
Required: Compute the expected return and standard deviation of a portfolio that
consists investment of shares in the following proportions:
(i) 1.0
(ii) 0.8
(iii) 0.5
(iv) 0.2
(v) 0
e) An investor expected a risk free rate of return (Rf) of 4.5%p.a and a market rate of
return (RM) of 14.5% two stocks A and B have the following betas and estimated
returns:
Stock Beta Estimated returns
A 1.2 16%
B 0.8 14%
Required:
- Use a graph to indicate the points where the stocks would be plotted on the
security market line (SML). (4mks)
- State whether stock A and stock B are undervalued or overvalued (2mks)
(TOTAL: 30 Marks)
QUESTION TWO
(a) The concept of cost of capital is essential in many aspects of corporate management.
Describe THREE methods that can be used in the estimation of cost of capital.
(9mks)
(b) Kabu ltd is considering two investment projects A and B for which the following
information has been provided.
Investment A Investment B
Sh. Sh.
Investment outlay 2,000,000 2,000,000
Expected return 0.20 0.20
Standard deviation 0.40 1.20
The finance director has formulated a risk adjustment relationship based on the
coefficient of variation as follows:
Required return on project = Risk free return + 0.04 C.v
He also takes into consideration the security market line (SML) relationship 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) Advice the company on which projects should be accepted first by assuming that the
projects are independent and second assuming that they are mutually exclusive.
(5mks)
(Total: 20 marks)
QUESTION THREE
Nakuru graphics limited is evaluating new technology equipment for its production. The
technology will have a three year life and would cost shs. 800,000. Its impact on the
company’s cash flows is subject to risk.
In the first year, management estimates that there is an equal chance that the technology
will either succeed or save the company shs. 800,000 or fail saving it nothing at all.
If the technology fails in the first year, savings in the last two years will be zero. If the
technology succeeds in the first year, the second year cash flows may be shs. 1,440,000,
1,120,000 or shs. 800,000 with probabilities of 0.20, 0.60 or 0.20 respectively. Third year
cash flows are then expected to be shs. 160,000 greater or shs. 160,000 less than cash
flows in the second year, with equal chance of either occurring.
All the cash flows above are after taxes.
Required :
a) A probability tree depicting the above cash flow possibilities. (6mks)
b) Net present values for each possibility using a risk-free rate of 10% (8mks)
c) The expected net present value of the technology using a risk-free rate of 10% (6mks)
(Total: 20 marks)
QUESTION FOUR
a) The management of a target company is considering which defense mechanism to use
in order to block an acquisition. Briefly explain to the management the following
strategies applicable in a hostile takeover situation:
i) Crown jewels strategy (2mks)
ii) Poison pill strategy (2mks)
iii) White knight strategy (2mks)
b) Mr. Upendo, a director of Yote Ltd met Mr. Mapenzi, a director of Toa Ltd during a
conference held in Kabarak University. They had some discussion about their
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 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 Yote share for every six Toa shares.
Yote Ltd. Toa 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) Compute the maximum price payable per share of Toa Ltd. (3mks)
(ii) Explain whether you agree with Mr. Upendo when he says that earnings per share
will rise by 13%. (Give relevant calculations). (7mks)
(iii)Compute the likely post acquisition price of a share (MPS) of Yote Ltd if the bid is
successful. (4mks)
(Total: 20 marks)
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