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Fnce 310: Corporate Finance Year 2010 Question Paper
Fnce 310: Corporate Finance Year 2010
Course:Bachelor Of Commerce
Institution: Kabarak University question papers
Exam Year:2010
1
KABARAK UNIVERSITY
UNIVERSITY EXAMINATIONS
2009/2010 ACADEMIC YEAR
FOR THE DEGREE OF BACHELOR OF COMMERCE
COURSE CODE: FNCE 310
COURSE TITLE: CORPORATE FINANCE
STREAM: Y3S1
DAY: MONDAY
TIME: 4.00 – 6.00 P.M.
DATE: 02/08/2010
INSTRUCTIONS:
1. Answer questions ONE and any other TWO questions only.
2. ALL necessary workings must be carefully shown.
QUESTION ONE (COMPULSORY)
a) Differentiate between the following pairs of terms as used in corporate finance:
(i) Agency costs and financial distress costs (3marks)
(ii) Money market and capital market (2marks)
(iii)Operating risk and financial risk (2Marks)
(iv) Market value and intrinsic value of a share (2marks)
(v) Weighted average cost of capital and Marginal cost of capital (4marks)
c) Dr Pesa, a director of Kabu Ltd met Mr Barasa,a director of Baraka Ltd during a seminar held
in Kabarak. They had some discussions about their companies. Dr Pesa later proposed to his
board of directors about acquisition of Baraka 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 about13%”. A bid would be based on an exchange of shares between the two
companies which would be one Kabu Ltd share for every six Baraka shares.
Kabu Ltd. Baraka Ltd.
(ShMillion) (ShMillion)
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) Briefly 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 Baraka Ltd. (3marks)
(iii)Explain whether you agree with Dr Pesa when he says that earnings per share will rise by
about 13%. (Give relevant calculations). (6marks)
(iv) Compute the likely post acquisition price of a share (MPS) of Kabu Ltd if the bid is
successful. (3marks)
[TOTAL: 30 Marks]
3
QUESTION TWO
a) Explain the effect of the use of debt capital on the weighted average cost of capital of a
company (2marks)
b) Millennium investments Ltd wishes to raise funds amounting to Sh10million to finance a
project in the following manner:
Sh6million from debt and
Sh4 million from floating new ordinary shares.
The present capital structure of the company is made up as follows:
1. 600,000 fully paid ordinary shares of sh10 each.
2. Retained earnings of sh4million
3. 200,000, 10% preference shares of sh20 each.
4. 40,000, 6% long term debentures of sh150 each.
The current market value of the company’s ordinary shares is sh60 per share. The expected
ordinary share dividend in a year’s time is sh2.40 per share. The average growth rate in both
dividends and earnings has been 10% over the past years and this growth rate is expected to
be maintained in the foreseeable future.
The company’s long term debentures currently change hands for sh100 each. The debentures
will mature in 10 years. The
preference shares were issued four years ago and still change hands at face value.
Required:
i) Compute the component cost of:
-Ordinary share capital (2mks)
-Debt capital (2mks)
- Preference share capital (2mks)
ii) Compute the company’s current weighted average cost of capital (6mks)
iii) The relevance of the WACC computed in b (ii) above in making decision by the
company (2mks)
iv) Compute the company’s marginal cost of capital if it raised the additional sh10
million as envisaged (assume a tax rate of 30%) (4mks)
[TOTAL: 20 mks]
4
QUESTION THREE
a) Explain the relevance of decision trees in the evaluation of capital investments. (2mks)
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) (8mks)
iii) Determine the standard deviation of the project’s cash inflows (5mks)
[TOTAL: 20 Marks]
QUESTION FOUR
a) The enactment of a pension’s management law will bring with it the need to evaluate the
performance of portfolio and fund managers. This process will require a careful
evaluation of the processes involved in fund management.
Required:
i) State and briefly discuss any two commonly used methods of evaluating portfolio
performance (4 mks)
ii) Why would each of the two methods you have stated in a (i) above be preferred to
the other? (2mks)
5
b) Mr Pesa is very happy with the current aspects of encouraging investments through the
Stock exchange. He wishes to put some money on Safaricom shares traded on the
exchange. He has approached you for an evaluation. The returns on the Nairobi Stock
exchange index and on Safaricon shares are shown below with the five possible states of
economy that might prevail next year.
Economic Probability Market Return Safaricom
Condition NSE -Index Returns
Recession 0.12 20% 10%
Recovery 0.40 18% 9%
Growth 0.25 15% 5%
Rapid Expansion 0.15 9 % 1%
Decline 0.08 3% -.2%
Required:
i) What is the expected return of Safaricom shares? (1½mks)
ii) What is the correlation coefficient between the returns on the NSE with
returns on Safaricom shares? Comment on the results. (8mks)
iii) Determine Beta coefficient of Safaricom security (21/2mks)
iv) Given that Risk free rate is 5%, compute the required rate of return on
Safari shares (2mks)
[TOTAL: 20Marks]
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