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Fnce 310: Corporate Finance Y3s1 Question Paper
Fnce 310: Corporate Finance Y3s1
Course:Bachelor Of Commerce
Institution: Kabarak University question papers
Exam Year:2008
COURSE CODE: FNCE 310
COURSE TITLE: CORPORATE FINANCE
STREAM: Y3S1
DAY: WEDNESDAY
TIME: 2.00 – 4.00 P.M.
DATE: 25/03/2009
INSTRUCTIONS:
1. Answer question ONE and any other TWO questions only.
2. ALL necessary workings must be carefully shown.
QUESTION ONE (COMPULSORY)
a) With the help of a diagram, differentiate between an efficient portfolio and an
optimum portfolio. (5mks)
b) Kabarak university has an investment capital of shs.1,000,000. The finance
manager wishes to invest in Two securities A and B in the following proportion:
shs.200,000 in security A and shs.800,000 in Security B.
The returns on these two securities depend on the state of the economy as shown
below:-
State of economy Probability Returns on Returns on
Security A Security B
Recovery 0.4 18% 24%
0.5 14% 22%
0.1 12% 21%
Required:
i) Compute the expected return and the risk of each stock. (6mks)
ii) Covariance and correlation coefficient between security A and security B.
(4mks)
iii) Compute the expected portfolio return. (2mks)
iv) Compute the portfolio risk (3mks)
c) Giving examples, distinguish between systematic risk and unsystematic risk.
Illustrate with the help of a diagram. (5mks)
d) In many countries including Kenya, the concept of corporate governance has
gained increasing prominence in recent times.
Identify and briefly explain the reasons motivating the increasing interest in
corporate governance. (5mks)
[Total: 30 Marks]
QUESTION TWO
A company that is all equity finance has a cost of capital (Required rate of return) of
18.5%. The risk free rate of return is 8% and the expected return on the aggregate market
portfolio is 15%.
The company is considering investing in the following projects.
Project’s Outlay(sh ‘000’) Receipts(sh. ‘000’) Beta (Bj)
A 1000 1095 0.3
B 1000 1130 0.5
C 1500 1780 1.0
D 2000 2385 1.5
E 2000 2400 2.0
NOTE: All projects are single period.
Required;
a) The company’s Beta coefficient. (3mks)
b) The CAPM required rate of return for each project (5mks)
c) The expected rate of return of each project. (5mks)
d) Based on B and C above which projects would you recommend and why?
(2mks)
e) If all the projects were evaluated using the company’s cost of capital
(18.5%), which project(s) would be recommended? In which situation(s)
would the company make an incorrect decision? Why? (5mks)
QUESTION THREE
a) Explain the relevance of decision trees in the evaluation of capital investments.
(4mks)
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 cost is 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) (6mks)
iii) Determine the standard deviation of the project’s cash inflows.
(5mks)
QUESTION FOUR
Merica Ltd is considering the acquisition of Bontana Ltd. Currently Merica has annual
earnings of Sh.50 million and 20 million ordinary shares, each share sells for sh.
150. Likewise the annual earnings for Bontana are sh.10 million and has 5 million
ordinary shares at a market price per share of sh.160.
The earnings of Merica are expected to grow at the rate of 5 percent p.a and those of
Bontana would grow at the annual rate of 12 percent in the absence of any mergers.
Merica offers 1.5 shares for each share of Bontana.
Required:
a) Determine the effect of the acquisition on each company’s EPS.
(6mks)
b) Given that shareholders of both companies are growth oriented investors,
what would be their likely reactions to the proposed acquisition? Explain
(Hint: Compute the combined growth rate of the two companies).
(5mks)
c) If the offer is not at the moment attractive to any of the two company’s
investors, on the basis of EPS when will it be attractive? (5mks)
d) Highlight four reasons why a company seeking to maximize the wealth of
its shareholders may wish to take over another company. (4mks)
QUESTION FIVE
a) What’s the objective of capital structure management? (2mks)
b) Identify and briefly explain four factors that need to be considered in making
capital structure decisions. (4mks)
c) Briefly explain Mudigliani and miller (MM) with taxes theory. (3mks)
d) Kabu Ltd is considering two investments projects A and B for which the
following information has been calculated:
Investment A (sh) Investment B (sh)
Investment outlay sh.2,000,000 sh.2,000,000
Expected return 0.2 0.2
Standard deviation 0.4 0.6
Beta of returns 1.8 1.2
The finance manager 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 management on which projects should be accepted
first by assuming that the projects are independent and sond that they are
mutually exclusive. (5mks)
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