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Advanced Financial Management Revision Kit – Past exam questions and answers for kasneb CPA course
This revision kit consists of kasneb past paper questions and their suggested answers to act as a revision guide for those students taking kasneb courses.
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TOPIC 1
ADVANCED CAPITAL BUDGETING DECISION
QUESTION 1
December 2023 Question One A
The management of Kapricon Ltd. are in the process of estimating utile and establishing the categories of investors. The management has approached CPA Samuel Okeyo, a financial management consultant and provided him with the following cases:
Case 1: There is 0.50 chance of receiving Sh.30 million and 0.50 chance of receiving Sh.100 million. The investor is willing to pay a maximum of Sh.60 million.
Case 2: There is 0.40 chance of receiving Sh.55 million and 0.60 chance of receiving Sh.100 million. The investor is willing to pay a maximum of Sh.82 million.
Case 3: There is 0.30 chance of receiving Sh.30 million and 0.70 chance of receiving Sh.60 million. The investor is willing to pay a maximum of Sh.45 million.
Assume that utile values of 0 and 1 are assigned to a pair of wealth representing the two extremes Sh.0 and Sh.100 million respectively.
Required:
Using the expected monetary value (EMV) technique, determine the category of investor in case 1, case 2 and case 3 above. (6 marks)
Compute the utile value for case 1, case 2 and case 3 respectively. (3 marks)
ANSWER
Category of investor in case 1, case 2 and case 3 above.
EMV = ε(Returns ×Probability)
Case 1:
EMV = 0.5 × {30,000,000 + 100,000,000}
= 0.5 × 130,000,000 = Sh. 65,000,000.00
Profit = 65 – 60 = 5M
The investor in case 1 is risk averse
Case 2:
EMV = [0.4 × 55,000,000] + [0.6 × 100,000,000]
= 22,000,000 + 60,000,000
= Sh. 82,000,000.00
Profit 82 – 82 = 0
The investor in case 2 is risk neutral
Case 3:
EMV= [0.3 × 30,000,000] + [0.7 × 60,000,000]
= 9,000,000 + 42,000,000 = Sh. 51,000,000.00
Return 51 – 45 = 9m
The investor in case 3 is risk averse.
Utile value for case 1, case 2 and case 3 respectively.
Utile = ε(probability ×u)
Case 1
Utile = (0.5 × 0) + (0.5 × 1) = 0.5 utile
Case 2
(0.4 × 0) + (0.6 × 1) = 0.6 utile
Case 3
(0.3 × 0) + (0.7 × 1) = 0.7 utile
QUESTION 2
August 2023 Question Two B
Tobin Ltd. is appraising an investment project which has a cost of Sh.20 million payable in full at the start of the first year of operation. The project life is expected to be four years. Forecast sales, volumes, selling prices, variable costs and fixed costs are as follows:
Year 1 2 3 4
Sales (units per year) 300,000 410,000 525,000 220,000
Selling price per unit (Sh.) 125 130 140 120
Variable cost per unit (Sh.) 71 71 71 71
Annual fixed cost (Sh.“000”) 3,000 3,100 3,200 3,000
Additional information:
Selling price and cost information are in current price terms before applying selling price inflation of 5% per year, variable cost inflation of 3.5% per year and fixed cost inflation of 6% per year.
Tobin Ltd. pays annual corporation tax of 30%, with the tax liability being settled in the year in which it arises.
The company can claim tax allowable depreciation on the full initial investment of Sh.20 million on a 25% straight line basis.
The company’s investment project is expected to have zero residual value at the end of four years.
Tobin Ltd. has a nominal after tax cost of capital of 12% and a real after tax cost of capital of 8%.
The general rate of inflation is expected to be 3.7% per year for the foreseeable future.
Required:
The nominal net present value (NPV) of Tobin Ltd.’s investment project. (8 marks)
ANSWER
NPV of Tobin Ltd.’s investment project
Nominal net present value
YEAR 1 2 3 4
Selling price Per Unit 125 130 140 120
Inflated by 5% annually 125×1.05
=131.25 130 × 〖1.05〗^2
=143.33 140× 〖1.05〗^3
=162.07 120× 〖1.05〗^4
=145.86
Sales (Units annually) 300,000 410,000 525,000 220,000
Sales Value in Sh. 39,375,000 58,765,300 85,086,750 32,089,200
Variable cost per unit 71 71 71 71
Inflated by 3.5% annually 71×1.035
=73.49 71× 〖1.035〗^2 =76.06 71 × 〖1.035〗^3= 78.72 71×〖1.035〗^4
= 81.47
Sales (Units annually) 300,000 410,000 525,000 220,000
Total variable cost 22,047,000 31,184,600 41,328,000 17,923,400
Fixed cost 3,000,000 3,100,000 3,200,000 3,000,000
Inflated by 6.0% annually 3,180,000 3,483,160 3,811,251 3,787,431
Tax allowance depreciation 5,000,000 5,000,000 5,000,000 5,000,000
Tax allowance depreciation benefit 1,500,000 1,500,000 1,500,000 1,500,000
Year 1 2 3 4
Sales 39,375,000 58,765,300 85,086,750 32,089,200
Less: Variable Cost 22,047,000 31,184,600 41,328,000 17,923,400
Contribution 17,328,000 27,580,700 43,758,750 14,165,800
Less: Fixed Cost 3,180,000 3,483,160 3,811,251 3,787,431
Cash flow before tax 14,148,000 24,097,540 39,947,499 10,378,369
Less: Tax 30% (4,244,400) (7,229,262) (11,984,250) (3,113,511)
Add: Tax depreciation allowance benefit 1,500,000 1,500,000 1,500,000 1,500,000
After tax cash flow 11,403,600 18,368,278 29,463,249 8,764,858
Discount factor 12% 0.8929 0.7972 0.7118 0.6355
10,182,274.44 14,643,191.22 20,971,940.64 5,570,067.26
Sum of present value of cash flows 51,367,476.56
Less: Initial Outlay (20,000,000)
Net present value 31,367,473.56
QUESTION 3
August 2023 Question Four A
Kobe Ltd. is about to replace its existing delivery vehicle with a new design of a vehicle that offers greater fuel economy. The company estimates that replacing the existing vehicle will save running costs of Sh.200,000 per year. There are two financing options available:
Option 1: Borrowing funds and purchasing the vehicle
The vehicle could be purchased for Sh.3,400,000 using a bank loan with an after tax cost of borrowing of 4% per year. The vehicle would have a useful life of four years and would have a residual value of Sh.1,400,000 at the end of that period. Straight line tax allowable depreciation is available on the vehicle. The vehicle would be subject to a special tax of Sh.60,000 at the end of each year of operation. The tax expenses are corporation tax deductible.
Option 2: Leasing the vehicle
The vehicle could be leased for a period of four years for a payment of Sh.600,000 per year, payable at the start of each year. The lessor will pay the special tax. Lease payments are a corporation tax deductible expense.
The firm after tax weighted average cost of capital is 8%. The company pays corporation tax at a rate of 30% one year in arrears.
Required:
Advise Kobe Ltd. on whether it should lease or borrow to finance the new vehicle.
(8 marks)
Examine THREE reasons other than possible after tax cost advantages why Kobe Ltd. may choose to lease rather than buy the new delivery vehicle. (3 marks)
ANSWER
(i) Kobe LTD
Borrowing option
000
0 1 2 3 4 5
Purchase price -3,400
Residual value 1,400
Depreciation tax shield 30% [( 3400-1400)/4] 150 150 150 150
Special tax -60 -60 -60 -60
Special tax benefit 30%*60 18 18 18 18
Net cash flow -3,400 -60 108 108 1508 168
Discount at 4% 1.0000 0.9615 0.9246 0.8890 0.8548 0.8219
Present value -3,400 -57.69 99.8568 96.0120 1289.0384 138.0792
Present value cost of borrowing Sh. (1,834,703.60)
Leasing option
000
0 1 2 3 4 5
Lease payment -600 -600 -600 -600
Lease payment tax benefit 30%*600 180 180 180 180
Net cash flow -600 -600 -420 -420 180 180
Discount at 4% 1.0000 0.9615 0.9246 0.8890 0.8548 0.8219
Present value -600 -576.90 -388.332 -373.380 153.864 147.942
Present value cost of leasing Sh. (1,636,806.00)
Advice
Kobe LTD should lease the vehicle since it has the lower present value of leasing
ii) Reasons why lease than buy
There are a number of reasons why organizations may choose to lease rather than buy an asset. Some of the most common reasons include:
To conserve cash: Leasing can help organizations to conserve cash flow, as they do not need to make a large upfront investment to purchase an asset. Instead, they can spread the cost of the asset over the term of the lease.
To gain access to the latest technology: Leasing can allow organizations to gain access to the latest technology without having to make a large investment to purchase it. This can be important in industries where technology changes rapidly.
To avoid maintenance and repair costs: Lease agreements often include maintenance and repair services, which can save organizations money and time.
To have more flexibility: Leasing can give organizations more flexibility in their asset management plans. For example, if an organization’s needs change, they can typically terminate a lease agreement early or upgrade to a different asset.
QUESTION 4
April 2023 Question One C
XYZ Limited is considering six investment projects with the following details:
Project Initial outlay Net present value
Sh. “000” Sh. “000”
1 1,000 390
2 750 325
3 1,125 590
4 1,850 840
5 1,300 635
6 1,500
Additional information:
1. Project 6 is expected to generate the following annual cash flows:
Year 1 2 3 4
Sh. “000” Sh. “000” Sh. “000” Sh. “000”
Sales 725 765 885 612
Cost 145 168 202 94
Project 6 cash flows are exclusive of inflation at the rate of 4% per year for sales income and 5% per year for costs.
2. The cost of capital is 10%.
3. Due to management reluctance to raise additional finance, the capital for investment is currently restricted to Sh.5,000,000.
4. Project 1, 3, 5 and 6 are all independent but project 2 and 4 are mutually exclusive.
5. All of the above projects are divisible and none can be delayed or repeated.
Required:
(i) The net present value (NPV) for project 6. (3 marks)
(ii) The optimum investment combination given the capital constraint. (6 marks)
(iii) The resulting net present value (NPV) in (c) (ii) above. (1 mark)
ANSWER
The (NPV) for project 6.
Inflated sales
Year ‘000’
1 725 × 〖1.01〗^1 754
2 765 × 〖1.04〗^2 827
3 885 × 〖1.04〗^3 996
4 612 × 〖1.04〗^4 716
Cot inflated at 5%
Year ‘000’
1 145 × 〖1.05〗^1 152
2 168 × 〖1.05〗^2 185
3 202 × 〖1.05〗^3 234
4 94 × 〖1.05〗^4 114
Year 1 2 3 4
‘000’ ‘000’ ‘000’ ‘000’
Sales 754 827 996 716
Less: Costs (152) (185) (234) (114)
Cashflow 602 642 762 602
〖PVIF〗_(10%,n)
0.9091 0.8264 0.7513 0.6830
PV 547 531 572 411
NVP = (547 + 531 + 572 + 411) – 1500
= 2061 – 1500
= 561
The optimum investment combination
Project PI Rank
1 390/1000=0.39 4
2 325/750=0.43
3 590/1125=0.52 1
4 840/1850=0.49 3
5 635/1300=0.49 2
6 561/1500=0.37 5
Project 2 and 4 are mutually exclusive and cannot be done together. Project 2 will not be considered since project 4 is better and being mutually exclusive it is excluded.
Capital allocation Sh ‘000’
Available capital 5000
Invest project 3 1,125
3,875
Invest project 5 1,300
2575
Invest project 4 1850
725
Invest project 1 725
0
Optimal project combination 1, 3, 4 and 5
The resulting net present value (NPV) in (c) (ii) above.
= 590 + 840 + 635 + (725/1000 ×390)
= 2065 + 282.75
= Sh. 2, 347, 750.00
KASNEB SYLLABUS
GENERAL OBJECTIVE
This paper is intended to equip the candidate with knowledge, skills and attitudes that will enable him/her to apply advanced financial management techniques in an organisation.
15.0 LEARNING OUTCOMES
A candidate who passes this paper should be able to:
– Make advanced capital budgeting decisions and make appropriate capital structure decisions for an organisation
– Evaluate portfolios and apply the capital asset pricing model and other multifactor Models in financial decision making
– Apply the relevant models and skills in prediction of corporate failure
– Apply derivatives in financial risk management and apply international finance concepts.
– Evaluate mergers and acquisitions
– Undertake corporate restructuring and re-organisation
– Apply valuation techniques in real estate finance.
CONTENT
15.1 Advanced capital budgeting decision
– Incorporating risk/uncertainty in capital investment decisions
– Techniques of handling risk: Basic Methods of analysis – Expected Monetary Value (EMV), The Standard deviation and Coefficient of Variation
– Advanced Methods of analysis; sensitivity analysis, scenario analysis, decision trees, simulation analysis, utility analysis, risk adjusted discounting rate (RADR) and certainty equivalent method
– Impact of financing on investment decisions – the concept of adjusted present value (APV)
– Incorporating capital rationing in capital investment appraisal; Single period capital rationing with divisible projects; Multi-period capital rationing with divisible capital investments.
– Incorporating inflation in capital investment appraisal
– Evaluation of projects of unequal lives; The equivalent annual annuity approach and the Replacement chain analysis (Constant scale finite period replication criteria)
– Project duration as a measure of risk
– The real options in Capital Budgeting-Characteristics of the real Options; Types of Options in Capital investment Appraisal-Strategic investment option (Expansionary Option), Timing option (Option to delay a project), abandonment option (Option to Withdraw a project), the replacement option and the Option to re-deploy a project, challenges in use of options in investment analysis.
– Common capital budgeting pitfalls
15.2 Portfolio theory and analysis:
– The modern portfolio theory: background of the theory; portfolio expected return; the actual and weighted portfolio risk; derivation of efficient sets; the capital market line (CML) model and its applications, the mean variance dominance rule; short comings of portfolio theory
– Capital Asset Pricing Model-CAPM: background of the theory; assumptions; beta estimation – beta coefficient of an individual asset and that of a portfolio and the interpretation of the result; security market line(SML) model and its applications; conceptual differences between portfolio theory and capital asset pricing model
– Shortcomings of the capital asset pricing model
– The Arbitrage pricing model (APM) and other multifactor models: background of the theory; conceptual differences between the Capital asset pricing model and the Arbitrage pricing model; application of the Arbitrage pricing model, shortcomings of Arbitrage pricing model; Pastor Stambaugh model
– Evaluation of portfolio performance: Treynor’s measure, Sharpe’s measure, Jensen’s measure, appraisal ratio measure, information ratio, Modigliani and Modigliani (M2)
15.3 Advanced financing decision
– The nature of financing decision, principle objectives of making financing decision
– Analysis of breakpoints in weighted marginal cost of capital schedule (more than two breakpoints)
– Capital structure theories: nature of capital structure; factors influencing the firm’s capital structure; traditional theories of capital structure – assumptions of the theories, Net income theory and Net operating income theory; Franco Modigliani and Merton Miller’s propositions – MM without taxes, MM with corporation taxes, MM with corporation and personal tax rates and MM with taxes and financial distress costs; other theories of capital structure; the pecking order theory; Static Trade-off theory and Agency effects, determination of the firm’s optimal capital structure using the Hamada model, CAPM and WACC
– Long term financing decisions; bond refinancing decision, lease-buy evaluation and rights issues
– Assess an organisation’s debt exposure to interest rate changes using the simple Macaulay duration and modified duration methods
– Benefits and limitations of duration including the impact of convexity
15.4 Mergers and acquisitions
– Nature of mergers and acquisitions
– Arguments for and against the use of acquisitions and mergers as a method of corporate expansion Acquisition and Mergers verses organic growth
– Valuation of acquisitions and mergers: problem of overvaluation; valuation models- ‘Book value-plus’ models, Market based models, cash flow models; apply appropriate methods, such as: risk-adjusted cost of capital, adjusted net present values and changing price/earnings multipliers resulting from the acquisition or merger, to the valuation process where appropriate Prediction of a takeover target: criteria for choosing an appropriate target for acquisition
– Defence tactics against hostile takeovers
– Financing of mergers and acquisitions: Outright purchase using cash, share for share exchange, share- Debenture exchange and share- preference share exchange, Analysis of combined operating profit (EBIT) and post-acquisition earning per share at the point of indifference in firm’s earnings under various financing options and Determination of range of combined operating profit within which to recommend a financing option
– Financial Evaluation of mergers and acquisitions – Post merger/Acquisition EPS, Post Merger/Acquisition MPS
– Regulatory framework for mergers and acquisitions
– Valuation of firms/ Shares for Mergers and acquisition Purposes- Use of Net asset basis, P/E ratio basis, Dividend growth model, Super profits model, Capital asset pricing Model and the Discounted free cash flow basis.
– Reasons why there are failed mergers and acquisitions
– Mergers and acquisitions in the Kenyan, regional and global context
15.5 Corporate restructuring and re-organisation
– Background on restructuring and reorganisation
– Indicators/symptoms of restructuring
– Causes of financial distress
– Forms of financial distress and solutions to financial distress
– Considerations in designing an appropriate restructuring programme
– Financial reconstruction: forms of financial reconstruction; impact of financial reconstruction on share price; impact of financial reconstruction on the weighted Average cost of capital (WACC)
– Portfolio reconstruction: various ways of unbundling a firm: divestment, de-merger, spin-off, liquidation, sell-offs, equity curve outs, strategic alliances, management buyout, leveraged buyouts and the management buy-ins.
– The relevance of the various forms of portfolio reconstruction
– Organisational reconstruction: The nature and benefits of this form of restructuring
– Other forms of restructuring
– Restructuring in the Public sector
– Models of predicting corporate failure; Quantitative Models-Multiple discriminant analysis (Z-Score model), Springate model, Fulmer model; Qualitative Models – Argenti Model
15.6 Financial risk management
– Types of risks: operational risks, political risks, economic risks, fiscal risks, regulatory risks, currency risks and interest rate risks
– The meaning, nature and importance of derivative instruments
– Operations of the derivatives market: The relative advantages and disadvantages of exchange traded versus over the counter (OTC) agreements; Key features, such as standard contracts, tick sizes, margin requirements and margin trading
– Types of derivatives: futures, forwards, options and swaps
– Application of option pricing theory in investment decisions: Apply the Black-Scholes Option Pricing (BSOP) model to financial product valuation and to asset valuation; assumptions, structure, application and limitations of the BSOP model; calculate and advise on the value of options to delay, expand, redeploy and withdraw using the BSOP model
– Binomial Option pricing model – Use of both riskless hedge and the risk neutral approach in Valuation of both European and American call and put options
– Foreign currency risk management: Types of forex risks, hedging currency risks, forward contracts, money market hedge, currency options, currency futures and currency swaps, Bilateral and Multilateral netting and Matching tools of managing forex risks
– Option trading Strategies- Spreads and Combinations
– Limitations of financial derivatives
15.7 International financial management
– Introduction – The nature of international finance, Motives for investing in foreign markets and Challenges experienced by the Multinational corporations
– International financial Systems – Players in the international financial systems such as International Monetary fund, World trade organisation, European Union and the World bank.
– International trade flows and foreign direct investments (FDI)
– Financing of International Trade – Methods of financing the trade.
– International Capital and Money Markets – The foreign exchange Market-Exchange rates, Foreign Exchange exposures, International arbitrage – locational arbitrage, triangular arbitrage and covered interest arbitrage, International parity conditions- Interest rate parity, purchasing power parity and International fisher effect, International capital markets and their importance
– International Capital Budgeting – Reasons for Investing abroad, Evaluation of capital investments using local cash flows and foreign cash flows.
– International Capital structure – Factors influencing capital structure of MNCs, Sources of international finance, Cost and benefits of the alternative sources of international finance, Factors leading to difference in cost of capital of domestic firms and Multinational corporations and Adjusting WACC for risk differential
15.8 Real estate finance
– Overview of real estate finance – Meaning of real estate finance, nature of real estate business, property rights and limitations of property rights, environment of real estate finance and participants in real estate business.
– Real estate valuation approaches (income approach, cost approach and sales comparison approach)
– Real estate investment trusts (REITS): Types; advantages and disadvantages
– Instruments of real estate financing – mortgages, lien, title, mortgage requirements and mortgage clauses
– Mechanics of real estate mortgage-mortgage payments, mortgage constant, amortisation schedules
– Secondary mortgage trading and mortgage securitisation and re-financing
– Financing real estate investments-optimal capital structure, review of capital MM Theories in relation to real estate finance, arbitrage process
– Permanent financing of commercial real estate-equity financing, debt financing, cash flow from operations, mechanics of leasing versus ownership
15.9 Contemporary issues and emerging trends
– Crypto currency
– Block chain technology
– Cloud funding
– Digitisation of financial transactions
– Big data project finance
– Islamic finance
– Behavioral finance
– Derivative markets in developing countries