CORPORATE FINANCE DECEMBER 2021 PAST PAPER

THURSDAY: 16 December 2021.          Time Allowed: 3 hours.

Answer ALL questions. Marks allocated to each question are shown at the end of the question. Show ALL your workings.

QUESTION ONE

1.         Discuss three forms of executive incentive schemes that a company could utilise to attract and retain high quality managers.          (6 marks)

2.         Explain four advantages of preference shares as a source of finance for a business enterprise.    (4 marks)

3.         Highlight four factors to be considered when formulating the dividend policy of a listed company.    (4 marks)

4.          The management of Tausi Ltd. has determined that it will require Sh.25,000,000 in cash for the coming year. The cost of converting marketable securities to cash is Sh.500 per transaction. Interest on marketable securities is  10% per annum.

Required:

Using the Baumol cash management model, determine:

The optimal cash conversion size.          (2 marks)

Average cash balance.            ( 1 mark)

Number of times the conversions should be made.           ( 1 mark)

Total cost of managing the optimal cash balance.           (2 marks)

(Total:   20 marks)

 

QUESTION TWO

1.          Highlight  three differences between an “operating lease” and ” a “finance lease”.        (6 marks)

2.          Elgon Ltd. is a small company that is finding it difficult to raise funds to acquire a new machine costing Sh.750,000. Elgon Ltd. would ideally like a four year loan for the full purchase price at an after tax interest rate of 6% per annum. The machine would have an expected useful life of four years. At the end of this period. the machine would have a residual value of Sh.50,000. Tax allowable servicing costs for the machine would be Sh.23,000 per year. Tax allowable depreciation on the full purchase price would be available on a 25% straight line basis.

A leasing company has offered a contract whereby Elgon Ltd. could have use of the machine for four years in exchange for an annual lease rental payment of Sh.200,000, payable at the start of each year. The contract states that the leasing company would undertake maintenance of the machine at no additional cost to Elgon Ltd. At the end of the four years, the leasing company would recover the machine from Elgon Ltd.

Elgon Ltd. pays corporation tax at the rate of 30% one year in arrears.

Required:

For the new machine, calculate:

The present value of the cost of borrowing to buy.        (4 marks)

The present value of the cost of leasing.    (4 marks)

Advise the management of Elgon Ltd. on best financing option based on your results in  (i) and  (ii) above.   (2 marks)

3.           An analyst has gathered the following information about the return of Sabaki Limited’s share and the market for the last six years:

Return (%)

Year                                            Sabaki Limited (S)                                 Market (M)

2015                                                          18                                                             15

2016                                                         9                                                               7

2017                                                         20                                                             16

2018                                                       —10                                                          —13

2019                                                         5                                                               4

2020                                                          12                                                             7

 

Required:

Calculate the beta coefficient for Sabaki Limited’s share.      (4 marks)

(Total: 20 marks)

 

QUESTION THREE

1.           Explain the following terms as used in mergers and acquisition:

Bootstrapping earnings.      (2 marks)

White knight defense.       (2 marks)

White squire defense.       (2 marks)

2.          There are six firms in a given industry, each with an equal market share. Two of the firms decide to merge.

Required:

Using Herfindahl-Hirschman index, determine whether the merger will be challenged by the authorities. (4 marks)

3.           JB Ltd. has 78 million shares outstanding while AZ Ltd. has 223 million shares outstanding. JB Ltd.’s shares were trading at a price of Sh.20 per share pre-announcement while AZ Ltd.’s shares were trading at Sh.43 per share. An analyst estimates the total present value of cost savings due to the merger will be Sh.200 million. AZ Ltd.’s board accepts a 1:2 share exchange offer (I share of AZ Ltd. per 2 shares of JB Ltd.)

Required:

The takeover premium paid to shareholders of JB Ltd.      (6 marks)

4.           X Ltd.’s total working capital requirements over a period of 5 days is as shown below:

 

Day of the week                                                                                  Total working capital requirements (Sh.)

Monday                                                                                                                           100,000

Tuesday                                                                                                                             80,000

Wednesday                                                                                                                      120,000

Thursday                                                                                                                          110,000

Friday                                                                                                                              130,000

 

Required:

Average daily permanent working capital.            (2 marks)

Average daily seasonal working capital.      (2 marks)

(Total: 20 marks)

 

QUESTION FOUR

1.           Describe six commonly used contracts in Islamic Finance.                 (6 marks)

2.           Hapco Limited is considering two mutually exclusive projects. The initial costs of both projects is S11.5.000,000 and each has an expected life of five years. Under three possible states of economy, their annual cash tlows and associated probabilities are as follows:

Cash flows

Economic state                                  Probability                        Project A              Project B

                                                                                                              Sh. “000”             Sh. “000”

Good                                                          0.30                                       6,000                     5,000

Normal                                                       0.40                                       4,000                     4,000

Bad                                                             0.30                                       2,000                     3,000

The discount rate is 7%.

 

Required:

The expected net present value (NPV) for each project.        (2 marks)

The standard deviation for each project.       (2 marks)

Advise the management on the project to undertake based on your results in  (i) and (ii) above. (2 marks)

3.          Zidisha Ltd. intends to raise additional capital for a new product line.

The following information is provided:

 

  1. The firm will issue 200,000 ordinary shares (Sh.l0 par value) at Sh.16 with a floatation cost per share of Sh. 1
  2. 75,000, 12% preference shares (Sh.20 par value) at Sh. 18 will be issued. This would lead to incurring of Sh. 1 50,000 as floatation costs.
  3. 50,000, 18% debentures (Sh.100 par value) at Sh.80 with no floatation cost.
  4. Raise Sh.5 million from 18% loan incurring Sh.200,000 as legal and processing fees.
  5. The company paid 28% ordinary dividends which is expected to grow at a rate of 4% per annum in the following year.
  6. Corporate tax rate is at 30% per annum.

Required:

Determine total capital raised net of floatation costs incurred.     (2 marks)

Compute the weighted marginal cost of capital (WMCC).     (6 marks)

(Total: 20 marks)

 

QUESTION FIVE

1.           Propose two forms of divestments in the context of corporate growth and restructuring.     (4 marks)

2.          Fineto Limited is considering going private through a leveraged buyout by management. Management presently owns 21% of the 5 million shares outstanding. The current market price per share is Sh.20 and it is felt that 40% premium over the present price will be necessary to entice public shareholders to tender their shares in a cash offer. Management intends to keep their shares and to obtain a senior debt equal to 8 0 % of the funds necessary to consummate the buyout. The remaining 20% will come from junior subordinated debt. Terms on the senior debt are 2% above the prime rate, with principal reduction of 20% of the initial loan at the end of each of the next 5 years. The junior subordinated debentures bear a 13% interest for the next 5 years and must be retired at the end of year 6. Management estimates that earnings before interest and taxes (EBIT) will be Sh.25 million per year.

Ignore taxation.

Required:

Evaluate whether the leveraged buyout is feasible if the prime rate is expected to average    10% over the next 5 years.    (8 marks)

3.           Adept Ltd. requires Sh.500,000 for construction of a new plant.

The following three financial plans are feasible:

  1. The company may issue 50,000 ordinary shares at Sh.10 per share.
  2.  The company may issue 25,000 ordinary shares at Sh.10 per share and denominations bearing 8% rate of interest. 2,500 debentures of Sh.100
  3. The company may issue 25,000 ordinary shares at Sh.10 per share and 2,500,   8% preference shares at Sh.100 per share.

The tax rate is 30% per annum.

 

Required:

Calculate the earnings per share using earnings before interest and taxes  (EBIT) of Sh.10,000, Sh.20,000, Sh.40,000, Sh.60,000 and Sh.100,000 respectively under each of the three financial plans above.     (3 marks)

Determine which alternative you would recommend based on your results in (i) above.  (2 marks)

Determine the indifference points.     (3 marks)

(Total: 20 marks)

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