QUESTION ONE Briefly explain three practical uses of the capital asset pricing model. ( 6 marks) Beta equity coefficient

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Georgiana Haynes
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1 QUESTIONS QUESTION ONE Briefly explain three practical uses of the capital asset pricing model. ( 6 marks) (b) Mr. P K is currently holding a portfolio consisting of shares of four companies quoted on the Suba Stock Exchange as follows: Company A B C D Number of shares held 20,000 30,000 30,000 20,000 Beta equity coefficient Market price per share Expected return on equity in the next year % The current market return is 14% per annum and the treasury bills yield is 9% per annum. Required: (i) Calculate the risk of P K s portfolio relative to that of the market. ( 5 marks) (ii) Explain whether or not P K should change the composition of his portfolio. ( 9 marks) (Total: 20 marks) QUESTION TWO Keha Company Ltd is considering various levels of debt. Currently it has no debt. It has a total market value of Sh.30 million. By undertaking debt it believes that it can achieve a net tax advantage equal to 20% of the amount of debt. However the company will incur bankruptcy and agency costs as well as lenders increasing their interest rate if it borrows too much. The company s managing director believes that the company can borrow up to Sh.10 million without incurring any of these costs. However, each additional Sh.10 million

2 increment in borrowing is expected to result in the three costs cited being incurred. Moreover, the three costs are expected to increase at an increasing rate with leverage. The present value cost of various levels of debt is as follows: Debt in millions of shillings PV cost of bankruptcy, agency and increased interest rate Required: a) Advise the managing director on the optimal amount of debt for Keha Company. (10 marks) (b) Mr. Mathu is contemplating acquiring Munu Flower Company. Incremental cash flows arising from the acquisition are expected to be the following: Average of years x Net cash flows Sh. millions Required: Munu has an all-equity capital structure. Its beta is 0.8 based on the past 60 months of data relating its excess returns to that of the market. The risk free rate is 9% and the expected return on the market portfolio is 14%. What is the maximum price that Mathu should pay for Munu? (10 marks) (Total: 20 marks)

3 NUMBER THREE The Katimawe Company needs to finance a seasonal rise in inventories of Sh.4 million. The funds are needed for six months. The company is considering using the following possibilities to finance the inventories: 1. A warehouse loan from a finance company. The terms are 18 per cent annualized with an 80% advance against the value of the inventory. The warehousing costs are Sh.350,000 for the six-month period. The residual financing requirement which is Sh.4 million less the amount advanced will need to be financed by forgoing cash discounts on its payables. Standard terms are 2/10 net 30: however the company feels it can postpone payment until the fortieth day without adverse effect. 2. A floating lien arrangement from the supplier of the inventory at an effective interest rate of 24 per cent. The supplier will advance the full value of the inventory. 3. A bank loan from the company s bank for Sh.4 million. The bank can lend at the rate of 22%. In addition, a 10% compensating balance will be required which otherwise would not be maintained by the company. Required: Which is the cheapest option for the company? (15 marks) (b) Highlight the limitations of using commercial paper as a form of short-term credit. (5 marks) (Total: 20 marks) NUMBER FOUR Explain the factors that finance managers should analyse before making a dividend decision. (5 marks) (b) Assume all things are held constant other than the item in question, for each of the companies below: A company with a large proportion of insider ownership all of whom are high-income individuals. A growth company with an abundance of good investment opportunities.

4 A company experiencing ordinary growth that has high liquidity and much unused borrowing capacity. A dividend paying company that experiences an unexpected drop in earnings from a trend. A company with volatile earnings and high business risk. Required: Explain whether or not you would expect each company to have a medium/high or a low dividend payment ratio and the reasons for such categorisation. (15 marks) NUMBER FIVE Identify and explain three methods of handling risks in capital budgeting. (8 marks) (b) Company A is considering investing in a project which has a three year life. The project would involve an initial investment of Sh.20 million. The finance manager has come up with expected probabilities for various possible economic conditions as follows: Year 0 Economic Conditions Sh. 000 Net cash flows (20,000) Probability High growth Average growth No growth High growth Average growth No growth High growth Average growth No growth 10,000 6,000 2,000 12,000 8,000 4,000 16,000 12,000 6,

5 Required: Assuming a discount rate of 15% should company A invest in the project? (12 marks) NUMBER ONE ANSWERS a) The practical applications of capital asset pricing model (CAPM) are as follows: Determination of cost of capital e.g. cost of equity Ke = Rf + (Rm Rf)Be Where: Be = equity beta factor Valuation of securities by comparing the expected and required returns if ER > Required return then the security is undervalued. Capital budgeting decision is appraising the projects in terms of betas Gearing adjustment between levered and unlevered firm. b) The risk of the portfolio in this case will be measured by portfolio Beta (Bp) relative to market portfolio beta. Bp n t 1 B n w n Where w n = weight based on market values of shares. Share Market value in Sh.M Weight A 20,000 Sh.65 = B 30,000 Sh.50 = C 30,000 Sh.45 = D 20,000 Sh.80 = Weight Beta Weighted Beta

6 Portfolio/overall Beta 1.10 c) Compute the required return using CAPM and compare with expected returns to determine whether the securities are over or undervalued. % required return = Rf + (Rm Rf)Beta Security % required return %ER(given) Comment A 9% + (5 x 1.12) = 14.6% 18% Undervalued hence buy more B 9% + (5 x 0.89) = 13.45% 23% Undervalued buy more C 9% + (5 x 0.7) = 12.5% 11% Overvalued sell D 9% + (5 x 1.60) = 17.0% 17% Correctly valued = hold Change the composition of the portfolio since: risk Some securities (A&B) are undervalued Security C is overvalued 4 securities are too few to constitute a portfolio and fall eliminate unsystematic NUMBER TWO a) In presence of agency and bankruptcy costs: V L = V u + T.D P.V of A.C & B.C Where: V L = Value of levered firm V u = Value of unlevered firm TD = debt tax shield = debt x tax rate A.C & B.C = Agency costs & Bankruptcy costs. Debt level Tax shield A.C & VI = Vu + T.D P.V of (T.D) B.C AC & B.C 0 20% x 0 = = % x 10M = = % x 20M = = % x 30M = = % x 40M = = 34.0

7 50 20% x 50M = = % x 60M = = 32 Optimal debt level = 40M since the value of the firm is maximised to be 34.0M b) Discounting rate using CAPM = Rf + (Rm Rf)Beta = 9% + (14% - 9%)0.8 = 13% Maximum price to pay = Total present value of all expected cash flows. P.V of year 1 5 cash flows Sh.M 50M x PVAF 13%,5 = 50M x = P.V of year 6 10 Cash flows: 90M(PVAF 13%,10 - PVAF 13%,5) = 90M( ) = P.V of year 11 - cash flows 130M (PVAF 13%, - PVAF 13%,10) 130(1/0.13 = ) = Maximum price to pay 642,240 NUMBER THREE Financing options (i) Warehouse loan Warehousing costs 350,000 Interest 80% x 4,000,000x18% x 6 288,000 % cost of discount = % , x = 24.5% p.a Cost of foregone discount 20% 4,000,000x24.5% x 6 12 x = 98,000 Total cost = 638, ,000 = 736,000 (ii) Floating lien Interest charges = 4,000,000 24% x 6 12 x = 480,000

8 (iii) Bank loan In presence of compensating balance, the effective interest rate = Nominal interest 100% - Compensating Balance = 22% = 24.44% Interest charges = 24.44% 4,000,000x 6 12 x = 488,000 The best option is the floating lien from the supplier. (b) - During economic boom when liquidity is high, it is difficult to sell the commercial paper. - It is used only by blue chip firms to raise short term capital - For the lender it is unsecured short term financial instrument - In Kenya the use of commercial paper to raise short term credit is subject to regulatory restrictions by capital market authority. NUMBER FOUR A company may pay a different dividend from another even if their issued capital is the same because of differences associated with: Liquidity of each firm The more liquid the firm, the higher the dividends other things constant. Tax position of shareholders e.g shareholders with low income from other sources will prefer high dividends to supplement their income. Profitability of the firm Other factors constant, the higher the profits, the higher the dividends. Bond/debt covenants e.g restrictions of payment of dividends from retained earnings. Availability of investment opportunities The more the projects yielding a positive NPV the higher the retained earnings and the lower the dividends. Access the capital markets e.g firms which can easily and cheaply secure debt capital can afford to pay high dividends and vice versa.

9 . Capital structure decisions If the firm wants to reduce gearing through increase in equity, retained earnings will be increased thus lower dividends paid. Level of business risk Firms with high volatility of earnings will generally pay low dividends (other factors constant) due to uncertainty of profits and reduced ability to borrow. Shareholders expectations If shareholders have been receiving increasing DPS, the firm would persist on this trend since any reverse trend may affect the market value of shares. (b) (i) A firm with a large proportion of high income individuals will pay low or no dividends. Such shareholders prefer high capital to reduce their tax burden since capital gains in Kenya are tax exempt. (ii) (iii) A growth company with abundance of good investment opportunities. Such a firm would pay low and retain more profits to finance its good investment opportunities. A company with ordinary growth and high liquidity. Such a firm could pay high dividends and retain less. With high liquidity and much unused debt capacity, the firm can easily borrow debt capital to achieve optimal debt capital. It has access to capital markets. (iv) A dividend paying company that experiences an unexpected drop in earnings from trend. Such a firm would pay medium dividends but if the drop in earnings persist in future it should adopt payment of low dividends. (v) A company with volatile earnings an high business risk. This firm should pay low dividends and retain more profits to finance its investments. With high business risk, the firm does not have access to capital markets and it is difficult to raise secure debt capital which would nevertheless increase the financial risk of the firm. NUMBER FIVE The methods of handling risk in capital budgeting are: Use of risk-adjusted discounted rate Certainty equivalent coefficient

10 Simulation Sensitivity analysis Decision trees Expected monetary value (EMV) approach Payback period method. (b) Year 1 Year 2 Year 3 EMV P.V Sh. 000 (10,000 x 0.2) + (6,000 x 0.7) x (2,000 x 0.1) = 6,400 5,568 15% = 6,400 x EMV = (12,000 x 0.3) + (8,000 x 0.5) + (4,000 x 0.2) = 8,400 6,350 15% = 8,400 x EMV = (16,000 x 0.4) + (12,000 x 0.3) + (6,000 x 0.3) = 11,800 7,764 15% = 11,800 x Total P.V 19,682 Less initial capital (20,000) N.P.V (318) Reject the investment since NPV is negative.

You have been provided with the following information about a project, which TOB Ltd. is planning to undertake soon.

NUMBER ONE QUESTIONS You have been provided with the following information about a project, which TOB Ltd. is planning to undertake soon. Cost of equipment Economic life Installation costs Depreciation