QUESTION ONE

The management of Kinyongoro Publishers has estimated the following net cashflows and probabilities for a new printing process.

 Year Net Cashflows

P = 0.2     P = 0.6     P = 0.2

0 (100,000)  (100,000)   (100,000)

1 20,000       30,000      40,000

2 20,000       30,000     40,000

3 20,000       30,000      40,000

4 20,000       30,000      40,000

5 20,000       30,000     40,000

5* 0               20,000       30,000

 Year 0 is the cost of the new process and Year 5* is the estimated salvage value. The cost of capital for a project of average risk is 10% p.a.

 Required:

 (a) Assuming that the above project has average risk, compute the projects base case net present value (NPV).(12 marks)

(b) Assume that all cashflows are positively perfectly correlated (i.e. there is only three possible cashflow scenarios over time namely worst case, most probable case and best case with probabilities 0.2, 0.6 and 0.2 respectively).

Find the projects expected NPV, standard deviation and coefficient of variation.(8 marks)

(c) Should the project be accepted?(2 marks)

(Total 22 marks)

QUESTION TWO

(a) The Capital Asset Pricing Model (CAPM) has been identified as a method for estimating the cost of Equity Capital.

Identify and describe how this model might be applied in actual practice by a company. What is the major weakness in using CAPM as a method of valuing a firm?(10 marks)

(b) Why would you consider the Arbitrage Pricing Theory to be much more robust than the Capital Asset Pricing Model.(8 marks)

(Total 18 marks)

 QUESTION THREE

Explain the role played by bankruptcy and agency costs in capital structure theory.(15 marks)

(Total 15 marks)

QUESTION FOUR

(a) A single working capital investment and financing policy that is optimal for all firms is not practical. Why is this? (5 marks)

(b) Prime Shoes Ltd manufactures various types of shoes. The company is now considering its working capital policy for 1994. Fixed assets are projected at Sh 30 million and current liabilities at Sh 27 million. Sales and Earnings before interest and Taxes (EBIT) are partially a function of the company's investment in working capital particularly its investment in stocks and debtors. Prime Shoe Ltd is considering the following three different working capital investment policies:

 Aggressive policy — small investment in current assets

Conservative policy — large investment in current assets

Moderate policy — moderate investment in current assets

 The following information relates to three policies:

 Aggressive Moderate Conservative

                          Sh`000'   Sh`000'     Sh`000'

Investment in

Current Assets         42,000        45,000        48,000

Projected Sales         88,500         90,000     91,500

EBIT                           8,500           9,000      9,150

 Required:

 (a) Determine the working capital investment policies for each of the following:

 i. Rate of return on total assets(3 marks)

ii. Net working capital(3 marks)

iii. Current ratio(3 marks)

(b) Describe the profitability-risk trade offs of these three policies.(6marks)

(Total 20 marks)

QUESTION FIVE

Umma Ltd and Lemma Ltd are identical in every respect except that Umma is unlevered while Lemma has Sh 10 million of 5% loan stock outstanding. You are also informed that:

 - All of MM assumptions are satisfied

- There are no corporate or personal taxes

- Earnings before interest and taxes (EBIT) is Sh 2 million

- The cost of equity to Umma is 10% p.a.

 Required:

(a) What market value would MM estimate for each firm?(4marks)

(b) What is the cost of equity for Lemma?(3marks)

(c) What is the market value of Lemma's equity?(3marks)

(d) What is the weighted average cost of capital for each firm?(3 marks)

(e) Suppose the market value of the assets of Umma is Sh 20 million and the market value for those of Lemma is Sh 22 million.

Are these equilibrium valuations? Use these figures to explain how equilibrium is established.

(7 marks)

(Total 20 marks)