1. Jabali Ltd is a quoted company which if financed by 10,000,000 ordinary shares and

Sh. 50,000,000 of irredeemable 8% debentures. The market value of the shares is

Sh.20 ex-div and an annual dividend of Sh.4 per share is expected to be paid in perpetuity. The debentures are considered to be risk-free and are valued at par.

Mr. Jabali the managing director of the company is wondering whether to invest in a project which would cost Sh. 20 million and yield Sh.3.8 million a year before tax in perpetuity. The project has an estimated beta value of 1.25. The return from a well-diversified market portfolio is 16%


(a) The weighted average cost of capital of the company (5 marks)

(b) The beta of the company (4 marks)

(c) The beta of an equivalent ungeared company ignoring taxes (4 marks)

(d) Advise the company whether or not the project should be accepted. In your explanation,

highlight the significance of your calculations in (a), (b) and (c) above. (7 marks)

(Total: 20 marks)

2. (a) The Arbitrage Pricing Theory (APT) and the Capital Asset Pricing Model (CAPM) have received much attention from practitioners and academicians for use in asset pricing and valuation


Explain the conceptual difference between the Arbitrage Pricing Theory (APT) and Capital Asset

Pricing Model (CAPM). (10 marks)

(b) The following are the historical returns for the Anita Computer Company Ltd

Year Anita Computer Company Ltd General Index

1 37 15

2 9 13

3 -11 14

4 8 -9

5 11 12

6 4 9


(i) Compute the correlation coefficient between Anita Computer Company LTd. And the

general index. (8 marks)

(ii) Compute the beta for the Anita Computer Company Ltd. (2 marks)

(Total: 20 marks)

3. (a) Futures contracts and options on futures contracts can be used to modify risk.


Identify the fundamental distinction between a futures contract and an option on a futures contract and explain the difference in the manner that futures and options modify portfolio risk. (10 marks)

(b) Maendeleo Industries is concerned about interest rates rising. It needs to borrow in the bond markets three months hence the company believes that an option on treasury bond futures is the best hedging device.

(i) Should the company buy a put option or a call option? Explain (3 marks)

(ii) Presently, the futures contract trades at Sh. 1,000 and 3 month put and call options both involve premiums of 1½ per cent based on this strike price. During the 3 months, interest rates rise so that the price on a treasury bond futures contract goes to Sh. 950. What is your gain or loss on the option per Sh. 1,000,000 contract? (4 marks)

(iii) What would be the outcome if the interest rates fell and the price went to Sh.1,030?

(3 marks)

(Total: 20 marks)

4. Gome Drug Products Ltd (GDPL) is faced with several possible investment projects. For each, the total cash outflows required will occur in the initial period. The cash outflows expected net present values and standard deviations are as follows:

Project Cost Sh. ‘000’ Net present value Standard deviations

A 10,000 1,000 2,000

B 5,000 1,000 3,000

C 20,000 2,500 1,000

D 1,000 500 1,000

E 50,000 7,500 7,500

All projects have been discounted at a risk-free rate of 8% and it is assumed that the distribution of their possible net present values are normal.


(a) Construct a risk profile for each of these projects n terms of the profitability index (5 marks)

(b) Ignoring size problems do you find some projects clearly dominated by others?(5 marks)

(c) What is the probability that each of the projects will have a net present value 0 (10 marks)

(Total: 20 marks)

5. KK Ltd and KT Ltd are two companies in the printing industry. The companies have the same business risk and are almost identical in all respects except for their capital structures and total market values. The companies capital structures are summarised below:

KK Ltd Sh ‘000’

Ordinary shares (sh. 50 par value) 40,000

Share premium account 90,000

Profit and loss account 73,000

Shareholders’ funds 203,000

KK Ltd shares are trading at sh.140

KT LtdSh ‘000’

Ordinary shares (Sh. 100 per value) 50,000

Share premium account 16,000

Profit and loss account 88,000

Shareholders’ funds 154,000

12% debentures (newly issued) 50,000


KT’s ordinary shares are trading at Sh 170 and debentures at Sh. 100. Annual earnings before interest and tax for each company is Sh. 50 million

Corporate tax is at the rate of 30%


(a) If you owned 4% of the ordinary shares of KT Ltd. and you agreed with the arguments of Modigliani and Miller, explain what action you would take to improve your financial position. (4 marks)

(b) Estimate by how much your financial position is expected to improve. Personal taxes may be ignored and the assumptions made by Modigliani and Miller may be used. (8 marks)

(c) If KK Ltd was to borrow Sh. 40 million, compute and explain the effect this would have on the company’s cost of capital according to Modigliani and Miller? What implications would this suggest for the company’s choice of capital structure? (8 marks)

(Total: 20 marks)