UNIVERSITY EXAMINATION 2017/2018

SCHOOL OF BUSINESS AND ECONOMICS

DEPARTMENT OF ACCOUNTING AND FINANCE

BBM/BCOM/BBIT/BIT/BREM/BECF/BSFS/BECS/BEDA/BSNE
SCHOOL BASED

UNIT CODE: BAF2104 UNIT TITLE: FINANCIAL MANAGEMENT I

DATE: AUGUST 2018 SPECIAL/SUPPLIMENTARY EXAM TIME: 2 HOURS

INSTRUCTIONS: ANSWER QUESTION ONE AND ANY OTHER TWO QUESTIONS

QUESTION ONE (30 MARKS)

(a) Briefly explain causes of agency conflict that may arise in a firm. (5 Marks)

(b) Distinguish between business risks and financial risks. (5 Marks)

c) Explain the reasons why there could be a conflict between profit maximization and
shareholder wealth maximization. (5 Marks)

d) The optional structure of a firm is given as follows:-

Shs. ‘000’
8% debt 300 000
5% preference shares 200 000
Ordinary shares (Kshs. 5 par) 500 000
1 000 000

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Additional Information.
1. New debt can be issued by the firm at the existing coupon rate with a par
value of ksh. 10 000. The bond will trade at a discount of 275/= with a life of
ten years.

2. Preference share capital can be raised at par in unlimited amounts.

3. The firm does not have any retained earnings in its books.

4. New issue of common stock can be made but a floatation cost of 2% of the
market price will be incurred.

5. In the year just ending, the firm paid a dividend of kshs. 3 per share.

6. The investors expect dividend to grow at a constant rate of 10% per annum
indefinitely. The current market price of eh firm’s stock is shs. 60.

Required:
Assuming that the firm is in the 30% tax bracket, compute its WACC. (15 Marks)

QUESTION TWO (20 MARKS)

(a) Identify and explain the factors that affect the structure of a firm. (10 Marks)

(b) Kakuzi Ltd. reported EPS of Shs. 4 in the last financial period. The earnings are
expected to grow at the rate of 10% p.a. for 6 years. The price earnings ratio
(PIE) of the company at the end of the 6th year period is 20. The required rate of
return is 15%. Calculate the theoretical value of this share for an investor who
intends to hold on to the shares for 6 years. The dividend payout ratio is 60%.
(10 Marks)

QUESTION THREE (20 MARKS)

(a) An institute investor has an investment fund of 2 million shillings and he intends
to apportion this fund to two securities A and B as follows; Shs. 400,000 in
security A and Shs. 1,600,000 in security B. The return on each security is
dependent on the states of the economy as shown below:

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 A B
Boom 0.4 18% 24%
Average 0.5 14% 22%
Recession 0.1 12% 21%

Required:

(i) Expected return of each security and portfolio. (5 Marks)

(ii) Standard deviation for each security. (5 Marks)

(iii) Correlation coefficient between security A and B. (5 Marks)

(iv) Assess the extent of risk diversification by the investor through the
portfolio holding. (5 Marks)

QUESTION FOUR (20 MARKS)

(a) Rudwell Ltd. wishes to expand its output by purchasing a new machine worth
170,000 shillings and installation costs are estimated at 40,000 shillings. In the
4th year, this machine will call for an overhead to cost shillings 80,000. Its
expected inflows are:

Shs.
Year 1 60,000
Year 2 72,650
Year 3 35,720
Year 4 48,500
Year 5 91,630
Year 6 83,715

This company can raise finance to purchase this machine at 12% interest rate.
Compute NPV and advice management accordingly. (10 Marks)

(b) Identify the advantages and disadvantages of using the NPV method to appraise
investment projects. (10 Marks)

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QUESTION FIVE
Highlight Ltd is considering two possible projects. The projects are mutually exclusive
and promise to generate the following cash flows:

Points in time (yearly intervals) Project A Project B

0 -420,000 -100,000
1 150, 000 75,000
2 150,000 75,000
3 150,000 -
4 150,000 -

The firm’s cost of capital is 12%. Assume unlimited funds and that these are the only
cash flows associated with the projects.

(a) Explain the characteristics of a good investment appraisal technique

(8 Marks)

(b) Determine the net present value (NPV) and internal rate of return (IRR) for each
project. (12 Marks)

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