DECEMBER 2008

QUESTION ONE

Jabali Ltd. is a quoted company which is 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 each 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 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%.

Required:
a The weighted average cost of capital of the company.
b) The beta of the company.
c)The beta of an equivalent ungeared company ignoring taxes.
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.
(Total: 20 marks)

QUESTION TWO
a)Futures contracts and options on futures contracts can be used to modify risk.
Required:
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 market 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.

ii)Presently, the futures contract trades at Sh.1,000 and 3 month put and call options both involve premiums of 1 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?
(10 marks)(Total: 20 marks)

QUESTION FOUR

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 10000 1000 2200

B 5000 1000 3000

C 20000 2500 1000
D 1000 500 1000
E 50000 7500 7500

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.

Required:
a)construct a risk profile for each of these projects in terms of the profitability index. (5 marks)
b)Ignoring size problems, do you find some projects clearly dominated by others? Should size problem be ignored?(5 marks)
c)What is the probability that each of the projects will have a net present value 0
(10 marks)

QUESTION FIVE

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
for their capital structures and total market values. The companies capital structures are summarised below:
KK Ltd. 0000

Sh.000

Ordinary shares (Sh.50 par value) 40000

Share premium account 9000
Profit and loss account 73000
Shareholders funds 23000
KK Ltd shares are trading at Sh.140

KT Ltd.

Sh.000

Ordinary shares (Sh.100 per value) 50000

Share premium account 1600
Profit and loss account 88000
Shareholders funds 154000
12% debentures (newly issued) 50000

2400000

KTs 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%.

Required:
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 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
companys cost o
f capital according to Modigliani and Miller. What implications would this suggest
for the companys choice of capital structure? (8 marks)