QUESTION ONE
(a) State the circumstances under which it would be advantageous to lenders and to borrowers from the issue of:

(i) Debentures with a floating rate of interest. (4 marks)
(ii) Zero-coupon bonds. (4 marks)
(Ignore taxation)

(b) (i) Briefly discuss the disadvantages of the constant growth dividend model as a valuation model. (4 marks)

(ii) The dividend per share of Mavazi Limited as at 31 December 2000 was Sh.2.50. The company’s financial analyst has predicted that dividends would grow at 20% for five years after which growth would fall to a constant rate of 7%. The analyst has also projected a required rate of return of 10% for the equity market. Mavazi’s shares have a similar risk to the typical equity market.

Required:
The intrinsic value of shares of Mavazi Ltd. As at 31 December 2000.
(8 marks)
(Total: 20 marks)

QUESTION TWO
(a) The management of Furaha Packers Ltd. is planning to carry out two activities at the same time to:
(i) determine the best credit policy for its customers
(ii) find out the optimal level of ordering orange juice from its suppliers.

The following data have been collected to assist in making the decisions:

1. Annual requirements of orange juice are 2,100,000 litres
2. The carrying cost of the juice is Sh.8 per litre per year
3. The cost of placing an order is Sh.1,400.
4. The required rate of return for this type of investment is 18% after tax.
5. Debtors currently are running at Sh.60 million and have an average collection period of 40 days.
6. Sales are expected to increase by 20% if the credit terms are relaxed and to result in an average collection period of 60 days.
7. 60% of sales are on credit.
8. The gross margin on sales is 30% and is to be maintained in future.

Required:
(i) Use the inventory (Baumol) model to determine the economic order quantity and the ordering and holding costs at these levels per annum. (8 marks)
(ii) Determine if the company should switch to the new credit policy. (4 marks)

(b) The Apollo Credit Collection Company Ltd. employs agents who collect hire purchase instalments and other outstanding amounts on a door to door basis from Monday to Friday. The agents bank their collections at the close of business everyday from Monday to Thursday. At the close of business on Friday the week’s bankings are withdrawn and, together with Friday’s collections, are remitted to the head office. The takings are evenly spread daily and weekly. The budget for the next year shows that total collections will amount to Sh.26 million. The bankings are used to reduce an overdraft whose interest rate is 19%.

The collection manager has suggested that instead of banking collections, they be remitted daily to the head office by the collectors.

Required:
Determine the increase in annual interest if the collection manager’s suggestion was adopted. (8 marks)
(Total: 20 marks)

QUESTION THREE
Rafiki Hardware Tools Company Limited sells plumbing fixtures on terms of 2/10 net 30. Its financial statements for the last three years are as follows:

1998
Sh.’000’ 1999
Sh.’000’ 2000
Sh.’000’
Cash
Accounts receivable
Inventory
Net fixed assets

Accounts payable
Accruals
Bank loan, short term
Long term debt
Common stock
Retained earnings

Additional information:
Sales
Cost of goods sold
Net profit 30,000
200,000
400,000
800,000
1,430,000

230,000
200,000
100,000
300,000
100,000
500,000
1,430,000

4,000,000
3,200,000
300,000 20,000
260,000
480,000
800,000
1,560,000

300,000
210,000
100,000
300,000
100,000
550,000
1,560,000

4,300,000
3,600,000
200,000 5,000
290,000
600,000
800,000
1,695,000

380,000
225,000
140,000
300,000
100,000
550,000
1,695,000

3,800,000
3,300,000
100,000

Required:
(a) For each of the three years, calculate the following ratios:
Acid test ratio, Average collection period, inventory turnover, Total debt/equity, Net profit margin and return on assets. (12 marks)

(b) From the ratios calculated above, comment on the liquidity, profitability and gearing positions of the company. (8 marks)
(Total: 20 marks)

QUESTION FOUR
(a) Explain fully the effect of the use of debt capital on the weighted average cost of capital of a company. (6 marks)

(b) Millennium Investments Ltd. wishes to raise funds amounting to Sh.10 million to finance a project in the following manner:

Sh.6 million from debt; and
Sh.4 million from floating new ordinary shares.

The present capital structure of the company is made up as follows:

1. 600,000 fully paid ordinary shares of Sh.10 each
2. Retained earnings of Sh.4 million
3. 200,000, 10% preference shares of Sh.20 each.
4. 40,000 6% long term debentures of Sh.150 each.

The current market value of the company’s ordinary shares is Sh.60 per share. The expected ordinary share dividends in a year’s time is Sh.2.40 per share. The average growth rate in both dividends and earnings has been 10% over the past ten years and this growth rate is expected to be maintained in the foreseeable future.

The company’s long term debentures currently change hands for Sh.100 each. The debentures will mature in 100 years. The preference shares were issued four years ago and still change hands at face value.

Required:
(i) Compute the component cost of:
– Ordinary share capital; (2 marks)
– Debt capital (2 marks)
– Preference share capital. (2 marks)

(ii) Compute the company’s current weighted average cost of capital. (5 marks)

(iii) Compute the company’s marginal cost of capital if it raised the additional Sh.10 million as envisaged. (Assume a tax rate of 30%). (5 marks)
(Total: 20 marks)

SECTION II

QUESTION FIVE
(a) The CMA (Capital Markets Authority) has put in place several tax incentives to encourage investments in capital markets.
Highlight some of the tax incentives by the Capital Markets Authority. (4 marks)

(b) Explain the benefits that are enjoyed by investors because of the existence of organized security exchanges. (8 marks)

(c) Briefly describe the benefits of the Central Depository System (CDS) to the following stakeholders.
(i) Government; (2 marks)
(ii) Capital Markets Authority and Nairobi Stock Exchange; (2 marks)
(iii) Investors. (2 marks)
(Total: 18 marks)

QUESTION SIX
(a) What are financial intermediaries and what role doe they play in the economy?
(9 marks)

(b) Foreign Direct Investment (FDI) plays a crucial role in revamping less developed economies.

Required:
Write brief notes on the obstacles to the flow of FDI into the Kenyan economy.
(9 marks)
(Total: 18 marks)