a) Citing two examples, briefly explain the term agency costs. [2 marks]

(b) Describe four ways that could be used to mitigate agency conflict between managers and shareholders. [8 marks]

(c) A firm is considering the following investment projects:

Cash flows (Sh.)ProjectYear 0Year 1Year 2Year 3A1,000,000500,000500,000-B1,000,000-650,000850,000C1,000,000300,000500,0001,000,000D1,000,000800,000400,000400,000

The firms opportunity cost of capital is 15%.

Required:

(i) Rank the projects using payback period. [3 marks]

(ii) Rank the projects using Net Present Value (NPV) method. [3 marks]

(d) Explain the requirements in favour of a stable dividend policy. [4 marks]

(e) James Chimende is considering the purchase of a 4-year Sh. 1,200,000 par value bond. The bond has a coupon interest rate of 10% per annum.

Required:

The current value of the bond. [3 marks]

(f) The objective of financial management is to maximize the value of the firm.

Required:

Explain how the achievement of this objective might be compromised by the conflict which may arise between the various stakeholders in the organization. [3 marks]

(g) Malikia Guyo borrowed Sh. 1,000,000 from Huduma Bank at an annual compound interest of 14% on reducing balance basis. The loan was repayable in annual instalments over a period of four years. The instalments were payable at the end of the year.

Required:

A loan amortization schedule. [4 marks]

QUESTION TWO (15 MARKS)

(a) Discuss the conflicts that might arise among the objectives of working capital management. [4 marks]

(b) Zedi Ltd. is forecasting a growth rate of 12% per annum for the next 2 years. The growth rate is likely to fall to 10% for the third and fourth years. After that the growth rate is expected to stabilize at 8% per annum. The company has just paid a dividend of Sh. 1.50 per share and the investors required rate of return is 16%.

Required:

The intrinsic value per share of Zedi Ltd. [6 marks]

(c) Outline the reasons that may constrain a company from paying dividends to its shareholders at the end of a financial year. [5 marks]

QUESTION THREE (15 MARKS)

(a) Explain the key issues to be considered by a financial manager in the day to day operations of an enterprise. [5 marks]

(b) XYZ Ltd. is considering three possible capital projects for next year. Each project has a one year life, and project returns depend on next years state of the economy.

The estimated returns are shown in the table below:

State of economyProbability of occurrenceReturn of return ABCRecession0.2510%9%14%Average0.5014%13%12%Boom0.2516%18%10%

Required:

(i) Compute the expected return of each project. [3 marks]

(ii) Compute the standard deviation of each project. [6 marks]

(iii) Based on relative risk, which security would you recommend? [1 mark]

QUESTION FOUR (15 MARKS)

(a) Explain why capital budgeting decisions are important. [5 marks]

(b) Aqua Ltd. has a proposal for a project whose cost is Sh. 50 million and has an economic useful life of 5 years. It has a nil residual value. The earnings before depreciation and tax expected from the project are as follows:

Year Earnings before depreciation and tax Sh. 000112,000215,000318,000420,000522,000

The corporate tax rate is 30% and depreciation is on a straight line basis.

Required:

The accounting rate of return. [5 marks]

(c) Explain the purpose of financial ratio analysis and why a careful reading of the financial statements is not enough. [5 marks]

QUESTION FIVE (15 MARKS)

(a) Rock Ltd. is planning to issue 10 million Sh. 0.25 shares with a current market price of Sh. 1.55 cum-dividend. An annual dividend of Sh. 0.09 has been proposed. The company earns an accounting rate of return on equity (R.O.E) of 10% and a dividend payout of 40%. The company also has 13% Sh. 100 redeemable debentures with a nominal value of Sh. 7 million, trading at Sh. 105. The debentures are due to be redeemed at par in five years time.

Assume a corporate tax rate of 30%.

Required:

The weighted average cost of capital (WACC) of the company. [5 marks]

(b) Explain the meaning of the term cost of capital. [2 marks]

(c) AQMW Systems, a medium sized software company that is contemplating to undertake two projects: Project A requires an initial investment of Sh. 42 million and Project B requires an initial investment of Sh. 45 million. The firms required rate of return is 10%. The projected relevant cash flows for the two projects are shown below:

Project AProject BInitial investmentSh. 42 millionSh. 45 millionOperating cash flow Year 1Sh. 14 millionSh. 28 millionYear 2Sh. 14 millionSh. 12 millionYear 3Sh. 14 millionSh. 10 millionYear 4Sh. 14 millionSh. 10 millionYear 5Sh. 14 millionSh. 10 millionAverageSh. 14 millionSh. 14 million

Required: Calculate for each project:

(i) The net present value. [4 marks]

(ii) The internal rate of return. [4 marks]