QUESTION ONE (TOTAL 20 MARKS)

(a).The following extract explains Kamaus comments on his life circumstances and investment outlook.

I must support my parents who live overseas on Fiji Island. The Fiji Island economy has grown rapidly over the past two years with minimal inflation, and consensus forecasts call for a continuation of these favourable trends for the foreseeable future. Economic growth has resulted from the export of a natural resource used in an exciting new technology application.

I want to invest 10% of my portfolio in Fiji Island Government Bonds. I plan to purchase long-term bonds because my parents are likely to live more than 10 years. Experts uniformly do not foresee a resurgence of inflation on Fiji Island, so I am certain that the total returns produced by the bonds will cover my parents spending needs for many years to come. There should be no exchange rate risk because the bonds are denominated in local currency. I want to buy the Fiji Island bonds but am not willing to distort my portfolios long-term asset allocation to do so. The overall mix of stocks, bonds, and other investments should not change. Therefore, I am considering selling one of my Kenyan bond funds to raise cash to buy the Fiji Islands bonds. One possibility is my High Yield Bond Fund, which has declined 5% in value year to date. I am not excited about this funds prospects; in fact, I think it is likely to decline more, but there is a small probability that it could recover very quickly. So, I have decided instead to sell my Core Bond Fund that has appreciated 5% this year. I expect this investment to continue to deliver attractive returns, but there is a small chance this years gains might disappear quickly.

Once that shift is accomplished, my investments will be in great shape. The sole exception is my Small company Fund, which has performed poorly. I plan to sell this investment as soon as the price increases to my original cost.

Required:

(i). Identify two behavioural biases illustrated in Kamaus comments and describe each of the biases using illustrations from the passage. (6 MARKS)

(ii). Discuss how an investor practicing traditional finance would challenge each of these biases. (4 MARKS)

(b). Major Ltd is acquiring Minor Ltd. The following are relevant financial data for the two companies.

Major Ltd Minor Ltd

Number of shares (millions) 8.50 2.50

Total market capitalisation (in shs. Millions) 450 75

Profit after tax (Kshs in Millions) 33.13 8.75

Earnings per share 8.75 7.50

Net sales (Kshs in Millions) 380 75

Dividend per share 6.30 5.60

Post merger Market price per share 65 -

Required:

(i).Determine the post-merger weighted price earnings ratio. (1 MARKS)

(ii). Explain the bootstrapping phenomenon using Major Ltd and Minor Ltd. (5 MARKS)

(iii). What would be the effect on earnings growth if Major Ltds earnings per share is expected to grow at 9% and Minors Ltd at 5 %. (4 MARKS).