Question 1
Advise which projects can be undertaken by the company
(25 marks)
The issue before hand is about project appraisal and capital budgeting. There are basically many
methods to use in financial management to evaluate the viability of projects so as to ration capital
which is always scarce. The methods include non-discounting cash flow methods such as the
Payback period and Accounting rate of return. The discounted cash flow methods include internal
rate of Return and Net present value to mention just a few. However, amongst all these methods,
the net present value enjoys most of the advantages over the other methods.
To establish how the scarce capital, that is, $90 000.00 should be rationed to the three projects,
there is need to establish the project which is most rewarding and all the projects will be ranked in
that fashion. After ranking the available capital will be paid in accordance to that ranking.
Calculation of Net Present value of Project A
PROJECT A
Investment
Cash flows before tax
Tax @ 30%
YEAR 0
40,000.00
Present values
40,000.00
1
40,000.00
NPV
10,717.59
Totals
DCF @ 20%
YEAR 1
YEAR 2
YEAR 3
30,000.00
-9000.00
35,000.00
-10500.00
40,000.00
-12000.00
21,000.00
0.833333333
17,500.00
24,500.00
28,000.00
0.694444444 0.578703704
17,013.89
16,203.70
Calculation of Net Present value of Project B
PROJECT B
Investment
YEAR 0
40,000.00
Cash flows before tax
Tax @ 30%
Present values
40,000.00
1
40,000.00
NPV
3,344.91
Totals
DCF @ 20%
YEAR 1
YEAR 2
YEAR 3
25,000.00
7,500.00
30,000.00
9,000.00
35,000.00
10,500.00
17,500.00
0.833333333
21,000.00
24,500.00
0.694444444 0.578703704
14,583.33
14,583.33
14,178.24
Calculation of Net Present value of Project B
PROJECT B
Investment
YEAR 0
-45,000.00
Cash flows before tax
Tax @ 30%
YEAR 1
YEAR 3
25,000.00
-7,500.00
30,000.00
-9,000.00
35,000.00
-10,500.00
21,000.00
0.694444444
24,500.00
0.578703704
14,583.33
14,178.24
Totals
DCF @ 20%
-45,000.00
1
17,500.00
0.833333333
Present values
-45,000.00
14,583.33
NPV
YEAR 2
-1,655.09
From the above calculations it is established that Project A has a higher positive NPV at
$10 717.59 followed by project B with a positive NPV of $3 344.91 and that Project C has a
negative NPV of $1 655.09. Furthermore, the decision rule of NPV is to accept projects with
positive NPV and to reject projects with negative NPV.
Basing on the above calculations it can be established that the Company will channel the available
funds ($90 00.00) to project A and project B only. The remaining $10 000.00 can be invested and
earn interests since the NPV decision rule rejects projects with negative NPV. Additionally, even
if it is established that project C is a divisible project, the decision rule rejects it outright.
Question 2
(a) What is a Derivative
A derivative is defined as an underlying security to provide contracts with specific terms
including fixed values or fixed time periods. In investing, derivatives typically fall into four
major categories: futures, forwards, swaps and options.
(b) Which are the general characteristics of call option?
By the definition a call option is a contract that confers the right, not the obligation, to buy
or sell an asset at a given price on or before a given date.
The under listed are the major characteristics of call option.
 An Option does not obligate the buyer to buy the underlying asset but requires the
seller to sell the asset if the former exercises the options contract.
 The time to exercise the option to buy the asset can be three months-1 year before
contract maturity.
 An option allows the trader to exercise the option, let the option expire, or sell the
option depending on their option trading strategy.
 At expiration, if the underlying asset price rises above the strike price, the buyer
makes a profit minus premium, whereas if it falls, the buyer loses the premium.
 The seller collects the premium in either case.
(c) A 20% Bond has a per value of $500,000 with a maturity of 5 years. Calculate the
present value of the bond if the required return is 30%
Calculation of annual interest
20% X 500 000 = $100 0000
Calculation of DCF and PVAF
DCF = (1+r)^-n
= (1.3) ^-5
= 0.26932
Annuity Factor for 5 Years
PVAF = [1- (1+r) ^-n]/ r
= [1- (1.3)^-5]/0.3
= 2.43556
Cash flow
DCF/PVAF @
30%
Present
Value
Bond
500,000.00
0.269329074
134,664.54
Interest
100,000.00
2.435569752
243,556.98
Present Value of
Bond
378,221.51
(3 marks)
d) An investor deposits $250,000 per annum for 5 years into an account that earns 20%
per annum compounded. The first deposit is made at the beginning of the first year. What
is the future value of the investment at the end of the years
YEAR
1
2
3
4
5
TOTAL
CASHFLOW COMPOUNDED20%
250,000.00
2.48832
250,000.00
2.0736
250,000.00
1.728
250,000.00
1.44
250,000.00
1.2
(3 marks)
COMPOUNDED
VALUE
622,080.00
518,400.00
432,000.00
360,000.00
300,000.00
2,232,480.00
Question 3
a) There are types of foreign exchange risk which organisations can encounter on
international trade. Mention and explain 3 types of foreign exchange risk
(3 marks).
Transaction risk
Transaction risk is the risk faced by a company when making financial transactions
internationally. The risk is posed by the change in the exchange rate before transaction
settlement.
Economic risk
This is the risk that a company’s market value is impacted by unavoidable exposure to
exchange rate fluctuations. This exposure to risk is usually created by macroeconomic
conditions such as geopolitical instability and/or government regulations.
Translation risk
Translation risk entails the risk faced by a company headquartered domestically but
conducting business in a foreign jurisdiction, and of which the company’s financial
performance is denoted in its domestic currency. Translation risk is mainly met when the
company is consolidating the results of foreign subsidiaries with the accounts of the parent.
b) Mention and explain at least 3 ways of reducing transaction exposure.
(3 marks)
Risk Shifting
The firm can completely avoid transaction exposure by not involving itself in foreign
exchange at all. All the transactions can be conducted in the home currency. However, this
is not possible for all types of businesses.
Currency Risk Sharing
The parties involved in the deal can have the understanding to share the transaction risk.
This can be done through use of options, forwards and futures.
Leading and Lagging
Leading and lagging entails manipulating currency cash flows in accordance with the
fluctuations, that is, by paying off liabilities when the currency is appreciating is known as
leading. While collecting receivables when the currency is at a low value is called lagging.
c) (i) Calculate Return on Capital employed (ROCE)
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑏𝑒𝑓𝑜𝑟𝑒 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑎𝑛𝑑 𝑡𝑎𝑥
𝑥 100
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑚𝑝𝑙𝑜𝑦𝑒𝑑
50000
=500000 𝑥100
(2 marks)
= 10%
The company’s investment in capital yields a 10% return. However it is worth to note that
the calculation used the given profit after tax instead of the profit before interest and tax
due to scant information provided.
(ii) Earnings per share (EPS)
(2 marks)
𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 − 𝑃𝑟𝑒𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠
𝑊𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑜𝑓 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 𝑠ℎ𝑎𝑟𝑒𝑠
$50 000
10 000
= $5 or 500 cents
(iii) Price earnings ratio (PE ratio)
(1 marks)
𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒/𝑠ℎ𝑎𝑟𝑒
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
=
$5
$5
=1
A price earnings ratio of 1 means that the shares are correctly valued.
(iv) Dividend per share
(1 marks)
𝐴𝑛𝑛𝑢𝑎𝑙 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑
𝑊𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑜𝑓 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 𝑜𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝑠ℎ𝑎𝑟𝑒𝑠
=
$5 000
10 000
= $0.50 or 50 cents
(v) Dividend pay-out ratio
(2 marks)
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑒𝑟 𝑆ℎ𝑎𝑟𝑒
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
50 𝑐𝑒𝑛𝑡𝑠
= 500 𝑐𝑒𝑛𝑡𝑠
= 0.1