KARATINA UNIVERSITY

UNIVERSITY EXAMINATIONS
AUGUST 2015/2016 ACADEMIC YEAR

FOR THE DEGREEIN BUSINESS MANAGEMENT

COURSE CODE: BBM 310

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INSTRUCTIONS TO CANDIDATES:

 SEE INSIDE

1
 INSTRUCTIONS: Answer question ONE and any other THREE questions

QUESTION ONE
(a) Highlight four main problems encountered in the construction and use of a stock market indices.
(4 mks)
(b) Differentiate between the following pairs of terms: (6 mks)
(i) (ii) Weighted cost of capital and marginal cost of capital.
(ii) Capital structure and financial structure.
(iii) Formal markets and over-the-counter markets.

(b) The following information was extracted from the books of Poncon Company Ltd on the
existing capital structure of the Company.
Shs.
Ordinary shares at Shs.10 par 1,000,000
Retained 800,000
12% preference shares Shs.10 par 400,000
16% loan Shs.100 par 300,000
Total capital employed 2,500,000

The company’s ordinary shares have a dividend cover of 3 times and pays a dividend of
10% on its ordinary share capital.
Ordinary shares sells at Shs.18
Preference shares sell at Shs.15
Debentures are selling at par.
The tax rate is 30%
Compute.
i) Growth in Equity. (5 mks)
ii) W.A.C.C. (10 mks)

QUESTION TWO
(a) The CMA (Capital Markets Authority) has put in place several tax incentives to encourage
investments in capital markets.
Highlight four tax incentives by the Capital Markets Authority. (4 mks)

(b) Explain the benefits that are enjoyed by investors because of the existence of organized
security exchanges. (5 mks)
(c) Briefly describe the benefits of the Central Depository System (CDS) to the following
stakeholders. (6 mks)
(i) Government;
(ii) Capital Markets Authority and Nairobi Stock Exchange;
(iii) Investors.

2
 QUESTION THREE
(a) Agency theory in finance and business at large is very important in the internal management and
external relationship with other stakeholders. Explain any four of these agency relationships.
(6 mks)
(b) Giving in your country, explain four functions of commercial banks to the economy of your
country. (6 mks)
(c) The Parapet Company Ltd is a medium enterprise with an operating Beta factor of 0.9, the
interest rate on government bonds issued in the present year is 9% and the market rate of return is
12.5%. Using the CAPM market mode, determine the cost of equity Ke, for Parapet company ltd.
(3 mks)
QUESTION FOUR
P. Muli was recently appointed to the post of investment manager of Masada Ltd. a quoted
company. The company has raised Sh.8,000,000 through a rights issue.P. Muli has the task of
evaluating two mutually exclusive projects with unequal economic lives. Project X has 7 years and
Project Y has 4 years of economic life. Both projects are expected to have zero salvage value.
Their expected cash flows are as follows:

Project X Y
Year Cash flows (Sh.) Cash flows (Sh.)
1 2,000,000 4,000,000
2 2,200,000 3,000,000
3 2,080,000 4,800,000
4 2,240,000 800,000
5 2,760,000 -
6 3,200,000 -
7 3,600,000 -
The amount raised would be used to finance either of the projects. The company expects to pay a
dividend per share of Sh.6.50 in one year’s time. The current market price per share is Sh.50.
Masada Ltd. expects the future earnings to grow by 7% per annum due to the undertaking of either
of the projects. Masada Ltd. has no debt capital in its capital structure.
Required:
(a) The cost of equity of the firm. (3 mks)
(b) The net present value of each project. (6 mks)
(c) Briefly comment on your results in (b) above. ( 3mks)
(d) Identify and explain the circumstances under which the Net Present Value (NPV) and the
Internal Rate of Return (IRR) methods could rank mutually exclusive projects in a
conflicting way. (3 mks)

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 QUESTION FIVE
(a) Define a “stock market index.” (2 marks)
(b) Highlight the main problems encountered in the construction and use of a stock market index.
(5 marks)
(c) Explain FOUR uses of security market indices. (8 marks)

QUESTION SIX
(a) Briefly explain the importance of capital budgeting in a business organization. (4 marks)
(b) Alima Ltd., a manufacturer of edible oils, is contemplating the purchase of a new oil
processing machine to replace the existing one. The existing machine was acquired two
years ago at a cost of Sh.4,000,000. the useful life of this machine was originally expected
to be five years with no salvage value, but after a critical analysis, the financial analyst has
now estimated that the machine will have an economic life of ten years with a salvage value
of Sh.500,000. The new machine is estimated to cost Sh.8,000,000 and Sh.400,000 would
be incurred in installing the machine. The new machine is estimated to have a useful life of
ten years. An expert in asset valuation estimates that the existing machine can be sold at
Sh.2,500,000 in the open market. The new machine is expected to lead to increased sales.
To support the increased sales, debtors would increase by Sh.320,000, stock by Sh.140,000
and creditors by Sh.300,000. The estimated profit before depreciation and tax over the next
ten years for the two machines is as given below.
Year New machine Old Machine
Sh. Sh.
1 350,000 280,000
2 400,000 300,000
3 420,000 320,000
4 410,000 340,000
5 410,000 340,000
6 380,000 320,000
7 380,000 310,000
8 350,000 280,000
9 300,000 260,000
10 280,000 240,000
The company’s cost of capital is 10%. Corporation tax applicable is 30%. The company
uses the straight-line method of depreciation.

Required:
(i) Initial investment required replacement of the old machine. (7 mks)
(ii) An evaluation of whether it is worthwhile for to undertake the replacement of
the machine. (8 mks)