Advanced financial management revision question and answer

Advanced Financial Management Block Revision Mock Exams

The Moon Company Ltd. has issued 10,000,000, Sh. 10 par equity shares which are at present selling for Sh. 30 per share. It has also issued 5,000,000 warrants, each entitling the holder to buy one equity share. The warrants are protected against dilution.

(a) The company has plans to issue rights to purchase one new equity share at a price of Sh. 20 per share for every four shares held.

(i) Calculate the theoretical ex-rights price of Moon Company Ltd.‟s equity shares.
(ii) The theoretical value of a right of the Moon Company Ltd. before the shares sell ex- rights.

(b) The chairman of the company receives a phone call from an angry shareholder who owns 100,000 shares. The shareholder argues that he will suffer a loss in his personal wealth due to this rights issue, because the new shares are being offered at a price lower than the current market value.

The chairman assures him that his wealth will not be reduced because of the rights issue, as long as the shareholder takes appropriate action.

(i) Explain whether the chairman is correct. What should the shareholder do?
(ii) A statement showing the effect of the rights issue on this particular shareholder‟s wealth, assuming:
• He sells all the rights.
• He exercises one half of the rights and sells the other half.
• He does nothing at all.
(iii) Are there any real circumstances which might lend support to the shareholder‟s claim?

(c) As a senior financial analyst of an investment bank, you are charged with the responsibility of estimating the expected returns of various securities. One o the securities you want to estimate is expected return in Alpha Steel works Ltd.

You have decided to use arbitrage pricing model and you have derived the following estimates for the factor betas and risk premiums.

(i) Identify the risk factor for Alpha Steel Works Ltd.

(ii) If the risk free rate is 5%, estimate the expected return on Alpha Steel Works Ltd.

(d) On the basis of a one-factor model, Mwangi assumes that the risk free rate is 6% and the expected return on a portfolio work unit sensitivity to the factor is 8.5%. Consider a portfolio of two securities with the following characteristics:

According to the arbitrage pricing theory, what is the portfolio‟s equilibrium expected
(a) (i)The firm will make a one for four rights issue

The chairman is right. If the market is efficient, there is no dilution in wealth if the shareholder either exercises the rights or sells the rights.

Wealth is diluted if the rights issue is ignored.

(ii) Wealth before rights issued = 100,000 shares x 30 = Sh 3,000,000

The investor has 100,000 rights attached to 100,000 shares and priced at Sh 2.00 per right.

After the rights issue, shares will sell at Sh 28.00

Exercise one – half of the rights and sell the other half


Do nothing (ignore rights issue)

The investor will remain with the original 100,000 shares valued at sh. 28 each after rights issue Net wealth = sh 28 x 100,000 = sh 2,800,000

(iii) It is possible for the shareholder‟s claim to be realistic if

The new capital raised is not invested but is misused

If the new capital is invested in a project whose rate of return is lower than the firm‟s cost of capital

If the market is inefficient and ex – right M.P.S is infact not sh 28 hence loss in wealth of investors who exercise the right.

If market is efficient and the project is highly profitable, the future share price will raise leading to increase in wealth of the investor.

(c) (i) If market is efficient as assumed arbitrage pricing Model (APM), the risk factor is 1.0

  • Risk premium = (ERA– Rf)

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