CHARTERED ACCOUNTANTS EXAMINATIONS

LICENTIATE LEVEL
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L6: CORPORATE FINANCIAL MANAGEMENT
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FRIDAY 18 DECEMBER 2015
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TOTAL MARKS 100; TIME ALLOWED: THREE (3) HOURS
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INSTRUCTIONS TO CANDIDATES

1. You have fifteen (15) minutes reading time. Use it to study the examination paper
carefully so that you understand what to do in each question. You will be told when to
start writing.

2. This paper is divided into TWO sections:

Section A: Two (2) compulsory questions.

Section B: Three optional questions. Attempt any two (2).

3. Enter your student number and your National Registration Card number on the front of
the answer booklet. Your name must NOT appear anywhere on your answer booklet.

4. Do NOT write in pencil (except for graphs and diagrams).

5. Cell Phones are NOT allowed in the Examination Room.

6. The marks shown against the requirement(s) for each question should be taken as an
indication of the expected length and depth of the answer.

7. All workings must be done in the answer booklet.

8. Present legible and tidy work.

9. Graph paper (if required) is provided at the end of the answer booklet.

10. Formulae, Present Value and Annuity tables are attached at the end of this question
paper.
SECTION A

Attempt both questions in this Section.

QUESTION ONE

Chakosa steel manufacturing Plc owns a machine that can manufacture a maximum of 3,500
units per hour. The initial cost of the machine was K95 million and the current profit margin
before tax is K6 per unit. Following the increasing demand for steel, the Production department
has proposed that the equipment be upgraded in order to meet the demand. An equipment
upgrade can change the maximum capacity of the machine to 5,000 units per hour. The cost of
this upgrade is K65 million, and it is expected that the machine will operate for a period of five
years after which a new major investment will be required. The machine is expected to continue
being operated at the current level of 40 hours per week at full capacity. The historical profit
margins for the past five years are shown below:

Years 1 2 3 4 5
Profit margin per unit (ZMW) 4.4 4.6 4.9 5.4 6.0

Chakosa has eight million shares trading at K15 per share and a 10% redeemable debt trading
at K115, with a book value of K45 million and five years to maturity. The debt was issued at a
par value of K100 and redeemable at a premium of 5%. Chakosa has an asset beta of 0.89.
The risk free rate is 7% and equity premium of 8%.

The profit margin per year is expected to increase in line with the historical profit margin
growth rate. Corporate tax is payable in the year that taxable profits arise at 15% per year.

Assume 365 days in a year.

Required:

(a) Based on the above information, Calculate the following:

(i) Net present value. (15 marks)

(ii) Internal rate of return . (4 marks)
(iii) Sensitivity analysis of discount rate and profit margin before tax. (4 marks)
(iv) Explain the results of each technique in (i) to (iii) above. (4 marks)

(b) State one weakness of each investment appraisal technique in (a) above. (3 marks)
[Total: 30 Marks]
QUESTION TWO

A senior manager in a consulting firm has been assigned two clients that want to improve
management of their working capital. Information on the two corporate clients is as follows:

(a) Sinda Petroleum Services (SPS)

SPS has annual credit sales of K24 million and cost of sales of K12 million. The companys
current assets are comprised of inventory and accounts receivable. Its current liabilities consist
of accounts payable and an overdraft with an annual average interest rate of 15%. The
company allows a credit period of one month to its trade debtors and on average is given a
credit period of two months by its trade creditors. It has a current ratio of 1.4 and an operating
cycle of four months.

(b) Kitwe Bottling Company (KBC)

The following financial information relates to KBC:

Statement of financial position at the current date (extracts)

K000 K000 K000
Non-current assets 50,000
Current assets:
Inventory 8,000
Accounts receivable 12,000
Sub total 20,000
Current liabilities:
Bank overdraft 8,000
Accounts payable 6,000
Sub total 14,000
Net current assets 6,000
Total assets less current liabilities 56, 000

Three months cash flow forecasts from the current date, assuming performance is maintained:
Month 1 Month 2 Month 3
Cash operating receipts (K000) 4,500 4,800 4,000
Cash operating payments (K000) (3,000) (4,000) (3,500)
Quarterly interest on BOZ bonds (K000) (200)
Capital expenditure (K000) (2,000)
KBC has an overdraft facility of K10 million. Interest on the facility is payable at a monthly rate
of 1.5%, with payments made based on the opening balance at the start of each month. Credit
sales for the year to date were K60 million and the cost of sales was K36 million. The level of
credit sales and cost of sales is expected to remain constant in the coming year.

The consultant has reviewed its working capital management practices and has made proposals
to improve accounts receivable days to the average sector value of 42 days. This reduction
would take six months to achieve from the current date, with equal monthly reductions. He also
plans to reduce inventory days by twenty days over a four-month period from the current date.
Changes in credit terms agreed with KBCs major trade creditors will reduce its accounts
payable days to 30 over the next five months. The consultant has also proposed that the capital
expenditure be postponed until a long term loan is secured.

Assume an annual calendar of 360 days.

Required:

(a) For SPS;

(i) Explain two (2) roles of factoring and invoice discounting in the management of
accounts receivables. (4 marks)

(ii) Explain three (3) factors which determine the level of investment in current assets.
(6 marks)

(iii) Calculate the size of its overdraft and the annual cost, and net working capital.
(4 marks)
(b) For KBC

(i) Discuss the role financial intermediaries can play in providing KBC with short-
term finance. (6 marks)

(ii) Prepare a three months cash flow forecast if its current performance is
maintained; and (5 marks)

(iii) Prepare the three months cash flow forecast if the consultants proposals are
implemented immediately. Comment on the improvement in the cash flow
position. (5 marks)

[Total: 30 marks]
SECTION B

Attempt any two (2) questions in this section.

QUESTION THREE

Dorica Plc is a stock exchange listed company that is concerned about its current dividend
policy and higher gearing level as measured by its debt to equity ratio. Dorica Plc issued 1 for 4
rights shares at an exercise price of K2.5 in order to reduce the gearing level. The market value
of its shares immediately prior to the rights issue was K3 per share. Dorica had one million
shares before the issuance of rights shares. Shareholders exercised half of their rights and sold
the reminder.

Required:

(a) Explain the meaning of theoretical ex rights price and why it may differ with the actual
market price of a share. (5 marks)

(b) Calculate the theoretical ex rights price and assess the effect on the shareholders

wealth assuming the actual market value of shares is equal to the theoretical ex rights
price. (9 marks)

(c) Explain three (3) factors that may be considered in formulating the dividend policy for
Dorica Plc. (6 marks)
[Total: 20 Marks]

QUESTION FOUR

(a) Feira Plc will shortly pay its annual dividend in respect of the financial year ended (y/e)
31 December 2013 and has the following financial information:

Number of ordinary shares 50 million

Ordinary market share price (ex div basis) K350

Earnings per share for ( y/e) 2013 K1.00
Proposed payout ratio 40%
Dividend per share for ( y/e) 2009 K0.20
Equity beta 1.5
Average sector price/earnings ratio 8
Risk- free rate of return 15%
Market risk premium 10%
 Required:

Determine the value of Feira Plc and give a possible explanation for the difference
between the computed value and the companys current market value. Use the following
methods:

(i) Price/earnings ratio;

(ii) Dividend growth model; (14 marks)

(b) To raise K250 million Feira Plc has issued a bond that will be redeemed at its par value
of K1,000 in ten years time and pays annual interest of 15%. The current ex interest
market price of the bond is K950. Ignore taxation.

Required:

(i) Compute the cost of the bond. (4 marks)

(ii)Give two (2) reasons different bonds issued by Feira Plc might have different
costs of debt. (2 marks)
[Total: 20 marks]
QUESTION FIVE

A Zambian company, Rhodes Engineering Ltd is considering bidding for a contract to build a
road in the Democratic Republic of Congo (DRC). The countrys currency is the Congolese Franc
(CDF). The tender price for the company to build the road now is estimated to be USD 90
million. A payment of 30% of the tender price will be paid at the start of the project and the
balance after completion in a years time.

(a) The following data is available on exchange and inflation rates:

Bank Currency Spot Forward

rates rates
(mid) (One year)
Bank X ZMW/USD 6.15 6.10
Bank Z ZMW/USD 6.15 6.55
Bank Z ZMW/CDF 0.01 -

Annual inflation rates: %

Zambia 10
USA 3

Annual yield rates on

securities:
Zambia 20
USA 14
The company is considering ways to manage foreign currency risk, given volatility in
international currencies.

Required:

(i) Determine the tender price the company should quote in Kwacha, taking into account
Purchasing Power Parity during execution of the project. (5 marks)

(ii) Explain how Rhodes can set-up a money market hedge to protect itself against adverse
exchange rate movements. (5 marks)

(b) Given the yield rates on securities and forward exchange rates from the two banks:

(i) Validate the forward exchange rates quoted by the two banks using Interest
Rate Parity, and comment on each banks outlook regarding the yield curve.
(6 marks)

(ii) Explain why forecasting future exchange rates using current interest or inflation
rate differentials may not be accurate. (4 marks)
[Total: 20 Marks]

END OF PAPER
 L6: CORPORATE FINANCIAL MANAGEMENT

SUGGESTED SOLUTIONS

DECEMBER 2015 EXAMINATIONS

SOLUTION ONE
a)
i) Net present value

YEAR 1 2 3 4 5

Units (W.1) 3,128,571 3,128,571 3,128,571 3,128,571 3,128,571

Profit per unit by 8% 6.48 7 7.56 8.16 8.82

Profit before tax (Km) 20.27 21.9 23.65 25.53 27.59

Tax @15% (Km) (3.04) (3.29) (3.55) (3.83) (4.14)

Cash flow after tax (Km) 17.23 18.61 20.1 21.7 23.45

Discount @14% (W6) 0.877 0.769 0.675 0.592 0.519

Present values (Km) 15.11 14.31 13.57 12.85 12.17

Total present values = K68.01m

Initial outlay = (K65.0m)

NPV = K3.01m

The NPV is positive and therefore, on financial grounds the upgrade of the machine should be
undertaken.

Workings

1. Additional units per year = (5000 3500) x 40 x 365/7 = 3,128,571

4 6
2. Growth rate = (4.4) 1 = 0.08 0r 8%
3. Cost of debt
Interest = 10% x 100 = 10
=10 x (1 0.15) = 8.5
Year Cash flow Discount@10% PV Discount@5% PV

0 MV (115) 1.000 (115) 1.000 (115)

1-5 Interest 8.5 3.791 32.22 4.329 36.80

5 Redemption 105 0.621 65.21 0.784 82.32

NPV (17.57) 4.12

Cost of debt = 5% + 4.12/(4.12+17.57) (10% - 5%) = 5.95%

4. Market values:
Equity = 8m x 15 = K120m
Debt = 115/100 x K45m = K51.75m
K171.75m
5. Cost of equity
Equity beta: 0.89 = Be x 120/120 +51.75(0.85)
= 1.22
Cost of equity = 7% + 1.22(8%)
= 16.76%
6. WACC = (16.76% x 0.70) + (5.95% x 0.30)
= 13.5% say 14%

ii) Internal Rate of Return (IRR)

Year 0 1 2 3 4 5

Km Km Km Km Km Km

Cash flows (65) 17.23 18.61 20.1 21.7 23.45

Discount@20% 1.000 0.833 0.694 0.579 0.482 0.402

Present values (65) 14.35 12.92 11.64 10.46 9.43

NPV= (6.2)

IRR = 14% + 3.01/ (3.01+6.2) (20%-14%)

= 15.96%

The IRR slightly higher than the cost of capital of 15% and therefore, on financial grounds the
upgrade can be undertaken.
iii) Sensitivity Analysis

Sensitivity analysis of cost of capital = 0.1596 0.14 = 0.0196

= 0.0196/0.14 x 100% = 14%

Sensitivity analysis of profit margin:

Year 1 2 3 4 5

Km Km Km Km Km

Profit margin 20.27 21.9 23.65 25.53 27.59

Discount@14% 0.877 0.769 0.675 0.592 0.519

Present values 17.78 16.84 15.96 15.11 14.32

Total present value = 80.01

Sensitivity of profit margin = 3.01/80.01 x 100% = 3.76%

The cost of capital can increase by 14% before the NPV becomes negative and the profit
margin can slightly reduce by 3.76% before the NPV becomes negative. The profit margin
appears to be more sensitive compare to the cost of capital and management should therefore
pay more attention the profit margin.

b)

Weakness of NPV

i) The net present value is difficult for non-financial managers to understand

ii) The cost of capital used in discounting cash flows may be difficult to estimate
and it changes over the life of the investment.

Weakness of IRR

i) Where cash flows patterns are non-conventional , there may be several IRRs which
affects decision making
ii) The reinvestment assumption underlying the IRR method cannot be substantiated.

Weakness of Sensitivity analysis

i) Sensitivity analysis does not examine the probability that any particular variation in
costs or revenues might occur.
ii) In itself it does not provide a decision rule. Parameters defining acceptability must
be laid down by managers.
SOLUTION TWO

(a)(i) Factoring can assist with managing receivables in the following ways:

Administration & debt collection of the companys sales ledger

Functions such as assessing the creditworthiness of new customers, recording sales,
sending out statements and reminders, collecting payments, identifying late payers
and collection of debts including taking appropriate legal action to recover debts where
necessary.
Financing
The factor can also offer finance to SPS by advancing up to 80% of the face value of
invoices raised for goods sold or services provided. The finance is repaid from the
settled invoices (minus finance costs) when debts are collected.
If factoring is without recourse, the factor provides credit protection to the client
against irrecoverable debts. When the service is with recourse, SPS would bear the
loss from any irrecoverable debt. The factors fee (a percentage of credit sales) will be
comparatively higher with recourse than with non-recourse factoring to reflect the cost
of the insurance offered.
Credit insurance
The factor insures the irrecoverable debts of the client. The factor then determines to
whom SPS offers credit.

Invoice discounting
Finance would be advanced to SPS against the security of invoices raised, rather than
employing the credit management and administration services of a factor.
A number of good quality invoices may be discounted, rather than all invoices, and
the service is usually only offered to companies meeting a minimum turnover
criterion.

(a)(ii) A number of factors determine the level of investment in current assets as follows:

Length of operating cycle

The working capital cycle or operating cycle is the period of time between when a
company settles its accounts payable and when it receives cash from its accounts
receivable. The longer the operating cycle the greater the amount of finance needed by a
company. Companies with comparatively longer operating cycles in the same industry
sector, will therefore require higher levels of investment in current assets.

Terms of trade
These determine the period of credit extended to customers, any discounts offered for
early settlement or bulk purchases, and any penalties for late payment. The more
generous a companys terms of trade are, the higher the investment in current assets.

Strategy for financing working capital

Companies will have different policies regarding the level of investment in current assets,
depending on their attitude to risk and working capital financing strategy. A company
with a comparatively conservative strategy to financing investment in current assets
would maintain higher levels of inventory, offer more generous credit terms and have
 higher levels of cash in reserve than a company with a comparatively aggressive
strategy. While the more aggressive strategy would be more profitable because of the
lower level of investment in current assets, it would also be more risky, for example in
terms of stock outs in periods of fluctuating demand and missing sales by not having
particular goods required by a customer.

Industry in which organisation operates

Another factor that influences the level of investment in current assets is the industry
within which an organisation operates. Some industries will have longer operating cycles
due to the length of time needed to manufacture finished goods and so will have
comparatively higher levels of investment in current assets than industries such as
supermarket chains, where perishables are bought for resale with minimal value addition.

(a)(iii) Calculation of size of overdraft

Inventory period = operating cycle + payables period receivables period = 4 + 2 1 = 5

months

Inventory = 12 m x 5/12 = K5million

Accounts receivable = 24m x 1/12 = K2million

Current assets = 5 + 2 = K7million

Current liabilities = current assets/current ratio = 7million/14 = K5million

Accounts payable = 12m x 2/12 = K2million

Overdraft = 5 2 = K3million

Net working capital = current assets current liabilities = 7 5 = K2million

Short-term financing cost = 3million x 0.15 = K0.45million

(b)(i)

The role of financial intermediaries in providing short-term finance for use by KBC would be
to act as a go between with investors who have surplus cash and the company, as a
borrower in need of financing.

Financial intermediaries aggregate or parcel up small amounts of cash provided by individual

investors, and lend borrowers such as KBC who need large amounts of cash. They would
therefore provide a convenient and readily accessible means for the company to obtain
necessary funds.

Small investors are averse to losing any capital, so financial intermediaries could also
provide risk transformation by assuming the risk of loss on short-term funds borrowed by
KBC, either individually or by pooling risks between financial intermediaries.
 Financial intermediaries also offer maturity transformation, in that savers can deposit funds
with the option of withdrawing them at short notice, while borrowers may require funds for
a fixed term and on a long-term basis, and vice versa. The needs of both KBC as a borrower
and lenders can therefore be satisfied.

(b)(ii)

Cash flow forecast for three months with current performance:

Month 1 2 3
K'000 K'000 K'000
Opening bank balance (8,000) (8,620) (7,949)
Receipts 4,500 4,800 4,000
Payments (3,000) (4,000) (3,500)
Interest on bonds (200)
Overdraft interest (120) (129) (119)
Capital expenditure (2,000)
Net cash flow (620) 671 181
Closing bank balance (8,620) (7,949) (7,769)

(b)(iii)
Cash flow forecast for three months with the consultants proposals implemented:

Month 1 2 3
K'000 K'000 K'000
Opening balance (8,000) (5,887) (4,442)
Receipts 4,500 4,800 4,000
Payments (3,000) (4,000) (3,500)
Interest on bonds (200)
Overdraft interest (120) (88) (67)
Capital expenditure - - -
Reduction in receivables 833 833 833
Reduction in inventory 500 500 500
Reduction in payables (600) (600) (600)
Net cash flow 2,113 1,445 966
Closing balance (5,887) (4,442) (3,476)

Improvements in cash flow position include:

A reduction in KBCS overdraft position for each month
A reduction in the monthly interest paid on the overdraft
Long term finance will be used to finance capex and therefore reducing interest
expenses
Reduction in the overdraft facility and charges
Workings:

Reduction in accounts receivable days

Current accounts receivable days = (12,000/60,000) x 360 = 72 days

Reduction in days over six months = 72 42 = 30 days
Monthly reduction = 30/6 = 5 days
Each receivables day is equivalent to 60,000,000/360 =K166, 667
0R 12,000,000/72 = K166, 667
Monthly reduction in accounts receivables = 5 x 166,667 = K833, 335

Reduction in inventory days

Current inventory days = (8,000/36,000) x 360 = 80 days

Reduction in days over four months = 20 days
Monthly reduction = 20/4 = 5 days
Each inventory day is equivalent to 8,000,000/80 = K100, 000
OR 36,000,000/360 = K100, 000
Monthly reduction in inventory = 100,000 x 5 = K500, 000

Reduction in payable days

Current payable days = (6,000/36,000) x 360 = 60 days

Reduction in days over five months = 60 30 = 30 days
Monthly reduction = 30/5 = 6 days
Each payable day is equivalent to 6,000,000/60 = K100, 000
OR 36,000,000/360 = K100, 000
Monthly reduction in accounts payables = 100,000 x 6 = K600, 000

Overdraft interest calculations

Monthly overdraft interest rate = 1.5%

If current position is maintained:

Period 1 interest = 8,000,000 x 1.5% = K120, 000
Period 2 interest =8,620,000 x 1.5% = K129, 300
Period 3 interest = 7,949,000 x 1.5% = K119, 235

If working capital proposals are effected:

Period 1 interest = 8,000,000 x 1.5% = K120, 000
Period 2 interest =5,887,000 x 1.5% = K88, 305
Period 3 interest = 4,442,000 x 1.5% = K66,630
SOLUTION THREE

a) Theoretical Ex-Rights Price (TERP) is a deemed value which is attributed to a company's

share immediately after a rights issue transaction occurs. In other words it denotes the
'theoretical' worth of a single share of a company immediately after a rights issue. TERP is
lower than the market value of a share prior to the rights issue because shares under rights
issue transactions are normally issued at a discount (price below the prevailing market
price).

Theoretical Ex-Rights Price may differ slightly from the actual market price of the stocks
prevailing after a rights issue due to varying perceptions of market participants concerning
the rights issue and stock market imperfections. This may happen as a result of transaction
costs, speculation or sale of rights over the subscription period.

b) 1 rights issue@K2.5 = 2.5

4 ordinary shares @ K3 = 12
5 14.5

TERP = 14.5/5 = K2.9 per share

Value per rights new share (K2.9 K2.5) = K0.4 per share

Assessment of selling half of the rights and excising half:

K000

Sale value of rights (125 x 0.4) = 50

Market value of shares (1000+ 125) x 2.9 = 3,262.5

3,312.5

Total value of shares cum rights (1000 x 3) = 3,000

Additional investment (125 x 2.5) = 312.5

3,312.5

The investment in the company by shareholders has increased by K312, 500 however; they
neither gained nor lost their wealth.

c)
i) The signaling effect
Assuming a semi-strong form efficient market, the dividend declared by Dorica
can be interpreted as a signal from directors to shareholders about the strength
of underlying project cash flows. Investors usually expect consistent dividend
policy from the company.
 ii) Liquidity
Dividends are cash payments and therefore, Dorica must have enough cash to
pay dividends it declares without compromising its working capital position.
iii) Gearing levels
If the gearing level for Dorica is high, then a low dividend payments can help to
keep retained earnings high which will then reduce the level of gearing as level
of reserves will be higher.

SOLUTION FOUR

(a) (i) Price/earnings ratio method valuation

Earnings per share of Feira Plc = ZMW 1.00

Average sector price/earnings ratio = 8

Implied value of an ordinary share of Feira Plc = 1.00 x 8 = ZMW 800

Number of ordinary shares = 50 million

Value of Feira Plc = 800 x 50m = ZMW 400 million

(a) (ii) Dividend growth model

Earnings per share of Feira = ZMW 1.00

Proposed payout ratio = 40%

Proposed dividend of Feira for y/e 2013 is therefore = 1.00 x 04 = ZMW0.4 per share

Four year average dividend growth rate = (0.4/0.2)1/4 -1 = 11892 -1= 0.1892 or 18.92% =
19%

Cost of equity of Feira using CAPM

= 15 + 15 x (10) = 30%

Value of each ordinary share of Feira Plc using DGM = (0.4 x 119)/(030 019) = ZMW
4.33

Value of Feira plc as a company = 4.33 x 50m = ZMW 216.5 million

The current market capitalization of Feira Plc = ZMW175m (ZMW350 x 50m).

The valuation of Feira Plc using the sector price/earnings ratio is higher at ZMW 216m, than
its current market capitalization of ZMW 175m, implying that Feira Plcs stock is undervalued
 by the market. Its price earnings ratio of 3.5 is lower than that of the sector averaging 8,
indicating that there may be scope for improving its financial performance, hence its
undervaluation.

The difference in valuation could also be explained by either the cost of equity or the
expected dividend growth rate used in the dividend growth model calculation been
inaccurate, or due to some inefficiency in the stock market.

Market sentiment regarding Feiras prospects might result in its undervaluation. For instance
perceptions of potential divestiture by a major investor can reduce the market price of its
stock.

(b)(i)

a) Cash flow DF@13% PV DF@17% PV

0 Market Value (950) 1 (950) 1 (950)

1 -10 Coupon payment 150 5.426 813.9 4.659 698.85

10 Redemption value 1,000 0.295 295 0.208 208

NPV 158.9 NPV (43.15)

Kd = 13% + [158.9/(158.9 + 43.15)*(17 13)] = 13% + 3.14% = 16.14%

(b)(ii) Differences in the cost of debt could be explained by the following reasons:

The duration of the bond - the longer the time to maturity of a debt, the higher will be the
interest rate and the cost of debt. A bond with the greater time to maturity would be
expected to have a higher interest rate and a higher cost of debt.

Liquidity preference theory - suggests that investors require compensation for not having
access to their cash, and so providers of debt finance require higher compensation for
lending for longer periods.

Expectations theory - suggests that the shape of the yield curve depends on expectations as
to future interest rates. At the time of issue if the expectation is that future interest rates will
be higher than current interest rates, the yield curve will slope upwards and vice versa

Market segmentation theory - suggests that future interest rates depend on conditions in
different debt markets, e.g. the short-term market, the medium-term market and the long-
term market. The shape of the yield curve therefore depends on supply and demand for
funds in the market segments.

The size of the debt - the greater the size of a bond issue, the higher the cost of debt.
SOLUTION FIVE

(a)

(i) Using Purchasing Power Parity (PPP):

Future Spot (ZMW/USD) in a year = So x (1 + hc )1 /(1 + hb )1 = 6.15 x (1+
10%)/(1+3%)
= 6.15 x (1.1)1/(1.03)1 = 6.57

Tender Price in Kwacha at spot rate = USD 90 million x 6.15 = ZMW 553.5 million

Tender price in Kwacha taking PPP into account (with 30% payable now and 70%
in a years time)
= [0.3x 90]*6.15 + [0.7 x 90]*6.57 = 166.05 + 413.91 = ZMW 579.96 million

(ii) 1 - The company can set-up a money market hedge, by borrowing Dollar (since
there is a risk that the Kwacha might strengthen, reducing its proceeds in
kwacha).
2 - Then converting the Dollar loan proceeds to Kwacha at the current
sport rate.
3 - The sum to be borrowed plus interest would total the amount of the
Dollar receipts in a years time.
4 - The funds converted to Kwacha at spot would immediately be
available or could be deposited until contract funds are received.
5 - The risk would be realized if the Kwacha was to appreciate against
the Dollar between the contract date and the time of receiving the
contract proceeds.

(b)

(i) Using Interest Rate Parity (IRP):

Future Spot (ZMW/USD) in a year = Fo x (1 + ic )1 /(1 + ib )1 = 6.15 x (1+
20%)/(1+ 14%)

= 6.15 x (1.2)1/(1.14)1 = 6.47

Bank X is expecting and thus quoting a stronger kwacha, while Z Bank is

expecting and quoting a weaker Kwacha during the year.

Bank Xs outlook for inflation and interest rates in Zambia is a reduction relative
to those of the USA. Its expectations are therefore that of a downward (inverted)
sloping yield curve during the year.

On the Contrary, Bank X expects inflation and interest rates in Zambia to

increase relative to those of the USA over the next year. Its outlook is therefore
that of an upward (normal) sloping yield curve.
(ii) Reason include:
Interest rate differentials may change during the year due to various
economic factors and therefore IRP and PPP are a poor unbiased and not
accurate predictors of future exchange rate
They assume movement from an equilibrium, which may not currently be
the case
Other than interest and inflation rates, there are other factors that influence
the Kwachas exchange rate including market operations by BOZ

END OF SOLUTIONS