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SUGGESTED ANSWERS EXTRA ATTEMPT, MAY 2014 EXAMINATIONS 1 of 9STRATEGIC FINANCIAL MANAGEMENT SEMESTER-5

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DISCLAIMER:The suggested answers provided on and made available through the Institute s website may only be referred, relied upon or treated as a guide and substitute for professionaladvice. The Institute does not take any responsibility about the accuracy, completeness or currency of the information provided in the suggested answers. Therefore, the Institute isnot liable to attend or receive any comments, observations or critics related to the suggested answers.

Q. 1 (a) Attending six (6) training courses per year: Rs. 000

YearTravel and

AccommodationCourseCosts

Total CashFlows

DiscountFactor

PresentValue

1 15,660 2,115 17,775 0.877 15,589 1

2 16,443 2,168 18,611 0.769 14,312 1

3 17,265 2,222 19,487 0.675 13,154 1

4 18,128 2,278 20,406 0.592 12,080 1

5 19,035 2,335 21,369 0.519 11,091 1

66,225

Workings:

Travel and accommodation: Rs. 000

Year-1 26,100 x 100 scholars x 6 courses 15,660

Year-2 15,660 (1.05) 16,443

Year-3 16,443 (1.05) 17,265

Year-4 17,265 (1.05) 18,128

Year-5 18,128 (1.05) 19,035 2

Course cost: Rs. 000

Year-1 352,500 x 6 courses 2,115

Year-2 2,115 (1.025) 2,168

Year-3 2,168 (1.025) 2,222

Year-4 2,222 (1.025) 2,278

Year-5 2,278 (1.025) 2,335 2

Proposed e-learning solution: Rs. 000

Year 0 1 2 3 4 5

Hardware 45,000 (1,500)

Software 1,050 1,050 1,050 1,050 1,050

Technical manager 900 954 1,011.24 1,071.91 1,136.23 1

Camera and sound 720 720 763.20 808.99 857.53 1

Trainers and course material 360 381.60 404.50 428.77 454.49 1

Broadband connection 900 855 812.25 771.64 733.06 1

46,050 3,930 3,960.60 4,041.19 4,131.31 1,681.31 1

Discount factor 1.000 0.877 0.769 0.675 0.592 0.519

Present value 46,050 3,446.61 3,045.70 2,727.80 2,445.74 872.60 1

Total present value = Rs. 58,588,446The e-learning system is recommended since it has the lowest present value. 1

Notes:

Depreciation is not a relevant cost and should not be included in the analysis.

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(b) Three alternative current assets financing policies:

(1) A moderate approach:

Here, the current asset financing involves matching the maturities of assets andliabilities, so that temporary current assets are financed with short-term nonspontaneous debt and permanent current assets are financed with long-term debt orequity, plus spontaneous debt. 1

(2) Aggressive approach:Under this approach, some permanent current assets, and perhaps even some fixedassets, are financed with short-term debt. 1

(3) A conservative approach:

Would be to use long-term capital to finance all permanent assets and some of thetemporary current assets. 1

(c) Good Health Ltd.Alternative Balance Sheets Rs. 000

Restricted (40%) Moderate (50%) Relaxed (60%)

Current assets 2,400 3,000 3,600 1Fixed assets 1,200 1,200 1,200 1

Total assets 3,600 4,200 4,800 1

Debt 1,800 2,100 2,400 1

Equity 1,800 2,100 2,400 1

Total liabilities and equity 3,600 4,200 4,800 1

OR 2 + 2 + 2 = 6

Good Health Ltd.Alternative Income Statements Rs. 000

Restricted Moderate RelaxedSales 6,000 6,000 6,000

EBIT 900 900 900 1

Interest (10%) 180 210 240 1

Earnings before taxes 720 690 660 1

Taxes (40%) 288 276 264 1

Net income 432 414 396 1

ROE432

1,800

414

2,100

396

2,400

24.0% 19.7% 16.5% 1

OR 2 + 2 + 2 = 6

(d) The NPVs, are calculated as follows:

For Model-S: Rupees

Year Cash Flow Discount Factor @ 10% PV

0 (200,000) 1.000 (200,000)

1 2 120,000 1.736 208,320

NPV 8,320 1

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For Model-L: Rupees

Year Cash Flow Discount Factor @ 10% PV

0 (200,000) 1.000 (200,000)

1 4 67,000 3.170 212,390

NPV 12,390 1

However, if we make our decision based on the raw NPVs, we would be biasing thedecision against the shorter model. Since the models are expected to be replicated,repeated after 2 years as under: Rupees

Year Cash Flow PV Factors @ 10% PV

0 (200,000) 1.000 (200,000)

1 120,000 0.909 109,080

2 (200,000) + 120,000 0.826 (66,080)

3 120,000 0.751 90,120

4 120,000 0.683 81,960

NPV 15,080

Thus, when compared over a 4-year common life, Model-S has the higher NPV, hence itshould be chosen.

(e) If the cost of Model-S is expected to increase, the replication model is not identical to theoriginal, and we would put the cash flows on a time line as follows: Rupees

Year Cash Flow PV Factors @ 10% PV

0 (200,000) 1.000 (200,000)

1 2 120,000 1.736 208,320

2 (210,000) 0.826 (173,460)

3 4 120,000 1.434 172,080

Common life NPV 6,940

Common life NPVS = 6,940

With this change, the common life NPV of Model-S is less than that for Model-L, andhence Model-L should be chosen. 1

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Q. 2 (a) Gearing and interest cover ratios:

Prior charge capitalGearing =

Shareholders funds

5002015 =

893.6= 56.0%

500

2016 = 875.8 = 57.1%

5002017 =

863.8= 57.9%

These are slightly below the covenant level of 60% and therefore appear acceptable.However, it would only take a fall of Rs.5 million per annum in shareholder funds forgearing to rise to an unacceptable level.

Interest cover: Rs. in million

Interest on debentures (14% x 300 m) 42

Interest on bank loans (10% x 200 m) 20

Total interest 62

2322015 =

62= 3.74 times

2002016 =

62= 3.23 times

2162017 =

62= 3.48 times

The covenant for EBIT/ total interest is 3.5 times so interest cover falls below acceptablelimits in 2016 and 2017.

There is a significant risk that XYZ will breach the debenture covenants so urgentaction is required to obtain alternative finance or restructure the business to

improve gearing and interest cover.

(b) Cost of debt for existing debenture: Rs. 000

YearCashFlow

DiscountFactor @ 3%

PVDiscount

Factor @ 6%PV

0 Market value (240.00) 1.000 (240.00) 1.000 (240.00) 1

1 4 Interest (after tax) 18.20 3.717 67.65 3.465 63.06 1

4 Capital repayment 200.00 0.888 177.60 0.792 158.40 1

5.25 (18.54)

After tax cost of debt = 3% + 18.545.25

5.25

!

(3%)

= 3% +23.79

5.25 (3%)= 3% + 0.66% = 3.66% 1

= 3.66%

Pre-tax cost of debt =0.35-1

3.66 = 5.63% 1

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Cost of debt for a 10% pre-tax bank loan: Rs. 000

YearCashFlow

DiscountFactor @ 6%

PVDiscount

Factor @ 8%PV

0 Loan (240.00) 1.000 (240.00) 1.000 (240.00) 1

1 4 *Interest (after tax) 15.60 3.465 54.05 3.312 51.67 1

4 Loan repayment 240.00 0.792 190.08 0.735 176.4 1

4.13 (11.93)

*240 x 0.10 = 24 (1-0.35) = 15.6

After tax cost of loan = 6% +11.934.13

4.13

!(2%)

= 6% +16.06

4.13 (2%)= 6% + 0.5% = 6.5% 1

Pre-tax cost of loan =0.35-1

6.5 =

0.65

6.5 = 10.0%

Decision:The debenture is therefore cheaper than the proposed replacement bank loan.

(c) Issue Price of proposed rights issue:

Current number of shares =10

400 = 40 million 1

Number of new shares to be issued =4

40 = 10 million 1

Rs.200 million is needed so theissue price

=sharesmillion10

million200Rs. = Rs.20 per share 1

Rupees

4 shares @ Rs.30 120

1 share @ Rs.20 20

140 1

Ex-right price (140 5) 28 1

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Q. 3 (a) (i) Alpha Ltd.s cost of capital:

Since the profits and dividends are expected to remain constant the formula Vo=i

Dis

applicable. Where Vo = ex div share price, d = dividend per share and i = cost ofordinary share capital.

Annual profit = Rs. 5,000,000

.. Dividend per share =1,000,0005,000,000 = Rs.5 per share 1

Market price = Rs.30 per share cum div

Ex-dividend = Rs.30 Rs.5 = Rs.25 per share 1

Applying above formula = 25 =i

5

Cost of equity (i) =25

5 = 0.2 or 20% 1

(ii) Beta Ltd. Ordinary share capital:

Rupees

Annual profit 5,000,000

Less: Debenture interest 1,500,000

Available for dividends 3,500,000 1

.. Dividendper share 3.5 1

Applying above formula = 14 =i

3.5

Cost of equity (i) =14

3.5 = 0.25 or 25% 1

(iii) Beta Ltd.

Weighted average cost of capital:Market Value

SourceRs. 000 Proportion

Cost of Capital(%)

WACC (%)

Equity 14,000 0.528 25 13.20 1

Debentures 12,500 0.472 12 5.66 1

26,500 1.000 18.86

(iv) Summary of results:

Company Cost of Equity WACC

Alpha Ltd. 20% 20.00%

Beta Ltd. 25% 18.66%

(b) The difference in the cost of ordinary share capital must be entirely explained in terms ofthe different gearing of the two companies. The effect of the higher gearing of Beta Ltd., isto increase the level of financial risk and, therefore, decrease the relative attractiveness ofthe ordinary shares. 1

This may be explained in terms of the objectives with which investors acquire and holdordinary shares. In the first place investors will seek to maximize their return. However, atthe same time investors are in general averse to risk and, therefore, will seek to minimizethe uncertainty inherent in those returns. Uncertainties may be explained in terms of the

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variance of the returns about their expected values.

Because, investors are averse to such uncertainty, they will demand a higher rate of returnto compensate them for the higher level of uncertainty. This clearly explains why the costof equity of Beta Ltd., (25%) is higher than that of Alpha Ltd., (20%). 1

(c) Improve in annual income of Mr. Siddiqui:

(i) Present annual income = 100,000 x Rs.3.5 = Rs. 350,000

(ii) Market value of holding = 100,000 x Rs.14 = Rs.1,400,000

(iii) Amount to be borrowed: Mr Siddiquis level of risk willbe unchanged if he employspersonal gearing to the same extent as Beta Ltd., i.e., so that debt is 47.2% of totalcapital and own funds are in the ratio 12,500 : 14,000. Amount to be borrowed is,therefore:

=1,400

1,250x 1,400,000 = Rs.1,250,000 1

(iv) Number of shares to be purchased:

Total capital available = 1,400,000 + 1,250,000 = Rs.2,650,000 1

Number of shares in Alpha Ltd., which can be purchased (ex div):

=25

2,650,000 = 106,000 shares 1

(v) Annual income following the scheme: Rupees

Dividend receipts 106,000 at Rs.5 530,000

Less: Interest at 12% on Rs.1,250,000 150,000

Net income 380,000 1

Mr. Siddiquis annual income would therefore increase by Rs.30,000 (380,000

350,000) or 8.6% [(350,000

30,000x 100)] as a result of the scheme.

1

Reservations:

(a) The level of gearing in Beta Ltd high. By adopting a similarly high personal level ofgearing Mr. Siddiqui is accepting a high risk from which he has no limited liability.

(b) Mr. Siddiqui may find it difficult to borrow such a large sum unless he providesadditional security. The cost may well be greater than the companys borrowing rate.

(c) Other investors may see the possibility of providing additional income by the sameprocess thus increasing the share price of Alpha Ltd., Mr. Siddiqui may therefore be

required to pay the higher price thus reducing his anticipated increase.

(d) Transaction costs have been ignored.

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Q. 4 (a) The estimated required rate of return for the acquisition is:

Blue Ltd. = Rf + (Rm Rf)

= 0.09 + (0.14 0.09)(0.80) = 0.13 2

Using this rate to discount the net cash flows, we obtain: Rupees

Years Net Cash Flow Present-Value Factor Present Value

1 5 100 3.5172 351,720 16 10 180 (5.4262 3.5172) 343,620 1

11 ! 260 [(1/0.13) 5.4262] 589,188 1

1,284,528 1

The maximum price that should be paid is Rs.1,284,528.

(b) To pay this price, the assumptions of the CAPM must hold. The company is being valuedaccording to its systematic risk only. The effect of the acquisition on the total risk of BlueLtd., Company is assumed not to be a factor of importance to investors. Additionally, weassume that the measurement of beta is accurate and that the estimates of R fand Rmare

reasonable. 1

Q. 5 (a) Replacement cost value: Rupees

Owners Equity 908,200

Free hold land and buildings (1,000,000 651,600) 348,400 1

Furniture and fixtures (200,000 521,280) (321,280) 1

Motor vehicles (250,000 130,320) 119,680 1

Inventory and work in progress (1,100,000 1,031,800) 68,200 1

1,123,200

(b) Realisable value: Rupees

Owners Equity 908,200

Free hold land and buildings (550,000 651,600) (101,600) 1

Furniture and fixtures (250,000 521,280) (271,280) 1

Motor vehicles (100,000 130,320) (30,320) 1

Inventory and work in progress (1,140,000 1,031,800) 108,200 1

Accounts receivable (1,490,000 x 0.02) (29,800) 1

583,400

(c) Looking at dividend growth over the past five years we have dividend of Rs.41,000 andRs.50,000 for year 2010 and 2014 respectively. If the annual growth rate in dividends isg.

50,000(1 + g)4 =

41,000= 1.2195

1 + g = = 1.0508

g = = 0.0508, say 5% 2

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Expected dividendMarket value ex-dividend =

0.12 g

50,000(1.05)=

0.07= Rs.750,000 2

(d) P/E ration model:

Comparable quoted companies to Friends Engineering Ltd have P/E ratios of about 10.Friends Engineering Ltd is much smaller and being unquoted, its P/E ratio would be lessthan 10, but how much less?

P/E ratio of 5, market value (104,400 x 5) 522,000

P/E ratio of 10 x 2/3, market value (104,400 x 10 x 2/3) 696,000

P/E ratio of 10, market value (104,400 x 10) 1,044,000 2

THE END

15-AF-503-SFM_ans

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