SUGGESTED ANSWERS EXTRA ATTEMPT, MAY 2014 EXAMINATIONS 1 of 9
STRATEGIC FINANCIAL MANAGEMENT SEMESTER-5
Marks
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Q. 1 (a) Attending six (6) training courses per year: Rs. 000
Year Travel and Accommodation Course Costs Total Cash Flows Discount Factor Present Value
Total present value = Rs. 58,588,446 The 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.
SUGGESTED ANSWERS EXTRA ATTEMPT, MAY 2014 EXAMINATIONS 2 of 9 STRATEGIC FINANCIAL MANAGEMENT SEMESTER-5 Marks
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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 and liabilities, so that temporary current assets are financed with short-term non spontaneous debt and permanent current assets are financed with long-term debt or equity, plus spontaneous debt. 1 (2) Aggressive approach: Under this approach, some permanent current assets, and perhaps even some fixed assets, 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 the temporary 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 1 Fixed 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
SUGGESTED ANSWERS EXTRA ATTEMPT, MAY 2014 EXAMINATIONS 3 of 9 STRATEGIC FINANCIAL MANAGEMENT SEMESTER-5 Marks
DISCLAIMER: The suggested answers provided on and made available through the Institutes website may only be referred, relied upon or treated as a guide and substitute for professional advice. The Institute does not take any responsibility about the accuracy, completeness or currency of the information provided in the suggested answers. Therefore, the Institute is not liable to attend or receive any comments, observations or critics related to the suggested answers.
However, if we make our decision based on the raw NPVs, we would be biasing the decision against the shorter model. Since the models are expected to be replicated, repeated after 2 years as under: Rupees
Thus, when compared over a 4-year common life, Model-S has the higher NPV, hence it should be chosen.
(e) If the cost of Model-S is expected to increase, the replication model is not identical to the original, 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, and hence Model-L should be chosen. 1
SUGGESTED ANSWERS EXTRA ATTEMPT, MAY 2014 EXAMINATIONS 4 of 9 STRATEGIC FINANCIAL MANAGEMENT SEMESTER-5 Marks
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Q. 2 (a) Gearing and interest cover ratios:
Prior charge capital Gearing = Shareholders funds
500 2015 = 893.6
= 56.0%
500 2016 = 875.8
= 57.1%
500 2017 = 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 for gearing 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
232 2015 = 62
= 3.74 times
200 2016 = 62
= 3.23 times
216 2017 = 62
= 3.48 times
The covenant for EBIT/ total interest is 3.5 times so interest cover falls below acceptable limits in 2016 and 2017.
There is a significant risk that XYZ will breach the debenture covenants so urgent action is required to obtain alternative finance or restructure the business to improve gearing and interest cover.
After tax cost of debt = 3% + 18.54 5.25 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
SUGGESTED ANSWERS EXTRA ATTEMPT, MAY 2014 EXAMINATIONS 5 of 9 STRATEGIC FINANCIAL MANAGEMENT SEMESTER-5 Marks
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After tax cost of loan = 6% + 11.93 4.13 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 the issue price = shares million 10 million 200 Rs. = Rs.20 per share 1 Rupees
SUGGESTED ANSWERS EXTRA ATTEMPT, MAY 2014 EXAMINATIONS 6 of 9 STRATEGIC FINANCIAL MANAGEMENT SEMESTER-5 Marks
DISCLAIMER: The suggested answers provided on and made available through the Institutes website may only be referred, relied upon or treated as a guide and substitute for professional advice. The Institute does not take any responsibility about the accuracy, completeness or currency of the information provided in the suggested answers. Therefore, the Institute is not liable to attend or receive any comments, observations or critics related to the suggested answers.
Q. 3 (a) (i) Alpha Ltd.s cost of capital: Since the profits and dividends are expected to remain constant the formula V o = i D is applicable. Where V o = ex div share price, d = dividend per share and i = cost of ordinary share capital.
Annual profit = Rs. 5,000,000 .. Dividend per share = 1,000,000 5,000,000 = 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 .. Dividend per 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 Source Rs. 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 of the different gearing of the two companies. The effect of the higher gearing of Beta Ltd., is to increase the level of financial risk and, therefore, decrease the relative attractiveness of the ordinary shares. 1 This may be explained in terms of the objectives with which investors acquire and hold ordinary shares. In the first place investors will seek to maximize their return. However, at the same time investors are in general averse to risk and, therefore, will seek to minimize the uncertainty inherent in those returns. Uncertainties may be explained in terms of the
SUGGESTED ANSWERS EXTRA ATTEMPT, MAY 2014 EXAMINATIONS 7 of 9 STRATEGIC FINANCIAL MANAGEMENT SEMESTER-5 Marks
DISCLAIMER: The suggested answers provided on and made available through the Institutes website may only be referred, relied upon or treated as a guide and substitute for professional advice. The Institute does not take any responsibility about the accuracy, completeness or currency of the information provided in the suggested answers. Therefore, the Institute is not liable to attend or receive any comments, observations or critics related to the suggested answers.
variance of the returns about their expected values. Because, investors are averse to such uncertainty, they will demand a higher rate of return to compensate them for the higher level of uncertainty. This clearly explains why the cost of 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 will be unchanged if he employs personal gearing to the same extent as Beta Ltd., i.e., so that debt is 47.2% of total capital and own funds are in the ratio 12,500 : 14,000. Amount to be borrowed is, therefore:
= 1,400 1,250 x 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 30,000 x 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 of gearing 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 provides additional 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 same process 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.
SUGGESTED ANSWERS EXTRA ATTEMPT, MAY 2014 EXAMINATIONS 8 of 9 STRATEGIC FINANCIAL MANAGEMENT SEMESTER-5 Marks
DISCLAIMER: The suggested answers provided on and made available through the Institutes website may only be referred, relied upon or treated as a guide and substitute for professional advice. The Institute does not take any responsibility about the accuracy, completeness or currency of the information provided in the suggested answers. Therefore, the Institute is not liable to attend or receive any comments, observations or critics related to the suggested answers.
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 1 6 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 valued according to its systematic risk only. The effect of the acquisition on the total risk of Blue Ltd., Company is assumed not to be a factor of importance to investors. Additionally, we assume that the measurement of beta is accurate and that the estimates of R f and R m are 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 and Rs.50,000 for year 2010 and 2014 respectively. If the annual growth rate in dividends is g.
50,000 (1 + g) 4 = 41,000 = 1.2195
1 + g =
= 1.0508
g =
= 0.0508, say 5% 2
SUGGESTED ANSWERS EXTRA ATTEMPT, MAY 2014 EXAMINATIONS 9 of 9 STRATEGIC FINANCIAL MANAGEMENT SEMESTER-5 Marks
DISCLAIMER: The suggested answers provided on and made available through the Institutes website may only be referred, relied upon or treated as a guide and substitute for professional advice. The Institute does not take any responsibility about the accuracy, completeness or currency of the information provided in the suggested answers. Therefore, the Institute is not liable to attend or receive any comments, observations or critics related to the suggested answers.
Expected dividend Market 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 less than 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