STRATEGIC FINANCIAL MANAGEMENT [C3]

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Extra Reading Time: 15 Minutes

Maximum Marks: 100 Roll No.:
Writing Time: 03 Hours
(i) Attempt all questions.
(ii) Write your Roll No. in the space provided above.
(iii) Answers must be neat, relevant and brief. It is not necessary to maintain the sequence.
(iv) Use of non-programmable scientific calculators of any model is allowed.
(v) Read the instructions printed inside the top cover of answer script CAREFULLY before attempting the paper.
(vi) In marking the question paper, the examiners take into account clarity of exposition, logic of arguments,
effective presentation, language and use of clear diagram/ chart, where appropriate.
(vii) DO NOT write your Name, Reg. No. or Roll No., or any irrelevant information inside the answer script.
(viii) Question Paper must be returned to invigilator before leaving the examination hall.
D U RING E X TR A R EA DIN G T IM E , W R IT ING IS ST RICT L Y P R OH IBITE D IN T HE ANS WER S CR IPT

EXAMINEES ARE ADVISED TO MANAGE SOLUTIONS/ ANSWERS WITHIN PROPOSED TIME

Question No. 1 Proposed Time: 30 Min. Total Marks : 15

Following is the extract of statement of financial position of Good Ways Ltd.:

Rs. 000
Assets less current liabilities 300,000
Debt capital (140,000)
160,000
Ordinary share capital (4 million shares of Rs. 10) 40,000
Retained earnings 120,000
160,000

The companys profits in the year just ended are as follows:

Rs. 000
Earnings before interest and taxes 42,000
Interest 12,000
Earnings before tax 30,000
Taxation 32% 9,600
Earning after tax 20,400
Dividends 13,000
Retained earnings 7,400

The company is now considering an investment of Rs. 50 million. This will add Rs. 10 million each year
to the earnings before interest and taxes.
The investment of Rs. 50 million could be financed by borrowing at interest of 8%. The money can also
be raised by means of ordinary shares at Rs. 50 per share or 12% preference shares.
The company will increase dividends per share next year from Rs. 3.25 to Rs. 3.50 whichever financing
method is used.

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 The company does not intend to allow its gearing level, measured debt finance as a proportion of equity
capital plus debt finance, to exceed 55% at the end of any financial year. In addition, the company will
not accept any dilution in earning per share.
Assume that the rate of taxation will remain at 32%.

Required:
(a) Calculate forecast earnings for next year, assuming that the new project is undertaken and is financed
by debt, equity or preference shares.
(b) Calculate the earnings per share for next year, under each financing method.
(c) Calculate the projected statement of financial position at the end of the year under each financing
method.
(d) Calculate the effect on gearing at the end of next year, with each financing method.
(e) Explain whether either or all methods of funding would be acceptable, if yes why?

Question No. 2 Proposed Time : 30 Min. Total Marks : 15

(a) Asma Ltd. sells stationery and office supplies for the last 25 years on wholesale basis. The most recent
accounts of the company shows an annual turnover of Rs. 8,000,000 and accounts receivable of
Rs. 1,100,000. The company employs two people in its credit control department at an annual salary of
Rs. 240,000 each. All sales are on 40 days credit with no discount for early payment. Bad debts
represent 3% of turnover and Asma Ltd. pays annual interest of 9% on its overdraft.
The company is considering to offer a discount of 1% to customers paying within 14 days, which it
believes will reduce bad debts to 2.4% of turnover. The company also expects that offering a discount
for early payment will reduce the average credit period taken by its customers to 26 days and it will
also redundant one employee of the credit department with no redundancy cost. Two-third of
customers are expected to take advantage of the discount.

Required:
(i) Determine whether a discount for early payment of 1% will lead to an increase in profitability for
Asma Ltd.
(ii) Will your decision change at (i) above, if both employees of credit department continue their
services?

(b) Ehsaan Ltd. is a renowned name in the auto-mobile industry for its quality products. The company
produces small parts for motor vehicles. In the past, the company has operated a very conservative
policy in respect of the management of its working capital.
You have recently joined the company as Financial Analyst and your director has asked you to review
this policy and evaluate the likely effect on the company if one or two alternative approaches to working
capital management are introduced from the next year.
The companys end-of-year forecast financial outcomes are as under:

Rs. 000
Existing policy:
Receivable 5,000
Inventory 4,000
Cash 1000
Non-current assets 2,500
Current liabilities 3,700
Forecast sales 16,000
Forecast operating profit (18% of sales) 2,880

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 The proposed parameters by director finance are as under:
Proposed Moderate Policy:
The receivable and inventory will decrease by 20%. Cash at bank will reduce to Rs. 500,000. There
would be no change in the non-current assets. However, the current liabilities will increase by 10%.
The forecast sale would be increased by 2% and no change would be expected in percentage profit of
sales.
Proposed Aggressive Policy:
The receivable and inventory will decrease by 30%. Cash at bank will reduce to Rs. 200,000. There
would be no change in the non-current assets. However, the current liabilities will increase by 20%.
The forecast sale would be increased by 4% and no change would be expected in percentage profit of
sales.
Required:
(i) Calculate the return on net assets and the current ratio under each of three scenarios shown
below:
The company continues with its present policy.
The company opts the moderate policy.
The company opts the aggressive policy.
(ii) What course of action would you recommend to the company based on your conclusion drawn
from scenario (b) (i) above?

Question No. 3 Proposed Time : 25 Min. Total Marks : 15

(a) The market price of a Rs. 1,000 par value bond, carrying a coupon rate of 12% and maturing after 5
years, is Rs. 1,040.

Required:
(i) What is the approximate yield to maturity (YTM)?
(ii) What will be the realised YTM if the reinvestment rate is 7%?

(b) Consider the Pakistan Investment Bond (PIB-1).

Rupees
PIB-1
Face value 1,000
Redemption value 1,000
Current market price 950
Years to maturity 3
Coupon (interest rate) payable annually 13%

Required:
Calculate the following:
(i) Yield to maturity (use the approximate formula).
(ii) Duration of bond.
(iii) Volatility.

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(c) An investor has forecasted following information for two stocks, namely, X and Y:

Description X Y
Expected return 20% 20%
Standard deviation 20% 30%
1.5 2
T-Bill rate 5.5%
Market risk premium 8.5%

Required:
Label each stock as undervalued, or overvalued, by showing appropriate computations.

Question No. 4 Proposed Time : 30 Min. Total Marks : 15

Farhan Ltd., a listed company, is performing quite well in pharmaceutical industry. The company has no
debt in its capital structure and it has paid an annual dividend of Rs. 4.50 per share on its 200,000 ordinary
shares for a number of years. The total market value of the company is Rs. 4,650,000 cum-dividend. The
next annual dividend of Rs. 900,000 would be paid in a few days. The shareholders perceive that the
companys dividends will remain indefinitely at the current level.
The directors of Farhan Ltd. are considering an immediate investment of Rs. 500,000 in a life saving drug
which would produce net annual receipts of Rs. 132,000 indefinitely. The first receipt would arise after one
year. The details of this particular project have not yet been communicated to the shareholders. However,
all net cash flows from the project would be distributed as dividends among shareholders when received.
If the project is undertaken, it would be financed in one of three ways:
(1) A rights issue of one new share for every four held at a price of Rs. 10 per share. The new shares would
qualify for dividend one year after issue.
(2) A decrease of Rs. 500,000 in the current dividend.
(3) A new issue of ordinary shares; the new shares would entitle for dividend one year after issue.
The managing director of Farhan Ltd. has the opinion that proposed price of the rights issue is very low and
suggests one new share for every five held at a price of Rs. 12.50 per share.
You may assume that directors expectations of future result would be communicated to, and believed by,
the stock market in case the project is accepted. The risk of the company would remain unaltered and the
issue cost of new shares and taxation may be ignored.

Required:
(a) Estimate the new market price per ordinary share, ex-dividend, if the project is accepted and financed
by rights issue, and by a reduction in the current dividend.
(b) Calculate the share price and number of new shares to be issued under option (3), if the total benefit
from the project is to go to existing shareholders.
(c) Calculate the total gain made by present shareholders under each of the three finance options.
(d) Comment briefly on the views expressed by the managing director.

SFM-MP [Syllabus 2016] 4 of 6

Question No. 5 Proposed Time : 15 Min. Total Marks : 10
The CEO of the Security Systems Ltd., has recently attended a seminar on leasing. He was very impressed
by the views expressed by one of the speakers that leasing was the most viable option for acquiring an
asset. The CEO has directed in the board meeting that the company must go for lease option for acquiring
new equipment for one of its department. The CFO of company has assured the CEO that decision of
acquiring the equipment would be taken in the best interest of the company and asked you to recommend
the most viable course of action. The following data has been collected by the finance department of
Security Systems Ltd.
The equipment could be acquired on lease for a 4-year contract period. The lease payment of Rs. 400,000
per year is to pay at the beginning of each year. The lease would also include maintenance of the
equipment.
The equipment could also be purchased for Rs. 1,600,000, financing the purchase by a bank loan for the
net purchase price. Under the borrow-to-purchase arrangement, Security Systems Ltd., would have to
maintain the equipment at a cost of Rs. 40,000 per year, payable at year end. The
company charge depreciation on diminishing balance method for such type of equipment. The depreciation
allowance is fully allowed for tax relief. The expected residual value of the machine after four years is
Rs. 400,000. Security Systems Ltd. plans to replace the lathe machine after four years irrespective of
whether it leases or buys. The company has a tax rate of 32% and its after tax cost of debt is 13%.

Required:
(a) Calculate the PV of the equipment cost under lease and purchase option.
(b) Would you support the CEOs view that lease is most viable option to purchase the equipment.

Question No. 6 Proposed Time : 25 Min. Total Marks : 15

Axe Ltd. is in the business of manufacturing clothes using raw materials. It is a widely growing company and
obtained a stock market listing 5 years ago. It is all-equity financed by ordinary share capital. Economic
conditions of the country are not very well and the chairman forecasted a lower rate of return than in recent
years.
Max Ltd. is in the same business but has been established much longer. Due to low performance of
management in recent few years, it is unable to earn as much as it should have to earn. Some financial
details of both companies are shown below:

For the year just ended June 30, 2016

Axe Ltd. Max Ltd.
Profit before tax 100 million 130 million
Ordinary share capital (Rs10 par) 7 million 8 million
Forecast growth rate for the next year 6% 6%

Axe Ltd. has recently approached the shareholders of Max Ltd. with a bid of 4 new shares in Axe Ltd. for
every 5 shares in Max Ltd. There is a cash alternative of Rs. 3.5 per share. Following the announcement of
the bid, the market price of Axe Ltd. shares fell by 10% while the price of Max Ltd. shares rose by 14%. The
price earning (P/E) ratio and dividend yield for Axe Ltd., Max Ltd. and two other listed companies in the
same industry immediately prior to the bid announcement are shown below:

Company P/E Dividend yield (%)

Axe Ltd. 12 2.4
Max Ltd. 8 3.1
Ox Ltd. 9 5.2
Rex Ltd. 15 2.3

Post-tax cost of equity capital of Axe Ltd. and Max Ltd. is estimated at 14% and 12% per annum
respectively. Both companies fall under tax bracket of 30%.
SFM-MP [Syllabus 2016] 5 of 6 PTO
Required:
As a qualified management accountant you are required to:
(a) Evaluate whether the proposed offer is likely to be beneficial to shareholders of both Axe Ltd. and Max
Ltd. You should use appropriate assumptions.
(b) As a benchmark, you should then value the two companies using the dividend valuation model.

Question No. 7 Proposed Time : 25 Min. Total Marks : 15

(a) What is "Interest Rate Swap"? How it works and Why it matters?

(b) Mr. Chand owns a Rs. 1,000,000 investment that pay him KIBOR +1% (Floating rate) every month and
Mr. Suraj owns a Rs. 1,000,000 investment that pay him 1.5% (Fixed rate) every month. Mr. Chand
decides that he would rather lock in a constant payment and Mr. Suraj decides that he rather take a
chance on receiving higher payments. Both agree to enter into an interest swap contract. Under the
terms of their contract, Mr. Chand agrees to pay Mr. Suraj KIBOR+1% per month on a Rs. 1,000,000
principal amount. Mr. Suraj agrees to pay Mr. Chand 1.5% per month on the Rs. 1,000,000.

Required:
What this deal looks like under different scenarios, if:
(i) monthly KIBOR = 0.25%
(ii) monthly KIBOR = 1%

THE END

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