15 AF 503 SFM - Ans

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

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. 58,588,446
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.

Marks


(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

Restricted Moderate Relaxed
Sales 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
ROE
432
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

Marks


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 the
decision 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 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

Marks


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.

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

Year
Cash
Flow
Discount
Factor @ 3%
PV
Discount
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% +
18.54 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

Marks


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

Year
Cash
Flow
Discount
Factor @ 6%
PV
Discount
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% +
11.93 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

4 shares @ Rs.30 120
1 share @ Rs.20 20
140 1
Ex-right price (140 5) 28 1

Marks


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

Marks


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.

Marks


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

Marks


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

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SUGGESTED ANSWERS EXTRA ATTEMPT, MAY 2014 EXAMINATIONS 1 of 9

STRATEGIC FINANCIAL MANAGEMENT SEMESTER-5

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