BUSINESS FINANCE
DECISIONS
PRACTICE KIT
ICAP
Practice Kit
Notice
Emile Woolf International has made every effort to ensure that at the time of writing the
contents of this study text are accurate, but neither Emile Woolf International nor its directors
or employees shall be under any liability whatsoever for any inaccurate or misleading
information this work could contain.
ii
C
Contents
Page
Section A
Questions
Section B
Answers
149
iii
iv
I
Index to questions and answers
Question
page
Answer
page
Company objectives
149
1.2
Possible conflicts
151
1.3
Ownership
152
Shockolat
154
2.2
Topaz Limited
156
2.3
Tychy Limited
157
159
3.2
160
3.3
163
Proglin
166
4.2
Light engineering
10
167
Badger plc
11
171
Question
page
Answer
page
6.2
12
172
6.3
13
172
6.4
14
173
6.5
Beta Limited
15
174
16
176
7.2
16
177
7.3
Alawada Limited
17
178
7.4
Kohat Limited
17
179
7.5
18
180
7.6
ARG Limited
19
182
7.7
Hafeez Ltd
22
185
23
187
8.2
Calm Plc
23
188
8.3
Outlook Plc
24
190
8.4
Zaheer Ltd
25
191
8.5
26
192
8.6
Khayyam Limited
26
193
Lease or buy
28
194
9.2
Mohani Limited
28
196
9.3
29
197
9.4
30
199
9.5
Crank Plc
30
200
9.6
Asset replacement
31
202
9.7
Rotor Plc
31
204
9.8
32
204
Equity ratios
33
206
10.2
33
207
10.3
34
209
vi
Capital rationing
36
211
11.2
Basril Company
36
212
11.3
CB Investment Limited
37
214
Rights
38
216
12.2
38
216
12.3
Rights issue
39
218
12.4
39
219
12.5
Convertible bonds
39
220
12.6
40
220
12.7
40
222
12.8
41
224
43
228
13.2
WACC
44
229
13.3
Redskins
44
229
13.4
45
230
13.5
Misteri Company
46
233
13.6
Faiz Limited
46
234
Two-asset portfolio
48
238
14.2
Coefficient of variation
49
237
14.3
Portfolio return
49
238
14.4
Dolphin Plc.
50
239
14.5
51
241
14.6
51
241
14.7
Sodium Plc
52
242
14.8
Dr Jamal
53
244
14.9
Mr Faraz
53
247
14.10
Mushtaq Limited
54
249
14.11
55
250
14.12
Iron Limited
56
252
14.13
56
253
vii
58
254
15.2
Ackers Plc
58
254
15.3
Dividend policy
59
256
15.4
YB Pakistan Limited
59
258
15.5
61
260
Gearing
62
263
16.2
Financing schemes
63
264
16.3
64
265
16.4
Diversify
64
265
16.5
65
266
16.6
Optimal WACC
66
267
16.7
Geared beta
66
268
16.8
66
269
16.9
APV method
67
272
16.10
More APV
68
274
16.11
Jalib Limited
69
275
16.12
Javed Limited
69
277
16.13
GHI Limited
70
278
16.14
NS Technologies Limited
71
278
16.15
71
279
16.16
72
282
Valuation model
74
285
17.2
Valuation
74
285
17.3
Valuation of bonds
74
285
17.4
75
286
17.5
75
287
17.6
Kencast Limited
76
288
17.7
78
290
17.8
79
292
17.9
80
293
17.10
Financial plan
80
294
17.11
Takeover
82
296
viii
17.12
MK Limited
83
299
17.13
Platinum Limited
84
302
17.14
EMH
85
303
17.15
86
304
Acquisition
87
307
18.2
Adam Plc
87
308
18.3
D Limited
88
309
18.4
89
310
18.5
Nelson Plc
90
312
18.6
Hali Ltd
91
313
18.7
92
316
18.8
FF International
93
319
95
324
96
325
20.2
96
325
20.3
Foreign investment
97
327
20.4
Gold Limited
97
328
20.5
Ghazali Limited
99
331
Foreign exchange
100
334
21.2
100
334
21.3
Dunborgen
101
335
21.4
Currency swap
101
335
21.5
102
337
21.6
103
340
21.7
Silver Limited
104
341
21.8
Khaldun Corporation
106
343
Currency futures
107
344
22.2
107
344
22.3
Basis
108
345
ix
22.4
108
346
22.5
Currency hedge
108
347
110
349
23.2
Currency options
110
350
23.3
111
351
23.4
111
352
FRA
113
354
24.2
Swap
113
354
24.3
Credit arbitrage
113
355
24.4
Credit arbitrage
114
355
24.5
114
356
24.6
114
356
24.7
115
357
24.8
116
359
24.9
Definitions
116
360
24.10
Imran Limited
117
362
Gazelle
118
363
25.2
119
364
25.3
120
365
25.4
Flexed budget
120
366
25.5
121
367
25.6
Three services
122
369
25.7
123
370
25.8
Headgear Limited
124
371
25.9
126
374
127
377
26.2
Moongazer
127
380
26.3
ABC Limited
128
383
27.4
Kasur Mf Limited
129
385
Toxic Kems
130
389
27.2
BRK
130
391
27.3
Carat
131
394
Two divisions
133
399
28.2
Shadow price
133
400
28.3
Froom Plc
134
400
28.4
Training company
135
401
28.5
Bricks
135
403
137
405
29.2
Working capital
137
406
29.3
Waseem Limited
139
408
Marx Limited
140
409
30.2
Engels Limited
140
410
30.3
Lenin Limited
140
411
142
413
31.2
142
414
31.3
143
415
31.4
143
416
31.5
144
417
31.6
Ulnad Co
145
418
31.7
Brutus Company
145
420
146
422
32.2
Renpec Co
146
422
32.3
Baumol
147
424
32.4
Cassius Company
147
425
xi
xii
SECTION
A
Questions
1.2
COMPANY OBJECTIVES
(a)
(b)
Outline other goals that companies claim to follow, and explain why these
might be adopted in preference to the maximisation of shareholder wealth.
POSSIBLE CONFLICTS
The major objective of financial management is to maximise the value of the
firm.
Analyse how the achievement of the above objective might be compromised by
the conflicts which may arise between the management and the other
stakeholders in an organisation.
1.3
OWNERSHIP
Ascertaining exactly who owns a companys shares and what, if any, are their
particular preferences and objectives is a basic piece of information needed by
management, if it is to ensure that, as far as possible, it is acting in the shareholders
interest.
(a)
Explain why a publicly quoted company might seek to know the detailed
composition of its shareholders and their objectives in investing in the
company.
(b)
Explain any FIVE the major advantages which may accrue to the corporate
finance manager from obtaining this information.
SHOCKLAT CO
Shoklat Co manufactures and sells one type of chocolate, which is sold as a very wellknown branded item at a price of Rs. 14 per kilogram. This product is targeted mainly
at children.
The product is made in a single process which combines a chocolate casing (material
M1) with a filling (material M2). Material M1 costs Rs. 9 per kilogram and material M2
costs Rs. 7 per kilogram. They are combined in the ratio of 3 kilos of material M1 for
every 4 kilos of material M2 and there is no loss in process.
The product research team, using information obtained from market research, has
now developed two possible new products. By adding an extra ingredient M3 to the
existing product formula Shoklat Co would be able to make a new chocolate product
(CP1) that might appeal to men. Similarly by adding an extra ingredient M4 to the
existing product formula it would be possible to make another new product (CP2) that
might have a particular appeal to women. The market research also suggests that the
appeal of the new products to the target customers would so strong that they could
each be sold for a premium price. The market research cost Rs. 20,000.
Senior management of Shoklat Co are trying to decide whether to experiment with the
two new products for a period of two or three months. The proposal is that about 10%
of normal monthly production would be processed further and made into the two new
products CP1 and CP2.
Data relating to this proposal for each month of the trial period is as follows.
(1)
35,000 kilos of the basic product will be produced and used to make the
CP1 and CP2. Production of this quantity of the basic product will require
2,000 direct labour hours. Direct labour is paid Rs. 20 per hour.
(2)
800 kilos of ingredient M3 will be added to 6,000 kilos of the basic product
to make 6,800 kilos of product CP1. M3 costs Rs. 19 per kilo. Additional
processing will require 900 extra direct labour hours. CP1 is expected to
sell for Rs. 30 per kilo.
(3)
(4)
(5)
Questions
(6)
Required
2.2
(a)
Explain briefly the financial and other factors that Shoklat Co should
consider when deciding whether or not to make the CP1 and CP2 for a test
period of three months. No calculations are required for this part of your
answer.
(b)
(c)
Calculate a selling price per kilogram for CP2 that would achieve
breakeven for production and sales of the product during the test period.
TOPAZ LIMITED
Topaz Limited (TL) is the manufacturer of consumer durables. Pearl Limited, one
of the major customers, has invited TL to bid for a special order of 150,000 units of
product Beta.
Following information is available for the preparation of the bid.
(i)
(ii)
Every 100 units of product Beta requires 150 labour hours. Workers are
paid at the rate of Rs. 9,000 per month. Idle labour hours are paid at
60% of normal rate and TL currently has 20,000 idle labour hours. The
standard working hours per month are fixed at 200 hours.
(iii)
The variable overhead application rate is Rs. 25 per labour hour. Fixed
overheads are estimated at Rs. 22 million. It is estimated that the special
order would occupy 30% of the total capacity. The production capacity
of Beta can be increased up to 50% by incurring additional fixed
overheads. The fixed overhead rate applicable to enhanced capacity would
be 1.5 times the current rate. The utilized capacity at current level of
production is 80%.
(iv)
(v)
TL has the policy to earn profit at the rate of 20% of the selling price.
Required
Calculate the unit price that TL could bid for the special order to Pearl Limited.
2.3
TYCHY LIMITED
Tychy Limited (TL) is engaged in the manufacture of specialised motors. The
company has been asked to provide a quotation for building a motor for a large
textile industrial unit in Punjab. Following information has been obtained by TLs
technical manager in a one-hour meeting with the potential customer. The
manager is paid an annual salary equivalent to Rs. 2,500 per eight-hour day.
(i)
The motor would require 120 ft. of wire-C which is regularly used by TL in
production. TL has 300 ft. of wire-C in inventory at the cost of Rs. 65 per ft.
The resale value of wire-C is Rs. 63 and its current replacement cost is Rs.
68 per ft.
(ii)
(iii)
The manufacturing process would require 250 hours of skilled labour and
30 machine hours.
The skilled workers are paid a guaranteed wage of Rs. 20 per hour and
the current spare capacity available with TL for such class of workers is
100 direct labour hours. However, additional labour hours may be obtained
by either:
Fixed overheads are absorbed at the rate of Rs. 25 per direct labour hour.
Required
Compute the relevant cost of producing textile motor. Give brief reasons for
the inclusion or exclusion of any cost from your computation.
Questions
38
22
(60)
40
Required
(a)
Prepare calculations showing the total relevant costs for making a decision
about the contract in respect of the following cost elements:
(i)
(ii)
skilled labour.
(ii)
(b)
Explain how you would decide which overhead costs would be relevant in
the financial appraisal of the contract.
(c)
3.2
GL3
HT4
21.00
28.50
27.30
2.0
3.0
3.0
Material R3 (kg/unit)
2.0
2.2
1.6
3.0
0.6
1.2
1.5
1.7
1.10
1.30
1.10
1.40
1.50
1.60
1.70
1.40
950
1,000
900
XY5
Products AR2, GL3 and HT4 are sold to customers of Wazir Manufacturing Ltd, while
Product XY5 is a component that is used in the manufacture of other products. The
company manufactures a wide range of products in addition to those detailed above.
Material R2, which is not used in any other of the companys products, is expected to
be in short supply in the next month because of industrial action at a major producer of
the material. Wazir Manufacturing Ltd has just received a delivery of 5,500 kg of
Material R2 and this is expected to be the amount held in inventory at the start of the
next month.
The company does not expect to be able to obtain further supplies of Material R2
unless it pays a premium price. The normal market price is Rs. 2.50 per kg. Material
R3 is available at a price of Rs. 2.00 per kg and the company does not expect any
problems in securing supplies of this material. Direct labour is paid at a rate of Rs. 4.00
per hour.
Kenzi Chemicals Ltd Company has recently approached Wazir Manufacturing Ltd with
an offer to supply a substitute for Product XY5 at a price of Rs. 10.20 per unit. Wazir
Manufacturing Ltd would need to pay an annual fee of Rs. 50,000 for the right to use
this patented substitute.
Required
(a)
Determine the optimum production schedule for Products AR2, GL3 and
HT4 for the next month, on the assumption that additional supplies of
Material R2 are not purchased.
(b)
(c)
(d)
Questions
3.3
Required
(a)
Outline the financial and other factors that Khokhar Perfumers Limited
should consider when making a further processing decision.
Note: no calculations are required.
(b)
(c)
Calculate the selling price per 100 ml for the female version of the product
that would ensure further processing would break even in the test month.
(d)
Questions
PROGLIN
(a)
Mark 1
Mark 2
Rs. 2
Rs. 4
3 hours
2 hours
5,000 units
unlimited
Direct materials and direct labour will be in restricted supply next year, as
follows:
Maximum available
Direct materials
Rs. 24,000
18,000 hours
Suppose that the maximum available amount of direct materials next year
is Rs. 24,001, not Rs. 24,000.
Required
(i)
Identify the quantities of Mark 1 and Mark 2 that should be made and
sold during the year in order to maximise profit and contribution.
4.2
LIGHT ENGINEERING
A light engineering company makes water tanks and water butts. Both products
involve the same staff and equipment. Each product passes through a cutting
and an assembly stage. One water tank makes a contribution of Rs. 50, and
takes six hours cutting time and four hours assembly time. One water butt makes
a contribution of Rs. 40, and takes three hours cutting time and eight hours
assembly time. There are a maximum of 36 cutting hours each week and 48
assembly hours.
The company has to produce at least two water tanks and three water butts.
Calculate the number of water butts and water tanks that should be produced
each week to maximise contribution.
Required
(a)
(b)
(c)
find the product mix that best suits company policy, and
(d)
calculate the shadow price of one more unit of cutting time and one more
unit of assembly time.
10
Questions
BADGER PLC
Badger plc., a manufacturer of car accessories is considering a new product line. This
project would commence at the start of Badger plc.s next financial year and run for
four years. Badger plc.s next year end is 31st December 2016.
The following information relates to the project:
A feasibility study costing Rs. 8 million was completed earlier this year but will not be
paid for until March 2017. The study indicated that the project was technically viable.
Capital expenditure
If Badger plc. proceeds with the project it would need to buy new plant and machinery
costing Rs. 180 million to be paid for at the start of the project. It is estimated that the
new plant and machinery would be sold for Rs. 25 million at the end of the project.
If Badger plc. undertakes the project it will sell an existing machine for cash at the start
of the project for Rs. 2 million. This machine had been scheduled for disposal at the
end of 2020 for Rs. 1 million.
Market research
Industry consultants have supplied the following information:
Market size for the product is Rs. 1,100 million in 2016. The market is expected to
grow by 2% per annum.
Market share projections should Badger plc. proceed with the project are as follows:
2017
7%
2018
9%
2019
15%
2020
15%
2017
Rs. m
Purchases
40
Payables (at the year-end)
8
Payments to sub-contractors, 6
2018
Rs. m
50
10
9
2019
Rs. m
58
11
8
2020
Rs. m
62
nil
8
110
100
99
90
90
80
Market share
Cost data:
Labour costs
At the start of the project, employees currently working in another department would
be transferred to work on the new product line. These employees currently earn Rs.
3.6 million per annum. They will not be replaced if they work on the new project.
An employee currently earning Rs. 2 million per annum would be promoted to work on
the new line at a salary of Rs. 3 million per annum. A new employee would be
recruited to fill the vacated position.
11
As a direct result of introducing the new product line, employees in another department
currently earning Rs. 4 million per annum would have to be made redundant at the end
of 2017 and paid redundancy pay of Rs. 6.2 million each at the end of 2018.
Material costs
The company holds a stock of Material X which cost Rs. 6.4 million last year. There is
no other use for this material. If it is not used the company would have to dispose of it
at a cost to the company of Rs. 2 million in 2017. This would occur early in 2017.
Material Z is also in stock and will be used on the new line. It cost the company Rs. 3.5
million some years ago. The company has no other use for it, but could sell it on the
open market for Rs. 3 million early in 2017.
Further information
The year-end payables are paid in the following year.
The companys cost of capital is a constant 10% per annum.
It can be assumed that operating cash flows occur at the year end.
Time 0 is 1st January 2017 (t1 is 31st December 2017 etc.)
Required
Calculate the net present value of the proposed new product line (work to the nearest
million).
6.2
(b)
Calculate the NPV of the machine and advise on its viability; and
12
Questions
6.3
Rs.
.000
4
Rs.
000
8,300
Rs.
000
5
Rs.
000
9,800
Rs.
000
550
340
580
360
620
410
520
370
600
220
2,100
250
650
300
220
2,100
650
300
220
2,100
650
300
220
2,100
650
Profit
3
Rs.
000
7,400
4,710
4,210
4,300
Rs.
000
5,800
4,160
2,690
4,090
5,500
1,640
Notes
(i)
The licence fee charge in Year 2 includes the payment that would be made
at the beginning of year 1 as well as the payment at the beginning of Year
2. The licence fee is paid to the Ruritanian government at the beginning of
each year.
(ii)
(iii)
The survey cost is for the survey that has been carried out by the firm of
specialists.
(iv)
The new equipment costing Rs. 10,400,000 will be sold at the end of Year
5 for Rs. 2,000,000.
13
(v)
A specialised item of equipment will be needed for the project for a brief
period at the end of year 2. This equipment is currently used by the
company in another long-term project. The manager of the other project
has estimated that he will have to hire machinery at a cost of Rs. 150,000
for the period the cutting tool is on loan.
(vi)
The project will require an investment of Rs. 650,000 working capital from
the end of the first year to the end of the licence period.
6.4
(b)
(c)
(e)
14
Questions
6.5
BETA LIMITED
Beta Limited (BL) is engaged in the business of manufacturing and marketing of
high quality plastic products to the large departmental stores in Pakistan and United
Arab Emirates. BL is presently experiencing a decline in sales of its products. Market
research carried out by the Marketing Department suggests that sustained growth
in sales and profits can be achieved by offering a wide range of products rather
than a limited range of quality products. In this regard, BL is considering the following
two mutually exclusive options:
Option I : Introduce low quality products in the market
Following information has been worked out by the Chief Financial Officer of the
company:
Net present value using a nominal discount rate of 13%
Discounted payback period
Rs. 82 million
3.1 years
10.5%
13.2% approximately
Year 0
Year 1
Year 2
Year 3
Year 4
(25.00)
(20.00)
(21.33)
(22.33)
(20.67)
22.47
24.15
25.23
23.37
333
350
414
450
(ii)
BL evaluates all its investment using nominal rupee cash flows and a
nominal discount rate.
(iii)
15
1
250
50
25
75
120
2
250
55
25
75
120
3
300
58
30
88
120
4
350
64
30
94
120
5
400
70
35
105
120
There will be tax allowances on the cost of the equipment, calculated at 25%
each year on the reducing balance basis. The first depreciation tax allowance
(capital allowance) would be claimed in year 0 (or very early in year 1).
Assume that:
(1)
taxable profits are defined as income minus direct costs and capital
allowances
(2)
Required
Calculate the net present value of the project and recommend whether or not the
project should be undertaken.
7.2
16
Questions
Required
Calculate the NPV of the project and state whether or not it should be
undertaken.
7.3
ALAWADA LIMITED
Alawada Limited is considering a five-year project whose initial cost would be Rs.
3million. The contribution consists of annual sales of Rs. 2.8million and variable
costs of Rs. 2million for 1,000,000 units of sales per annum. These are the
expected money values in year 1.
All sales would be made through a single distributor who has asked for a fixed
selling price of Rs. 2.80 per unit for three years after which prices could be
increased by 20% for year 4 and held constant at this new price for years 4 and
5. The variable cost is Rs. 2.00 per unit and it consists of material cost of
Rs.0.80 which is expected to increase by 5% per annum and the balance
represents labour cost which is expected to increase by 10% per annum for each
year. The companys cost of capital is assumed to be 10%.
Required
7.4
(a)
Calculate the net present value of the project and advise on its viability.
(b)
(c)
KOHAT LIMITED
Kohat Limited (KL) is considering to set-up a plant for the production of a single
product IGM3. The initial capital investment required to set up the plant is Rs. 15
billion. The expected life of the plant is only 5 years with a residual value of 20% of
the initial capital investment. The plant will have an annual production capacity of 1.0
million tons.
A local group has offered to purchase all the production for Rs. 8,000 per ton in
year 1 and thereafter at a price to be increased 5% annually. Other relevant
information is as under:
(i)
In year 1, operating costs (other than wages and depreciation) per annum
would be Rs. 2,000 per ton. They are expected to increase in line with
Producer Price Index (PPI). Annual wages would be Rs. 1.0 billion and are
linked to Consumer Price Index (CPI).
(ii)
KLs cost of capital for this project, in real terms is 6%. General inflation rate
is 11%.
(iii)
The tax rate applicable to the company is 30% and the tax is payable in
the same year. The company can claim normal tax depreciation at 20% per
annum under the reducing balance method.
17
2010
2011
2012
2013
2014
2015
PPI
107
119
130
142
160
175
CPI
112
125
139
155
173
195
The costs linked to the above indices are expected to grow at their historic
compound annual growth rate.
Required
Advise whether KL should invest in the project.
7.5
The restaurant will be launched on the first day of the next year.
(ii)
The club membership has been increasing at the rate of 5% per annum.
As a result of this facility, it is expected that the rate would increase to 10%
per annum.
(iii)
(iv)
(v)
(vi)
The annual fixed overheads for the current year are estimated at Rs. 4.8
million. 15% of the fixed overheads are allocated to the snack bar. As a
result of the establishment of the restaurant the annual expenditure would
increase as follows:
Rupees
Electricity and gas
340,000
Advertising
170,000
85,000
18
Questions
JAPs post tax cost of capital is 17% per annum before adjustment for
inflation. The rate of inflation is 10%.
Required
Advise whether JAP should invest in the project. Assume that each year has 360
days.
7.6
ARG COMPANY
ARG Company is a leisure company that is recovering from a loss-making venture into
magazine publication three years ago. Recent financial statements of the company are
as follows.
Statement of profit or loss for the year ending 30 June 20X5
$000
140,400
Sales revenue
Cost of sales
112,840
27,560
Gross profit
Administration costs
23,000
4,560
900
3,660
1,098
2,562
400
2,162
19
$000
50,000
Current assets
Inventory
Receivables
2,400
20,000
Cash
1,500
23,900
73,900
2,000
Capital reserves
27,000
Accumulated profits
1,900
30,900
10,000
33,000
73,900
The company plans to launch two new products, Alpha and Beta, at the start of July
20X5, which it believes will each have a life-cycle of four years. Alpha is the deluxe
version of Beta. The sales mix is assumed to be constant.
Expected sales volumes for the two products are as follows.
Year
Alpha
60,000
110,000
100,000
30,000
Beta
75,000
137,500
125,000
37,500
The standard selling price and standard costs for each product in the first year will be
as follows.
Product
Direct material costs
Incremental fixed production costs
Standard mark-up
Selling price
20
Alpha
Beta
$/unit
$/unit
12.00
8.64
20.64
10.36
31.00
9.00
6.42
15.42
7.58
23.00
Questions
(b)
Identify and discuss any likely limitations in the evaluation of the proposed
investment in Alpha and Beta.
(c)
21
7.7
HAFEEZ LTD
Hafeez Ltd is planning to bid for a contract to supply a machine under an operating
lease arrangement, for 5 years. The terms of proposed contract include a special
arrangement whereby the supplier / lessor will have to operate and maintain the
machine, during the term of lease. Hafeez Ltd is required to quote a consolidated
annual fee consisting of lease rentals and operating changes which shall be payable in
arrears. The following relevant information is available:
(i)
The cost of machine is Rs. 50 million and the expected useful life is 10
years. The residual value at the end of five years is estimated to be 25% of
the cost of machine.
(ii)
Operating cost for the first year is estimated at Rs. 6 million and is expected
to increase at the rate of 10% per annum.
(iii)
The tax rate applicable to the company is 35% and the tax is payable in the
same year. The company can claim initial and normal depreciation at 25%
and 10% respectively under the reducing balance method.
(iv)
Required
(a)
Calculate the annual consolidated fee to be quoted for the contract if the
companys target is to achieve a pre-tax net present value of 15% of total
capital outlay.
(b)
Using the fee quoted above, calculate the projects internal rate of return
(IRR) to the nearest percent
22
Questions
Probability
Units
2,000
0.2
3,000
0.6
5,000
0.2
The sales demand in each year will be the same. For example, if the demand is
2,000 units in Year 1, it will be 2,000 units for every year of the project.
Taxation and fixed costs will be unaffected by any decision made.
Easts cost of capital is 6%.
Required
8.2
(a)
Calculate the NPV for each of investment options, Machine A and Machine
B, for each of the possible levels of sales demand.
(b)
(c)
Calculate the probability that the NPV of the project will be negative
(ii)
Calculate the minimum annual sales required for the NPV of the
project to be positive.
CALM PLC
Calm Plc designs and manufactures Personal Stress-Monitoring Device (PSMD).
The device is designed for checking individuals stress levels. A typical device
has a commercial life of three years.
Recently, the company developed a new device known as SIMPLE and paid
Rs. 10 million as development cost.
23
Year 1
Rs. m
Year 2
Rs. m
Year 3
Rs. m
0.25
240
500
160
If demand is average
If demand is below average
0.60
0.15
140
50
340
180
80
50
Variable costs will amount to 30% of sales. Sales revenue and variable cost will
be received and paid respectively on the last day of the year in which they arise.
If SIMPLE is produced, a special machine will have to be purchased at the
beginning of Year 1 at a cost of Rs. 190 million, payable at the time of purchase.
The machine will have a scrap value of Rs. 10 million at the end of the products
life. The amount is receivable one year after the last year in which production
takes place. If purchased, the machine will be installed in an unused part of one
of Calm Plc.s factories. The company has been trying to let this unused factory
space at a rent of Rs. 16 million per annum. Although, there seems to be no
chance of letting the space in year 1, there is a 60% chance of letting it for two
years at the beginning of year 2 and a 50% chance of letting it for one year at the
beginning of year 3 provided it has not been let at the beginning of year 2. All
rental income will be received annually in advance. Fixed costs, which include
depreciation of the special machine on a straight-line basis, are expected to
amount to Rs. 70 million per annum.
These costs which are all specific to the production of SIMPLE and will be paid
on the last day of the year in which they arise with the exception of depreciation,
Advertising expenses will be paid on the first day of each year and will amount to
Rs. 30 million at the start of year 1, Rs. 20 million at the start of year 2 and Rs. 10
million at the start of year 3. Calm Plc. has a cost of capital of 20%.
Required
Analyse and evaluate the production of SIMPLE based on expected present
value. (Show all relevant calculations).
8.3
OUTLOOK PLC
Outlook Plc is considering a new project for which the following information is
relevant:
24
Questions
(b)
8.4
Sales price
(ii)
Initial outlay
(iii)
Sales volume
(iv)
Variable cost
(v)
Fixed cost
ZAHEER LTD
Zaheer Ltd is a manufacturer of auto parts and is currently operating at below capacity
due to slump in the demand for automobiles. The company has received a proposal
from a truck assembler for supply of 40,000 gear boxes per annum for five years at Rs.
1,900 per gear box.
The cost of each gear box is as follows:
Rupees
800
500
150
200
150
1,800
Material costs
Labour costs
Variable production overheads
Variable selling overheads
Fixed overheads (allocated)
Company has already incurred a cost of Rs. 5 million on the preparation of technical
feasibility. The additional cost for setting up the facility for this order would be Rs. 20
million. The company qualifies for tax allowable depreciation on the cost of setting up
the facility on a straight-line basis over the life of the project.
The company has a post-tax cost of capital of 15%. The rate of tax applicable to the
company is 30%.
Required
(a)
(b)
Material costs
Labour costs
25
8.5
Rs. 0.75
Re. 1
Rs. 1.25
Subscribers in million
Recession
0.30
0.70
0.50
0.30
Moderate
0.50
0.80
0.60
0.40
Boom
0.20
0.90
0.80
0.60
He foresees that the average airtime usage per subscriber would be 1800 minutes or
1600 minutes with a probability of 40% and 60% respectively. In order to cater to the
increased subscriber base, the company would need to commission new cell sites,
details of which are as follows:
No. of subscribers (in million)
Up to 0.5 million
180.00
300.00
540.00
It is assumed that the present customers of the company would continue to use the
existing packages.
Required
Evaluate the proposal submitted by the Marketing Director and advise the most
suitable call rates.
8.6
26
Questions
KLs Budget and Planning Department anticipates that Net Cash Inflows After Tax
(NCIAT) are dependent on exchange rate of the US $ and has made the following
projections:
Exchange Rate
Exchange Rate
Exchange Rate
Rs. 84-87
Rs. 88-91
Rs. 92-95
NCIAT
Probability
NCIAT
Probability
NCIAT
Probability
250
65%
320
35%
-:
If Year 1
exchange
rate is
Rs. 84-87
280
20%
330
65%
360
15%
If Year 1
exchange
rate is
Rs. 88-91
340
5%
380
50%
400
45%
Year 1
Year 2
(b)
27
LEASE OR BUY
A company is considering whether to acquire a new machine. The machine has a
purchase cost of Rs. 30,000, an expected useful life of five years and a disposal
value of Rs. 6,000 at the end of year 5. The machine would generate additional
cash flows of Rs. 10,000 in each of its five years.
Two methods of financing are under consideration:
(i)
To buy the machine with money obtained from a bank loan, at an interest
rate of 8% after tax.
(ii)
To lease the machine. The lease payments to the lessor would be Rs.
7,000 at the end of each of the next five years.
9.2
(a)
(b)
MOHANI LIMITED
Mohani Limited (ML) has decided to acquire an additional machine to augment
its production. The cost of the machine is Rs. 3,200,000 and the expected useful life
of the machine is 5 years. The salvage value at the end of its useful life is
estimated at Rs. 400,000.
To finance the cost of machine, the company is considering the following options:
(A)
5 years
Security deposits
Insurance costs
payable by lessor
Installment
28
Questions
(B)
Obtain a 5 year bank loan at an interest of 11% per annum. The loan
including interest would be repayable in 5 equal annual instalments to be
paid at the end of each year.
The company plans to depreciate the machine using straight-line method. The
insurance premium is Rs. 96,000 per annum. The corporate tax rate is 35%. For
the purpose of taxation, allowable initial and normal depreciation is 50% and 10%
respectively under the reducing balance method. The weighted average cost of capital
is 14%.
Required
Which of the two methods would you recommend to the management? Show all
relevant calculations.
9.3
(b)
Assume that BP has the following two options for financing the cost of
machine:
(i)
(ii)
29
9.4
Frequency
Rs. in million
Monthly
Quarterly
Half yearly
At the end of 2nd year
0.50
1.00
3.00
15.00
9.5
CRANK PLC
The Board of Directors of Crank Plc. is concerned about the optimal replacement
cycle of one of its equipment. The initial outlay required to purchase a new
equipment is Rs. 1.5million. The longer the asset is held, the higher the
operating and maintenance costs and the lower the residual value. Relevant
data on the various cost items relating to the equipment are given below:
Year
600
750
750
600
1500
300
1,050
Required
Determine the optimal period of replacing the equipment using the annual
equivalent cost method.
30
Questions
9.6
ASSET REPLACEMENT
A business entity is considering its policy for the replacement of machines. One
type of machine in regular use is machine X. This machine has a maximum
useful life of four years, but maintenance costs and other running costs rise with
use. An estimate of costs and disposal values is as follows:
Machine X: Purchase cost Rs. 40,000
Year
Disposal value
at the end of the year
Rs.
8,000
12,000
20,000
25,000
1
2
3
4
Rs.
25,000
20,000
10,000
0
(b)
(c)
(d)
9.7
ROTOR PLC
Rotor Plc is considering investment in a computer-controlled machine which can
be replaced by an identical one when it gets to the end of its economic life. The
machine has a maximum life of four years but, as its productivity declines with
age, it could be replaced after either one, two, three or four years. The financial
details of the machine are as given below:
Cost
Running cost:
Year
Rs.000
6,000,000
1
2
3
4
450,000
480,000
570,000
630,000
1
2
3
4
4,500,000
3,900,000
3,000,000
2,100,000
31
The board of directors of Rotor Plc is concerned with deciding on its replacement
policy.
As the financial manager of the company, you are required to advise the board
on the optimal replacement policy of the machine assuming that the companys
cost of capital is 10%.
9.8
Written
Down Value
Estimated
Cost of
Overhauling
Current
Disposal
Value
Replacemen
t
Cost
945,000
5,250,000
Amount in Rupees
3,900,000
(ii)
1,750,000
2,200,000
the generator can be used for another two years. However, running
cost of overhauled generator would be Rs. 440 per hour which is
10% higher in comparison with the running cost of the new
generator.
(iii)
The company rents out the generator at Rs. 2,000 per hour and such
generators are hired for approximately 2,500 hours per annum, irrespective
of their age.
(iv)
The companys cost of capital is 17% per annum before adjustment for
inflation. The rate of inflation is 8%.
(v)
The company receives all payments after deduction of tax at the rate of 6%
which is considered full and final settlement of its tax liability.
Required
(a)
(b)
32
Questions
EQUITY RATIOS
The following figures have been extracted from the annual accounts of Rainy:
Issued share capital: 1,000,000 ordinary shares of Rs. 1 each, fully paid.
Issued debt capital: Rs. 250,000 10% debentures.
Reserves
Capital (share premium reserve)
Accumulated profits
Rs. 200,000
Rs. 800,000
The current market price of Rainys equity shares is Rs. 3.20 each. Its
debentures are priced at Rs. 90 per cent. The companys rate of corporation tax
(income tax) is 30%.
Required
Calculate the ratios that are likely to be of interest to an investor or potential
investor in Rainy.
Comment on each.
10.2
Lire (million)
20X0
20X1
20X2
20X3
432
55
567
76
693
102
810
126
1,058
1,330
1,620
2,001
Equity beta
Company 2 in
Zedland
Revenue
Profit after tax
Share price (francs)
155
Francs (000)
20X0
20X1
20X2
20X3
12,000
12,430
13,100
14,569
1,840
2,004
2,320
2,540
236
192
204
229
Equity beta
098
33
20X0
Retail price
(inflation) index
Stock market index
Risk free rate
Zedland
Retail price
(inflation) index
Stock market index
20X1
4503
6102
20X2
20X3
7731
9242
5,005
6,002
7,450
20X0
20X1
20X2
9,470
19%
20X3
1043
8,896
1071
9,320
1108
9,457
100
10,200
4%
The equity betas and the risk free rate were estimated over the period 20X0
20X3.
Required
10.3
(a)
Prepare a report for the client discussing the performance of the two
companies. Relevant calculations should be included in the report.
(b)
Revenue
Division
A
Division
B
Rs.'000
Rs.'000
840
610
Operating profit
Interest
95
6
78
8
Taxable profit
89
70
Non-current assets
Current assets
Current liabilities
580
290
210
430
250
180
40
620
55
445
Capital employed
660
500
34
Questions
The results for the current year have just been announced as:
Division
A
Division
B
Rs.'000
Rs.'000
1,000
650
Operating profit
Interest
122
18
94
8
Taxable profit
104
86
Non-current assets
Current assets
Current liabilities
680
350
260
440
240
170
140
630
55
455
Capital employed
770
510
Revenue
Required
Analyse the performance of the two divisions, and from the perspective of the
future strategic development of Khan Industries suggest what controls the
directors of Khan Industries might introduce to influence the future development
of the divisions.
35
CAPITAL RATIONING
A company has identified five investment projects that it would like to undertake.
None of the investments can be delayed. If they are not undertaken now, the
opportunity to invest will be lost. Details of the five investments are as follows:
Capital investment
required in Year 0
Rs.
Rs.
60,000
12,000
B
C
80,000
50,000
21,600
8,500
45,000
10,800
55,000
9,900
Investment
Capital is in short supply, and only Rs. 150,000 is available for investment. The
company cannot therefore undertake all five investments.
Required
In order to maximise the total NPV of its investments, recommend which
investments to undertake:
11.2
(a)
(b)
assuming that none of the five investments is divisible, and the choice is
either 0% and 100% of each investment.
BASRIL COMPANY
Basril Company is reviewing investment proposals that have been submitted by
divisional managers. The investment funds of the company are limited to Rs.
800,000 in the current year. Details of three possible investments, none of which
can be delayed, are given below.
Project 1
An investment of Rs. 300,000 in work station assessments. Each assessment
would be on an individual employee basis and would lead to savings in labour
costs from increased efficiency and from reduced absenteeism due to workrelated illness. Savings in labour costs from these assessments in money terms
are expected to be as follows:
Year
85
90
95
100
95
Project 2
An investment of Rs. 450,000 in individual workstations for staff that is expected
to reduce administration costs by Rs. 140,800 per annum in money terms for the
next five years.
36
Questions
Project 3
An investment of Rs. 400,000 in new ticket machines. Net cash savings of Rs.
120,000 per annum are expected in current price terms and these are expected
to increase by 3.6% per annum due to inflation during the five-year life of the
machines.
Basril Company has a money cost of capital of 12% and taxation should be
ignored.
Required
(a)
11.3
Determine the best way for Basril Company to invest the available funds
and calculate the resultant NPV:
(i)
(ii)
(b)
(c)
CB INVESTMENT LIMITED
CB Investment Limited (CBIL) has identified various projects for investments.
Details of the projects are as follows:
Projects
(300)
(120)
(240)
(512)
(800)
(400)
150
50
140
256
440
300
10%
11%
12%
11%
13%
14%
(ii)
(iii) Project D, E and F are mutually exclusive. They cannot be scaled down but
can be scaled up.
Total financing available with the company is Rs. 1,000 million. It may be
assumed that all cash flows would arise at the beginning of the year.
Required
Determine the most beneficial investment mix.
37
RIGHTS
A company wishes to increase its production capacity by purchasing additional
plant and equipment. To finance the new investment, the company will make a 1
for 4 rights issue. The shares are currently quoted on the Stock Exchange at Rs.
5.50 per share and the new shares will be offered to shareholders at Rs. 4.50 per
share.
Ignore the transaction costs of the share issue.
Required
Calculate:
12.2
(a)
(b)
(b)
(c)
(i)
(ii)
The money raised from the rights issue may be used to execute the
following;
Buy back all the 15% debentures at their current market value.
It is expected that this investment will be priced to offer
investors a yield of 9% which is the current market-yield on
debenture loan.
Required
(i)
(ii)
(iii)
(iv)
Note:
The total finance required for (i) and (ii) should be rounded up to the next Rs.
100,000 for the purpose of the rights issue.
38
Questions
12.3
RIGHTS ISSUE
Smeaton Furniture wishes to increase its production capacity by purchasing
additional plant and equipment at a cost of Rs. 3.8 million. The abridged profit
and loss account for the year ended 30th November 20X6 is as follows:
Rs. m
Sales turnover
140.6
8.4
Interest
6.8
1.6
Tax
0.4
1.2
15 cents
In order to finance the purchase of the new plant and equipment, the directors of
the company have decided to make a rights issue equal to the cost of the
equipment. The shares are currently quoted on the Stock Exchange at Rs. 2.70
per share and the new shares will be offered to shareholders at Rs. 1.90 per
share.
Required
(a)
(b)
12.4
12.5
Calculate:
(i)
(ii)
(iii)
What are the options available to a shareholder who receives a rights offer
from a company?
(b)
What are the types of issue costs that are associated with obtaining a stock
exchange listing?
CONVERTIBLE BONDS
A company has the following equity shares and bonds in issue:
2,000,000 equity shares of Rs.0.50 each.
Rs. 1,000,000 of 4% convertible bonds.
39
12.6
12.7
(a)
(b)
The company has been approached by Mr. Alam, a large investor, who has
offered to provide the required capital as computed in (a) above at a
discount of 10% of market value. Compute the % holding of Mr. Alam in the
company, if his proposal is accepted.
40
Questions
400
Retained earnings
150
Non-current liabilities
600
Current liabilities
100
1,250
Fixed assets
1,100
Current assets
150
1,250
125
EPS
3.13
12.8
(a)
(b)
(c)
(d)
41
The following information has been extracted from the financial statements of PSD
for the year ended March 31, 2016:
Rs. in million
Issued ordinary shares Rs. 10 each
200
Retained earnings
390
590
350
940
The shares of the company are currently traded at Rs. 16 per share. The profit before
interest and taxation of PSD for the year ended March 31, 2016 is Rs. 95 million.
It is expected that the right issue will not affect PSDs current price earnings ratio.
However, the issue of TFCs would result in fall in price earnings ratio by 30%.
The tax rate applicable to the company is 35%.
Required
(a)
(b)
(ii)
(iii)
42
Questions
(b)
(c)
(d)
(ii)
(iii)
Y has 1 million ordinary shares, the dividend just paid was Rs. 10 per
share and it is expected to grow at 5% per annum; cost of equity
15%.
(iv)
Z has 10,000 shares in issue, dividends for the next five years are
expected to be constant at Rs. 10 per share and then grow at 5% per
annum to perpetuity; cost of equity 15%.
Given the following data about share price, compute the cost of equity in
each case.
(i)
Market price per share Rs. 150 ex-dividend. Dividend just paid Rs.
7.5, which is expected to remain constant.
(ii)
(iii)
Market price per share Rs. 120 ex-dividend. Dividend just paid Rs.
24, with expected annual growth rate of 5%.
(iv)
(ii)
(iii)
(iv)
(v)
Calculate the current post-tax cost with a corporation tax rate of 30% of the
loans in (a) above.
43
13.2
WACC
A company has just paid an annual dividend of Rs.0.18. Investors expect the
annual dividend to grow by 3% each year in perpetuity, The current share price is
Rs. 1.55 and the total market value of the companys shares is Rs. 1,200,000.
The company has debt capital on which the yield is 7.8% before tax. The rate of
tax is 30%. The total value of the companys debt is Rs. 350,000.
Calculate the weighted average cost of capital. Use the dividend growth model to
estimate the cost of equity.
13.3
REDSKINS PLC
Redskins plc has an authorised share capital of 10 million Rs. 25 ordinary shares, of
which 8 million have been issued. The current ex-dividend market price per ordinary
share is Rs. 110. A dividend of Rs. 10 per share has been paid recently. This is
expected to grow at 9% per annum for the foreseeable future.
Extracts from Redskins latest statement of financial position are given below.
Redskins
Rs. m
2,000
1,960
3,745
_____
7,705
_____
3% irredeemable debentures
9% debentures
6% loan stock
Bank loans
1,400
1,500
2,000
1,540
_____
6,440
_____
All debt interest is payable annually and all the current years payments will be made
shortly.
The current cum-interest market prices for Rs. 100 nominal value stock are Rs. 31.60
and Rs. 103.26 for the 3% and 9% debentures respectively. Both the 9% debentures
and the 6% loan stock are redeemable at par in ten years time.
The 6% loan stock is not traded on the open market but the analyst estimates that its
actual pre-tax cost is 10% per annum.
The bank loans bear interest at 2% above base rate (which is currently 11%) and are
repayable in six years. The effective tax rate of Redskins plc is 30%.
Required
Calculate the effective after-tax weighted average cost of capital for Redskins.
44
Questions
13.4
Rs.000
Non-current assets
1,276
Current assets
4,066
1,925
2,141
3,417
Financed by:
Ordinary share capital
1,000
Reserves
1,553
Deferred taxation
164
Debentures
700
3,417
Earnings
(before tax)
Rs.000
Rs.000
Earnings
(after tax)
Rs.000
2013
200
575
350
2014
230
723
452
2015
230
682
410
2016
260
853
536
2017
300
906
606
The new investment which has the same risk characteristics as the existing
projects, would require an immediate outlay of Rs. 1,500,000 and would generate
an annual net cash inflow of Rs. 500,000 indefinitely.
45
Required
13.5
(a)
(b)
(c)
(d)
MISTERI COMPANY
Misteri Company is considering whether to purchase a machine for the
manufacture of a new product, Product X. It has been estimated that Product X
would have a life of four years and at a selling price of Rs. 8 per unit, annual
sales demand would be 400,000 units in Year 1, 600,000 units in Year 2 and
800,000 in each of Years 3 and 4.
Variable production and selling costs would be Rs. 6per unit. Incremental annual
fixed cost expenditures (all cash cost items) would be Rs. 500,000 in Year 1,
rising by Rs. 20,000 each year.
The machine, which has an annual output capacity of 700,000 units of Product X,
would cost Rs. 1,200,000 and would have a resale value of Rs. 200,000 at the
end of Year 4. Capital allowances would be available on a 25% annual reducing
balance basis, with a balancing charge or allowance in the year of disposal. Tax
at 25% is payable one year in arrears of the profits to which it relates.
Misteri Company is financed 70% by equity capital and 30% by debt capital. The
equity has a cost of 10% and the debt has a cost of 8.9%.
Required
Calculate the net present value of the proposed project and recommend whether
the investment in the machine should be undertaken.
13.6
FAIZ LIMITED
The share capital and term finance certificates (TFCs) of Faiz Limited (FL) are listed
on the Karachi Stock Exchange. An extract from the companys latest statement of
financial position as on December 31, 2016 is as follows:
Rs. in million
Ordinary share capital of Rs. 10 each
400
Revenue reserves
350
Other reserves
150
900
595
80
1,575
46
Questions
6 years TFCs were issued on January 1, 2016. The coupon rate is 6% payable
annually and the expected IRR is 10%. These TFCs were issued to fund a medium
term project. The prevailing commercial rate for similar risk bonds is KIBOR plus 2%.
The accounting policy of the company states that TFCs and other held to maturity
liabilities are carried at the amortised cost.
KIBOR is currently 9% which can be considered as risk free. FL has an equity beta
value of 1.6 with market equity premium of 6.25%. The rate of income tax is 35%.
The dividend paid in the year 2016 was 12.5% and current years dividend will be
paid shortly. The dividend is expected to grow at a constant rate of 10%.
Required
Compute the following as on December 31, 2016:
(a)
(b)
47
TWO-ASSET PORTFOLIO
An investor is planning to invest in two securities, Security X and Security Y. The
expected return from each security will depend on the state of the economy, as
follows:
State of the
economy
Probability
Return from
Security X
Return from
Security Y
Strong
0.25
15
20
Fair
0.60
10
Weak
0.15
(6)
Required
(a)
Calculate the mean and standard deviation of the expected return from
Security X.
(b)
Calculate the mean and standard deviation of the expected return from
Security Y.
(c)
Calculate the covariance of the returns from Security X and Security Y. The
formula for a covariance is:
Cov x,y 6r x x y y
(d)
Calculate the correlation coefficient for returns from Security X and Security
Y, for a portfolio consisting of 50% of the funds invested in Security X and
50% of the funds invested in Security Y. The formula for correlation
coefficient is:
U x,y Cov x,y
Vx x Vy
where:
V x = the standard deviation of returns from Security X
Vy
48
Questions
14.2
COEFFICIENT OF VARIATION
A multinational company is planning to invest in two developing countries, and it will
invest equal amounts of capital in each country. It is looking at returns and risk in each
of three possible countries that might be selected for investment.
The company is particularly concerned about the political risk in each country, and the
threat of political risk to its expected returns. A firm of management consultants has
produced the following statistical estimates of expected returns ad political risk in each
of the countries.
Expected investment
return (%)
Political
risk (%)
Country A
16
25
Country B
22
36
Country C
30
45
Country
The expected return from investing in any of the three countries is independent of the
returns that would be obtained from the other countries.
Required
(a)
(b)
14.3
Calculate the risk, return and coefficient of variation of the following three
investment portfolios:
(i)
(ii)
(iii)
PORTFOLIO RETURN
A client has asked for advice on his investment portfolio. Details of his securities
in the stock market (which is regarded as efficient) with the associated risk
characteristics are given below:
SECURITIES
X
15
14
80
40
60
30
30
40
49
The expected return on shares in general and on the basis of past return and
inflationary expectation was estimated to be 20%. It is expected that the risk
premium will be about 5%. The risk of the market as measured by its standard
deviation is 8%. All the three securities lie on the Securities Market Line (SML).
Required
Prepare the following computations for a discussion with your client, as a
prelude to your advice:
14.4
(i)
(ii)
DOLPHIN PLC.
Dolphin Plc. is all equity financed.
The directors are considering investment in one of two projects which are
mutually exclusive. The cash flows of the two projects are as follows:
Project A
Project B
(Mortgage Finance)
Initial Outlay
Rs. 10 million
Rs. 24 million
Years 1 3
Years 4 and 5
Rs. 1million
Rs. 1 million
Cash flow:
Residual Value
Rs. 150
Rs. 15
10%
0.7
9%
17%
Required
(a)
Evaluate the viability of each project using the Capital Asset Pricing Model
(CAPM) and Dividend Growth Model (DGM).
(b)
(c)
Explain the THREE factors that must be estimated for any valuation model.
50
Questions
14.5
Risk ()
Project 1
0.80
Project 2
1.60
Project 3
Not yet
calculated
Project 4
Not yet
calculated
Required
14.6
(a)
(b)
Suggest which of the four projects the divisional manager will select.
+2
+3
+3
+5
+ 0.5
+ 1.0
Month
EV of monthly return
Required
(a)
the standard deviation of the monthly return from the market portfolio
and
(ii)
51
(b)
Calculate the correlation coefficient for the market returns and the returns
from Security Y. This is calculated as:
Um, y Cov m, y
Vm x Vy
where:
Vm = the standard deviation of returns from the market portfolio
Vy
Cov x,y 6x x y y
(c)
Use this data to calculate the beta factor for Security Y. You can use either
of the following formulas.
Cov m, y
Var m
Alternatively
E
14.7
Um, y x V y
Vm
SODIUM PLC
Sodium Plc is a highly diversified company operating in a number of different
industries. Its shares are widely traded on the Stock Exchange and have a
current market price of Rs. 3.20.
Its dividend payments over the last five years are:
Year
DPS
2016
0.25
2015
0.23
2014
0.20
2013
0.19
2012
0.18
Sodium Plc is considering two investment opportunities: one is the Hotel and
Tourism (H&T) sector and the other is the Food and Beverages (F&B) sector.
Both projects have relatively short lives and their cash flows are as follows:
H&T
F&B
Year
Rs.m
Rs.m
85
190
170
180
150
200
52
Questions
The investment in Hotel and Tourism would cost Rs. 300 million while that in
Food and Beverages would cost Rs. 400 million.
The directors have discovered that industry beta for Hotel & Tourism and Food
and Beverages sectors are 1.2 and 2.2 respectively. They believe the
investments being considered are typical of projects in the relevant industries.
Sodium Plc industries beta is 1.6, treasury bill rate is 9% and the average return
on companies quoted on the stock exchange is 14%.
Required
(a)
(b)
14.8
(i)
Compute the net present values of both projects using the companys
weighted average cost of capital as a discount rate.
(ii)
Compute the NPVs using a discount rate which takes account of the
risk associated with the individual projects.
(iii)
Enumerate the uses and limitations of the Capital Asset Pricing Model
(CAPM)
DR JAMAL
Dr Jamal has the following portfolio of shares in five listed companies:
Companies
Black
Blue
Yellow
Purple
White
15,000
18,000
10,000
12,000
20,000
Rs.0.50
Rs.0.60
Rs.0.40
Rs.0.25
Rs.0.35
Black
Blue
Yellow
Purple
White
Rs. 2.50
Rs. 2.20
Rs. 1.90
Rs. 1.50
Rs.0.60
2.2%
4.0%
5.2%
2.6%
1.8%
Beta factor
1.32
1.20
0.80
1.05
0.80
At present the risk-free rate of return is 8% while the market return is 14%.
Required
(a)
(b)
14.9
Calculate
(i)
(ii)
MR. FARAZ
Mr. Faraz, a large investor, wants to invest Rs. 100 million in the stock market by
developing a portfolio consisting of those shares which have a track record of good
performance.
53
He contacted a Stock Analyst to identify such stocks. After a detailed study, the
Stock Analyst recommended investments in shares of five different companies.
Based on his recommendation, Mr. Faraz invested the amount on January 1, 2016.
The relevant details are as follows:
Investment
(Rs.)
Company
Price per
Share on
Jan 1, 2016
(Rs.)
Expected
Dividend
Yield
Standard
Deviation
Covariance
with
KSE 100
15,000,000
60
3.50%
24%
2.10%
18,000,000
245
3.00%
22%
3.00%
22,000,000
225
2.50%
18%
2.60%
25,000,000
130
8.00%
15%
1.90%
20,000,000
210
5.00%
20%
2.80%
The stock analyst also informed him that the standard deviation and market return of
the KSE-100 Index is 15% and 20% respectively. The risk free rate of return is 8%.
Required
14.10
(a)
Assuming that Mr. Faraz estimates his cost of equity by using the
Capital Asset Pricing Model, compute the required rate of return on each
security.
(b)
Portfolio beta.
MUSHTAQ LIMITED
Mushtaq Limited is considering two possible investment projects. Both the projects
have a life of one year only. The returns from new projects are uncertain and depend
upon the growth rate of the economy. Estimated returns at different levels of economic
growth are shown below:
Economic
Probability of
Returns (%)
Growth
Occurrence
Project 1
Project 2
Market
1%
0.25
20
22
30
3%
0.50
30
28
25
5%
0.25
40
40
40
(Annual Avg.)
54
Questions
14.11
in 000
Rupees
Rupees
25
150
0.15
0.024
27
2.00
15
230
0.24
0.039
17
1.00
46
190
0.16
0.044
52
2.50
106
50
0.32
0.033
111
4.00
75
100
0.19
0.018
85
2.00
114
120
0.22
0.041
125
3.00
239
60
0.19
0.032
220
5.50
156
80
0.21
0.04
168
3.00
145
35
0.18
0.034
170
2.50
67
45
0.22
0.033
75
1.00
The average market return of the KSE-100 Index companies is 12% and
the standard deviation is 18%.
(ii)
(iii)
The correlation between the market value of securities held by AITF and
KSE-100 Index is 0.737.
(iv)
Required
(a)
Compute the AITF's systematic risk and assess the extent to which AITF
has matched the performance of KSE-100 Index.
(b)
Determine whether AITF achieves the return according to its risk profile.
(c)
(d)
55
14.12
IRON LIMITED
Iron Limited (IL) is considering four projects for investing the excess liquidity
available with the company. Each project will last for three years. The details are as
follows:
Projects
A
85
87
90
95
Expected return
16%
14%
17%
15%
20%
18%
27%
30%
0.82
0.85
0.91
0.78
The current market returns are 14% with a standard deviation of 16%. Risk free rate of
return is 10%.
Required
14.13
(a)
(b)
Determine the overall systematic risk that would be associated with the
above investments if IL decides to invest in all the projects selected in (a)
above.
A
Information on proposed
investment
Date of investment
01-Jul-16
Amount of investment
Estimated net asset value on
acquisition
Estimated net asset value as
on December 31, 2016
Expected dividends
(during the investment
holding period)
Cash dividend to be received
Bonus to be received
56
Rs. 500,000
01-Aug-16
Rs.
1,000,000
01-Sep-16
Rs. 500,000
Rs. 10.50
Rs. 10.00
Rs. 9.70
Rs. 10.40
Rs. 10.00
Rs. 9.90
Rs. 9,500
10%
Rs. 15,000
5%
5%
Questions
Mutual Funds
B
A
Funds characteristics
Front end load (Buying load)
Back end load (Selling load)
Sharpe ratio
Correlation with benchmark
indices
Expected performance of
benchmark indices
Benchmark index
Total annual return %
Standard deviation of annual
returns
3.00%
1.00%
0.71
2.00%
0.00%
0.31
1.50%
2.00%
0.16
0.75
0.9
0.83
KSE 100
16
KSE 30
17
KMI 30
12
0.1
0.18
0.13
Estimate the effective annual yield which FR would earn, from the date of
investment up to December 31, 2016.
(b)
57
15.2
(a)
25% of earnings
(b)
50% of earnings
(c)
70% of earnings
ACKERS PLC
Ackers Plc. has been experiencing difficult trading conditions over the past few
years. In the current year, net earnings are likely to be Rs. 20 million, which will
just be sufficient to pay a dividend of Rs. 1 per share. The earnings and
dividends for the company over the past five years are shown below:
Year
Net earnings
per share
Net dividend
per share
Rs.
Rs.
2012
1.40
0.84
2013
1.35
0.88
2014
1.35
0.90
2015
1.30
0.95
2016
1.25
1.00
There are 20,000,000 ordinary shares in issue, majority of which, are owned by
private investors. There is no debt in the capital structure. Members of the Board
of Directors are considering a number of strategies for the company, some of
which, will have an impact on the companys future dividend policy. The
companys shareholders require a return of 15% on their investment.
The following four dividend payment options are being considered:
(i)
(ii)
Pay a dividend of 50% out of earnings and retain the remaining 50% for
future investment
58
Questions
(iii)
Pay a dividend of 25% out of earnings and retain the remaining 75% for
future investment.
(iv)
The directors have not been able to agree on any of the four options.
Some of them prefer option (i) because they believe that doing anything else
would have an adverse impact on the share price.
Others favour either option (ii) or option (iii) because the company has identified
some good investment opportunities and they believe one of these options would
be in the best long-term interest of the shareholders.
An adventurous minority favours option (iv) and thinks that the option will allow
the company to take over a relatively small but vibrant competitor.
Required
(a)
Discuss the companys dividend policy between 2012 and 2016 and its
possible consequences on earnings.
(b)
Advise the directors of Ackers Plc. on the share price which might be
expected immediately following the announcement of their decision if they
pursue each of the four options, using an appropriate valuation model
15.3
DIVIDEND POLICY
The objective of dividend policy should be to maximise the shareholders return
so that the value of their investment is maximised.
(a)
State and explain any SIX factors which determine the dividend policy of a
large public company whose shares are quoted on the stock exchange.
(b)
(c)
Mainland Plc. has just made earnings of Rs. 2,250,000. Its Directors are
trying to decide on a dividend policy. If they retain 20% of earnings, they
believe they can achieve an annual growth rate of 5% in earnings and
dividend. If they retain only 10% of earnings, the growth rate would be 2%
and shareholders would expect a return of 14%.
Which retention policy would maximise the value of the companys shares.?
15.4
YB PAKISTAN LIMITED
YB Pakistan Limited is engaged in the manufacture of pharmaceutical products. On
April 1, 2016 the Board of Directors approved a plan which envisages an investment of
Rs. 300 million on account of capital expenditures over the next five years. Following
information has been extracted from the management accounts of the company
which have been prepared in respect of the year ended March 31, 2016:
59
Rs. in millions
Sales revenue
190.00
110.00
Operating expense
30.00
Interest expense
15.00
100.80
Shareholders equity
135.00
(ii)
(iii)
(iv)
Interest rates on existing and future long term debts are expected to be
the same and are not expected to change during the next five years. The
current debt is repayable at the end of five years. All future debts would be
repayable on or after six years.
(v)
The company has a short term financing facility of Rs. 50 million. The
outstanding balance as of March 31, 2016 was Rs. 20 million. Assume
that interest @ 16% is payable at the end of each year on the closing
balances.
(vi)
The company invests its surplus funds into highly secured investments
which yield 8% per annum.
The company follows the residual dividend policy for payment of dividends.
You may assume that all cash flows are incurred at year end.
Required
(a)
Calculate the expected dividend for the next five years in accordance with
the existing payout policy of the company.
(b)
Ascertain whether the company would be able to pay off its existing loan at
the expiry of five years.
60
Questions
15.5
(b)
(c)
(i)
20% dividend
(ii)
Nil dividend
61
GEARING
The following information is available about Company A and Company B:
Capital structure
Equity shares of Rs. 1
Reserves
Annual profit
Sales
Variable costs
Contribution
Fixed operating costs
Profit before interest and tax
Interest costs
Profit
Tax (20%)
Profit after tax (= earnings after interest and tax)
Company A
Rs.
10,000
20,000
Company B
Rs.
10,000
90,000
30,000
70,000
100,000
0
100,000
100,000
Rs.
80,000
10,000
Rs.
80,000
60,000
70,000
60,000
20,000
10,000
10,000
7,000
10,000
0
3,000
600
10,000
2,000
2,400
8,000
Assume that annual sales now increase for both companies by 25% to Rs.
100,000.
Required
(a)
(b)
(ii)
(iii)
62
Questions
16.2
FINANCING SCHEMES
The statement of financial position of Brunel as at 31st November Year 6 is as
follows:
Statement of financial position as at 30th November Year 6
Rs. m
Non-current assets
Current assets
Inventory
Trade receivables
Bank
Rs. m
24.8
18.5
21.4
1.9
41.8
Total assets
66.6
10.0
22.4
Total equity
10% Debentures
Current liabilities
Trade payables
Taxation
32.4
15.0
15.1
4.1
19.2
66.6
An statement of profit or loss for the year to 30th November Year 6 is as follows:
Rs. m
Sales
Profit before interest and taxation
Interest payable
Profit before taxation
Tax (25%)
Profit after taxation
115.4
17.9
1.5
16.4
4.1
12.3
Issuing 9 million Rs.0.50 equity shares at a premium of Rs. 1.50 per share.
(ii)
Issuing 12 million 12% Rs. 1 preference shares at par and Rs. 6 million
10% debentures at par.
63
(iii)
Issuing 6 million equity shares at a premium of Rs. 1.50 per share and Rs.
6 million 10% debentures at par.
(b)
16.3
prepare a projected statement of profit or loss for the year ended 30th
November Year 7.
(ii)
calculate the expected earnings per share for the year ended 30th
November Year 7.
(iii)
Assess each of the three financing schemes under consideration from the
viewpoint of an existing equity shareholder in Brunel.
16.4
(a)
(b)
DIVERSIFY
Bustra Company is engaged in plastics manufacture. It is now considering a new
investment that would involve diversification into chemicals manufacture, where
the business risk is very different from the plastics manufacturing industry.
Research has produced the following information about three companies
currently engaged in chemicals manufacturing, in the same part of the industry
that Bustra is planning to invest.
Company
Equity beta
Financed by:
2.66
1.56
1.45
Bustra is financed by 60% equity capital and 40% debt capital, and would intend
to maintain this same capital structure if the new capital investment is
undertaken.
64
Questions
The risk-free rate of return is 5% and the return on the market portfolio is 9%. Tax
is at the rate of 25%. You should assume that the debt capital of Bustra and
Companies A, B and C is risk-free.
Required
16.5
(a)
(b)
Suggest a weighted average cost of capital that should be used to carry out
an investment appraisal (NPV calculation) of the proposed project.
Rs.000
1,800
720
360
1,080
720
190
530
186
344
Calculate the change in earnings per share if the company introduces the
new production process.
(b)
(ii)
(iii)
65
16.6
OPTIMAL WACC
A company has estimated that its cost of debt capital varies according to the level
of gearing, as follows:
Gearing
Cost of debt
%
20
5.0
30
5.4
40
5.8
50
6.5
60
7.2
16.7
GEARED BETA
A company has Rs. 1,500,000 in equity capital and Rs. 500,000 in debt capital
(at market values). The beta value of the equity is 1.126 and the beta of the debt
capital is 0.
The risk-free cost of capital is 5% and the market portfolio return is 11%. The tax
rate is 30%.
Required
16.8
(a)
(b)
Calculate the asset beta for the company and explain what this means.
(c)
Calculate what the equity beta, the cost of equity and the WACC would be
if the company consisted of 60% equity and 40% debt.
66
Questions
Issue costs, which are tax-allowable, will be 5% for the equity and 2% for the debt,
measured as a percentage of the net finance raised.
The plastics industry has an average equity beta of 1.356 and an average debt: equity
ratio of 1:5, at market values. Harveys current equity beta is 1.8 and 20% of its capital
(at market value) consists of long-term debt which is regarded as risk-free.
The risk-free rate is 10% per annum and the expected return on an average market
portfolio is 15%. Corporation tax is at 35%, payable one year in arrears. The machine
will attract a 70% capital allowance in the first year, and the balance will be allowable
against tax over the next three years, at an equal amount in each year.
Required
Carry out an appraisal of the investment using each of the three following methods:
16.9
(a)
(b)
NPV of the project, using a WACC adjusted for business risk and financial
risk
(c)
APV METHOD
A company in the engineering industry is considering making an investment in a
telecommunications project. The investment will cost Rs. 2,000,000, and will be
financed by a new issue of Rs. 1,000,000 in equity and a new issue of Rs. 1,000,000
debt capital.
The companys current gearing level is 30% debt and 70% equity.
The telecommunications industry has an average industry equity beta of 1.30625. The
average gearing ratio in the industry is 20% debt and 80% equity.
The rate of taxation is 25%.
The risk-free rate of return is 4% and the average market return is 9%. The companys
debt is risk-free.
The cash flows from the project before taxation are expected to be:
Year
Cash flow
Rs.
100,000
140,000
120,000
67
Required
Calculate:
16.10
(a)
the NPV of the project, using the Modigliani and Miller formulas to derive a
cost of capital for the project
(b)
MORE APV
Pobol Company specialises in business consultancy, but its directors are considering
an investment in software development, which would represent a major diversification
of the companys business activities. The following draft financial proposal has been
prepared:
Year
Rs.000
Rs.000
Rs.000
Rs.000
Rs.000
Revenue
6,800
7,800
8,800
9,200
600
120
5,500
100
500
-
6,600
150
400
-
7,100
150
300
-
7,500
200
200
-
720
6,100
7,150
7,550
7,900
Expenditure on equipment
Working capital
3,000
400
(2)
All prices are calculated in money terms, allowing for inflation. After Year 4,
it is expected that revenues and cash operating costs will remain
unchanged in real terms, but will increase at the rate of inflation which is
expected to be 3% per year. Royalty payments are expected to be Rs.
200,000 per year in Years 5 and 6.
(3)
(4)
(5)
(6)
(7)
The cash for the royalty payments and market research in Year 0 come
from internally-generated cash flows.
68
Questions
(8)
Tax is payable at the rate of 25%, and is payable in the same year that the
tax liability arises.
(9)
(10) The average equity beta of companies in the software sector that Pobol
Company is considering is 1.39. The market return is 10% and the risk-free
interest rate is 6%.
(11) The average gearing of companies in the software sector that Pobol
Company is considering is 80% equity and 20% debt.
Required
Calculate the adjusted present value (APV) of this project.
16.11
JALIB LIMITED
Jalib Limited (JL) is planning to invest in a project which would require an
initial investment of Rs. 399 million. The project would have a positive net present
value of Rs. 60 million if funded only from equity. There are no internal funds
available for this investment and the company wants to finance the project through
debt. However, JLs existing TFCs contain a covenant that at any point in time, the
debt to equity ratio in terms of Market Values should not exceed 1:1.
Currently, the market values of JLs equity (40 million shares are outstanding) and
debt are Rs. 672 million and Rs. 599 million respectively. Markets can be
assumed to be strong form efficient.
Required
(a)
Using Modigliani & Miller theory relating to capital structure, calculate the
minimum amount of equity that the company will have to issue to comply
with the TFCs covenant.
(b)
the right share ratio and the price at which right shares may be issued
to raise the amount of equity as determined in (a) above, without
affecting the market price of shares.
(Round off all the amounts to nearest millions and price computations to two decimal
places)
16.12
JAVED LIMITED
Javed Limited is a listed company and is engaged in the business of manufacture and
export of garments. 100% of the companys revenue comes from exports which are
taxable @ 1% under final tax regime.
An extract of the companys latest statement of financial position as on June 30,
2016 is as follows:
69
Rs. in million
100
40
85
225
150
375
Term Finance Certificates (TFCs) are due to be redeemed at par on June 30,
2010. TFCs carry floating mark up i.e. 6 months KIBOR plus 2% which is payable
at half yearly intervals. Currently, TFCs with similar credit rating are available at
six months KIBOR plus 1%.
During the year ending June 30, 2017, the company expects to post a net profit
of Rs. 15 million. Cost of equity of a similar ungeared company is 19%. The
shares of other companies in this sector are being traded at P/E ratio of 8. On
June 30, 2016 the six monthly KIBOR was 14%.
Required
Compute the weighted average cost of capital of the company as at July 1, 2016.
16.13
GHI LIMITED
GHI Limited is an all equity financed company with a cost of capital of 14%. For
last several years, the company has been distributing 70% of its profits to the
ordinary shareholders and is expected to continue to do as in future. The company
plans to enter into a new line of business. Taking it as an opportunity to reduce the
cost of capital, it is considering to issue debt to finance the expansion. The Corporate
Consultant of GHI has provided the following industry data relating to different levels
of leverage:
Debt/Assets
0%
10%
40%
50%
Cost of Debt
8%
10%
12%
Equity Beta
1.20
1.30
1.50
1.70
The estimated value of assets after the investment in new line of business
would be Rs. 250 million.
(ii)
The forecasted revenue for the next year is Rs. 200 million.
(iii)
Fixed costs for the next year are estimated at Rs. 40 million whereas
variable costs will be 60% of the revenue.
(iv)
(v)
The rate of return on 1-year Treasury Bills is 6% and the market return is 10%.
Required
Advise the optimal capital structure which GHI Limited should formulate. Show all
relevant workings.
70
Questions
16.14
NS TECHNOLOGIES LIMITED
(a)
Briefly explain the Adjusted Present Value (APV) method and identify its
advantages over the Weighted Average Cost of Capital method.
(b)
(ii)
The investment is expected to generate pre-tax net cash flows of Rs. 180
million per year.
(iii)
(iv)
NS maintains a debt equity ratio of 55:45 whereas its equity beta is 0.9.
(v)
(vi)
The market rate of return is 14% whereas yield on one year treasury bills is
6%.
(vii) Costs associated with the issuance of debt and equity instruments are
estimated at 1% and 3% respectively.
(viii) Tax rate applicable to the company is 35%. Tax is paid in the same year
as the income to which it relates.
(ix)
In case the contract is not renewed upon expiry, after tax cash flows of
Rs. 90 million would be generated from disposal of allied resources.
Required
Evaluate the above proposal using the APV method.
16.15
>8
6 to 8
4 to 6
2 to 4
8%
9%
11%
13%
71
The management has found that the following two debt equity ratios are usually
prevalent in the industry and are also acceptable to the companys banker.
(i)
(ii)
272
Depreciation
50
Interest @ 9%
55
Capital expenditure
150
Market value of existing equity and debt is Rs. 825 million and Rs. 550 million
respectively. CILs equity beta is 1.25 and its debt beta may be assumed to be
zero. The risk-free rate of return and market return are 7% and 15% respectively.
Applicable tax rate is 35%.
Assume that:
CILs cash flow growth rate would remain constant and would not be
affected by any change in capital structure.
Required
(a)
(b)
16.16
Calculate the following under the current as well as each of the above debt
equity ratios being considered by the company:
(i)
(ii)
72
Questions
Rs. in
million
7,000
Retained earnings
23,000
28,000
Current liabilities
32,000
Assets
Rs. in
million
Non-current assets
50,000
Current assets
40,000
90,000
90,000
The existing TFCs carry mark-up @ 11.5% per annum and are due for redemption at
par in 2020.
Currently, MFLs shares and TFCs are traded at Rs. 80 and Rs. 102.50
respectively. Equity beta of the company is 1.3.
The proposed investment has been evaluated at a discount rate of 17% which is
based on existing cost of equity plus a premium that takes cognisance of the risks
inherent in the steel industry. However, there are divergent views among the
directors regarding the discount rate that has been used.
Director A is of the view that the premium charged to reflect the risk in the
steel industry is too low. He is of the opinion that the companys existing
weighted average cost of capital is more appropriate discount rate for
evaluation of this investment.
900 million shares of Rs. 10 each are outstanding which are currently
being traded at Rs. 35.
Long term loan amounted to Rs. 8,000 million obtained from local
banks at the average rate of 13%.
You have been appointed as the Lead Advisor by an Investment Bank working on
this transaction. You have obtained the following information:
Interest rate for 6-months treasury bills
8%
Market return
13%
30%
73
VALUATION MODEL
The shareholders in a company expect a return of 8% per year on their
investment. In the year just ended, the company paid dividends of Rs.0.24 per
share.
Required
(a)
Assume that the company pays out all of its annual profits as dividends,
and the annual dividend per share is expected to be Rs. 24 in perpetuity.
Using the dividend valuation model, suggest what the expected share price
of the company should be.
(b)
(c)
Assume that the company is expected to retain 60% of its profits and
reinvest the money to earn an annual return of 9%.
Using the dividend growth valuation model (the Gordon growth model),
suggest what the expected share price of the company should be.
17.2
VALUATION
A company has just paid an annual dividend of Rs. 38. The board of directors
has a target of increasing the share price to Rs. 800, and is considering policies
for investment and growth.
Shareholders expect a return on their investment of 10% per year.
Required
Calculate the annual expected growth rate in dividends that would be required to
raise the share price to Rs. 800. Use the dividend growth model to make your
estimate.
17.3
VALUATION OF BONDS
Assume that bond investors require a return of 9% per year on their investments.
Required
Estimate the market value of the following bonds:
(a)
(b)
Bonds paying coupon interest of 6% per year annually, that are redeemable
at par in four years time.
(c)
Bonds paying coupon interest of 10%, redeemable at par after three years,
where interest is payable every six months.
74
Questions
Notes:
An annual cost of capital of 9% is equal to a six-monthly cost of capital of
4.4%.
DCF factor at 4.4%, periods 1 7 = 5.914
DCF factor at 4.4%, periods 1 8 = 6.623
(d)
17.4
(ii)
Assume that the yield required by investors is 5%, and that this is 2.5%
each half year for the purpose of valuing the 8% coupon bond.
(b)
17.5
Calculate the value of both bonds in part (a) of the question if the yield
required by investors goes up by 1%, to 6% for the zero coupon bond and
3% each half year for the 8% coupon bond.
Rs. 4.40
(ii)
Rs. 5.20
(iii)
Rs. 6.00
(iv)
Rs. 6.80
75
In each of the four cases (i)(iv), advise the holders of the convertibles and
warrants whether they should exercise their conversion and option rights.
Ignore taxation.
(b)
(ii)
For the first full year following conversion of all the convertibles in
Conver and the exercise of all the warrants in Warren.
Profits for each company are currently Rs. 1.2 million each year
before interest and taxation. The corporation tax rate is 50%.
Assume that any new cash raised by the company will be invested to
earn 10% each year before taxation.
17.6
KENCAST LIMITED
The entire share capital of Kencast Limited, an unlisted company, is held by the
three directors of the company Parvez, Qadir and Rizwan. They have decided
to sell their shares in order to complete a divestment proposal agreed with
management and, as such, wish to know the likely value of the shares before
approaching prospective buyers. Should they fail to get buyers for the shares,
the company will go into liquidation.
The following information is provided in respect of the company:
(a)
Rs.000
Rs.000
6,500
15,600
Inventories
6,975
Accounts receivables
4,825
650
12,450
4,150
8,300
30,400
(b)
2016
2017
Rs.000 Rs.000
Rs.000
Depreciation
2,250
2,250
2,250
Directors remuneration
2,500
2,900
3,000
76
Questions
2015
2016
2017
Rs.000 Rs.000
Rs.000
3,250
3,600
4,175
Dividends
2,250
2,250
2,250
(d)
(e)
The relevant data of the two listed companies engaged in similar line of
business as Kencast Limited are as follows:
Dividend yield
Price earnings
Company 1
9%
5.4
Company 2
11%
6.6
Liquidation
values
values
Rs.000
Rs.000
Freehold properties
15,000
15,000
Equipment
8,650
5,400
Inventories
4,350
8,000
Required
(a)
Compute the value for the entire share capital of Kencast Limited using
(i)
77
(ii)
(iii)
17.7
Identify any TWO limitations associated with each of the methods above.
A Plc
B Plc
Rs.000
Rs.000
1,000,000
500,000
200,000
20,000
380,000
40,000
150,000
50,000
1,730,000
610,000
A Plc
B Plc
Rs.
Rs.
240,000,000
150,000,000
2.40
2.70
Current EPS
0.24
0.30
10
125%
125%
P/E ratio
Current market price of debts
The companys income tax rate is 30%.
Required
Determine the offer which the directors of A Plc would make to the shareholders
of B Plc on each of the following bases:
(a)
Net Asset
(b)
Earnings
(c)
Market value
(d)
Financial analysis
78
Questions
17.8
PQ (Pvt.)
Limited
RS Limited
Rupees in millions
Share capital (Rs 10 each)
Retained earnings
TFCs
Current liabilities
Non-current assets
Investment held for trading
Current assets
1,500
800
1,200
700
300
350
1,000
400
500
300
100
200
3,500
1,600
2,250
3,000
1,400
1,800
300
500
200
150
3,500
1,600
2,250
PQ (Pvt.)
Limited
RS
Limited
Rupees in millions
Sales
2,500.00
800.00
1,200.00
1,250.00
400.00
540.00
Interest
(100.00)
(48.00)
(55.00)
Depreciation
(450.00)
(180.00)
(270.00)
Other income
200.00
20.00
45.00
900.00
192.00
260.00
(315.00)
(67.20)
(91.00)
Net profit
585.00
124.80
169.00
292.50
87.36
84.50
Tax @ 35%
79
Additional information:
(i)
(ii)
(iii)
The risk free rate of return is 8% per annum and the market return is
13% per annum. The market applies a premium of 300 basis point on the
required returns of unlisted companies.
(iv)
(v)
Required
Which of the two companies should be acquired by MNO Chemicals Limited?
Show necessary computations to support your answer.
17.9
400,000
600,000
Dividend payments
Depreciation charges
1,200,000
550,000
150,000
1,000,000
Discretionary expenditure
700,000
Required
Calculate the expected amount of free cash flow next year.
17.10
FINANCIAL PLAN
The board of directors of NNW have asked for a four-year financial plan to be prepared
for Year 5 to Year 8. They have approved the following assumptions for the plan:
(1)
Sales growth will be at the rate of 8% each year into the foreseeable future.
(2)
(3)
Investment in new plant and equipment is expected to grow in line with the
growth in sales, and the net book value of plant and equipment will grow at
the same rate.
(4)
80
Questions
(5)
Inventory, receivables, cash and trade payables will also increase at the
same rate as the growth in sales.
(6)
(7)
(8)
(9)
The statement of profit or loss of NNW for the year to 31st December Year 4 is as
follows:
Rs. million
Sales
1,800
(1,260)
EBITDA
Tax allowable depreciation
540
(160)
380
(78)
302
(91)
211
Dividends
(135)
Retained profit
76
520
640
30
1,190
3,210
Total assets
Share capital (shares of Rs.0.05 each)
Reserves
Long term loan at 8%
Trade payables
Bank overdraft
Rs. m
2,020
81
450
1,200
1,650
800
450
310
3,210
Required
17.11
(a)
Prepare a financial plan for Years 5 to 8, showing the profit after tax,
dividends, retained profits for each year and a summary statement of
financial position as at the end of each year.
(b)
Calculate the expected free cash flow in each year of the financial plan.
(c)
(d)
Use the dividend growth model to estimate a market value per share as at
the end of Year 8 (the end of the financial planning period). State any
assumptions that you make in your estimate.
TAKEOVER
Flat Company intends to make a takeover bid for Slope Company, a company in the
same industry. The initial offer will be to exchange every 3 shares in Slope for 2 new
shares in Flat.
The most recent annual data for the two companies is shown below.
Sales revenue
Operating costs
Tax allowable depreciation
Earnings before interest and taxation
Interest
Profit before tax
Tax at 30%
Dividends
Retained earnings
Flat
Rs.000
7,619
4,962
830
1,827
410
1,417
425
992
500
492
Slope
Rs.000
6,000
3,480
700
1,820
860
960
288
673
410
263
920
790
Flat
Slope
5%
4%
3%
2%
25%
320
6
7%
1.20
40%
154
9
8%
1.35
82
Questions
The takeover will result in some cost savings in operations so that the earnings before
interest and taxation of the combined group would be Rs. 4,100,000 in Year 1 after the
takeover, and growth in sales, costs, depreciation and replacement capital expenditure
would by 5% per year for the following three years and then 4% per year from Year 5
onwards.
The senior financial manager of Flat Company has been assessing the value of the
takeover bid for the shareholders of both companies, and has decided to use free cash
flow analysis as a basis for valuing the companies before and after the takeover. He
believes that the total equity value of the group after the takeover will be significantly
higher than the sum of the current equity values of the two separate companies.
The weighted average cost of the combined company should be calculated as the
weighted average of the current cost of capital of the individual companies, weighted
by the current market value of their debt and equity.
Required
(a)
17.12
Using free cash flow analysis, and making any assumptions you consider
necessary, calculate a value for:
(i)
(ii)
(iii)
(b)
(c)
Give your views as to whether the takeover bid is likely to have the support
of the shareholders in (1) Flat Company and (2) Slope Company.
MK LIMITED
MK Limited is presently considering a proposal to acquire 100 % shareholdings
of ZA Limited which is engaged in the same business. The financial data extracted
from the latest audited financial statements and other records of the two companies
is presented below:
Sales revenue
Operating expense excluding depreciation
Depreciation
Profit before interest and tax
Interest
Profit after interest
Taxation (35%)
Profit after taxation
Dividend payout
Capital expenditure during the year (Rs. in million)
Debt ratio
Market rate of interest on debentures
Number of shares issued (in million)
Market price of share (Rs.)
Equity beta
83
MK
ZA
Rs. in million
12,000
8,460
(7,695)
(4,905)
(1,305)
(990)
3,000
2,565
(644)
(1,494)
2,356
1,071
(825)
(375)
1,531
696
50%
55%
700
650
40%
55%
6.5%
7.5%
100
90
20
12
1.1
1.3
(ii)
Year 3 onward
MK
4.0%
5.0%
ZA
5.5%
5.0%
(iii)
(iv)
5.0%
Year 3 onward
5.5%
Required
17.13
(a)
(b)
PLATINUM LIMITED
(a)
Briefly discuss the possible synergistic effects which are the primary
motivation for most mergers and takeovers.
(b)
84
Questions
Total assets
Shareholders equity
Ordinary shares (Rs. 10 each)
Reserves
900
1,089
1,989
2,546
4,535
Total liabilities
Total equity and liabilities
192
121
313
646
959
Turnover
Profit before tax
Tax
Profit after tax
Required
17.14
(i)
Total value of the proposed bid based on PLs current share price.
(ii)
(iii)
EMH
Several studies show that the annual reports and financial statements are
regarded as important sources of information for making decisions on equity
investment. Other types of studies indicate that the market price of the shares in
a company does not react in the short term to the publication of its annual reports
and financial statements.
85
Required
(a)
Explain briefly the concept of the Efficient Market Hypothesis (EMH) and
each of its forms and the degree to which existing empirical evidence
supports them.
The company has 50 million shares in issue and at close of trading on 30th
April these had a market value of Rs. 4 each.
Required
State what would happen to the share price of the company if the stock
market:
17.15
(i)
(ii)
(iii)
(b)
given that:
(i)
(ii)
86
Questions
ACQUISITION
Big Entity is considering a takeover bid for Little Entity, another company in the
same industry. Little is expected to have earnings next year of Rs. 86,000.
If Big acquires Little, the expected results from Little will be as follows:
Year after the acquisition
Year 1
Year 2
Year 3
Sales
Cash costs/expenses
Capital allowances
Interest charges
Cash flows to replace assets and finance growth
Rs.
200,000
120,000
20,000
10,000
25,000
Rs.
280,000
160,000
30,000
10,000
30,000
Rs.
320,000
180,000
40,000
10,000
35,000
From Year 4 onwards, it is expected that the annual cash flows from Little will
increase by 4% each year in perpetuity.
Tax is payable at the rate of 30%, and the tax is paid in the same year as the
profits to which the tax relates.
If Big acquires Little, it estimates that its gearing after the acquisition will be 35%
(measured as the value of its debt capital as a proportion of its total equity plus
debt). Its cost of debt is 7.4% before tax. Big has an equity beta of 1.60.
The risk-free rate of return is 6% and the return on the market portfolio is 11%.
Required
18.2
(a)
Suggest what the offer price for Little should be if Big chooses to value
Little on a forward P/E multiple of 8.0 times.
(b)
(c)
Suggest what the offer price for Little might be using a DCF-based
valuation.
ADAM PLC
Adam Plc is considering acquiring Eve Plc. The summary of their most recent
accounts is presented below:
Statement of financial position
Adam Plc
Eve Plc
Rs.m
Rs.m
Net assets
3,150
946
Ordinary shares
1,000
500
Reserves
2,150
446
3,150
946
87
Rs.m
Rs.m
400
150
(300)
(50)
100
100
Both companies retain the same proportion of profits each year and are expected
to do so in the future. Adam Plcs return on investment is 16%, while that of Eve
Plc is 21%. After the acquisition in one years time, Adam Plc will retain 60% of
its earnings and expects to earn a return of 20% on new investment.
The dividends of both companies have been paid. The required rate of return of
ordinary shareholders of Adam Plc is 12% and Eve Plc 18%. After the
acquisition, this will become 16%.
Required
(a)
(b)
18.3
(ii)
Briefly explain the following actions a target company might take to prevent
a hostile takeover bid:
(i)
White knight
(ii)
Shark repellants
(iii)
Pac-man defence
(iv)
Poison pill
(v)
Golden parachute
D LIMITED
D Limited is a private company established about a decade ago to produce
plastic bottles. The first six years of the company witnessed strong growth,
generally facilitated by successful business operations and reduced competition.
As a result of the global economic meltdown and losses sustained in recent
years, the directors and the entire management of the company became worried
and were contemplating closing down the company for six months in the first
instance. The concomitant effect of the proposed closure would be further loss of
sales and profits. For how long will this continue? This was the question being
asked by the chairman and chief executive of the company.
In an attempt to avert the problem, the management held an emergency meeting
where various suggestions were put forward but none of them seems to proffer
solutions to the problem. The chairman and chief executive thought of outright
sale of the company to a willing competitor, F Limited, but this idea was not
acceptable to the board of directors as this could lead to the extinction of the
company.
88
Questions
Current earnings
Number of shares in issue
Earnings per share
D Limited Ltd
F Limited Ltd
Rs. 20,000,000
4,000,000
Rs. 5
Rs. 9,000,000
3,000,000
Rs. 3
Rs. 80
16 Times
Rs. 30
10 Times
18.4
(a)
(b)
If merger option is adopted, what are the likely financial effects on the
shareholders of the two companies?
Non-current assets
Current assets
Less current liabilities
Total assets less current liabilities
Less long term loans
Issued share capital and reserves:
Share capital
Rs. 1 each
0.5 rupees each
Reserves
Note: Current assets include stock of
89
Clooney Plc
Rs.m
750
900
(600)
1,050
(300)
750
Pitt Plc
Rs.m
360
210
(210)
360
(180)
180
300
450
750
300
150
30
180
150
Clooney Plc
Rs.m
Pitt Plc
Rs.m
Rs.m
Rs.m
150
60
90
30
21
9
Price per share of Clooney Plc is Rs. 5 while that of Pitt Plc is Rs. 2.
Required
18.5
(a)
Calculate the price earnings ratios of Clooney Plc and Pitt Plc before the
merger.
(b)
Determine what the price earnings ratio of the group will be if the value of
Clooney Plcs shares increases by Rs.0.5 after the merger.
(c)
(d)
Calculate the net dividend income the holder of 1 share in Pitt Plc would
receive before and after the merger assuming that Clooney Plc maintains
the same dividend per share as before the merger.
NELSON PLC
Nelson Plc is considering making an offer for Drake Plc. The offer is in the form
of merger where the shares in both companies will be swapped for shares in
Nelson Plc. Extract of the latest accounts of the two companies are as follows:
Statements of financial position:
Net Assets
Ordinary shares
Reserves
Nelson Plc
Drake Plc
Rs.
Rs.
1,419,000
4,725,000
750.000
1,500,000
669,000
3,225,000
1,419,000
4,725,000
Rs.
Rs.
225,000
(75,000)
600,000
(450,000)
Retained Profit
150,000
150,000
The two companies retain the same proportion of profits each year and this is
expected to continue indefinitely. Nelson Plc earns a return of 21% on new
investments while Drake Plc earns 16%. After the merger, Nelson Plc is
expected to retain 60% of its earnings and earn a return of 20% on investment.
90
Questions
18.6
(a)
(b)
HALI LTD
Hali Ltd. (HL) is listed on the stock exchange of Country X and has its operations
in Country X and Country Y. The functional currency of both the countries is Rupee
(Rs.). In the latest statement of financial position of the company, net assets were
represented by the following:
Rupees in
50
170
220
30
40
290
The current market price of ordinary shares and debentures are Rs. 90 per share
and Rs. 130 per certificate respectively. In view of various legal and taxation issues,
HL is considering a demerger scheme whereby two different companies, HX and HY
will be formed. Each company would handle the operations of the respective country.
Mr. Bader, a director of HL, has proposed the following demerger scheme:
(i)
The existing equity would be split equally between HX and HY. New
ordinary shares would be issued to replace the existing shares.
(ii)
The debentures which are redeemable at par value of Rs. 100 in 2012,
would be transferred to HX as these were issued in Country X.
(iii)
The long term loan was obtained in Country Y and will be taken over by HY.
Demerger would require a one time cost of Rs. 17 million in year one, which would
be split between the two companies equally. The finance director has submitted the
following projections in respect of the demerged companies:
HX
Year 1 Year 2
HY
Year 3 Year 1 Year 2 Year 3
Rupees in million
39
42
44
26
34
36
Depreciation
12
11
13
10
11
91
18.7
(a)
the feasibility of the demerger scheme for the equity shareholders of Hali
Limited, based on discounted cash flow technique. Your answer should be
supported by all necessary workings.
(b)
the additional information and analysis which could assist the Board of
Directors in the process of decision making.
URD
CHI
Rs. in million
1,500
400
200
100
100
300
250
40:60
50:50
60:40
70:30
Interest rate
16%
17%
18%
20%
The shares of URD are currently traded at Rs. 52.50. According to the prevailing
practice in the market, price earning ratios of unlisted companies are 10% less than
those of listed companies.
Required
Write a report to the Board of Directors, on behalf of Mr. Shah Rukh, the Chief
Financial Officer of the company, discussing the following:
(a)
92
Questions
(ii)
(b)
18.8
What other matters should be considered and what impact these may
have on the decision arrived in (a) above?
FF INTERNATIONAL
FF International (FFI) is considering the opportunity to acquire CS Limited (CSL).
You have been appointed as a consultant to advise the FFIs management on the
financial aspects of the bid.
The latest summarized annual financial statements of CSL are given below:
Summarised Statement of Financial Position
Rs. in
million
5,000
Total assets
Share capital
Accumulated profit
Long term loan
Short term loan
Other current liabilities
2,000
150
700
1,300
850
5,000
Sales
Less: Cost of sales
Gross profit
Selling and administration expenses
Financial charges
Profit before taxation
Taxation
Profit after taxation
Rs. in
million
1,000
(430)
570
(250)
(280)
40
(14)
26
CSL produces a single product X-201 and has a market share of 30%.
A market survey conducted to identify the impact of increase or decrease in
price has revealed the following relationship between price of X-201 and
market share:
Increase / (decrease) in price
(10%)
5%
10%
93
Market share
45%
23%
20%
(ii)
(iii)
Fixed production costs amount to Rs. 100 million which include depreciation
of Rs. 75 million.
(iv)
80% of selling and administration expenses are fixed. Fixed costs include
depreciation of Rs. 25 million and salaries of Rs. 160 million. After
acquisition, FFI expects to reduce the staff in sales and administration by
making one-time payment of Rs. 100 million. It would reduce the
departments salaries by 25% and the remaining fixed costs by 30%.
(v)
Long term loan carries mark- up @ 15% per annum. The balance
amount of principal is repayable in five equal annual instalments payable
in arrears.
(vi)
Mark up on short term loan is 14% per annum. CSL has failed to meet
certain debt covenants and therefore its bankers have advised CSL to
reduce the short term loan to Rs. 1,000 million.
Tax rate applicable to both companies is 30% and tax is payable in the
same year. CSL has unutilized carry forward tax losses of Rs. 80 million.
(x)
All costs as well as sales are expected to increase by 10% per annum.
(xi)
Free cash flows of CSL are expected to grow at 5% per annum after Year
5.
(xii) Based on the risk analysis of this investment, the discounting rate is
estimated at 18%.
Required
(a)
(b)
(c)
Amount of cash flow gap at optimal level of sales during the first five
years of acquisition.
Calculate the bid price that FFI may offer for the acquisition of CSL
assuming that cash flow gap identified in (b) above would have to be filled
by FFI by way of an interest free loan.
94
Questions
(b)
95
Francs
1
10 million
2
20 million
3
25 million
4
10 million
The current exchange rate is 1 = 5 francs. The expected annual rate of inflation in the
UK for the next four years is 3% and in Frankland it is 5%.
Tax in the UK is 30%, and will be payable one year in arrears of dividend receipts. The
companys weighted average cost of capital is 9%.
Required
Calculate the NPV of the companys expected sterling cash flows, to decide whether
the project should be undertaken.
20.2
Ringgit
(Million)
160
80
2
3
96
64
Appraise the viability of the project, discounting the foreign cash flows at
the foreign cost of capital
(b)
96
Questions
20.3
FOREIGN INVESTMENT
Green Limited is a company whose domestic currency is dollars. It is considering an
investment in a country, Francia, where the domestic currency is Francs (FR).
The investment will involve buying equipment in the foreign country at a cost of
1,000,000 Francs. The currency to make the purchase will be bought spot in the FX
market.
The equipment and the project will have a four-year life. At the end of this time, the
equipment will have no residual value. The equipment will attract an allowance for tax
purposes of 25% of its cost each year. The first capital allowance will be claimed
against profits in Year 1.
The cash profits from the project will be 500,000 Francs in each of the four years. Tax
is payable at 40% and is paid one year in arrears of the profits to which they relate.
There are foreign exchange restrictions in the country, and only 50% of the profits after
tax each year can be paid to any shareholder in another country. The balance of the
profits from the project can be paid out as a dividend to Green Limited at the end of
Year 5.
Green Limited has a cost of capital of 10%, but a cost of capital of 16% is considered
appropriate for evaluating the investment cash flows.
The current exchange rate is $1 = FR3.00. However, the rate of inflation is expected to
be 10% in each year in the Francia and 4% each year in Green Limiteds country.
Required
20.4
(a)
Calculate the NPV of the project in the currency of the investment, using a
discount rate appropriate to the investment.
(b)
(c)
(d)
GOLD LIMITED
Gold Limited (GL) manufactures textile machinery. The management has explored
opportunities in various South Asian countries and is optimistic that there is
considerable demand for GLs machines in the region. However, exports from
Pakistan are not financially viable on account of higher input costs. Therefore, GL
intends to establish a subsidiary either in Bangladesh or in Sri Lanka. Based on
initial studies, the management projections, at current prices, are as follows:
Alternative 1: Subsidiary in Bangladesh (SIB)
(i)
SIB would require immediate outlay of BDT 110 million for the construction
of a new factory, i.e. BDT 80 million for acquisition of land and BDT 30
million as advance payment for construction of factory. Balance payment of
BDT 75 million would be made in year 1.
97
(ii)
(iii)
(iv)
Production and sales in year 2 are estimated at 3,000 units and in years 35 at 4,000 units per annum. The average price in year 2 is estimated at
BDT 300,000 per unit.
(v)
Total variable costs in year 2 are expected to be BDT 165,000 per unit.
(vi)
(vii) Allowable tax depreciation on all fixed assets except land is 20% per
annum on a reducing balance method.
(viii) Applicable tax rate on SIB is 35%.
Alternative 2: Subsidiary in Sri Lanka (SISL)
(i)
(ii)
(iii)
Pre-tax net cash flows (including tax savings from depreciation) are
estimated at LKR 27 million in year 1 and LKR 35 million in year 2.
(iv)
All the above projections are based on current prices and are expected to increase
annually at the current rate of inflation. Inflation rates for each of the next five years
in Pakistan, Bangladesh and Sri Lanka are expected to be 12%, 10% and 8%
respectively.
The after-tax realizable value of the investment at the prices prevailing in year 5,
is estimated at BDT 145 million and LKR 115 million in case of Bangladesh and Sri
Lanka respectively.
Current exchange rates are as follows:
BDT /PKR
LKR/PKR
GLs cost of equity is 18%. It would finance the investment by borrowing at 12%
per annum in
Pakistan after which its debt equity ratio would be approximately 30:70.
The tax rate applicable to GL in Pakistan is 30%. Pakistan has double taxation
treaty agreements with both the countries.
98
Questions
Required
Evaluate which of the two subsidiaries (if any) should be established by GL.
(Assume that tax in all countries is payable in the same year and that all cash
flows arise at the end of the year)
20.5
GHAZALI LIMITED
Ghazali Limited (GL) operates a chain of large retail stores in country X where the
functional currency is CX. The company is considering expanding its business by
establishing similar retail stores in country Y where functional currency is CY. As
a policy, GL evaluates all investments using nominal cash flows and a nominal
discount rate.
The required investments and the estimated cash flows are as follows:
(i)
Investment in country X
CX 7 million would be required to establish warehouse facilities which
would stock inventories for supply to the retail stores in country Y at cost. At
current prices, the annual expenditure on these facilities would amount to
CX 0.5 million in Year 1 and would grow @ 5% per annum in perpetuity.
Investment in country Y
Investment of CY 800 million would be made for establishing retail stores
in country Y. At current prices, the net cash inflows for the first three
years would be CY 170 million, 250 million and 290 million respectively.
After Year 3, the net cash inflows would grow at the rate of 5% per annum,
in perpetuity.
(ii)
Inflation in country X and Y is 7% and 20% per annum respectively and are
likely to remain the same, in the foreseeable future. Presently, country Y is
experiencing economic difficulties and consequently GL may face problems
like increase in local taxes and imposition of exchange controls.
(iii)
(iv)
Required
Prepare a report to the Board of Directors evaluating the feasibility of the
proposed investment. Your report should include the following:
(a)
(b)
(c)
99
FOREIGN EXCHANGE
(a)
1.8570
1.8580
3 months forward
1.8535
1.8543
1.3015
1.3025
25c
18c
2 months forward
Premium
1.9820
0.002
4 months forward
1.9760
0.003
21.2
100
Questions
Required
21.3
(a)
Show how the company can create a money market hedge for its exposure
to a fall in the value of the dollar.
(b)
DUNBORGEN
The treasurer of Dunborgen Company wants to hedge an exposure to currency
risk. Dunborgen is a company whose domestic currency is the euro, and the
company must make a payment of US$500,000 to a US supplier in six months
time.
The following market rates are available:
Exchange rates: $ per 1
Spot
1.604 r 0.002
6 months forward
1.570 r 0.004
Borrowing
Deposits
Euro
4.8%
4.4%
US dollar
2.5%
2.0%
(b)
21.4
CURRENCY SWAP
Small Company, a UK company, has an opportunity to invest in Zantland for
three years, by setting up and operating an operations centre on behalf of the
Zantland government. The cost of establishing the centre will be 3 million zants.
At the end of the three years, the Zantland government will pay 6 million zants to
purchase the centre from Small Company and take over the operations. During
the three years that Small Company will operate the centre, the Zantland
government will pay an annual fee of 200,000 zants. The entire operation will be
free from tax.
The current exchange rate is 1 = 9.00 zants spot. There is no forward market in
zants. Economic conditions in Zantland are unstable, and the expected inflation
rate in the country over the next three years could be anywhere between 10%
and 50%. Inflation is expected to be negligible in the UK.
101
Zants
Small Company
6.5%
ZIBOR + 2%
Zantland counterparty
8.5%
ZIBOR + 1.5%
ZIBOR is the Zantland inter-bank offered rate, which is usually set very close to
the inflation rate in Zantland.
The bank would take an annual fee of 0.5% in sterling for arranging the swap, and
Small Company would receive 75% of the net arbitrage benefit from the swap.
Required
(a)
(b)
21.5
First consignment of 4,000 tons will be shipped in the last week of June
2016 and the balance will be shipped during the last week of July 2016.
It was agreed with the Thai Company that MIL shall make the payment on shipment,
at the rate of Thai Bhat 50,000 per ton.
MIL has a policy to hedge all foreign currency transactions in excess of Rs. 25
million by obtaining forward cover. MILs bank has arranged the forward cover and
advised the following exchange rates on May 31, 2016:
102
Questions
Thai Bhat
Buy
Sell
US $
Buy
Sell
Spot
Rs. 2.33
Rs. 2.36
1 month forward
Rs. 2.30
Rs. 2.33
Rs. 2.31
Rs. 2.29
(b)
on July 31, 2016, the parties agree to delay the second shipment for a
period of two months. The rates expected to prevail on July 31, 2016 are as
follows:
Thai Bhat
(c)
21.6
US$
Rs. 2.29
Rs. 2.32
1 months forward
Rs. 2.27
Rs. 2.30
2 months forward
Rs. 2.25
Rs. 2.28
3 months forward
Rs. 2.23
Rs. 2.26
the second shipment is cancelled on July 31, 2016. The exchange rates are
expected to be the same as in (b) above.
Amount
Import of IT equipment
Due date of
payment/receipt
223,500
98,500
Mar.15, 2017
77,000
Rs. 22,500,000
Mar.15, 2017
103
(ii)
Sell
Spot
Rs. 124.22
Rs. 124.52
3 months forward
Rs. 123.62
Rs. 123.96
6 months forward
Rs. 123.21
Rs. 123.54
11%
5%
6.5%
3%
Required
(a)
(b)
Calculate the net rupee receipts/payments that QIL should expect from
the above transactions under each of the following alternatives:
(i)
(ii)
21.7
SILVER LIMITED
Silver Limited (SL) is a large manufacturing concern in Malaysia. It deals in four
major product lines. As the financial controller of the company, you are faced with the
following situations:
(I)
Purchases from
Pakistani Supplier
USD 1,020,000
USD 775,000
USD 1,224,000
USD 1,347,000
104
Questions
(II)
Buy
Sell
Spot rate
MYR 3.030
MYR 3.110
MYR 0.071
MYR 0.073
MYR 0.160
MYR 0.164
Interest Rates
Lending
Borrowing
MYR
6.6% p.a.
7.9% p.a.
USD
5.8% p.a.
7.2% p.a.
SL has sold one of its product lines for MYR 15 million. The proceeds
are expected to be received at the end of February, 2016. SL plans to
use these funds in September, 2016 for one of its major expansion project.
Consequently, the management wants to invest this amount in a fixed
deposit account for a period of six months at 6% per annum.
The management is considering to hedge the interest rate risk by using
interest rate futures. The current price of March six months futures is 95.50
whereas the standard contract size is MYR 3 million.
Required
(a)
(b)
(ii)
(ii)
105
21.8
KHALDUN CORPORATION
Khaldun Corporation (KC) is a Pakistan based multinational company and has
number of inter- group transactions with its two foreign subsidiaries KA and KB,
which are located in USA and UK respectively. Details of receipts and payments
which are due after approximately three months are as follows.
Receiving Company
Paying Company
KC (Pak)
KA (USA)
KB (UK)
in million
KC (Pak)
KA (USA)
US $ 1.50
KB (UK)
Rs. 131
-
4.00
5.10
US $ 4.50
1.80
UK 1
Buy
Sell
Buy
Sell
Spot
Rs. 86.56
Rs. 86.80
3 months forward
Rs. 87.00
Rs. 87.20
Interest Rates
Borrowing
Lending
KC (Pak)
10.50%
8.50%
KA (USA)
5.20%
4.40%
KB (UK)
5.90%
5.00%
Required
(a)
(b)
Calculate the net rupee receipts/payment that KC (Pak) should expect from
the above transactions under each of the following alternatives:
106
Questions
CURRENCY FUTURES
The euro/US dollar currency future is a contract for 125,000. It is priced in US
dollars, and the tick size is $0.0001.
Currency futures are not normally used by companies to hedge currency risks.
However, assume that a French company intends to use currency futures to
hedge the following currency exposure.
It is now February. The French company has to make a payment of US$640,000
in May to a supplier.
The price of June euro/US dollar futures is currently 1.2800.
The company is concerned that the value of the dollar will increase in the next
few months, and it therefore decides to use futures to hedge the exposure to
currency risk.
Required
(a)
How should the company hedge its currency risk with futures?
(b)
Suppose that in May when the company must make the payment in dollars,
the June futures price is 1.2690 and the spot rate (US$/1) is 1.2710.
Show what will happen when the futures position is closed, and calculate
the effective exchange rate that the company has obtained for the
US$640,000.
22.2
How should the company hedge its currency risk with futures?
(b)
Suppose that in January when the company receives the sterling payment,
the March futures price is 1.8420 and the spot rate (US$/1) is 1.8450.
Show what will happen when the futures position is closed, and calculate
the effective exchange rate that the company has obtained for the
400,000.
107
22.3
BASIS
It is 1st March. The current spot exchange rate for dollars against sterling (US$/1) is
1.8540. The exchange rate is volatile, and the June futures price for sterling/US dollar
futures is 1.8760.
Assume that the settlement date for the June futures contract is 30th June.
A company has used sterling/US dollar futures to hedge two currency exposures, one
relating to a cash payment on 1st May and the other relating to a cash payment in midJune.
Required
Calculate the expected futures price for June futures:
22.4
(a)
at the end of the days trading on 30th April, if the spot sterling/dollar rate is
1.8610
(b)
at the end of the days trading on 15th June, if the spot sterling/dollar rate is
1.8690.
22.5
(a)
To what extent does the futures position provide a hedge for the company
against currency risk, between 20th April and 20th July? To do this,
compare the gain or loss on the underlying currency exposure with the gain
or loss on the futures position.
(b)
CURRENCY HEDGE
It is now the end of July. A UK company expects the following receipts and payments
in euros at the end of the month in three months time (at the end of October):
Receipts
Payments
540,000
2,650,000
108
Questions
(b)
(c)
1.4537
1.4542
3 months forward
1.4443
1.4448
Borrow
Invest
Sterling (UK)
6.2%
5.6%
Euro
3.8%
3.4%
Currency futures
Currency futures for sterling/euro are each for 100,000 and are priced in sterling.
Assume that the futures contracts mature at the end of the month.
Assume for the purpose of this question that when the futures position is closed at the
end of October, the basis is 0.
Futures prices as at end of July
September futures
0.6890
December futures
0.6929
Required
Calculate the net cost in sterling of hedging the currency risk:
(a)
(b)
(c)
109
March
Calls
40
10
Puts
15
50
Required
23.2
(a)
Explain how this investor might use options to speculate on a fall in the
TBA.
(b)
Assuming that the investor purchased options with the lowest strike price
show what would happen when the options expire if the TBA share price is
910.
CURRENCY OPTIONS
A UK company will receive US$2 million in six months time. It is now 20th March. The
company is not sure whether the US dollar will rise or fall in value against sterling over
the next few months, and it has decided to hedge its exposure to currency risk using
traded currency options.
On the Philadelphia Stock Exchange, traded currency options are available in a
contract size of 31,250. Options are priced in cents per 1. Assume that option
contracts expire on 20th of each month.
The following option prices are currently available:
Exercise price
1.8500
Calls
June
1.4
Puts
September
1.9
June
4.0
September
5.1
(b)
Show what would happen if the options are still held by the company at
expiry and the spot exchange rate is $1.9150 1.9200.
110
Questions
23.3
(II)
However, when the price of oil actually increased on May 21, 2016, DESC
revised its power tariff upward while due to tough competition SPLs margins are
expected to decline. As a result, the company feels that it is now advisable to
reconsider the situation. While evaluating various options, the management has
gathered the following information:
(i)
As of June 1, 2016, the ready market price per share and one month future
price per share were as follows:
Ready market
prices
1-month future
prices
SPL
DESC
(ii)
DEF can obtain finances at the rate of KIBOR plus 2%. Presently, the
rate of KIBOR is 12.5%.
(iii)
Required
Based on the available information, recommend the best strategy to the management.
23.4
111
Sell
Spot rate
Rs. 1.9223
Rs. 1.9339
Rs. 1.9335
Rs. 1.9451
Rs. 1.9410
Rs. 1.9493
Investing
Japan
5%
3%
Pakistan
8%
5%
Rs. 1.9365
October 2016
Rs. 1.9421
January 2017
Rs. 1.9490
The contracts can mature at the end of the above months only.
Currency options
Options have a contract size of JPY 250,000. The premiums (paisa per Rupee)
payable on various options and the corresponding strike prices are shown below:
Calls
Puts
Strike
31 July
31 October
31 July
31 October
price
2016
2016
2016
2016
Rs.
Paisas
1.90
2.88
3.55
0.15
0.28
1.91
1.59
2.32
1.00
1.85
1.92
0.96
1.15
2.05
2.95
112
Questions
FRA
A company will need to borrow $5 million for six months in three months time. It can
borrow at LIBOR + 0.50%. It expects interest rates to rise before it borrows the money,
and so has decided to use an FRA to hedge the risk.
The following FRA rates are available:
2v5
3v6
3v9
6v9
3.82
3.85
3.97
3.92
3.77
3.80
3.91
3.87
Required
24.2
(a)
How would the company use an FRA to hedge its interest rate risk, and
what effective interest rate would be obtained by the hedge.
(b)
What is the difference between an FRA and an interest rate coupon swap?
SWAP
A company has a bank loan of $8,000,000 on which it pays a floating rate of US
LIBOR plus 1.25%. The company believes that interest rates will soon increase
and remain high for the foreseeable future, and it would therefore like to switch its
debt liabilities from floating rate to fixed rate.
The loan has four years remaining to maturity. A bank has quoted the following
rates for four-year interest rate swaps in dollars:
5.20% - 5.25%
Required
Show how an interest rate swap can be used to switch from floating rate to fixed
rate liabilities, and calculate what the effective fixed rate would be.
24.3
CREDIT ARBITRAGE
Entity A has an AA credit rating and Entity B has a BBB- credit rating. Both
companies want to raise the same amount of long-term debt capital. Entity A
wants to borrow at a floating rate of interest and Entity B wants to borrow at a
fixed rate.
They are able to borrow at the following rates:
Fixed rate
Floating rate
Entity A
6.35%
LIBOR + 0.75%
Entity B
7.25%
LIBOR + 1.25%
113
A bank has identified an opportunity to arrange interest rate swaps with the
companies. It would expect to receive a profit margin on the arrangement of
0.10% of the notional principal amount in the swap. The remaining benefits of the
credit arbitrage should be shared equally between the two entities.
Required
Explain how the interest rate swaps might be arranged, and show the effective
interest rate that will be paid by each entity as a result of the swap.
24.4
CREDIT ARBITRAGE
Company X can borrow for six years at a fixed rate of 7.25% or a variable rate of
LIBOR plus 1.25%. Company Y can borrow for six years at a fixed rate of 8.00% or a
variable rate of LIBOR plus 1.50%.
Company X wants to borrow at a floating rate and company Y wants to borrow at a
fixed rate.
The rates available on six-year swaps are 6.27 6.30.
Required
Show how an interest rate swap can be used by both companies to reduce their
borrowing costs.
24.5
24.6
114
Questions
94.20
March futures
93.70
Assume that the settlement date for futures is the last day of the relevant month.
Required
(a)
(b)
24.7
Explain how you would lock in an effective interest rate for the income from
investing the 8.2 million, using:
(1)
FRAs
(2)
115
(b)
24.8
Show what will happen at the end of July if the three-month LIBOR rate is
4.25% and the interest rate exposure had been hedged as indicated in part
(a) of the answer, using:
(1)
FRAs
(2)
94.740
June
94.610
September
94.500
24.9
Calls
Puts
March
June
September
March
June
September
94750
0.140
0.200
0.280
0.320
0.390
0.500
95000
0.124
0.080
0.120
0.470
0.560
0.850
DEFINITIONS
Briefly describe each of the following financial instruments:
(a)
(b)
Forwards
(c)
Futures
(d)
Options
(e)
116
Questions
24.10
IMRAN LIMITED
Imran Limited wants to borrow Rs. 70 million for two years with interest payable at six
monthly intervals. Due to recent hike in inflation, the company expects that the rate of
interest is likely to rise over the next 2 years. The company can borrow this amount
from a local bank at a floating rate of KIBOR plus 2% but wants to explore the use of
swap to protect it from any interest rate increase, during the next two years.
Another bank has offered the company that it will be willing to receive a fixed rate of
11% in exchange for payments of six month KIBOR.
Required
(a)
(b)
KIBOR is 13.5%.
KIBOR is 9%.
117
GAZELLE LIMITED
Gazelle Limited uses a budgeting system to control the costs of its only product
called KZX. The cost accountant for Gazelle Limited has asked for your
assistance in producing the budget for the year ending December 2017. He has
provided you with the following information:
(i)
The standard cost card for KZX for the immediately preceding year ended
31 December 2016 is as follows:
Rs.
(ii)
Selling price
250
(32)
(90)
Contribution
128
1,200
1,300
1,400
1,500
-150
200
300
-350
Seasonal variation
(sales units)
(iii)
The sales trend figures for the first two quarters of 2017 are estimated at
1,600 and 1,700 units respectively. Quarterly seasonal variations are
expected to be as for 2016.
(iv)
Required
Prepare the following budgets for each of the four quarters of the year ending 31
December 2017.
(a)
(b)
(c)
118
Questions
25.2
Product A
Product B
Rs. 2.50
Rs. 4.00
50,000
80,000
Required
Prepare the sales budget for the company for next year.
Production budget
A company produces Product L. Budgeted sales for Product L are 20,000 units
for next year. Opening inventory is 2,500 units and planned closing inventory is
2,000 units.
Required
Prepare the production budget for Production L for next year.
Labour budget
A company makes Product DOY which requires two grades of labour, Grade I
and Grade II.
Product DOY requires 4 hours of Grade I labour and (at Rs. 12 per hour) and 7
hours of Grade II labour (at Rs. 15 per hour).
Budgeted production of Product DOY is 25,000 units for the forthcoming year.
Required
Prepare the labour budget for Product DOY for the forthcoming year.
Materials budget
A company manufactures a single product. A single direct material, material X, is
used in its manufacture. A budget is being prepared for next year. Opening
inventory is expected to be 2,000 units of finished goods and 30,000 kilos of
direct material X. Each unit of the product requires 5 kilos of material X.
Budgeted sales next year are 25,000 units of the product. It is also planned to
increase finished goods inventory to 4,000 units before the end of the year and to
reduce inventories of direct material X by 50%.
Required
Prepare a materials usage budget and a material purchase budget for material X.
119
25.3
Quantity
Price each
Sales
1000
110
2000
115
1500
120
X1
X2
X3
Unit cost
Product
X1
X2
X3
1st June
1100
1050
520
30th June
1200
1450
480
X1
X2
X3
1st June
22000
18000
14000
30th June
33400
26000
16000
Required
25.4
(a)
(b)
(ii)
production quantities;
(iii)
(iv)
FLEXED BUDGET
LAW operates a system of flexible budgets and the flexed budgets for
expenditure for the first two quarters of Year 3 were as follows:
120
Questions
Quarter 1
Quarter 2
9,000
14,000
10,000
13,000
Rs.
Rs.
130,000
169,000
Production labour
74,000
81,500
Production overhead
88,000
109,000
Administration overhead
26,000
26,000
29,700
36,200
347,700
421,700
Sales units
Production units
Budget cost allowances
Direct materials
The cost structures in quarters 1 and 2 are expected to continue during quarter 3
as follows:
(a)
(b)
(c)
(d)
Required
Prepare a statement of the budgeted cost allowance for quarter 3. The activity
levels during quarter 3 were:
Units
25.5
Sales
14,500
Production
15,000
121
From January to June 2016, 5,600 patients were treated. The actual variable
overhead costs incurred during this six-month period are as follows:
Expenses
Rs.
79,500
Maintenance
35,000
65,000
Miscellaneous
10,000
Total
189,500
The hospital accountant believes that the variable overhead costs will be incurred
at the same rate during the second half year (July December 2016).
Fixed overheads budgeted for the whole year are as follows:
Expenses
Rs.
Supervision
300,000
Depreciation
197,500
Miscellaneous
150,000
647,500
25.6
(a)
Present an overhead budget for the period of July December 2016. You
are to show each expense, but should not separate individual months.
What is the total overheads cost for each patient that would be incorporated
into any statistics?
(b)
Examine how well the Organisation exercises control over its overheads,
given that the Organisation actually treated 6,400 patients during the July
December 2016 period. The actual variable overheads were Rs. 206,000
and the fixed overheads were Rs. 380,000.
THREE SERVICES
A company provides three types of delivery service to customers: service A,
service B and service C. Customers are a mix of firms with a contract for service
with the company, and non-contract customers.
The following information relates to performance in the year to 31st December
Year 1:
Service A
Service B
Service C
350,000
250,000
20,000
60%
60%
80%
Rs. 9
+ 30%
Rs. 15
+ 50%
Rs. 300
+ 20%
122
Questions
All employees in the company were paid Rs. 45,000 per year and sundry
operating costs, excluding salaries and fuel costs, were Rs. 4,000,000 for the
year.
The following operational data for the year relates to deliveries:
Services A and B
Service C
400
600
Number of vehicles
50
18
300
300
For Year 2, the company has agreed a fixed price contract for fuel. As a result of
this contract, fuel prices will be:
(a)
(b)
Sales prices will be 3% higher in Year 2 than in Year 1, and salaries and
operational expenses will be 5% higher. Sales volume will be exactly the same
as in Year 1.
The number of employees will also be the same as in Year 1: 60 employees
working full-time on Services A and B and 25 employees working full-time on
Service C.
Required
25.7
(a)
(b)
Adults below
65 year of age
Children and
individuals aged 65
years old and over
Rs.
Rs.
50
30
Minor treatment
200
120
Major treatment
600
280
123
Treatment
Adults
45%
No treatment
20%
Children
25%
Minor treatment
70%
30%
Major treatment
10%
The salary of each doctor is Rs. 240,000, assistants earn Rs. 100,000 and
administrators earn Rs. 80,000. In addition, everyone receives a 5% bonus at the
end of the year.
The medical practice expects to pay Rs. 414,300 for materials next year and
other (fixed) costs will be Rs. 733,600.
Required
Using the information provided, present a statement of profit or loss for the
medical practice for next year. (Ignore the effects of inflation.)
25.8
HEADGEAR LIMITED
Headgear Limited manufactures and sells fur hats for men. The company is wellestablished and has a well-developed system of budgeting and budgetary control with
variance analysis. Departmental managers are responsible for the preparation and
control of their departmental budgets. Unusually, the company allows departmental
managers to ask for permission to revise their budgets during the year when planning
errors become apparent. When budgets are revised, variances are subsequently
reported as a combination of planning and operational variances.
A newly-appointed managing director has reported to the board that in the past year or
so the number of budget revisions by departmental managers has increased
significantly. As a consequence, most operational variances have been favourable but
there have been larger adverse planning variances. The managing director has
suggested to his colleagues on the board of directors that this is reducing the value of
the budgetary control information. He believes that revisions to the budget by
departmental managers are permitted far too often.
Required
(a)
124
Questions
in the department were due largely to the use of largely poorly-qualified and
poorly-motivated staff. He asked for board permission to begin a
programme of recruitment of better-qualified but more highly paid staff into
the department, to replace the existing staff over a period of about two
years.
The board agreed to this request, and a programme of recruitment of
experienced marketing managers and university graduates was started. A
consequence in the current year staff costs in the department are much
higher than budgeted, and the manager asked for permission to revise the
departmental labour budget.
(2)
Required
(b)
In each of the two cases described above, discuss the request for a budget
revision and give your reasoned views as to whether a budget revision
should be allowed.
The market for mens hats has been in decline as fashions have changed. Headgear
Limited has produced the following data relating to the sale of fur hats for the year to
date.
Budget
Sales volume
11,200 units
Rs. 225
Rs. 100
10,900 units
Rs. 200
The total market for the style of mens hats sold by Headgear Limited was estimated in
the budget to be 112,000 units. The actual total market for the same period declined to
just 100,000 units.
125
Required
25.9
(c)
Calculate the sales price variance and sales volume (contribution) variance.
(d)
Analyse the total sales volume variance into a market size variance and a
market share variance.
(e)
Quarter 1
Quarter 2
Quarter 3
Quarter 4
Year 5
Rs. 2,700,000
Rs. 3,500,000
Rs. 3,400,000
Rs. 3,000,000
Year 6
Rs. 3,100,000
Rs. 3,900,000
Rs. 3,600,000
Rs. 3,400,000
Sales in Quarter 1 of Year 7 were Rs. 3,600,000. There is two weeks to go until the
end of Quarter 2 and the managing director of Daska Design Limited is confident that it
will achieve sales of Rs. 4,400,000 in this quarter.
The existing sales forecasts for the two remaining quarters of the year were made by
the sales director (who has been with the company for several years) during last years
budget-setting process. These forecasts are Rs. 3,800,000 for Quarter 3 and Rs.
3,600,000 for Quarter 4.
Budgets within Daska Design Limited have traditionally been prepared and agreed by
the directors of the company before being implemented by junior managers. As a
basis for revising the sales forecasts for the two remaining quarters of Year 7, the
management accountant of Daska Design Limited has begun to apply time series
analysis in order to identify the seasonal variations in sales. He has so far calculated
the following centred moving averages, using a base period of four quarters.
Year
Quarter 1
Quarter 2
Year 5
Year 6
Rs. 3,375,000
Rs. 3,450,000
Quarter 3
Quarter 4
Rs. 3,200,000
Rs. 3,300,000
Rs. 3,562,500
Rs. 3,687,500
Required
(a)
Using the sales information and centred moving averages provided, and
assuming an additive model, forecast the sales of Daska Design Limited for
Quarter 3 and Quarter 4 of Year 7, and comment on the sales forecasts
made by the sales director.
(Note that you are NOT required to use regression analysis)
(b)
Discuss the limitations of the sales forecasting method used in part (a).
(c)
126
Questions
50
20
12
26.2
(a)
(b)
Assuming now that the company uses absorption costing, recalculate the
fixed production overhead variances
(c)
Discuss possible causes for the labour variances you have calculated.
MOONGAZER
MoonGazer produces a product the telescope. Actual results for the period were:
127
2 kg u Rs. 15
30
Direct labour
34
Variable overhead
5
77
The standard unit selling price is Rs. 100. The cost card is based on production and
sales of 450 units in each period.
The company values its inventories at standard cost.
Required
Produce an operating statement to reconcile budgeted and actual gross profit.
26.3
ABC LIMITED
ABC Limited produces and markets a single product. The company operates a
standard costing system. The standard cost card for the product is as under:
Sale price
Direct material
Direct labour
Variable overheads
Fixed overheads
Budgeted production
The company maintains finished goods inventory at 25,000 units throughout the year.
Actual results for the month of August 20X3 were as under:
Rupees in 000
Sales
480,000 units
295,000
Direct material
950,000 kgs
55,000
Direct labour
990,000 hours
Variable overheads
105,000
26,000
Fixed overheads
5,100
Required
Reconcile budgeted profit with actual profit using relevant variances.
128
Questions
26.4
KASUR MF LIMITED
Kasur Mf Limited is comparing budget and actual data for the last three months.
Budget
Rs.
Rs.
950,000
Sales
Cost of sales
Raw materials
Direct labour
Variable production overheads
Fixed production overheads
133,000
152,000
100,700
125,400
Actual
Rs.
Rs.
922,500
130,500
153,000
96,300
115,300
512,100
495,100
438,900
427,400
The budget was prepared on the basis of 95,000 units of production and sales, but
actual production and sales for the three-month period were 90,000 units.
Kasur Mf Limited uses standard costing and absorbs fixed production overheads on a
machine hour basis. A total of 28,500 standard machine hours were budgeted. A total
of 27,200 machine hours were actually used in the three-month period.
Required
(a)
(b)
(c)
(d)
(i)
(ii)
(iii)
(iv)
(v)
(ii)
(iii)
129
TOXIC KEMS
A company make a product that involves three chemicals. The standard input per
batch is:
Material
Tonnes
A
B
C
460
345
345
1,150
Usage
Cost
9,000 tonnes
Rs. 1,935,000
4,000 tonnes
Rs. 1,368,000
7,000 tonnes
Rs. 3,164,000
It is now recognised that the material prices used in the standard cost card were 10%
too low.
Output from the process was 17,000 tonnes.
27.2
(a)
(b)
Using the updated prices calculate a materials mix variance for each
material and an overall yield variance.
(c)
BRK
BRK operates an absorption costing system and sells three products, B, R and K
which are substitutes for each other. The following standard selling price and cost data
relate to these three products:
Product
Selling
price per
unit
Rs. 1400
Rs. 1500
Rs. 1800
130
Questions
Budgeted fixed production overhead for the last period was Rs. 81,000. This was
absorbed on a machine hour basis. The standard machine hours for each product and
the budgeted levels of production and sales for each product for the last period are as
follows:
Product
03 hrs
06 hrs
08 hrs
10,000
13,000
9,000
Actual volumes and selling prices for the three products in the last period were as
follows:
Product
Actual selling price per unit
Actual production and sales (units)
Rs. 1450
Rs. 1550
Rs. 1900
9,500
13,500
8,500
Required
Calculate the following variances for overall sales for the last period:
(i)
(ii)
(iii)
(iv)
and reconcile budgeted profit for the period to actual sales less standard cost.
27.3
CARAT
Carat plc, a premium food manufacturer, is reviewing operations for a three-month
period. The company operates a standard marginal costing system and manufactures
one product, ZP, for which the following standard revenue and cost data per unit of
product is available:
Selling price
Rs. 12.00
Direct material
Direct material
Direct labour
Fixed production overheads for the three-month period were expected to be Rs.
62,500.
131
Direct material A
Direct material B
Direct labour
Fixed production
overheads
Rs. 64,000
Budgeted sales for the three-month period were 50,000 units of Product ZP.
Required
(a)
(c)
132
Questions
TWO DIVISIONS
A company has two operating divisions, X and Y each of which is treated as a
profit centre for the purpose of performance reporting.
Division X makes two products, Product A and Product B. Product A is sold to
external customers for Rs. 62 per unit. Product B is a part-finished item that is
sold only to Division Y.
Division Y can obtain the part-finished item from either Division X or from an
external supplier. The external supplier charges a price of Rs. 55 per unit.
The production capacity of Division X is measured in total units of output,
Products A and B. Each unit requires the same direct labour time. The costs of
production in Division X are as follows:
Product A
Product B
Rs.
Rs.
Variable cost
46
48
Fixed cost
19
19
Full cost
65
67
Required
You have been asked to recommend the optimal transfer price, or range of
transfer prices, for Product B.
28.2
(a)
(b)
What would be the optimal transfer price for Product B if there is spare
production capacity in Division X?
(c)
SHADOW PRICE
Division A supplies a special chemical to Division B, another profit centre in the
same group. The output capacity for making the special chemical in Division A is
limited.
The variable cost of making the chemical is Rs. 500 per kilo.
There is no external intermediate market for the chemical.
Division B uses the chemical to manufacture a tablet. Each tablet uses ten grams
of the chemical.
Sales demand for the tablet exceeds the production capacity of Divisions A and
B.
133
The selling price for each tablet is Rs. 10. Further variable processing costs in
Division B to make the tablet from the special chemical are Rs. 2 per tablet.
Required
28.3
(a)
Calculate the shadow price of each kilo of the special chemical. (The
shadow price of the special chemical is the amount by which total
contribution would be reduced (or increased) if one unit less (or more) of
the chemical were available.)
(b)
(c)
Suggest whether this transfer price will provide a suitable basis for
performance evaluation of the two divisions.
FROOM PLC
(a)
(b)
Froom Plc. has two divisions: A and B. The company is into the production
of bicycles. Division A produces the bicycle frame and Division B
assembles the bicycles components onto the frame. There is a market for
both the
sub-assembly and the final product. Each division has been
designed as a profit centre. The transfer price for the sub-assembly has
been set at the long-run average market price. The following data are
available for each division:
Rs.
Estimated selling price for final product
30,000
20,000
15,000
12,000
30,000
20,000
15,000
Contribution
Rs.
35,000
(5,000)
Required
(i)
(ii)
134
Questions
28.4
TRAINING COMPANY
A Pakistan training company has two training centres, one in Karachi and one in
Lahore, each treated as a profit centre for the purpose of transfer pricing.
Each training centre hires its training staff to client organisations, and charges a
fixed rate for each trainer day. Trainers are either full-time staff of the company,
or are hired externally. Externally-hired trainers are all vetted for quality, and are
used when client demand for training exceeds the ability of the division to meet
from its full-time staff.
The Karachi centre is very busy and charges its client Rs. 2,000 per trainer day.
It pays Rs. 1,200 per day to external trainers. The variable cost of using its own
full-time trainers is Rs. 200 per day.
The other training centre is in Lahore. The manager of the Lahore centre is
meeting with the manager of the Karachi centre to discuss the possibility of the
Karachi centre using trainers from the Lahore centre instead of external trainers.
They have agreed this arrangement in principle, but need to agree a daily fee
that the Karachi centre should pay the Lahore centre for these of its trainers.
It has been estimated that if trainers from the Lahore centre are used in Karachi,
the variable costs incurred will be Rs. 200 per day, plus Rs. 250 per day for travel
and accommodation costs. These costs will be paid by the Lahore centre.
Required
Identify the optimal charge per day for the use of Lahore trainers by the Karachi
training centre, in each of the following circumstances:
28.5
(a)
(b)
assuming that the Lahore training centre is fully occupied charging clients
Rs. 750 per trainer day
(c)
assuming that the Lahore training centre is fully occupied charging clients
Rs. 1,100 per trainer day.
BRICKS
ABC Company is organised into two trading groups. Group X makes materials
that are used to manufacture special bricks. It transfers some of these materials
to Group Y and sells some of the materials externally to other brick
manufacturers. Group Y makes special bricks from the materials and sells them
to traders in building materials.
The production capacity of Group X is 2,000 tonnes per month. At present, sales
are limited to 1,000 tonnes to external customers and 600 tonnes to Group Y.
The transfer price was agreed at Rs. 200 per tonne in line with the external sales
trade price at 1st July which was the beginning of the budget year. From 1st
December, however, strong competition in the market has reduced the market
price for the materials to Rs. 180 per tonne.
The manager of Group Y is now saying that the transfer price for the materials
from Group X should be the same as for external customers. The manager of
135
Group X rejects this argument on the basis that the original budget established
the transfer price for the entire financial year.
From each tonne of materials, Group Y produces 1,000 bricks, which it sells at
Rs.0.40 per brick. It would sell a further 400,000 bricks if the price were reduced
to Rs.0.32 per brick.
Other data relevant are given below.
Group X
Group Y
Rs.
Rs.
70
60
100,000
40,000
The variable costs of Group Y exclude the transfer price of materials from Group
X.
Required
(a)
Prepare estimated profit statements for the month of December for each
group and for ABC Company as a whole, based on transfer prices of Rs.
200 per tonne and of Rs. 180 per tonne, when producing at
(i)
80% capacity
(ii)
(b)
Comment on the effect that might result from a change in the transfer price
from Rs. 200 to Rs. 180.
(c)
136
Questions
Year 2
Year 3
Rs.
Rs.
Rs.
Inventory:
Raw materials
108,000
145,800
180,000
Work in progress
75,600
97,200
93,360
Finished goods
86,400
129,600
142,875
Purchases
518,400
702,000
720,000
756,000
972,000
1,098,360
Sales
864,000
1,080,000
1,188,000
Trade receivables
172,800
259,200
297,000
86,400
105,300
126,000
Trade payables
Required
29.2
(a)
calculate the length of the working capital cycle (assuming 365 days in the
year); and
(b)
list the actions that the management of Entity M might take to reduce the
length of the cycle.
WORKING CAPITAL
DON is a small manufacturing company. Its summarised accounts for the last two
years are presented below:
Statements of financial position as at 31st March
Year 5
Rs.000
Fixed assets
Year 6
Rs.000
Rs.000
820
Rs.000
1,000
Current assets
Inventory
340
420
Trade receivables
360
570
137
Year 5
Rs.000
Cash
Year 6
Rs.000
Rs.000
10
Rs.000
0
710
990
1,530
1,990
400
400
Accumulated profits
450
530
Total equity
850
930
200
200
Total assets
Equity and liabilities
Current liabilities
Bank overdraft
140
250
Trade payables
280
510
Other payables
60
100
480
860
1,530
1,990
Sales
Year 5
Year 6
Rs.000
Rs.000
1,800
2,900
Gross profit
210
260
120
160
30
40
90
120
Taxation
DON paid dividends of Rs. 40,000 each year to the equity shareholders.
Required
Evaluate whether DON is over-trading.
Over-trading is defined as expanding a business quickly with insufficient longterm finance, and relying excessively on short-term sources of finance. A
business entity is therefore over-trading when it attempts to carry on a growing
volume of business with insufficient working capital.
138
Questions
29.3
WASEEM LIMITED
Waseem Limited is engaged in manufacture and sale of consumer products. Its
management is in the process of developing the sales plan for the next year.
The sales director is of the view that the main hurdle in increasing the sales is
the availability of finance.
The summarized statement of financial position as of November 30, 2016 is shown
below:
Rs. in million
ASSETS
Fixed assets
950
Current assets
730
1,680
250
Retained earnings
450
700
465
515
1,680
It has been established from the companys past record that any increase
in sales require an investment of 140% of the additional sales amount, in
inventories and accounts receivable. Further, the accounts payable of the
company also increase by 25% of the additional sales amount.
(ii)
The current sales of the company is Rs. 1,100 million while the net profit
after tax is 10% of sales.
(iii)
It is the policy of the company to distribute 20% of its profit after tax among
the shareholders of the company.
Required
Assuming that you are the Chief Financial Officer of the company, advise the
management on the following:
(a)
(b)
What would be the maximum growth in sales that the company can achieve
if:
139
MARX LIMITED
The finance manager of Marx Limited has recognised the need for some
improvements in working capital management, and is looking in particular at inventory.
The companys main inventory item is Material M. Current policy is to purchase 50,000
units of Material M when the inventory level falls to 25,000 units. Annual demand for
Material M is currently 400,000 units. The cost of holding one unit of Material M in store
is Rs. 0.75 per year, and the cost of placing a purchase order for Material M is Rs. 240.
These costs are expected to remain constant for the foreseeable future. Orders are
delivered exactly two weeks after they are placed with the supplier. You should
assume constant demand throughout the year and a 50-week year.
Required
30.2
(a)
Explain the main objectives of working capital management and the conflict
that may arise between them.
(b)
Calculate the annual cost of the current inventory ordering policy and the
saving that would be achievable if the company switched to using the
Economic Order Quantity (EOQ) model to decide purchase quantities for
Material M.
ENGELS LIMITED
The recently-appointed financial manager of Engels Limited has gathered the following
information as part of an investigation into inventory.
The current policy is to order 100,000 units when the inventory level falls to 35,000
units. Forecast demand to meet production requirements during the next year is
625,000 units. The cost of placing and processing an order is Rs. 250, while the cost of
holding a unit in stores is Rs. 050 per unit per year. Both costs are expected to be
constant during the next year. Orders are received two weeks after being placed with
the supplier. You should assume a 50-week year and that demand is constant
throughout the year.
Required
Calculate the cost of the current ordering policy and determine the saving that
could be made by using the economic order quantity model.
30.3
LENIN LIMITED
(a)
Discuss the key factors which determine the level of investment in current
assets.
(b)
Lenin Limited wishes to minimise its inventory costs. Annual demand for a
raw material costing Rs. 12 per unit is 60,000 units per year. Inventory
management costs for this raw material are as follows:
Ordering cost:
Holding cost:
140
Questions
The supplier of this raw material has offered a bulk purchase discount of
1% for orders of 10,000 units or more.
If bulk purchase orders are made regularly, it is expected that annual
holding cost for this raw material will increase to Rs. 2 per unit per year.
Required
(i)
Calculate the total cost of inventory for the raw material when using
the economic order quantity.
(ii)
141
Rs.
Raw materials
180,000
Work in progress
31.2
Year 3
93,360
Finished goods
142,875
Purchases
720,000
1,098,360
Sales
1,188,000
Trade receivables
297,000
Trade payables
126,000
(b)
142
Questions
31.3
(ii)
(iii)
Non-notification factoring
Chishtian Construction Plc. has just won a big contract and needs
additional working capital of Rs. 9.5 billion to be able to execute the
contract. Investigations carried out by the company revealed the following
three feasible sources of funds:
(i)
(ii)
(iii)
Required
Determine, on the basis of annualised percentage cost, which alternative
the company should select.
(b)
31.4
(b)
Entity C has monthly sales of Rs. 100,000. A factor has offered to take over
the administration of Entity Cs trade receivables, on a non-recourse basis
(or without recourse basis). It would charge a fee of 4% of the value of
invoices processed. If the factor takes over this work, Entity C would save
143
monthly administration costs of Rs. 2,000 and would avoid its bad debts,
which are 0.75% of sales.
Entity C has been informed by the factor that the average collection period
(the time between issuing an invoice and receiving payment from the
customer) will be reduced from 2 months to 1 month.
The factor will also provide finance by lending 80% of the value of unpaid
invoices, charging interest at an annual rate of 8% on the cash that it lends.
At the moment, Entity C finances its trade receivables with bank overdraft
finance at 9% per year interest.
Calculate the net effect on annual profits of Entity C if the factor took over
the administration of the trade receivables and provided finance on the
terms described above.
31.5
(b)
144
Questions
31.6
ULNAD CO
Ulnad Co has annual sales revenue of Rs. 6 million and all sales are on 30 days
credit, although customers on average take ten days more than this to pay.
Contribution represents 60% of sales and the company currently has no bad
debts. Accounts receivable are financed by an overdraft at an annual interest rate
of 7%.
Ulnad Co plans to offer an early settlement discount of 1.5% for payment within
15 days and to extend the maximum credit offered to 60 days. The company
expects that these changes will increase annual credit sales by 5%, while also
leading to additional incremental costs equal to 0.5% of turnover. The discount is
expected to be taken by 30% of customers, with the remaining customers taking
an average of 60 days to pay.
Required
31.7
(a)
Evaluate whether the proposed changes in credit policy will increase the
profitability of Ulnad Co.
(b)
BRUTUS COMPANY
Brutus Company has annual sales revenue of Rs. 8 million. It has a contribution
to sales ratio of 45% and its annual fixed costs are Rs. 2.5 million. These figures
exclude bad debts which are currently 1.25% of sales. All sales are on credit and
standard credit terms are 30 days, although customers take on average 45 days
to pay. Accounts receivable are financed by a bank overdraft on which interest is
payable at 8%.
The companys management are considering whether to offer a discount of 2.5%
for all customers who pay within 14 days, and to extend the credit period for other
customers to 60 days. It has been estimated that if this policy is introduced, 25%
of customers would take the settlement discount and the rest would take the full
60 days credit offered.
The new policy would result in higher administration costs equal to 0.5% of total
gross sales. It is expected that total (gross) sales would be boosted, and would
increase by 3% per year. It is also expected that bad debts would fall to 1% of
gross sales.
Required
Calculate the effect that the new policy would have on annual profit and
recommend whether the new policy should be introduced. Suggest an alternative
policy for the management of receivables that might improve profit by a larger
amount.
145
Entity X uses a bank account for its daily expenditures. There are no
payments into the account. Instead, whenever the account needs more
cash, Entity X sells a quantity of marketable securities. These currently
provide an interest yield of 5% per year. The cost of selling securities is Rs.
60 per transaction, regardless of the size of the transaction.
Annual payments from the account are Rs. 3,000,000.
Required
Use the Baumol cash management model to decide the optimal size of
transaction for selling marketable securities, and the frequency with which
securities will be sold. Assume a 365-day year.
(b)
Entity Y uses a bank account for its daily income and expenditures. Each
year, it expects income and expenditure to be Rs. 3,000,000. However,
daily cash flows are variable, and the standard deviation of daily cash flows
is Rs. 2,200. The annual interest rate is 5%.
If the cash balance goes above a certain level, the entity will buy
marketable securities to earn interest on the surplus cash. If the cash
balance reaches a minimum level, the entity will sell some marketable
securities to obtain more cash. The cost of buying or selling securities is
Rs. 60 per transaction.
Entity Y uses the Miller-Orr cash management model. It has decided that it
should have a minimum cash balance of Rs. 20,000.
Calculate:
32.2
(a)
(b)
(c)
RENPEC CO
Renpec Co has set a minimum cash account balance of Rs. 7,500. The average
cost to the company of making deposits or selling investments is Rs. 18 per
transaction and the standard deviation of its cash flows was Rs. 1,000 per day
during the last year. The average interest rate on investments is 5.11%.
Required
(b)
Determine the spread, the upper limit and the return point for the cash
account of Renpec Co using the Miller-Orr model and explain the relevance
of these values for the cash management of the company.
(d)
146
Questions
32.3
BAUMOL
Explain how the Baumol cash model can be used to reduce the costs of cash
management and discuss whether the model might be of any assistance to the
finance manager of a travel company.
32.4
CASSIUS COMPANY
Cassius Company is a subsidiary of Brutus. It uses the Miller-Orr model to
manage its cash balances and has set a minimum cash balance of Rs. 12,500.
The average rate received on investments is currently 5.68%. Over the past year,
the standard deviation of daily cash flows has been Rs. 2,800. The cost to the
company of selling investments or making deposits is Rs. 20 per transaction.
Required
(a)
Calculate the spread, the upper limit and the return point for cash balances
using the Miller-Orr model and explain the meaning and purpose of these
amounts for the purpose of cash management.
(b)
Suggest with reasons how Cassius Company might invest its short-term
cash surpluses.
147
148
SECTION
B
Answers
COMPANY OBJECTIVES
(a)
149
Another justification from the individual firms point of view is to argue that it
is in competition with other firms for further capital and it therefore needs to
provide returns at least as good as the competition. If it does not it will lose
the support of existing shareholders and will find it difficult to raise funds in
the future, as well as being vulnerable to potential take-over bids.
Against the traditional and legal view that the firm is run in order to
maximise the wealth of ordinary shareholders, there is an alternative view
that the firm is a coalition of different groups: equity shareholders,
preference shareholders and lenders, employees, customers and suppliers.
Each of these groups must be paid a minimum return to encourage them
to participate in the firm. Any excess wealth created by the firm should be
and is the subject of bargaining between these groups.
At first sight this seems an easy way out of the objectives problem. The
directors of a company could say Lets just make the profits first, then well
argue about who gets them at a later stage. In other words, maximising
profits leads to the largest pool of benefits to be distributed among the
participants in the bargaining process. However, it does imply that all such
participants must value profits in the same way and that they are all willing
to take the same risks.
In fact the real risk position and the attitude to risk of ordinary shareholders,
loan creditors and employees are likely to be very different. For instance, a
shareholder who has a diversified portfolio is likely not to be so worried by
the bankruptcy of one of his companies as will an employee of that
company, or a supplier whose main customer is that company. The
problem of risk is one major reason why there cannot be a single simple
objective which is common to all companies.
(b)
Separate from the problem of which goal a company ought to pursue are
the questions of which goals companies claim to pursue and which goals
they actually pursue. Many objectives are quoted by large companies and
sometimes are included in their annual accounts. Examples are:
to improve liquidity
to improve productivity
to be market leaders
150
Answers
(i)
(ii)
(iii)
(iv)
dysfunctional goals.
The last category is goals which should not be followed because they do
not benefit in the long run. Examples here include the pursuit of market
leadership at any cost, even profitability. This may arise because
management assumes that high sales equal high profits which is not
necessarily so.
In practice, the goals which a company actually pursues are affected to a
large extent by the management. As a last resort, the directors may always
be removed by the shareholders or the shareholders could vote for a takeover bid, but in large companies individual shareholders lack voting power
and information. These companies can, therefore, be dominated by the
management.
There are two levels of argument here. Firstly, if the management do
attempt to maximise profits, then they are in a much more powerful position
to decide how the profits are carved up than are the shareholders.
Secondly, the management may actually be seeking prestige goals rather
than profit maximisation. Such goals might include growth for its own sake,
including empire building or maximising turnover for its own sake, or
becoming leaders in the technical field for no reason other than general
prestige. Such goals are usually dysfunctional.
The dominance of management depends on individual shareholders having
no real voting power, and in this respect institutions have usually preferred
to sell their shares rather than interfere with the management of
companies. There is some evidence, however, that they are now taking a
more active role in major company decisions.
From all that has been said above, it appears that each company should
have its own unique decision model. For example, it is possible to construct
models where the objective is to maximise profit subject to first fulfilling the
target levels of other goals. However, it is not possible to develop the
general theory of financial management very far without making an initial
simplifying assumption about objectives. The objective of maximising the
wealth of equity shareholders seems the least objectionable.
1.2
POSSIBLE CONFLICTS
Achievement of the objective of maximisation of the value of a firm might be
compromised by conflicts which may arise between the managers and the other
stakeholders in an organisation. Such conflicts include:
151
(i)
(ii)
(iii)
(iv)
(v)
(vi)
Managers might take a more short-term view of the firms performance than
the shareholders would wish.
1.3
Since senior managers do not own the business, they may be more
concerned with their benefits rather than maximizing the wealth of
shareholders.
OWNERSHIP
(a)
(b)
(ii)
Advantages that may accrue to the corporate finance manager include the
following:
(i)
(ii)
(iii)
152
Answers
(iv)
(v)
(vi)
153
SHOCKLAT CO
(a)
Factors to consider
When making any decision with a financial impact, the relevant costs and
benefits of the decision should be considered.
(b)
(1)
(2)
(3)
(4)
Product safety. The company must be fully satisfied about the safety
of the new products CP1 and CP2 before introducing them to the
market. If testing has not yet been carried out, this will have an
incremental cost to take into consideration.
154
Rs.
135,000
140,000
275,000
40,000
315,000
Answers
Rs.
490,000
175,000
Rs. 87.50
The market research cost is not relevant because it has already been
incurred.
(2)
The cost of the supervisor is not relevant because his salary will be
paid anyway, and there will be no extra cash spending on
supervision.
(3)
Rs.
Rs.
204,000
84,000
120,000
15,200
18,000
78,750
111,950
8,050
155
Rs.
Rs.
619,100
406,000
213,100
96,000
25,000
109,375
230,375
(17,275)
2.2
The breakeven selling price per kilo of CP2 would be the initial selling price
of Rs. 20.50 plus Rs.(17,275/30,200) = Rs. 20.50 + Rs.0.572 = Rs. 21.072.
TOPAZ LIMITED
Calculation of unit price to be quoted to Pearl Limited:
Rs.
Material (25,000 u 200)+(53,125 u 225) + 80,000
W1
17,033,125
W2
9,838,125
5,765,625
W3
3,300,000
35,936,875
8,984,219
Sale price
44,921,094
299
W1: Material
Input units of material C (150,000 / 96%) 0.5
156
78,125
Answers
W2: Labour
Labour hours completed units 150,000 u 1.50
225,000
lost units
{[(150,000 / 0.96) 150,000] u 1.5 u 60%}
5,625
230,625
W3: Capacity
2.3
30%
20%
10%
TYCHY LIMITED
Tychy Limited (TL)
Note
Rs.
NIL
Wire C
8,160
Wire D
600
Components
2,400
Direct labour
3,250
450
Fixed overhead
NIL
14,860
Notes:
1.
2.
3.
157
4.
5.
The 100 hours of direct labour are presently idle and hence have zero
relevant cost. The remaining 150 hours are relevant. TL has two
choices: either use its existing employees and pay them overtime at
Rs. 23 per hour which is a total cost of Rs. 3,450: or engage the
temporary workers which would cost TL Rs. 3,250 including supervision
cost of Rs. 100. The relevant cost is the cheaper of the two alternatives
i.e. Rs. 3250.
6.
7.
Fixed overhead costs are incurred whether the work goes ahead or not
so it is not a relevant cost.
158
Answers
(i)
Materials
Rs.
K: 3,000 kg at (Rs. 19,600 2,000) u 1.05
L: 200 kg at Rs. 11
30,870
2,200
33,070
(ii)
Skilled labour
Rs.
Labour cost 800 hours at Rs. 950
Opportunity cost of labour 800 hours at (Rs. 40
4)
7,600
8,000
15,600
(iii)
15,600
Materials
33,070
Total
48,670
Given that the extra cost of completing the contract in house is Rs.
48,670 the company should not be prepared to pay more than this to
outsource
(b)
Any variable overhead costs associated with the contract would be relevant
because they would represent additional or incremental costs caused
directly by the contract.
Fixed overhead costs would only be relevant if the total fixed overhead
costs of the company increased as a direct consequence of the contract
being undertaken. In that case the relevant amount would be the specific
increase in the total fixed overhead costs caused by the acceptance of the
contract. Arbitrary apportionments of existing fixed overhead costs would
not be relevant. Similarly sunk and committed costs would not be relevant.
(c)
To:
From:
Management Accountant
Concerning:
Outsourcing
Introduction
Outsourcing can have a major impact on the structure operation of a
business. If successful it can enhance quality and profitability. If it fails it
can threaten the existence of the business.
159
Relevant costing
Outsourcing decisions based on relevant costing can be misleading. If
relevant fixed costs savings are included, for instance, how certain can the
company be that these savings will actually arise? The absence of such
savings may lock a company into higher costs than expected rendering the
outsourcing uneconomic
Reversibility
If a product or service is outsourced, how easy is it for a company to
reverse this process if the relationship proves unsatisfactory or the supplier
goes out of business? Loss of key personnel may the most critical factor
here. If it is difficult/impossible to reverse should the company undertake
the outsourcing?
Impact on remaining business
Closure of a significant part of a business due to outsourcing may have an
adverse effect on staff morale, particularly if significant redundancies are
involved. The impact of this needs to be quantified and included in the
assessment process.
Reaction of customers
Are customers likely to react adversely to an outsourcing decision?
Consider, for example, the negative reaction of UK customers to the
outsourcing of bank account and broadband support to Indian call centres.
Flexibility
Is the outsourcing company able to scale its production to match our
needs? If our business doubles in size in 18 months will the outsource
company be able to cope. Equally, what is the financial cost of this
flexibility? If we don't meet forecast levels of activity are there financial
penalties?
Quality
There is a danger that by focussing on costs we forget quality. What
guarantees of quality do we have. Does the supplier have a track record of
high quality output/service provision?
Summary
Whilst outsourcing potentially offers the company significant benefits, a
wide range of criteria need to be considered. Relevant costing is a useful
tool here but a range of non-financial factors should be considered.
3.2
Tutorial note
Though this question looks complex due to the volume of information, it is
actually relatively straightforward. At its heart this is a limiting factor question.
What production mix maximises return on material R2? Work out the
contribution per unit of R2 used for each of the products these figures are then
used to prioritise production.
160
Answers
AR2
GL3
HT4
Rs. per
unit
Rs. per
unit
Rs. per
unit
Material R2
2.5 u 2
5.00
2.5 u 3
7.50
2.5 u 3
7.50
Material R3
2u2
4.00
2 u 2.2
4.40
2 u 1.6
3.20
4 u 0.6
2.40
4 u 1.2
4.80
4 u 1.5
6.00
Labour
Variable overhead
1.10
1.30
1.10
Variable costs
12.50
18.00
17.80
Selling price
21.00
28.50
27.30
Contribution
8.50
10.50
9.50
Rs.
4.25
Rs.
3.50
Rs. 3.17
Ranking
Product
Demand
R2 used
Production
Contribution
units
kg
units
Rs.
950
1,900
950
8,075
AR2
1,000
3,000
1,000
10,500
GL3
900
600
200
1,900
HT4
5,500
20,475
The optimum production schedule is 950 units of Product AR2, 1,000 units of
GL3 and 200 units of HT4, giving a total contribution of Rs. 20,475.
Tutorial note:
The fixed production overheads are ignored in this analysis because they are
assumed not to vary with changes in the level of production.
(b)
161
(c)
Tutorial note
Any decision cannot just involve comparison of variable costs as there is an
incremental cost of Rs. 50,000 to be accounted for.
Strong answers will also distinguish between short and long-term decisionmaking, together with considering non-financial criteria.
The variable cost of Product XY5:
Rs./unit
Material R3: 3 u 2 =
6.00
Labour: 1.7 u 4 =
6.80
Variable overhead:
1.40
14.20
The substitute offered by Kenzi Chemicals Ltd gives a saving of Rs. 4 per unit.
However, Wazir Manufacturing Ltd would also pay an annual fee of Rs. 50,000
for the right to use the substitute.
The company would need to manufacture more than Rs. 50,000/Rs. 4 = 12,500
units per year of Product XY5, or 1,042 units per month, in order for the offered
substitute to be financially acceptable.
If it needed less than 12,500 units of Product XY5 per year, it would be cheaper
to manufacture the product internally.
This evaluation is from a short-term perspective: in the longer term, buying in
may lead to fixed cost savings and lower investment, increasing the benefits of
buying in and lowering the break-even point.
Wazir Manufacturing Ltd would also need to assure itself that the quality of the
substitute was acceptable and that this quality could be maintained: the lower
price offered by Kenzi Chemicals Ltd might be associated with poorer quality
than the minimum standard of quality considered necessary by Wazir
Manufacturing Ltd. Orders for the substitute product would also need to be
delivered promptly in order to avoid production hold-ups.
Wazir Manufacturing Ltd could also become dependent on Kenzi Chemicals Ltd
for supplies of the substitute product and might be vulnerable to future price
increases by the supplier. Such price increases might reduce or even eliminate
the cost saving of buying in.
(d)
162
Answers
A major limitation with using marginal costing as the basis for making short-term
decisions is the assumption that fixed costs are irrelevant to short-term
decisions. In the longer term, fixed costs will change: for example, rent is usually
regarded as a fixed cost and in the longer term rent might be expected to
increase due to inflation. However, a change in fixed costs may be the result of a
short-term decision: for example, if a product is discontinued and as a result the
work of the marketing department decreases, in the longer term marketing costs
would be expected to decrease.
This points to the danger of relying on a simplistic analysis of costs into fixed
costs and variable costs, and of assuming that only variable costs are relevant
for decision-making purposes. It is possible for a fixed cost to be a relevant cost.
It is also possible for a variable cost to be irrelevant, for example in the case
where a variable cost is common to two decision alternatives. If fuel costs are
incurred whether a machine is leased or bought, for example, these costs are
not relevant to the decision on whether to lease or buy.
Reliance on marginal costing as a basis for making short-term decisions may
therefore lead to sub-optimal decisions overall for a company, as the analysis
may fail to consider all relevant costs.
3.3
163
(b)
Material cost
Labour
Total
Cost per litre
Sales price per litre
Rs.
180,000
19,800
199,800
30,000
229,800
22980
39980
Female version
Rs.
Rs.
Hormone
2 ltr x Rs. 7,750/ltr
15,500 8 ltr x Rs. 12,000/ltr
96,000
Supervisor
Sunk cost
0 Sunk cost
0
Labour
500 hrs x Rs. 100/hr 50,000 700 hrs x Rs. 100/hr 70,000
Fixed cost
Sunk cost
0 Sunk cost
0
Market research Sunk cost
0 Sunk cost
0
Total
65,500
166,000
Incremental revenues
Male version
Female version
Rs.
Rs.
Standard
200 ltr x Rs. 39980/ltr 79,960 800 ltr x Rs. 39980 319,840
Hormone added 202 ltr x Rs. 750/ltr 151,500 808 ltr x Rs. 595/ltr
480,760
Incremental revenue
71,540
160,920
Net benefit/(cost)
6,040
(5,080)
The Male version of the product is worth further processing in that the extra
revenue exceeds the extra cost by Rs. 6,040.
The Female version of the product is not worth further processing in that the
extra cost exceeds the extra revenue by Rs. 5,080.
In both cases the numbers appear small. Indeed, the benefit of Rs. 6,040 may
not be enough to persuade management to take the risk of damaging the brand
and the reputation of the business. To put this figure into context: the normal
output generates a contribution of Rs. 170 per litre and on normal output of
about 10,000 litres this represents a monthly contribution of around Rs. 17m
(after allowing for labour costs).
164
Answers
Future production decisions are a different matter. If the product proves popular,
however, Khokhar Perfumers Limited might expect a significant increase in
overall volumes. If Khokhar Perfumers Limited could exploit this and resolve its
current shortage of labour then more contribution could be created. It is worth
noting that resolving its labour shortage would substantially reduce the labour
cost allocated to the hormone added project. Equally, the prices charged for a
one off experimental promotion might be different to the prices that can be
secured in the long run.
(c)
The selling price charged would have to cover the incremental costs of Rs.
166,000. For 808 litres that would mean the price would have to be
(Rs.166,000 + Rs.319,840)
= Rs.601.29/ ltr
808 ltrs
or about Rs. 6013 per 100 ml.
This represents an increase of only 105% on the price given and so clearly
there may be scope for further consideration of this proposal.
(d)
165
PROGLIN
(a)
Linear programme
Let the number of units of Mark 1 be x
Let the number of units of Mark 2 be y.
The objective function is to maximise total contribution: 10x + 15y.
Subject to the following constraints:
Direct materials
Direct labour
Sales demand, Mark 1
Non-negativity
2x + 4y
3x + 2y
x
x, y
24,000
18,000
5,000
0
These constraints are shown in the graph below. The graph also shows an
iso-contribution line (10x + 15y = 60,000).
x = 5,000
9,000
3x + 2y = 18,000
6,000 A
B
4,000
C
D
5,000
6,000
12,000
The feasible solutions are shown by the area 0ABCD in the graph.
Using the slope of the iso-contribution line, it can be seen that contribution is
maximised at point B on the graph.
At point B, we have the following simultaneous equations:
(1)
(2)
Multiply (2) by 2
(3)
Subtract (1) from (3)
Therefore
Substitute in equation (1)
2x + 4y
3x + 2y
=
=
24,000
18,000
6x + 4y
36,000
4x
x
=
=
12,000
3,000
2 (3,000) + 4y
4y
y
=
=
=
24,000
18,000
4,500
166
Answers
30,000
67,500
Total contribution
97,500
(b)
2x + 4y
24,001
(2)
Multiply (2) by 2
3x + 2y
18,000
(3)
Subtract (1) from (3)
6x + 4y
36,000
4x
11,999
2,999.75
3 (2,999.75) + 2y
2y
=
=
18,000
9,000.75
4,500.375
Therefore
Substitute in equation (2)
29,997.500
67,505.625
Total costs
97,503.125
4.2
Light Engineering
(a)
Tutorial note: The first step is to make a clear statement of what is taken
to be x and what is taken to be y.
Let x = weekly production of water tanks
Let y = weekly production of water butts
Define the objective function:
The objective is to maximise contribution. Since each water tank (x)
contributes Rs. 50.00 and each water butt (y) contributes Rs. 40.00, the
objective function can be written as:
C = 50x + 40y
167
Cutting time:
6x + 3y d 36
(ii)
Assembly time:
4x + 8y d 48
(iii)
Minimum constraints
The company has to produce at least two water tanks and three water
butts.
xt2
yt3
(b)
(2)
12
Butts
6
P
Feasible
Region
3
168
Tanks
12
Answers
(c)
Tutorial note: The quickest way to find the contribution maximising mix of
products is to plot an iso-contribution line on to the graph. Slowly move the
line out from the origin the last point inside the feasible region that it
passes through is the optimum product combination.
In this example this is point P.
P is the intersection of the lines:
(1)
6x + 3y = 36
(2)
4x + 8y = 48
(4)
6x + 3y = 37
(2)
4x + 8y = 48
(4)
169
6x + 3y = 37
6x + 11.667 = 37
6x = 25.33
x = 4.22
6x + 3y = 36
(2)
4x + 8y = 49
(4)
6x + 3y = 36
6x + 12.501 = 36
6x = 23.499
x = 3.917
170
Answers
BADGER
Cash Flows
Machine
Existing machine
01/01/17
Rs. m
0
(180)
2
31/12/17
Rs. m
1
31/12/18
Rs. m
2
31/12/19
Rs. m
3
31/12/20
Rs. m
4
25
(1)
79
(32)
103
(48)
175
(57)
179
(73)
(6)
(13)
(9)
(10)
(8)
(9)
(8)
(10)
(3)
(3)
(6)
(3)
(3)
2
(3)
(1)
(179)
1.000
25
25
0.909
27
27
0.826
98
98
0.751
109
109
0.683
(179)
23
22
74
74
Operating flows
Sales W1
Purchases W2
Payments to
subcontractors
Fixed overhead
Labour costs:
Promotion
Redundancy
Material
X
Y
Net operating flows
Discount factor (10%
NPV
14
WORKINGS
(1)
Sales
2016
Rs. m
2017
Rs. m
2018
Rs. m
2019
Rs. m
2020
Rs. m
1,100
1,122
1,144
1,167
1,191
0.07
0.09
0.15
0.15
79
103
175
179
Opening payables
Add purchases
Less closing payables
2017
40
(8)
2018
8
50
(10)
2019
10
58
(11)
2020
11
62
-
32
Market size
Market share
Sales
(2)
Purchases
171
48
57
73
6.2
[1 - (1+ r) - n]
r
1 - ( 1.12) -20
0.12
7.4694
: . Annual repayment
=
=
(b)
,5000,000
7.4694
Rs. 334,698.90
Cash flow
(Rs.)
(3,000,000)
(250,000)
540,000
250,000
DF@
12%
1.0000
1.0000
3.6048
0.5674
NPV
PV
(Rs.)
(3,000,000)
(250,000)
1,946,592
141,850
(1,161,558)
Advice:
The machine should not be bought, as its purchase would result in the
reduction of the shareholders wealth by Rs. 1,161,558.
6.3
0
1
2
3
4
5
Rs.000 Rs.000 Rs.000 Rs.00 Rs.000 Rs.000
Sales
7,400 8,300
9,800
5,800
Wages
(550) (580)
(620)
(520)
Materials
(340) (360)
(410)
(370)
Licence fee
(300)
(300)
(300) (300)
(300)
Overheads
(100) (100)
(100)
(100)
Equipment
(5,200) (5,200)
2,000
Specialised equipment
(150)
Working capital
(650)
650
(5,500) (6,150)
5,960 6,960
8,370
7,460
Discount factor at 10%
Present value
1.000
0.909
0.826
0.751
0.683
0.621
(5,500) (5,590)
4,923
5,227
5,717
4,633
172
Answers
6.4
(b)
(i)
(ii)
(c)
Cash flows
Rs.000
(260,000)
0
1-12
480,000
i.e. 40m x 12
13 - 20
272,000
i.e. 34m x 8
Payback period
60,000,000
0,000,000
years
6.5 years
The project should be accepted because its payback period is less than
the projects life.
(d)
Cash flow
DF(15%)
Rs.000
Present Value
Rs.000
(260,000)
1.0000
(260,000)
1 12
40,000
5.4206
216,824
13 20
34,000
0.8387
28,516
(14,660)
Cashflow
DF(12%)
Rs.000
Rs.000
(260,000)
1.0000
(260,000)
1 12
40,000
6.1944
247,776
13 20
34,000
1.2750
43,350
Present Value
173
31,126
DFp
NPVp NPVp
IRR
31,126 u 15 12
= 12% +
31,126 (14,660
= 12% + 2.039%
= 14.039%
6.5
BETA LIMITED
(a)
Option II
82
107.41 (W1)
3.10
3.83 (W2)
10.50%
15.11% (W3)
13.20%
14.30% (W4)
On financial ground, the project to be accepted should be the one with the
higher NPV, i.e. Option 2. NPV shows the absolute amount by which the
project is forecast to increase shareholders' wealth and is theoretically
more sound than the IRR and MIRR. However, In this case, both IRR and
MIRR back up the NPV.
The discounted payback period shows that Option II is more risky as it
takes longer to recover the present value.
WORKINGS
W1: Net present value
Year 0
Year 1
Year 2
Year 3
Year 4
Rs. in million
Outside Pak nominal cash flows
(W1.1)
(2,252.25)
244.23
308.25
348.35
357.65
366.30
423.50
551.03
658.85
(2,252.25)
610.53
731.75
899.38 1,016.50
0.885
0.783
0.693
0.613
540.32
572.96
623.27
623.11
Year 3
Year 4
1.000
(2,252.25)
107.41
174
Year 0
Year 1
Year 2
0.0111
0.0104
0.0097
0.0091
0.0085
Answers
in million
US$ net cash flows at current
prices
US $ net nominal cash flows (3%
inflation)
US$ nominal cash flows (Rs.)
(25.00)
2.47
2.82
2.90
2.70
(25.00)
2.54
2.99
3.17
3.04
BA
(2,252.2
5)
244.23
308.25
348.35
357.65
Year 1
Year 2
Year 3
Year 4
(2,252.25)
572.96
623.27
623.11
( 515.70)
107.41
540.32
Discounted payback
period =
3.83 years
Year 1
Year 2
Year 3
Year 4
in million
Nominal cash flows in
million Rs.
Discount factor at 16%
Present value
Net present value
By Interpolation, the IRR
is :
(2,252.25)
610.53
731.75
899.38
1,016.5
0
1.000
0.862
0.743
0.641
0.552
(2,252.25)
526.28
543.69
576.50
561.11
(44.67)
15.11% per annum
(Years 1 2,359.66
2,252.25
13%
MIRR = 14.3%
175
Year of
claim
Rs.
600,000
(150,000)
Cost
Allowance (25%)
Cash
flow year
Rs.
52,500
39,375
29,531
22,148
16,611
49,834
450,000
(112,500)
Allowance (25%)
337,500
(84,375)
Allowance (25%)
253,125
(63,281)
Allowance (25%)
189,844
(47,461)
Allowance (25%)
142,383
0
Disposal
142,383
Note: It is assumed that the company has taxable profits against which it can
claim an allowance in Year 0 (or early in Year 1).
Year
Rs.000
Rs.000
Rs.000
Rs.000
Rs.000
Rs.000
Rs.000
250
(50)
(25)
250
(55)
(25)
300
(58)
(30)
350
(64)
(30)
400
(70)
(35)
175
170
(61)
212
(60)
256
(74)
295
(90)
Sales
Materials
Labour
Cash profits
Tax at 35%
Capital
equipment
Cash effect of
allowances
Net cash flow
DCF factor at
15%
PV of cash flow
NPV
(103)
(600)
53
39
30
22
17
50
(600)
1.000
228
0.870
148
0.756
182
0.658
204
0.572
222
0.497
(53)
0.432
(600)
198
112
120
117
110
(23)
34
176
Answers
The project is just worthwhile, because the NPV is + Rs. 34,000. However, the
NPV is quite small in relation to the size of the capital investment, and in view of
the fact that it is a five-year project.
It might be appropriate to carry out some risk and uncertainty analysis on the
project, before deciding whether or not to undertake it.
7.2
Cost
Allowance (25%)
Rs.
250,000
(62,500)
Tax saving
(35% of allowance)
Rs.
Cash flow
year
21,875
16,406
12,305
9,228
(7,314)
Allowance (25%)
187,500
(46,875)
Allowance (25%)
140,625
(35,156)
Allowance (25%)
105,469
(26,367)
79,102
100,000
Disposal
(20,898)
NPV calculation
Year
0
Rs.
1
Rs.
Capital
equipment
(250,000)
Working capital
(38,000)
Cash profits before tax
Tax on profits (35%)
Cash effect of allowances
(12,000)
120,000
2
Rs.
3
Rs.
4
Rs.
5
Rs.
21,875
120,000
(42,000)
16,406
120,000
(42,000)
12,305
100,000
50,000
120,000
(42,000) (42,000)
9,228 (7,314)
(288,000)
1.000
129,875
0.909
94,406
0.826
90,305
0.751
237,228 (49,314)
0.683
0.621
(288,000)
118,056
77,979
67,819
162,027 (30,624)
NPV
+ 107,257
The NPV is + Rs. 107,257. This indicates that the project should be undertaken.
177
7.3
ALAWADA LIMITED
(a)
CF
PV
DF @
10%
Rs.
Rs.
800,000
0.9091
727,280
640,000
0.8264
528,896
466,000
0.7513
350,106
836,700
0.6830
571,466
630,675
0.6209
391,586
2,569,334
(3,000,000)
(430,666)
The project is not viable since the NPV shows a negative figure of Rs.
430,666.
Workings
Year
Sales (Rs.)
Less:
Materials
Labour
Net MCF
(b)
(c)
1
2,800,000
2
2,800,000
3
2,800,000
4
3,360,000
5
3,360,000
(800,000)
(1,200,000)
800,000
(840,000)
(1,320,000)
640,000
(882,000)
(1,452,000)
466,000
(926,100)
(1,597,200)
836,700
(927,405)
(1,756,920)
630,675
(ii)
The benefits will accrue over a long period of time, usually well over
one year and often much longer, so that the benefits cannot all be set
off against costs in the current years Statement of profit or loss.
(iii)
(iv)
(i)
(ii)
(iii)
(iv)
(v)
178
Answers
7.4
KOHAT LIMITED
Inflation
factor
Investment
Years
0
2
3
Rs. in million
(15,000)
Revenue (Rs.
8,0001 million)
5%
8,000
8,400
8,820
9,261
9,724
Operating
costs(excluding
wages) (W1)
10.34%
(2,000)
(2,207)
(2,435)
(2,686)
(2,965)
Wages (W2)
11.73%
(1,000)
(1,117)
(1,248)
(1,395)
(1,558)
5,000
5,076
5,137
5,180
5,201
Profit before
taxation
Residual value
(Rs.
15,00020%)
3,000
Tax @ 30 %
(W3)
Net inflows
(600)
(803)
(965)
(1,093)
(617)
(15,000)
4,400
4,273
4,172
4,087
7,584
0.850
0.722
0.614
0.522
0.444
(15,000)
3,740
3,085
2,562
2,125
3,367
Discount factor
(W4)
Net present
value
(121)
Conclusion: The projective has a negative NPV. KL should not invest in the
project.
W1: Compound annual growth rate for CPI
175
CAGR for CPI
(1 i) 5
107
1/5
(1.6355) = 1 + i
1 + i = 1.1034
i = 10.34%
W2: Compound annual growth rate for PPI
195
= (1 + i) 5
112
(1.7411)1/5 = 1+i
1+i = 1.1173
i = 11.73%
179
Profit before
taxation
Depreciatio
n
Loss on
disposal
Taxable
profit/loss
Tax@ 30%
YEARS
3
5,000
5,076
5,137
5,180
5,201
(3000)
(2400)
(1920)
(1536)
(1229)
(1,915)
2,000
600
2,676
803
3,217
965
3,644
1,093
2,057
617
7.5
2017
Initial
investment
(7,000,000)
Residual value
1
Restaurant
contribution
5,040,000
Lost contribution
from snack bar
(2,025,000)
(W4)
Salaries
Additional
overheads
Net cash flows
Tax payment
(W1)
Net cash flow
after tax
Discount factor
(W3)
2018
Rupees
2019
2020
510,000
5,544,000
6,098,400
6,708,240
(1,991,250)
(1,942,313)
(1,876,079)
(800,000)
(800,000)
(1,000,000)
(1,000,000)
(595,000)
1,620,000
(595,000)
2,157,750
(595,000)
2,561,087
(595,000)
3,747,161
45,500
(295,838)
(551,849)
(456,413)
(7,000,000)
1,665,500
1,861,912
2,009,238
3,290,748
0.940
0.884
0.831
0.781
(7,000,000)
-
(7,000,000) 1,565,570
Present value
1,645,930
1,669,677
2,570,074
Net present
value
451,251
Conclusion:
The company should invest in the project as it would generate higher net cash
flows as compare to existing business.
180
Answers
2018
2019
2020
Rupees
Net cash flows
Less: Depreciation for
the year (W2)
Taxable profit
1,620,000
2,157,750
2,561,087
3,747,161
(1,750,000)
(1,312,500)
(984,375)
(2,443,125)
4,595,000
5,806,500
6,786,025
6,773,815
(45,500)
295,838
551,849
456,413
7,000,000
5,250,000
3,937,500
2,953,125
(1,750,000)
(1,312,500)
(984,375)
*(2,443,125)
5,250,000
3,937,500
2,953,125
510,000
Tax payments
(Taxable profit x 35%)
250
263
276
289
304
No. of members
with restaurant
150
165
181.5
199.65
Lost
members/day
113
111
108
104
Rate (u)
50
50
50
50
360
360
360
360
2,025,000
1,991,250
1,942,313
1,876,078
Years
No. of members
without restaurant
181
7.6
ARG COMPANY
(a)
Discount factors
Present values
1
$
3,585,000
(1,395,000)
(1,000,000)
(500,000)
690,000
(172,500)
250,000
2
$
6,769,675
(2,634,225)
(1,050,000)
(200,000)
2,885,450
(721,362)
3
4
$
$
6,339,000
1,958,775
(2,466,750) (761,925)
(1,102,500) (1,157,625)
(200,000)
2,569,750
39,225
(642,438)
(9,806)
1,200,000
1,000,000
767,500
0.885
679,237
2,164,088
0.783
1,694,481
1,927,312
0.693
1,335,626
2,229,419
0.613
1,366,634
$
Sum of present values
Initial investment
5,075,978
3,000,000
2,075,978
31.00
31.93
32.89
33.88
60,000
110,000
100,000
30,000
1,860,000 3,512,300 3,289,000 1,016,400
23.00
23.69
24.40
25.13
75,000
137,500
125,000
37,500
1,725,000 3,257,375 3,050,000
942,375
3,585,000 6,769,675 6,339,000 1,958,775
12.00
12.36
12.73
60,000
110,000
100,000
720,000 1,359,600 1,273,000
182
13.11
30,000
393,300
Answers
Year
Beta materials cost
Unit cost ($/unit)
Sales (units per year)
Total cost ($/year)
Total materials cost
(b)
9.00
9.27
9.55
75,000
137,500
125,000
675,000 1,274,625 1,193,750
1,395,000 2,634,225 2,466,750
9.83
37,500
368,625
761,925
The evaluation assumes that several key variables will remain constant,
such as the discount rate, inflation rates and the taxation rate. In practice
this is unlikely.
(1)
(2)
Specific inflation rates are difficult to predict for more than a short
distance into the future and in practice are found to be constantly
changing. The range of inflation rates used in the evaluation is
questionable, since over time one would expect the rates to
converge. Given the uncertainty of future inflation rates, using a
single average inflation rate might well be preferable to using specific
inflation rates.
(3)
Looking at the incremental fixed production costs, it seems unusual that nominal
fixed production costs continue to increase even when sales are falling. It also
seems unusual that incremental fixed production costs remain constant in real
terms when production volumes are changing. It is possible that some of these
fixed production costs are stepped, in which case they should decrease.
The forecasts of sales volume seem to be too precise, predicting as they do the
growth, maturity and decline phases of the product life-cycle. In practice it is
likely that improvements or redesign could extend the life of the two products
beyond five years. The assumption of constant product mix seems unrealistic,
as the products are substitutes and it is possible that one will be relatively more
successful. The sales price has been raised in line with inflation, but a lower
sales price could be used in the decline stage to encourage sales.
Net working capital is to remain constant in nominal terms. In practice, the level
of working capital will depend on the working capital policies of the company, the
value of goods, the credit offered to customers, the credit taken from suppliers
and so on. It is unlikely that the constant real value will be maintained.
The net present value is heavily dependent on the terminal value derived from
the sale of non-current assets after five years. It is unlikely that this value will be
achieved in practice. It is also possible that the machinery can be used to
produce other products, rather than be used solely to produce Alpha and Beta.
(c)
183
184
Answers
7.7
HAFEEZ LTD
(a)
50,074,626
7,500,000
NPV of fees
57,574,626
NPV of fees (W1)
Annual Fees
=
Cum disc factor
57,574,626
=
16,770,937
3.433
W1: NPV of Costs
Tax Allowance on
Operating
Costs
Depreciation
and Disposal
(W2)
Operating
Costs
Total Cash
Outflows
Discount
Factor
(14%)
Rupees
0
PV of
Costs
(Rupees)
(50,000,000)
(50,000,000)
1.000
(50,000,000)
(6,000,000)
5,687,500
2,100,000
1,787,500
0.877
1,567,638
(6,600,000)
1,181,250
2,310,000
(3,108,750)
0.769
(2,390,629)
(7,260,000)
1,063,125
2,541,000
(3,655,875)
0.675
(2,467,716)
(7,986,000)
956,813
2,795,100
(4,234,087)
0.592
(2,506,580)
(8,784,600)
4,236,312
3,074,610
11,026,322
0.519
5,722,661
12,500,000
(50,074,626)
Tax Allowance
WDV
Initial
@35%
Normal
Tax
Allowance on
Disposal
Total
Allowance
Rupees
1
50,000,000
12,500,000
3,750,000
5,687,500
5,687,500
33,750,000
3,375,000
1,181,250
1,181,250
30,375,000
3,037,500
1,063,125
1,063,125
27,337,500
2,733,750
956,813
956,813
24,603,750
2,460,375
861,131
3,375,181
4,236,312
(W3)
185
12,500,000
22,143,375
(9,643,375)
(3,375,181)
a + [ (A/A-B) (b-a) ]%
14%
20%
7,500,000
(W5)
(426,261)
(50,000,000)
Net Cash
Flows
Disc
Factor
Rupees
20%
(50,000,000)
1.00
(50,000,000)
NPV
Rupees
1,787,500
16,770,937
18,558,437
0.83
15,403,503
(3,108,750)
16,770,937
13,662,187
0.69
9,426,909
(3,655,875)
16,770,937
13,115,062
0.58
7,606,736
(4,234,087)
16,770,937
12,536,850
0.48
6,017,688
11,026,322
16,770,937
27,797,259
0.40
11,118,903
(426,261)
186
Answers
Year
0
1
2
3
Discounted
cash flows
Year 0
1
2
3
(Rs. 4 - Rs.
1)/unit
Discount factor
at 6%
1.000
0.943
0.890
0.840
2,000
demand
3,000
demand
5,000
demand
Rs.
(15,000)
6,000
Rs.
(15,000)
9,000
Rs.
(15,000)
15,000
6,000
6,000
9,000
9,000
15,000
15,000
PV
PV
PV
Rs.
(15,000)
5,658
5,340
5,040
Rs.
(15,000)
8,487
8,010
7,560
Rs.
(15,000)
14,145
13,350
12,600
NPV
1,038
9,057
25,095
Expected value of NPV = (0.2 1,038) + (0.6 9,057) + (0.2 25,095) = Rs.
10,661
Machine B
2,000
demand
3,000
demand
5,000
demand
Rs.
(20,000)
10,500
10,500
10,500
Rs.
(20,000)
17,500
17,500
17,500
Year
0
1
2
3
(Rs. 4 - Rs.0.5)/unit
Rs.
(20,000)
7,000
7,000
7,000
Discounted
cash flows
Discount factor at
6%
PV
PV
PV
Year 0
1
2
3
1.000
0.943
0.890
0.840
Rs.
(20,000)
6,601
6,230
5,880
Rs.
(20,000)
9,902
9,345
8,820
Rs.
(20,000)
16,503
15,575
14,700
8,067
26,778
NPV
(1,289)
187
calculate the cash flows and NPV for annual sales of 3,200 units.
However, this approach makes it more difficult to carry out risk and uncertainty
analysis.
On the basis of the figures, it would seem that Machine A should be
purchased.
(c)
It is also a lower risk option, because the NPV will be positive even when
sales are only 2,000 units each year. With machine B, the NPV would be
negative if the annual sales are just 2,000 units.
Machine A also gives a higher NPV if sales are 3,000 units, which is the
most likely outcome.
The NPV is + Rs. 1,038 even when sales are 2,00 units each year. The
probability of a negative NPV is 0%. (With machine B, the risk of a
negative NPV is 20%).
(ii)
The project will achieve a 6% return if the NPV of annual cash profits is
Rs. 15,000.
Discount factor at 6% for years 1 3 = 2.673
Annual cash profits to achieve a PV of Rs. 15,000 = Rs. 15,000/2.673 =
Rs. 5,612.
The contribution per unit is Rs. 3.
Therefore minimum annual sales to achieve an NPV of Rs.0 = Rs.
5,612/Rs. 3 per unit
= 1,871 units.
If annual sales exceed 1,871 units, the NPV with Machine A will be
positive at a discount rate of 6%.
8.2
CALM PLC
Calculation of expected sales of the device is based on the probabilities
determined by the analysis of previous experience as given in the question.
Expected sales are obtained as follows:
Year 1 = Rs.(240,000,000 x 0.25) + (140,000,000 X 0.60) + (50,000,000 x 0.15)
= Rs. 151,500,000
188
Answers
Year 1
Year 2
Year 3
Rs.m
Rs.m
Rs.m
Rs.m
0.6
0.60
16
16
0.4 x 0.5
0.20
16
0.4 x 0.5
0.20
1.00
9.6
12.8
Nil
Year
0
Rs.m
1
Rs.m
2
Rs.m
3
Rs.m
4
Rs.m
Initial Outlay
(190)
Advertisement
Fixed cost less depreciation
Scrap value
Rent Forgone
(30)
-
(20)
(10)
(9.6)
(10)
(10)
(12.8)
(10)
-
10
-
106.05
249.2
66.85
(220)
1.00
66.45
0.83
216.4
0.69
56.85
0.58
10
0.48
PV
(220)
55.154
149.316
32.973
4.8
ENPV
DECISION: Since the Expected Net Present Value is positive, the new product
should be produced all things being equal.
189
8.3
OUTLOOK PLC
(a)
Calculation of NPV
Year
Items
NCF
(Rs.)
DF@
15%
Initial Outlay
(350,000)
1.0000
(350,000)
1 - 10
1 - 10
(25,000)
(300,000)
5.0188
5.0188
(125,470)
(1,505,640)
1 - 10
Sales
400,000
5.0188
2,007,520
NPV
26,410
NOTE:
PV
(Rs.)
Contribution
Rs. 100,000
Rs. 501,880
Sensitivity Analysis:
NPV
100
u
PV of Sales
1
(i)
Sales Price =
(ii)
Initial Outlay =
(iii)
Sales Volume =
(iv)
Variable Cost =
NPV
100
u
PV of Outlay
1
(b)
Fixed Cost =
1.32%
26,410 100
u
350,000
1
7.55%
NPV
100
u
PV of Contributi on
1
NPV
100
u
PV of Variable Cost
1
(v)
26,410
100
u
2,007,520
1
NPV
100
u
PV of FC
1
26,410 100
u
501,880
1
26,410
100
u
1,505,640
1
26,410 100
u
125,470
1
5.26%
1.75%
21.05%
(ii)
These are derived from the sensitivity analysis workings above as these
are the two least NPVs in terms of sensitivity.
The sales price must not fall by more than 1.32% and the variable cost
must not increase by more than 1.75%.
190
Answers
8.4
ZAHEER LTD
(a)
(b)
4,000,000
30%
1,200,000
Rupees
250
u40,000
10,000,000
(3,000,000)
7,000,000
3.352
Sensitivity analysis
Material costs Labour costs
800
500
u40,000
u40,000
32,000,000
20,000,000
(9,600,000)
(6,000,000)
22,400,000
14,000,000
191
3.352
75,084,800
3.352
46,928,000
7,486,400
75,084,800
0.0997
9.97%
7,486,400
46,928,000
0.1595
15.95%
Set-up cost
20,000,000
(4,022,400)
15,977,600
Cost
PV of tax saving
Present value
Sensitivity
NPV of project
PV of costs (see above)
7,486,400
15,977,600
0.4685
46.85%
Conclusion:
The outcome of the order is most sensitive to material costs.
0.7
0.7
0.3
0.3
1,600
1,800
0.8
0.8
0.5
0.5
0.9
0.9
0.75
1.00
1.25
Expected
incremental
earnings
Expected
incremental
Costs
Cost of cell
sites
Expected
incremental
revenue
Probability
Probability
Airtime
minutes
No. of
subscribers in
million
8.5
Rupees in million
0.6
0.4
AxBxCxDx
E
151
113
300
300
54
36
ETR ECOS
97
77
1,600
1,800
0.6
0.4
288
216
300
300
90
60
198
156
0.2
0.2
1,600
1,800
0.6
0.4
540
540
0.5
0.5
0.3
0.3
1,600
1,800
0.6
0.4
130
97
995
144
108
180
180
65
43
348
32
22
65
54
647
112
86
0.6
0.6
0.5
0.5
1,600
1,800
0.6
0.4
288
216
300
300
90
60
198
156
0.8
0.8
0.2
0.2
1,600
1,800
0.6
0.4
300
300
0.3
0.3
0.3
0.3
1,600
1,800
0.6
0.4
154
115
1,025
108
81
180
180
36
24
264
32
22
118
91
761
76
59
0.4
0.4
0.5
0.5
1,600
1,800
0.6
0.4
240
180
180
180
54
36
186
144
0.6
0.6
0.2
0.2
1,600
1,800
0.6
0.4
144
108
861
300
300
36
24
204
108
84
657
HxCxE
Conclusion:
Tariff of Re. 1 is most suitable because it gives the highest value of pay-off.
192
Answers
Cash Outflow
(Rs. 500
million)
Path 1
Path 2
Path 3
Path 4
Path 5
Path 6
(b)
Discount
factor
PV
PV of total
inflow
Cash outflow
0.8772
219.30
*330
0.7695
253.94
473.24
500
(26.76)
0.1300
(3.48)
2 250
0.8772
219.30
*380
0.7695
292.41
511.71
500
11.71
0.4225
4.95
3 250
0.8772
219.30
*410
0.7695
315.50
534.80
500
34.80
0.0975
3.39
4 320
0.8772
280.70
*390
0.7695
300.11
580.81
500
80.81
0.0175
1.41
5 320
0.8772
280.70
*430
0.7695
330.89
611.59
500
111.59
0.1750
19.53
6 320
0.8772
280.70
*450
0.7695
346.28
626.98
500
126.98
0.1575
20.00
Probability
Amount
NPV
PV
1 250
Path
Discount
factor
PV of NCIAT of Year
2
Amount
PV of NCIAT of Year
1
Expected NPV
Joint
8.6
45.80
*including salvage value of Rs. 50 million
Comment: Since the expected net present value of project is positive, it is suggested to accept
investment proposal.
193
LEASE OR BUY
(a)
Tax saving
(30% of
allowance)
Rs.
30,000
(7,500)
Cost
Allowance (25%)
Cash flow
year
Rs.
2,250
1,688
1,266
949
1,048
22,500
(5,625)
Allowance (25%)
16,875
(4,219)
Allowance (25%)
12,656
(3,164)
Allowance (25%)
9,492
6,000
Disposal
Balance
(3,492)
Year
Rs.
(30,000)
Rs.
Rs.
Equipment
Tax relief
Project cash flows
Tax on these at 30%
Net cash
flow
DCF factor
at 10%
Present
value
6
Rs.
Rs.
Rs.
1,688
10,000
(3,000)
1,266
10,000
(3,000)
Rs.
6,000
949
10,000
(3,000)
2,250
10,000 10,000
(3,000)
Cash flows
3
4
1,048
(3,000)
(30,000)
10,000
9,250
8,688
8,266
13,949
(1,952)
1.000
0.909
0.826
0.751
0.683
0.621
0.564
7,641
6,525
5,646
8,662
(1,101)
(30,000)
9,090
194
Answers
(b)
Leasing
Cash flows
Year
Rs.
Rs.
Rs.
Rs.
Rs.
Rs.
(7,000)
(7,000)
(7,000)
(7,000)
(7,000)
2,100
2,100
2,100
2,100
2,100
(7,000)
(4,900)
(4,900)
(4,900)
(4,900)
2,100
DCF factor at
8%
0.926
0.857
0.794
0.735
0.681
0.630
Present value
(6,482)
(4,199)
(3,891)
(3,602)
(3,337)
1,323
Lease
payments
Tax relief
Cash flows
0
1
Rs.
Equipment
Rs.
DCF factor
at 8%
Present
value
Rs.
Rs.
4
Rs.
(30,000)
5
Rs.
6
Rs.
6,000
Tax relief
Net cash
flow
2,250
1,688
1,266
949
1,048
(30,000)
2,250
1,688
1,266
6,949
1,048
1.000
0.857
0.794
0.735
0.681
0.630
(30,000)
1,928
1,340
931
4,732
660
195
9.2
MOHANI LIMITED
I would recommend to the management of the company to consider option B as
this option provides NPV of cash outflow of Rs. 1,988,750 to the company which
is lower by Rs. 455,798 in comparison to option A. Detailed computation is as
follows:
Year
Security
deposits
Salvage
value
Tax
benefits
35%
Lease
payment
Net cash
outflow
PV
Factor
14%
Rupees
0
320,000
860,000
860,000
PV
Rs.
1,180,000
1.000
1,180,000
(301,000)
559,000
0.877
490,243
860,000
(301,000)
559,000
0.769
429,871
860,000
(301,000)
559,000
0.675
377,325
860,000
(301,000)
559,000
0.592
330,928
(301,000)
(701,000)
0.519
(363,819)
(400,000)
2,444,548
Alternative answer
Description
Rupees
PV
PV
factor
Rupees
Security deposit
320,000
320,000
Lease payments
860,000
3.913
3,365,180
301,000
3.432
(1,033,032)
Salvage value
400,000
0.519
(207,600)
2,444,548
Installment Amount
Rs. 3,200,000
R
Y
ea
r
Loan
payment
Intere
st @
11%
Principal
Repayme
nt
1 (1 i )n
i
865,825
Depreciation
Balance
Insuran
ce
Initial
PV
Fact
or
@14
%
Norma
l
Tax
Shield @
35%
Salva
ge
value
Outfl
ow
96,000
(772,800)
Rupees
PV
(Rs.)
3,200,000
96,000
865,825
352,000
513,825
2,686,175
96,000
865,825
295,479
570,346
2,115,829
96,000
144,000
(187,418)
865,825
232,741
633,084
1,482,023
96,000
129,600
(160,419)
865,825
163,102
702,723
780,023
96,000
116,640
(131,510)
865,825
85,802
780,023
104,976
*(291,081)
1,600,000 160,000
196
1.000
96,000
98,960
Answers
*This includes tax benefit / loss on disposal amounted to Rs. 190,674. Computation of this tax
benefit is as follows:
Rs.
3,200,000
2,255,216
944,784
400,000
544,784
Cost of machine
Less: Initial and normal depreciation
Tax WDV
Less: Sales value
Tax loss
Tax benefits @35%
9.3
190,674
(a)
0
Principal
repayment
Interest
(Principal
outstanding x 16%)
5.00
5.00
5.00
5.00
3.20
-
2.40
(3.40)
1.60
(1.31)
0.80
(0.99)
(3.41)
(2.00)
8.20
0.85
4.00
0.72
5.29
0.61
2.81
0.52
(3.41)
0.44
6.97
2.88
3.23
1.46
(1.50)
13.04
2.236
Annual rental
5.83
Years
0
Rupees in million
WDV at start of year
20.00
13.50
12.15
10.93
5.00
1.50
1.35
-
1.22
-
1.09
7.84
6.50
1.35
1.22
8.93
13.50
12.15
10.93
2.00
197
Note: Disposal value i.e. Rs. 2 million (10% of Rs. 20 million) - WDV at the
end of year 4 i.e. 9.84 = Rs. 7.84 million (Loss on disposal)
Years
1
2
3
Rupees in million
0
Total tax allowance as
computed above
Interest payment computed
above
6.50
1.35
1.22
8.93
3.20
9.70
2.40
3.75
1.60
2.82
0.80
9.73
3.40
1.31
0.99
3.41
1.00
Tax savings
Discount factor @ 18%
PV factor of income
Total PV of income
(b)
1.00
1.000
1.000
2.236
2
3
Rupees
1.00
1.00
1.00
(0.35)
0.65
0.850
0.553
(0.35) (0.35)
0.65 (0.35)
0.610 0.520
0.397 (0.182)
(0.35)
0.65
0.720
0.468
Years
Leasing
Rupees in million
Annual rental
7.00
7.00
7.00
7.00
(2.45)
(2.45)
(2.45)
(2.45)
7.00
4.55
4.55
4.55
(2.45)
0.833
0.694
0.578
0.482
7.00
3.79
3.16
2.63
(1.18)
Discount at 20%
PV of cash flow
15.40
Purchase Outright
Years
0
Rupees in million
Principal outstanding
(Opening - Loan
payment + Interest)
15.4
20.00
198
16.17
11.65
6.30
0.00
Answers
Interest (@18% of
opening principal)
B
Maintenance costs
Tax allowance as
computed above
7.43
7.43
7.43
7.43
3.60
2.91
2.08
1.13
0.60
0.60
0.60
0.60
6.50
1.35
1.22
8.93
10.70
4.86
3.90
10.66
(3.75
)
(1.70
)
(1.37
)
(3.73)
(2.00
)
Recovery of residual
value
Cash outflow to BP
8.03
4.29
6.33
4.67
(3.73)
Discount at 20%
0.833
0.694
0.578
0.482
0.402
PV of cash outflow
6.69
2.97
3.66
2.25
(1.50)
A+B+C
NPV of purchase
option
14.07
W1:
Installment amount = Rs. 20 million
4
1 (1 0.18)
0.18
7.43
Conclusion:
The feasible option is the outright purchase.
Note: Insurance costs are ignored in our computation as these are the
same in both options.
9.4
Cash flow
Security deposit
Amo
unt
(Rs.
in
millio
n)
Interest
rate
/period
(W1)
10.00
Lease rentals
7.46
Lubricants and
filters
1.00
Parts replacement
3.00
Staff cost
0.50
Frequency
Total no.
of
payment
s (Rs. in
million)
Quarterly
Discoun
t factor
(annuity
factor)
PV
(Rs. in
million)
1.000
10
12
4.00%
*9.385
*70
12
4.00%
*9.385
*9
half yearly
8.00%
*4.623
*14
monthly
36
1.33%
*28.460
*14
Quarterly
199
Overhaul
15.00
Residual value
(20.0
0)
End of 2
year
nd
End of 3
year
0.731
11
0.625
(13)
rd
Total present
value
115
10
11
12
Total
11.
0
11.
0
11.
0
11.
0
12.
1
12.
1
12.
1
12.
1
13.
31
13.
31
13.
31
13.
31
0.96
2
0.9
25
0.8
89
0.8
55
0.8
22
0.7
90
0.7
60
0.7
31
0.7
03
0.6
76
0.6
50
0.6
25
10.5
8
10.
18
9.7
8
9.4
1
9.9
5
9.5
6
9.2
0
8.8
5
9.3
6
9.0
0
8.6
5
8.3
2
112.84
Conclusion
PUSs option is better as it gives lower overall cost in present value terms
W1 : Finding the rate offered by BAL
PV of inflow = Present value of outflows (annuity) = R Annuity Factor (AF)
Hence, 80 10 = 7.46 AF
AF = 70 7.46 = 9.383
IRR is 4% per quarter i.e. the figure corresponding to annuity factor of 9.383
and 12 periods, on the annuity table.
9.5
CRANK PLC.
Year
DF
(10%)
Rs.000
Rs.000
Rs.000
1.0000
(1,500.00)
(1,500.00)
(1,500.00)
0.9091
(272.73)
(272.73)
(272.73)
0.8264
(495.84)
(495.84)
0.7513
PV of scrap
NPV
Annuity factor
Annual Equivalent Cost:
(563.48)
(1,772.73)
(2,268.57)
(2,832.05)
954.56
619.80
450.78
(818.17)
(1,648.77)
(2,381.27)
0.9091
1.7355
2.4868
(899.98)
(950.02)
(957.56)
The optimal replacement cycle is one-year because it has the lowest cost.
200
Answers
ALTERNATIVE SOLUTION
Decision: Replace every 1 year.
Year
Cash Flow
DF@ 10%
PV
Rs.
Rs.
(1,500,000) 1.0000
(1,500,000)
(300,000) 0.9091
(272,730)
1,050,000 0.9091
954,555
(818,175)
Cash Flow
DF@ 10%
PV
Rs.
Rs.
(1,500,000) 1.0000
(1,500,000)
(300,000) 0.9091
(272,730)
(600,000) 0.8264
(495,840)
750,000 0.8264
619,800
(1,648,770)
Cash Flow
DF@ 10%
PV
Rs.
0
Rs.
(1,500,000) 1.000
(1,500,000)
(300,000) 0.9091
(272,730)
600,000 0.8264
(495,840)
750,000 0.7513
(563,475)
600,000 0.7513
450,780
(2,381,265)
(818,175)/0.9091
(899,984)
Every 2 years
(1,648,770)/1.7355 =
(950,026)
Every 3 years
(2,381,265)/2.4868 =
(957,562)
201
9.6
Asset replacement
(a)
Year
Discount
factor at
10%
Rs.
PV
Rs.
Purchase cost
(40,000)
Running costs
(8,000)
Disposal value
25,000
17,000
1.000
(40,000)
0.909
15,453
(24,547)
0.909
Rs.(27,004)
(b)
Year
Discount
factor at
10%
Rs.
PV
Rs.
Purchase cost
(40,000)
1.000
(40,000)
Running costs
(8,000)
0.909
(7,272)
Running costs
(12,000)
Disposal value
20,000
0.826
6,608
8,000
(40,664)
1.736
Rs.(23,424)
202
Answers
(c)
Year
Discount
factor at
10%
Rs.
PV
Rs.
Purchase cost
(40,000)
1.000
(40,000)
Running costs
(8,000)
0.909
(7,272)
Running costs
(12,000)
0.826
(9,912)
Running costs
(20,000)
Disposal value
10,000
0.751
(7,510)
(10,000)
(64,694)
2.487
Rs.(26,013)
(d)
Year
Discount
factor at
10%
Rs.
PV
Rs.
Purchase cost
(40,000)
1.000
(40,000)
Running costs
(8,000)
0.909
(7,272)
Running costs
(12,000)
0.826
(9,912)
Running costs
(20,000)
0.751
(15,020)
Running costs
(25,000)
0.683
(17,075)
(89,279)
3.170
Rs.(28,1
64)
Recommendation
The machine should be replaced every two years, because this
replacement policy gives the lowest equivalent annual cost.
203
9.7
ROTOR PLC
YEAR
DF
(10%)
0.9091
(409,095)
(409,095)
(409,095)
(409,095)
0.8264
__
(396,672)
(396,672)
(396,672)
0.7513
__
__
(428,241)
(428,241)
0.6830
__
__
__
(430,290)
PV of costs
PV of scrap
value
4,090,950
NPV
3,222,960
2,253,900
1,434,300
Annuity
factor ()
0.9091
Annual
equivalent
cost
1.7355
2.4868
3.1698
9.8
Cost of
overhau
ling
Net
Revenu
e
Residu
al
value
Net cash
flow
Rupees
0
(2,200,000
)
Discou
nt rate
@
8.33%
(W1)
Net
present
value
Rupees
(2,200,000)
1.0000
(2,200,000)
*13,600,00
0
3,600,000
0.9231
3,323,160
3,600,000
787,500
4,387,500
0.8521
3,738,589
4,861,749
204
1.7752
Rs.
Answers
Value
2,738,705
Option 2: Replacement
Year
Capital
Cost
Net
Revenue
Residu
al
value
Net cash
flow
Rupees
0
1
2
3
*1(4,305,000
)
-
(W1)
*23,700,000
3,700,000
3,700,000
Discou
Net
nt rate present
@
value
8.33%
Rs.
1,312,50
0
(4,305,000
)
3,700,000
3,700,000
5,012,500
(4,305,000
)
3,415,470
3,152,770
1.0000
0.9231
0.8521
0.7866
3,942,833
6,206,073
2.5618
Rs.
2,422,54
4
1 17%
1 8% 1 8.33%
Conclusion:
Since annual equivalent NPV of overhaul and continue option is higher,
this equipment should be overhauled.
Rupees
(b)
Total required NPV of replacement option
(Rs. 2,422,544 1.7752)
Less: NPV of overhauling and continue option
Difference
% change in overhauling cost at which management would
be indifferent (Rs. 561,249 Rs. 2,200,000)
205
4,300,500
4,861,749
(561,249)
25.51%
EQUITY RATIOS
Earnings per share (EPS)
Rs.
600,000
25,000
575,000
172,500
402,500
1,000,000
EPS
Rs.0.4025
The above ratio shows that investors are ready to pay Rs. 7.95 for an earning of
Rs. 1. The ratio indicates the confidence of investors in a company with a higher
PE ratio implying higher confidence.
This ratio shows how much a company is paying as a dividend for each Rs. 1 of
its market value. The above example shows that the company pays Rs. 0.0625
out of every Rs. 1 of market value.
This shows that the profit available to the ordinary shareholders covers the
dividend by a factor of 2. In other words, approximately 50% of the earnings for
the year have been paid out as dividends and the remainder reinvested in the
company.
This shows that the effective interest income on debenture is 11.1%. An investor
earns Rs. 11.1 for each Rs. 100 invested in these debentures.
This shows the extent to which the company is financed by outsiders and how
much by the owners. In the above scenario 11.1% of financing is by lenders and
the remaining by equity holders implying that the company has low gearing.
206
Answers
10.2
% growth
20X0
20X1
20X2
20X3
20X0-1
20X1-2
20X2-3
Revenue
100
131.2
160.4
187.5
31.2
22.2
16.9
Profit
100
138.2
185.5
229.1
38.2
34.2
23.5
RPI
Share price
100
100
135.5
125.7
171.7
153.1
205.2
189.1
35.5
25.7
26.7
21.8
19.5
23.5
Stock market
100
119.9
148.9
189.2
Zedland
19.9
24.1
27.1
Indexed trends
% growth
20X0
20X1
20X2
20X3
20X0-1
20X1-2
20X2-3
Revenue
Profit
100
100
103.6
108.9
109.2
126.1
121.4
138.0
3.6
8.9
5.4
15.8
11.2
9.5
RPI
Share price
Stock market
100
100
100
104.3
81.4
87.2
107.1
86.4
87.2
110.8
97.0
92.7
4.3
(18.6)
(12.8)
2.7
6.2
4.8
3.5
12.3
1.5
Ayeland 237%
Zedland (10%)
Indicators for the Ayeland company are mixed. Growth in turnover has
lagged behind a broad measure of inflation, the retail price index, yet profit
after tax has performed relatively well. Despite this profit performance the
companys share price has only increased by a similar amount to the
general stock market index.
The performance of the company in Zedland appears to be better, with
turnover, profit and share price all growing faster than the relevant country
indices.
However, comparisons such as this ignore the risk of the two companies.
The company in Ayeland appears to be much more risky, as evidenced by
its relatively high beta. Performance measures incorporating risk would be
much more useful.
A possible performance measure is the historic alpha coefficient associated
with the investment, the actual return less the required return for the risk of
the investment.
207
For an investor who is not well diversified, a measure using total risk (the
standard deviation of returns) is more appropriate.
investmentreturn - risk free rate
standard deviationof returns
Based upon the available data, the company in Zedland appears to have
been the more successful during the last four years.
(b)
(ii)
(iii)
Information about whether or not profits, RPI and other data are
calculated in the same way in the two countries.
(iv)
Total returns from the relevant stock markets and for investors in the
companies. The data provided only shows the return from share price
movements, and excludes the dividend yield, which might be
significant.
(v)
Exchange rate movements between the two countries and the UK.
The client is likely to be interested in returns in sterling, not in foreign
currencies.
(vi)
208
Answers
(viii) Macro economic information about the two countries and their
prospects. Ayeland is a relatively high inflation country. Is the
government likely to bring this under control? What are key economic
indicators and trends?
(ix)
10.3
How stable are the governments in the two countries and would there
be significant political risk with the investments?
Current
year
Last
year
Current
year
Operating profit
Sales
11.3%
12.2%
12.8%
14.5%
Operating profit
Capital employed
14.4%
15.8%
15.6%
18.4%
Current ratio
1.38
1.35
1.39
1.41
6%
22%
12%
12%
Revenue
19%
6.6%
Taxable profit
17%
23%
Non-current assets
17%
2%
12.5%
Division
Growth rates:
Working capital
Based upon the above financial ratios and growth rates the two divisions have
both improved their performance during the last year. There is, however, no data
allowing comparisons with similar operations to allow assessment of whether the
improved performance is of the standard that might be expected in the
industry(ies) concerned.
The only detrimental elements are the small reduction in the current ratio of
division A, and the increase in gearing of division A to 22% probably in order to
finance the purchase of fixed assets. It is unlikely that either of these factors
would be of major concern.
209
These results have, however, been achieved in different ways. Division A seems
to be taking a longer term perspective and has expanded its operations and
invested heavily in new fixed assets. Division B's apparent good performance, for
example in return on capital employed, has been achieved using existing assets.
Division B is more likely to have ensured that the short-term results look good
without considering the long-term implications of the lack of investment. It
depends on companies objectives as to whether it would like to increase its short
term profits or be inclined towards long term benefits.
The board of Khan Industries should be much more explicit in what is meant by
'an improvement in performance'. Controls should be introduced to ensure that
the development of the divisions is in line with the long-term strategic plans of
Khan Industries, including the nature of products in the divisions, and the markets
to be served by the divisions.
The short termism approach of division B should be discouraged, and divisions
should be encouraged to focus on the cash flows of their activities. Investments
should be judged on their likely effect on cash flows and the value of the
business (e.g. through the expected NPV of investments) rather than accounting
ratios.
210
Answers
CAPITAL RATIONING
(a)
A
B
C
D
E
Capital
investment
NPV per
Rs. 1
invested
NPV
Rs.
60,000
80,000
50,000
45,000
55,000
Rs.
12,000
21,600
8,500
10,800
9,900
Ranking
Rs.
0.20
0.27
0.17
0.24
0.18
3rd
1st
5th
2nd
4th
Capital investment
NPV
Rs.
80,000
45,000
125,000
25,000
150,000
Rs.
21,600
10,800
B
D
A
Total
(b)
(balance)
5,000
37,400
Investments
A+B
B+D
C+D+E
(60,000 + 80,000)
(80,000 + 45,000)
(50,000 + 45,000 + 55,000)
Rs.
140,000
125,000
150,000
Total
NPV
Rs.
33,600
32,400
29,200
Notes:
If A is undertaken there would only be enough cash left to undertake any
one of the remaining investments. B has the highest NPV so other
combinations involving A can be ignored.
Similarly, if B is undertaken there would only be enough cash left to
undertake any one of the remaining investments. A + B has already been
considered. Of the remainder, D has the highest NPV so other
combinations involving B can be ignored.
211
11.2
BASRIL COMPANY
(a)
(i)
Year
Project 1
12%
Project 3
Cash flow
PV
Cash flow
PV
Rs.
Rs.
Rs.
Rs.
1.000
(300,000)
0.893
85,000
0.797
(300,000)
(400,000)
(400,000
)
75,905
124,320
111,018
90,000
171,730
128,795
102,650
0.712
95,000
167,640
133,432
195,004
0.636
100,000
163,600
138,236
187,918
0.567
95,000
153,865
143,212
181,201
NPV
32,740
Profitability index
32,740/300,000:
0.109 or
10.9%
77,791
77,791/400,000:
0.194 or
19.4%
Project
Profitability
index
Ranking Investment
NPV
Rs.
Rs.
19.4%
1st
400,000
77,791
12.8%
2nd
400,000
800,000
212
128,977
Answers
(ii)
Investment
NPV
Rs.
Rs.
1 and 2
750,000
1 and 3
The NPV decision rule requires that a company invest in all projects that
have a positive net present value. This assumes that sufficient funds are
available for all incremental projects, which is only true in a perfect capital
market. When insufficient funds are available, that is when capital is
rationed, projects cannot be selected by ranking them in order of their NPV.
Choosing a project with a large NPV may mean not choosing smaller
projects that, in combination, give a higher NPV. Instead, if projects are
divisible, they can be ranked using the profitability index in order to make
the optimum selection. If projects are not divisible, different combinations of
available projects must be evaluated to select the combination with the
highest NPV.
(c)
The NPV decision rule, to accept all projects with a positive net present
value, requires the existence of a perfect capital market where access to
funds for capital investment is not restricted. In practice, companies are
likely to find that funds available for capital investment are restricted or
rationed.
Hard capital rationing is the term applied when the restrictions on raising
funds are due to causes external to the company. For example, potential
providers of debt finance may refuse to provide further funding because
they regard a company as too risky. This may be in terms of financial risk,
for example if the companys gearing is too high or its interest cover is too
low, or in terms of business risk if they see the companys business
prospects as poor or its operating cash flows as too variable. In practice,
large established companies seeking long-term finance for capital
investment are usually able to find it, but small and medium-sized
enterprises will find raising such funds more difficult.
Soft capital rationing refers to restrictions on the availability of funds that
arise within a company and are imposed by managers. There are several
reasons why managers might restrict available funds for capital investment.
Managers may prefer slower organic growth to a sudden increase in size
arising from accepting several large investment projects. This reason might
apply in a family-owned business that wishes to avoid hiring new
managers. Managers may wish to avoid raising further equity finance if this
will dilute the control of existing shareholders. Managers may wish to avoid
issuing new debt if their expectations of future economic conditions are
such as to suggest that an increased commitment to fixed interest
payments would be unwise.
213
One of the main reasons suggested for soft capital rationing is that
managers wish to create an internal market for investment funds. It is
suggested that requiring investment projects to compete for funds means
that weaker or marginal projects, with only a small chance of success, are
avoided. This allows a company to focus on more robust investment
projects where the chance of success is higher1. This cause of soft capital
rationing can be seen as a way of reducing the risk and uncertainty
associated with investment projects, as it leads to accepting projects with
greater margins of safety.
11.3
CB INVESTMENT LIMITED
Project duration
Forecasted net cash inflows start
from year
Discount rate
10%
11%
12%
11%
13%
14%
3.487
4.102
2.690
4.696
2.668
1.877
(1.000)
3.487
3.102
(1.901)
2.690
2.795
2.668
1.877
150.00
50.00
140.00
256.00
440.00
300.00
523.05
155.10
376.60
715.55
1,173.92
563.10
376.60
715.55
1,173.92
563.10
(240.00)
(512.00)
(800.00)
(400.00)
678.15
(300.00)
(120.00)
(420.00)
(240.00)
(512.00)
(800.00)
(400.00)
258.15
136.60
203.55
373.92
163.10
Profitability index (b a)
0.615
0.569
0.398
0.467
0.408
Ranking
NPV
Rs. in million
Rank 1
420.00
258.15
Rank 2
240.00
136.60
660.00
394.75
However, the company might be able to increase the available NPV by investing
more of its available funds.
Hence other options should be considered. While selecting other options the
basic presumption should be to select the last project (balancing amount) which
214
Answers
can be scaled down i.e. Project C. Considering the above, there are four more
options as shown below:
Option 2: Invest in Rank 4 ahead of Rank 2 which can be scaled down
If we consider the rank 4 project which requires lesser investment as compare to
rank 5 project, we would be able to utilize about 75% of rank 2 project, as
against option 3 in which Project C is only 28% utilized.
Investment
NPV
Rs. in million
Rank 1
420.00
258.15
Rank 4
400.00
Rank 2 (balance)
180.00
102.45
1,000.00
523.70
Rank 1
Rank 5
Rank 2 (balance)
Investment
NPV
Rs. in million
420.00
258.15
512.00
203.55 Because it cannot be scaled down.
68.00
38.70
1,000.00
500.40
Rank 3
Rank 2(balance)
Investment
NPV
Rs. in million
800.00
373.92 Because it cannot be scaled down.
200.00
113.83
1,000.00
487.75
Option 5: Invest in Rank 4, Rank 5 and Rank 2 which can be scaled down
Rank 4
Rank 5
Rank 2(balance)
Investment
NPV
Rs. in million
400.00
163.10
512.00
203.55 Because it cannot be scaled down.
88.00
50.09
1,000.00
416.74
Conclusion:
The most beneficial mix for the company is to invest in Projects A, B, F and C
(balancing amount) which gives the highest NPV to the company.
215
RIGHTS
(a)
Rs.
4 shares
1 new share
22.00
4.50
5 shares
26.50
Rs.
5.50
5.30
Value of rights
0.20
This is the theoretical value of the rights, for each existing share.
12.2
(b)
(ii)
(iii)
The flotation costs of a rights issue are significantly lower than those
of a public issue because a rights issue is not underwritten.
(iv)
(v)
A rights issue does not lead to dilution of control except the rights are
not fully taken up by the shareholders whereas a public issue can
lead to dilution of control.
216
Answers
(c)
(i)
Finance required:
The finance required to redeem the debenture and finance the new
project is the addition of the current price of the debenture and the
cost of the new project. This is obtained as follows:
Calculation of the current value of the debenture
15% Redeemable debenture
= Rs. 6,000,000
Annual interest
Rs. 900,000
Year
Item
Cashflow
Rs.
DCF @
9%
PV
(Rs.)
1 10
10
Interest
Debt redeemed
900,000
6,000,000
6.4177
0.4224
5,775,930
2,534,400
Current value
8,310,330
Rs. 8,310,330
Rs. 1,600,000
Rs. 9,910,330
= Rs. 10,000,000
approx.
(ii)
= 2,000,000 shares
Issue price
0,000,000
2,000,000
= Rs. 5.00
(iii)
18.60
5.00
4 shares
23.60
(iv)
Rs.
23.60/4
Rs. 5.90
Rs. 5.90
Issue price
5.00
0.90
217
0.90/3
Rs.0.30
12.3
RIGHTS ISSUE
(a)
Calculations
(i)
21.6
3.8
Total
25.4
(u Rs. 2.70)
10.80
1.90
12.70
(12.70/5)
Rs. 2.54
(ii)
Rs.
Current market value of existing share
Theoretical ex-rights price
2.70
2.54
0.16
(iii)
(b)
Buy all the shares offered to him in the rights issue. This would
maintain his percentage shareholding in the company.
218
Answers
12.4
Sell the rights. Rights can be sold on the stock market. The
theoretical market price is Rs.0.16 for the rights attached to one
existing share.
Buy some of the shares offered to him in the rights issue and sell
some rights.
(ii)
(iii)
(iv)
(v)
(vi)
Disadvantages
A stock market quotation has the following disadvantages:
(i)
(ii)
(iii)
(iv)
Take-overs. With shares in the hands of the public, risk of take-over may
be increased.
219
12.5
CONVERTIBLE BONDS
Earnings = profit after interest and tax.
Rs.
Current total annual earnings (2,000,000 Rs.0.25)
On conversion:
Reduction in interest cost (Rs. 1,000,000 4%)
Minus increase in taxation (30%)
Rs.
500,000
40,000
(12,000)
28,000
528,000
Shares
Shares currently in issue
New shares on conversion of the bonds
(Rs. 1,000,000 u 40/Rs. 100)
2,000,000
400,000
2,400,000
12.6
Rupees in
million
2,800 Working 1
700 Working 2
2,100
Since the market value of debt on June 30, 2016 is the same as the
market value of debt on March 31, 2016, the company has to maintain the
same level of equity also.
Working 1: Market value of net equity and debt as of March 31, 2016
Rupees in
million
2,000
2,800
6,533
220
Answers
2,000
1,222 Working 3
778
700
Decline in Stock
Correlation
Decline in companys portfolio value
Listed portfolio value as at March 31, 2016
(Rs. in million)
Loss on portfolio (5,555 x 22%)
(Rs. in million)
5,555 Working 4
1,222
Rupees in
million
6,533 Working 1
726
2,000 Given
9,259
5,555
7.00
221
2,100
333.33
100.00
433.33
76.92%
12.7
Right Ratio
Rs.
1,076.39
Rs. 20.00
held.
(b)
[W7])
(c)
10.42
per share
Theoretical Ex - rightsprice
(d)
Million
Rs. in
million
800
144
944
944
17.54
53.82
Value of Right
Valueof right
20 - 10.42
2.89
= 3.31
222
Answers
Workings
W1 : Market value after expansion
MV
d1
r-g
MV =
Rs. in million
1,250
300
1,550
Net profit
Total Assets
125
10.00%
1,250
125
u (1 - 70%)
550
= 6.82%
W7: Debt: Equity ratio
D/E ratio =
Debt
600,000
52%
Debt Equity 600,000 550,000
223
12.8
Rupees
80.00
25.00
105.00
15.00
(ii)
15.00
12.50
2.50
0.500
224
Rupees
in
million
320
100
96
516
18.43
95.00
(35.00)
60.00
(21.00)
39.00
Rs.
1.95
8.21
Answers
EPS
Rs. 45.17 million / 28 million shares
Rs. 39.32 million / 20 million shares
New share price
Rs. 1.61 x 8.21
Rs. 1.97 x 8.21 x 70%
104.50
(35.00)
69.50
24.33
45.17
104.50
(35.00)
(9.00)
60.50
21.18
39.32
Rs.
Rs.
1.61
1.97
13.22
11.31
(b) PSD already has a gearing level of 37% (350 940). If it is at or near its
optimal level of gearing, shareholders may take negatively to the additional
debt which would push the gearing level up to 43% (450 1,040).
Accordingly the cost of equity would rise and the ordinary share price
would fall.
225
COST OF CAPITAL
(a)
(ii)
(iii)
(iv)
No growth therefore:
Total MV
MV per share
No growth therefore:
Total MV
MV per share
Constant growth
Therefore use:
Total MV
MV per share
1 to 5
6 to f
Total MV
521,850
857,066
335,216
85.71
Cost of equity
(i)
re
7 .5
100
150
= 5%
(ii)
re
15
100
165 15
= 10%
226
Answers
Note: The dividend valuation model always uses the ex-div price. Rs.
15 is deducted from the cum-div price of Rs. 165 in order to arrive at
the ex-div price.
(c)
(iii)
re
24 u (1 0.05)
100 + 5
120
= 26%
(iv)
re
1 .5
100
10
= 15%
Cost of debt
(ii)
Cost of debt
(iii)
Cash flow
Discount
factor
PV
Discount
factor
PV
Market value
(74)
1.000
(74.00)
1.000
(74.00)
Interest
10
0.833
8.33
0.800
8.00
Interest
10
0.694
6.94
0.640
6.40
Interest +
redemption
110
0.579
63.69
0.512
56.32
NPV
?
(iv)
Try 25%
kd
4.97
= 20% +
Cost of debt
(3.28)
4.97
(25% 20%) = 23%
4.97 3.28
Cost of pref.
Cost of debt
227
(1 t)
10% u (1 0.3) = 7%
(ii)
Cost of debt
Yr.
0
Market value
Try 20%
PV
Discount
factor
PV
(74)
1.000
(74.00)
1.000
(74.00)
0.870
6.09
0.833
5.83
0.756
5.29
0.694
4.86
107
0.658
70.41
0.579
61.95
NPV
7.79
(1.36)
15% +
(iv)
7.79
(20 15)% = 19.26% ?
(7.79 + 1.36)
Cost of debt
Cost of pref.
228
Answers
13.2
WACC
Cost of equity
181.03
0.03
155
= 0.1496 or 14.96%.
WACC
350
1,200
1,200 350 u7.81 0.30 1,200 350 u14.96
= 1.23 + 11.58
= 12.81%.
13.3
REDSKINS PLC
Post-tax weighted average cost of capital
(i)
Cost of debt
3% irredeemable debentures
For irredeemable stock kd
Interest (1 - T)
Ex interest market value
Rs.3.00 (1 - 0.30)
= 7.34%
Rs.(31.60 - 3.00)
Note: Rs. 3 is deducted from the cum-div price of Rs. 31.6 in order to arrive
at the ex-div price.
9% redeemable debentures
Calculate the internal rate of return of the after-tax cash flows.
Cash
flows
Rs.
(94.26)
6.30
100.00
PV
at 5%
Rs.
(94.26)
48.65
61.40
15.79
PV
at 10%
Rs.
(94.26)
38.71
38.60
(16.95)
Rs.15.79
5% = 7.41%
Rs.(15.79 + 16.95)
229
The after-tax cost is the discount rate which equates the after-tax cash
flows to a present value of Rs. 75.47, i.e.
Cash
flows
Rs.
(75.47)
4.20
100.00
PV
at 5%
Rs.
(75.47)
32.43
61.40
18.36
PV
at 10%
Rs.
(75.47)
25.81
38.60
(11.06)
18.36
5% = 8.12%
29.42
Bank loans
After-tax cost of bank loan
Cost of equity
Cost of equity
The values of the various sources of finance are as follows.
MV
Cost (%)
Weighted
average
Rs.000
3% debt
1,400 0.286
400
7.34
0.21
9% debt
1,500 0.9426
1,414
7.41
0.77
6% debt
2,000 0.7547
1,509
8.12
0.90
1,540
9.10
1.03
8,800
19.00
12.24
Bank loan
Equity
8,000 1.1
Total
1,540
15.14
WACC = 15.14%
13.4
The net dividend has increased by 1.5 times from the end of 2013 to the
end of 2017, a period of 5 years. This represents an approximate
annualized growth rate of:
g
Latest dividend
230
Answers
300
4 1.5-1 x 100%
10.6%
d1
+g
po
k3
Where d1 = do (1 + g)
Ke
do (1 g )
g
po
30 (1.1067)
0.1067
376
0.195 OR
19.5%
MV
Interest
Cashflow
Rs.
0
Rs.
(75)
(67)
100
100
1-20
20
CF
DF
PV
DF
PV
(Rs.)
(10%)
Rs.
(20%)
Rs.
67
1.00
1-20
8.5136
68.11
4.8696
38.96
100
0.1486
14.86
0.0261
2.61
20
(67)
1.00
15.97
? Kd
(25.43)
Rs. 15.97
15.97 + Rs. 25.53
10% + Rs.
10 + 0.3857 (10)
13.86%
231
(67)
(20 -10)%
WACC Computation
Market
Value
Rs.000
Source of capital
Equity (1m x Rs. 3.76)
Cost (%)
Total
Rs.000
3,760
19.50
733.20
469
13.86
65.00
4,229
98.20
WACC
(b)
(c)
,229.00
798.20
100
= 18.87%
(ii)
(iii)
The existing gearing ratio will be maintained and the optimal capital
structure of the company already attained.
(iv)
The market values used for the computation of the WACC can never
remain constant but subject to changes due to market forces
particularly that of debentures when approaching the redemption
time.
(v)
CF
DF
PV
(Rs.)
(18.87%)
Rs.
Initial outflow
(1,500,000)
1.00
(1,500,000)
1-f
Cash inflows
500,000
1/r = 1/.1887
2,658,161
1,658,161
Dividends
Rs.000
Earnings
before tax
Rs.000
Earnings
after tax
Rs.000
Dividend as a
% of earnings
after tax (%)
2013
200
575
350
57
2014
230
723
452
51
2015
2016
230
260
682
853
410
536
56
49
2017
300
906
606
50
232
Answers
13.5
MISTERI COMPANY
Workings
WACC
WACC = (70% u 10%) + [(30%) u (8.9%)(1 0.25)] = 7% + 2% = 9%.
Capital allowances
Year
Tax
Rs.
1,200,000
(300,000)
Allowance
WDV
Capital
allowance
Year of
saving
Rs.
Tax
saved
at 25%
Rs.
300,000
75,000
225,000
56,250
168,750
42,188
306,250
76,562
900,000
(225,000)
Allowance
675,000
(168,750)
Allowance
506,250
(200,000)
Disposal value
Balancing allowance
306,250
Year 1
Sales (units)
400,000
Contribution per unit: Rs. 2
Rs.
Total contribution
800,000
Fixed costs (cash)
(500,000)
Cash profit
Tax at 25%
Year 2
600,000
Year 3
700,000
Year 4
700,000
Rs.
1,200,000
(520,000)
Rs.
1,400,000
(540,000)
Rs.
1,400,000
(560,000)
300,000
680,000
860,000
880,000
(170,000)
(215,000)
(220,000)
Year 4
Rs.
880,000
Year 5
Rs.
(75,000)
Cash profits
Year 1
Rs.
300,000
Year 2
Rs.
680,000
233
Year 3
Rs.
860,000
Tax on profits
Tax benefit of cap.
allowances
Disposal of machine
(75,000) (170,000)
75,000
56,250
(220,000)
76,562
200,000
(215,000)
42,188
300,000
680,000
746,250
907,188
(143,438)
NPV calculation
Year
Net cash
flow
Rs.
(1,200,000)
300,000
680,000
746,250
907,188
(143,438)
0
1
2
3
4
5
Discount
factor at 9%
1.000
0.917
0.842
0.772
0.708
0.650
Present
value
Rs.
(1,200,000)
275,100
572,560
576,105
642,289
(93,235)
NPV
+ 772,819
Recommendation
The NPV of the project is + Rs. 772,819.
The project would appear to provide a DCF return well in excess of the WACC,
and on financial considerations (assuming that the estimates of costs and
revenues are reasonably reliable) the project should be undertaken.
13.6
FAIZ LIMITED
(a) Market Price of share
K eg
= 9% + 6.25% x 1.6
= 19%
Current dividend expected (Rs. 1.25 x (1+10%)
Rupees
1.375
1.375 x (1 10%)
19% - 10%
16.806
18.181
234
Answers
1.000
3.696
0.593
Amount
(Rs.)
6.00
6.00
130.98
(W1)
PV
(Rs.)
6.00
22.18
77.67
105.84
Issue price
(4.355[Factor] x
Less: Present value of coupons at 10%
Rs. 6)
Hence PV of redemption price must be
Price on redemption @ 10% (Rs. 73.87 / 0.564 [Factor])
26.13
73.87
130.98
Equity (ex-dividend)
TFCs (ex-interest)
Bank loan
(equals to book value)
Price
Rs.
No. of
shares
16.806
*99.84
40,000,000
**5,410,000
Value
Rs.
Million
672
540
80
1,292
Cost %
19.00%
11.00%
12.00%
235
TWO-ASSET PORTFOLIO
(a)
Security X
EV of return ( x )
= (0.25 x 15) + (0.60 x 10) + (0.15 x 2) = 10.05.
(b)
Probability
Return
x x
p(x x )2
p
0.25
0.60
0.15
x
15
10
2
4.95
(0.05)
(8.05)
6.1256
0.0015
9.7204
Variance V2
15.8475
15.8475 3.98 .
EV of return ( x )
= (0.25 x 20) + (0.60 x 8) + (0.15 x (6)) = 8.90
Probability
Return
y y
p(y y )2
p
0.25
0.60
0.15
y
20
8
(6)
11.10
(0.90)
(14.90)
30.8025
0.4860
33.3015
Variance V 2
64.5900
(d)
8.04 .
64.59
Covariance
Probability (p)
x x
y y
0.25
0.60
0.15
4.95
(0.05)
(8.05)
11.10
(0.90)
(14.90)
13.7363
0.0270
17.9917
Cov x,y
31.7550
p(x x )( y y )
Correlation coefficient
U x,y
31.7550
= + 0.992.
3.98 u 8.04
This shows a high level of positive correlation between the returns from
Security X and the returns from Security Y.
236
Answers
(e)
(f)
35.9869 6.0%.
14.2
COEFFICIENT OF VARIATION
Portfolio
Expected
return
19.0
23.0
26.0
VU
V A x 2 V B 1 x 2x1 xUA, BV A V B
2
However, since the returns from each country are independent of each other, the
covariance of returns (A,B ) is 0; therefore the second half of the formula can be
ignored because its value is zero.
Standard
deviation
of returns
Portfolio
[(252 0.52) + (362 0.52)]1/2
[(252 0.52) + (452 0.52)]1/2
[(362 0.52) + (452 0.52)]1/2
21.9
25.7
28.8
237
Coefficient of variation
The coefficient of variation is the ratio of the risk (standard deviation of returns) to
the expected return.
Portfolio
Coefficient of
variation
50% Country A, 50% Country B
50% Country A, 50% Country C
50% Country B, 50% Country C
21.9/19.0 =
25.7/23.0 =
28.8/26.0 =
1.15
1.12
1.11
The ratio of risk to expected returns is roughly the same for all three portfolios.
14.3
PORTFOLIO RETURN
(i)
x u Cox
Standard deviation x Correlatio n coefficient
=
m
Market standard deviation
Security:
X
0.05 x 0.8
0.08
0.5
0.15 x 0.4
0.08
0.75
0.14 x 0.6
0.08
1.05
E(Ri) = Rf +
E (Rm Rf)
17.5%
18.75%
20.25%
238
Answers
(ii)
18.975% = 19%
The risk of the portfolio is the addition of the Beta factor for each
security X proportion of the available investment funds invested in
each security.
i.e.
E p = E x x Wx + E y x Wy + E z x Wz
which is:
(0.5 x 0.3) + (0.75 x 0.3) + (1.05 x 0.4)
=
0.795
79.5% = 80%.
Determination of Rf
14.4
Rm Rf
Premium
i.e.
0.20 Rf
0.05
Rf
0.05 0.20
Rf
0.15
15%
DOLPHIN PLC.
(a)
+ 0.10
Using CAPM
239
Year
Details
Project A
Project B
Cash flows
PV
DF
(15%)
Cash flow
PV
Rs.
Rs.
Rs.
Rs.
Rs.
(10,000,000)
(10,000,000)
1.0000
(24,000,000)
(24,000,000)
Initial Outlay
13
Inflow
4,800,000
10,959,360
2.2832
7,800,000
17,008,960
4&5
Inflow
5,600,000
5,986,400
1.069
8,900,000
7,514,100
Inflow
1,000,000
497,200
0.4972
1,000,000
497,200
NPV
(ii)
Year
7,442,960
3,820,260
Project A
Project B
Cash flows
PV
DF
(21%)
Cash flow
PV
Rs.
Rs.
Rs.
Rs.
Rs.
(10,000,000)
(10,000,000)
1.0000
(24,000,000)
(24,000,000)
Initial Outlay
13
Inflow
4,800,000
9,954,720
2.0739
7,800,000
16,176,420
4&5
Inflow
5,600,000
4,771,760
0.8521
8,900,000
7,583,690
Inflow
1,000,000
385,600
0.3856
1,000,000
385,600
NPV
5,112,080
145,710
(b)
Under the two methods, i.e. the CAPM and the DGM, Project A has a
higher Net Present Value and should therefore be selected. Assuming the
two projects are not mutually exclusive, both would have been accepted on
the basis of positive Net Present Values.
(c)
Life of the Asset: The life of assets can differ. For instance, bonds
have a fixed maturity life, while equity has no fixed maturity life.
(ii)
(iii)
Appropriate discount rate: This will reflect the risk attached to the
asset. The higher the risk, the higher the discount rate. The rate of
equity is subjective, but that of bond is typically determined.
240
Answers
14.5
Project 3
(0.6 6) + (0.4 1) = + 4.0
Return
r
Probability
p
p(r- r )2
6.0
1.0
Variance ()2
2.40
3.60
6.00
2.45
(b)
0.6
0.4
Project 4
(0.5 8) + (0.5 1) = + 3.5
Return
r
Probability
p
8.0
1.0
0.5
0.5
p(r- r )2
10.125
10.125
20.250
4.5
The divisional manager will invest in projects that are more risky provided
that they offer a higher return.
The manager will not invest in Project 4 because it offers a lower expected
return than Project 3 but higher risk.
The expected return from Project 1 is (0.8 4) + (0.2 2) = + 3.6.
The expected return from Project 2 is (0.7 5) + (0.3 1.5) = + 3.95.
The highest expected return is offered by Project 3, which has a higher risk
than Project 1 and Project 2. It would seem that the divisional manager will
invest in Project 3 because he is prepared to take the higher risk for a
higher expected return. However, Project 2 might seem more attractive: its
expected return is almost as high as for Project 3 and the risk is much less.
14.6
Standard deviations
Month
Market portfolio
Security Y
x x
(x x )2
y y
(y y
)2
+ 1.5
2.25
+2
(1.5)
2.25
(3)
(2.5)
6.25
(3)
+ 2.5
6.25
+4
16
17.00
Standard deviation of market returns =
38
17.00 4.123%.
241
38
6.164%.
(b)
Correlation coefficient
Month
x x
y y
+ 1.5
(1.5)
(2.5)
+ 2.5
+2
(3)
(3)
+4
1
2
3
4
(x
x ) (y y )
+ 3.0
+ 4.5
+ 7.5
+ 10.0
+ 25.0
(c)
25.0
= + 0.984.
4.123u 6.164
Cov m, y
25
1.47
17
Var m
Alternatively
E
14.7
U m, y xV y
0.984u 6.164
1.47
4.123
Vm
SODIUM PLC
(a)
(i)
Cash Flow
0
1
2
3
Rs.m
(300)
85
170
150
Discount
Factor
@17%
1
0.8547
0.7305
0.6244
NPV
PV
Rs.m
(300.00)
72.65
124.19
93.66
(9.50)
Cash Flow
Rs.m
(400)
190
180
200
242
Discount Factor
@17%
1
0.8547
0.7305
0.6244
NPV
PV
Rs.m
400.00
162.39
131.49
124.88
(18.76)
Answers
(ii)
Cash Flow
Discount
Factor
PV
Rs.m
@15%
Rs.m
(300)
(300.00)
85
0.8696
73.92
170
0.7561
128.54
150
0.6575
98.63
NPV
(1.09)
(iii)
(b)
Cash Flow
Discount
Factor
PV
Rs.m
@20%
Rs.m
400
400.00
190
0.8333
158.33
180
0.6944
124.99
200
0.5787
115.74
NPV
(0.94)
In view of the high risk inherent in the Food and Beverages project,
the Hotel and Tourism project should be selected. The positive NPV
before the incorporation of the risk factor on the F&B project should
not be taken for viability as the NPV became negative after adjusting
for risk.
Uses of CAPM
(i)
(ii)
(iii)
Limitations of CAPM
(i)
(ii)
(iii)
It only considers systematic risk which does not remain stable over
time.
(iv)
(v)
(vi)
243
Workings
Cost of capital using CAPM:
Hotel & Tourism (HT)
Rs.
Rf + B(Rm Rf)
9% + 6%
15%
Rf + B(Rm Rf)
9% + 11% =
20%
n-1 - 1
5-1
Ke
14.8
Ke
+g
-1
1
4
0.085 or 8.5%
0.25(1.085 )
0.085
3.20
0.169 = 16.9%
-1
DR JAMAL
(a)
(i)
Black Plc.
Blue Plc.
Yellow Plc.
Purple Plc.
White Plc.
Total
Market
Price
Rs.
2.50
2.20
1.90
1.50
0.60
15,000
18,000
10,000
12,000
20,000
244
Market
Value
(MV)
Rs.
37,500
39,600
19,000
18,000
12,000
126,100
Beta
Factor
(B)
1.32
1.20
0.80
1.05
0.80
MVx
Rs.
49,500
47,520
15,200
18,900
9,600
140,720
Answers
(MVx)/MV
140,720/126,100
=
(ii)
1.11594
Rf + (Rm Rf)
Beta factor
Rm =
Rf
Rf +(Rm Rf)
14.6956%
Selected return
Rs. 18,531
R (%)
(MV)
R x MV
Rs.
Black Plc.
Blue Plc.
1.32
1.20
15.92
15.20
37,500
39,600
5,970
6,019
Yellow Plc.
Purple Plc.
White Plc.
0.80
1.05
0.80
12.80
14.30
12.80
19,000
18,000
12,000
2,432
2,574
1,536
Total
(b)
18,531
Portfolio theory will assist Dr Jamal with a formal means of evaluating the
systematic risk profile of his portfolio. He can decide the level of risk that
he is happy to accept and express this in terms of a target beta factor for
his portfolio as a whole. He can then select securities which will provide
him with this risk/return profile. As has been demonstrated above, he can
245
(ii)
(iii)
Liquidity
The manager must ensure that liquid funds are available to
meet current commitments. This may mean that the portfolio at
any one time contains a higher than predicted element of riskfree securities which are being held in anticipation of a known
payment.
Purpose
The purpose for which the portfolio is being held will influence
its make-up. For instance, if the overall fund is small and
transaction costs are significant, and the fund is being invested
with the intention of providing a regular income, then the
manager will select high income securities in preference to
growth stocks. This may mean that the optimum portfolio from
the point of view of the theory may not be the one which should
be selected in practice.
Investment Criteria
The owners of the fund may lay down investment criteria such
as the ethical status of the companies in which to invest. This
may restrict the choice available to the portfolio manager.
Again, this may mean that the optimum portfolio is not chosen.
Thus, it can be seen that the theory does have relevance to a
portfolio manager in his selection of securities, but it does not
provide the complete answer to the structuring of a portfolio.
246
Answers
14.9
MR. FARAZ
(a)
CAPM=RF+(RM-RF) x Beta
Beta =
Market
Standard
Deviation
Market
Varianc
e
Covariance
with
market
Beta
B=A2
C/B
15%
0.0225
2.10%
0.93
8%
12%
19.16%
15%
0.0225
3.00%
1.33
8%
12%
23.96%
15%
0.0225
2.60%
1.16
8%
12%
21.92%
15%
0.0225
1.90%
0.84
8%
12%
18.08%
15%
0.0225
2.80%
1.25
8%
12%
22.88%
Compan
y Name
(i)
RM-RF
20%-8%
Required
Return
Price on
Jan. 1,
2016
Dividend
yield
Co. Name
(b)
RF
Require
d.
Return
%
(P)
(y)
(x)
(A)
(B)
AXB
60
3.50%
19.16%
69.40
15m/60 =
250,000
17,350,000
245
3.00%
23.96%
296.35
18m/245 =
73,469
21,772,538
225
2.50%
21.92%
268.70
22m/225 =
97,778
26,272,949
130
8.00%
18.08%
143.10
25m/130 =
192,308
27,519,275
210
5.00%
22.88%
247.55
20m/210 =
95,238
23,576,167
(Rs.)
(Rs.)
P[1 + (x y)]
No. of
Shares
Portfolio
Value on
Dec 31 (Rs.)
116,490,929
247
(ii)
Compa
ny
Name
Portfolio Value on
Dec 31
New
Investment
Weightage
Beta
Weighted
Beta
Rs.
AXB
17,350,000
14.89%
0.93
0.14
21,772,538
18.65%
1.33
0.25
26,272,949
22.55%
1.16
0.26
27,519,275
23.62%
0.84
0.20
23,576,167
20.24%
1.25
0.25
116,490,929
Estimated Total return on portfolio
Co. Name
(iii)
1.10
Beg. Price
End Price
Capital Gain
Dividend
(A)
(B)
B-A
A x Div. yield
Total
Return
Rs.
Rs.
Rs.
Rs.
Rs.
15,000,000
17,350,000
2,350,000
525,000
2,875,000
18,000,000
21,772,538
3,792,538
540,000
4,312,538
22,000,000
26,272,949
4,272,949
550,000
4,822,949
25,000,000
27,519,275
2,519,275
2,000,000
4,519,275
20,000,000
23,576,167
3,576,167
1,000,000
4,576,167
4,615,000
21,105,92
9
16,490,929
OR
Company
Name
Portfolio Value on
January 1
Required
return
Rs.
Rs.
15,000,000
19.16%
2,875,000
18,000,000
23.96%
4,312,538
22,000,000
21.92%
4,822,949
25,000,000
18.08%
4,519,275
20,000,000
22.88%
4,576,167
100,000,000
Total Return
248
21,105,929
Answers
14.10
MUSHTAQ LIMITED
Computation of market variance
Probability
Market
Return
Probable
Market
Return
3 =1 x 2
p1
Rm
pRm
Rm R m
0.25
30
7.5
0.5
25
12.5
-5
12.5
0.25
40
10
10
25
Deviation from
Mean
Market
Variance
2
5 = 1x (4)
p(Rm - Rm) 2
30
37.5
Project
Return
Probable
Project
Return
3=1 x 2
p1
Rp1
pRp1
0.25
0.5
0.25
20
30
40
5
15
10
30
Deviation
from Mean
Market
Variance
Covariance
5 ( above)
1x 4 x 5
Rp1 Rp1
p(Rm - Rm)
-10
0
10
0
12.5
25
37.5
0
0
25
25
Project
Return
Probable
Project
Return
3=1 x 2
Deviation
from Mean
Market
Variance
Covariance
5 (above)
1x4x5
p2
Rp2
pRp2
Rp 2 Rp2
p(Rm - Rm)
0.25
0.50
0.25
22
28
40
5.50
14.00
10.0
29.50
-7.5
-1.5
10.5
0
12.5
25
37.5
0
3.75
26.25
30.00
249
(project2)
14.11
AITF's actual return is 11% which is less than the return which AITF
should achieve according to its risk profile i.e. 11.6% (W1) as per its
current systematic risk.
W1: Required return of the fund
The required return of AITF in terms of CAPM would be
R = Rf + (Rm Rf)
= 8% + (12% - 8%) 0.901
= 11.60%
250
25
15
d=(b+c-
Remarks
return (W1)
=Rf+(R
m-Rf)
(e)
a)a
Required
Co-variance
Variance
Market
share
(Rs.) per
Dividend
()
Beta
(f)
g=f
27
2.0
16.0%
0.0324
0.024
11.0%
17
1.0
20.0%
0.0324
0.039
12.8%
13.4%
1.35
46
52
2.5
18.5%
0.0324
0.044
under
1.01
106
111
4.0
8.5%
0.0324
0.033
12.1%
performing
10.2%
13.1%
performing
0.55
75
85
2.0
16.0%
0.0324
0.018
114
125
3.0
12.3%
0.0324
0.041
under
1.26
(d)
return
1.20
Total
0.74
per share
Forecasted price
(c)
Name of company
Current price
Answers
under
0.98
239
220
5.5
-5.6%
0.0324
0.032
12.0%
under
1.23
156
168
3.0
9.6%
0.0324
0.040
performing
12.9%
performing
12.2%
12.1%
1.04
145
170
2.5
19.0%
0.0324
0.034
9
1.01
67
Name
of
compan
75
1.0
Current
price
13.4%
No. of
shares
0.0324
0.033
Value Rs.
in 000
000
Beta
Weighted
beta
c=axb
(c) x d / (c)
25
150
3,750
0.741
0.088
15
230
3,450
1.204
0.132
46
190
8,740
1.357
0.376
75
100
7,500
0.556
0.132
145
35
5,075
1.049
0.169
67
45
3,015
1.019
0.097
31,530
251
0.994
14.12
IRON LIMITED
(a)
A
14.12%
16%
(b)
Projects
B
C
13.84% 16.16%
14%
17%
Invest
Invest
Invest
1.13
1.01
1.05
PV
10%
14%
0.96
10%
14%
1.54
13.84%
16.16%
10%
14%
1.46
15.8
4%
0.85
0.91
0.78
18%
16%
0.96
27%
16%
1.54
30%
16%
1.46
Weighted
0.34
0.32
0.52
1.18
1.03
0.96
1.54
197.20
202.71
201.60
601.51
D
15.84%
15%
Not to
invest
85.00
87.00
90.00
2.32
2.33
2.24
197.20
202.71 201.60
1 (1 i)n
i
252
Answers
14.13
(b)
A
500,000
B
1,000,000
C
500,000
10.82
10.20
9.85
No of units acquired
Bonus units received
(10%, 5%, 5%)
Total units at year end
Redemption value per unit
(NAV at 31-Mar-2016 (1
+ Sales Load))
c=ab
46,210.72
98,039.22
50,761.42
d
e=c+d
4,621.07
50,831.79
4,901.76
102,940.98
2,538.07
53,299.49
10.30
10.00
9.71
Value of investment at
year end
g= e x f
523,567
1,029,410
517,538
Increase in NAV
Cash dividend received
Total return
No. of days
Effective annual yield
h=g-a
i
j=h+i
k
(j a)x365k
23,567
9,500
33,067
183
13.19%
29,410
15,000
44,410
152
10.66%
17,538
17,538
121
10.58%
A
12.15%
B
11.08%
C
10.92%
13.19%
Over
performe
d
10.66%
10.58%
Under
performed
Under
performed
253
A
16%
0.71
17%
0.31
12%
0.16
13.19%
9%
10.66%
9%
10.58%
9%
0.06
0.75
0.10
0.05
0.92
0.18
0.10
0.83
0.13
0.45
12.15%
0.26
11.08%
0.64
10.92%
(b)
0.50 (1.0675)
(0.09 0.0675)
Rs. 23.72
(c)
1.00 (1.045)
(0.09 0.045)
Rs. 23.22
15.2
1.40 (1.027)
(0.09 0.027)
Rs. 22.82
ACKERS PLC
(a)
Year
Net Earnings
per share
(Rs.)
Net dividend
per share
(Rs.)
Dividend as %
of Earnings
%
2012
1.40
0.84
60
2013
1.35
0.88
65
2014
2015
2016
1.36
1.30
1.25
0.90
0.95
1.00
67
73
80
Change in EPS =
0.15
0.16
u 100 = 10.7% DPS
u 100 = 19%
1.40
0.84
During this period, earnings per share have declined by 10.7%, while at the
same time, dividend per share has increased by 19.0%
The payment ratio has increased from 60% in 2009 to 80% in 2013, and
thus the proportion of earnings retained has fallen to 20%. If it is assumed
that the capital structure has not changed over the period, then it can be
seen that both actual earnings and return on capital employed have
declined over the period.
254
Answers
Rate of return
For the purposes of calculation, it is assumed that any new investment will
earn a rate of return equivalent to that required by the shareholders (i.e.
15%), and that this will also be the level of return that is earned on existing
investments for the foreseeable future. It is further assumed that investors
are indifferent as to whether they receive their returns in the form of
dividend or as capital appreciation.
Option 1
The amount of dividend per share is Rs. 1.00 with no growth forecast. The
rate of return required by shareholders is 15%. The theoretical share price
can be estimated using the dividend valuation model.
k3
d1
po
where ke
Cost of equity
d1
Po
0.15Po
Rs. 1.00
? Po
.00
0.15
NOTE Po
d1
r g
255
where d1
do (1+g)
Po
0.5 u 1.075
= Rs. 7.17
0.15 0.075
or Rs. 7.17 plus 0.50 rupee = Rs. 7.67 cum-div
Option 3
In this case, 25% of the expected return is paid in form of dividend while
75% is retained.
Therefore,
g
Po
0.25 u 1.1125
= Rs. 7.416
0.15 0.1125
or
Rs. 7.42 plus 0.25 rupee dividend
=
Option 4
In this case, for a share price of Rs. 6.67, investors would need to believe
that retained profits will be invested in projects yielding annual growth of
15% and that the share price will be at this rate. 100% of the expected
return is provided in the form of capital appreciation under this option.
15.3
Dividend policy
(a)
The factors that determine the dividend policy of a large public company
whose shares are quoted on the stock exchange include:
(i)
may only be paid out of profits but not those from the sale of
capital assets (unless that is the business of the company): and
(ii)
(iii)
256
Answers
(v)
(vi)
(x)
Taxation
(xi)
(c)
(i)
Rs. 1,800,000
MV
D0 (1+ g)
Ke - g
MV
=
=
,800,000 (1.05)
0.14-0.05
Rs. 21,000,000
257
(ii)
Retain 10%
Dividend payable
MV
Rs. 2,025,000
,,000 (1.0)
0.14-0.02
Rs. 17,212,500
Advice:
The retention policy that favours the company is that of the retention of
20% as it will make the market value of the company higher than when
10% is retained.
15.4
YB PAKISTAN LIMITED
YEARS
(a)
1
Rupees in million
Existing operating profit
from current projects
[67.79(W1)x1.12]
75.92
85.03
95.23
5.85
13.05
106.66 119.46
22.95
32.85
48.22
71.08
84.35 100.39
59.13
29.90
37.84
46.91
55.67
66.26
6.50
9.04
7.31
16.07
17.66
258
Answers
(b)
The company would have surplus cash of Rs. 79.55 million (W5) which is
less than Rs. 90 million. However, the company may pay the amount by
obtaining the balance amount from its short term running finance facility.
WORKINGS
Rs. in
millions
50.00
17.79
Operating profit
67.79
13%
16%
22%
22%
outlay for
percentage
0%
Rs. in million
Year wise planned
CAPEX (Rs. 300m
CAPEX %)
A
B
39.00
48.00
66.00
66.00
39.00
87.00
153.0
0
219.00
5.85
13.05
22.95
32.85
100.8
0
85.68
105.9
8
130.8
8
167.35
39.00
48.00
66.00
66.00
Depreciable value
100.8
0
124.6
8
153.9
8
196.8
8
233.35
15.12
18.70
23.10
29.53
35.00
85.68
105.9
8
130.8
8
167.3
5
198.35
90.00
90.00
259
105.6
0
124.8
0
151.20
15.60
105.6
90.00
0
11.80
13.84
19.20
124.8
0
16.36
26.40
151.2
0
19.82
26.40
177.6
23.28
0.78
(0.79)
(2.26)
(4.09)
(6.36)
12.58
13.05
14.10
15.73
16.92
YEARS
1
20.00
3.90
4.80
6.60
6.60
4.88
0.78
Interest income
15.5
4.88
(0.79)
(2.26)
(4.09)
(6.36)
(ii)
(iii)
260
Answers
(v)
(vi)
Po
OR
P1
Po u (1 Ke) - D1
Rs. 80.00
D1
Rs. 2.00
Ke (W1)
P1 {80x(1+0.144)-2} {80x(1+0.144)-0}
Not
declared
Rs.
80.00
-
14.4%
14.4%
Rs. 89.52
Rs.
91.52
8%
u 0.8 1.28
5%
261
Net income
Less: Dividend paid
Retained earnings
Less: New investments
Amount to be raised through right
issue
390.00
350.00
89.52
91.52
C=AB
D
4.36
20.00
3.82
20.00
E=C+D
24.36
23.82
BE
2,180
2,180
262
Answers
GEARING
(a)
(b)
100,000
12,500
87,500
60,000
%
increase
25%
Company B
Rs.
100,000
75,000
25,000
10,000
%
increase
25%
27,500
7,000
20,500
4,100
175%
15,000
0
15,000
3,000
50%
16,400
583.3%
12,000
50%
Further calculations
Company A
Operational gearing
= Increase in earnings before
interest and tax/increase in sales
Company B
(175/25)
7.0
(50/25)
2.0
Financial gearing
= Increase in earnings after interest
and tax/ increase in earnings
before interest and tax
(583.3/175)
3.3
(50/50)
1.0
(583.3/25)
23.3
(50/25)
2.0
263
16.2
FINANCING SCHEMES
(a)
Projected statements of profit or loss for the year ended 30th November
Financing method
i
ii
iii
Rs. m
Rs. m
Rs. m
22.9
22.9
22.9
Interest payable
1.5
2.1
2.1
21.4
20.8
20.8
Taxation (25%)
5.4
5.2
5.2
16.0
15.6
15.6
0.0
1.4
0.0
16.0
14.2
15.6
Preference dividend
Profit available to ordinary shareholders
Number of shares
20.0 + 9.0
29.0m
20.0m
20.0 + 6.0
26.0m
Rs.0.552
Rs.0.71
Rs.0.60
Rs. m
Rs. m
Rs. m
17.8
17.8
17.8
16.0
14.2
15.6
(8.7)
(6.0)
(7.8)
25.1
26.0
25.6
Equity shares
14.5
10.0
13.0
Share premium
13.5
0.0
9.0
General reserve
4.6
4.6
4.6
57.7
40.6
52.2
15.0
21.0
21.0
0.0
12.0
0.0
72.7
73.6
73.2
44.8%
28.7%
264
Answers
(b)
Financing scheme (i) produces the lowest EPS of the three options. This
EPS is also lower than the current EPS of Rs.0.615.
Financing scheme (ii) produces the highest EPS. It is also the only option
that produces a higher EPS than the current EPS. However the gearing
ratio is substantially higher than the current gearing ratio or the gearing
ratios of the other options. The projected statements of profit or loss show a
high level of coverage for interest payments under this option and therefore
the relatively high level of gearing is unlikely to be a problem.
Financing option (iii) produces an EPS that is lower than the current EPS
and lower than the EPS of option (ii). However the gearing ratio is fairly low,
indicating a relatively low level of financial risk.
16.3
44.5
(15.0)
29.5
The total value of the equity in the geared company is lower than when the
company was geared, but there are fewer shares left in issue and the value per
share will be higher.
16.4
DIVERSIFY
(a)
The first step is to use the equity betas of the three chemical manufacturing
companies (proxy companies) to estimate an asset beta for the business risk in
chemicals manufacturing.
Company
It is assumed that the asset beta is a simple average of these three values:
(1.25 + 1.25 + 1.22)/3 = 1.24.
265
This asset beta can be used to calculate an equity beta for Bustra, for the
investment in chemicals manufacturing:
1.24 =
E u
60
60 + 40 (1 0.25)
0.667 E = 1.24
E = 1.86
If an appropriate equity beta for Bustra in chemicals manufacturing is 1.86, the
cost of equity (using the CAPM) is:
5% + 1.86 (9 5)% = 12.44%
(b)
If the cost of equity is 12.44%, the pre-tax cost of debt is 5% (= risk-free rate) and
tax is 25%, a suitable discount rate (WACC) for evaluating the proposed
investment would be:
(60% u 12.44%) + [40% u 5 (1 0.25)%] = 8.964%, say 9%.
16.5
$344,000/8 00,000
$0.43
1,800
300
480
$377,000
800,000
Rs.00
0
780
1,020
440
580
203
377
$0.4713
(i)
Contribution
Profit before interest and tax
266
Answers
1800 300
1020
1.47 times
(ii)
1020
1020 440
1.76 times
(iii)
16.6
OPTIMAL WACC
The optimal WACC is the lowest WACC, because this will maximise the value of
the company and the wealth of shareholders.
Step 1
Calculate the geared beta for equity at each level of gearing.
Gearing
Geared beta
20%
0.90 u
30%
0.90 u
40%
0.90 u
50%
0.90 u
60%
0.90 u
80 + 20 (1 - 0.30)
80
70 + 30 (1 - 0.30)
70
60 + 40 (1 - 0.30)
60
50 + 50 (1 - 0.30)
50
40 + 60 (1 - 0.30)
40
1.057
5
1.170
1.320
1.530
1.845
Step 2
Use the geared beta value and the CAPM to calculate a cost of equity at each
gearing level.
Gearing Cost of equity (4% + E (9 4)%
20%
30%
40%
50%
60%
4 + 1.0575 5
4 + 1.170 5
4 + 1.320 5
4 + 1.530 5
4 + 1.845 5
=
=
=
=
=
7.17%
7.51%
7.96%
8.59%
9.54%
Step 3
Calculate the WACC at each level of gearing, and identify the gearing level with
the lowest WACC.
267
Gearing
WACC
20%
+ [80% 7.17]
= 6.44%
30%
+ [70% 7.51]
= 6.39%
40%
+ [60% 7.96]
= 6.40%
50%
+ [50% 8.59]
= 6.58%
60%
+ [40% 9.54]
= 6.84%
Conclusion
The optimal gearing level is 30%, because the WACC is lowest at this gearing
level. However, the WACC is almost as low at a gearing level of 40%.
16.7
GEARED BETA
(a)
(b)
E
E + D (1 T)
75
75 + 25 (1 0.30)
A = 1.126 u
A = 0.913
(c)
If the company is geared differently, its equity beta will not be 1.126
because its financial risk will be different. A geared beta can be calculated
for the new gearing level.
0.913 Bgeared u
Bgeared
60
60 40 1 0.30
0.913
1.339
0.6818
268
Answers
This geared beta factor can now be used to calculate the cost of equity at
this gearing level.
Cost of equity = 5% + 1.339 (11 5)% = 13.03%.
WACC at this gearing level. It is assumed that the cost of debt remains
risk-free.
WACC = (60% u 13.03%) + [40% u 5%(1 0.30)] = 9.218%, say 9.2%
16.8
0
1
2
3
(a)
Tax saving at
35%
Rs.
450,000
(315,000)
135,000
(45,000)
90,000
(45,000)
45,000
(45,000)
0
Year of
cash flow
Rs.
110,250
15,750
15,750
15,750
Current WACC
Cost of equity = 10% + 1.8(15 10)% = 19%.
WACC
Year
Machine
Tax saved, tax
allowances
Cash profits
Tax on cash profits
(35%)
Net cash flow
Discount factor at
16.5%
Present value
NPV = + Rs.
17,420
Rs.000
Rs.000
Rs.000
Rs.000
Rs.000
110.25
220.00
15.75
220.00
15.75
220.00
15.75
(450)
330.25
(77.0)
158.75
(77.0)
158.75
(77.00)
(61.25)
1.000
0.858
0.737
0.632
0.543
(450)
283.35
117.00
100.33
(33.26)
(450)
269
(b)
5
= 1.20
5 11 0.35
The companys gearing is 60% equity and 40% debt; therefore we need to
re-gear the equity beta for the company.
1.20 Beta geared u
60
60 401 0.35
Betageared = 1.72
The cost of equity for the project is therefore 10% + 1.72 (15% 10%) =
18.6%.
WACC = (0.60 18.6%) + (0.40 10% (1 0.35)) = 13.76%, say 14%.
Year
Net cash flows
(as in (a))
(c)
Rs.000
Rs.000
Rs.000
Rs.000
Rs.000
(450.00)
330.25
158.75
158.75
(61.25)
1.000
0.877
0.769
0.675
0.592
Present value
NPV = Rs. 32,610
(450.00)
289.63
122.08
107.16
(36.26)
APV method
Step 1
The ungeared beta for the plastics industry is 1.20 (see above)
The cost of ungeared equity in the industry is 10% + 1.20 (15% 10%) =
16%.
The cash flows of the project are discounted at this cost of capital, to obtain
the base case NPV.
Year
Net cash flow
DCF factor at 16%
Present value
Base case NPV =
Rs. 20,580
Rs.000
(450.00)
Rs.000
330.25
Rs.000
158.75
Rs.000
158.75
Rs.000
(61.25)
1.000
0.862
0.743
0.641
0.552
(450.00)
284.68
117.95
101.76
(33.81)
270
Answers
Net finance
obtained
Issue
costs
Rs.
180,000
270,000
Rs.
3,600
13,500
17,100
2%
5%
The PV of issue costs is calculated using the risk-free rate of 10% as the
discount rate.
Year
Item
Cash flow
Discount
factor at 10%
Rs.
(17,100)
5,985
0
Issue costs
1
Tax saved at 35%
PV of issue costs
PV
Rs.
(17,100)
5,440
(11,660)
1.000
0.909
Year
$183,600
$73,824
2, 487
Balance at
beginning of
year
Loan
payment
Interest at
10%
Rs.
73,824
Rs.
18,360
Rs.
55,464
73,824
12,814
61,010
67,126
73,824
6,713
(67,111)
15 (rounding error)
67,111
Rs.
(183,600)
(55,464)
128,136
(61,010)
1
2
3
Balance
Year of
interest cost
1
2
3
Interest
Year of
tax
saving
Rs.
18,360
12,814
6,713
2
3
4
PV of tax shield
271
Tax saving
at 35%
Rs.
6,426
4,485
2,350
Loan
repayment
DCF
factor at
10%
0.826
0.751
0.683
PV of
tax
saving
Rs.
5,308
3,368
1,605
10,281
16.9
20,580
(11,660)
10,281
+ 19,201
APV METHOD
(a)
80
80 201 0.25
= 1.10
The companys gearing is 70% equity and 30% debt; therefore we need to
re-gear the equity beta for the company.
70
70 301 0.25
Betageared = 1.45
The cost of equity for the project is therefore 4% + 1.45 (9% 4%) =
11.25%.
WACC = (0.70 11.25%) + (0.3 4% (1 0.25))
= 7.875% + 0.9%
= 8.775%, say 8.8%
Year
Capital expenditure
Cash profits
Tax at 25%
Net cash flow
DCF factor at 8.8%
Present value
Rs.
(200,000)
Rs.
Rs.
Rs.
Rs.
100,000
(200,000)
100,000
165,000
(25,000)
140,000
120,000
(41,250)
78,750
(30,000)
(30,000)
1.000
1/(1.088)
1/(1.088)2
1/(1.088)3
1/(1.088)4
(200,000)
91,912
118,269
61,145
(21,409)
(b)
APV method
The ungeared beta for the telecommunications industry is 1.10 (see above)
The cost of ungeared equity in the industry is 4% + 1.10 (9% - 4%) = 9.5%.
The cash flows of the project are discounted at this cost of capital, to obtain
the base case NPV.
272
Answers
Year
Capital
expenditure
Cash profits
Tax at 25%
Rs.
(200,000)
Rs.
Rs.
Rs.
Rs.
100,000
165,000
(25,000)
120,000
(41,250)
(30,000)
(200,000)
100,000
140,000
78,750
(30,000)
DCF factor at
8.8%
1.000
1/(1.095)
1/(1.095)2
1/(1.095)3
1/(1.095)4
Present value
(200,000)
91,324
116,762
59,980
(20,867)
PV of issue costs
Rs.
Equity
Rs. 1,000,000
4/96
Rs. 1,000,000
3/97
Debt
Total issue costs
41,667
30,928
72,595
Item
Cash flow
Rs.
(72,595)
18,149
0
Issue costs
1
Tax saved at 25%
PV of issue costs
7
Discount
factor at 4%
1.000
0.962
PV
Rs.
(72,595)
17,459
(55,136)
PV of tax shield
The amount borrowed will be Rs. 1,000,000 + Rs. 30,928 = Rs. 1,030,928.
The interest rate will be 4%.
The annual interest cost will be Rs. 1,030,928 4% = Rs. 41,237 each year,
years 1 3.
The reduction in tax due to the interest payments = Rs. 10,309 (= 25%
Rs. 41,237) each year, years 2 4.
Discount factor at 4%, years 1 4
Discount factor at 4%, year 1
Discount factor at 4%, years 2 4
3.630
0.962
2.668
273
Rs.
Base case NPV
PV of issue costs
PV of tax shield
APV
16.10
47,199
(55,136)
27,504
+ 19,567
MORE APV
It is assumed that the companys debt capital will be risk-free.
The asset beta for the industry is 1.39 80/[80 + 20(1 0.25)] = 1.17
The cost of ungeared equity in the industry is 6% + 1.17 (10 6)% = 10.68%.
This will be rounded up to 11%.
Only relevant cash flows should be included in the DCF analysis. Non-relevant
costs are the market research cost (already incurred, so a sunk cost) and head
office allocated charges (a non-cash cost).
Note: an increase in head office spending as a result of undertaking a project
would be a relevant cost.
Year
Rs.000
Rs.000
Rs.000
Rs.000
Rs.000
Rs.000
Rs.000
Revenue
6,800
7,800
8,800
9,200
9,476
9,760
Operating costs
5,500
6,600
7,100
7,500
7,725
7,957
50
50
50
60
60
60
500
400
300
200
200
200
Lost contribution
100
100
Tax-allowable
depn
600
480
480
480
480
480
600
6,750
7,630
7,930
8,240
8,465
8,697
(600)
50
270
870
960
1,011
1,063
150
(13)
(68)
(218)
(240)
(253)
(266)
(450)
37
202
652
720
758
797
600
480
480
480
480
480
Head office
Royalty
payments
Taxable profit
Tax at 25%
Add back depn
Equipment
Working capital
Net cash flow
DCF factor 11%
Present value
600
(3,000)
(400)
400
(3,850)
637
682
1,132
1,200
1.000
0.901
0.812
0.731
0.659
(3,850)
574
554
827
791
1,238
0.593
734
1,277
0.535
897
The base case NPV, discounting the cash flows at the ungeared cost of equity, is
(in Rs.000) + 527.
274
Answers
Issue costs
Issue costs will be 2%. The net borrowing after issue costs needs to be Rs.
3,400,000; therefore the gross amount borrowed will need to be Rs. 3
million/0.98 = Rs. 3,469,400. Issue costs will be (2%) Rs. 69,000. It is assumed
that this is a Year 0 cost.
There is no tax relief on issue costs
Tax shield
The annual interest cost will be Rs. 3,469,400 6% = Rs. 208,164.
Tax relief each year will be (25%) Rs. 52,041
Annuity factor at 6% (the risk-free cost of capital), Years 1 6 = 4.917.
Present value of tax shield = Rs. 255,886, say Rs. 256,000.
Rs.000
527
(69)
256
+ 714
16.11
JALIB LIMITED
Rs. in
million
672
599
(a)
Existing value of equity
Existing value of debt
Total MV of the company before investments
1,271
60
399
1,730
35% of X
Rs. 1,730 +
35% of X
Rs. 865 +
17.5% of X
Existing debt
599
275
Rs. 266 +
17.5% of X
322
399
77
Rs. in
million
(i)
Existing equity
New equity
NPV of the new project (ungeared)
672
77
60
113
922
Rs. 16.8
54,880,952
40,000,000
14,880,952
(ii)
3.72:10
Rs.
77,000,000
Rs. 5.17
Rs.
922,000,000
40,000,000
5,500,000
45,500,000
276
Rs. 20.26
Answers
16.12
JAVED LIMITED
Weighted average cost of capital
Value
Cost
Cost
rupees
rupees
Equity
(W3)120,000,000
(W1)24.09
28,905,120
Debt
(W5)152,538,000
15.00
22,880,700
272,538,000
WACC
51,785,820
51,785,820
272,538,000
= 19%
W1: Cost of equity
Ke(g) = Ke(u) + [(Ke(u)-Kd) x D/E)]
Ke(g) = 19% + [(19% - 15%) x 1.27115 (W2)
Ke(g) = 24.09%
W2: Debt Equity Ratio
152,538,000 (W5)
=
120,000,000 (W3)
= 1.27115
W3: Market value of equity
Market value of equity = Profit P/E ratio
= 15,000,000 8 = 120,000,000
W4: Market value of TFCs
Cost of debt (6 months KIBOR +1%) i.e. (14% + 1%)
15.00%
16.00%
Discount
factor 15.00%
Date
Description
PV
31-Dec-08
Markup payment
12,000,000
0.930
11,160,000
30-Jun-09
Markup payment
12,000,000
0.865
10,380,000
31-Dec-09
Markup payment
12,000,000
0.805
9,660,000
30-Jun-10
Markup payment
12,000,000
0.749
8,988,000
30-Jun-10
Redemption
150,000,000
0.749
112,235,000
152,538,000
277
16.13
GHI LIMITED
Advise:
Debt ratio of 40% is the optimal debt structure as at this level the WACC is at
the lowest.
Weighted Average Cost of Capital (WACC)
Debt ratios
10%
40%
10.00%
40.00%
8.00%
10.00%
90.00%
60.00%
50%
50.00%
12.00%
50.00%
10.80%
35.00%
11.20%
35.00%
12.00%
35.00%
12.80%
35.00%
10.80%
10.60%
9.80%
10.30%
Beta
Rf
Rm
0%
1.20
6.00%
10.00%
Debt ratios
10%
40%
1.30
1.50
6.00%
6.00%
10.00%
10.00%
50%
1.70
6.00%
10.00%
Re = Rf + E(Rm - Rf)
10.80%
11.20%
12.80%
Wd
Kd
We
Ke
(Working 1)
Tax
WACC =
WdKd (1-t) + WeKe
0%
0.00%
0.00%
100.00%
16.14
12.00%
NS TECHNOLOGIES LIMITED
(a) APV separates project value into one component associated with the
unlevered operating cash flows and another associated with financing the
project. Each component is evaluated separately.
The disaggregation of cash flows is undertaken so that different discount
rates may be used. As operating cash flows are more risky, they are
discounted at higher rate.
Comparative advantages of APV over WACC
(i)
(ii)
(iii) Show better result when there are significant changes in capital
structure.
278
Answers
Investments
After tax cash flows (180 x 0.65)
Cash flows
(Rs. in
million)
Rs in million
Discount
@
18.72%
(W1)
(600.00)
1.00
1
Present
value
(Rs. in
million)
(600)
1-8
117.00
* 3.99
467
90.00
0.30
27
Residual value
(106)
65
(5)
(2)
(48)
1 (1 0.1872)8
0.1872( W 1)
1 (1 0.06)8
0.06
Conclusion
The project is not feasible for the company as the APV of the project is
negative.
W1: Cost of equity
Ke = Rf + (Rm Rf) x e
Ke = 6% + (14% 6%) x 1.59 (W2)
= 18.72%
W2: Calculating Equity Beta for Telecommunication Industry
a
1.5 e
16.15
D (1 - t)
E
d
E D(1 t)
E D(1 t)
40(1 0.35)
60
1.3
60 40(1 0.35)
60 40(1 0.35)
1.59
Existing WACC =
(Equity % (W1) x Ke (W2)) + (Debt % (W1) x Kd (1-t))
= (60% x 17%(W2) ) + (40% x 9% x 65%) = 12.54%
279
112.55 x 1.0403
0.1270 0.0403(W 5)
1350 million
112.55 x 1.0403
0.1283 0.0403(W 5)
1330 million
Equity
Debt
825
60%
1375
550
40%
1375
Existing
Ke = rf + (rm - rf)
Ke = 7% + (15% - 7%) x 1.25 = 17%
E D(1 - t)
E
* 0.872
280
Answers
E D(1 - t)
E
1.25
* 0.872
D(1 t)
E
d
E D(1 t)
E D(1 t)
825
0 = 0.872
825 550 x 65%
W3 : Cost of debt
? Kd = 8%
* Profit before interest and tax
Rs. in million
272.00
Add: Interest
55.00
327.00
114.45
212.55
Add:
Depreciation
Less
:
Capital expenditures
50.00
(150.00)
112.55
281
1375
FCF1
1375
(k - g)
FCF1
(k - g)
112.55(1 g )
0.1254 g
The existing debt equity structure gives the lowest WACC i.e. 12.54%.
16.16
282
Answers
(102.5
0)
Interest
(Rs. 100 11.5% (130%)
Repayment
Price of TFC
1-5
5
Cash
flows
(Rs.)
Description
Discoun
t factor
(6%)
PV
(Rs.)
Discoun
t factor
(9%)
PV
(Rs.)
1.000
(102.50
)
1.000
(102.50)
8.05
4.212
33.91
3.890
31.31
100
0.747
74.70
0.650
65.00
6.11
(6.19)
where,
,
283
Get the project beta on the basis of steel company un-geared beta
existing WACC only reflects the current business and financial risk. It does
not incorporate the additional risk of the new sector as well as additional
return required by the company's shareholders.
the proportion of debt in the investment i.e. 55% is quite high as compare to
existing debt proportion i.e. 34%. The financial risk has therefore increased
and it could therefore be argued that current WACC is not an acceptable
discount rate.
rate used for evaluation of the project i.e. 17% is too high as it is based only
on the relatively high cost of equity and ignores the amount of debt that will
be used to finance the project.
The suggestion given by the Director B is worthwhile as the project specific cost
of capital (based on steel industry's risk) incorporates the business and financial
risk of the new sector, in which MFL intends to invest and also incorporates the
higher return expectation of the shareholder because of increase in financial risk.
284
Answers
VALUATION MODEL
(a)
(b)
(c)
17.2
4(1.054)
=73
(0.08-0.054)
VALUATION
The dividend growth model:
800
381 g
0.10 g
800 (0.10 g)
80 800g
838g
g = 0.05 or 5%.
=
=
=
38 (1 + g)
38 + 38g
42
17.3
VALUATION OF BONDS
(a)
(b)
6% redeemable bond
Year
Item
1 3 Interest
4
Interest plus capital
Cash flow
Discount
factor at 9%
6
106
2.531
0.708
PV
15.19
75.05
90.24
The market value of the bonds should be 90.24 for each Rs. 100 nominal
value of bonds.
(c)
Item
17
8
Interest
Interest plus capital
285
Cash flow
Discount
factor at 4.4%
5
105
5.914
1/(1.044)8
PV
29.57
74.40
103.97
The market value of the bonds should be 103.97 for each Rs. 100 nominal
value of bonds.
(d)
Convertible bond
Year
Item
1 3 Interest
3
Value of shares acquired
(20 shares u Rs. 7)
Cash
flow
Discount
factor at 9%
PV
2.531
12.66
140
0.772
108.08
120.74
The market value of the bonds should be 120.74 for each Rs. 100 nominal
value of bonds.
17.4
(a)
(i)
1
1
Annuityu 1
r 1 r n
Valueof zerocouponbond
100u
1.05 10
= 100 0.6139
= 61.39.
(ii)
4u
1
1
1
20
0.025 1.025
= 160 [0.3897]
= 62.35
Cash
flow
Period
1 20
Interest
20
Redemption
Value of bond
(b)
4
100
Discount
factor (2.5%)
See above
1/(1.025)20
PV
62.35
61.03
123.38
When interest yields rise, bond prices fall. Edit: the below boxes needs the
x replaced
(i)
Valueof zerocouponbond
100u
1.06 10
= 100 0.5584
= 55.84.
286
Answers
(ii)
PV of annuity
4u
1
1
1
0.03 1.03 20
= 133.33 [0.4463]
= 59.51
Cash
flow
Period
1 20 Interest
20
Redemption
Value of bond
17.5
Discount factor
at 3%
4
100
See above
1/(1.03)20
PV
59.51
55.37
114.88
Convertibles
Share
price
Value of equity if
converted per Rs.
100 of bonds
(20 shares)
Value as
debt if not
converted
Value of
convertibles
Convert?
Rs. 88
Rs. 104
Rs. 120
Rs. 136
Rs. 105
Rs. 105
Rs. 105
Rs. 105
Rs. 105
Rs. 105
Rs. 120
Rs. 136
No
No
Yes
Yes
Rs. 4.40
Rs. 5.20
Rs. 6.00
Rs. 6.80
Warrants
Share price
Rs. 4.40
Rs. 5.20
Rs. 6.00
Rs. 6.80
(b)
Exercise
price
Value of
warrant
Rs. 5
Rs. 5
Rs. 5
Rs. 5
Rs.0
Rs.0.20
Rs. 1.00
Rs. 1.80
Exercise?
No
Yes
Yes
Yes
Convertibles
Before
conversion
After
conversion
Rs.000
1,200
300
900
450
450
Rs.000
1,200
1,200
600
600
Number of shares
2,000,000
2,500,000
Rs.0.225
Rs.0.24
287
Warrants
Before
exercise
After
exercise
Rs.000
1,200
-
Rs.000
1,200
250
1,200
600
600
2,000,000
1,450
725
725
2,500,000
Rs.0.30
Rs.0.29
17.6
KENCAST LIMITED
(a)
Price/Earnings Basis:
Value of Business
Computation of earnings:
Profit
Overvaluation of opening
inventory
Overcharge of directors
remuneration
Undercharged depreciation
(3000 2250)
Adjusted Profit
Earnings (Average)
2015
Rs.000
3,250
2016
Rs.000
3,600
2017
Rs.000
4,175
600
625
1 025
1 125
(750)
(750)
(750)
3,725
3,875
4550
= Rs. 4,050,000
Computation of P/E ratio:
Company 1
5.4
Company 2
6.6
Total
Average
12.0
12
/2 =
6.0
288
Answers
(iii)
Rs.000
15,000
5,400
8,000
4,825
650
33,875
4,150
29,725 i.e. Rs. 29,725,000
9%
Company 2
11%
Total
20%
Average
12
/2 =
Value of business:
(b)
(i)
(ii)
10%
Total Dividend
Dividend Yield
Rs. 2,250,000
10%
289
(iii)
17.7
=
=
=
=
,380,000,000
1,000,000,000
Rs. 1.38
60,000
500,000,000
Rs. 1.12
Comment
A Plc is expected to issue 112 of its own shares in exchange for every 138
of those in B Plc, which it acquires
To acquire the whole of the issued share capital of B Plc, A Plc should
issue.
500,000,00 0
u 112 = 405,797,101 new Rs. 1 shares
138
(b)
Earnings Basis
Earnings per share (EPS) =
EPS for A Plc
=
EPS for B Plc
=
=
290
Rs.0.24
50,000,000
500,000,000
Rs. 0.30
Answers
Comment
A Plc is expected to issue 30 new shares in exchange for 24 existing
shares in B Plc. This leads to a total issue of
500,000,00 0
u 30 = 625,000,000 new Rs. 1 shares
24
(c)
00,000
x 9 = 562,500,000 new Rs. 1 shares
8
(d)
Financial Analysis
A Plc current cost of equity (assuming no expected growth) is:
Maintainab le annual profit 100%
u
Market value of equity
1
=
=
A Plc cost of debt is:
40,000,000
,400,000,000
100%
1
Coupon rate x
=
10% x
8%
Nominal value
Market value
100
125
8 (0.7)
The maximum price that A Plc would be prepared to pay to B Plc for this to
be an acceptable project under conventional capital project appraisal
methods
is:
Earning of B P
Cost of capital of
291
50,000,000
0.0968
Rs. 1.549,586,777
,549,586,777
.40
=
This is an offer of about 129 new shares in A Plc for 100 shares in B Plc as
follows:
645,661,157
500,000,000
17.8
Merger
with RS
Rupees in million
Investment required to be made (W 1)
848.00
1,888.75
124.80
169.00
37.05
47.39
161.85
216.39
19.09%
11.46%
Return on investment
Conclusion:
By acquiring PQ (Pvt.) Ltd., the shareholders of MNO Chemicals will earn a
higher return on investment as compared to the acquisition of RS. Hence,
acquisition of PQ is financially feasible for the shareholders of MNO Chemicals.
W1: Value of equity i.e. investment required to be made by MNO
PQ
RS
Rupees in million
Total value of the company (W 2)
1,248.00
2,388.75
(400.00)
(500.00)
848.00
1,888.75
292
Answers
156 (W - 3) x (1 4%)
17% (W - 4) - 4%
204.75(W - 3) x (1 5%)
14% (W - 4) - 5%
1,248
2,388.75
PQ
RS
Rupees in million
Net profit after tax
Add Interest (PQ : 48 0.65) (RS : 55 0.65)
Maintainable earnings
124.80
169.00
31.20
35.75
156.00
204.75
PQ
RS
Rupees in million
585.00
156.00
204.75
17.9
585.00
741.00
789.75
5%
6%
37.05
47.39
3,000,000
(440,000)
(600,000)
550,000
(150,000)
(1,000,000)
1,360,000
293
17.10
FINANCIAL PLAN
(a)
Tutorial note. Many of the figures for the financial plan can be calculated
by increasing the amount by 8% each year, in line with sales growth. The
bank overdraft interest each year is calculated by taking the bank overdraft
at the end of the previous year. The bank overdraft is a balancing figure in
the statement of financial position, that makes the equity and liabilities add
up to the total assets.
Year 5
Year 6
Year
7
Year 8
Rs. m
Rs. m
Rs. m
Rs. m
EBITDA
(+ 8% per year)
583
630
680
735
Depreciation
(+ 8% per year)
(173)
(187)
(202)
(218)
410
443
478
517
(86)
(95)
(106)
(118)
324
348
372
399
Tax (30%)
(97)
(104)
(112)
(120)
227
244
260
279
(145)
(159)
(166)
(179)
82
85
94
100
(+ 8% per
year)
2,182
2,356
2,545
2,748
(+ 8% per
Inventory +
receivables trade year)
payables
767
828
894
966
(+ 8% per
year)
32
35
38
41
2,981
3,219
3,477
3,755
450
450
450
450
1,283
1,368
1,462
1,562
1,733
1,818
1,912
2,012
800
800
800
800
2,533
2,618
2,712
2,812
448
601
765
943
2,981
3,219
3,477
3,755
Earnings before
interest
(see workings)
Interest
(64%)
Dividends
Retained earnings
Plant and
equipment
Cash
Share capital
(add retained
profit)
Reserves
Long-term loan
Bank overdraft
(balancing
figure)
Workings
(1)
294
Answers
(2)
Interest charges
Long-term loan
Bank overdraft
(b)
(8% 800)
(7% previous
year)
Year
5
Rs. m
64
Year
6
Rs. m
64
Year
7
Rs. m
64
Year
8
Rs. m
64
22
86
31
95
42
106
54
118
There are several definitions of free cash flow. Other definitions are
acceptable for your answer.
Year 5
Rs. m
EBIT (1 t)
Earnings
interest less
30%
Year 7
Rs. m
Year 8
Rs. m
287
173
(162)
310
187
(174)
335
202
(189)
362
218
(203)
(57)
241
(61)
262
(66)
282
(72)
305
before
tax at
Depreciation
Increase in plant and equipment
Increase in inventory + receivables payables
Free cash flow
(c)
Year 6
Rs. m
A feature of the financial plan that might need review is the cash position of
the company. The bank overdraft is forecast to increase from Rs. 310,000
to Rs. 943,000, although the company expects to make a profit each year.
The free cash flow each year, as measured, is not much more than the
interest payments and dividend payments.
This suggests that the company might need to reconsider its dividend
policy, and pay lower dividends. In addition, the company might possible
consider alternative sources of finance, so that it does not have to rely so
much on an overdraft facility. More long-term debt might be appropriate, if
this can be obtained at a suitable interest rate.
(d)
179 (1.08)
(0.12 0.08)
= Rs. 4,833 million.
There are 9,000,000 shares of Rs.0.05 each . This gives a valuation of Rs.
537 per share.
295
17.11
TAKEOVER
(a)
Cost of equity in Flat Company, using the CAPM = 5% + 1.20 (11 5)% =
12.2%
WACC in Flat Company = (12.2 75%) + (7 (1 0.30) 25%) = 10.375%,
say 10.4%
Cost of equity in Slope Company, using the CAPM = 5% + 1.35 (11 5)%
= 13.1%
WACC in Slope Company = (13.1 60%) + (8 (1 0.30) 40%) = 10.1%.
Free cash flow is defined here as EBIT less tax, plus tax-allowable
depreciation minus replacement capital expenditure.
Free cash flows and valuation of Flat Company based on free cash
flows
Year
Rs.000
Rs.000
Rs.000
Rs.000
1,918
2,014
2,115
2,221
Tax at 30%
(575)
(604)
(635)
(666)
1,343
1,410
1,480
1,555
872
915
961
1,009
Less: Replacement
capital spending
(966)
(1,014)
(1,065)
(1,118)
1,249
1,311
1,376
1,446
0.906
0.820
0.743
0.673
Present value
1,132
1,075
1,022
973
1,446 (1.03)
=
(0.104 0.03)
296
Answers
Free cash flows and valuation of Slope Company based on free cash
flows
Year
Rs.000
Rs.000
Rs.000
Rs.000
Earnings before
interest and tax
1,893
1,969
2,047
2,129
Tax at 30%
(568)
(591)
(614)
(639)
1,325
1,378
1,433
1,490
728
757
787
819
Less: Replacement
capital spending
(822)
(854)
(889)
(924)
1,231
1,281
1,331
1,385
Discount factor at
10.1%
0.908
0.825
0.749
0.681
Present value
1,118
1,057
997
943
1,385 (1.02)
(0.101 0.02)
Cost of
value
capital
MV
Cost
Rs. m
Flat equity
(6m 3.20)
Flat debt
(19.2m/0.75) 25%
Slope equity
(9m 1.54)
Slope debt
(13.86m/0.60)
40%
19.20
0.104
1.9968
6.40
0.049
0.3136
13.86
0.101
1.3999
9.24
0.056
0.5174
48.70
4.2277
297
Rs.000
Rs.000
Rs.000
Rs.000
4,100
4,305
4,520
4,746
(1,230)
(1,292)
(1,356)
(1,424)
2,870
3,013
3,164
3,322
1,607
1,687
1,771
1,860
(1,860)
(1,885)
(1,980)
(2,079)
2,617
2,815
2,955
3,103
0.920
0.846
0.779
0.716
Present value
2,408
2,381
2,302
2,222
3,103 (1.04)
(0.087 0.04)
Rs. m
17.879
15.992
33.871
58.475
24.604
On the basis of these estimates, the value of equity (as valued on a free
cash flow basis) will increase by about 72.6% as a result of the takeover.
(b)
The estimates of equity value might not be reliable, for several reasons.
(1)
298
Answers
(2)
(3)
(c)
The estimates for the increase in the combined Year 1 EBIT might be
unrealistic, and the estimates of higher growth in sales and earnings
should also be questioned.
Valuations based on a dividend growth model, rather than a free cash
flow model, would produce a lower valuation.
Shareholders in Slope are being offered 2 shares in Flat (current value Rs.
6.40) for every three shares they hold (current value Rs. 4.62). On the
basis of current market values, they are being offered a price that is 38.5%
above the current share price. This is a very high premium in a takeover
bid, and is likely to be very attractive to them.
For the same reason, shareholders in Flat might oppose the takeover bid,
because value is being given to the shareholders of Slope and a very high
premium is being offered for the shares. The shareholders in Flat will only
support the bid if they believe that it will unlock value in the shares or
result in substantial synergy gains through higher sales, cost savings or
faster business growth.
17.12
MK LIMITED
(a)
VALUE OF MK LIMITED
Years
1
Rupees in million
Sales
4%
12,480
12,979
75%
(9,360)
(9,734)
3,120
3,245
35%
(1,092)
(1,136)
4%
1,357
1,411
4%
(728)
(757)
2,657
2,763
0.911
0.830
Present value
2,421
2,292
4,713
9.8%
2,763(1.05)
x 0.83 = Rs. 50,166 million
0.098 0.05
299
Rate
WACC
60%
13.50%
8.1%
kd (6.5% x 0.65)
40%
4.23%
1.7%
WACC
9.8%
VALUE OF ZA LIMITED
Years
1
Rupees in million
Sales
5.5%
8,925
9,416
5.5%
(6,219)
(6,561)
2,706
2,855
35%
(947)
(999)
5.5%
1,044
1,101
5.5%
(686)
(724)
2,117
2,233
0.916
0.839
Present value
1,939
1,873
3,812
9.2%
2,233(1.05)
x 0.839 = Rs. 46,837 million
0.092 0.05
D/E %
WACC
14.5%
45%
6.5%
4.9%
55%
2.7%
9.2%
300
Answers
Rupees in million
Combined Sales
5%
21,483
22,557
70%
(15,038)
(15,790)
6,445
6,767
35%
(2,256)
(2,368)
5%
2,410
2,531
5%
(1,418)
(1,489)
5,181
5,441
0.911
0.830
Present value
4,720
4,516
9,234
9.8%
5,441(1.055)
x 0.83 = Rs. 110,800 million
0.098 0.055
2,000
1,400
1,333
1,320
6,053
13.50%
14.5%
4.23%
4.98%
270.00
203.00
56.00
65.00
594
9.8%
120,036
54,879
50,649
105,528
301
14,508
17.13
PLATINUM LIMITED
(a) Synergistic effects can arise from five sources:
(i)
(ii)
(iii) Tax effects, where the combined enterprise pays less in taxes than the
separate firms would pay.
(iv) Differential efficiency, which implies that management of one firm is
more efficient and that the weaker firms assets will be more productive
after the merger.
(v)
(b) (i)
Rs. 2.57
Rs. 38.55
(ii)
EPS of PL following a successful acquisition:
Rs. in
million
231.00
58.00
24.00
313.00
112.40
Rs. 2.78
50.04
3.02
57.38
114.76
Present Value of
each (W1)
130.17
302
Answers
will be high chance that it will satisfy those shareholders too who are
interested in equity instrument.
Such shareholders will be able to
swap debentures with PLs shares in market.
W1
PV of 3 debentures
of Rs. 100 each
17.14
Redeemable value
(Rs.)
8 year DF @ 11% PV
300
0.4339
130.17
EMH
(a)
(b)
(i)
(ii)
303
per share) and rise to Rs. 4.08 on 12th May the date that the
announcement is made to the market.
(iii)
17.15
(i)
= Rs. 480,000,000
The decision of the private meeting does not reach the market, hence
share-prices will remain unchanged.
DAY 5
The takeover bid was announced, but no information is available yet
about the operating savings, hence, value of X Plc. shares will be
(Rs. 5 x 30,000,000) = Rs. 150,000,000
Value of Y Plc.
Rs.
480,000,000
90,000,000
570,000,000
150,000,000
420,000,000
Number of shares ()
80,000,000
Rs. 5.25
304
Answers
Value of Y Plc.
Rs.
Previous value (R
420,000,000
Potential savings
80,000,000
500,000,000
(ii)
Number of shares ()
80,000,000
Rs. 6.25
Rs.
480,000,000
90,000,000
570,000,000
150,000,000
420,000,000
105,000,000
Rs. 5.43
500,000,000
150,000,000
650,000,000
105,000,000
Rs. 6.29
305
(b)
(i)
(ii)
306
Answers
ACQUISITION
(a)
The earnings of Little next year are expected to be Rs. 86,000. A forward
P/E multiple of 8.0 could be applied to this estimate, and the valuation of
the equity shares in Little would be:
Rs. 86,000 8.0 = Rs. 688,000.
(b)
(c)
Sales
Cash costs
Year 1
Rs.
200,000
(120,000)
Year 2
Rs.
280,000
(160,000)
Year 3
Rs.
320,000
(180,000)
120,000
(30,000)
(10,000)
140,000
(40,000)
(10,000)
80,000
(20,000)
(10,000)
Capital allowances
Interest
Taxable profit
Tax at 30%
50,000
(15,000)
Cash flow
90,000
(27,000)
35,000
56,000
63,000
35,000
20,000
56,000
30,000
63,000
40,000
55,000
(25,000)
Asset replacement
80,000
(24,000)
86,000
(30,000)
103,000
(35,000)
30,000
56,000
68,000
307
$68,000 1.04
= Rs. 1,010,286
0.11 0.04
Cash flow
Discount
factor at
11%
PV
Rs.
1
2
3
4 onwards
Rs.
30,000
56,000
68,000
1,010,286
0.901
0.812
0.731
0.731
27,030
45,472
49,708
738,519
Total value
860,729
18.2
ADAM PLC
(a)
(i)
return on investment
retention ratio
0.16 x 0.25
= 4%
12,000,000
d
=
0.12-0.04
r g
0.21, b = 2/3
Market Value
=
=
(ii)
7,000,000
0.18-0.14
Rs.m
416
171
587
Dividend in 1 year
308
Rs. 234,800,000
Answers
34,800,000
0.16-0.12
(i)
= Rs. 5,870,000,000
White Knight
A situation in which the target company looks for a friendly company
whose offer is more appealing for the takeover bid.
(ii)
Shark Repellant
This involves amending the companys memorandum and articles of
association in such a way that makes the takeover difficult for the
acquiring company.
An example is increasing the margin of majority votes required at an
Annual General Meeting called to approve such a take-over.
(iii)
Pac-man Defence
An anti-takeover strategy in which the target company tries to buy up
the shares of the acquiring company.
(iv)
Poison-Pill
A strategy sometimes employed by target companies in a take-over
bid to reduce the attractiveness of their securities to the prospective
acquiring companies. This is often done by enlarging the outstanding
shares of a target company through a new issue of shares to its
shareholders at a discount to the market price, thus making the takeover quite expensive to the prospective acquiring company.
(v)
Golden Parachutes
This refers to provisions in the executives employment contract that
call for payment of severance pay or other compensation should they
lose their jobs as a result of a successful takeover.
18.3
D LIMITED
(a)
309
(ii)
(iii)
(b)
Comment:
The merger improves the Earnings Per Share (EPS) of D Limited from Rs.
5.00 to Rs. 5.27. However, the shareholders of F Limited suffer a drop in
their EPS from Rs. 3.00 to Rs. 2.64 (i.e. Rs. 5.27/2)
18.4
EPS
PAT
No
of
shares
150
600
P/E
ratio
Share price
EPS
0.25
Clooney
Plc
Pitt Plc
Rs.m
Rs.m
= 0.25
= 20 times
(b)
30
150
= 0.2
0.2
= 10 times
Share price
Earning Per Share
310
Answers
EPS
Total Earnings
No of shares
150.0
Pitt Plc
30.0
4.5
184.5
Therefore EPS
184,500,00 0
= Rs.0.27
675,000,00 0
If EPS
Rs.0.27 and
Share price
Then, the Price Earning (P/E) Ratio of the group would be:
.50
0.27
(c)
20.37 times
(d)
3,000
=
=
=
300
45
3,345
=
=
1,000,000
150,000,000
Rs.0.14
After merger: assuming Clooney Plc maintains the same dividend per
share as before the merger:
DPS
=
=
60,000,000
600,000,000
Rs.0.10
311
Therefore, a holder of 1 share in Pitt Plc will now get Rs.0.1 2 = Rs.0.5
since the ratio of offer is 2:1.
Comment:
The shareholders of Pitt Plc would be losing Rs.0.09, that is, (0.14 0.5) on
each of their shareholding since they were earning Rs.014 on each holding,
before the merger.
18.5
NELSON PLC
(a)
Nelson Plc:
Using rb model where:
r=
return on investment
b=
r=
21% or 0.21
/3
Rs. 85,500
=
=
=
=
(ii)
5,500
18%-14%
5,500
4%
5,500
0.4
Rs. 2,137,500
Drake Plc
g = rb where: r = 16%
b = (or 0.25)
g = 0.16 x 0.25 = 0.04
= 4%
Dividend in the next one year
Market Value
=
=
=
312
68,000
12%-14%
68,000
0.08
Rs. 5,850,000
Answers
(b)
256,500
624,000
880,500
20%; b = 60%
g = rb = 20% x 60%
12%
=
=
=
52,200
0.16-0.12
52,200
0.04
Rs. 8,805,000
Maximum Price = Market Value after merger Market value before merger
18.6
Rs. 6,667,500
HALI LTD
(a)
To:
Board of Directors
From: XYZ
Date: June 4, 2016
Sub: Report on Demerger Scheme
Dear Sirs,
My comments on demerger scheme are as follows:
a) If the company opts for demerger scheme, the ordinary shareholder
will get a surplus of Rs. 28.64 million details of which are as follows:
Rupees
in million
Value of OCX
276.59
Annexure A
Value of OCY
281.05
Annexure B
557.64
313
450.00
79.00
Surplus
529.00
28.64
As the demerger of two separate divisions has increased the value of two
companies by approx. 5.4% as compare to current market value, it
appears that HL should float the two divisions separately.
(b)
Other details of items included in the profit and loss statement and
information such as expected future growth could have been
useful in determining the operating cash flows more accurately.
(ii)
(iii)
(iv)
(v)
(vi)
(vii)
(viii)
Annexure A Value of HX
Year
3 onward
Total
Rupees in million
Profit before tax and depreciation
39.00
42.00
44.00
Depreciation
12.00
11.00
13.00
27.00
31.00
31.00
Tax (30%)
(8.10)
(9.30)
(9.30)
18.90
21.70
21.70
314
Answers
12.00
11.00
13.00
(8.50)
22.40
32.70
34.70
0.8929
0.7972
6.6432
20.00
26.07
230.52
3 onward
W2
276.59
1.18
1.05
6.6432
Annexure B Value of HY
Year
Total
Rupees in million
Profit before tax and depreciation
26.00
34.00
36.00
9.00
10.00
11.00
17.00
24.00
25.00
Tax (30%)
(4.25)
(6.00)
(6.25)
12.75
18.00
18.75
9.00
10.00
11.00
(8.50)
13.25
28.00
29.75
0.9091
0.8265
8.2644
12.05
23.14
245.87
Depreciation
W4
281.05
1.18
1.07
315
18.7
Where the acquisition is financed by debt and equity in the ratio of 60:40.
Existing
(Without
acquisition)
Option 1
(acquisition
thru 100%
debt)
Option 2
(acquisition
thru 60% debt
and 40%
equity)
W1
42 : 58
59 : 41
47 : 53
W3
52.50
64.00
57.75
Increase in
shareholders wealth
because of acquisition
(Rs. in million)
W4
460.00
388.50
316
Answers
Option 1
(acquisition
thru 100% debt)
in
1,500
*13,075
*22,445
(W2) 2,100
2,100
*32,730
59 : 41
47 : 53
in
Option 2
(acquisition thru
60% debt and
40% equity)
317
W2:
Rs. in million
URD
300.00
250.00
40.00
7.50
7.00
CHI
x
90
%
2,100.00
6.30
1,575.00
Rs. in
million
300.00
250.00
(184.28)
365.72
2,560.0
4
Post-acquisition value
40m shares)
250.00
(104.42)
445.58
Shares in
million
318
40.00
14.00
Answers
45)
Total number of shares to be outstanding after right issue
54.00
PKR
57.75
Market Capitalization
Option 1
(acquisition
thru 100%
debt)
Market capitalization
Option 1: (40 x 64)
Option 2
(acquisition
thru 60% debt
and 40%
equity)
2,560.00
18.8
PKR
8.25
3,118.50
-
(630.00)
(2,100.00
)
(2,100.00)
460.00
388.50
FF INTERNATIONAL
Advantages of growth by acquisition
(a)
(i)
(ii)
(iii)
319
(iv)
(b)
(i)
(ii)
(iii)
Market share
Price increased
by
Price
decreased
by
5%
10%
10%
30%
23%
20%
45%
Rs. m
Rs. m
Rs. m
Rs. m
3,667
3,667
3,667
3,667
1,100.00
843.41
733.40
1,650.15
42.17
73.34
(165.02)
1,100.00
885.58
806.74
1,485.13
(363.00)
(278.33)
(242.02)
(544.55)
(55.00)
(42.17)
(36.67)
682.00
565.08
528.05
858.07
(30.00)
(82.51)
320
Answers
15%)
(22.50)
Incremental profit
682.00
565.08
528.05
805.57
Year 1
Growth rate
Operating profit excluding
depreciation (W1)
One time cost of
employees lay off
Net operating cash flow
Fin. charges - Long term
loan (W2)
Financial charges - Short
term loan (1,000 14%)
Net cash flow before
taxation
Taxation (W3)
Net cash flow
Year 2
Year 3
Year 4
Year 5
10%
10%
10%
10%
10%
634.52
697.97
767.77
844.55
929.01
767.77
844.55
(102.00)
(76.50)
(51.00)
(140.00)
(140.00)
(140.00)
267.02
455.97
(17.11)
(97.79)
249.91
358.18
(100.00)
534.52
(127.50)
697.97
551.27
(126.38)
(140.00)
653.55
(157.07)
424.89
496.48
(300.00)
(170.00)
(170.00)
(170.00)
Increase in working
capital (W4)
(194.05)
(59.40)
(65.34)
(Deficit ) to be filled in by
cash
(414.14)
128.78
Net deficit
(414.14)
(285.36)
189.55
(170.00)
(71.88)
254.60
929.01
(25.50)
(140.00)
763.51
(190.05)
573.46
-
(170.00)
(79.07)
324.39
(95.81)
805.57
(27.50)
321
(132.00)
Other fixed costs ((Rs. 250m 80%) - 25m 160m) 1.1 70%
(11.55)
634.52
700.00
Addition
150.00
850.00
Repayment
Year 2
Year 3
680.00
Year 5
510.00
340.00
170.00
510.00
340.00
170.00
680.00
Year 4
(170.00)
(170.00)
(170.00)
(170.00)
(170.00)
Closing balance
680.00
510.00
340.00
170.00
127.50
102.00
76.50
51.00
25.50
W3: Taxation
Year 1
Net cash flow before taxation
Less: Depreciation (75+25+30)
Year 2
267.02
(130.00)
Taxable income
137.02
(80.00)
455.97
(130.00)
325.97
Year 3
Year 4
551.27
653.55
(130.00)
(130.00)
(130.00)
421.27
523.55
633.51
421.27
523.55
633.51
Year 5
763.51
Tax profit/(loss)
57.02
Tax @ 30%
17.11
97.79
126.38
157.07
190.05
Existing
Year 1
Year 2
Year 3
Year 4
Year 5
1,000.00
1,485.13
1,797.00
1,976.70
325.97
Sales
1,633.64
Increase in sales
485.13
148.51
163.36
179.70
Additional working
capital required (40%
of increased sales)
194.05
59.40
65.34
71.88
322
2,174.37
197.67
79.07
Answers
(c)
Year 1
Year 2
Year 3
Year 4
Year 5
249.91
358.18
424.89
496.48
573.46
267.50
242.00
216.50
191.00
165.50
(414.14)
128.78
189.55
95.81
(194.05)
(59.40)
(65.34)
(71.88)
(79.07)
Terminal value*
5,968.52
Cash flows
(90.78)
669.56
765.60
711.41
6,628.41
Discounting factor at
18%
0.8475
0.7182
0.6086
0.5158
0.4371
PV
(76.94)
480.88
465.94
366.95
2,897.28
4,134.11
323
(a)
(b)
324
Answers
5.00 (1.05/1.03)1
5.00 (1.05/1.03)2
5.00 (1.05/1.03)3
5.00 (1.05/1.03)4
5.00
5.10
5.20
5.30
5.40
Cash flows in
francs
Cash flows in
(45,000,000)
10,000,000
20,000,000
25,000,000
10,000,000
(9,000,000)
1,960,784
3,846,154
4,716,981
1,851,852
Tutorial note: You may have calculated the exchange rate to three or more
decimal places. Here, the exchange rate has been estimated to just two decimal
places.
These cash flows in sterling should be discounted at the WACC.
Year
0
1
2
3
4
NPV
Cash flow
Discount factor
PV
(9,000,000)
1,960,784
3,846,154
4,716,981
1,851,852
9%
1.000
0.917
0.842
0.772
0.708
(9,000,000)
1,798,039
3,238,462
3,641,509
1,311,111
+ 989,121
The NPV in sterling is positive. The project is financially viable and should be
undertaken.
20.2
Spot
22(1.02)
2
2
3
22 (1.02)
22(1.02)3
Rs.
22.00
22.44
=
=
22.89
23.35
In order to determine the cost of capital in ringgit using Interest Rate Parity,
the following formula is adopted.
325
RF = 7.8% 8%
Computation of NPV in ringgits.
Cash flow
Year (ringgitm)
Discount factor
(8%)
Present
value
(ringgitm)
(160)
1.0000
(160.000)
80
0.9259
74.072
96
0.8573
82.301
64
0.7938
50.803
47.176
Since the NPV at the required rate of return gives a positive value, the
project is viable.
(b)
(ii)
(iii)
(iv)
(v)
Diversification.
(vi)
Tax avoidance.
326
Answers
20.3
FOREIGN INVESTMENT
(a)
Calculate the NPV of the project in the currency of the investment, using a
discount rate appropriate to the investment.
The annual tax allowance on the cost of the equipment is 25% of 1,000,000
Francs = 250,000 Francs each year for 4 years.
This will result in tax savings of 100,000 Francs (40% 250,000 Francs)
each year in years 2 5.
Year
Equipment
Tax saved
on capital
allowances
Cash profit
Tax on cash
profit
Net cash
flow
FR
(1,000,000)
FR
FR
FR
FR
FR
100,000
500,000
100,000
500,000
100,000
500,000
100,000
500,000
(200,000)
(200,000)
(200,000)
(200,000)
400,000
400,000
400,000
(100,000)
(1,000,000)
DCF factor
at 16%
Present
value
500,000
1.000
0.862
0.743
0.641
0.552
0.476
(1,000,000)
431,000
297,200
256,400
220,800
(47,600)
NPV = + 157,800
(b)
Dividend payments
Year
FR
500,000
FR
500,000
FR
500,000
FR
500,000
(200,000)
(200,000)
(200,000)
(200,000)
100,000
100,000
100,000
100,000
400,000
400,000
400,000
400,000
Dividend
(50%)
Retained
200,000
200,000
200,000
200,000
200,000
200,000
200,000
200,000
Year
FR
FR
FR
FR
FR
200,000
200,000
200,000
200,000
800,000
Cash profit
Tax on profit
Tax saving
from capital
allowance
Profit after tax
FR
800,000
(c)
Dividend
in FR
327
Exchange
rate
Dividend
in $
(d)
3
(1.10/1.04)
3
2
(1.10/1.04)
3
3
(1.10/1.04)
3
4
(1.10/1.04)
3
5
(1.10/1.04)
= 3.1731
= 3.3561
= 3.5498
= 3.7546
= 3.9712
63,030
59,593
56,341
53,268
201,450
0
1
2
3
4
5
NPV
Cash flow
Equipment
Dividend
Dividend
Dividend
Dividend
Dividend
PV
Discount factor at
10%
$
(333,333)
63,030
59,593
56,341
53,268
201,450
$
(333,333)
57,294
49,224
42,312
36,382
125,100
(23,021)
1.000
0.909
0.826
0.751
0.683
0.621
20.4
the Franc is expected to fall in value against the dollar over the next
five years
GOLD LIMITED
Years
Evaluation of
investment in
Bangladesh
BDT in million
Total contribution (W1)
490.05
(80.00)
Building
(30.00)
718.74
790.62
869.68
(563.68)
66.55
252.89
278.18
306.00
(23.29)
(88.51)
(97.36)
(107.10)
16.73
13.38
10.71
8.56
(82.50)
(126.50)
328
Answers
(22.00) (111.10)
(13.31)
(14.64)
(16.11)
322.16
(51.11)
164.45
176.89
513.48
0.8250
0.8103
0.7958
0.7816
0.7676
(63.68)
206.65
226.32
668.94
0.87
0.75
0.66
0.57
0.49
(47.76)
136.39
129.00
327.78
(110.00) (231.00)
0.8400
1.00
171.24
29.16
40.82
44.09
47.62
51.43
Tax @ 25%
(7.29)
(10.21)
(11.02)
(11.91)
(12.86)
(2.88)
(3.11)
(3.36)
(3.63)
(3.92)
Cost of acquisition
(90.00)
(18.00)
(36.00)
167.9
(144.00)
18.99
27.50
29.71
32.08
202.55
1.3250
1.2777
1.2320
1.1880
1.1456
1.1047
(108.68)
14.86
22.32
25.01
28.00
183.35
(1.14)
(1.66)
(1.85)
(2.07)
(2.34)
13.72
20.66
23.16
25.93
181.01
1.00
0.87
0.75
0.66
0.57
0.49
11.94
15.49
15.29
14.78
88.70
37.52
329
300,000
(165,000)
135,000
163,350
179,685
197,654
217,419
3,000
4,000
4,000
4,000
490.05
718.74
790.62
869.68
0.8400
0.8250
0.8103
0.7958
0.7816
0.7676
LKR / PKR
1.3250
1.2777
1.2320
1.1880
1.1456
1.1047
Year 1-5:
Year 1-5:
30.00
Machinery
Building
30.00
82.50
30.00
239.00
191.20
152.96
122.37
239.00
191.20
152.96
122.37
47.80
38.24
30.59
24.47
191.20
152.96
122.37
97.90
16.73
13.38
10.71
8.56
126.50
Less: 20%
depreciation
allowance
30.00
239.00
239.00
BDT in million
Working capital
inflation factor
22.00
133.10
146.41
161.05
177.16
Increase in working
capital
22.00
111.10
13.31
14.64
16.11
330
Answers
Sri Lanka
Working capital
inflation factor
LKR in million
36.00
38.88
41.99
45.35
48.98
52.90
36
2.88
3.11
3.36
3.63
3.92
Increase in working
capital
WACC
15.12%
1.33
-
Additional Tax in
Pakistan @ 5%
29.16
40.82
44.09
47.62
51.43
1.28
1.23
1.19
1.15
1.10
22.78
33.19
37.05
41.41
46.75
1.14
1.66
1.85
2.07
2.34
Sri Lanka
(LKR)
145.00
115.00
177.16
52.90
322.16
167.90
Conclusion:
Gold Limited should invest in Bangladesh as it gives higher NPV.
20.5
GHAZALI LIMITED
To: Board of Directors
Date: 7 December 2016
Subject: Evaluation of proposed investment in Country Y
(a)
331
the future nominal cash flows of the investment, in both Country X and Y. All
foreign cash-flows are converted to CX and total is discounted at a
shareholders' required rate i.e. 22% per annum. The theory of purchasing
power parity has been used to estimate future currency exchange rates.
This predicts that if currencies are allowed to float freely on the market, they
will adjust in the long run to compensate for differences in countries' inflation
rates.
The results show that the investment has an expected net present value of
approximately CX 81.252 million, which indicates that it is worthwhile and
should add to shareholder value.
Calculations
Growth Inflation
YEARS
0
5%
7%
20% (17.778)
4.042
6.360
7.894
(24.778)
3.507
5.759
7.219
1.000
0.766
0.587
0.450
Present value
(24.778)
2.686
3.381
3.249
(15.462)
(1.876)
98.59
81.252
332
Answers
(b)
(c)
(ii)
A slow payback: in present value terms the project will probably not
break even until Year 8 or 4.
(iii)
(iv)
Management strategies
To counter the increase in local taxes
(i)
(ii)
(ii)
(iii)
Back to back loans with other multinational companies and banks with
complimentary cash needs
333
FOREIGN EXCHANGE
(a)
A hedge against the risk can be obtained by entering into a forward rate
agreement to buy $750,000. The forward rate is the forward rate that
favours the bank. This is 1.8535 (and not 1.8543).
The cost of buying the dollars will be $750,000/1.8535 = 404,639.87.
(b)
1.3025
(0.0018)
1.3007
21.2
The company will receive $600,000 in six months, and will want to receive
sterling and pay dollars.
It can do this with a money market hedge by borrowing US dollars now.
The interest rate for six months in dollars is 3.5% 6/12 = 1.75%. It will
need to borrow now:
$600,000/1.0175 = $589,680.59.
It can immediately exchange these dollars into sterling at the spot rate of
1.8800, to obtain:
$589,680.59/1.8800 = 313,659.89.
After six months, the dollar loan will be repayable with interest. The total
repayment will be $600,000, and the payment can be made from the
$600,000 received from the customer.
(b)
The company can do anything with the sterling it receives now from the
hedging transaction. If it chose to invest the cash for six months at 5% per
year (2.5% for six months), the investment of 313,659.89 would increase
to:
313,659.89 1.025 = 321,501.39.
To avoid opportunities for arbitrage between the money markets and the
forward FX markets, the six-month forward exchange rate would therefore
need to be:
$600,000/321,501.39 = 1.8662.
334
Answers
21.3
DUNBORGEN
Forward exchange contract
The six-month forward rate is 1.566 1.574.
Dunborgen would need to buy $500,000, and the bank would charge a rate of
$1.566.
The cost to Dunborgen in euros in six months time = 500,000/1.566 = 319,285.
Money market hedge
The spot exchange rate is 1.602 1.606
Dunborgen could borrow euros now, convert them into dollars and put the dollars
on deposit for six months.
The six month interest rate for US dollar deposits = 2.0% u 6/12 = 1.0%.
To have $500,000 in six months time, Dunborgen would need to deposit:
$500,000 u (1/1.01) = $495,050.
The cost in euros of buying $495,050 spot = 495,050/1.602 = 309,020.
It is assumed that the euros to purchase the dollars spot would be obtained by
borrowing for six months at 4.8%. Interest for six months would be 4.8% u 6/12 =
2.4%.
The cost in euros to Dunborgen of a money market hedge, for comparison with
the cost of a forward contract, would therefore be:
309,020 u 1.024 = 316,436.
Comparison of hedging methods
A money market hedge would be less expensive in this case, and is therefore
recommended as the method of hedging the currency risk exposure.
21.4
CURRENCY SWAP
(a)
Small company will want to borrow 3 million zants, but can borrow in
sterling at a rate that is 2% lower than the rate that the Zantland
counterparty can obtain. The Zantland counterparty presumably wants to
borrow in sterling (the equivalent of 3 million zants), but can borrow in zants
at a rate that is 0.5% lower than the rate that Small Company can obtain.
This provides an opportunity for credit arbitrage of 2% + 0.5% = 2.5%.
The bank would take 0.5% in fees, leaving 2% of net credit arbitrage for the
swap counterparties to share. Small Company would have three-quarters of
this amount, which is 1.5%.
335
Zantland
counterparty
(6.5)
(ZIBOR + 1.5)
ZIBOR
6.5
Receive
6.0
ZIBOR
Net cost
ZIBOR + 0.5%
8.0
Borrow direct
Swap
Pay
Small company would pay 1.5% less than by borrowing direct (at ZIBOR +
2%) and the Zantland counterparty would borrow at 0.5% less than by
borrowing sterling direct at 8.5%.
(b)
It is assumed that 15% is the appropriate discount rate for evaluating the
projects cash flows in sterling. (A DCF rate of 15% would be very low for
evaluating the cash flows in zants, considering the expected high rate of
inflation in Zantland.)
It is also assumed that the swap will be undertaken, and in Year 0 Small
Company will spend 333,333 (3 million zants at the spot rate of 9.00). At
the end of Year 3, it is assumed that Small Company will receive the same
amount (333,333) on the termination of the currency swap, and a further
3,000,000 zants for the remainder of the sale price of the operations centre.
The project cash flows will therefore be as follows:
Year
0
(333,333)
200,000 zants
200,000 zants
200,000 zants
3,000,000 zants
3,000,000 zants
Year
Spot rate
Best case
Worst case
10% inflation
50% inflation
9.00
9.00
9.90
13.50
10.89
20.25
11.98
30.38
336
Answers
Year
Cash
flow
DCF
factor
at
15%
zants
0
1
2
3
3
NPV
200,000
200,000
3,200,000
3,000,000
1.000
0.870
0.756
0.658
0.658
Best case
Worst case
Cash
PV
Cash
PV
flow
flow
Conclusion
On the basis of the assumptions used, the project would have a positive
NPV if inflation in Zantland exceeds inflation in the UK by 10% per year, but
will have a negative NPV if inflation in Zantland exceeds inflation in the UK
by 50% per year.
There is consequently an element of risk in the project due to uncertainty
about the spot exchange rate, and this risk element should be assessed
more closely before a decision is taken about the investment.
21.5
Per ton
cost
(bhat)
Qty.
(ton)
Amount
(bhat)
Conv.
rate
Rupees
June (Buy
one month
forward)
50,000
4,000
200,000,000
2.33
466,000,000
50,000
6,000
300,000,000
2.31
693,000,000
1,159,000,000
Sales
Month
Per ton
revenue
(US $)
Qty.
(ton)
Amount
(US$)
Conv.
rate
Rupees
2,000
4,000
8,000,000
65.77
526,160,000
2,000
6,000
12,000,000
66.10
793,200,000
337
1,319,360,000
Profit on transactions
(sales minus purchases)
160,360,000
(247,836)
160,112,164
Per ton
cost
(bhat)
Qty.
(ton)
Amount
(bhat)
Conv.
rate
Rupees
June (Buy
one month
forward)
50,000
4,000
200,000,000
2.33
466,000,000
50,000
6,000
300,000,000
2.31
693,000,000
July
(Cancelled at
spot)
50,000
2.29
(687,000,000)
July (Buy 2
months
forward)
50,000
2.28
684,000,000
(6,000) (300,000,000)
6,000
300,000,000
1,156,000,000
Sales
Month
Per ton
revenue
(US $)
Qty.
(ton)
Amount
(US$)
Conv.
rate
Rupees
2,000
4,000
8,000,000
65.77
526,160,000
Aug. (Sell
three month
forward)
2,000
6,000
12,000,000
66.10
793,200,000
July (Buy 1
month
forward)
2,000
(6,000)
(12,000,000)
65.96
(791,520,000)
July (Sell 3
month
forward)
2,000
6,000
12,000,000
66.38
796,560,000
338
Answers
1,324,400,000
Profit on transactions
(sales minus purchases)
168,400,000
(475,044)
167,924,956
Per ton
cost
(Bhat)
Qty.
(ton)
Amount
(bhat)
Conv.
Rate
Rupees
50,000
4,000
200,000,000
2.33
466,000,000
50,000
6,000
300,000,000
2.31
693,000,000
July
(Cancelled
at spot)
50,000
2.29
(687,000,000)
(6,000) (300,000,000)
472,000,000
Sales
Month
Per ton
revenue
(US $)
Qty.
(ton)
Amount
(US$)
Conv.
rate
Rupees
2,000
4,000
8,000,000
65.77
526,160,000
2,000
6,000
12,000,000
66.10
793,200,000
July (Buy 1
month
forward)
2,000
(6,000)
(12,000,000)
65.96
(791,520,000)
527,840,000
55,840,000
(247,836)
55,592,164
339
21.6
Three months
Export Receivable
98,500
Import - (Payable)
77,000
(223,500)
Six months
98,500
(146,500)
Forward Market
Three months contract
Rs.
Receipt of export amount at the end
of third month
98,500 x
123.62
12,176,570
146,500 x
123.54
18,098,610
Money Market
Three months payment
Since the company is expecting to receive . Therefore, to hedge currency
rate risk we need to convert the same into definite Rupee receivables.
Borrow in Euro and invest in Rupee, so that at the end of third month repay
Euro borrowing from export proceeds and receive a definite Rupee
amount.
97,284
Rs.
12,084,618
12,280,993
340
Answers
146,500 (1 + 3% 2)
144,335
Rs.
17,972,594
18,961,087
Recommendation:
Feasible option for 3 month net payment -------------------------------> Money Market
Feasible option for 6 month net payment -------------------------------> Forward Cover
21.7
SILVER LIMITED
(a)
1,020,000
Payment due
(775,000)
245,000
245,000
7.2%
1
245,000
1.018
240,668
1,224,000
Payment due
(1,347,000)
(123,000)
341
123,000
5.8%
1
123,000
1.02900
7.9%
371,751x 1
2
119,534
386,435
Conclusion:
For the first quarter, SL would be better off with money market hedge
as it would receive more MYR than with a forward contract.
(b) SL wishes to lend and so will buy 5 (MYR 15,000,000 / MYR 3,000,000) interest
rate February Futures.
(i) If interest rates fall by 0.75% and March Futures price increases by 1%, the
net hedging position of the interest rate future would be as follows:
MYR
Future outcome
75,000
393,750
Net outcome
468,750
450,000
18,750
(ii) If interest rates rise by 1% and March Futures price decreases by 1%, the
net hedging position of the interest rate future would be as follows:
MYR
Future outcome
15,000,000 x 6/12 x 1%
(75,000)
525,000
Net outcome
450,000
Target outcome
450,000
342
Answers
21.8
KHALDUN CORPORATION
(a) USA
The full receipt i.e. US $ 1.50 will be hedged.
Hedging through Forward Contract
KC would sell US $ 1.5 million three months forward at Rs. 87.0 per US $
and receive
Rs. 130.5 million.
Hedging through Money Market
To obtain US $ 1.5 million, borrow now: (1.5 million
[1+(5.20%x3/12)] =
$ 1.48
Rs. 128.11
Rs. 130.83
UK
The receipts and payments can be netted off : ( 5.10 - 4.0) = 1.10
Hedging through Forward Contract
KC should buy 1.1 million three months forward at Rs. 136.18 per
and pay Rs. 149.8 million.
Hedging through Money Market
To earn 1.1 million, invest now: 1.1 million [1+(5.00%
x 3/12)] =
1.09
Rs. 147.29
Rs. 151.16
Payments
(b)
Receipts
KC-(Pak)
KA-(USA)
Total
KB-(UK)
Rs. in million
KC-(Pak)
131.00
688.30
819.30
KA-(USA)
130.02
390.06
520.08
KB-(UK)
539.84
242.93
782.77
Total receipts
669.86
373.93
1,078.36
2,122.15
(819.30 )
(520.08 )
(782.77 )
(2,122.15)
149.44
146.15
(295.59)
Total
payments
Net payment
/ (receipts)
343
CURRENCY FUTURES
(a)
(b)
It will close its position in May, when the futures price is 1.2690.
The value of 1 tick for this contract is 125,000 $0.0001 = $12.50.
Original selling price
1.2800
1.2690
0.0110
22.2
344
Answers
The US company will close its position in January, when the futures price is
1.8420.
The value of 1 tick for this contract is 62,500 $0.0001 = $6.25.
Original selling price
Buying price to close the position
Gain per contract
1.8600
1.8420
0.0180
738,000
6,750
744,750
22.3
BASIS
(a)
1.8540
1.8760
0.0220
The basis is 220 points, with the futures rate higher than the spot rate.
The basis at the end of June when the futures reach settlement will be 0.
It is assumed that basis will decrease to zero at a constant rate per day.
The basis will therefore reduce by (220 points/122 days) = 1.80328 points
per day.
At close of trading on 30th April, there are (31 + 30) 61 days remaining to
the settlement of the June futures. The expected basis at this date is
therefore:
1.80328 points per day 61 days = 110 points.
345
1.8610
0.0110
1.8720
22.4
1.8690
0.0027
1.8717
1,128,125
1,106,250
21,875
1.7800
1.7600
0.0200
Total gain (10 contracts) = 10 contracts 200 ticks per contract 6.25 per
tick = $12,500.
The futures position has failed to provide a perfect hedge, resulting in a net
loss of $9,375.
Effective exchange rate
1,100,000
12,500
1,112,500
346
Answers
(b)
22.5
The reason why the hedge is not perfect in this case is explained by the
existence of basis. When the futures position was opened, the basis was
250 points (1.8050 1.7800). When the position was closed, the basis was
100 points (1.7700 1.7600). The spot price has moved in value during the
three months by more than the movement in the futures price, by 150
points. The value of this difference is $9,375 (10 contracts 150 ticks per
contract 6.25 per tick).
CURRENCY HEDGE
(a)
(b)
(c)
347
The payments are due in October. The company should therefore buy
futures with the next settlement date following. It should buy December
contracts at 0.6929.
The remaining 10,000 that is not hedged by futures can be purchased
forward at 1.4443, at a cost of 6,924.
If the basis is 0 when the futures position is closed in October, the effective
exchange rate for the 2,100,000 will be 0.6929 = 1, or 1 = 1.4432.
The net cost in sterling will be:
2,100,000 at $1.4432/1
10,000 at 1.4443/1
Total cost in sterling
1,455,100
6,924
1,462,024
348
Answers
Number of options
purchased with 12,000
300
1,000
40
12
The investor could purchase 12 put options at a strike price of 1,000 (10)
or 40 put options at a strike price of 950 (9.50).
Tutorial note:
The investors decision will depend on how far he expects the share price
to fall. The options with a strike price of 1,000 (10) are currently in the
money but the investor can only buy 12 such contracts. As the share price
falls, the intrinsic value of these options rise but the intrinsic value of the
options with a strike price of 950 (9.50) will remain at zero until the share
price falls below 9.50. For any fall below this the investor will gain more
from these 40 contracts than he would from the 12 other contracts.
The share price at which the investor would be indifferent between the two
options can be found as follows:
Let x = the share price at which each course of action would yield the same
return.
The investors return would be equal when:
12(1,000 x) = 40 (950 x)
12,000 12x = 38,000 40x
28x = 26,000
x = 928.57 (9.29)
If the investor expects the share price to fall below this he should invest in
40 put options with a strike price of 950.
If the investor expects the share price to fall but not below 9.29 he should
invest in 12 put options with a strike price of 1,000.
(b)
If the share price is 910 at expiry and the investor still holds the options, the
options will be exercised. It is assumed that he buys the options at 950.
Traded equity options are settled by physical delivery. The investor would
need to buy shares at 910 and exercise the option to sell them at 950.
349
728,000
760,000
Profit on exercise
Cost of options
Net profit on speculative investment
32,000
12,000
20,000
(Note: This calculation of the profit ignores the time value of money. The
options are paid for when they are bought, but the profit is made only when
the options are exercised).
Traded equity options can be bought and sold on the exchange, and the
investor is likely to sell the put options before they expire, making a profit
on the sale. As the options become increasingly in-the-money, their market
value will increase.
23.2
Currency options
(a)
(b)
Expiry
At the expiry date, the options are in-the-money if the spot exchange rate is
1.9200. They will therefore be exercised, at a profit of $0.07 per 1 (1.9200
1.8500).
Gain on exercise of 35 option contracts = 35 31,250 $0.07 =
$76,562.50.
The total dollar income of the company will therefore be $2,076,562.50.
This can be exchanged into sterling at the spot rate, to obtain 1,081,543
($2,076,562.50/1.9200).
The option premium cost was 11,340, therefore ignoring the time value of
money, the net revenue for the company is 1,081,543 11,340 =
1,070,203.
This gives an effective exchange rate for the $2 million dollar receipts of
1.8688 (2,000,000/1,070,203).
350
Answers
23.3
SPL
(future rate)
Rupees
17,000,000
17,300,000
(15,500,000)
(15,500,000)
1,500,000
1,800,000
17,500,000
351
DESC
(future rate)
Rupees
17,500,000
(21,250,000)
(21,750,000)
(3,750,000)
(4,250,000)
Conclusion:
The best strategy for the company is:
DEF should square its position in SPL shares by exercising the option and
selling the shares at the future price as it gives the highest return.
DEF should not exercise option of DESC shares as this will result in loss to the
company.
23.4
JPY
175,000,000
Rs.
341,127,500
JPY
173,267,327
Rs.
335,081,683
Rs.
344,017,195
1,750
Rs.
339,867,500
Rs. 35,000
Rs.
339,902,500
352
Answers
700
Rs.
338,012,500
Rs. 40,250
Rs.
338,052,750
Total
cost
Premium
Remarks
Rs
1.90
0.0355
1.9355
1.91
0.0232
1.9332
1.92
0.0115
1.9315 Cheapest
Conclusion
Hedging using option is the cheapest option and should be selected.
353
FRA
(a)
The company wants to borrow in three months time for a period of six
months; therefore to create a hedge with an FRA, it must buy a 3v9 FRA.
The interest rate for the FRA is 3.97%.
The company will borrow in three months time at the current LIBOR
rate plus 0.50%.
6.00
(1.53)
4.47
24.2
An FRA works on the same principles as an interest rate coupon swap. The
main difference is that an FRA is for one interest period only, although a
company can arrange a series of FRAs. A coupon swap is longer-term, and
covers several settlement dates.
SWAP
The company should enter into a four-year interest rate coupon swap in which it
receives the floating rate and pays the fixed rate (5.25%).
The effective interest rate will change from floating rate to fixed rate, as follows:
%
Bank loan interest
Swap
Pay
Receive
Effective rate
(LIBOR + 1.25)
(5.25)
LIBOR
(6.50)
354
Answers
24.3
CREDIT ARBITRAGE
%
Entity A can borrow more cheaply at a fixed rate by (7.25 6.35)
0.90
0.50
0.40
0.10
0.30
If the entities share the benefit equally, each will be able to reduce its effective
cost of borrowing by (0.30/2) 0.15%.
(6.35)
(LIBOR)
5.75
(LIBOR + 0.60)
(LIBOR + 1.25)
(5.85)
LIBOR
(7.10)
The banks profit would come from the difference between the fixed rate received
from Entity B (5.85%) and the fixed rate paid to Entity A (5.75%).
This assumes that the two Entities each arrange their swap with the bank, and
not directly with each other.
24.4
CREDIT ARBITRAGE
Company X
%
Borrow:
Fixed rate
Swap
Receive fixed
(7.25)
6.27
355
Company Y
%
Borrow:
Floating rate
Swap
Pay fixed
(LIBOR + 1.50)
(6.30)
Pay floating
Net cost
Cost of variable rate
borrowing
(LIBOR)
Receive floating
LIBOR
(LIBOR + 0.98)
Net cost
Cost of fixed rate
borrowing
(7.80)
(LIBOR + 1.25)
Saving in cost
24.5
0.27
Saving in cost
(8.00)
0.20
= 15 contracts.
Conclusion
The company should sell 15 March short sterling futures.
24.6
The company wants a hedge against the risk of higher interest rates. It
should therefore sell short-term interest rate futures.
The borrowing period will begin in February; the company should therefore
buy March futures, which have the next settlement date following the start
of the loan period.
The planned borrowing period is 4 months, but with futures, the notional
deposit period is only 3 months. To get round this difficulty, the number of
futures contracts should be adjusted.
= 16 contracts.
Conclusion
The company should sell 16 March eurodollar futures at 93.70.
(b)
356
0.9450
0.9370
0.0080
Answers
It is now the end of October. The March futures will reach settlement date
in five months time.
If we assume that the basis will reduce from 80 points at the end of October
to 0 by the end of March at an equal amount each month, by the end of
January the basis should be:
2 months to settlement
u 80 points = 32 points
5 months original time to settlement
0.9250
0.0032
0.9218
0.9370
0.9218
0.0152
7.50
(1.52)
5.98
24.7
FRAs
The company can use an FRA to fix the interest rate receivable on 8.2
million. A 4v9 FRA is required, and the bank will offer a rate of 4.52%.
The company will therefore fix a rate of 4.52% for LIBOR and if it can invest
at LIBOR + 0.40% this means that the effective investment rate will be
4.92%.
357
Futures
The company wants to fix an interest rate for income, so it should buy
futures. The money for investment will be received at the end of July, so
September futures should be used.
The company should buy (8.2 million /500,000) (5 months/3 months) =
27.33 futures contracts, say 27 futures, and the price is 95.35.
(b)
FRAs
At the end of July when the 8.2 million, the company will invest the money
for 5 months. If it can still obtain a rate of LIBOR + 0.40%, it will invest the
money at 4.65%.
The FRA contract must also be settled, as follows:
%
(4.25)
4.52
0.27
Pay LIBOR
Receive
Profit on settlement
95.867
95.350
0.517
358
Answers
24.8
Futures
The company wants a hedge against the risk of a rise in two-month interest
rates. It should therefore sell futures. Since the interest period will be 2 months
and futures are for a three-month deposit, the quantity of futures sold should
be:
(21 million/500,000) 2/3 = 28 contracts.
The loan period will begin in mid-June; therefore sell 28 June contracts, at
a price of 94.610.
Options on futures
The company will want options to sell futures; therefore it should buy put
options on 28 June futures. The premium cost will depend on the strike
price chosen. (Since the options are needed for two months, apply a factor
of 2/12).
Strike price
94750
95000
Premium
(21,000,000 0.500% 2/12)
(21,000,000 0.850% 2/12)
17,500
29,750
FRA
The company should buy a 3v5 FRA, for a notional principal amount of 21
million. The FRA rate will be 5.38%.
(Note: The FRA rate is more favourable than the futures rate of 5.39% (100
94.610). The company would therefore prefer to buy an FRA than sell
futures. However, it might prefer to buy put options on futures rather than
buy an FRA).
In mid-June, the company will borrow 21 million for two months. If the
LIBOR rate is 6%, it will borrow at 6.75% (LIBOR + 0.75%) for two months.
Futures
The futures price in mid-June can be estimated as follows:
June futures price in mid-March
LIBOR rate in mid-March
Basis in mid-March
94.610
95.000
0.390
94.000
00.005
93.995
The company will close its position by buying 28 June futures at 93.995.
359
94.610
93.995
00.615
Strike price
94750
Strike price
95000
94.750
93.995
0.755
95.000
93.995
1.005
26,42
5
35,175
However, after taking into account the cost of the option premiums, the net
gain is reduced.
FRA
The companys FRA bank will make a payment equivalent to (6% - 5.38%)
= 0.62% per year on 21 million for two months, to settle the FRA.
The gain on the FRA will offset the higher interest cost of borrowing.
24.9
DEFINITIONS
(a)
In essence, party A agrees to pay the interest on party Bs loan, whilst party
B agrees to pay the interest on party As loan.
360
Answers
(b)
Forwards
A forward contract is a binding agreement to exchange a set amount of
goods at a set future date at a price agreed today.
Forward contracts are used by business to set the price of a commodity
well in advance of the payment being made. This brings stability to the
company who can budget with certainty the payment they will need to raise.
Forwards are particularly suitable in commodity markets such as gold,
agriculture and oil where prices can be highly volatile.
Forward contracts are tailor-made between the two parties and therefore
difficult to cancel (as both sides need to agree). A slightly more flexible
approach would be to use futures
(c)
Futures
Futures share similar characteristics to Forward contracts i.e.:
Options
An option gives the owner the right, but not the obligation to trade
something. The something might be shares, a foreign currency or a
commodity.
There are two types of options:
Over the counter (OTC) options these are bespoke and the terms
are agreed specifically between the two counterparties.
(e)
Exercise the right to buy (a call option) or sell (a put option) at the
pre-determined price (the exercise price)
361
24.10
A collar combines both caps and floors thus maintaining the interest
rate within a particular range.
IMRAN LIMITED
(a) Rate of interest is
KIBOR+2
11%
13%
(b) (i)
4,550,000
Rupees
5,425,000
(A)
875,000 (B)
Imran Limited
Net payable by Imran Limited
A-B
4,550,000
Rupees
3,850,000
(A)
700,000 (B)
Imran Limited
Net payable by Imran Limited
A+B
362
4,550,000
Answers
GAZELLE LIMITED
(a)
Sales budget
Sales budget for year ending 31/12/2017
Quarter
1
2
3
Forecast trend
1600
1700
1800
Seasonal variation
-150
+200
+300
1450
1900
2100
Forecast sales (Units)
Sales price per unit
Rs. 250
Rs. 250
Rs. 250
Sales value (Rs.)
(b)
362,500
475,000
525,500
4
1900
-350
1550
Rs. 250
387,500
Production budget
Production budget for year ending 31/12/2017
Quarter
1
2
Forecast sales (units)
1,450
1,900
Add planned closing inventory
950
1,050
Forecast sales (Units)
Less: Planned opening
inventory
2,400
1,675
NOTE:
2,950
(725)
3
2,100
775
4
1,550
925
2,875
2,475
(950)
(1,050)
(775)
2000
1825
1700
2000
(150)
1,850
Q4
1,700
u6
Hrs used
Labour cost per hour
10,050
u Rs. 1
12,000
u Rs. 1
10,950
u Rs. 1
10,200
u Rs. 1
150,750
180,000
164,250
153,000
363
25.2
Sales price
50,000
Rs. 2.50
Rs. 125,000
80,000
Rs. 4.00
Rs. 320,000
Product
Sales
revenue
Rs. 445,000
Total
Production budget
Units
Sales budget in units
20,000
2,000
(2,500)
19,500
Labour budget
Grade I
Grade II
hours
hours
100,000
175,000
Rs. 12
Rs. 15
Rs.
1,200,000
Rs.
2,625,000
Total
275,000
Rs.
3,825,000
Materials budget
Production budget
Units
Closing inventory
4,000
Sales
25,000
29,000
Opening inventory
(2,000)
Budgeted production
27,000
Kilos of material X
15,000
135,000
150,000
Opening inventory
(30,000)
Budgeted production
120,000
364
Answers
25.3
Sales quantities
1000
2000
1500
Selling prices
110
115
120
110,000
230,000
Sales value
(ii)
Total
180,000
520,000
(iii)
Sales quantities
1000
2000
1500
1200
1450
480
2200
3450
1980
1100
1050
520
Units to be produced
1100
2400
1460
Materials
Quantities
X1
Units
per
product
G 1100
X2
Total
Units
per
product
3300
B 2400
D 1460
Total
Units
per
product
Total
3300
1100
4800
7200
4800
5840
2920
13940
365
X3
10500
8820
(iv)
X2
X3
13,940
10,500
8,820
33,400
26,000
16,000
47,340
36,500
24,820
22,000
18,000
14,000
Purchase in quantities
25,340
18,500
10,820
126,700
148,000
25.4
Total
75,740 350,440
FLEXED BUDGET
Workings
The high low method will be used to estimate fixed and variable costs.
Production
labour
Production
overhead
Rs.
Rs.
81,500
109,000
74,000
88,000
7,500
21,000
Variable production labour cost per unit = Rs. 7,500/3,000 units = Rs. 2.50.
Variable production overhead cost per unit = Rs. 21,000/3,000 units = Rs. 7.00.
Production
labour
Production
overhead
Rs.
Rs.
74,000
88,000
25,000
70,000
Fixed costs
49,000
18,000
Rs.
36,200
29,700
6,500
Variable selling and distribution overhead cost per unit = Rs. 6,500/5,000 units =
Rs. 1.30.
366
Answers
Rs.
29,700
11,700
Fixed costs
18,000
Fixed cost
Variable
cost per unit
Rs.
Rs.
13.00
49,000
2.50
Production overhead
18,000
7.00
26,000
18,000
1.30
Summary
Direct materials (Rs. 130,000/10,000
units)
195,000
86,500
1,250
123,000
Administration overhead
26,000
36,850
468,600
25.5
The rate per patient for the variable overheads on the basis of experience
during January June are as follows:
Expense
Salaries &Wages
Maintenance
Printing & Stationery
Miscellaneous
367
Since the expected level of activity in the full year is 10,000, the expected
level of activity for July- December is 4,400 (i.e10,000 5,600). Thus, the
budget for July December will be as follows:
Variable cost
Rs.
(4,400 x 14.20)
62,480
Maintenance
(4,400 x 6.25)
27,500
Printing /Stationery
(4,400 x 11.61)
51,084
Miscellaneous
(4,400 x 1.79)
7,876
148,940
Rs.
Fixed Cost:
Supervision
6/12 (300,000)
150,000
Depreciation
6/12 (197,500)
98,750
Miscellaneous
6/12 (150,000)
75,000
323,750
472,690
Rs. 107.43
For July-December 2016, the actual activity was 6,400 patients. For a valid
comparison with the actual outcome, the budget will need to be revised to
reflect this activity as follows:
Rs.
Rs.
Rs.
Variable Cost
206,000
216,640 (Note 1)
10,640 F
Fixed Cost
380,000
323,750 (Note 2)
56,250 A
586,000
540,390
45,610 A
The company is able to control its variable costs per patient, however the
company could not control its fixed costs, as a result of the number of
patients attended to.
This led to a total adverse variance of Rs. 45,610.
Note 1
Variable cost: 6,400 units @ Rs. 33.85 = Rs. 216,640
Note 2: Fixed cost: as computed in the budget above.
368
Answers
25.6
THREE SERVICES
(a)
Rs.
1,946,700
Rs.
2,317,500
Rs.
4,944,000
Rs.
9,208,200
1,687,140
2,317,500
1,483,200
5,487,840
Total revenue
3,633,840
4,635,000
6,427,200
14,696,040
Costs:
Salaries
Fuel:
Services A and B
Service C
4,016,250
2,400,000
2,592,000
4,992,000
4,200,000
13,208,250
Net profit
1,487,790
Workings
Revenue:
Service A: contract customers 350,000 u 60% u Rs. 9 u 1.03 = Rs.
1,946,700
Service A: non-contract customers 350,000 u 40% u Rs. 9 u 1.30 u 1.03
= Rs. 1,687,140
Service B: contract customers 250,000 u 60% u Rs. 15 u 1.03 = Rs.
2,317,500
Service B: non-contract customers 250,000 u 40% u Rs. 15 u 1.50 u 1.03
= Rs. 2,317,500
Service C: contract customers 20,000 u 80% u Rs. 300 u 1.03 = Rs.
4,944,000
Service C: non-contract customers 20,000 u 20% u Rs. 300 u 1.20 u 1.03 =
Rs. 1,483,200
Salaries: Rs. 45,000 u 85 employees u 1.05 = Rs. 4,016,250
Sundry operational costs: Rs. 4,000,000 u 1.05 = Rs. 4,200,000
Fuel
Services A and B 400 km u 50 vehicles u 300 days u Rs.0.40 = Rs.
2,400,000
Service C 600 km u 18 vehicles u 300 days u Rs.0.80 = Rs. 2,592,000
369
(b)
Vehicle utilisation
There is no information about weight carried, only about distance travelled.
All vehicles were used for 300 days in the year. Presumably, vehicles might
be used for 365 days per year, indicating an overall utilisation ratio for all
vehicles of 82.2%.
Other utilisation measure: a revenue measure might be used as an
indication of the utilisation of vehicles.
Services A and B
Service C
(Rs. 8,268,840/50)
Rs. 165,377
(Rs. 6,427,200/18)
Rs. 357,067
25.7
Rs.
93,150
1,304,100
558,900
1,956,150
Rs.
31,050
434,700
144,900
610,650
Costs:
Salaries
Doctors
(5 u Rs. 240,000)
Assistants
(5 u Rs. 100,000)
Administrators
(2 u Rs. 80,000)
Rs.
161,460
2,260,440
877,680
3,299,580
1,200,000
500,000
160,000
1,860,000
93,000
Bonus
1,953,000
414,300
733,600
Materials costs
Other costs
Total costs
Net profit
Rs.
37,260
521,640
173,880
732,780
Total
3,100,900
198,680
370
Answers
Workings
Total number of patients per year = 5 doctors u 18 patients per day u 5 days per
week u 46 weeks per year = 20,700.
Total
20,700
Treatment
None: 20%
Minor: 70%
Major: 10%
Patients
Adults
Children
65 years and
over
(45%) =
9,315
(25%) =
5,175
(30%) = 6,210
1,863.0
6,520.5
931.5
1,035.0
3,622.5
517.5
1,242
4,347
621
Revenue:
Adults, no treatment: 1,863 u Rs. 50 = Rs. 93,150
Adults, minor treatment: 6,520.5 u Rs. 200 = Rs. 1,304,100
Adults, major treatment: 931.5 u Rs. 600 = Rs. 558,900
Children, no treatment: 1,035 u Rs. 30 = Rs. 31,050
Children, minor treatment: 3,622.5 u Rs. 120 = Rs. 434,700
Children, major treatment: 517.5 u Rs. 280 = Rs. 144,900
65 years and over, no treatment: 1,242 u Rs. 30 = Rs. 37,260
65 years and over, minor treatment: 4,347 u Rs. 120 = Rs. 521,640
65 years and over, major treatment: 621 u Rs. 280 = Rs. 173,880.
25.8
HEADGEAR LIMITED
(a)
371
(2)
Situation 1
Argument in favour of a budget revision
The board approved the request for a change in recruitment policy. It might
therefore be argued that the change in policy is outside the influence of
operational management in the sales and marketing department.
Arguments against a budget revision
The board approved a request from the departmental manager. The
problem with the existing staff in the department was an operational matter,
within the control of the departmental managers. The increase in the
departmental labour costs is therefore due to operational factors for which
management should be held responsible in performance reports.
If there is any improvement in the efficiency and effectiveness of the
department as a result of the new recruitment policy, the departmental
management will receive the credit in the departmental performance
(variance) reports. It is inappropriate to allow a budget revision for one
aspect of a policy change (higher staff costs) and at the same time give
management credit for other aspects of the policy change (improving
efficiency and/or effectiveness).
Situation 2
Argument in favour of a budget revision
The insolvency of the original cloth supplier was outside the control of the
purchasing department.
The buying department could argue that they did what they could under the
circumstances to maintain supplies of cloth to the company, and it is
unreasonable to blame the department for adverse price variances in the
three-month period.
The department was aware that the short-term solution was not adequate
for the longer term, and after further searching a cheaper source of supply
was found. It may therefore be argued that the performance of the buying
department should be commended and not criticised with an adverse price
variance.
Arguments against a budget revision
The management of any department need to be fully aware if the risks that
they face, including the risks of insolvency of a major supplier. Contingency
plans should have been in place to respond to the insolvency of the original
372
Answers
2,452,500
2,180,000
272,500 (A)
units
11,200
10,900
300 (A)
Rs. 125
Rs. (A)
37,500
(d)
units
Budgeted sales volume
11,200
10,000
1,200 (A)
Rs. 125
Rs. (A)
150,000
373
units
Expected market share of actual market size
(10% of 100,000)
10,000
10,900
(e)
900 (F)
Rs. 125
Rs. (F)
112,500
The analysis of the sales volume variance shows that there has been a fall
in sales volume due to a fall in the total market share, and if Headgear
Limited had maintained its market share the decline in the size of the
market would have caused a fall in contribution and profit of Rs. 150,000.
This is the market size variance.
However the company was able to gain a larger share of the market than
expected, which had the effect of boosting contribution and profit by Rs.
112,500, in spite of the decline in market size. This is the market share variance.
The net effect was an adverse overall sales volume variance of Rs. 37,500.
25.9
Tutorial note
Being provided with moving average totals speeds up the process of forecasting
considerably.
In order to make the forecast the first step is to calculate seasonal variations
(actual trend). These can then be averaged to work out seasonal factors for
each quarter.
The slope of the trend (moving average) line also ha to be forecast.
Using these data it is then possible to make forecasts.
Remember the question asks for the additive model (Y=T+S) not the
multiplicative model Y =TxS. If you use the wrong model both working and right
answer mars will be lost.
Quarter
Year 5
Q3
Q4
Year 6
Q1
Q2
Q3
Q4
Actual
sales (Y)
Rs.000
3,400
3,000
3,100
3,900
3,600
3,400
Centred moving
average (T)
Rs.000
3,200
3,300
3,375
3,450
3,562.5
3,687.5
374
Seasonal
variation (Y-T)
Rs.000
200
(300)
(275)
450
37.5
(287.5)
Answers
To make a forecast the slope of the trend (moving average) line has to be
calculated.
(3,6875 3,200)/5 = Rs. 97,500 increase per quarter
The average seasonal variations and the residual error term can now be
calculated.
Quarter 1
Quarter 2
Quarter 3
Quarter 4
Rs.000
Rs.000
Rs.000
Rs.000
200
(300)
Year 5
Year 6
(275)
450
37.5
(287.5)
Average
(275)
450
118.75
(293.75)
Total
Rs.000
nil
375
(c)
376
Answers
Rs.
26,400
29,700
3,300 (A)
kg
5,500
6,300
800 (A)
Rs. 4
Rs. 3,200 (A)
Rs.
14,400
14,220
180 (F)
hours
3,300
3,600
300 (A)
Rs. 4
Rs. 1,200 (A)
Rs.
10,800
11,700
900 (A)
377
1,300
1,100
200 (A)
Rs. 9
Rs. (A)
1,800
Budgeted profit
Budgeted contribution
Budgeted fixed costs
Budgeted profit
Rs.
11,700
(6,000)
5,700
Actual profit
Rs.
Sales
Materials
Less closing inventory (300kg u Rs. 4.00)
Rs.
57,200
29,700
(1,200)
28,500
14,220
11,700
4,000
Labour
Variable overheads
Fixed costs
Total
Actual loss in the period
(58,420)
(1,220)
Operating statement
Rs.
5,700
1,800 (A)
2,200 (F)
6,100
Budgeted profit
Sales volume variance
Sales price
Cost variances
F
Rs.
Materials price
Materials usage
Labour rate
Labour efficiency
A
Rs.
3,300
3,200
180
1,200
378
Answers
900
900
2,000
2,180
9,500
7,320 (A)
(1,220)
Tutorial note
If the company uses absorption costing with a direct labour hour absorption
rate, we can calculate an expenditure, capacity and efficiency variance for
fixed production overheads.
The first step is to calculate a budgeted absorption rate per hour
Budgeted fixed cost
Budgeted labour hours (1,300 u 3)
Budgeted absorption rate per hour
Rs. 6,000
3,900 hrs
Rs. 1.5384
Rs. 6,000
1,300 units
Rs. 4.6254
1,300
Actual production
1,100
Under production
200 (A)
Rs. 4.6154
3,900
3,600
300 (A)
Rs. 1.54
379
Labour rate
The labour rate variance is favourable indicating a lower rate per hour was paid
than expected. This is perhaps because more junior or less experienced staff
were used during production. Though less likely, it is possible that staff had a
pay cut imposed upon them. Finally, an incorrect or outdated standard could
have been used.
Labour efficiency
This is significantly adverse, indicating staff took much longer than expected to
complete the output. This may relate to the favourable labour rate variance,
reflecting employment of less skilled or experienced staff. Staff demotivated by
a pay cut are also less likely to work efficiently.
It may also relate to the reliability of machinery as staff may have been
prevented from reaching full efficiency by unreliable equipment.
26.2
MOONGAZER
(a)
Tutorial note
A good place to start with an operating statement is to calculate the
budgeted and actual profits for the period and then from this to calculate
variances.
Budgeted profit
Budgeted gross profit = (Rs. 100 Rs. 77) u 450 = Rs. 10,350.
Actual gross profit
Rs.
Sales
Materials
Less closing inventory (125 u Rs. 15)
Labour
Variable overheads
Fixed costs
Cost of sales
Actual profit
Rs.
47,300
17,700
(1,875)
15,825
14,637
3,870
2,400
36,732
10,568
Rs.
43,000
47,300
4,300 (F)
380
Answers
430
20 (A)
Rs. 23
18,000
17,700
300 (F)
860
1,075
215
(A)
Rs. 15
3,225
(A)
Rs.
14,450
14,637
187 (A)
1,720
1,700
381
20
(F)
Rs. 8.50
170 (F)
3,400
3,870
470 (A)
2,250
2,400
150 (A)
450
Actual production
430
20 (A)
Rs. 5
Rs. 100 (A)
Operating statement
Rs.
10,350
460 (A)
9,890
4,300 (F)
14,190
382
F
Rs.
300
A
Rs.
3,225
187
170
470
40
510
150
100
4,132
3,622 (A)
10,568
Answers
26.3
ABC LIMITED
Operating statement
Rs.000
Budgeted gross profit
107,500
Sales volume
(4,300)
(A)
103,200
Sales price
7,000
(F)
110,200
F
Rs.000
Rs.000
Materials price
7,500
Materials usage
12,500
Labour rate
6,000
Labour efficiency
3,000
1,250
750
100
200
Total
12,500
18,800
(6,300)
(A)
103,900
Budgeted profit
Per unit
Sales price
Rs.
600
Direct material
125
Direct labour
Variable overheads
200
50
Fixed overheads
10
Cost of sales
385
Budgeted profit
215
500,000
107,500
295,000
Materials
55,000
Labour
105,000
Variable overheads
26,000
Fixed costs
5,100
Cost of sales
191,000
103,900
383
The inventory level and how it is measured (standard cost) does not change so
can be ignored in the above calculations
Sales price variance
Rs.000
480,000 units should sell for (u Rs. 600)
288,000
295,000
7,000 (F)
500,000
480,000
20,000 (A)
215
(4,300) (A)
47,500
(7,500) (A)
55,000
950,000
250,000 (F)
Rs. 50
12,500 (F)
99,000
105,000
(6,000) (A)
hours
960,000
990,000
(30,000)
Rs. 100
(3,000)
384
(A)
(A)
Answers
24,750
(1,250) (A)
26,000
5,000
5,100
100 (A)
500,000
Actual production
480,000
20,000 (A)
10
26.4
200 (A)
KASUR MF LIMITED
(a)
Tutorial note
Remember that in a flexed budget, fixed costs do not change with the volume of
activity.
The flexed budget will be based on the actual activity level of 90,000 units.
Rs.
Sales: Rs. 950,000 u 90/95 =
Rs.
900,000
Cost of sales
Raw materials: 133,000 u 90/95 =
126,000
144,000
95,400
125,400
490,800
409,200
385
(b)
Raw materials cost variance
Rs.
126,000
130,500
4,500 (A)
Rs.
144,000
153,000
9,000 (A)
27,000
27,200
200 (A)
Rs.
4.40
28,500
27,200
1,300 (A)
386
Rs. 4.40
5,720 (A)
Answers
125,400
115,300
10,100 (F)
(d)
Tutorial note
The question makes it clear that only three purposes are needed. Select three
from planning, motivating, communicating, co-ordinating, evaluating, rewarding
and controlling. The scope of the answer below is for illustration purposes only.
Planning
One of the key purposes of a budgeting system is to require planning to occur.
Strategic planning covers several years but a budget represents a financial plan
covering a shorter period, i.e. a budget is an operational plan. Planning helps an
organisation to anticipate key changes in the business environment that could
potentially impact on business activities and to prepare appropriate responses.
Planning also ensures that the budgeted activities of the organisation will
support the achievement of the organisations objectives.
387
Co-ordination
Many organisations undertake a number of activities which need to be coordinated if the organisation is to meet its objectives. The budgeting system
facilitates this co-ordination since organisational activities and the links between
them are thoroughly investigated during budget preparation, and the overall
coherence between the budgeted activities is reviewed before the master
budget is agreed by senior managers. Without the framework of the budgeting
system, individual managers may be tempted to make decisions that are not
optimal in terms of achieving organisational objectives.
Communication
The budgeting system facilitates communication within the organisation both
vertically (for example between senior and junior managers) and horizontally (for
example between different organisational functions). Vertical communication
enables senior managers to ensure that organisational objectives are
understood by employees at all levels. Communication also occurs at all stages
of the budgetary control process, for example during budget preparation and
during investigation of end-of-period variances.
Control
One of the most important purposes of a budgeting system is to facilitate cost
control through the comparison of budgeted costs and actual costs. Variances
between budgeted and actual costs can be investigated in order to determine
the reason why actual performance has differed from what was planned.
Corrective action can be introduced if necessary in order to ensure that
organisational objectives are achieved. A budgeting system also facilitates
management by exception, whereby only significant differences between
planned and actual activity are investigated.
Motivation
The budgeting system can influence the behaviour of managers and employees,
and may motivate them to improve their performance if the target represented
by the budget is set at an appropriate level. An inappropriate target has the
potential to be demotivating, however, and a key factor here is the degree of
participation in the budget-setting process. It has been shown that an
appropriate degree of participation can have a positive motivational effect.
Performance evaluation
Managerial performance is often evaluated by the extent to which budgetary
targets for which individual managers are responsible have been achieved.
Managerial rewards such as bonuses or performance-related pay can also be
linked to achievement of budgetary targets. Managers can also use the budget
to evaluate their own performance and clarify how close they are to meeting
agreed performance targets.
388
Answers
TOXIC KEMS
(a)
Tutorial note
Planning variances compare the old and new sstandards. Operational
variances compare actual results are compared with the revised (ex post)
standard.
Material A price planning variance
Rs.
1,800,000
1,980,000
180,000 (A)
Rs.
1,400,000
1,540,000
140,000 (A)
Rs.
3,150,000
3,465,000
315,000 (A)
Rs.
1,980,000
1,935,000
45,000 (F)
Rs.
1,540,000
1,368,000
389
172,000 (F)
Rs.
3,465,000
3,164,000
301,000 (F)
Tutorial note
Remember that a separate mix variance is needed for each material and
that these are calculated using the revised standard costs.
The first step is to work out the proportion of each chemical in the standard
mix:
Material
Tonnes Percentage
460
40%
345
30%
345
30%
1,150
100%
Total
tonnes
tonnes
Mix variance
in value
tonnes
Standard
price per
kilo
Mix variance
in quantities
Standard
mix
Material
Actual mix
Rs.
Rs.
9,000
(40%)
8,000
1,000 (A)
220
220,000 (A)
4,000
(30%)
6,000
2,000 (F)
385
770,000 (F)
7,000
(30%)
6,000
1,000 (A)
495
495,000 (A)
20,000
20,000
55,000 (F)
390
Answers
19,550
20,000
450 (A)
Rs. 352
Historical standards
These are standards that were set some time ago and have not been
subsequently up-dated. These are used to measure progress in the long term
and they do not have a motivational impact on staff as current performance will
be well in excess of the standard.
Current standards
These are standards that take into account current levels of performance e.g.
staff training, efficiency, equipment levels and so on. They are the standard staff
should achieve at the present time. Again they have little motivational impact on
staff as they are already achieving the standard.
Attainable standards
To reach these standards staff will have to improve on current performance.
However, they are set in a way that staff can reach them in the foreseeable
future. This is the most motivational form of standard and can lead to significant
improvement in output.
Ideal standards
These are the standards that should be reached under perfect operating
conditions. Clearly perfect operating conditions are unlikely to occur. The level
of improvement required to reach this type of standard is often so great that it
can be demotivational. Perfect standards can be held out as long-term
aspirational targets but they should not be used to reward staff in the short term.
27.2
BRK
Variances
Before sales volume variances can be calculated standard profits have to be
determined.
Calculation of standard profit
Budgeted machine hours:
(10,000 03) + (13,000 06) + (9,000 08) = 18,000 hours
391
Product
B (Rs.)
R (Rs.)
K (Rs.)
Total
Direct material
3 180
540
125 328
410
194 250
485
Direct labour
05 650
325
08 650
520
07 650
455
Fixed production
overhead
03 450
135
06 450
270
08 450
360
Standard cost
1000
1200
1300
Selling price
1400
1500
1800
400
300
500
10,000
13,000
9,000
32,000
40,000
39,000
45,000
Rs.
124,000
Rs. 124,000
32,000
= Rs. 3.875
per unit
(i)
Actual sales
9,500 Rs. 14.5
Total
Rs.
Rs.
Rs.
Rs.
137,750
209,250
8,500 Rs. 19
161,500
133,000
13,500 Rs. 15
202,500
8,500 Rs. 18
153,000
4,750 (F)
392
6,750 (F)
8,500 (F)
20,000 (F)
Answers
(ii)
Sales volume
R
Actual sales
31,500
9,500
13,500
8,500
Budgeted sales
32,000
10,000
13,000
9,000
(500)
500
(500)
(2,000)
1,500
(2,500)
(iii)
(3,000)
(A)
31.25%
R:
40.625%
K:
28.125%
Product
B
(31.25%)
(iv)
Actual
sales mix
Standard
sales mix
Mix
variance in
quantities
Standard
profit per
unit
Mix
variance in
profit
units
units
units
Rs.
Rs.
9,500
9,843.750
343.750 (A)
1,375.000
(A)
R
(40.625%)
13,500
12,796.875
703.125 (F)
2,109.375
(F)
K
(28.125%)
8,500
8,859.375
359.375 (A)
1,796.875
(A)
31,500
31,500.000
1,062.500
(A)
31,500
32,000
500
Rs. 3.875
Rs.
1,937.50
393
(A)
(A)
1,062.50
(A)
1,937.50
(A)
3,000.00
(A)
Reconciliation
Rs.
Rs.
124,000
20,000 (F)
1,064 (A)
1,936 (A)
3,000 (A)
17,000 (F)
141,000
27.3
CARAT
(a)
Rs. /unit
1200
425
180
270
875
Standard contribution
325
Units
50,000
48,000
Variance
2,000
Unit contribution
Rs. 3.25
Variance (Rs. )
Rs. 6,500
(A)
Rs.
576,000
580,800
Variance:
4,800 (F)
(A)
394
(F)
Answers
Rs.
200,000
207,317
Price variance
7,317
Rs.
84,000
80,640
Price variance
3,360
(F)
(A)
Rs. /kg
Standard cost
2.5
Rs. 1.7
425
1.5
Rs. 1.2
180
4.0
605
Standard Standard
Mix
ratio
mix
variance
(kg)
Standard
cost per
kg
Mix
variance
(Rs)
121,951
2.5
118,220
3,731
1.7
6,343 (A)
67,200
1.5
70,931
(3,731)
1.2
(4,477) (F)
189,151
189,151
1,866 (A)
48,000
47,288
Extra yield
712
Rs. 6.05
Yield variance
395
Alternative calculation
AQ AM SC
A
121,951
Rs. 1.7/kg
207,317
67,200
Rs. 1.2/kg
80,640
189,151
287,957
MIX
(1,866)
(A)
AQ SM SC
189,151 Rs. 6.05/4kg
286,091
YIELD
4,309 (F)
SQ SM SC
192,000 Rs. 6.05/4kg
290,400
48,000 4kg
or 48,000 units 6.05
Labour variances
Labour rate
Actual hrs actual rate
Rs.
117,120
115,200
Rate:
1,920 (A)
Labour efficiency
Rs.
113,400
129,600
Efficiency:
16,200 (F)
Hours
19,200
18,900
300
Standard rate
Rs. 6
1,800 (A)
396
Answers
(b)
Budgeted profit: (50,000 units x Rs. 3.25) - Rs. 62,500 Rs. 100,000
Actual profit Rs. 580,800 (Rs. 200,000 + Rs. 84,000 + Rs. 117,120 + Rs.
64,000) = Rs. 115,680
Rs.
Budgeted gross profit
Rs.
Rs.
100,000
(6,500)
4,800
98,300
Cost variances
Materials price A
7,317
Materials price B
3,360
Material mix
1,866
Material yield
4,309
Labour rate
1,920
1,800
Labour efficiency
16,200
(c)
1,500
27,827
10,446
17,380
115,680
The favourable material A price variance indicates that the actual price per
kilogram was less than standard. Possible explanations include buying
lower quality material, buying larger quantities of material A and thereby
gaining bulk purchase discounts, a change of supplier, and using an out-ofdate standard.
The adverse material A mix variance indicates that more of this material
was used in the actual input than indicated by the standard mix. The
favourable material price variance suggests this may be due to the use of
poorer quality material (hence more was needed than in the standard mix),
or it might be that more material A was used because it was cheaper than
expected.
The favourable material A yield variance indicates that more output was
produced from the quantity of material used than expected by the standard.
This increase in yield is unlikely to be due to the use of poorer quality
material: it is more likely to be the result of employing more skilled labour,
or introducing more efficient working practices.
397
398
Answers
TWO DIVISIONS
(a)
the selling division will want to sell units to the other profit centre,
because this will add to its divisional profit
the buying division will want to buy units from the other profit centre,
because this will add to its divisional profit
(b)
When Division X has spare capacity, its only cost in making and selling
extra units of Product B is the variable cost per unit of production, Rs. 48.
Division Y can buy the product from an external supplier for Rs. 55.
It follows that a transfer that is higher than Rs. 48 but lower than Rs. 55, for
additional units of production, will benefit both profit centres as well as the
company as a whole. (It is in the best interests of the company to make the
units in Division X at a cost of Rs. 48 than to buy them externally for Rs.
55.)
(c)
48
16
64
Division Y can buy the product from an external supplier for Rs. 55, and will
not want to buy from Division X at a price of Rs. 64. The maximum price it
will want to pay is Rs. 55.
The company as a whole will benefit if Division X makes and sells Product
A.
It makes a contribution of Rs. 16 from each unit of Product A.
If Division X were to make and sell Product B, the company would benefit
by only Rs. 7. This is the difference in the cost of making the product in
Division X (Rs. 48) and the cost of buying it externally (Rs. 55).
The same quantity of limited resources (direct labour in Division X) is
needed for each product, therefore the company benefits by Rs. 9 (Rs. 16
Rs. 7) from making units of Product A instead of units of Product B.
On the basis of this information, the transfer price for Product X should be
Rs. 64 as long as there is unsatisfied demand for Product A. At this price,
there will be no transfers of Product B.
399
28.2
SHADOW PRICE
(a)
The shadow price of the special chemical is the amount by which total
contribution would be reduced (or increased) if one unit less (or more) of
the chemical were available.
1 kilogram = 1,000 grams; therefore one kilogram of special chemical will
produce 100 tablets (1,000/10 grams per tablet).
Shadow price of the chemical
Rs.
1,000
200
800
(b)
500
300
(c)
The transfer price is needed to share the profit from selling the tablets
between divisions A and B. It is an internally negotiated price. Changing the
price will not affect the total profit for the company as a whole, provided that
division A produces the chemical up to its production capacity.
The transfer price itself should not be used as a basis for judging
performance. Having agreed a transfer price, key financial measures of
performance will be control over costs for division A and control over costs
and the selling price for tablets for division B.
(The divisions are profit centres, and so the performance of the divisional
managers should not be assessed on the basis of ROI or residual income.)
28.3
FROOM PLC
(a)
400
Answers
(b)
(ii)
(iii)
(iv)
(v)
DIVISION B
Rs.
Selling price
Incremental Cost (A)
Rs.
Rs.
20,000
30,000
30,000
(12,000)
(20,000)
(12,000)
(15,000)
(15,000)
(5,000)
3,000
COMPANY
8,000
(i)
(ii)
600,000
6,400,000
7,000,000
28.4
TRAINING COMPANY
(a)
If the Lahore centre has spare capacity, it will be in the best interest of the
company for the Karachi centre to use Lahore trainers, at a variable cost of
Rs. 450 per day including travel and accommodation, instead of hiring
external trainers at a cost of Rs. 1,200.
401
Since the Lahore centre will have to pay Rs. 450 per trainer day, any
transfer price per day/daily fee in excess of Rs. 450 would add to its profit.
Since the Karachi centre can obtain external trainers for Rs. 1,200 per day,
any transfer price below this amount would add to its profit.
An appropriate transfer price would therefore be a price anywhere above
Rs. 450 per day and below Rs. 1,200 per day.
(b)
If the Lahore centre is operating at full capacity and is charging clients Rs.
750 per trainer day, there will be an opportunity cost of sending its trainers
to work for the Karachi centre. The opportunity cost is the contribution
forgone by not using the trainers locally in Lahore. Assuming that the
variable cost of using trainers in Lahore would be Rs. 200 per day, the
opportunity cost is Rs. 550 (Rs. 750 Rs. 200).
The minimum transfer price that the manager of the Lahore centre would
want is:
Rs.
Variable cost of trainer day
200
250
550
1,000
The maximum price that the Karachi centre would be willing to pay is Rs.
1,200, which is the cost of using an external trainer.
The company should encourage the use of Lahore trainers by the Karachi
centre, because this will add to the total company profit.
The optimal transfer price is above Rs. 1,000 per day, so that the Lahore
centre will benefit from sending trainers to Karachi, but below Rs. 1,200 so
that the Karachi centre will also benefit.
A transfer price of Rs. 1,000 per day might be agreed.
(c)
If the Lahore centre is operating at full capacity and is charging clients Rs.
1,100 per trainer day, the opportunity cost of sending its trainers to work for
the Karachi centre is Rs. 900 (Rs. 1,100 Rs. 200).
The minimum transfer price that the manager of the Lahore centre would
want is:
Rs.
Variable cost of trainer day
200
250
900
1,350
402
Answers
The maximum price that the Karachi centre would be willing to pay is Rs.
1,200, which is the cost of using an external trainer.
It would be in the best interests of the company as a whole to use the
Lahore trainers to work for Lahore clients, earning a contribution of Rs. 900
per day, rather than use them in Karachi to save net costs of Rs. 750 per
day (Rs. 1,200 Rs. 200 Rs. 250).
The transfer price should be set at Rs. 1,350 per trainer day. At this rate,
the Karachi centre will use external trainers, and all the Lahore trainers will
be used in Lahore.
28.5
BRICKS
(a)
Profit statements
(i)
Group
X
Group
Y
Total
Group
X
Group
Y
Total
External
180
240
420
180
240
420
Transfers
120
108
Total
300
240
420
288
240
420
(120)
(108)
Variable
(112)
(36)
(148)
(112)
(36)
(148)
Fixed
(100)
(40)
(140)
(100)
(40)
(140)
Total
(212)
(196)
(288)
(212)
(184)
(288)
Profit
88
44
132
76
56
132
Sales:
Costs
Transfers
Group
X
Group
Y
Total
Group
X
Group
Y
Total
External
180
320
500
180
320
500
Transfers
200
180
Total
380
320
500
360
320
500
(200)
(180)
Variable
(140)
(60)
(200)
(140)
(60)
(200)
Fixed
(100)
(40)
(140)
(100)
(40)
(140)
Total
(240)
(300)
(340)
(240)
(280)
(340)
Profit
140
20
160
120
40
160
Sales:
Costs
Transfers
403
(b)
The effect of a change in the transfer price from Rs. 200 to Rs. 180 will
result in lower profit for Group X and higher profit for Group Y, but the total
profit for the company as a whole will be unaffected.
A reduction in the transfer price to Rs. 180 (or possibly lower) is
recommended, because this is the price at which Group Y can buy the
materials externally. At any price above Rs. 180, Group Y will want to buy
externally, and this would not be in the interests of the company as a
whole.
Significantly, at a transfer price of both Rs. 200 and Rs. 180, Division Y
would suffer a fall in its divisional profit if it reduced the selling price of
bricks to Rs.0.32 and increased capacity by 400,000 bricks each month. A
reduction in price would be in the best interests of the company as a whole,
because total profit would rise from Rs. 132,000 per month to Rs. 160,000.
(c)
Ignoring the transfer price, the effect on Division Y of reducing the sale
price of bricks to Rs.0.32 would be to increase external sales by Rs. 80,000
and variable costs in Division Y by Rs. 24,000 (400 tonnes u Rs. 60). Cash
flows would therefore improve by Rs. 56,000 per month. To persuade
Division Y to take the extra 400 tonnes, the transfer price should not
exceed Rs. 140 (Rs. 56,000/400). This is below the current external market
price, although there is strong price competition in the market.
The transfer price for Division X should not be less than the variable cost of
production in Division X, which is Rs. 70 per tonne.
However, if the transfer price is reduced to Rs. 140 per tonne or less,
Division X might try to sell more materials in the external market, by
reducing the selling price.
It would appear that although the ideal transfer price might be Rs. 140 or
below, this will not be easily negotiated between the group managers. An
imposed settlement may be necessary. Intervention by head office might be
needed to impose a transfer price, and require Division Y to reduce its
sales price to Rs.0.32.
404
Answers
Year
2
Year
3
days
days
days
76
76
91
(61)
(55)
(64)
15
21
27
37
37
31
42
49
47
73
88
91
167
195
196
Production cycle
(Work-in-progress/Cost of sales) 365 days
Finished goods inventory cycle
(Finished goods/Cost of sales) 365 days
Credit to customers
(Trade receivables/Credit sales) 365 days
Total length of working capital cycle
A long working capital cycle means that a large amount of capital will be
tied up in working capital.
Actions to reduce the length of the cycle
405
29.2
WORKING CAPITAL
Overtrading (sometimes referred to as under-capitalisation) occurs when a
business entity attempts to expand its sales rapidly without adequate finance,
especially medium and long-term finance.
There are several symptoms of overtrading. These are:
(a)
(b)
(c)
(d)
Payments to suppliers and other creditors are delayed. The total of trade
payables therefore increases significantly.
(e)
(f)
(g)
(h)
(i)
406
Answers
(b)
Inventory levels have increased by 23%. However, this is much less than
the increase in sales turnover.
Trade receivables have increased by 58%, which is slightly less than the
growth in sales. The average credit period for customers has fallen from 73
days to 72 days (an insignificant change).
(c)
(d)
(e)
Equity
Trade payables
Bank overdraft
Medium-term bank loan
Year 5
Year 6
%
56
22
9
13
%
47
31
13
10
Year 5
Year 6
1.48
0.77
1.15
0.66
Year 5
Year 6
1.18
1.46
Sales are being supported by a lower amount of assets per Rs. 1 of sales.
This might indicate overtrading, but it might also be the result of increased
efficiency.
(h)
Gross margin
Profit before tax/sales
Year 5
Year 6
11.7%
6.7%
8.96%
5.5%
From the above data it is appears that DON is showing many of the
symptoms of overtrading.
Although DON is profitable, it is likely to experience cash flow problems if
the overtrading gets worse.
407
29.3
WASEEM LIMITED
Rupees in
million
(a)
Additional finance required:
Expected increase in assets (1,100 x 20% x 140%)
308.00
(55.00)
(105.60)
147.40
408
Answers
MARX LIMITED
(a)
To ensure that the entity has sufficient working capital to conduct its
operations efficiently. In order to achieve this objective, there must be
sufficient working capital to provide adequate liquidity.
(ii)
The two requirements of liquidity and profitability may conflict with each
other. The need for liquidity suggests having sufficient working capital,
whereas the need to maximise profitability suggests a need to avoid too
much investment in working capital. Working capital management involves
finding a balance between the two objectives.
(b)
Current policy
Demand per week = 400,000/50 = 8,000 units
Re-order level = 25,000 units
Demand during the re-order period = 8,000 u 2 weeks = 16,000 units.
Buffer inventory = 25,000 16,000 = 9,000 units.
Average inventory = 50,000/2 + 9,000 = 34,000 units.
Annual costs
Rs.
1,920
25,500
27,420
EOQ
2 x 240 x 400,000
0.75
= 16,000 units.
It is assumed that the buffer inventory will remain the same, 9,000 units.
Average inventory = 16,000/2 + 9,000 = 17,000 units.
Annual costs
Rs.
6,000
12,750
18,750
409
(Tutorial note: The annual holding costs and the annual ordering costs are not
equal, because of the buffer inventory of 9,000 units, which adds Rs. 6,750 to
annual holding costs.)
Conclusion
If the company changes to using the EOQ to decide the order quantity,
annual savings would be Rs. 8,670 (= 27,420 18,750). However, reducing
the buffer inventory would reduce costs further by up to Rs. 6,750 per year.
30.2
ENGELS LIMITED
Cost of current ordering policy of Engels Limited
Ordering cost = Rs. 250 x (625,000/100,000) = Rs. 1,563 per year
Weekly demand = 625,000/50 = 12,500 units per week
Consumption during 2 weeks lead time = 12,500 x 2 = 25,000 units
Buffer stock = re-order level less usage during lead time = 35,000 25,000 = 10,000
units
Average stock held during the year = 10,000 + (100,000/2) = 60,000 units
Holding cost = 60,000 x Rs. 050 = Rs. 30,000 per year
Total cost = ordering cost plus holding cost = Rs. 1,563 + Rs. 30,000 = Rs. 31,563 per
year
Economic order quantity = ((2 x 250 x 625,000)/05)1/2 = 25,000 units
Number of orders per year = 625,000/25,000 = 25 per year
Ordering cost = Rs. 250 x 25 = Rs. 6,250 per year
Holding cost (ignoring buffer stock) = Rs. 050 x (25,000/2) = Rs. 050 x 12,500 = Rs.
6,250 per year
Holding cost (including buffer stock) = Rs. 050 x (10,000 + 12,500) = Rs. 11,250 per
year
Total cost of EOQ-based ordering policy = Rs. 6,250 + Rs. 11,250 = Rs. 17,500 per
year
Saving for Engels Limited by using EOQ-based ordering policy = Rs. 31,563 Rs.
17,500 = Rs. 14,063 per year
410
Answers
30.3
LENIN LIMITED
(a)
(b)
(i)
411
412
Answers
(22,424)
(20,000)
(42,424)
30,000
(12,424)
Rs.
Raw materials
Work in progress
Finished goods
(25% 180,000)
(25% 93,360)
(25% 142,875)
45,000
23,340
35,719
104,059
(31,500)
150,534
223,093
9%
Rs.
20,078
Rs.
(12,424)
20,078
7,654
Reducing the credit period to 60 days will result in annual savings of Rs. 7,654.
To achieve these savings, there would have to be a fall in sales by 25%.
Senior management might decide that the size of the savings does not justify
such a large fall in annual sales, because of the longer-term consequences this
might have for the business.
413
31.2
Credit sales
45 days
Rs.
45
x Rs. 4,800,000 x 14.5%
365
85,808
48,000
133,808
30
x Rs. 3,840,000 x 12%
365
37,874
Overdraft
30
x Rs. 960,000 x 14.5%
365
11,441
49,315
120,000
(96,000)
73,315
Conclusion
The factor option is cheaper by Rs. 60,493 (Rs. 133,808 Rs. 73,315)
based on the above calculations. Management is therefore advised to
accept the services of the factor.
NOTE:
**Rs. 3,840,000 = 80% of Rs. 4,800,000
*
(b)
(ii)
(iii)
414
Answers
(c)
31.3
(iv)
When the companys fixed assets are limited and it cannot obtain
additional finance without offering security.
(v)
(i)
(ii)
(iii)
x 100
= 14/90 x 100
= 15.56%
(ii)
cost
=
=
= 14.11%
415
= Rs. 1,140,000,000
Rs. 4,740,000,000
= Rs. 3,000,000,000
Rs. 1,740,000,000
1,740,000,000
9,500,000,000
100
1
= 18.3%
Decision:
From the computations above, trade credit is the cheapest source of
finance, hence Chishtian Construction Plc should take advantage of
the discount.
(b)
31.4
(ii)
(iii)
(iv)
(v)
(vi)
The cost of additional finance required for any increase in the volume
of receivables (or the savings from a reduction in receivables). The
cost might be bank overdraft interest, or the cost of long-term finance.
(b)
416
Answers
Annual costs
Without the factor
Administration (12 u Rs. 2,000)
Bad debts (0.75% u Rs. 1,200,000)
Interest cost of finance (9% u Rs. 200,000)
Rs.
Rs.
24,000
9,000
18,000
51,000
48,000
6,400
1,800
56,200
5,200
31.5
60 days
Rs.
933,333
40,000
Total cost
(ii)
973,333
Factors finance charges: x
Bank overdraft (interest) x
453,333
93,333
546,666
800,000
1,346,666
52,000
1,294,666
417
Comment:
Factoring is more expensive in this case because of the 2 percent charge
on sales that is Rs. 800,000. This appears too high . However, since the
service charge cannot be eliminated or reduced (in this case), the resulting
difference of Rs. 321,333 (Rs. 1,294,666- Rs. 973,333) makes factoring of
the companys debt unattractive hence it is not advisable for Vehari IT
Solutions Limited to engage the services of a factor.
(b)
31.6
Releasing key staff engaged in debt recovery exercise for other tasks
The fear customers have for factors may prompt the debtors to pay
up.
(ii)
ULNAD CO
(a)
418
802,603
(657,534)
145,069
7%
10,155
31,500
28,350
70,005
180,000
109,995
Answers
Rs. 6 million
W2 New receivables
New credit sales
(b)
40 days
Rs. 657,534
Rs 724,932
Rs 802,603
Rs 77,671
419
31.7
BRUTUS COMPANY
Rs.
Contribution from higher sales (45% Rs. 240,000)
108,000
100,000
82,400
17,600
Benefits
125,600
1,094,904
(986,301)
108,603
Cost of finance
8%
8,688
51,500
41,200
(101,388)
24,212
If all the estimates are correct the discount policy will increase annual profit by
about Rs. 24,000. This is a fairly small amount in relation to the companys
annual profits of Rs. 1 million after bad debts, and management should consider
the reliability of the estimates before deciding whether or not to introduce the
discount policy. The expected increase in total annual sales would seem to be a
key estimate.
By improving the collection of receivables and reducing the average collection
period to the expected current 30 days, the company could reduce average
receivables by Rs. 328,767 (Rs. 8 million 15/365) and this would reduce annual
interest costs (at 8%) by about Rs. 26,300 per year more than the expected
benefit from the discount policy.
420
Answers
Workings
W1: Existing receivables
Current credit sales
Rs. 8 million
Rs. 986,301
W2 New receivables
New credit sales (8 Million u1.03)
Rs. 8,240,000
Rs 1,015,890
Rs 1,094,904
Rs 79,014
421
2 u 60u 3,000,000
0.05
= Rs. 84,852, say Rs. 85,000.
The frequency of investment sales
(b)
u 60 u 4,840,000
0.000137
3u
1/3
(iii)
32.2
RENPEC CO
(a)
Determination of spread:
Daily interest rate = 5.11/ 365 = 0.014% per day
Variance of cash flows = (1,000)2 = Rs. 1,000,000 per day
Transaction cost = Rs. 18 per transaction
Spread
422
Answers
423
32.3
BAUMOL
The Baumol cash model is similar in concept to the economic order quantity
model for inventory.
It can be used when an entity has a continual demand for cash to make
payments, and the cash requirements are obtained regularly by cashing in
interest-bearing investments. The cash is transferred into a current bank account,
on which it is normally assumed that the interest rate is zero. The demand for
cash should be constant and predictable.
The Baumol model calculates the optimal amount of cash to transfer on each
occasion, in order to minimise cash management costs. Cash management costs
are the combined costs of:
(1)
making the transactions to transfer the cash to the current bank account
and
(2)
r2 = the interest rate receivable, if any, on money held in the current bank
account.
The Baumol model is unlikely to be of any assistance to a travel company
because of the assumptions that are used in the model. In particular, the model
assumes a constant rate of demand for cash for spending. In practice, most
companies have varying cash needs through the course of each week, month or
year. In particular, a travel company will experience peaks of demand, for
example, in holiday seasons.
424
Answers
32.4
CASSIUS COMPANY
(a)
It is assumed that the volatility of daily cash flows will continue the same as
in the past.
Standard deviation of cash flows per day = Rs. 2,800
Variance of daily cash flows = Rs.(2,800) = Rs. 7,840,000.
Annual interest yield on investments = 5.68%
Daily interest yield on investments = 5.68%/365 = 0.0155616%
Using the Miller-Orr model, the spread should be:
20 7.84 million
3
1/3
0.000155616
= 3 Rs. 9,108.6 = Rs. 27,326.
Minimum cash balance = Rs. 12,500
Spread = Rs. 27,326
Upper limit = Rs. 12,500 + Rs. 27,326 = Rs. 39,826
Return point = Rs. 12,500 + (1/3 Rs. 27,326) = Rs. 21,609.
In practice, the spread and the return point might be rounded to a
convenient whole number.
The company has established a minimum cash holding as a matter of
policy. It will manage its cash so that cash holdings do not become too
high. When cash holdings exceed the upper cash limit of Rs. 39,826, some
cash will be invested in interest-earning investments. The amount of cash
invested will be an amount to reduce cash holdings to the return point of
Rs. 21,609.
When cash holdings fall to the minimum cash balance, some investments
will be sold to restore the amount of cash held. The amount of investments
sold should be sufficient to restore cash holdings to the return point.
(b)
The company would invest its surplus cash in investments that provide
some interest yield. Normally, the company would want the investments to
be convertible into cash at fairly short notice and without any significant risk
of capital loss.
A bank might be willing to offer cash deposit facilities, although there might
be a penalty payment if cash is withdrawn without a minimum notice period.
A bank might not want to provide a bank deposit facility to a corporate
customer if the company intends to withdraw cash regularly
An alternative would be to invest in short-term money market instruments
such as Treasury bills or short-dated government bonds. These can be sold
at short notice although there would be some risk of capital loss (in the
event that interest rates rise).
The company is unlikely to invest surplus cash in short-term equities, if it
wants to avoid the risk of capital losses.
425
426
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2015
BUSINESS FINANCE
DECISIONS
PRACTICE KIT