ICMA.

Pakistan
Extra Reading Time: Writing Time:
(i) (ii) (iii) (iv) (v) (vi) (vii)

FALL 2013 (FEBRUARY 2014) EXAMINATIONS Monday, the 17th February 2014 STRATEGIC FINANCIAL MANAGEMENT (AF-503)
SEMESTER-5 Maximum Marks: 100 Roll No.:

15 Minutes 03 Hours

Attempt all questions. Answers must be neat, relevant and brief. In marking the question paper, the examiners take into account clarity of exposition, logic of arguments, effective presentation, language and use of clear diagram/ chart, where appropriate. Read the instructions printed inside the top cover of answer script CAREFULLY before attempting the paper. Use of non-programmable scientific calculators of any model is allowed. DO NOT write your Name, Reg. No. or Roll No., or any irrelevant information inside the answer script. Question Paper must be returned to invigilator before leaving the examination hall.
(9:15 a.m. or 2:15 p.m. [PST] as the case may be).

Answer Script will be provided after lapse of 15 minutes Extra Reading Time

Marks Pak Bakers Ltd., a relatively new name in the confectionery products, started its business a few years back. Initially, the company faced a lot of problems due to adverse market conditions, tough competition, low demand of its products and sales force not fully conversant with the industry norms. However, the company has steadily captured the market share due to its quality products at competitive rates. Suppose you are a fresh qualified Cost and Management Accountant and have just been hired as business manager of Pak Bakers Ltd. The company has not previously hired the services of any professional accountant. Resultantly, the techniques of corporate finance are not being implemented in letter and spirit while taking the strategic business decisions. The company is not following capital budgeting techniques and there is no working capital policy. When you took your financial management course, your instructor stated that most firms owners would be financially better off if the firms used some debt. But, you noticed that Pak Bakers Ltd., is not using any portion of debt. You are quite determined to implement the financial management techniques in strategic business decisions of the company. Like all financial managers, you are also concerned with three basic elements on which the building of corporate finance is constructed. You have refreshed your memory and recalled the three basic elements concerning the financial analysis as under: ! Evaluating the firms long-term investments. Evaluating the size, timing, and risk of future cash flows is the essence of capital budgeting. ! The ways in which the firm obtains and manages the long-term financing needs to support its long-term investments. ! Working capital management. Capital Budgeting: Pak Bakers Ltd., is considering to install a state-of-the-art oven. The expected life of this oven is five years. The previous Finance Director has undertaken an analysis of the proposed project; the summary of his analysis are shown below. He has recommended that the project should not be undertaken because the estimated annual accounting rate of return is only 12.3%. But, you think that accounting rate of return has its own flaws because it ignores the time value of money. Moreover, it uses an arbitrary benchmark cut-off rate and it is based on book values instead of cash flows and market values. Proposed Oven Project Rs. 000 Year 0 1 2 3 4 5 Investment in depreciable fixed assets 9,000 Sales 7,000 9,800 10,640 11,480 10,640 Materials 1,070 1,500 1,800 2,100 1,800 Labour 2,140 3,000 3,600 4,200 3,600 Overhead 100 200 200 200 200 Interest 1,152 1,152 1,152 1,152 1,152 Depreciation 1,800 1,800 1,800 1,800 1,800 6,262 7,652 8,552 9,452 8,552 Taxable profit 738 2,148 2,088 2,028 2,088 Taxation 258 752 730 710 730 Profit after tax 480 1,396 1,358 1,318 1,358 SFM-Feb.2014 1 of 4 PTO Q. 1

Marks Total initial investment is Rs. 9,600,000 and average annual after tax profit is Rs. 1,182,000. All the above cash flow and profit estimates have been prepared in terms of present day costs and prices, since the previous Finance Director assumed that the sales price could be increased to compensate for any increase in costs. You have available the following additional information: ! Selling prices and overhead expenses are expected to increase by 5% per year. ! Material costs and labour costs are expected to increase by 10% per year. ! Depreciation is allowable for taxation purposes against profits at 20% per year on a straight line basis. ! Taxation on profits is at a rate of 35%, payable in the same year. ! The fixed assets have no expected salvage value at the end of five years. ! The companys real after-tax weighted average cost of capital is estimated to be 8% per year, and nominal after-tax weighted average cost of capital 15% per year. Capital Structure: Pak Bakers Ltd., currently has no debt in its capital structure and is currently financed with all equity; it has 400,000 shares outstanding; and P0 = Rs. 20 per share. Since no expansion is planned Pak Bakers Ltd., pays out all earnings as dividends without retaining any part for capital expenditure. You have apprised the CEO, the potential benefits of debt in the capital structure of the company, and he has asked you to show how the company would look like after incorporating some portion of debt in companys capital structure. So, you are considering a restructuring that would involve issuing debt and using the proceeds to buy back some of the outstanding equity. The firms assets have a market value of Rs. 8 million. The proposed debt issue would raise Rs. 4 million; the interest rate would be 15%. After the restructuring, the company would have a capital structure with 50% debt. You may assume that the market price per share will remain at Rs. 20 after issuing the debt. The company falls under the tax rate of 35%. To investigate the impact of the proposed restructuring. You intend to compare the firms current capital structure to the proposed capital structure under three scenarios. The scenarios reflect different assumptions about the firms EBIT. Under the expected scenario, the EBIT is Rs. 2,000,000. In the recession scenario, EBIT falls to Rs. 1,000,000. In the expansion scenario, it rises to Rs. 3,000,000. Working Capital Management: Pak Bakers Ltd., has not yet formulated any working capital policy. The following information has been presented to you, from the viewpoint of the implications it has for working capital policy of the company: Rs. 000 Present Position Budgeted Position for Next Year Sales 12,500 14,400 Cost of goods sold 10,500 12,400 Purchases 7,000 8,500 Accounts receivable 1,562 1,800 Accounts payable 1,050 1,500 Raw material inventory 1,750 3,000 Work-in-process inventory 875 1,500 Finished goods inventory 2,000 2,150 Required: (a) Would it financially be viable for the Pak Bakers Ltd., to undertake the proposed oven project (show computation)? (b) What is meant by financial leverage and financial risk? How does financial risk differ from business risk? (c) What would be the EPS and ROE under three scenarios, if Pak Bakers Ltd., remains an all equity company? How the company would look like after incorporating proposed portion of debt in companys capital structure. Do you think that the company would be better off under each scenario of debt option? (d) Calculate the percent (%) increase or decrease in working capital for next year. (e) Do you forecast that cash operating cycle of the firm would be changed? (Show computations) (f) Is there any need for additional finance for working capital? What strategy the firm may adopt to overcome the problem of additional finance? Suppose the firm is unable to arrange additional finance from outside.
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Marks Q. 2 The management of the Dost Engineering Ltd., an all equity company, is reviewing the companys dividend policy. The company has 400,000 shares of Rs. 10 par value outstanding. Due to sudden death of its CEO in the last week of 2013, the company has lower growth expectations and relatively few attractive new investment opportunities. In the past, the company plowed back 80% of its earnings to finance growth which averaged 12% per year. However, it is expected that only 5% growth rate could be achieved, if the dividend payout ratio is increased. In the current year 2014, it is expected that new investment projects of Rs. 1,600,000 could be undertaken and projected net income of Rs. 4,000,000 could be achieved but shareholders would ask for 14% required rate of return. If the existing 20% dividend payout were continued, retained earnings would be Rs. 3,200,000 for 2014. However, there would be no change in new investment projects of Rs. 1,600,000 that yields 14% cost of equity. Required: (a) Assuming that new investment projects would be financed entirely by earnings retained during the year, calculate DPS in 2014, assuming that Dost Engineering Ltd., uses the residual dividend model. (b) What would be payout ratio for 2014? (c) If a 60% payout ratio is maintained for the foreseeable future, what is your estimate of the present market price of the common stock? How does it differ with the market price that should have prevailed under the assumptions existing just before the CEOs death? If the two values of P0 are different, comment why is it so? Q. 3 Alpha Ltd., has decided to install a new lathe machine. The machine costs Rs. 1,200,000 and it would have a useful life of five years with a scrap value of Rs. 240,000 at the end of the fifth year. A decision has now to be taken on the method of financing the project. The two under consideration proposals are as under: (i) The company could purchase the machine for cash, using bank loan facilities on which the current rate of interest is 9% after tax. (ii) The company could lease the machine under an agreement which would entail payment of Rs. 288,800 at the end of each year for the next five years. The company can claim depreciation allowances of 25% on reducing balance basis over the machines five year, life, if it is purchased. Depreciation is also deductible for tax purpose in case of lease and the company uses straight-line depreciation method in its accounts under lease arrangement. The implicit interest at 6.4% of the lease payments is also deductible for tax purposes. The company falls under the tax regime of 35%. Required: Calculate the present value of the lathe machine cost under lease and purchase option. What method of financing would you recommend and why? Q. 4 (a) In the beginning of the current year, the total market value of the Syed Limited was Rs. 170 million. The companys market value capital structure, shown below, is considered to be optimal. Assume that there is no short-term debt. Rupees Debt 70,000,000 Common equity 100,000,000 Total capital 170,000,000 Syed Limited is considering a project that will result in initial after-tax cash savings of Rs. 14 million at the end of the first year and these savings will grow at a rate of 5% per year indefinitely. The firm has a target debt-equity ratio of 0.70, cost of equity of 13% and after-tax cost of debt of 5.5%. The cost-saving proposal is some what riskier than the usual projects the firm undertakes; management uses the subjective approach and applies an adjustment factor of plus 2% to the cost of capital for such risky projects. Required: (i) Should the company take on the project if the initial investment is Rs. 200 million? What would be the outcome of the project? (Show all your computations.) 07 (ii) Syed Limited is to raise Rs. 200 million for a new project externally and its flotation costs for selling debt and equity are 2% and 16%, respectively. If flotation costs are considered, what is the true initial investment of the new project? Is the project viable considering the flotation cost? 05 3 of 4 PTO

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Marks (b) A feasibility study, covering all aspects of a project undertaken by a carefully selected team is vital in assessing whether an investment is worthwhile or not. Feasibility studies are essential for investments and projects that are likely to be long-term in nature and complicated. State five key areas in which a project must be feasible, if it is to be selected. Also briefly explain any two (2) key areas out of five. National Packages Limited has to decide between two mutually exclusive investment projects. The project cost of Rs. 15,500,000 each and has an expected life of 3 years. Annual net cash flows from each project begin one (1) year after the initial investment is made and have the following probability distributions: Rs. 000
Project A Probability 0.2 0.6 0.2 Net Cash Flows 14,000 15,500 17,000 0.2 0.6 0.2 Project B Probability Net Cash Flows 0 15,500 38,000

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The company has decided to evaluate the more risky project at 12% rate and the less risky project at 10% rate. Required: (i) What is the expected value of the annual net cash flows from each project? What is the coefficient of variation? 07 02

(ii) What is the risk-adjusted NPV of each project? Which project the company should accept? (iii) If it were known that Project B was negatively correlated with other cash flows of the firm whereas Project A was positively correlated, how would this knowledge affect the decision for opting the project? (b) ABC Ltd., is considering an investment in a small project that has a cost of Rs. 300,000. The project will produce 1,000 cartons of Product-X per year indefinitely. The current sales price is Rs. 276 per carton. The current variable cost per carton is Rs. 210. The tax rate of the firm is 35%. The sales price and cost are expected to rise at a rate of 6% per annum. The firm uses only equity, and its cost of capital is 15%. You may assume that there would be no fixed cost or depreciation. Would you recommend ABC Ltd., to accept the project?

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THE END
PRESENT VALUE FACTORS 11% 12% 13% 14% 15% 16% 17% 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.812 0.797 0.783 0.769 0.756 0.743 0.731 0.731 0.712 0.693 0.675 0.658 0.641 0.624 0.659 0.636 0.613 0.592 0.572 0.552 0.534 0.593 0.567 0.543 0.519 0.497 0.476 0.456 0.535 0.507 0.480 0.456 0.432 0.410 0.390 0.482 0.452 0.425 0.400 0.376 0.354 0.333 0.434 0.404 0.376 0.351 0.327 0.305 0.285 0.391 0.361 0.333 0.308 0.284 0.263 0.243 0.352 0.322 0.295 0.270 0.247 0.227 0.208 CUMULATIVE 10% 11% 12% 0.909 0.901 0.893 1.736 1.713 1.690 2.487 2.444 2.402 3.170 3.102 3.037 3.791 3.696 3.605 4.355 4.231 4.111 4.868 4.712 4.564 5.335 5.146 4.968 5.759 5.537 5.328 6.145 5.889 5.650 PRESENT VALUE FACTORS 13% 14% 15% 16% 17% 18% 19% 0.885 0.877 0.870 0.862 0.855 0.847 0.840 1.668 1.647 1.626 1.605 1.585 1.566 1.547 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.974 2.914 2.855 2.798 2.743 2.690 2.639 3.517 3.433 3.352 3.274 3.199 3.127 3.058 3.998 3.889 3.784 3.685 3.589 3.498 3.410 4.423 4.288 4.160 4.039 3.922 3.812 3.706 4.799 4.639 4.487 4.344 4.207 4.078 3.954 5.132 4.946 4.772 4.607 4.451 4.303 4.163 5.426 5.216 5.019 4.833 4.659 4.494 4.339

Year 1 2 3 4 5 6 7 8 9 10

9% 0.917 0.842 0.772 0.708 0.650 0.596 0.547 0.502 0.460 0.422

10% 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467 0.424 0.386

18% 0.847 0.718 0.609 0.516 0.437 0.370 0.314 0.266 0.225 0.191

19% 0.840 0.706 0.593 0.499 0.419 0.352 0.296 0.249 0.209 0.176

20% 0.833 0.694 0.579 0.482 0.402 0.335 0.279 0.233 0.194 0.162

Year 1 2 3 4 5 6 7 8 9 10

9% 0.917 1.759 2.531 3.240 3.890 4.486 5.033 5.535 5.995 6.418

20% 0.833 1.528 2.106 2.589 2.991 3.326 3.605 3.837 4.031 4.192

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